SYLLABUS

Course Title : Economic Analysis for Management Decisions

Course Code : MSPS 12

Course Credit : 6

COURSE OBJECTIVE

Course Objective :

CO 1. Explain managerial economics and its execution while making a business

decision and apply the concepts of microeconomics such as utility and
demand analysis

CO 2. Discuss the supply and cost analysis and develop thorough knowledge of the

production theories and cost while dealing with factors of production.

CO 3. State key characteristics and consequences of different forms of markets
and apply different pricing strategies for products under different market
structures.
CO 4. Assess cost volume profit analysis, illustrate techniques to measure profit
and demonstrate profit maximization.
CO 5. Explain different concepts of national income and its measurements, factors
affecting national income and state monetary and fiscal policy.

BLOCK 1 Overview of Managerial Economics & Demand Analysis

Managerial Economics – Meaning, Nature and Scope – Managerial Economics and
Business decision making – Role and responsibility of Managerial Economist –
Fundamental Concepts of Managerial Economics – limitations - Utility analysis -
Demand Analysis – Meaning, Determinants and Types of Demand – Elasticity of
demand – Demand forecasting -methods.

BLOCK 2 Supply & Cost Analysis

Supply: Meaning and determinants, Law and Elasticity of Supply, Equilibrium of
demand and supply; Production: factors- Types of production functions –
Isoquants- law of variable proportions, Economies and diseconomies of scale. Cost
analysis: – types – cost-output relationships.
BLOCK 3 Market Structure
Market Structure – Various forms – Equilibrium of a firm – Perfect competition –
Monopolistic competition – Oligopolistic competition – Pricing of products under
different market structures – Methods of pricing – Factors affecting pricing decision
– Differential pricing – Government Intervention and pricing.

BLOCK 4 Profit & Cost Volume Analysis

The concept of profit: Profit planning, control and measurement of profits. Profit
maximization – Cost Volume Profit analysis.

BLOCK 5 National Income

National Income – concepts and components-computation /measurement of national
income –difficulties in measurement-factors affecting national income – inequalities
of income –Monetary and Fiscal Policy.

References:
1. Ahuja, H.L., (2017) Managerial Economics, latest Edition, S. Chand & Company
Ltd., New Delhi
2. Chaturvedi, (2012), Business Economics (Theory & Application), latest Edition,
IBH, New Delhi
3. Joel Dean, (2008), Managerial Economics, latest Edition, PHI Learning Private
Ltd., New Delhi
4. Justin Paul, Leena, Sebastian, (2012) Managerial Economics, latest Edition,
Cengage, USA
5. Maheshwari, (2014), Managerial Economics, latest Edition, Sultan & Chand,
New Delhi.
6. Mithani, D.M., (2009), Managerial Economics, latest Edition, Himalaya
Publishing House, New Delhi.
7. Moti Paul S. Gupta, (2007), Managerial Economics, latest Edition, Tata McGraw
Hill Pub., New Delhi.
8. Narayanan Nadar, E. and S. Vijayan, (2013), Managerial Economics, latest
Edition, PHI Learning Private Ltd., New Delhi.
9. Petersen & Lewis, (2003), Managerial Economics, 4th edition, Prentice Hall of
India (P) Ltd., New Delhi.
10. Sumitrapal, (2011), Managerial Economics Cases & Concepts, latest Edition,
Macmillan, Chennai.
11. https://epgp.inflibnet.ac.in/Home/ViewSubject?catid=ahLCajOqz6/GWFCSpr/XY
g==

12. https://archive.nptel.ac.in/courses/110/101/110101149/

13. https://corporatefinanceinstitute.com/resources/economics/market-structure/

14. https://www.wallstreetmojo.com/cost-volume-profit-analysis/
15. https://www.economicsdiscussion.net/national-income/4-main-concepts-of-
national-income/17241

Course Outcome :
CLO 1. Comprehend the nature of managerial economics and its relevance in
decision-making. Interpret the use of price elasticity of demand in pricing
decision. Predict the revenue and profit effects of a price change with
techniques of demand forecasting.
CLO 2. Analyse supply and cost, thereby assessing the functional relationship
between production and factors of production. List out the various costs
associated with the production.
CLO 3. Integrate the concept of price and output decisions of firms under a various
market structure.
CLO 4. Recognize profit planning and interpret cost - volume profit analysis and
construct profit maximistaion.
CLO 5. Critically analyse various concepts of national income and the factors that
affect national income.
 CONTENT
BLOCK 1 OVERVIEW OF MANAGERIAL ECONOMICS &
DEMAND ANALYSIS

UNIT 1 CONCEPTS AND TECHNIQUES 2

1.1 Meaning of Managerial Economics 3

1.2 Definitions of Managerial Economics 3

1.3 Nature of Managerial Economics 4

1.4 Scope of Managerial Economics 5

1.5 Managerial Economics and Business Decision 6

Making

1.6 Role of Managerial Economist 7

1.7 Fundamental Concepts of Managerial Economics 8

UNIT 2 UTILITY ANALYSIS 15

2.1 Meaning and definition of Utility Analysis 15

2.2 Assumptions of Utility Analysis 16

2.3 Features of Utility Analysis 17

2.4 Concept of Utility Analysis 17

UNIT 3 DEMAND ANALYSIS 21

3.1 Meaning of Demand 22

3.2 Definitions of Demand 22

3.3 Determinants of Demand 22

3.4 Types of Demand 23

3.5 Law of Demand 23

3.6 Elasticity of Demand 24

UNIT 4 DEMAND FORECASTING AND METHODS 34

4.1 Objectives of demand forecasting 35

4.2 Methods of demand forecasting 35

4.3 Features of a good forecasting method 43

BLOCK 2 SUPPLY & COST ANALYSIS

UNIT 5 SUPPLY ANALYSIS 47

5.1 Meaning of Supply 48

5.2 Determinants of Supply 48

5.3 Supply Analysis 49

5.4 Law of Supply 50

5.5 Exceptions of the Law of Supply 52

5.6 Change in Supply 52

5.7 Shift in Supply Curve 53

5.8 Equilibrium Between Demand and Supply 53

5.9 Determinants of the Law of Supply 55

5.10 Elasticity of Supply 56

5.11 Determinants of Elasticity of Supply 57

UNIT 6 PRODUCTION ANALYSIS 60

6.1 Definition of Production Function 61

6.2 Factors of Production 61

6.3 Types of Production 64

6.4 Law of Production Function 68

6.5 Law of Variable Proportions 70

 6.6 Law of Return to Scale 73

6.7 Least Cost Combination 77

UNIT 7 COST ANALYSIS 81

7.1 Types of Cost 82

7.2 Cost-output Relationship 84

7.3 Economies and Diseconomies of Scale 88

7.4 Cost Functions 91

BLOCK 3 MARKET STRUCTURE

UNIT 8 MARKET STRUCTURE 96

8.1 Meaning of Market 97

8.2 Definitions of Market 97

8.3 Market Structure 97

8.4 Forms of Market Structure 97

8.5 Equilibrium of a Firm 98

8.6 Pricing Under Different Market Structure 98

UNIT 9 ORGANISATION STRUCTURE 107

9.1 Perfect Competition 108

9.2 Meaning of Perfectly Competitive Market 109

9.3 Definition of Perfectly Competitive Market 109

9.4 Assumptions behind a Perfectly Competitive Market 109

9.5 Characteristics of Perfectly Competitive Market 110

9.6 Price and Output Determination 110

9.7 Perfect v/s pure competition 111

 9.8 Short run equilibrium of the firm and industry 112

9.9 Long run equilibrium of the firm and industry 113

9.10 Derivation of the supply curve of the firm 114

9.11 Derivation of the supply curve of the industry 116

9.12 Price and output determination under perfect 118

competition

9.13 Demand under Perfect Competition 119

9.14 Supply under Perfect Competition 119

9.15 Equilibrium under Perfect Competition 120

9.16 Price and output determination in long run 120

9.17 Long run supply curve of a competitive industry 123

UNIT 10 MONOPOLISTIC COMPETITION 126

10.1 Meaning of Monopolistic Competition 127

10.2 Features of Monopolistic Competition 127

10.3 Foundation of monopolistic competition model 128

10.4 Price and Output Determination in short Run 130

10.5 Price and Output Determination in long Run 130

10.6 Analysis of selling cost and firm’s equilibrium 132

10.7 Critical appraisal of Chamberlin’s theory of 133

Monopolistic

UNIT 11 OLIGOPOLY MARKET 138

11.1 Oligopoly 139

11.2 Oligopoly Market 139

11.3 Characteristics of Oligopoly 139

 11.4 Causes of Oligopoly 140

11.5 Effects of Oligopoly 141

11.6 Price determination under oligopoly 142

11.7 Price Determination Models of Oligopoly 142

11.8 Game theory approach to oligopoly 145

BLOCK 4 PROFIT & COST VOLUME ANALYSIS

UNIT 12 PRICING 149

12.1 Methods of Pricing 150

12.2 Factors affecting Pricing Decision 155

12.3 Differential Pricing 157

12.4 Government Intervention and Pricing 158

UNIT 13 PROFIT 162

13.1 Concept of Profit 163

13.2 Profit Planning 163

13.3 Profit Control 164

13.4 Measurement of Profit 164

13.5 Profit Maximization 171

UNIT 14 COST VOLUME PROFIT ANALYSIS 175

14.1 Introduction 176

14.2 Meaning of Break-Even Analysis 176

14.3 Break Even Point 176

14.4 Determination of BEP 177

14.5 Assumptions of BEP 179

 14.6 Managerial Uses Break Even Analysis 180

14.7 Limitations Of Break-Even Analysis 183

BLOCK 5 NATIONAL INCOME

UNIT 15 NATIONAL INCOME 187

15.1 Meaning of National Income 188

15.2 Definition of National Income 188

15.3 National Income Concepts 188

15.4 Measurement of National Income 189

15.5 Importance of National Income Estimate 189

15.6 Difficulties Encountered in the Estimation of National 190

Income

UNIT 16 FISCAL POLICY 194

16.1 Fiscal policy 195

16.2 Objectives of fiscal policy of India 195

16.3 Fiscal policy and economic growth 196

16.4 Fiscal policy and full employment 197

16.5 Fiscal policy and social justices 197

16.6 Fiscal policy and Economic stabilization 199

16.7 Role of fiscal policy in developing countries 199

UNIT 17 MONETERY POLICY 202

17.1 Meaning of the Monetary Policy 202

17.2 Neutrality of Money 203

17.3 Price Stability and Control of Business Cycles 204

17.4 Full Employment 205

17.5 Monetary Policy and Economic Growth 205

Plagiarism Report 210

 BLOCK 1

OVERVIEW OF MANAGERIAL ECONOMICS &

DEMAND ANALYSIS

Unit 1: Concepts and Techniques

Unit 2: Utility Analysis

Unit 3: Demand Analysis

Unit 4: Demand Forecasting and Methods

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Unit 1

CONCEPTS AND TECHNIQUES

STRUCTURE

Overview

Learning Objectives

1.1 Meaning of Managerial Economics

1.2 Definitions of Managerial Economics

1.3 Nature of Managerial Economics

1.4 Scope of Managerial Economics

1.5 Managerial Economics and Business Decision Making

1.6 Role of Managerial Economist

1.7 Fundamental Concepts of Managerial Economics

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Modern business and management are complex. Hence a systematic
knowledge and techniques of Managerial Economics is an absolute
requirement these days. Managerial Economics provides the analytical
framework and understanding of economic behaviour, logical thinking and
useful techniques for decision making and highlights the role of
managerial economist in decision making. Further, Managerial
Economics deals with the demand for and supply of commodities, pricing
methods, profit planning etc. In this unit, we will discuss the concept,
scope and fundamental concepts.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• explain the meaning and nature of managerial economics.
• discuss the scope of managerial economics
• define the fundamental concepts of managerial economics
• list out the role of managerial economist.

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1.1 MEANING OF MANAGERIAL ECONOMICS
Managerial Economics is a specialized discipline of management studies
which deals with the application of economic concepts, theories and tools
of analysis for decision making process in business. In other words,
Managerial Economics is an applied economics in business management.
In brief, Managerial Economics is the integration of economic principles
with business management practices. It is the branch of Economics which
serves as a bridge between abstract theory and managerial practice.
Since Economics is a science concerned with the problem of allocation of
scarce resources, Managerial Economics is the application of Economics
to the problem of choice of scarce resources by the firms. Hence,
Managerial Economics deals with the application of economic theory that
can be helpful in solving the problems of management. In management
studies, the terms ‘Managerial Economics’, ‘Business Economics’,
‘Economics of Firm’, ‘Economics of Business Enterprise’, ‘Economics for
Managers’, ‘Economics of Business Management’, ‘Economics of
Business Decisions’, ‘Economics for Decision Making’ and ‘Economic
Analysis in Management Decision’ are used as synonyms.

1.2 DEFINITIONS OF MANAGERIAL ECONOMICS

Following are some of the important definitions of Managerial Economics:

1. “Managerial Economics is the integration of economic theory with the
business practice for the purpose of facilitating decision making and
forward planning by the Management"– Milton, H., Spencer and
Louis Siegelman.
2. “Managerial Economics consists of the use of economic modes of
thought to analyse business situations” – Malcom P. Mc. Nair and
Richard S. Meriam.
3. “Managerial Economics is concerned with business efficiency” –
Christopher I. Savage and John R. Small.
4. “Managerial Economics is Economics applied in decision making. It
is a special branch of Economics bridging the gap between abstract
theory and managerial practice” – Haynes.
5. “Managerial Economics is a study of the behaviour of the firms in
theory and practice” – James Bates and J.R. Parkinson.
6. “Managerial Economics is the application of economic theory and
methodology to business administration practice” – Eugene F.
Brigham and James L. Pappas.

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 7. “Managerial Economics is a fundamental academic subject which
seeks to understand and to analyse the problems of business
decision making” – D.C. Haynes
8. “Managerial Economics can be defined as the use of economic logic
and principles to aid management decision making” – J.R. Davies
and S. Hughes.
9. “Managerial Economics is concerned with the application of
economic concepts and economic analysis to the problems of
formulating rational management decision” – Edwin Mansfield.

1.3 NATURE OF MANAGERIAL ECONOMICS

i) Managerial Economics is the use of economic analysis in the
process of making managerial decisions. It is not a part of economic
theory but a separate branch by itself.
ii) Managerial Economics is pragmatic. It is concerned with analytical
tools that are useful in decision making. It is an applied science.
iii) Managerial Economics combines and synthesises, ideas as well as
methods from the various functional fields of business management
like Accountancy, Production Management, Marketing etc. Thus, it
employs a multi-disciplinary approach.
iv) The main aim of Managerial Economics is to increase business
efficiency.
v) Managerial Economics is a part of Normative Economics. It is
prescriptive rather than descriptive in character.
vi) Managerial Economics is micro economic in character but it uses
some of the macro-economic concepts in forecasting.
vii) Managerial Economics serves as a tool in the study of Business
Administration because its theories, methods and techniques of
analysis are used in the functional areas of Business Administration
such as production, marketing, accounting etc.
viii) Managerial Economics serves as an integrating course combining
the various functional areas and showing not only how they interact
with one another but also how the firm interacts with the environment
in which it operates.
ix) Managerial Economics is both conceptual and metrical. It takes the
help of conceptual framework to understand and analyse the
decision problems and takes the help of quantitative techniques to
measure the impact of different factors and policies.

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1.4 SCOPE OF MANAGERIAL ECONOMICS
The scope of a subject means area or the extent of coverage of a
particular subject. In that aspect, Managerial Economics includes the
following:

a) Demand Analysis

b) Production and Cost Analysis

c) Pricing

d) Profit Management

e) Capital Budgeting
a) Demand Analysis: Understanding the basic concepts of demand is
essential for demand forecasting. Demand analysis deals with
demand determinants, demand distinctions (i.e., different types of
demand) and demand forecasting. Demand analysis also highlights
the factors which influence the demand for a product. This helps to
manipulate demand. Demand forecasting has become an
increasingly important function of a modern Managerial Economist.
b) Production and Cost Analysis: Production and Cost Analysis is
concerned with the supply side of the market. Production analysis
studies the production function, factors of production, least cost
combination, returns to scale etc. Cost analysis deals with various
types of costs and their role in decision making, determinants of
costs, cost-output relationship in both the short-run and long-run and
cost control. The production and cost analysis are essential for
effective project planning.
c) Pricing: Pricing of the product or products produced by firms is a
very important aspect of Managerial Economics since firm’s revenue
mainly depends on its pricing policy. The chief function of the firm is
pricing. Pricing depends upon the cost of production. Price affects
profit which in turn affects the business. Pricing explains how prices
are determined under different market conditions such as, Perfect
Competition, Monopoly, Duopoly, Oligopoly and Monopolistic
Competition. The manager is required to have a thorough
knowledge of profit. The manager of the business has to determine
suitable pricing policies. The success or failure of a firm mainly
depends on accurate price decisions. A correct pricing policy makes
firm successful, while an incorrect pricing policy leads to its
elimination.

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 d) Profit Management: Since the aim of the firm is generally to
maximise profit. Profit management is also an important area of
study in Managerial Economics. Profit management deals with the
nature, functions and measurement of profit, profit policies, profit
planning like Break-Even Analysis and control. Profit making is the
major goal of firms. There are several constraints on account of
competition from other products, changing input prices etc. Hence,
there is always certain amount of risk involved. Managerial
Economics deals with techniques that minimizing risks and
maximizing profit. The success or failure of a firm is measured only
in terms of profit.
e) Capital Budgeting: Capital is a scarce and expensive factor of
production. Lack of capital may result in the small size of the
operations. Availability of capital from various sources may help to
undertake large scale. Hence capital management is one of the
most important functions of the managers. This capital management
is done by means of capital budgeting. Capital budgeting is
concerned with the long-term allocation of resources. It deals with
the analysis of capital expenditure, demand for and supply of capital,
cost of capital etc.

1.5 MANAGERIAL ECONOMICS AND BUSINESS DECISION MAKING

Decision making means the process of selecting a particular suitable
course of action from among the various alternative courses of action.
Every Business Manager has to work on uncertainties and the future
cannot be precisely predicted accurately, Hence, decision making is an
integral part of modern management. The most important function of the
Business Manager is decision making.

Business decisions are classified into the following:

a) Financial Decisions: Financial decisions relates to costing,
budgeting, accounting, capital structure, dividend etc.
b) Production Decisions: These decisions relate to product,
technology, product mix, location of the plant, maintenance etc.
c) Personnel Decisions: Such decisions relate to selection,
recruitment, training, placement, promotion, transfer, retrenchment,
etc.
d) Marketing Decisions: Marketing decisions relates to sales volume,
sales force, sales promotion, market research, packaging,
advertisement etc.

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 e) Miscellaneous Decisions: These decisions relate to all residual
items like purchasing, processing, public relations etc.

1.6 ROLE OF MANAGERIAL ECONOMIST

The Managerial Economist has a significant role to play in assisting the
management of the firm in decision making and forward planning by using
specialised skills and techniques. The ‘Managerial Economist’ is also
called ‘Business Economist’, ‘Company Economist’ or ‘Economic
Adviser’. The following are the important functions of the Managerial
Economist:
i) The job of the Managerial Economist lies in designing the course of
operations to maintain and improve the systems of the firm like
productivity and market share. He assists the entrepreneur in making
a rational choice among alternative ways of producing goods.
ii) The Managerial Economist is an economic adviser to a firm. By virtue
of his expertise, he helps the businessmen in arriving at correct
decisions. It is the Managerial Economist of a firm who has to advise
them on all matters of trade.
iii) Forecasting is a fundamental activity of a Managerial Economist. He
is an effective model builder. He deals with the business problems in
a sharp manner.
iv) The Managerial Economist should be well aware of the current and
changing trends in the national as well as international economy.
Knowledge of balance of payments position, exchange rates, import
and export policies of the Government are also essential for the
Managerial Economist.
v) The Managerial Economist has also been keeping an eye on the fast-
changing technological developments. He has to suggest ways and
means of economizing and thereby to minimize the cost of
production.
vi) The Managerial Economist has to help the management in business
planning by providing guidance for the correct and economical
organization and running of the enterprise.
vii) The most important role of the Managerial Economist relates to
demand forecasting. He prepares a short term forecast of general
business activity and relates general economic forecasts to specific
market trends.

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viii) The success of a firm depends upon a proper pricing strategy. The
Managerial Economist has to be very alert to take correct pricing
decision.

1.7 FUNDAMENTAL CONCEPTS OF MANAGERIAL ECONOMICS

The basic concepts that are used in Managerial Economics are the
following:

a) The Incremental Concept

b) The Concept of Time Perspective

c) The Discounting Principle

d) The Concept of Opportunity Cost

e) The Equi-Marginal Principle

a) The Incremental Concept: The Incremental Concept is the most
important concept in Economics and is certainly the most frequently
used in Managerial Economics. The Incremental Concept involves
the impact of decision alternatives on total cost and total revenue
due to changes in output.

There are two fundamental concepts in this analysis. They are:

I. Incremental Cost
II. Incremental Revenue
Incremental Cost is the change in the total cost due to a decision.
Similarly, the Incremental Revenue is the change in the total revenue
due to a decision.
Marginal Revenue and Incremental Revenue
Marginal Revenue (MR) is the additional revenue made to total revenue
by selling one more unit of the commodity. The formula to calculate the
Marginal Revenue is:

MR = [Change in Revenue]/[Change in Output]

= R1 – R0 / Q2 – Q1

where,

MR = Marginal Revenue

R0 = New Total Revenue

R1 = Old Total Revenue

Q1 = New Quantity
Q0 = Old Quantity

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Incremental Revenue (IR) is the difference between the old revenue (R 0)
and new revenue (R1) resulting from a new decision taken by the firm. In
other words, Incremental Revenue is the change in total revenue as a
result of new decision taken by the firm. When incremental revenue
exceeds the incremental cost resulting from a particular decision, it is
regarded as ‘profit’. The formula to calculate Incremental Revenue is:

IR = R1 – R0

Illustration
The difference between Incremental Revenue and the Marginal Revenue
can be illustrated as follows:
Suppose the price of a commodity falls from Rs. 15 to Rs. 10 per unit and
hence the sales go up from 1000 units to 2500 units. Calculate
Incremental Revenue and Marginal Revenue.

IR = R1 – R0

= (Rs.10 x 2500) – (Rs.15 x 1000)

= Rs.25,000 – Rs.15,000
= Rs.10, 000.

MR = R1 – R0 / Q2 – Q1

= 25000 – 15000 / 15-10

= 10000 / 5 = Rs.2000

Marginal Cost and Incremental Cost

Marginal Cost is the additional cost made to the total cost by producing
one more unit of output. The formula to calculate Marginal Cost is:

MC = [Change in Cost]/[Change in Output]

= C1 – C0 / Q1 – Q0

Where,

MC = Marginal Cost

C1 = New Total Cost

C0 = Old Total Cost

Q1 = New Quantity

Q0 = Old Quantity
Incremental Cost is the change in total cost as a result of new decision.
In other words, Incremental Cost is the difference between old cost and

9
new cost resulting from a new decision taken by the firm. The formula to
calculate Incremental Cost is: IC = C 1 – C0

Where,

IC = Incremental Cost

C1 = New Total Cost

C0 = Old Total Cost

b) The Concept of Time Perspective: Marshall was the first
Economist who introduced the ‘time element’ in the value analysis.
According to him, time plays an important role in determining the price of
a commodity. Marshall distinguished the time element into four. They
are
i) Market Period or Very Short Period: The Market Period is a very
short period in which the commodities are perishable and the supply
of such commodities being fixed, i.e., perfectly inelastic. For example,
if the demand for commodities like vegetables, flowers, meat, fish,
eggs, fruits, milk increases, its supply cannot be increased on the
same day. Since the supply of such commodities is fixed, its price is
determined by the demand on that day. The price prevailing in the
market period is called the ‘Market Price’.
ii) Short Period: The Short Period is a period in which the supply can
be changed in accordance with the demand. This is possible by
changing the variable factors only. This means, in the short period, it
is not possible to change the fixed factors. In this time period, the
commodity is non-perishable and also reproducible by using variable
factors like raw materials, wage earnest etc.,
iii) Long Period: The Long Period is a period in which supply can be
fully adjusted to demand. This is done by changing the fixed factors
like machines, equipment’s, plants, scale of productions, organization
and management. In the long period, new firms can enter the industry
and old firms can leave the industry.
iv) Very Long Period or Secular Period: Secular Period is a period in
which changes in demand fully adjust themselves to supply.
c) The Discounting Principle
The Discounting Principle is very useful in Managerial Economics in
making investment decisions. A sum of money available at present is
considered more valuable at than the same amount at some other
period. Hence, present gain is valued more than a future gain.
Therefore, it is necessary to know the techniques for measuring the
value today (i.e., the present value of money) to be received in future.

10
 The equation for the future value (FV) of any amount ‘S’ for ‘n’ periods
at an interest rate of ‘r’ is

FV = S(1 + r)n
Where,

FV = Future Value

S = Present Value

r = Rate of Interest

N = Number of Years

The equation for the computation of present value (PV) of an

amount due in future is:

PV = FV (1/ (1+r) n)

The process of reducing future values of their present values is

often referred to as “Discounting”. In this context, the interest rate
used in present value problem is sometimes referred to as
“Discounting Rate”.

d) The Concept of Opportunity Cost

The Opportunity Cost is the cost of using something in a particular
venture is the benefit foregone by not using it in its best alternative
use. In Managerial Economics, opportunity costs are the costs of
displaced alternatives. They represent only sacrificed alternatives.
They involve the measurement of sacrifices made in taking a particular
decision. Hence, opportunity cost is not recorded in any financial
account.
For example, a farmer who is producing paddy can also produce
wheat with the same inputs. Therefore, the opportunity cost of a
quintal of paddy is the amount of output of wheat given up.
The concept of opportunity cost has a wide application in Managerial
Economics. It is applied in determining factor prices and product
prices, consumption and public expenditure.

e) The Equi-Marginal Principle

The Equi – Marginal Principle states that an input should be allocated
in such a way that the value added by the last unit is the same in all
uses.
Let us explain this principle with a simple illustration. A firm is involved
in four activities, namely A, B, C and D. All these activities require the

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 services of labour. According to this principle, the optimum output will
be obtained when the value of Marginal Product of Labour is equal in
all activities. That is, output is maximum when,

VMPLA = VMPLB = VMPLC = VMPLD

Where,

VMP = Value of Marginal Product

L = Labour and

A, B, C and D are various activities.

LET US SUM UP
This unit expresses the meaning, nature and scope of Managerial
Economics. Managerial Economics is the application of economic
principles in business decision. Managerial Economics is pragmatic. It is
a part of Normative Economics. The scope of Managerial Economics
includes Demand Analysis, Production and Cost Analyses, Pricing, Profit
Management and Capital Budgeting. Decision making means the
process of selecting a particular suitable course of action from among the
various alternative courses of action. The role of Managerial Economist
has also been discussed in this unit. In this unit you have also been
exposed to an overview of fundamental concepts like incrementalism,
time perspective, discounting, opportunity cost and equi-marginalism.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. The process of selecting a particular suitable course of action from

among the various alternative courses of action means ___________

a) Capital budgeting b) Profit management

c) Demand analysis d) Decision making

2. The difference between the old revenue and new revenue resulting

from a new decision taken by the firm is___________

a) Total revenue b) Average revenue

c) Incremental revenue d) Marginal revenue

3. Additional cost made to the total cost by producing one more unit of

output is___________

a) Total Cost b) Average Cost

c) Incremental Cost d) Marginal Cost

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4. Market period is also called ___________

a) Very Short Period b) Short Period

c) Very Long Period d) Long Period

5. Very long period is also known as___________

a) Secular Period b) Short Period

c) Nuclear Period d) Long Period

GLOSSARY

Pricing : Pricing of the product or products produced

by firms is a very important aspect of
Managerial Economics since firm’s
revenue mainly depends on its pricing
policy.

Profit management : Profit management deals with the nature,

functions and measurement of profit, profit
policies, profit planning like Break-Even
Analysis and control.

Capital budgeting : Capital is a scarce and expensive factor of

production. Lack of capital may result in
small size of operations. Availability of
capital from various sources may help to
undertake large scale.

Decision making : Decision making means the process of

selecting a particular suitable course of
action from among the various alternative
courses of action.

Equi-marginal : The Equi – Marginal Principle states that

principle an input should be allocated in such a way
that the value added by the last unit is the
same in all uses.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.

13
 3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company
Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics,
Margham Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.analyticssteps.com/blogs/scope-managerial-
economics
8. https://www.economicsdiscussion.net/managerial-
economics/concepts-of-managerial-economics-with-
diagram/19260
9. https://www.google.com/search?q=NATURE+and+scope+OF+MA
NAGERIAL+ECONOMICS&sxsrf=ALiCzsZGBF5Q7fqlchMLg7jv3
_8JYeCxLA:1668740593581&source=lnms&tbm=vid&sa=X&ved=
2ahUKEwiAv7WS37b7AhVgZWwGHVSgACAQ_AUoBHoECAEQ
Bg&biw=1280&bih=577&dpr=1.5#fpstate=ive&vld=cid:3303332e,
vid:A9daYVRKewM

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) c 3) d 4) b 5) a

14
Unit 2

UTILITY ANALYSIS
STRUCTURE

Overview

Learning Objectives

2.1 Meaning and definition of Utility Analysis

2.2 Assumptions of Utility Analysis

2.3 Features of Utility Analysis

2.5 Concept of Utility Analysis

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
The Cardinal Approach or Utility Analysis to the theory of consumer
behavior is based upon the concept of utility. This unit is to explain Utility
Analysis its Meaning, Definition, Assumptions, Features, and Concept. It
assumes that utility is capable of measurement. It can add, subtract,
multiply, and so on. Cardinal utility analysis is the oldest theory of demand
which provides an explanation of consumer’s demand for a product and
derives the law of demand which establishes an inverse relationship
between price and quantity demanded of a product.

Learning Objectives

After completing this lesson, you should be able to

• define Utility Analysis

• discuss the features of utility analysis

• describe the concept of utility analysis.

2.1 MEANING AND DEFINITION OF UTILITY ANALYSIS

Cardinal utility approach to the theory of demand has been subjected to
severe criticisms and as a result, some alternative theories, namely,
Indifference Curve Analysis, Samuelson’s Revealed Preference Theory,

15
and Hicks’ Logical Weak Ordering Theory have been propounded.
According to this approach, the utility can be measured in cardinal
numbers, like 1,2,3,4, etc. Fisher has used the term “Util” as a measure
of utility. Thus, in terms of cardinal approach, it can be said that one gets
from a cup of tea 5 utils, from a cup of coffee 10 utils, and a Rasgulla 15
utils worth of utility.

Meaning and definition of Utility Analysis

The term utility in Economics is used to denote that quality, in a goods or
service by which our wants are satisfied. In, other words utility is defined
as the want satisfying power of a commodity.
According to Mrs. Robinson, “Utility is the quality of commodities that
makes individuals want to buy them.”
According to Hibdon,“Utility is the quality of a good to satisfy a want.”

2.2 ASSUMPTIONS OF UTILITY ANALYSIS

Cardinal utility analysis of demand is based upon certain important
assumptions. Before explaining how cardinal utility analysis explains
consumer’s equilibrium regarding the demand for a good, it is essential to
describe the basic assumptions on which the whole utility analysis rests.
As we shall see later, cardinal utility analysis has been criticized because
of its unrealistic assumptions.

Figure 2.1 Utility Analysis

The utility analysis is based on a set of following assumptions:

• The utility analysis is based on the cardinal concept which assumes
that utility is measurable and additive like weights and lengths of
goods.
• Cardinal or Utility is measurable in terms of money.

• The marginal utility of money is assumed to be constant

16
 • The consumer is an rational who measures, calculates, chooses
and compares the utilities of different units of the various
commodities and aims at the maximization of utility.
• He has full knowledge of the availability of commodities and their
technical qualities.
• He possesses perfect knowledge of the choice of commodities
open to him and his choices are certain.
• They know the exact prices of various commodities and thei r
utilities are not influenced by variations in their prices.
• There are no substitutes.

2.3 FEATURES OF UTILITY ANALYSIS

The utility analysis has the following main features

1. Subjective: The utility is subjective because it deals with the mental
satisfaction of a man. A commodity may have different utility for
different persons. Cigarette has utility for a smoker but for a person
who does not smoke, the cigarette has no utility. Utility, therefore, is
subjective.
2. Relative: The utility of a good never remains the same. It varies with
time and place. The fan has utility in the summer but not during the
winter season.
3. Usefulness: A commodity having utility need not be useful. Cigarette
and liquor are harmful to health, but if they satisfy the want of an addict
then they have utility for him.
4. Morality: The utility is independent of morality. Use of liquor or opium
may not be proper from the moral point of views. But as these
intoxicants satisfy wants of the drunkards and opium eaters, they have
utility for them.

2.4 CONCEPT OF UTILITY ANALYSIS

There are three concepts of utility analysis;

1. Initial: The utility derived from the first unit of a commodity calls initial
utility. Utility derived from the first piece of bread calls initial utility. Thus,
the initial utility is the utility obtained from the consumption of the first
unit of a commodity. It is always positive.
2. Total: Total utility is the sum of utility derived from different units of a
commodity consumed by a household.

17
According to Left witch,“Total utility refers to the entire amount of
satisfaction obtained from consuming various quantities of a commodity.”
Supposing a consumer gets four units of apple. If the consumer gets 10
utils from the consumption of first apple, 8 utils from the second, 6 utils
from third, and 4 utils from the fourth apple, then the total utility will be
10+8+6+4 = 28.

Accordingly, the total utility can calculate as:

TU = MU1+ MU2+ MU3+ ……… + MUn

or

TU = EMU`

Here TU = Total utility and MU 1, MU2, MU3, + MUn

The Marginal Utility derived from the first, second, third……….and nth
unit.
3. Marginal: The Marginal Utility is the utility derived from the additional
unit of a commodity consumed. The change that takes place in the total
utility by the consumption of an additional unit of a commodity calls
marginal utility.

According to Chapman,
“Marginal utility is the addition made to total utility by consuming
one more unit of commodity.”
Supposing a consumer gets 10 utils from the consumption ofone mango
and 18 utils from two mangoes then, the marginal utility of second mango
will be 18-10=8 utils.
The marginal utility can be measured with the help of the following
formula MUnth = TUn – TUn-1

Here;

MUnth= Marginal utility of nth unit.

TUn= Total utility of “n” units, and.

TUn-1 = Total utility of n-1 units.

Types of Marginal utility

The types of marginal utility can be; positive marginal utility, zero
marginal utility, or negative marginal utility.
1. Positive: If by consuming additional units of a commodity, total
utility goes on increasing, marginal utility will be positive.

18
 2. Zero: If the consumption of an additional unit of a commodity
causes no change in total utility, the marginal utility will be zero.
3. Negative: If the consumption of an additional unit of a commodity
causes falls in total utility, the marginal utility will be negative.

LET US SUM UP
The Cardinal Approach or Utility Analysis to the theory of consumer
behavior is based upon the concept of utility. We have explained Utility
Analysis Meaning, Definition, Assumptions, Features, and Concept in this
lesson.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1._____________ is the quality of commodities that makes individuals
want to buy them
a) Utility b) Stock

c) Money d) Strategic
2. The marginal utility of money is assumed to be ____________

a) Semi Variable b) Constant

c) Average d) Variable

3. Consuming additional units of a commodity, total utility goes on

____________Marginal utility will be positive

a) Increasing b) Decreasing
b) Partly increase and Partly Decrease d) Stable

4. Consumption of an additional unit of a commodity causes no change

in total utility, the marginal utility will be ____________

a) No Change b) Zero

c) Positive d) Negative

5. If the consumption of an additional unit of a commodity cause falls in

total utility, the marginal utility will be negative___________

a) No Change b) Zero

c) Positive d) Negative

19
GLOSSARY

Utility : Utility is the quality of commodities that

makes individuals want to buy them

Subjective : The utility is subjective because it deals

with the mental satisfaction of a man. A
commodity may have different utility for
different persons. Cigarette has utility for
a smoker but for a person who does not
smoke, the cigarette has no utility. Utility,
therefore, is subjective.

Positive : If by consuming additional units of a

commodity, total utility goes on
increasing, marginal utility will be
positive

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.yourarticlelibrary.com/economics/elasticity-as-
demand/the-neo-classical-utility-analysis-assumptions-total-utility-
vs-marginal-utility/10634
8. https://www.economicsdiscussion.net/articles/utility-features-
creation-and-concepts-on-utility/2024

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) a 4) b 5) d

20
Unit 3

DEMAND ANALYSIS
STRUCTURE

Overview

Learning Objectives

3.1 Meaning of Demand

3.2 Definitions of Demand

3.3 Determinants of Demand

3.4 Types of Demand

3.5 Law of Demand

3.6 Elasticity of Demand

Let Us Sum Up

Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Now you are familiar with the meaning and nature of Managerial
Economics. You have also acquired an idea about the scope and
fundamental concepts of Managerial Economics. This unit is going to the
most important aspects of Managerial Economics, namely Demand
Analysis Elasticity of Demand explain you and Demand Forecasting.
Demand depends upon price. Demand forecasting has an important
influence on production planning. It is essential for a firm to produce the
required quantities at the right time.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define demand and elasticity of demand

• mention the factors influencing elasticity of demand

• Analyse the methods of demand forecasting.

21
3.1 MEANING OF DEMAND
In common parlance, demand means the desire for a commodity. But in
Economics demand means the desire backed up by willingness and ability
to buy a commodity at some price in a given period of time. Hence,
demand is always at a price for a definite quantity in a specified time.
Demand depends upon price.

3.2 DEFINITIONS OF DEMAND

To Stonier and Hague, “Demand in Economics means demand backed
up by enough money to pay for the goods demanded.”
To Benham, “the demand for anything at a given price is the amount of it
which will be bought per unit of time at that price.”

3.3 DETERMINANTS OF DEMAND

The demand for goods may change not only due to change in price but
also due to change in certain conditions or factors. These factors are
known as “Determinants of Demand”.
a) Changes in Climate: Change in climate will cause a change in
demand. For example, the demand for cool drinks is high during
summer.
b) Changes in Tastes, Preferences and Fashions: Changes in tastes,
preferences and fashions will also cause a change in demand. For
example, sarees are out of fashion among Indian ladies and chudithars
have come into fashion. Hence, the demand for chudithars has
increased.
c) Changes in Size and Composition of Population: If population
increases, the demand for commodities automatically increases
without any change in price.

Note: Real income itself depends on price level.

d) Expectations: If the consumers expert that there will be a rise in price
in future, the demand for the commodity will increase at present
irrespective of the current price and vice versa.
e) Changes in the price of Substitutes: The demand for a commodity
may change due to a change in price of its substitutes. For example,
the demand for cigarette increases at the same price, because due to
rise in the price of beedi.
f) Changes in the Distribution of Income: When there is equal
distribution of income and wealth, the demand for commodities will

22
 increase more than when there is inequality in the distribution of
income and wealth.
g) Advertisement: The demand for goods increases due to
advertisement, publicity, attractive label and packing.

3.4 TYPES OF DEMAND

1. Durable and non-Durable

2. Perishable and non-perishable

3. Autonomous demand and Indeemed demand

4. Individual demand and firm demand

3.5 LAW OF DEMAND

The Law of Demand was originally introduced by Cournot. But the final
credit goes to Alfred Marshall who improved this concept.

Definition
Marshall defines the Law of Demand as, “Other things remain the same,
the amount demanded increases with a fall in price and diminishes with a
rise in price”.

Explanation
This Law states that there is an inverse relationship between the price and
the quantity demanded of a commodity.

Demand Schedule
A tabular statement which shows the relationship between the price and
the quantity demanded for a commodity is ‘Demand Schedule’.

Table 3.1 Demand Schedule

Price Quantity Demanded

1 50

2 40

3 30

4 20

5 10

In Table 3.1, when price is Re.1, the quantity demanded of the commodity
is 50 units. If price is increased from Re.1 to Rs.2, the demand decreased
from 50 units to 40 units. Similarly, if price is Rs.5, the quantity demanded

23
of commodity is 10 units. If price is decreased from Rs.5 to Rs.4, the
demand increased from 10 units to 20 units.

Demand Curve
The graphical representation of the demand schedule is said to be the
“Demand Curve”.
6
5
4
Price

3
2
1
0
10 20 30 40 50
Quantity

Quantity Demand

Figure.3.1 Law of Demand

In Figure 3.1, DD is the demand curve, which slopes downward from left
to right. It indicates that when price falls, the demand expands and when
price rises, the demand contracts.

Assumptions
The Law of Demand is based on the following assumptions:
1. The income, taste, habit and preference of the consumer remains
constant.

2. The prices of related goods remain constant.

3. No substitute for the commodity.

4. There should be continuous demand for the commodity.

3.6 ELASTICITY OF DEMAND

The Law of Demand explains the direction of change in demand due to
change in price. That is, a fall in the price of a commodity leads to an
increase in its quantity and vice versa. But, it does not explain the rate of
change in demand due to a small change in price. The Elasticity of
Demand explains the exact rate change in demand due to change in price.

24
3.6.1 Definition
In the words of Marshall, “The Elasticity (or Responsiveness) of demand
in a market is great or small accordingly as the amount demanded
increased much or little for a given fall in price and diminishes much or
little for a given rise in price”.

3.6.2 Types of Elasticity of Demand

Elasticity of Demand can be broadly divided to three. They are:

i. Price Elasticity of Demand

ii. Cross Elasticity of Demand

iii. Income Elasticity of Demand

a) Price Elasticity of Demand

Alfred Marshall stated: "The elasticity (or responsiveness) of demand in a
market is great or small as the amount demanded increases much or little
for a given fall in price and diminishes much or little for a given rise in
price”. It is the rate at which quantity purchased changes as the price
changes.
Price elasticity of demand is a measure of responsiveness of demand for
a product to a change in its price. It is a ratio of proportionate change in
quantity demanded to a given proportionate change in price. The simple
formula for this is as follows:
Percentage change in quantity demanded
PE = Percentage change in price
(𝑄 −𝑄 )/ 𝑄
PE = (𝑃2 −𝑃1)/ 𝑃 1
2 1 1

Where

PE = price elasticity of demand

Q1 = quantity demanded before changes

Q2 = quantity demanded after changes

P1 = price before change

P2 = price after change

b) Cross Elasticity of Demand

The quantity demanded of a particular commodity varies according to the
price of other commodities. Cross elasticity measures the responsiveness
of the quantity demanded of a commodity due to changes in the price of
another commodity. For example, the demand for tea increases when the
price of coffee goes up. Here the cross elasticity of demand for tea is high.

25
If two goods are substitutes then they will have a positive cross elasticity
of demand. In other words, if two goods are complementary to each other
than negative income elasticity may arise.
The responsiveness of the quantity of one commodity demanded to a
change in the price of another good is calculated with the following
formula.
% change in demand for commodity A
Ec= % change in price of commodity B
If two commodities are unrelated goods, the increase in the price one of
the good does not result in any change in the demand for the other goods.
For example, the price fall in Tata salt does not make any change in the
demand for Tata Nano.

c) Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of quantity
demanded to a change in income. It is measured by dividing the
percentage change in quantity demanded by the percentage change in
income. If the demand for a commodity increases by 20% when income
increases by 10% then the income elasticity of that commodity is said to
be positive and relatively high. If the demand for food were unchanged
when income increases, the income elasticity would be zero. A fall in
demand for a commodity when income rises results in a negative income
elasticity of demand.

3.6.3 Types of Price Elasticity of Demand

The following classification of price elasticity is also applicable to the
income elasticity and the cross elasticity.
i) Perfectly Elastic Demand or Infinitely Elastic Demand: Though
there is no change in the price level, there will be some changes n the
demand is called are perfectly elasticity demand. For example
Price demand
50 100
50 120
EP= ∞

Figure. 3.2 Perfectly Elastic Demand

26
ii) Perfectly Inelastic Demand or Zero Elastic Demand: It refers to that
situation where there is no change in the quantity demanded of the
commodity due to a substantial change in price.

EP= 0

Figure.3.3 Perfectly Inelastic Demand

iii) Relatively Elastic Demand or More Elastic Demand: It refers to that
situation where a proportionate change in the quantity demanded is
greater that the proportionate change in price. EP > 1

Figure.3.4 Relatively Elastic Demand

iv) Relative Inelastic Demand or More Inelastic Demand: It refers to
that situation where a proportionate change in quantity demand is less
than the proportionate change in price. EP < 1

Figure. 3.5 Relatively Inelastic Demand

27
v) Unit Elastic Demand: It refers to that situation where the
proportionate change in the quantity demanded of a commodity is
equal to the proportionate change in price.
EP = 1

Figure. 3.6 Unitary Elastic Demand

3.6.4 Methods of Measuring Price Elasticity of Demand

Generally, four methods are used to measure the price elasticity of
demand. They are:
a) Total Outlay Method (Total Expenditure Method): This method was
introduced by Alfred Marshall. In this method, we consider the change in
total outlay or expenditure of a consumer due to change in price of the
commodity. To calculate the elasticity, rate the following formula is used
TR =P ×Q

Were

P = Price

Q = Quantity demand
a) If change in price does not cause any change in the total
expenditure, then the elasticity of demand is equal to unity.
b) If change in price will lead to the increase in total expenditure, then
the elasticity of demand is greater than unity.
c) If change in price will lead to decrease in total expenditure, then
the elasticity of demand is less than unity.

Figure. 3.7 Total Outlay Method

28
In Figure 3.7, Panel (A) represents an upward sloping total revenue
curve (T1R) indicating that when price rises from P 1to P2total outlay
(or total revenue) rises from R1to R2. It shows how the demand is
relatively inelastic (e < 1).
Panel (B) represents a vertical straight-line total revenue curve
(T2R). Here, total revenue remains unchanged (OR), whether price
changes from P1to P2or vice versa. It means that the demand is
unitary elastic (e = 1).
Panel (C) represents a downward sloping total revenue curve (T 3R).
So, with the rise in price from P1to P2, total revenue decreases from
R1to R2. It means that the demand is relatively elastic (e > 1).
b) Arc Method: To calculate a price elasticity over some portion of
the demand curve rather than at a point, the concept of arc elasticity
of demand is used (See Figure 3.8).
In Figure 3.8, point elasticity is measured at a point (say ‘a’) on the
demand curve. Arc elasticity is measured on a range of demand
curve, say between ‘a and b.’ The formula for arc elasticity
measurement is:

Figure 3.8 Point vs Arc Elasticity

∆𝑄 𝑃 +𝑃
earc =∆𝑃 × 𝑄1 + 𝑄2
1 2

Where,

P1= original price,

P2= new price,

Q1= original quantity demand,

Q2= new demand,

∆ P = P2– P1; ∆ Q = Q2– Q1

29
c) Point Method: Marshall also suggested another method called the
point elasticity method or geometrical method for measuring price
elasticity at a point on the demand curve.
The simplest way of explaining the point method is to consider a linear
(straight-line) demand curve. Let the straight-line demand curve be
extended to meet the two axes, as in Figure 3.9. When a point is plotted
on the demand curve like point Pin Figure 3.9, it divides the curve into two
segments. The point elasticity is, thus, measured by the ratio of the lower
segment of the curve below the given point to the upper segment of the
curve above the point.

For brevity, we may again put that:

Lower segment of the curve below the given point
Po int Elasticity = Upper segment of the demand curve above the point

or, to remember through symbols, we may put as:

𝐿
e=U

where, e stands for point elasticity, L stand for lower segment, and U for
the upper segment.

Figure. 3.9 Point Method

In Figure 3.9, AB is the straight-line demand curve and P is a given
point. Thus, PB is the lower segment and PA the upper segment.
𝐿 𝑃𝐵
e = U = PA

d) Percentage Method: According to this method, the elasticity of

demand can be measured by comparing the ratio of percentage change
in the quantity demanded to the percentage change in the price of the
commodity. Therefore,
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞
EP = × 100
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝

By Percentage Method, five kinds of price elasticity of demand can be

measured as follows:

30
 i. EP =1, when =1, e.g.:= 1

ii. EP >1, when>1, e.g.:= 2

iii. EP <1, when<1, e.g.:= 0.5

iv. EP = ∝, when = ∝1, eg:= ∝

v. EP = 0, when= 0, e.g.: = 0

3.6.5 Factors Influencing Elasticity of Demand

i) The demand for necessities is less elastic or inelastic, while the
demand for luxury and comfortable goods is elastic.
ii) The demand for a commodity on which a consumer spends only a
small portion of his income is less elastic.
iii) The demand for a commodity is more elastic, when the commodity
has several uses.
iv) The demand for a commodity is more elastic, if the commodity has
good substitutes.
v) The demand for a commodity to which the consumer is accustomed
is inelastic.
vi) When the demand for a commodity is post ponable, its demand is
more elastic.
vii) The demand for commodities will be less elastic in the short period
and will be more elastic in the long period.
viii) The demand for complementary goods like pen and ink, petrol and
car is less elastic or inelastic.

3.6.6 Uses of Elasticity of Demand

a) Monopolist has to consider the elasticity of demand for his product
when he fixes the price for his product. If his products have inelastic
demand, he may fix a higher price for it and if his products have
elastic demand, he may fix a lower price for it.
b) The concept of elasticity of demand is also helpful to the finance
minister before levying tax for a commodity. If increasing tax on a
commodity has inelastic demand for that commodity, there will be
imposition of higher tax rates on Alcohol, Cigarette consumption.
c) The concept of elasticity of demand is also useful in the
determination of the rewards for various factors of production. For
example, if the demand for labour in a particular industry is relatively
inelastic, the trade unions can bargain for higher wages.

31
 d) The terms of trade between two countries can be calculated by
taking into account the mutual elasticities of demand for each other’s
product.
e) The concept of elasticity of demand also helps the Government in
fixing appropriate foreign exchange rate.

LET US SUM UP
In this unit we have shown the meaning and determinants of demand.
Demand means desire backed by willingness and ability to pay. Further
we have highlighted the meaning, methods and factors influencing
Elasticity of Demand.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. The change in demand for a commodity, due to change in the price of
its substitute is called___________

a) Price demand b) Income demand

c) Cross demand d) Law of demand

2. The desire backed up by a willingness to buy a commodity at some
price is said to be __________

a) Demand b) Supply

c) Cross demand d) Income demand

3. The rate of change in demand due to change in price is said to be
___________
a) Cross Elasticity b) Price Elasticity

c) Cross demand d) Law of Elasticity

4. The ratio of percentage change in quantity demanded of a commodity
to a given percentage change in the price of the substitute is called
______________

a) Cross Elasticity b) Price Elasticity

c) Cross demand d) Law of Elasticity

5. The demand for a commodity to which the consumer is accustomed
is __________

a) Elastic b) Less elastic

c) Inelastic d) Law of Elasticity

32
GLOSSARY

Demand : Demand in Economics means demand

backed up by enough money to pay for
the goods demanded

Elasticity of Demand : The Elasticity (or Responsiveness) of

demand in a market is great or small
according as the amount demanded
increased much or little for a given fall in
price and diminishes much or little for a
given rise in price

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.economicsdiscussion.net/elasticity-of-
demand/measuring-price-elasticity-of-demand-4-methods/21878
8. https://www.youtube.com/watch?v=Olh4je1JLWA

ANSWERS TO CHECK YOUR PROGRESS

1) c 2) a 3) b 4) c 5) c

33
Unit 4

DEMAND FORECASTING AND METHODS

STRUCTURE

Overview

Learning objectives

4.1 Objectives of demand forecasting

4.2 Methods of demand forecasting

4.3 Features of a good forecasting method

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Forecasting is a prediction or estimation about a future event which is
most likely to happen under given conditions. Thus, demand forecasting
refers to an estimate of future demand for the product. Demand
forecasting has an important influence on production planning. It is
essential for a firm to produce the required quantities at the right time.
Demand forecasts relate to production, inventory control etc. Since
management operates under conditions of uncertainty, one of the most
important functions of the managerial economist is that of demand
forecasting.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• describe the objectives of demand forecasting

• analyse the methods of demand forecasting

• discuss the features of demand forecasting method.

34
4.1 OBJECTIVES OF DEMAND FORECASTING

The following are the important objectives of demand forecasting:

(i) To eliminate the gap between demand for and supply of goods,
demand forecasting helps the producers to take up production
planning.
(ii) Demand forecasting induces the producers to maintain sufficient
inventory stock, so that when supply falls and demand increases,
the stock may be released to the market to fill up the gap.
(iii) Demand forecasting helps the businessmen to formulate appropriate
price policies, so that the prices do not fluctuate over a period of time.
(iv) Demand forecasting helps the businessmen to determine sales
targets.
(v) Demand forecasting is very helpful to the businessmen to prepare
the budget.
(vi) Demand forecasting enables the companies to decide about the
production capacity.
4.2 METHODS OF DEMAND FORECASTING
The demand forecasting can be done for established (existing) products
as well as and for new products. Let us see the methods of demand
forecasting for established products.
Methods of Demand Forecasting for Established Products
The methods of demand forecasting for established products can be
classified into two. They are

1.Survey Methods

Survey Methods are further classified into the following:

i) Consumers’ Survey Method: In this method, consumers are contacted
personally and asked to give their opinions about their consumption in the
near future. This method is the most ideal method. Though this method
is very simple, it is the most expensive method. Because, the consumers
are numerous in number and scattered. Further, the consumers may be
hesitant to reveal their purchase plans because of commercial secrecy.

Consumers’ survey method may be undertaken in three ways. They are:

a) Complete Enumeration Method: Under this method, a complete
survey of all the consumers of the product is made. The interviewer asks
every consumer the quantity he would like to buy in the near future. Once

35
this information is collected, the demand forecasts are obtained by simply
adding the probable demands of all the consumers. As first-hand
information is collected, this method is free from bias. However, this
method is impracticable, because the consumers are numerous in
number and scattered. Hence, this method is most expensive
b) Sample Survey Method: Under this method, a sample of few
consumers is interviewed. The total demand of all the consumers in the
sample is finally blown up to generate the total demand of all the
consumers in the forecast period. This method is easy, less costly, time
saving and also highly useful. But, if the sample selected is not
representative, then wrong results will be obtained.
c) End Use Method: Under this method, data regarding the demand for
the product in the near future from different sectors such as industries,
consumers, export and import are collected.
d) Experts’ Opinion Method: Under this method, the experts like
wholesalers and retailers of the product are requested to tell their opinions
about the demand in the near future. Since the wholesalers and retailers
have been dealing in the products for a long period, they are in a position
to predict the likely demand for the product in the near future on the basis
of experience.

Advantages
• This method is very simple.

• The calculation is also very easy.

• This method is less costly.

• This method is time saving.

Disadvantages
• This method is purely subjective.

• Different experts may give different kinds of forecasts.

• The experts may be biased.

e) Opinion Survey Method

This method is also known as Sales – Force – Composite Method or
Collective Opinion Method. Under this method, the company asks its
salesmen to submit the estimates of the future demand for the product in
their respective regions.

36
Advantages
• This method is very simple.

• This method is less costly.

• This method is time saving.

• Since this method requires less statistical skill, there is no need for
special technical skill.

Disadvantages
• This method is purely subjective.

• The salesmen may not be aware of the changes that affect the
demand for the product in near future.

f) Delphi Method
Under this method, a panel is selected to give suggestions to solve the
problems in hand. Both internal and external experts can be the members
of the panel. Panel members are kept apart from each other and express
their views in an anonymous manner. There is also a coordinator who acts
as an intermediary among the panelists. The coordinator prepares the
questionnaire and sends it to the panelists. At the end of each round, the
coordinator prepares a Let us sum up report. On the basis of the Let us
sum up report, the panel members have to give suggestions. This method
has been used in the area of technological forecasting. It has proved
more popular in forecasting non-economic rather than economic
variables.

2. Statistical Methods
The Statistical Methods are:
• The Trend Projection Method

This method is based on analysis of past sales patterns. A firm will

have accumulated considerable data regarding sales for a number of
years. Such data is arranged chronologically with regular intervals of
time. This type of data is called ‘Time Series’.
The trend in time series can be estimated by using any one of the
following methods:

a) The Least Square Method

The common technique used in constructing the line of best fits is
by the method of least squares. The trend is assumed to be linear.
The equation for the straight-line trend is y = a + bx, where ‘a’ is the

37
 intercept and ‘b’ is the slope, i.e., the impact of the independent
variable. The ‘y’ intercept and the slope of the line are found by
making the appropriate substitutions in the following normal
equations:
∑y = na + b∑x ……… (1)

∑xy = a∑x + b∑x2 ……… (2)

According to the principle of Least Squares, if Sx is equal to zero, then

a = and b =

Examples
1. Calculate the trend value from the following data using the method
of least square and estimate the production for 2007.

Years 1999 2000 2001 2002 2003 2004

Production 9 12 18 27 36 45
(in tons)

Solution

Years x Y x2 xy
1999 -3 9 9 -27

2000 -2 12 4 -24
2001 -1 18 1 -18
2002 1 27 1 27
2003 2 36 4 72
2004 3 45 9 135
Sx = 0 Sy = 147 2
Sx = 28 Sxy=165

a = 24.5

b = 5.89

Therefore =a + bx

= 24.5 + 5.89x

Y 1999 = 24.5 + 5.89 (-3) = 24.5 – 17.67 = 6.83 tons

Y 2000 = 24.5 + 5.89 (-2) = 24.5 – 11.78 = 12.72 tons

Y 2001 = 24.5 + 5.89 (-1) = 24.5 – 5.89 = 18.61 tons

Y 2002 = 24.5 + 5.89 (1) = 24.5 + 5.89 = 30.39 tons

Y 2003 = 24.5 + 5.89 (2) = 24.5 + 11.78 = 36.28 tons

38
 Y 2004 = 24.5 + 5.89 (3) = 24.5 + 17.67 = 42.17 tons

Y 2005 = 24.5 + 5.89 (6) = 24.5 + 35.34 = 59.84 tons

2. With the help of the following data, project the trend values for the
next five years.

Years 2000 2001 2002 2003 2004

Sales (Rs. In 50 60 72 87 107

crores)

Solution

Years X Y x2 xy

2000 -2 50 4 -100

2001 -1 60 1 -60

2002 0 72 0 0

2003 1 87 1 87

2004 2 107 4 214

Sx = 0 Sy = 376 Sx2 = 10 Sxy =

141

a = 75.2
b = 14.1
Therefore, y = a + bx = 75.2 + 14.1x
Y 2005 = 75.2 + 14.1 (3) = 75.2 + 42.3 = Rs. 117.5 crores
Y 2006 = 75.2 + 14.1 (4) = 75.2 + 56.4 = Rs. 131.6 crores
Y 2007 = 75.2 + 14.1 (5) = 75.2 + 70.5 = Rs. 145.7 crores
Y 2008= 75.2 + 14.1 (6) = 75.2 + 84.6 = Rs. 159.8 crores
Y 2009 = 75.2 + 14.1 (7) = 75.2 + 98.7 = Rs. 173.9 crores

b) The Free Hand Curve Method

This method of demand forecasting is very simple. In this method,
we must plot the original data on the graph. Draw a smooth curve
carefully which will show the direction of the trend. The time is shown
on the X axis and the values are represented in Y axis.

39
c) The Moving Average Method
In the Moving Average Method, the average value for a number of years
or months or weeks is taken into account and placing it at the centre of
the period of moving average. It is calculated from overlapping groups
of successive time series data. Moving average can be calculated for 3,
4,5,6,7,8 or 9 years period.

d) The Method of Semi Averages

In this method, the original data is divided into two equal parts and
averages are calculated for both the parts. These averages are called
‘Semi Averages’.
• The Regression Method: Regression Analysis is the most popular
method of demand forecasting. In regression, the demand function
is an expression of the relationship between sales and other
determinants. The regression method makes use of both economic
theory and statistical estimation techniques to generate sales
forecasts from past data. The first step in regression analysis is to
specify the variables that are supposed to affect the demand for the
product in question. The variables are generally chosen from the
determinants of demand, namely, price of the product, price of its
substitute's income, taste and preferences of the consumers.
These variables are treated as independent variables. Once
independent variables are specified, the second step is collection of
time series data on the independent variables. After the necessary
data are collected, the next step is to specify the form of equation
which can appropriately describe the nature and extent of
relationship between the dependent and independent variables.
The final step is to estimate the parameters in the equation with the
help of statistical techniques.
• The Barometric Method: Barometric Method is an improvement
over the trend projection method. In the trend projection method,
the future demand is an extension of the past demand while in the
Barometric Method; the present demand is used to predict the future
demand. This is done by the use of certain economic and statistical
indicators from the selected time series to predict variables. There
are three kinds of indicators of time series, namely,
a) Leading Series

b) Coincident Series

c) Lagging Series

40
The leading series provide data on the variables which move up
or down behind some other series. For example, the bank rate is
leading the interest rate. The rates at which the commercial banks
lend to private sectors are coincident series and the rates at which
the private money lenders lend to individuals are the lagging
series.
The following indicators are used in estimating the future demand
for certain products:
a) Construction Contracts – Demand for building materials like
cement.
b) Increased Prices of - Demand for agricultural inputs
Agricultural Commodities like fertilizers.
c) Automobile Registration – Demand for Petrol.
In the Barometric Method, firstly it is necessary to find out the
existence of any relationship between the demand for the product
and the indicators. Then establish the relationship with the help of
the method of least squares and then form the regression equation.
Assuming the relationship to be linear, the equation will be of the
form y = a + bx. Once the regression equation is derived, the value
of ‘y’ i.e., the demand for the product can be estimated for any value
of ‘x’.
The advantage of Barometric Method is that it is simple. The
limitations of this method are:

1. It is not always possible to find a leading indicator

2. The link between sales and its leading variables may vary
over time

3. It is useful only for short-term forecasting.

• The Simultaneous Equation Method
In this method, all variables are considered simultaneously, for
every variable influences other variables. It is a system of ‘n’
equations with ‘n’ unknowns. The advantage of this method is that
an estimate of future demand for the product can be made with pre-
determined variables.
This method is a highly complicated. Further, this method is time
consuming and costly method and it requires historical data on the
variables affecting sales.

41
Although this method is theoretically better than any other statistical
methods, its severe limitations are responsible for its unpopularity.

Demand Forecasting for New Products

The methods of demand forecasting for new products are quite different
from those for established products. For the new products, an intensive
study of the economic and competitive characteristics of the product
provides the key to intelligent forecasting of demand. Joel Dean provides
six possible approaches of forecasting the demand for new products.
They are as follows:
i) Evolutionary Approach: Forecast the demand for the new product is
an outgrowth and evolution of an established product. For example,
start with the assumption that color television picks up where black
and white television left off. The evolutionary approach is useful only
when the new product is very close to the existing product. The 100
CC two wheelers are an improvement of Rajdoot and Bullet.
ii) Substitute Approach: According to this approach, the new product
is to be considered as a substitute for the established product. Then
forecast the demand for the new product (i.e., substitute) on the basis
of the established product. For example, the new laser typesetting
substitutes photographic composition for the established type-setting
equipment. Likewise, any toilet soap or tooth paste is a close
substitute for the existing soap or tooth pastes.
iii) Growth Curve Approach: Estimate the rate of growth and the
ultimate level of demand for the new product on the basis of the
pattern of growth of established products. For example, analysis of
growth curves of all established household appliances and try to
establish an empirical law of market development is applicable to a
new household appliance. Likewise, a company which is producing a
new washing soap should estimate the growth trends of all the
washing soaps of different brands.
iv) Opinion – Polling Approach: Under this approach, the demand for
the new product will be estimated by making direct enquiries of the
ultimate consumers in the sample area. Then extend the sample to
derive the total demand for the product by the population as a whole.
Sending a representative for a new industrial product to a sample
company is an example.
v) Sales Experience Approach: According to this approach, the
demand for the new product will be estimated by offering the new

42
 product for sale in a sample market and then estimate the total
demand.
vi) Vicarious Approach: By this approach, the reactions of the
consumers are indirectly studied. The specialized dealers who are
able to judge the needs, tastes and preferences of the consumers are
contacted. Since the dealers having link with consumers, they will be
able to know how the customers will receive the new product. The
opinions of dealers are very much solicited regarding the demand for
the new products. This approach is easy but difficult to quantify.
Another limitation of this approach is that the bias of the dealers
cannot be ruled out completely.

4.3 FEATURES OF A GOOD FORECASTING METHOD

We have studied about various methods of demand forecasting. Some of
these methods are costlier and some of them are cheaper. Further, some
methods are flexible and some require skill. Therefore, there is a problem
of choosing the best method of demand forecasting. Hence, in order to
choose the best method, the following criteria have to be considered:
i) Accuracy: The method of forecasting should be very accurate. Then
only the management will have confidence in the techniques adopted.
It is very important to verify the accuracy of the past forecasts against
present and present forecasts against the future forecast.
ii) Plausibility: Plausibility means belief. The management should have
good knowledge of the method chosen and also, they should have
belief in the method used for that purpose. The plausibility increases
the accuracy of the result.
iii) Durability: Whenever a forecast is chosen, it should hold good for a
certain period of time. The durability of a forecast depends upon the
reasonableness and simplicity of the functions fitted.
iv) Simplicity: Whenever a forecast is chosen, it should be of simple in
nature. Mathematical and econometric procedures are not desirable
by the management.
v) Availability: Adequate availability of data is very important for the
forecasting method. Then only the method should yield quick and
accurate result.
vi) Economy: The cost of forecasting should be less. If the forecast is of
very little importance, there is no need to spend a large amount of
money for the demand forecasting.

43
LET US SUM UP
The demand forecasting refers to an estimate of future demand for the
product. The demand forecasting methods are broadly divided into two
namely, Survey Methods and Statistical Methods.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. ___________ shows the relationship between price and quantity
demanded of a commodity at a particular time period in the market.

a) Law of demand b) Investment alternatives

c) Evaluation of alternatives d) All of the above.

2. ___________refers to the process of predicting the future demand for
the firm's product.

a) Law of demand b) Demand Forecasting

c) Evaluation of alternatives d) All of the above

3. ___________ refers to the rate of variation of demand with respect to
the rate of variation of prices of related or substitutable goods.

a) Law of demand b) Demand Forecasting

c) Cross Elasticity of demand d) All of the above

4.Related goods are of kinds ___________

a) One b) Two

c) Four d) Three
5. ___________forecasting is predicting a commodity/product/service
price by evaluating the characteristics

a) Law of demand b) Demand Forecasting

c) Cross Elasticity of demand d) Price

GLOSSARY

Demand : Forecasting is a prediction or estimation

Forecasting about a future event which is most likely to
happen under given conditions. Thus,
demand forecasting refers to an estimate
of future demand for the product. Demand
forecasting has an important influence on
production planning. It is essential for a

44
 firm to produce the required quantities at
the right time.

Accuracy : The method of forecasting should be very

accurate. Then only the management will
have confidence in the techniques
adopted. It is very important to verify the
accuracy of the past forecasts against
present and present forecasts against the
future forecast.

Plausibility : Plausibility means belief. The

management should have good
knowledge of the method chosen and also
they should have belief in the method used
for that purpose.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company
Limited, New Delhi.
5. Sankaran,S. Dr, 3rd Editions (2012), Business Economics,
Margham Publications, Chennai.
6. Varshney, R.L.,Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://managementknowledgeforall.blogspot.com/2014/03/metho
ds-of-demand-forecasting.html
8. https://www.economicsdiscussion.net/demand-
forecasting/demand-forecasting-concept-significance-objectives-
and-factors/3557

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) c 4) b 5) d

45
 BLOCK 2

SUPPLY & COST ANALYSIS

Unit 5 : Supply Analysis

Unit 6: Production Analysis

Unit 7: Cost Analysis

46
Unit 5

SUPPLY ANALYSIS
STRUCTURE

Overview

Learning Objectives

5.1 Meaning of Supply

5.2 Determinants of Supply

5.3 Supply Analysis

5.4 Law of Supply

5.5 Exceptions of the Law of Supply

5.6 Change in Supply

5.7 Shift in Supply Curve

5.8 Equilibrium Between Demand and Supply

5.9 Determinants of the Law of Supply

5.10 Elasticity of Supply

5.11 Determinants of Elasticity of Supply

Let Us Sum Up
Check Your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Supply may be the amount of goods offered for sale per unit of time. This
unit will explain the concept of supply analysis with the help of the law of
supply, supply schedule and the supply curve. Supply has a direct relation
with price. The tendency of the producer is to sell more as the price
increases .Therefore, market supply will also increase. The second part
of this unit explains about the change in the supply curve and the shift in
the supply curve. After studying this, we can learn about the major factors
determining supply. The final part of this unit will explain the Elasticity of
supply as well as Advertisement elasticity of supply.

47
LEARNING OBJECTIVES

After completing this unit, you should be able to,

• explain the concept of supply

• express the law of supply, supply schedule and supply curve

• identify the factors influencing the law of supply

• describe the elasticity of supply

• indicate how the equilibrium between the Law of Demand and

supply.

5.1 MEANING OF SUPPLY

The word ‘Supply’ implies the quantities of a commodity offered for sale
by the producer at a particular price during a given period of time. Hence,
the supply of a commodity is the amount of that commodity which the
sellers or producers are able and willing to offer for sale at a particular
price during a given period of time.

5.2 DETERMINANTS OF SUPPLY

The supply of a commodity not only depends on the price of the
commodity, but also on several factors. These factors are called
‘Determinants’ or ‘Conditions’ of supply. They are:
a) Price of the Commodity: If the price of the commodity is high, there
will be more profit. The higher the profit, the greater will be the supply.
b) Cost of Production: The cost of production of a commodity depends
on the cost of various factors of production. If the prices of various
factors of production rise, the production cost will also rise and in turn
price for the same level of output. Similarly, a fall in the price of the
factors of production would reduce the cost of production and in turn,
the price too . In both the cases, the supply will be affected.
c) Technology: The supply of a commodity also depends upon the
methods of production. Most of the inventions and innovations have
greatly contributed to increase the supply of commodities at lower
cost.
d) Weather Conditions: The natural calamities like floods, epidemics
cause fluctuations in the supply of goods, especially agricultural
goods. The war and earthquakes may destroy productive assets of a
commodity and curtail future supplies.
e) Tax and Subsidy: A tax on a commodity or a factor of production
raises the cost of production of the commodity and hence the price of

48
 the commodity is increased. Consequently, production is reduced.
On the other hand, subsidy provides an incentive to production and
hence supply has increased.

5.3 SUPPLY ANALYSIS

Supply analysis is a study of sales offered by any producer in the market
at a particular price in a given time period. Normally this supply analysis
focuses only on the producer’s intention. It is the tendency of the producer
to maximize profit with minimum expenses. As a law of demand, supply
can also be studied individually or collectively.
Individual supply analysis is the supply of commodity in some quantity like
kilogram, litre, meter etc., by a single producer or firm in a given price at
a particular time. The following supply schedule explains this.
Table 5.1 Individual Supply Schedule

Price of Shampoo in Rs. Supply of Shampoo

29 100

32 130

34 140

From the above schedule, it could be inferred that as price increases from
Rs. 29 per 100 gm to Rs. 32 the producer is willing to increase supply
from 100 units to 130 units. Further, when the price goes up to Rs. 34 the
producer is willing to increase his sales to 140 units. It shows that
because of higher price, the producer is willing to increase his sales.
In the case of market supply analysis, it includes the number of firms
willing to sell some specific quantity of the product in a given price at a
particular time. In short it is the total supply of a product in a market at a
given price in a particular time period.
The table 5.2 shows how when the price of shampoo is Rs. 4. Vaiduriya
is willing to sell 10 units, Abinaya is willing to sell 5 units and Yoga Priya
is willing to sell 8 units. The total sales in the market is 23 units in the
price level of Rs. 4. The same way total market sales increases to 34
units because of an increase in price to Rs.8. Further increase in price
from Rs. 8 to Rs. 10 leads to increase in the market sales to 45 units.

49
 Table 5.2 Market Supply Schedule of Shampoo

Price Vaiduriya Abinaya Yoga Priya Market Supply

4 10 5 8 23

8 12 10 12 34

10 17 13 15 45

12 20 15 18 53

The term supply implies producer’s willingness or desire to offer the

commodity at a particular price in a given period of time. Supply is a
function of the price of the product and the demand for the product.
Supply = f (demand, advertisement, competitive advantage etc.)

5.4 LAW OF SUPPLY

According to Alfred Marshall law of supply is defined as, “Other things
remaining the same a small increase in price leads to an increase in the
supply and a fall in price leads to a decrease in sales”.
According to this law there is a direct relationship between the sales and
the price of the product at a particular point of time. The law of supply can
be explained with the help of supply schedule and supply curve.

5.4.1 Supply Schedule

Supply Schedule is a two column, ‘n’ row explanation. The first column
represents price level, and the second column represents the quantity of
sales. This can be illustrated as follows.

Table 5.3 Supply Schedule

Price of wheat Supply of wheat

in kg

10 70

15 80

20 140

From the above table it can be found that when the price of wheat is Rs.10
and the producer is willing to sell only 70kg of wheat. The producer is

50
willing to increase the supply to 140kg because of increased price level to
Rs. 20.

5.4.2 Supply Curve

In the Supply Curve ‘X’ axis represents the quantity of sales and the ‘Y’
axis represents the price of the product. Using the table we can get the
following supply curve.

Figure. 5.1 Supply Curve

The above Figure shows that there is a positive relationship between the
price and sales. Increase in price level leads to an increase in sales to
100 kilograms of wheat.

5.4.3 Assumptions of Law of Supply

Following are the various assumptions of the Law of Supply. In the
definition it was mentioned as ‘other thing remaining the same’.
i) There should not be any change in the cost of production: If there
is any change in the cost of production, that would affect the sales
irrespective of market price variation. For example, increase in the
cost of production leads to the reduced quantity of sales though there
is no change in price.
ii) There is no change in technology: If the producer uses any new
technology, then that will increase the sales irrespective of price
variation. Over the long run, usage of modern technology leads to
increase in the output level of the company. Therefore, changes in
the technology leads to increased sales, rather than the changes in
the price level of the commodity
iii) There is no Government intervention: If the Government regulates
the business activity then, that tends to affect the sales in the market.
iv) There is no change in the competitor’s action: There should not
be any change in the competitors’ action. If any one of the competitors
is going to change, even the product design, advertisement etc., that

51
 leads to create some reaction among other sellers also. Because of
this reaction, their cost of production will increase, that will in turn
affect the sales of all other competitors.

5.5 EXCEPTIONS OF THE LAW OF SUPPLY

There are some exceptions of the law of supply. They are as follows.
a) Future expectations: When prices are expected to fall much, sellers
will try to sell more at present in order to clear the stock and avoid
loss. The same way if he expects the price to increase in the near
future then he will try to store the product and sell it in the future with
the intention of gaining more profit.
b) Changes in Technology: If any company is going to use modern
technology that creates changes in the taste and preferences, that in
turn affects the existing firms. Therefore, the existing firm will try to
dispose off their product.
c) Changes in the Taste and Preference: If there is a vast change in
the taste, habits and fashion of the consumers, they will try to use
only modern products.
d) Changes in natural elements: Changes in the weather, national
and international disturbances will also influence the supply of the
commodities. In all the above-mentioned reasons the supply curve
slopes downward like as follows:
e) Backward sloping Supply Curve: One more reason for the
exceptional supply curve is when the wages rise to a level where the
workers get maximum satisfaction level (Saturation point). Then they
will work less than before in order to have more leisure time. The
supply curve in such a situation is “backward sloping”.

5.6 CHANGE IN SUPPLY

The concept of change in supply occurs because of changes in the price
level. Here we operate on the assumption, “no other factor will influence
the sales, only price is allowed to operate the sales”.
Change in the supply curve occurs because of changes in the price.
Changes in supply curve includes the ‘expansion’ of sales. Expansion
occurs because of increase in price level. It leads to increase in sales.
Another aspect is called as ‘contraction’ of sales. This means, that
decrease in price leads to decrease in sales.

52
5.7 SHIFT IN SUPPLY CURVE
Shift in supply occurs because of influence of many other factors other
than the price level. At a particular time period any one of the external
factors will influence the sales. Because of this change there will be shift
in the supply curve either towards right or to the left side. This can be
explained with the help of the supply curve analysis.

Figure. 5.2 Shifts in Supply

In Figure 5.3, an increase in supply in indicated by the shift of the supply
curve from S1 to S2. Because of an increase in supply, there is a shift at
the given price OP, from A 1 on supply curve S1 to A2 on supply curve S2.
At this point, large quantities (i.e. Q2 instead of Q1) are offered at the given
price OP.
On the contrary, there is a shift in the supply curve from S1 to S3 when
there is a decrease in supply. The amount supplied at OP is decreased
from OQ1 to OQ3 due to a shift from A 1 on supply curve S 1 to A3 on supply
curve S3.
However, a decrease in supply also occurs when producers sell the same
quantity at a higher price (which is shown in Figure) as OQ1 is supplied at
a higher price OP2.
5.8 EQUILIBRIUM BETWEEN DEMAND AND SUPPLY
Equilibrium between the demand and supply is the balance between the
demand and sales of a product in a given price level at a particular point
of time. At the equilibrium point both producer and the consumer will
maximize their satisfaction level. Here the producers’ aim is to maximize
profit and the consumers’ objective is to maximize satisfaction. The
following schedule explains this equilibrium point.

53
 Table 5.4 Equilibrium

Price Demand Supply

10 30 10

15 20 20

20 10 30

The above table indicates that at Rs.10 the product leads the consumer
to buy 30 units and the supplier is willing to sell only 10 units. Here we
have an excess demand of 20 units. Further increase in price to RS. 20
leads to reduction in the consumption level to 10 units, but the producer
is willing to offer 30 units for sales. Here we have an excess supply of 20
units.
Because of this excess demand or sales that leads to automatic
adjustment between the producers and the consumers, which make them
to consume or sell 20 units at Rs 15. This can be explained with the help
of following curve.

price
25
20
Axis Title

e
15
10
5
0
0 10 20 30 40
Axis Title

Figure 5.3 Equilibrium between Demand and Supply

where point ‘e’ indicates the equilibrium between the demand and supply.
If the price is Rs.20 the consumer is willing to consume 10 units but seller
is willing to sell 30 units, reselling in 20 units of excess supply. The
producer can’t keep it up for a long time. Therefore, he is willing to accept
a lower price. Likewise, the consumer is also willing to accept some higher
price than Rs10, since having decided to purchase the product; the
consumer cannot afford to postpone his consumption. This type of
automatic adjustment between the producer and the consumer leads to
equilibrium point ‘e’ where the price level is Rs15 and the quantity is 20
units. Hence, both the producer and the consumer are happy with the
price and quantity.

54
5.9 DETERMINANTS OF THE LAW OF SUPPLY

Following are the major determinants of supply

a) Cost of production: Total expenses incurred for the production of
any commodity is called as cost of production. This cost of production
includes,

a. Expenses incurred for the purchase of Raw Materials

b. Labour Charges

c. Rent for the capital

d. Other administrative expenses.

If all these expenses increase, that leads to an increase in the cost of
production.
b) Change in the technology: Changes in technology are also very
important determinants of the supply. Modern usage of technology
leads to increased sales.
c) Competition: Market competition is also a very important determinant
of supply.
d) Type of market: Type of market is also another important determinant
of supply. Type of market includes local market, national, international
markets. According to the type of market the sellers will attempt to
sell more or less.
e) Government Regulation: The degree of Government regulation is
also a very important determinant of supply. Heavy imposition of tax,
price regulation etc., are the major instruments of the Government
regulations. Based on these there could be either an increase or
decrease in sales.
f) Type of consumers: We are having three types of consumers:
Hardcore consumer, soft-core consumer and switchers. Higher the
elasticity of demand lower will be the sales, the reason being that the
type of consumer here switchers. Switchers are those who are not
satisfied with any one brand but prefer to taste different brand.
Inelasticity leads to more profits, the reason being the consumer here
is the loyal hardcore consumer.
g) Price expectation: If the seller expects any future increase in price
level, then he will try to hoard the product and try to sell it in future.
Therefore, price expectation is an important factor that will influence
the sales in the market.

55
h) Natural Factors: Supply is governed by the natural factors like rain,
drought, etc. This is more so in agro-industries. Normally monsoon
failure may lead to poor power generation; this in turn affects the
production in other sectors also.

5.10 ELASTICITY OF SUPPLY

Elasticity of supply explains the responsiveness of sales with respect to
price. Supply may be called as elastic if the responsiveness of sales is
greater than the rate of change in price (E>1) or the supply may be
inelastic, if the rate of variation of sales is lesser than the rate of variation
of price.
In short, elasticity of supply measures the adjustability of supply to price.
This is expressed as the ratio between the proportionate changes in the
quantity supplied and proportionate changes in the price. The formula for
this is as follows.
Proportionate Change in the quantity supplied
Es = Proportionate Change in the price

This can be calculated with the help of following supply schedule.

Table 5.5 Elasticity of Supply

Price Sales

100 200

80 100
50
ES = 20 = 2.5 > 1

In the above given table, the elasticity of supply is relatively elastic.

Like demand elasticity, supply elasticity also has five classifications as
follows:
a) Relative elasticity of supply: When the rate of variation of sales
is greater than the rate of variation of price, then it is called as
relatively elastic supply. It is denoted as E > 1.
b) Relative inelasticity of supply: When the rate of variation of
sales is lesser than the rate of variation of price then, it is called
as relatively inelastic supply. It is denoted as E < 1.
c) Perfectly elasticity of supply: Though, there is no change in the
price level there will be variation in the sales. It is called as the
perfectly elastic sales. It is denoted as E = œ

56
 d) Perfectly inelastic supply: Though, there is heavy change in the
price level there will be no variation in the sales. It is called as
perfectly inelastic sales. It is denoted as E = 0
e) Unit elasticity of supply: The rate of variation of sales is exactly
equal to the rate of variation of price. It is called as the unit
elasticity of supply. It is denoted as E = 1.

Advertisement Elasticity of Supply

Advertisement elasticity can be calculated either for sales or for
demand. It depends either on available sales data or the demand data.
Here we are going to calculate advertisement elasticity of sales with
respect to advertisement expenses.

Table 5.6 Advertisement Elasticity

Advertisement Sales of Toilet Soaps

Expenses

50,000 1,00,000

1,00,000 1,50,000

The following formula is used to calculate the advertisement elasticity of

sales.
Proportionate Change in Sales
Ea = Proportionate Change in advertisement expenses
50
= = .5 < 1
100

Advertisement elasticity of sales is relatively inelastic.

5.11 DETERMINANTS OF ELASTICITY OF SUPPLY

The following are the various determinants of elasticity of supply.

a) Availability of suitable formula: For calculating the supply
elasticity, selection of suitable formula is important. We can use Arc
Method or Percentage Method or Graphical Method. Based on the
available production or sales data we should select the suitable
method.
b) Gestation Period: Gestation period means the period of investment
and the period of production and sales. Higher the gestation period
lower will be the elasticity of supply (inelastic sales). Lower the
gestation period the sales will be highly elastic (E > 1).

57
 c) Possibilities of changing the technique of production: If the firm
is able to change its techniques of production immediately then the
elasticity will be elastic sales. If it is having very low possibilities then
the rate of variation of sales is relatively inelastic sales.
d) Availability of competitors in the market: If the product is having
more competition in the market, then the elasticity rate will be very
low (relatively inelastic sales).

LET US SUM UP
After reading this unit you would have gained sufficient knowledge about
the concepts of supply analysis, individual and market sales analysis. The
law of supply states that as the price increases sales would also increase.
This can be explained with the help of supply schedule and the supply
curve. The fast part also explained about the reason for exceptional
supply curve, supply shift and change in the supply curve. The second
part explained the equilibrium between demand and supply. And the final
part of this unit explained the elasticity of supply and the advertisement
elasticity of supply with the major determinants of supply curve.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. ___________ is a study of sales offered by any producer in the market
at a particular price in a given time period

a) resource allocation b) deductive methods

c) case studies method d) supply analysis

2. ___________ explains the responsiveness of sales with respect to
price

a) resource allocation b) deductive methods

c) elasticity of supply d) supply analysis

3. ___________ Determinants of the law of Supply

a) cost of Production b) deductive methods

c) elasticity of supply d) supply analysis

4. ___________ between the demand and supply is the balance between
the demand and sales of a product in a given price level at a particular
point of time.

a) equilibrium b) deductive methods

c) elasticity of supply d) supply analysis

58
5. Higher the ___________ lower will be the sales, the reason being that
the type of consumer here switchers.

a) equilibrium b) elasticity of supply

c) elasticity of demand d) supply analysis

GLOSSARY

Law of Supply : According to Alfred Marshall law of supply

is defined as, “Other things remaining the
same a small increase in price leads to an
increase in the supply and a fall in price
leads to a decrease in sales”.

Advertisement : Advertisement elasticity can be calculated

Elasticity either for sales or for demand. It depends
either on available sales data or the
demand data.

Cost of Production : the actual cost or money incurred for the

production process the actual cost or
money incurred for the production process

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.youtube.com/watch?v=H8VLO6as7pc
8. https://www.economicsonline.co.uk/competitive_markets/shifts_in_s
upply.html/

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) c 3) d 4) a 5) c

59
Unit 6

PRODUCTION ANALYSIS
STRUCTURE

Overview

Learning Objectives

6.1 Definition of Production Function

6.2 Factors of Production

6.3 Law of Production Function

6.4 Law of Variable Proportions

6.5 Law of Return to Scale

6.6 Least Cost Combination

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
This unit will explain two major parts of the production process. The first
part explains about the factors of production. We have four factors of
production such as land, labour, capital and organisation. The second part
of this unit explains about the production function and the law of
production functions. Law of production function includes law of Return to
Scale and the law of variable proportion. After reading these laws you can
have a better knowledge about the various stages of production process,
by using different input combinations. Based on these analyses you can
find out the least cost combination, where you can minimize your cost and
maximize the revenue.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• identify the various factors of production

• describe the concepts related to the production

• explain the least cost combination

60
 • describe the law of variable proportion

• define the Law of Production

• discuss about the economies of scale.

6.1 DEFINITION OF PRODUCTION FUNCTION

Production is a simple relationship between the physical inputs and
physical outputs of a firm at any particular time period where physical
inputs are (in management it is called as 6Ms) Men and Women, Money,
Materials, Method, Market and Machine. Physical output includes goods
and services. In short production is the transformation of resources into
commodities and services over time.

Definition
According to Jane Bates and J.R. Parkinson “Production is the organized
activity of transforming resources into finished products in the form of
goods and services and the objective of production is to satisfy the
demand of such transformed resources”.

In algebraic terms, the production function may be written as

Q = f (land, labour, capital and Technology) here ‘Q’ represents
quantity of output per unit of time.

6.2 FACTORS OF PRODUCTION

Productive resources required to produce a given product are called
factors of production. These productive resources may be raw material or
services of the various categories of workers or of capitalists supplying
capital or of an entrepreneur assembling the factors and organizing the
work of production. They are now generally called as “inputs”.
Fraser defined the factor of production as, “a group or class of original
productive resources”. The factors of production have been traditionally
classified as Land, Labour, Capital and Organisation. Now we shall briefly
deal with them one by one. These factors are complementary in the sense
that their co-operation or combination is essential in the production
process.
6.2.1 Land: Land stands for all natural resources which yield an income
or which have exchange value. It represents those natural resources,
which are useful and scarce, actually or potentially. The term ‘Land’ has
been given a special meaning in Economics. It does not mean soil as in
the ordinary speech, but it is used in a much wider sense. Let us discuss
the peculiarities of land.

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Peculiarities of Land
• Land is nature’s gift to man

• Land is fixed in quantity

• Land is permanent

• Land lacks mobility

• Land provides infinite variations of the degree of fertility and

situation, so that no two pieces of land are exactly alike.
6.2.2 Labour: In Economics labour is defined as “any work, whether
manual or mental which is undertaken for a monetary consideration”. The
work done for the sake of pleasure or love does not fall under labor in the
economics sense.

Peculiarities of Labour

The following are the major peculiarities of labour:

• The labour has to sell his labour in person.

• Labour is perishable.

• Labour has very weak bargaining power.

• Supply of labour cannot be quickly adjusted with the demand of

labour.
As age increases, the physical productivity level of the labour will come
down.

Factors determining the efficiency of labour

The following are some of the main factors, which affect labour efficiency.
• Climatic Factors: A cool bracing climate is conducive to hard work,
whereas the tropical climate is enervating.
• Education: Labour efficiency also depends on the education and
knowledge level of the workers.
• Working Hours: Long working hours leads to reduced productivity
of the labour. Normal working hours with breaks proves to be more
productive (Ref. Hawthorne Study)
• Personal Qualities: A worker’s efficiency also depends upon his
personal qualities like physique, resourcefulness and initiatives etc.,
• Factory Environment: Surrounding within the organisation will
affect the working efficiency of an employee. Cramped and ill

62
 ventilated factories, situated in crowded and unsanitary surroundings
are not conducive to efficiency.

Division of Labour
Division of labour is an important characteristic feature of modern
production. Division of labour is associated with the efficiency of
production. “The division of labour is not a quaint practice of eighteenth-
century pin factories; it is the fundamental principles of economic
organisation”. In short division of labour implies instead of making an
article by the same employee, the articles can be split into a number of
processes and sub-processes and each process or sub process is carried
out by a separate group of people.

Advantages
Division of labour facilitates the following advantages:
• Increases the productivity: Since the same employee is going to do
the same job or process, he can produce more output.
• Higher productivity or efficiency of the labour leads to saving time.

• Innovation: Because of this excess time the employee can do

innovative things for an economy.
• By doing the same job repeatedly the employee can become an
expert in that process.
6.2.3 Capital: Capital refers to that part of a man’s wealth, which is used
in producing further wealth, which yields excess income. It is a
“Produced means of production”. Therefore, capital is not a primary or
original factor of production. The term “capital’ is generally used for
capital goods, for example plant and machinery tools and accessories,
stocks of raw materials, goods in process, and fuel. The raw materials
are used up in a single act of consumption. Moreover, money spent on
them is fully recovered when goods made with them are sold in the
market. But, plant and machinery are permanent investment.

Importance
Capital plays a vital role in the modern productive system. Production
without capital is hard for us even to imagine. Nature cannot furnish goods
and materials to man unless he has the tools and machines for mining,
farming, foresting, fishing etc.
Because of its strategic role in raising productivity, capital occupies a
central position in the process of economic development. In fact, capital
formation is the core of economic development

63
Another important economic role of capital formation is the creation of
employment opportunities in the country. Capital formation creates
employment at two stages. First, when the capital is produced; some
workers have to be employed to make capital goods like machinery,
factories etc. Secondly more men have to be employed when capital has
to be used for producing further goods.

6.2.4 Enterprise
The fourth factor of production is enterprise, which is supplied by the
entrepreneur. The entrepreneur’s functions may be summarized as,
i) Initializing a business enterprise by mobilizing and harnessing the
necessary productive resources.
ii) Taking the final responsibility of the business enterprise risk – taking
and uncertainty – bearing.

iii) The entrepreneur’s role as an innovator.

In the words of professor Harvey Leibenstein, the entrepreneur’s role is to
“search and discover economic opportunity, evaluate economic
opportunities, marshal the financial resources necessary for the
enterprise, make time-binding arrangements, take ultimate
responsibilities for management, be the ultimate uncertainty or risk -
bearer, provide and be responsible for the motivational system within the
firm, search and discover new economic information, translate new
information into new markets, techniques and good, and provide
leadership for the work group”.

6.3 TYPES OF PRODUCTION

There are different types of production functions that can be classified
according to the degree of substitution of one input by the other.

Cobb Douglas Production Function

64
The Cobb Douglas production function, given by the American
economists, Charles W. Cobb and Paul. H Douglas, studies the relation
between the input and the output.
The Cobb Douglas production function is that type of production function
wherein an input can be substituted by others to a limited extent.
For example, capital and labour can be used as a substitute of each other,
however to a limited extent only. Cobb Douglas production function can
be expressed as follows:

Q = AKa Lb

Where,

A = positive constant

a and b = positive fractions

b = 1–a

Another way of expressing Cobb- Douglas production function is:

Q = 𝐴𝐾𝑎 𝐿1−𝑎
Let us take up an example to understand the calculations involved in the
cobb-Douglas function.

Assume A = 40, a = 0.3 and b= 0.7 , K = 3 and L = 5

Therefore,

Q = 40 (3)0.3 (5)0.7

log Q = log 40 + 0.3 log 3 + 0.7 log 5

log Q = 1.6020 + (0.3 X 0.4771) + (0.7 X 0.6989)

log Q = 1.6020 + 0.1431 + 0.4892

log Q = 2.2343
Now, we will take the antilog of the above to get the value of Q.
antilog log Q = antilog 2.2343

Q = 171.5141

Cobb Douglas Production Function Properties

The main attributes of the Cobb Douglas production function are
discussed as follows:
• It enables the conversion of the algebraic form into log linear form,
represented as follows:

log Q = log A + a log K + b log L

65
 This production function has been estimated with the help of linear
regression analysis.
• It acts as a homogeneous production function, whose degree can
be calculated by the value obtained after adding values of a and
b. If the resultant value of a+b is 1, it implies that the degree of
homogeneity is 1 and indicates the constant returns to scale.
• It makes use of parameters a and b, which signifies the elasticity
coefficients of output for inputs, labour and capital, respectively.
Output elasticity coefficient is the change in output that occurs due
to adjustment in capital while keeping labour at constant.
• It depicts the non-existence of production at zero cost.

6.3.1 Leontief Production Function

Leontief production function, evolved by W. WassilyLeontif, uses the fixed
proportion of inputs having no substitutability between them.
It implies that if the input-output ratio is independent of the scale of
production, there is existence of Leontief production function. It assumes
strict complementarily of factors of production. Leontief production
function is also called as fixed proportion production function.

This production function can be expressed as follows:

q= min (z1/a, z2/b)

where, q = quantity of output produced

z1 = utilized quantity of input 1

z2 = utilized quantity of input 2

a and b = constants
Minimum implies that the total output depends upon the smaller of the two
ratios.
The coefficients a and b are the fixed input requirements for producing a
single unit of output. It means that if we want to produce q units of output,
we need aq units of capital (z1) and bq units of labour (z2).
Or we can mathematically state that, z 1 = aq represents the capital
requirements and z2 = aq represents the labour requirements.
Therefore, z1 / z1 = a/b. that is, there is a particular fixed proportion of
capital and labour required to produce output. That is if we increase one
of the factors without increasing the other factor proportionally, then there
will be no increase in output.

66
For example, suppose the Leontief production functions for goods X is

X = min [ 3 Lx , 7 Kx]
This implies that for producing a single unit of X, a minimum of 1/3 unit of
labour and 1/7 unit of capital would be required.

X = min [ Lx / (1/3) , Kx / (1/7)]

In this case, the values 1/3 and 1/7 depict labour activities and therefore,
are activity coefficients as they depict labour activities.
Now, say 1/3 of a day’s work is required to produce 1 unit of X, and the
activity required of capital 1/7 of a day’s work to produce 1 unit of X.

With Lx = 5 and Kx = 3, X = min [ 15, 21] = 15 units of X.

Therefore, with 15 units of X ; Lx = 5 and Kx = 2, you get X = min [15, 14]
= 14 units of X.
The logical capital-labor ratio in the X industry to choose will be Kx / Lx =
3/5 = 0.6

6.3.2 CES Production Function

CES stands for constant elasticity substitution. CES production function
displays a constant change produced in the output due to change in input
of production.

It is expressed as:
Q = A [𝛼K–β + (1–𝛼) L–β]–1/β

CES has the homogeneity degree of 1 that implies that output would be
increased with the increase in inputs. For example, labour and capital has
increased by constant factor m.
Q’ = A [𝛼 (mK)–β + (1–𝛼) (mL)–β]–1/β

Q’ = A [m–β {𝛼K–β + (1–𝛼) L– β}]–1/β

Q’ = (m–β) –1/β .A [𝛼K–β + (1-𝛼) L–β]-1/β

Because, Q = A [𝛼K–β + (1-𝛼) L–β]-1/β

Therefore, Q’ = mQ
This implies that CES production function is homogeneous with degree
one.
For example, let us assume that the CES production function’s
parameters are as follows:

A = 1.0

67
a = 0.3

b = 0.7

β = 0.18

s = 1/(1+β) = 1/(1+0.18) = 0.847

L = 50

K = 30

The CES production function will be formed as follows:

Q = A [𝛼K–β + (1–𝛼) L–β]–1/β

Q = 1.0 * .3 X (L0.18) + .7 X (K0.18)

Q = 1.0 * .3 X 500.18 + .7 X 300.18

Q = 1.0 * .3 X 1 + .7 X 1

Q = 1.0 * 1

Q = 1.0 / 11/.18

Q=1

1. Properties of CES Production Function

The properties of CES function are as follows:

• The value of elasticity of substitution depends upon the value of a.

• The marginal products are positive and slope downwards.

2. Merits of CES Production Function

The merits of CES production are as follows:

• Covers a number of parameters, such as efficiency and
substitutability
• Easy to estimate

• Free from unrealistic assumptions, such as fixed technology, etc.

3. Demerits of CES function

The demerits of CES production system are as follows:

• Fails to fit for manufacturing industries

• Cannot be maximization in case of n factors of production

• Fails to give correct economic implications

68
6.4 LAW OF PRODUCTION FUNCTION
Law of production function considers two types of Input-Output
relationships:
a) The input-output relationship when certain inputs are kept fixed and
other inputs are made variable. It is called as Law of variable
proportion;
b) When all the inputs are made variable. It is called as Law of returns to
scale.

6.4.1 Iso Quant

To understand the production function with two variable inputs, iso-quant
curve is used. These curves show the various combinations of two
variable inputs resulting in the same level of output. The shape of an Iso-
quant reflects the ease with which a producer can substitute among inputs
while maintaining the same level of output. From the graph we can
understand that the iso-quant curve indicates various combinations of
capital and labour usage to produce 100 units of motor pumps. The points
a, b or any point in the curve indicates the same quantum of production.
If the production increases to 200 or 300 units definitely the input usage
will also increase therefore the new iso-quant curve for 200 units (Q1) is
shifted upwards. Various iso-quant curves presented in a graph is called
as iso- quant map.

Figure.6.1 Iso-Quant
The above graph explains clearly that the iso quant curve for 100units of
motor consists of ‘n’ number of input combinations to produce the same
quantity. For example, at ‘a’ to produce 100 units of motors the firm uses
OC amount of capital and OL amount of labour, more capital and less
labour force. At ’b’ OC1 amount of capital and OL1 labour force is used to
produce the same that means more labour and less capital.

69
6.4.2 Iso – Cost
Different combination of inputs that can be purchased at a given
expenditure level.
Optimal input combination: The points of tangency between the iso
quant and the iso cost curves depict optimal input combination at different
activity levels.

Figure.6.2 Combination of iso-quant and iso-cost

Expansion path: Optimal input combinations as the scale of production
expand. From the graph it is clear that the optimum combination is
selected based on the tangency point of the iso cost (budget line) and the
iso- quant i.e., a, b respectively. The point ‘a’ indicates that to produce
100 units of motor the best combination of capital and labour are OC and
OM which is within the budget. Over a period of time a firm will face
various optimum levels, if we connect all the points , that we derive at the
expansion path of a firm.

6.5 LAW OF VARIABLE PROPORTIONS

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 possible 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 the others remains constant. Since all the factors
are not easily available in the required quantities, it becomes necessary
to keep the scarce factor constant and increase the quantity of other
factors. Such factors whose quantities are given and fixed are called
Fixed Factors, while those whose supply can be easily changed are called
Variable Factors. Therefore, to bring about an increase in the output, the
producer would use more of the variable factor with the given quantity of

70
the fixed factors. In the theory of production, the law that examines the
relationship between one variable factor and output, keeping the
quantities of other factors fixed, is called the Law of variable proportions.
Under this law we study the effects on output of variations in factor
proportions and this has come to be known as the law of variable
proportions. Different economists have variously defined this law.
“As the proportion of the factor in a combination of factors is increased,
after a point, first the marginal and then the average product of that factor
will diminish”.

Assumptions of the Law of Variable Proportions

The law is based upon the following assumptions:

• The state of technology in production remains constant and
unchanged. If there is any improvement in technology, the average
and marginal output will not decrease but increase.
• Only one factor of input is made variable and other factors are kept
constant. This law does not apply in case all factors are
proportionately varied. Behaviour of output as a result of the
variations in all inputs is studied under “Returns to Scale”.
• 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.
• All units of the variable factor are homogeneous.

• 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

The behaviour of the output when the varying quantity of one factor is
combined with a fixed quantity of the other can be divided into three
distinct stages. The three stages could be better understood by the Table
6.2. With data of the schedule, the law is illustrated by means of a Figure
6.2 by taking the variable factor in the X axis and the output in the Y axis.

71
 Figure. 6.3 Stages of 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.

Fixed Variable Total Average Marginal

Factor(Machine) Factor(Labour) Prod. Prod. Prod. (in
(in (in units)
units) units)

(1) (2) (3) (4) (5)

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 9.1 0

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

72
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 to the
increasing stage where the total product, the marginal product and
average product are increasing. It is the Increasing Returns Stage.
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 place the Second Stage ends. In
this stage, the marginal product 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 cuts the X axis.
This second Stage is the Stage of Diminishing Returns.
Stage III: In this Stage, the total Product declines and therefore the TP
curve slopes downwards. The marginal product becomes negative
cutting the x axis. This Stage is called the Negative Returns Stage.
Thus, the total product, Marginal product and average product pass
through three phase’s viz., increasing, diminishing and negative returns
stage. The law of variable proportions is nothing but the combination of
the Law of Increasing and Diminishing Returns.
Now, the question is in which Stage will the producer seek to produce the
commodities. Being rational, a producer will not come to the third Stage
where the marginal product becomes negative. The producer will not
choose to produce to get negative returns. The producer will also not
choose to produce in Stage I, as he will not be making the best use of the
fixed factor and he will not be utilizing fully the opportunities of increasing
production by increasing quantity of the variable factor whose average
product continues to rise throughout the Stage I. So, the rational producer
will not stop in Stage I, but expand further. Stage I and III are stages of
economic absurdity representing non-economic region in production
function. Hence the producer will produce in Stage II, where the total
product leads to the maximum at which particular point of the Second
Stage the producer will decide to produce depending upon the prices of
factors. Stage II represents the range of rational production.

6.6 LAW OF RETURN TO SCALE

The law of return to scale explains how the proportionate increase or
decrease of all the factors of production to have some impact on the
output. Normally this law of return to scale can be operated only in the
long-run phenomenon, as during this period any alteration of any or all the
factors of production is possible. But in the shot-run only variable factors
can get altered, so this law is not meant for the short run.

73
Whenever the firm expands its activities through the input alterations, one
can get three types of possibilities

a. the return in unit may increase more than proportionally.

b. It may be at equal proportion or

c. the return may be less than proportionate to the inputs. All these
three possibilities are called as various stages of return to scale. The
return in units is normally measured with the help of marginal
products (MP).

Stages of Return to Scale

Following are the different stages of return to scale:

Assumptions
• Technique of production is unchanged

• All units of factors are homogeneous

• Returns are measured in physical terms

i) Law of Increasing Return to Scale

The law of increasing returns describes increasing returns to scale.
There are increasing returns to scale when a given percentage
increase in input will lead to a greater relative percentage increase in
the resultant output.
∆Q ∆F
Algebraically, Q , F
∆Q
Where =Proportionate change in output and
Q
∆F
= Proportionate change in inputs (factors).
F

The production function coefficient (PFC) in the long run is, thus,
measured by the ratio of the proportionate change in output to a given
proportionate change in input. In symbolic terms:
(∆Q/Q) ∆Q 𝐹
PFC = or Q × ∆𝐹
(∆F/F)

If PFC > 1, it means increasing returns to scale.

74
 Figure. 6.3 Returns to Scale
Diagrammatically, the law of increasing returns may be represented
as in Figure. 6.3. In Figure. 6.3(A), the curve IR is an upward sloping
curve denoting increasing returns to scale. The increasing returns to
scale are attributed to the 75ealization of internal economies of scale
such as labour economies, managerial economies, technical
economies, etc., with the expansion of the size of the firm.
Marshall explains increasing returns in terms of ‘increased efficiency’ of
labour and capital in the improved organisation with the expanding scale
of output and employment of factor input. It is referred to as ‘the economy
of organisation’ in the earlier stages of expansion.
In short, increasing returns may be attributed to improvements in large
scale operation, division of labour, use of sophisticated machinery, better
technology, etc. Thus, increasing returns to scale are due to indivisibilities
and economies of scale and technological advancement.

Law of constant return to Scale

The process of increasing returns to scale, however, cannot go on forever.
It may be followed by constant returns to scale. As the firm continues to
expand its scale of operations, it gradually exhausts the economies
responsible for the increasing returns. Then, the constant returns may
occur. There are constant returns to scale when a given percentage
increase in inputs leads to the same percentage increase in output.
∆Q ∆F
Algebraically, = . It implies that the doubling of factor inputs doubles
Q F
the output.Thus, PFC = 1 under constant returns to scale.
Diagrammatically, the law of constant returns may be represented as in
Figure 6.3(B).
In Figure 6.3(B), the curve CR is a horizontal straight-line depicting
constant returns to scale. The operation of the law of constant returns to
scale implies that the effect of internal economies emerging in certain
factors is neutralized by internal economies that may result in some other

75
factors, so that the output increases in the same proportion as input. It
must be noted that constant returns to scale are relevant only for the time
periods in which adjustment of all factors is possible.
According to Marshall, the law of constant returns tends to operate when
the actions of the laws of increasing returns and decreasing returns are
balanced out; or in other words, economies and diseconomies of scale
are exactly in balance over a range of output.
Constant returns to scale are quite often assumed in economic theoretical
models for simplification. Such an assumption is based on the following
conditions:

1. All factors are homogeneous.

2. All factors are perfectly substitutable.

3. All factors are infinitely divisible.

4. The supply of all factors is perfectly elastic at the given prices.

ii) Law of diminishing returns to scale

As the firm expands, it may encounter growing diseconomies of the
factors employed .As such when powerful diseconomies are met by feeble
economies of certain factors, decreasing returns to scale set in. There are
decreasing returns to scale when the percentage increase in output is less
than the percentage increase in input.
∆Q ∆F
Algebraically, Q < F . Thus, PFC < 1 under decreasing returns to scale.

Diagrammatically, the law of decreasing returns may be presented as in

Figure 6.3©.
In Figure 6.3 ©, the curve DR is a downward sloping curve denoting
decreasing returns to scale.
Decreasing returns to scale are usually attributed to increased problems
of organization and complexities of large-scale management which may
be physically very difficult to handle.
Economists generally consider the following causes for the decreasing
returns to scale:
1. Though all physical factor inputs are increased proportionately,
organisation and management as a factor cannot be increased in
equal proportion.
2. Business risk increases more than proportionately when the scale
of production is enhanced. An entrepreneurial efficiency has its
own physical limitations.

76
 3. When scale of production increases beyond a limit, growing
diseconomies of large-scale production set in.
4. The increasing difficulties of managing a big enterprise. The
problem of supervision and coordination becomes complex and
intractable in a large-scale of production. A very large enterprise
may become unwieldy to manage.
5. Imperfect substitutability of factors of production causes
diseconomies resulting in a declining marginal output.

6.7 LEAST COST COMBINATION

The problem here is to find out a combination of inputs, which should cost
the least, i.e., minimization of cost. The tangency of iso-cost and iso-quant
would indicate the least cost combination of X1and X2, i.e., slope of iso-
quant = slope of iso-cost. Least cost combination is given, algebraically,
by equating
∆𝑋1 P𝑋
MRSx2x1 = =− Q𝑋2 , i.e., - Px1(∆X1) = Px2(∆X2)
Q𝑋2 1

Figure. 6.4 Least Cost Combination

If - Px1 (ΔX1) > Px2 (ΔX2 ), then, the cost of producing the given output
amount could be reduced by increasing X2 and decreasing X1 because
the cost of an added unit of X2 is less than the cost of the units of X1, it
replaces. On the other hand, if between two points of the isoquant, Px 1
(ΔX1) < - Px2 (ΔX2), then the cost of producing the specified quantity of
output can be reduced by using less X2 and adding X1. The marginal
physical product equations can be used to determine the returns per
rupee spent at the least cost point. Rewriting the l east cost combination
as:

77
Limitation

i) Factors may not be always perfectly divisible as labour and capital

ii) It will be very difficult to calculate the marginal product of each
factor.
iii) The producer has to decide not only the best proportion of factors,
but also the best scale of production.

LET US SUM UP
A firm is a business unit that undertakes the activity of transforming inputs
into outputs of goods and services. In the production process, a firm
combines various inputs in different quantities and proportions to produce
different levels of outputs. The producer is intention in to produce those
outputs with least cost combination of various inputs. This concept again
leads to minimized cost and expanded business operations. Analysis of
production helps the students to know about various stages of law of
returns to scale. It explains how proportionate change in the combination
of two inputs leads to different stages in the law.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1.Marginal product of labour is the addition to the total product resulting
from a unit increase in the employment of ___________

a) Labour b) Engineer

c) Expert d) None of them

2.The scale of production of a firm is determined by the amount of
__________

a) Factors units b) Fixed units

c) Both of them d) None of the above

3.An ISO-quant derived from quantity and the Greek word __________

a) IGO b) SD

78
 c) ISO d) None of the above
4.The technological-physical relationship between inputs and outputs is
referred to as the __________

a) Demand Function b) Production function

c) Supply Function d) None of them

5.The average product refers to the total product per unit of a given
_____________factor.

a) Variable b) Fixed

c) Sloping Curve d) None of them

GLOSSARY

Production function : Production function expresses in

physical terms the relationship between
factor input and the resulting output.
Average product of labour is the ratio of
total product to the units of labour input.

The law of variable : The law of variable proportion is based

proportions upon the fact that all factors of
production cannot be substituted for one
another.

ISO-quant : An ISO-quant derived from quantity and

the Greek word ISO, meaning equal is
a contour line drawn through the set of
points at which the same quantity of
output is produced while changing the
quantities of two or more inputs.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.

79
 5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://corporatefinanceinstitute.com/resources/economics/factors-
of-production/
8. https://www.youtube.com/watch?v=7phzEfJmUKc
9. https://www.economicsdiscussion.net/notes/study-notes-on-
isoquants-with-diagram/16342

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) c 4) b 5) a

80
Unit 7

COST ANALYSIS
STRUCTURE

Overview

Learning Objectives

7.1 Types of Cost

7.2 Cost-output Relationship

7.3 Economies and Diseconomies of Scale

7.4 Cost Functions

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
The cost analysis is essential for effective project planning. It is
concerned with the supply side of the market. Cost is the basis for pricing.
Price affects profit, which in turn affects the business. Hence, this unit will
discuss the various Cost Concepts and Cost-output relationship both in
the short-run and long-run. The advantages of large-scale production are
also helpful to the small entrepreneurs to work hard and to improve their
business.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define various cost concepts

• describe the cost-output relationship

• analyse the forms of internal and external economies

• discuss the different cost functions.

81
7.1 TYPES OF COST

(i) Money Cost and Real Cost

The total money expenses incurred by a firm or a producer in the
production of goods is said to be the ‘Money Cost’.

Example: Rent, wage, interest, EB bill, fuel etc.

Real Cost is not explained in terms of money. It is explained in terms
of efforts, troubles, sacrifices etc.

(ii) Explicit Cost and Implicit Cost

The direct money payments by a firm towards rent, wage, interest,
taxes etc., is known as the ‘Explicit Cost’.
The money payments made to the factors contributed by the
entrepreneur is called ‘Implicit Cost’. The implicit Cost is also called
‘Imputed Cost’.

(iii) Opportunity Cost

Wants are unlimited and means to satisfy them are limited. This
scarce means also capable of alternative uses. Thus, the problem
of choice is involved. Hence, when we select the resource in one
use, the second alternative use of the resources is to be sacrificed.
Thus, the sacrifice or loss of opportunity of alternative use of a given
resource is called ‘Opportunity Cost’ or ‘Alternative Cost’.
(iv) Short-run Cost and Long-run Cost
Short-run is a period in which at least one factor input remains
constant. Therefore, short-run cost is the cost which varies with
output when the plant and equipment remains constant.
Long-run is a period in which all the factor inputs including the plant
and equipment are varied. Therefore, long-run cost is the cost which
varies with output when all the factor inputs including plant and
equipment vary.

(v) Out of Pocket Cost and Book Cost

Out of Pocket Costs are those costs that involve immediate cash
payments to outsiders.

Example: Salaries to employees.

Book Costs are those costs which do not involve immediate cash
payments. Such costs are included in the books of account.

Example: Salary to the owner. Credit Purchase

82
(vi) Past Cost and Future Cost
Past Costs are the actual costs incurred in the past and they are
furnished in the statement of income or financial accounts.
Future Costs are those costs which are likely to be incurred by a firm
in future periods.

(vii) Acquisition Cost

Acquisition Costs are those costs incurred to acquire a commodity.
These costs are generally recorded in the account books.

Example: hiring land, labour, capital, management etc..

(viii) Historical Cost and Replacement Cost

Historical Cost of an asset is the actual cost of the asset at the time
of purchase of the asset.
Replacement Cost of an asset is the cost which will likely to be
incurred in case the said asset is to be purchased now.

(ix) Separable (Traceable) Cost and Common (Non-Traceable) Cost

Separable Costs are those costs which can be attributed (or traced)
to a particular product or a department or a process.

Example: The cost of raw materials.

Common Costs are those costs which cannot be traced to any
particular product or a department or a process.
Example: Electricity charges.
(x) Escapable (Avoidable) Cost and Inescapable (Unavoidable)
Cost
Escapable Costs are those costs which can be reduced by affecting
contraction in the activities of the business enterprise.

Example: Painting the factory building.

Inescapable Costs are those costs which cannot be avoided by
reducing the output.

Example: Depreciation Costs.

(xi) Sunk Cost and Incremental Cost

Sunk Cost is one which cannot be affected or altered by a change
in the level of output or nature of business activity or business
decision. This cost will remain the same, whatever be the level of

83
 activity of the firm. Incremental Cost is one, if it results from a
decision.

(xii) Controllable Cost and Uncontrollable Cost

Controllable Costs are those costs which can be identified and
controlled by the business executives.

Example: Labour cost, raw materials etc.

Uncontrollable Costs are those costs which cannot be controlled by
business executives.

Example: Property tax.

7.2 COST-OUTPUT RELATIONSHIP

The Cost – Output relationship has two aspects:

i) Cost-Output relationship in the Short-Run and

ii) Cost-Output relationship in the Long-Run.

Cost-Output relationship in the Short-Run

The short-run is a period in which at least one factor input remains
constant. Hence, in the short-run, any increase in output can be achieved
by using the existing equipment. Since fixed equipment of the firm cannot
be altered in the short-run, more output can be achieved only at higher
marginal cost. The short-run cost – output relationship refers to a
particular scale of operation or to a fixed plant. The cost – output
relationship in the short-run may be studied in the following terms:

Total Cost
The Total Cost is the aggregate of expenditure incurred by a firm in
producing a given level of output. Total Cost is the sum of Total Fixed
Cost and Total Variable Cost.

TC =TFC + TVC

Total Fixed Cost

The Total Fixed Cost is a cost which does not vary with output in the short-
run. But it may vary in the long-run. It includes rent, depreciation, interest
etc.

84
 Figure.7.1 Total Costs

Total Variable Cost

The Total Variable Cost is a cost which do vary with output. In other
words, the total variable cost is a cost which rise when output expands
and fall when output contracts. It includes wages, raw materials,
power, fuel etc.

Average Fixed Cost

The Average Fixed Cost is obtained by dividing the Total Fixed Cost
by Total Output. Therefore,
TFC
AFC= N

Figure 7.2. Average Fixed Cost

Average Variable Cost

The Average Variable Cost is obtained by dividing the Total Variable
Cost by Total Output. Therefore,
TVC
AVC= N

85
 Figure 7.3 Average Variable Cost

Average Cost (or) Average Total Cost

The Average Cost or the Average Total Cost or Cost per Unit is
obtained by dividing the Total Cost by Total Output.
TC
ATC or AC =
N

= AFC + AVC
Therefore, Average Cost is the sum of Average Fixed Cost and
Average Variable Cost.

Figure 7.4 Average Cost or Average Total Cost

Marginal Cost
The Marginal Cost is the additional cost made to the total cost by
producing one more unit of the output. Mathematically, Marginal Cost
is the first order derivative of the total cost function. Hence, Marginal
Cost gives the slope of the total cost curve.
MC =TCn – TCn-1

Where MC = Marginal cost

TCn = Total cost of current output

TC n-1= Total cost of precious output

86
The following Figure is used to explain MC

Figure 7.5 Marginal Cost

Cost – Output relationship in the short-run is summarized below:

1. TFC remains constant at all levels of output.

2. TVC initially increases at a diminishing rate, but after a point,
it increases at an increasing rate.
3. TC varies in the same proportion as TVC.

4. AFC declines continuously as output increased.

5. AVC first declines, reaches a minimum and then rises as
output is increase.

6. AC ‘u’‘U’ shaped curve.

7. MC also first declines and then increases as output
increased.

i) Cost-Output relationship in the Long-Run.

In order to study the cost – output relationship in the long-run, it is
imperative to know the concept of long-run cost. The long-run cost is
a cost which varies with output when all the factor inputs including
plant and equipment vary. The long-run cost-output relationship is
shown graphically by the Long-Run Cost Curve (LAC) – a curve
showing how costs would change when the scale of production is
changed. To draw a long-run cost curve, we have to start with a
number of Short-Run Average Cost Curves (SACs), each curve
representing the size of the plant.

Figure. 7.6 Long-Run Average Cost Curve (LAC)

87
 In Figure 7.6, SAC1 indicates the initial SAC. In this case output is
OQ1 units at the lowest average cost P 1Q1. If output is increased from
OQ1 to OQ2, the average cost is increased from P 1Q1 to P2Q2. If
output is further increased from OQ2 to OQ3, the average cost is
increased from P2Q2 to P3Q3. If we join the three points P 1, P2 and P3,
we can get the LAC curve.

7.3 ECONOMIES AND DISECONOMIES OF SCALE

7.3.1 Economies of Scale

Under large scale production, the producer obtains a number of
advantages. These advantages are called ‘Economies of Scale’. These
economies of scale may be classified into two. They are:

i) Internal Economies and

ii) External Economies.

i) Internal Economies
Internal Economies are those economies which accrue to a single firm
when its size expands. They emerge within the firm itself as its scale
of production increases. Thus, internal economies are the functions of
the size of the firm.

Forms of Internal Economies

• Labour Economies: Large scale production leads to division of
labour. This division of labour increases the production, and in
turn, the cost of production is low.
• Technical Economies
• As a firm expands its size, it can use modern machines and
techniques. Such modern machines are more efficient and
hence their output is large.
• The large scale producer can establish his own research which
reduces the cost of production.
• The large-scale producer can make use of waste materials for
manufacturing by-products.
• Marketing Economies
• The large scale producer can purchase raw materials on a
large scale at low cost than a small scale producer.
• The large-scale producer can use effective advertisements
which increases the demand for his product.

88
 • The large-scale producer can employ the transport
companies. Hence, he can secure low rates from them.
• Managerial Economies

When output increases, the cost per unit of management will

fall. Thus, with the increasing scale of output, greater
managerial economies are enjoyed by an expanding firm. A
good manager can organise a large output with the same
efficiency. Further, his remuneration normally remains the
same whether the output is large or small. A large scale firm
can employ an efficient manager by paying good salary and
hence its overall administration will be more efficient as well as
economical.
• Financial Economies

Since large scale producer enjoys a good reputation in the

market and greater influence in the money market, he can
easily secure credit facilities at cheaper rates of interest than
to the small scale producers.
• Risk Bearing Economies

The large scale firm is able to reduce risks by compensating

the loss of one market by the profit from another market.

ii) External Economies.

External Economies are those economies which accrue to all the firms
in an industry when their size expands. Hence, external economies
are enjoyed by all the firms in an industry. External economies accrue
to all the firms in an industry, irrespective of their size and scale of
production.

Forms of External Economies

The types of external economies are grouped under the following
headings:
• Economies of Localization

When large number of firms producing the same commodity are

located in a particular place, all the firms enjoy mutual advantages
like skilled labour, transport facilities, credit facilities, repairs and
maintenance of machines.

89
 • Economies of Information

In a large industry, research work is done jointly. Hence, producers

are saved from independent research which is more costly. Each
firm enjoys the benefits of research. Market information is also
readily available to all the firms.
• Economies of By-Products

Under large industry, waste materials can be converted by-

products.

7.3.2 Diseconomies of Scale

When there is an expansion of the firm beyond an optimum limit, certain
disadvantages of large scale production (diseconomies) emerge. They
are:
• Difficulties of Management
As a firm expands, problems of management increase. The manager
finds it difficult to control the organisation. The problem of supervision
becomes complex which leads to mismanagement.
• Difficulties of Coordination

As the size of the firms increases, the task of coordination becomes

more difficult. Hence, the manager has to face many problems of
decision making which increases the cost of production.
• Labour Diseconomies

In a large firm, the contact between the management and workers

becomes less. Hence, there are more chances for labour disputes and
unrest.
• Increased Risk

As the scale of production increases, investment also increases and

hence the risks of business also increase. For example, if the
anticipated demand for the product is incorrect, there will be heavy loss
to the firm.
• Evils of Factory System

Since large numbers of firms producing the same commodity are

located in a particular area, there may be evils of factory system like
overcrowded, poor housing, pollution, long hours of work etc.

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7.4 COST FUNCTIONS
Cost Function explains the relationship between the costs (expenditure)
incurred in production and the output of a commodity.

C = f (x)
There are three types of cost functions namely, linear, quadratic and
cubic.

Linear Cost Function

A linear short-run cost function is stated as:

TC = a + bQ

Where,
a and b are constant parameters, a is intercept, b is slope coefficient.
Here, ‘a’ represents total fixed cost and ‘bQ’ represents total variable cost.
Thus:
TFC a
AFC = =Q
Q
TTC
AFC = =b
Q
TC a+bQ a
ATC =Q = = Q+ b
Q
dTC
MC = dQ = b

When plotted graphically linear cost function depicts TC, AC and MC

curves as illustrated in Figure 7.7.

Figure. 7.7 Linear Cost Function

Quadratic Cost Function

Quadratic Cost Function is represented by the equation.

C=a + bQ + cQ2

In this case:
a
AC= + b + cQ
Q

91
 MC= b + 2cQ
The graphical representation of the Quadratic Function is
inFigure7.8.

Figure. 7.8 Quadratic Cost Function

Cubic Cost Function

Cubic Cost Function is represented by the equation,

TC=a + bQ – cQ2 + dQ3

a
AC=Q + b – cQ + dQ2

MC=b – 2cQ + 3dQ2

The shape of the curve of the Cubic Cost Function will be as in Figure 7.9.

Figure. 7.9 Cubic Cost Function

LET US SUM UP
In this unit we have emphasized the different types of costs, cost functions
and the cost-output relationship in the short run and long run. We have
also analysed the economies and diseconomies of scale. The
advantages obtained by the large-scale producer are called ‘Economies
of Scale’. In this unit, we have discussed the cost functions. Cost
Function explains the relationship between the costs incurred in
production and the output of a commodity. Linear, Quadratic and Cubic
Cost functions are also analysed.

92
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Total cost divided by total output is ___________

a) Marginal cost b) Average cost

c) Average variable cost d) Average fixed cost

2. The additional cost made to total cost by producing one more unit of
output is___________

a) Marginal cost b) Average cost

c) Money cost d) Real cost

3. TFC + TVC =___________

a) Marginal cost b) Total cost

c) Money cost d) Real cost

4. Cost per unit is also called ___________

a) Marginal cost b) Average cost

c) Money cost d) Real cost

5. The relationship between the cost incurred in production and the output
of a commodity is known as___________

a) Marginal cost b) Average cost

c) Money cost d) Cost function

GLOSSARY

Total cost : The Total Cost is the aggregate of expenditure

incurred by a firm in producing a given level of
output.

Average cost : The Average Cost or the Average Total Cost

or Cost per Unit is obtained by dividing the
Total Cost by Total Output.

Marginal cost : The Marginal Cost is the additional cost

made to the total cost by producing one more
unit of the output. Mathematically, Marginal
Cost is the first order derivative of the total
cost function.

93
Economies of scale : Under large scale production, the producer
obtains a number of advantages. These
advantages are called ‘Economies of Scale’.

Diseconomies of : When there is an expansion of the firm

scale beyond an optimum limit, certain
disadvantages of large scale production
(diseconomies) emerge.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S.
Chand Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan
Chand & Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics :
Concepts & Cases, Tata McGraw-Hill Publishing Company Limited,
New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://study.com/academy/lesson/economies-diseconomies-of-
scale.html
8. https://theintactone.com/2019/10/01/me-u3-topic-2-cost-output-
relationship-in-short-run-long-run-cost-curves/
9. https://www.economicsdiscussion.net/production/cost-of-
production/8-main-types-of-costs-involved-in-cost-of-production-
and-revenue-with-diagram/13829

ANSWERS TO CHECK YOUR PROGRESS

1) b 2) a 3) b 4) b 5) d

94
 BLOCK 3

MARKET STRUCTURE

Unit 8 : Market Structure

Unit 9 : Perfect Competition Market

Unit 10 : Monopolistic Competition

Unit 11 : Oligopoly Market

Unit 12 : Pricing

95
Unit 8

MARKET STRUCTURE
STRUCTURE

Overview

Learning Objectives

8.1 Meaning of Market

8.2 Definitions of Market

8.3 Market Structure

8.4 Forms of Market Structure

8.5 Equilibrium of a Firm

8.6 Pricing under Different Market Structure

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
The price-output decisions by a firm are influenced by the structure and the different
forms of the market. The structure of the market is determined by the nature and
pattern of competition which prevails. There are many market structures. Different
market structures affect the behaviour of the buyers and sellers. If there are large
number of buyers and sellers are selling homogeneous products, perfect competition
will prevail. If there is existence of many firms and also there is product differentiation,
then monopolistic competition will prevail and if there are few sellers in the ma rket,
oligopoly will be obtained.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define the concept of market

• classify the various market structures

• determine pricing of products under different market structures.

96
8.1 MEANING OF MARKET
In ordinary language, market refers to a place where goods and services are bought
and sold. But, in Economics, it has no reference to a place, but to a commodity which
is being bought and sold. That is a market refers to a group of buyers and sellers
dealing with a particular commodity for a price at a particular time.

8.2 DEFINITIONS OF MARKET

Different Economists have defined market in different ways:

Cournot defines market as “… not any particular market place in which things are
bought and sold, but the whole of any region in which buyers and sellers are in such
free intercourse with each other that the prices of the same goods tend to equal easily
and quickly.”
To Ely, “Market means the general field within which the force determining the price
of particular product operate”.
According to 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”.
Stonier and Hague defines market as “any organisation whereby buyers and sellers
of a good are kept in close touch with each other …”

8.3 MARKET STRUCTURE

The price – output decisions which are taken by a firm are very much influenced by
the forms and structure of the market for goods and services. The structure of the
market, commodity market as well as factor market is determined by the nature and
pattern of competition which prevails. There are many different market structures,
which affect the behaviour of buyers and sellers. Further, different prices and trade
volumes are influenced by different market structures.

8.4 FORMS OF MARKET STRUCTURE

The Economists have standard forms of market structure that are based on the
nature of competitive conditions. They are:
i. Perfect Competition
A perfectly competitive market is one which satisfies the following features:
• A large number of buyers and sellers in the market.

• The sellers are selling homogeneous or identical products.

• The firms are free to enter or leave the industry.

• There exists perfect knowledge on the part of the buyers and sellers
regarding the market conditions.

97
 • There is perfect mobility of factors.

• There are no transport costs.

• There is only one price for the commodity.

ii) Monopoly
Monopoly is a market situation in which there is only one seller of the commodity
which has no substitutes.

iii) Discriminating Monopoly

It means charging of different prices from different consumers for the same
commodity at the same time.

iv) Bilateral Monopoly

It is a market situation in which single seller faces a single buyer.

v) Monopsony
It is a market situation in which there are many sellers but there is a single buyer
of a commodity.

vi) Duopoly
It refers to a market situation in which there are only two sellers selling
homogenous products.

vii) Oligopoly
It refers to a market situation in which there are few sellers selling either
homogeneous products or products which are having close substitutes but no
perfect substitutes.
vii) Monopolistic Competition
It refers to a market situation in which there are many producers produce products
which are close substitutes.

8.5 EQUILIBRIUM OF A FIRM

In the short-run, a firm is said to be in equilibrium at the point of intersection of the
marginal cost and marginal revenue curves. The first condition for the equilibrium of
a firm is that marginal revenue should be equal to marginal cost. The second
condition for equilibrium requires that marginal cost curve should cut the marginal
revenue curve from below. In the long-run, firms are in equilibrium when they have
adjusted their plant so as to produce at the minimum point of their long-run AC Curve.

8.6 PRICING UNDER DIFFERENT MARKET STRUCTURE

In this section, let us study the pricing of products under Perfect Competition,
Monopolistic Competition and Oligopoly.

98
8.6.1 Pricing Under Perfect Competition
In a market, the exchange value of a product expressed i n terms of money is called
price. In a market economy, the equilibrium price is determined by the market forces.
Under perfect competition, there is a single ruling market price the equilibrium price,
determined by the interaction of forces of total demand (of all the buyers) and total
supply(of all the sellers) in the market.
Thus, both the market or equilibrium price and the volume of production in a market
under perfect competition are determined by the intersection of total demand and total
supply. To elucidate the prices of intersection, let us consider hypothetical data on
market demand for and market supply of wheat, as in Table 8.1.

Table 8.1 Market Demand and Supply Schedules for Wheat

Price of Total Total Supply Pressure on

Wheat (in Demand (in (in Kg) Price
Rs. Per kg) Kg)

20 1000 10000 Downward

19 3000 8000 Downward

18 4000 6000 Downward

17 5000 5000 Neutral

16 7000 4000 Upward

15 10000 2000 Upward

Comparing the market demand and supply position at alternative possible prices, we
find that when the price is Rs. 20, supply of wheat is 10,000 kg., but demand for wheat
is only 1,000 kg. Hence,9,000 kg. of wheat supply remains unsold. This would bring
a downward pressure on price, as the seller would compete and the force will push
down the price. When the price falls to Rs. 19, demand rises to 3,000 kg., while the
supply will contract to 8,000 kg. Still the supply is in excess of demand. Thus, the
surplus of the supply causes a further downward pressure on price. Eventually, the
price will tend to fall. This process continues till the price settles at Rs. 17 per kg. at
which the same amount (5,000 kg.)is demanded as well as supplied. This is termed
as equilibrium price. Equilibrium price is the market clearing price. In this price, market
demand tends to be equal to the market supply.
If, however, we begin from a low price (Rs. 15 per kg.), we find that the
demand(10,000 kg.) exceeds the supply (2,000 kg.). Thus, there is a shortage at Rs.
15 per kg. This causes an upward pressure on the price, so the price will tend to move
up. When the price rises, the demand contracts and the supply expands. This process

99
continues till the equilibrium price is reached, at which the demand becomes equal to
the supply. At equilibrium price, there is neutral pressure of demand and supply forces
as both are equal in quantity. In general, a pictorial depiction of price is determined at
the intersection point of the demand curve and the supply curve.
In Figure 8.1, PM is the equilibrium price, at which OM is the quantity demanded as
well as supplied. At point P, the demand curve intersects the supply curve. To
understand the process of equilibrium, suppose the price is not at the equilibrium
point. Now, if the price is higher than the equilibrium price, as OP1, then at this price
the supply is P1b, while the demand is P1a. Thus, there is a surplus amounting to ab.
That is to say, more is offered for sale than what the people are willing to buy at the
prevailing price. Hence, to clear the stock of unsold output, the competing sellers will
be induced to reduce the price. Eventually, a downward movement and adjustment,
as shown by the downward pointed arrows, will begin, which would lead to: (i) the
contraction of supply, as the firms will be prompted to reduce their resources in the
industry, and (ii) the expansion of demand, as the marginal buyers* and other potential
buyers will be attracted to buy in the market and old buyers also may be induced to
buy more at the falling price. Similarly, if the price is below the equilibrium level, the
demand tends to exceed the supply.

Figure. 8.1 Market Price Determination

At OP2price, for instance, the demand is P 2d, while the supply is P 2c. Thus, there is a
shortfall of supply amounting to cd. That is to say, buyers want to purchase more than
what is available in the market at the prevailing price. This induces the competing
buyers to bid up the price. So, an upward push and adjustment will develop as shown
by the arrows pointed upwards. Thus, the demand contracts as marginal buyers will
be driven away from the market and some buyers will buy less than before. On the
other hand, the supply expands as the existing firms will increase their output to which
new firms will also add their output. Evidently, when the price is set at an equilibrium
point at which the demand curve intersects the supply curve, shortages and surpluses
disappear, hence there is perfect adjustment between demand and supply under the
given conditions. So long as demand and supply positions are unchanged, the ruling
equilibrium price will prolong over a period of time.

100
8.6.2 Pricing Under Monopolistic Competition
A firm under monopolistic competition is a price-maker. Thus, unlike perfect
competition, there is a pricing problem. The firm has to determine a suitable price for
its product which yields a maximum total profit. Assuming a given variety of product
and constant selling outlays, when price is considered as the only variable factor, the
short-run analysis of price adjustment by an individual firm under monopolistic
competition, more or less, entails the same features like that of price-output
determination under pure monopoly. In the long-run, however, a major difference is
noticeable in the equilibrium process and position due to a change in demand
conditions and other factors associated with the process of group equilibrium.

The Short-run Equilibrium

To explain the process of individual equilibrium, we assume that all other producers
are in equilibrium with respect to their prices, varieties of products, and sales outlays.
We further assume that the firm which we have taken in our consideration has also a
given variety of product and constant sales expenditure. Hence, there is only the
problem of price and output determination.
In the short-run, the firm can adopt an independent price policy, with least
consideration for the varieties produced and prices charged by other producers. The
firm being rational in determining the price for a given product will seek to maximise
total profits.
Since the quality of product is assumed to be given, we have a definite demand
schedule for it. Again as the product is differentiated, the demand curve is downward
sloping. The demand curve or the sales curve of the firm in a monopolistically
competitive market is, however, much more elastic than that of a firm in a pure
monopoly. This is so because there is a large number of a competitor selling similar
products as close substitutes, whereas in the case of pure monopoly, there is absence
of competition. The precise shape and degree of elasticity contained in the demand
curve of a firm under monopolistic competition, however, depends on two factors:

(i) the number of firms in the group, and

(ii) the extent of product differentiation.

If, however, the group has a large number of firms and if the product differentiation is
relatively weak, the demand curve of each firm will be highly elastic. If, however, the
group is relatively small and the product differentiation is prominently significant, then
the demand curve of each firm will tend to be less elastic.
Knowing the demand curve, which is the sales curve of the firm for a given product,
we can easily derive its marginal revenue curve. The demand curve itself is the
average revenue curve, which is downward sloping curve for a firm in a

101
monopolistically competitive market. The marginal revenue curve also slopes
downward and lies below the average revenue curve.
In order to maximise its total profits or minimise its losses in the short-run, the firm
produces that level of output at which marginal cost is equal to marginal revenue (i.e.,
MC= MR). Thus, equilibrium output is determined at the point of intersection of the
MC curve and the MR curve as shown in Figure 18.2.

Figure.8.2 Short-run Equilibrium of a Monopolistically Competitive Firm

In Figure, 8.2, we have assumed the case of a representative firm with hypothetical
cost and revenue data in a monopolistically competitive market. For the sake of
simplicity, it is thus assumed that: (i) demand conditions, and (ii) cost conditions are
identical for all the firms in the group. These assumptions, in fact, are the bold
assumptions made by Chamberlin in his theory of monopolistic competition and its
characteristic, i.e., diversity of group under product differentiation. No doubt, these
assumptions very much simplify our model, but they are not altogether unrealistic. In
the case of retail shops such as provision stores or chemist shops, etc; standardized
products will tend to have more or less identical demand and cost conditions, as their
product differentiation is confined to only locational differences.

Equilibrium point E is determined where, SMC = SMR. OP price.

OQ output. PABC is profit.

In Figure 8.2, we see that the firm attains equilibrium when OQ output is produced at
which SMR = SMC. In relation to the given demand curve (SAR curve), the firm will
set OP price to sell OQ output. The firm as such earns supernormal profits to the tune
of PABC. Such profits in the short-run are possible when there are not enough rivals
who sell closely competitive substitutes to compete these profits away.

The Long-run Equilibrium

When firms in the short-run earn supernormal profits in a monopolistically competitive
market, some new firms will be attracted to enter the business, as the group pertaining
to the industry is open. On account of rivals’ entry, the demand curve faced by the
typical firm will shift to the origin and it will also tend to be more elastic, as its share in
the total market is reduced due to competition from an increasing number of close
substitutes. Gradually, in the long-run, when the firm’s demand curve (AR curve)

102
becomes tangent to its average curve, the firm earns only normal profits. The situation
is depicted in Figure 8.3.
As shown in Figure 8.3 in the long-run, the firm produces OQ level of output, at which
LMC = LMR, (EQ). At this equilibrium output, the LMR curve is tangent to the LAC
curve at point P. Thus, PQ, is the price which is equal to the average cost. Apparently,
OQPA is the total revenue as well as total cost, so the firm earns only normal profit in
the long run. Existing competitors in the market in the long-run will be producing
similar products, and their economic profits will be competed away. Thus, in the
absence of long-run profits, there is an incentive to the entry of new firms.
Furthermore, it can also be noticed that when a typical firm attains equilibrium and
determines the price (= AC), by producing OQ level of output as shown in Figure 8.3,
it is just breaking even. Since the LAR curve is tangent to the LAC curve at point P,
which is attainable only by producing OQ level of output, any output less than that
implies that AR < AC, indicating a loss. So also, any output more than OQ means P
< AC and a loss.

Figure. 8.3: Long-run Equilibrium of a Monopolistically Competitive Firm

At E, LMC = LMR. Further, PQ Price = LAR. Only normal profit.

It should be noted that monopolistic competition implies severe competition between
a large number of firms producing close substitute products. Hence, this market
situation is more similar to perfect competition than monopoly. In a monopolistic
group, owing to the unrestricted entry of new firms, abnormal profits are usually
competed away in the long-run, and firms will always seek to realize pure economic
profits once again by advertising and innovation in products or processes.
Consequently, firms will resort to non-price competition, i.e., competition in product
variation as well as by increasing their advertising expenditure (selling costs).

8.6.3 Pricing Under Oligopoly

Pricing under Oligopoly has been explained by Prof. Paul M. Sweezy by using “Kinked
Demand Curve”. That means, the demand curve will have a ‘kink’ or ‘bend’. The
Kinked Demand Model represents a condition in which he has no incentive either to
increase or decrease the price. But keeps the price rigid. This is because, if a firm
increases the prices while other firms maintain the same price, it will lose its

103
customers and if it decreases the prices, the other firms have to reduce the price and
hence profit of all firms will be reduced. Hence, the firms stick on the present price.
An important point involved in kinked demand curve is that it accounts for the kinked
average revenue curve to the oligopoly firm. The kinked average revenue curve, in
turn, implies a discontinuous marginal revenue curve MA-BR (as shown in Figure.
8.4). Thus, the kinky marginal revenue curve explains the phenomenon of price rigidity
in the theory of oligopoly prices.

Figure.8.4 Discontinuous Marginal Figure.8.5 Oligopoly Price Rigidity

Revenue Curve
Because of discontinuous marginal revenue curve (MR), there is no change in
equilibrium output, even though marginal cost changes hence, there is price rigidity.
OP does not change.
It is observed that quite often in oligopolistic markets, once a general price level is
reached whether by collusion or by price leadership or through some formal
agreement, it tends to remain unchanged over a period of time. This price rigidity is
on account of conditions of price interdependence explained by the kinky demand
curve. Discontinuity of the oligopoly firm’s marginal revenue curve at the point of
equilibrium price, the price output combination at the kink tends to remain unchanged
even though marginal cost may change, as shown in Figure 8.5.
In the Figure 8.5, it can be seen that the firm’s marginal cost curve can fluctuate
betweenMC1and MC2within the range of the gap in the MR curve, without disturbing
the equilibrium price and output position of the firm. Hence, the price remains at the
same level OP, and output OQ, despite change in the marginal costs.

LET US SUM UP
In this unit, we have defined the concept market. Market refers to a group of buyers
and sellers dealing in a particular commodity. We have also explained the meaning
of various forms of market structure namely, Perfect Competition, Monopoly, Duopoly,
Oligopoly, Monopolistic Competition etc. Further we have analysed the price-output
determination under Perfect Competition, Monopolistic Competition and Oligopoly.

104
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. A market situation in which there is only one seller is called___________

a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

2. A market situation in which there are few sellers is known as___________

a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

3.__________refers to a market situation in which there are only two

sellers.

a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

4. It is a market situation in which there are many sellers but there is a

single buyer of a commodity. ___________

a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

5.It refers to a market situation in which there are only two sellers selling

homogenous products___________
a) Monopoly b) Monopsony

c) Duopoly d) Oligopoly

GLOSSARY

Market : Market refers to a place where goods and services

are bought and sold. But, in Economics, it has no
reference to a place, but to a commodity which is
being bought and sold. That is, market refers to a
group of buyers and sellers dealing with a
particular commodity for a price at a particular time.

Monopoly : Monopoly is a market situation in which there is

only one seller of the commodity which has no
substitutes.

105
 Duopoly : It refers to a market situation in which there are
only two sellers selling homogenous products

Oligopoly : It refers to a market situation in which there are few

sellers selling either homogeneous products or
products which are having close substitutes but no
perfect substitutes.

Perfect Competition : A perfectly competitive market is a hypothetical

market where competition is at its greatest possible
level. Neo-classical economists argued that perfect
competition would produce the best possible
outcomes for consumers, and society.

Monopolistic : Monopolistic competition is a type of imperfect

Competition competition such that many producers sell products
that are differentiated from one another (e.g. by
branding or quality) and hence are not perfect
substitutes.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.youtube.com/watch?v=frHyR9FiKt4
8. https://www.economicshelp.org/microessays/markets/
9. https://www.tutorialspoint.com/managerial_economics/market_structure_p
ricing_decisions.htm

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) c 4) b 5) c

106
Unit 9

PERFECT COMPETITION MARKET

STRUCTURE

Overview

Learning Objectives

9.1 Perfect Competition

9.2 Meaning of Perfectly Competitive Market

9.3 Definition of Perfectly Competitive Market

9.4 Assumptions behind a Perfectly Competitive Market

9.5 Characteristics of Perfectly Competitive Market

9.6 Price and Output Determination

9.7 Perfect v/s pure competition

9.8 Short run equilibrium of the firm and industry

9.9 Long run equilibrium of the firm and industry

9.10 Derivation of the supply curve of the firm

9.11 Derivation of the supply curve of the industry

9.12 Price and output determination under perfect competition

9.13 Demand under Perfect Competition

9.14 Supply under Perfect Competition

9.15 Equilibrium under Perfect Competition

9.16 Price and output determination in long run

9.17 Long run supply curve of a competitive industry

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

107
OVERVIEW
A perfectly competitive market is a hypothetical market where competition is at its
greatest possible level. Neo-classical economists argued that perfect competition
would produce the best possible outcomes for consumers, and society.

LEARNING OBJECTIVES

After reading this unit, you should be able to,

• explain perfect competition market and its features

• distinguish between perfect v/s pure competition

• describe an equilibrium of the firm

• explain the derivation of the supply curve of the firm

• draw the derivation of the supply curve of the industry

• discuss the price and output determination under perfect competition

• tell the long run supply curve of a competitive industry.

9.1 PERFECT COMPETITION

Perfect competition describes markets such that no participants are large enough to
have the market power to set the price of a homogeneous product. As the conditions
for perfect competition are strict, there are few if any perfectly competitive markets.
Still, buyers and sellers in some auction-type market say for commodities or some
financial assets may approximate the concept. Perfect competition serves as bench
mark against which to measure real-life and imperfectly competitive markets.
In neoclassical economics there have been two strands of looking at what perfect
competition is. The first emphasis is on the inability of any one agent to affect prices.
Usually it is justified by the fact that any one firm or consumer is so small relative to
the whole market that their presence or absence leaves the equilibrium price very
nearly unaffected. This assumption of negligible impact of each agent on the
equilibrium price has been formalized by Aumann (1964) by postulating a continuum
of infinite malagents. The difference between Aumann’s approach and that found in
undergraduate textbooks is that in the first, agents have the power to choose their
own prices but do not individually affect the market price, while in the second it is
simply assumed that agents treat prices as parameters. Both approaches lead to the
same result.
Perfect competition is a theoretical market structure that features no barriers to entry,
an unlimited number of producers and consumers, and a perfectly elastic demand
curve.
The degree to which a market or industry can be described as competitive depends
in part on how many suppliers are seeking the demand of consumers and the ease

108
with which new businesses can enter and exit a particular market in the long run. The
spectrum of competition ranges from highly competitive markets where there are
many sellers, each of whom has little or no control over the market price- to a situation
of pure monopoly where a market or an industry is dominated bygone single supplier
who enjoys considerable discretion in setting prices, unless subject to some form of
direct regulation by the government.
In many sectors of the economy markets are best described by the term oligopoly -
where a few producers dominate the majority of the market and the industry is highly
concentrated. In duopoly two firms dominate the market although there may be many
smaller players in the industry.

9.2 MEANING OF PERFECTLY COMPETITIVE MARKET

A perfectly competitive market is a hypothetical market where competition is at its
greatest possible level. Neo-classical economists argued that perfect competition
would produce the best possible outcomes for consumers, and society.
9.3 DEFINITION OF PERFECTLY COMPETITIVE MARKET
According to Prof. Marshall, “The more nearly perfect a market is, the stronger is
the tendency for the same price, to be paid for the same thing at the same time in all
parts of the market”.
According to Prof. Benham, “A market is said to be perfect when all the potential
sellers and buyers are promptly aware of the price at which transactions take place
and all of the offers made by other sellers and buyers and when any buyer can
purchase from any seller and vice-versa”.

9.4 ASSUMPTIONS BEHIND A PERFECTLY COMPETITIVE MARKET

1. Many suppliers each with an insignificant share of the market – this means that
each firm is too small and relative to the overall market to affect price via a change
in its own supply and each individual firm is assumed to be a price taker.
2. An identical output produced by each firm: In other words, the market supplies
homogeneous or standardized products that are perfect substitutes for each
other. Consumers perceive the products to be identical
3. Consumers have perfect information about the prices all sellers in the market
charge – so if some firms decide to charge a price higher than the ruling market
price, there will be a large substitution effect away from this firm
4. All firms (industry participants and new entrants) are assumed to have equal
access to resources (technology, other factor inputs) and improvements in
production technologies achieved bygone firm can spill-over to all the other
suppliers in the market

109
5. There are assumed to be no barriers to entry and exit of firms in long run. This
means that the market is open to competition from new suppliers –this affects
the long run profits made by each firm in the industry. The long run equilibrium
for a perfectly competitive market occurs when the marginal firm makes normal
profit only in the long term
6. No externalities in production and consumption so that there is no divergence
between private and social costs and benefits

9.5 CHARACTERISTICS OF PERFECTLY COMPETITIVE MARKET

Perfectly competitive markets exhibit the following characteristics:

i) Infinite buyers and sellers: Infinite consumers with the willingness and ability
to buy the product at a certain price, and infinite producers with the willingness
and ability to supply the product at a certain price.
ii) Zero entry and exit barriers: It is relatively easy for a business to enter or exit
in a perfectly competitive market.
iii) Perfect factor mobility: In the long run factors of production are perfectly
mobile allowing free long term adjustments to changing market conditions.
iv) Perfect information: Prices and quality of products are assumed to be known
to all consumers and producers.
v) Zero transaction costs: Buyers and sellers incur no costs in making an
exchange (perfect mobility).
vi) Profit maximization: Firms aim to sell where marginal costs meet marginal
revenue, where they generate the most profit.
vii) Homogeneous products: The characteristics of any given market good or
service do not vary across suppliers.
viii) Non-increasing returns to scale: on-increasing returns to scale ensure that
there are sufficient firms in the industry.

9.6 PRICE AND OUTPUT DETERMINATION

Before Marshall there was controversy among economists on whether the force of
demand (i.e. marginal utility) or the force of supply (i.e. cost of production) is more
important is determining price. Marshall gave equal importance to both the demand
and supply in determination of price. According to him, “As both blades of a scissors
are important for cutting a cloth, so is both demand and supply essential for
determination of price.”
As we know that quantity demanded and quantity supplied varies with the price, the
equilibrium price is determined at the point where quantity demanded and quantity
supplied are equal. If the equality between quantity demanded and quantity supplied

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doesn’t hold for some price, buyer’s and seller’s desires are inconsistent. In case of
either quantity demanded by the buyers is more than that offered by the sellers or the
quantity supplied by the sellers is greater than the quantity demanded by the buyers
the price will change so as to bring about equality between quantity demanded and
quantity supplied. The process of price determination can be explained with the help
of following table below:

Table9.1 Process of Price Determination

Price per Quantity Quantity Pressure on

Unit Demanded Supplied Price

5 9 18 Falling

4 10 16 Falling

3 12 12 Neutral

2 15 07 Rising

1 20 00 Rising

It is seen in the table that when price is Rs 3 per unit, quantity demanded and quantity
supplied are equal at 12 units. When price is Rs 5 per unit, quantity demanded is 9
units and the amount offered at this price is 18 unit is greater than demand and there
will be the tendency for the price to fall, because at the price Rs.5 some of the seller
will be unable to sell all the quantity they want to sale therefore they will reduce the
price in order to attract the customers. Similarly at price Rs 4quantity demanded 10
units is less than the quantity supplied 16 units’ causes to fall in price. Similarly at
price Rs 1 quantity demanded 20 are greater than quantity supplied zero causes to
increase in price. In the other words, at this price the buyers who are willing to buy
will find that quantity offered is not sufficient to satisfy their wants. Hence those
consumers who have not been able to satisfy their wants will induce to increase the
price or are willing to pay more for getting commodity.

9.7 PERFECT V/S PURE COMPETITION

Pure Competition Perfect Competition

Pure competition is said to exist in In perfect competition, all the three

a market where (a) there is a large features of pure competition exist.
number of buyers and sellers (b) Besides these, perfect competition
products are homogeneous and has more features. These are (d)
perfect knowledge of the buyers

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 (c) there is freedom of entry and and sellers regarding the market
exit of buyers and sellers. conditions (e) perfect mobility of
factors of production (f) absence
of transport cost and (g) uniform
price.

The essential feature of pure Perfect competition is not only

competition is the absence of any pure but also free from other
monopoly element. imperfection. It is a broader
concept than pure competition.

Under pure competition, there is Under perfect competition, there is

limited number of buyers and large number of buyers and
sellers. sellers.

9.8 SHORT RUN EQUILIBRIUM OF THE FIRM AND INDUSTRY

Under perfect competition a firm takes price as given. In other words imperfect
competition at a single firm and consumer cannot influence the price by varying their
supply and demand respectively. Hence price remains constant in perfect
competition. So, the problem is to determine the output level to maximize profit.
We know that in short run total fixed cost incurred even if the output is nil or fixed cost
remains same whatever be the level of output.. If the price falls below the minimum
average variable cost then the firm will shut down in order to minimize losses. So the
minimum variable cost sets a limit to the price in short run.
As we know that firm will be in equilibrium when it is earning maximum profit.
According to marginal cost and marginal revenue approach a firm will make maximum
profit when MR and MC are equal and MC cuts MR from below. The short run
equilibrium of the firm requires short run equality between demand and supply. This
can be explained clearly with the help of following diagram:

Figure.9.1 Short Run Equilibrium of the Firm

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It is seen in the Figure that the market price OP has been determined by the
intersection point of the demand curve (D) and supply curve(S).

9.9 LONG RUN EQUILIBRIUM OF THE FIRM AND INDUSTRY

In the long-run, all the inputs available to the firms are variable, so that the concept of
fixed cost is absent and the total cost (TC) equals the total variable cost (TVC).
Therefore, we need only to deal with the long-run average cost (LAC= LTC/q). We
assume the LAC to be U-shaped exhibiting the fact that at the low levels of output,
the cost is falling and beyond a point, it rises. We have stated above that a perfectly
competitive market is characterized by free entry and exit of the firms. As in the short-
run, the firms are making profits; there will be entry of new firms in the market. As a
result, the industry supply would go up and price would fall. This would continue until
the profits are driven down to zero. Such a process is described in the following
diagram.

Figure. 9.2 Long run Profit of Competitive Firm

In Figure at price P1, the firm is producing an output q1 whereby it is making profit
shown by the shaded area. At price, P1, the industry output is Q1. As the existing
firms are making profit, there will be entry into the market. As a result, the total supply
in the market would go up and the price in market would fall. If at the new price the
firms are still making some profit, then there will be further entry and market supply
would go up.
Consequently, the price would go down further level. This process would continue
until the price falls to such a level that all profits are eliminated. From the diagram, the
shaded area ceases to exist. This price is P 2, where P= MC= AC and therefore profit
is zero. The zero profit scenarios faced by the firms means that the economic profit is
zero implying that the firms earn no more than they would elsewhere. In other words,
the firms are breaking even at priceP 2. At P2, as the firms are earning zero profit, there
is no incentive for other firms to enter the industry. Hence, price P 2 would represent
an equilibrium price level withQ 2 as the equilibrium output. With that the long-run

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equilibrium is characterized by a situation where the economic profits for the firms are
zero.

9.10 DERIVATION OF THE SUPPLY CURVE OF THE FIRM

‘short-run’ is meant as a period of time in which the size of the plant and machinery
are fixed, and the increased demand for the commodity is met only by an intensive
use of the given plant, i.e., by increasing the amount of the variable factors.
Under perfect competition, a firm produces an output at which marginal cost equals
the Price. If the price is higher than the marginal cost, it will pay the firm to expand its
output, so, as to equal its price. If, on the other hand, the price is less than the marginal
cost, it is incurring a loss, and it will reduce its output till the marginal cost and the
price are made equal. Hence, the marginal cost curve of the firm is the supply curve
of the perfectly competitive firm in the short-run.
But, even in the short-run, a firm will not supply at a price below its minimum average
variable cost. That is, in the short-run, a firm must try to cover its’ Variable cost at
least. Hence, the short-run supply curve of a firm coincides with that portion of the
short-run marginal cost curve which lies above the minimum point of the short-run
average variable cost (SAVC) curve. The following diagram [Figure. 10.3(a)) will make
it clear:

Figure. 9.3 deriving short-run Supply curve

In this diagram, Figure. 9.3(a) relates to a firm and 9.3(b) gives the supply curve of
the industry. First look at the Figure. 9.3(a), which relates to a single firm. Along the
axis OX are represented the output supplied and along OY the prices SMC curve is
the short-run marginal cost curve, and, as mentioned above, it is the short-run supply
curve of the firm. But only that portion of SMC curve which lies above the short-run
average variable cost (SAVC), which means the thick portion above the dotted portion
has be taken into consideration.
Thus, at the price OP 0, OM0 output will be supplied, at OP1 price, OM1, quantity will
be supplied at OP 2 price, and OM2 will be supplied, and so on. Nothing will be
supplied below the price OP”, because prices below OP 0 correspond to the dotted

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portion of the SMC which is below the minimum point of the SAVC (short-run average
variable cost) curve.
Now from the supply curve of a firm, let us derive the supply curve of the “entire”
industry of which all the firms are a constituent par) The supply curve SRS of the
industry “‘is derived by the lateral summation (i.e., adding up sideways) of that part of
all the firms’ marginal cost curves which lies above the minimum point on their
average friable cost curves. This industry is supposed to consist of 100identical firms
like the firm represented by the Figure. 9.3(a).
It can be seen that at OP„ price, 100 OM1 are supplied, at OP, price 100OM, are
supplied, at OP, price 100 OM, are supplied, and so on. We see that the short-run
supply curve SRC of the industry rises upwards, because the short-run marginal curve
SMC rises upwards.

Long-run Supply Curve

The long-run is supposed to be a period sufficiently long to allow changes to be made
both in the size of the plant and in the number of firms in the industry. Whereas in the
short period, an increase in demand is met by over-using the existing plant, in the
long-run, it will be met not only by the expansion of the plants of the existing firms but
also by the entry into the industry of new firms.
Moreover, we have seen that, in the short-run, a firm produces that output at which
its marginal cost is equal to the price. But, in the long-run, the price must be equal to
both the-marginal cost and the average cost. The reason is that an industry will be in
equilibrium when all firms in the industry are making normal profits, and they will be
making normal profits only if the price, i.e., average revenue (AR) is equal to average
cost AC.
The shape of supply curve, in the long run, will depend on whether the industry is
subject to the law of constant return (i.e., constant costs), or to diminishing returns
(i.e., increasing costs) or to increasing returns (i.e., diminishing costs). We show these
curves below.

Supply Curve of Constant Cost Industry

The supply curve of the constant cost industry is shown in the following diagram
(Figure. 9.4).

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 Figure. 9.4 Long-run Supply Curve of a Constant Cost Industry
In the Figure. 9.4(a) which relates to a firm, LMC is the long-run marginal cost curve,
and LAC is the long-run average cost curve. They intersect at R which means that at
the point R, the marginal cost is equal to the average cost. Here they are also equal
to price OP. The output at this point is OM. Thus, at the output, MC = AC = Price.
Now look at the Figure. 9.4(b). Corresponding to OP price, the long-run supply curve
is LSC, which is a horizontal straight line parallel to the X-axis. This means that
whatever the output along the X-axis, price is the same OP where the marginal cost
and average cost are equal. The cost remains the same, because it is a constant cost
industry.
It is an industry in which, even if the output is increased (or decreased), the economies
and diseconomies cancel out so that the cost of production does not change. Also,
when new firms enter the industry to meet the increased demand, they do not raise
or lower the cost per unit.
Thus, the industry is able to supply any amount of the commodity at the price OP
which is equal to the minimum long-run average cost which ensures normal profit to
all the firms engaged in the industry. That is, every firm will be in the long run
equilibrium where Price = MC = AC. All firms have identical cost conditions.
Hence, in the case of a constant cost industry, the long-run supply curve LSC is a
horizontal straight line (i.e., perfectly elastic) at the price OP, which is equal to the
minimum average cost. This means that whatever the output supplied, the price would
remain the same.

9.11 DERIVATION OF THE SUPPLY CURVE OF THE INDUSTRY

In the case of an increasing cost industry, the cost of production increases as the
existing firms expands or the new firms enter into the industry to meet an increase in
demand. The external diseconomies outweigh the external economies. The increased
demand for the productive resources required to produce larger output to meet
increased demand for the product raises their prices resulting in higher cost of
production.

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The rise in costs will shift both the average and marginal cost curves upward and the
minimum average cost will rise. This means that the additional supplies of the product
will be forthcoming at higher prices, whether the additional supplies come from the
expansion of the existing firms or from the new firms which may have entered the
industry. All this is shown in the following diagram

Figure. 9.5 Long-run Supply curve of Increasing cost Industry

The Figure. 9.5(a) shows the position of individual firms. The position of the dotted
LMC and LAC curves shows that they have been shifted upwards where each firm
achieves a long-run equilibrium so that the price OP, =MC = AC. But, in the Figure.
9.5 (b) which relates to the industry, we find that at the price OP is larger amount ON1
is supplied than at the price OP (i.e., ON).
This means that the long-run supply curve LSC slopes upwards to the right as the
output supplied increases. That is, more will be supplied at higher prices. This is
probably typical of the actual competitive world, because higher prices have to be
paid for the scarce productive resources to attract them from other uses so that
production in this particular industry may be increased. Thus, we see that in the case
of an increasing cost industry, the long-run supply curve slopes upward to the right.

Supply Curve of a Decreasing Cost Industry

In a decreasing cost industry, costs decrease as output is increased either byte
expansion of the existing firms or by the entry of new firms. In this case, the economies
of scale out-weight the diseconomies, if any. This happens when young industry
grows in a new territory where the supply of productive resources is plentiful. The net
external economies will push the cost curves down so that the additional supplies of
the output are forthcoming at lower prices. The following diagram (Figure. 9.6) makes
the whole thing clear:

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 Figure. 9.6 long run supply curve of a Decreasing Cost Industry
The Figure. 9.6(a) shows how the new, i.e., dotted LMC and LAC curves have been
shifted downwards from their original position, when the LMC and LAC curves
intersect at E where every firm was the equilibrium and was producing OM. The new
curves intersect at E1 which means that, at this point, the firms in the industry have
achieved the- long-run equilibrium, each producing OM, output, so-that the price OP
=MC =AC. But looking at the Figure. 9.6(b), we find that, at OP1price, ON is supplied
which is more than ON supplied at the original price OP.
The LSC slopes downwards to the right which means that the additional supplies of
the output are forthcoming at lower prices, since both the marginal cost and average
cost have fallen owing to cheaper supplies of the productive resources.

9.12 PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION

Perfect competition refers to a market situation where there are a large number of
buyers and sellers dealing inhomogeneous products.
Moreover, under perfect competition, there are no legal, social, or technological
barriers on the entry or exit of organizations.
In perfect competition, sellers and buyers are fully aware about the current market
price of a product. Therefore, none of them sell or buy at a higher rate’s result, the
same price prevails in the market under perfect competition.
Under perfect competition, the buyers and sellers cannot influence the market price
by increasing or decreasing their purchases or output, respectively. The market price
of products imperfect competition is determined by the industry. This implies that in
perfect competition, the market price of products is determined by taking into account
two market forces, namely market demand and market supply.
In the words of Marshall, “Both the elements of demand and supply are required for
the determination of price of a commodity in the same manner as both the blades of
scissors are required to cut a cloth. "As discussed in the previous units, market

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demand is defined as a sum of the quantity demanded by each individual organization
in the industry.
On the other hand, market supply refers to the sum of the quantity supplied by
individual organizations in the industry. In perfect competition, the price of a product
is determined at a point at which the demand and supply curve intersect each other.
This point is known as equilibrium point as well as the price is known as equilibrium
price. In addition, at this point, the quantity demanded and supplied is called
equilibrium quantity.

9.13 DEMAND UNDER PERFECT COMPETITION

Demand refers to the quantity of a product that consumers are willing to purchase at
a particular price, while other factors remain constant. A consumer demands more
quantity at lower price and less quantity at higher price. Therefore, the demand varies
at different prices.

Figure.9.7Demand Curve under Perfect Competition

As shown in Figureure9.7, when price is OP, the quantity demanded is OQ. On the
other hand, when price increases to OP 1, the quantity demanded reduces toOQ1.
Therefore, under perfect competition, the demand curves (DD’) slopes downward.

9.14 SUPPLYUNDER PERFECT COMPETITION

Supply refers to quantity of a product that producers are willing to supply ata particular
price. Generally, the supply of a product increases at high price and decreases at low
price.

Figure. 9.8 Supply curve under perfect competition

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In Figure 9.8, the quantity supplied is OQ at price OP. When price increases to OP1,
the quantity supplied increases to OQ1. This is because the producers are able to
earn large profits by supplying products at higher price. Therefore, under perfect
competition, the supply curves (SS’) slopes upward.

9.15 EQUILIBRIUMUNDER PERFECT COMPETITION

As discussed earlier, in perfect competition, the price of a product is determined at a
point at which the demand and supply curve intersect each other. This point is known
as equilibrium point. At this point, the quantity demanded and supplied is called
equilibrium quantity.

Figure. 9.9 Price ant Output Determination under perfect competition

In Figure 9.9, it can be seen that at priceOP 1, supply is more than the demand.
Therefore, prices will fall down to OP. Similarly, at priceOP 2, demand is more than the
supply. Similarly, in such a case, the prices will rise to OP. Thus, E is the equilibrium
at which equilibrium price is OP and equilibrium quantity is OQ.
9.16 PRICE AND OUTPUT DETERMINATION IN LONG RUN
The long run is a period of time which is sufficiently long to allow the firms to make
changes in all factors of production. In the long run, all factors are variable and none
fixed. They may expand their old plants or replace the old lower-capacity plants by
the new higher-capacity plants or add new plants.
Besides, in the long run, new firms can enter the industry to compete the existing
firms. On the contrary, in the long run, the firms can contract their output level by
reducing their capital equipment; they may allow a part of the existing capital
equipment tower out without replacement or sell out a part of the capital equipment.
Moreover, the firms can leave the industry in the long run. The long-run equilibrium
then refers to the situation when free and full adjustment in the capital equipment as
well as in the number of firms has been allowed to take place. It is therefore long-run
average and marginal cost curve which are relevant for deciding about equilibrium
output in the long run. Moreover, in the long run, it is the average total cost which is
of determining importance, since all costs are variable and none fixed.

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As explained above, a firm is in equilibrium under perfect competition when marginal
cost is equal to price. But for the firm to be in long-run equilibrium, besides marginal
cost being equal to price, the price must also be equal to average cost.
For, if the price is greater or less than the average cost, there will be tendency for the
firms to enter or leave the industry. If the price is greater than the average cost, the
firms will earn more than normal profits. These supernormal profits will attract outer
firms into the industry.
With the entry of new firms in the industry, the price of the product will go down as a
result of the increase in supply of output and also the cost will go up as a result of
more intensive competition for factors of production. The firms will continue entering
the industry until the price is equal to average cost so that all firms are earning only
normal profits.
On the contrary, if the price is lower than the average cost, the firms would make
losses. These losses will induce some of the firms to quit the industry. As a result, the
output of the industry will fall which will raise the price.
On the other hand, with some firms going out of the industry, cost may go down as a
result of fall in the demand for certain specialized factors of production. The firms will
continue leaving the industry until the price is equal to average costs that the firms
remaining in the field are making only normal profits. It, therefore, follows that for a
perfectly competitive firm to be in long-run equilibrium, the following two conditions
must be fulfilled.

1. Price - Marginal Cost

2. Price =Average Cost
If price is equal to both marginal cost and average cost, then we have a double
condition of long-run perfectly competitive equilibrium:

Price =Marginal Cost –Average Cost

But from the relationship between marginal cost and average cost we know that
marginal cost is equal to average cost only at the minimum point of the average cost
curve.

Therefore, the condition for long-run equilibrium of the firm can be written as:

Price =Marginal Cost =Minimum Average Cost.

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 Figure. 9.10 Long-run Equilibrium of the firm
Figure. 9.10 represents long-run equilibrium of firm under perfect competition. The
firm cannot be in the long-run equilibrium at a price greater than OP in Figure. 9.10.
This is be-cause if price is greater than OP, then the price line (demand curve)would
lie somewhere above the minimum point of the average cost curves that marginal cost
and price will be equal where the firm is earning abnormal profits.
Since there will be tendency for new firms to enter and compete away these abnormal
profits, the firm cannot be in long-run equilibrium at any price higher than OP.
Likewise, the firm cannot be in long-run equilibrium at a price lower than O Pin Figure.
9.10 under perfect competition.
If price is lower than OP, the average and marginal revenue curve will lie below the
average cost curve so that the marginal cost and price will be equal at the point where
the firm is making losses. Therefore, there will be tendency for some of the firms in
the industry to go out with the result that price will rise and the firms left in the industry
make normal profits.
We therefore conclude that the firm can be in long-run equilibrium under perfect
competition only when price is at such a level that the horizontal demand curve (that
is, AR curve) is tangent to the average cost curve so that price equals average cost
and firm make sonly normal profits.
It should be noted that a horizontal demand curve can be tangent to a U-shaped
average cost curve only at the latter’s minimum point. Since at the minimum point of
the average cost curve the marginal cost and average cost are equal, price in long-
run equilibrium is equal to both marginal cost and average cost. In other words, double
condition of long-run equilibrium is fulfilled at the minimum point of the average cost
curve.
It is clear from above that long-run equilibrium of the firm under perfect competition is
established at the minimum point of the long-run average cost curve. Working at the
minimum point of the long-run average cost curve signifies that the firm is of optimum
size, that is, it is producing output at the lowest possible cost. The fact that the firm,
working under conditions of perfect com-petition tends to be of optimum size in the
long run is beneficial from the social point of view into ways. Firstly, working at

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optimum size implies that the resources of the society are being utilized in the most
efficient way. Secondly, it signifies that the consumers are getting the goods at the
lowest possible price.

9.17 LONG RUN SUPPLY CURVE OFA COMPETITIVE INDUSTRY

The supply curve in the long run will be totally elastic as a result of the flexibility
derived from the factors of production and the free entry and exit of firms imagine the
firm-entry process portrayed before a few more times. In the long run, market demand
will only affect the number of firms but not to the quantity produced by each of these
firms. Therefore, we can assume that the equilibrium in the long run is the point where
profits are maximised (although each firm achieves zero economic profit), there are
neither firm’s entries nor exits and there is market clearance.

LET US SUM UP
Perfect competition refers to the market structure where competition among the
sellers and the buyers prevails in its most perfect form. Ina perfectly competitive
market, a single market price prevails for a commodity, which is determined by the
forces of total demand and total supply in the market. Under perfect competition, every
participant (whether a seller or a buyer) is a price-taker. Everyone has to accept the
prevailing market price as individually no one is in a position to influence it.
A distinction is often made between pure competition and perfect competition. But this
distinction is more a matter of degree than of kind. For a market to be purely
competitive, three fundamental conditions must prevail. These are: (i) a large number
of buyers and sellers; (ii) homogeneity of product. (iii) Free entry or exit of firms. For
the market to be perfectly competitive, four additional conditions must be fulfilled, viz.,
(a) perfect knowledge of market, (b) perfect mobility of factors of production, (c)
absolute government non-intervention, and (d) no transport cost difference.
Perfect competition is an ‘ideal concept’ of market rather than an actual market reality.
To some extent, the perfect competition model fits into the market for farm products
like rice, cotton, wheat, etc., when all the units of each commodity are identical.
Moreover, all conditions of perfect competition may not are satisfied.
In realty, competition is never perfect. So there is imperfect competition when perfect
form of competition among the sellers and buyers does not exist. This happens as the
number of firms maybe small or products maybe differentiated by different sellers in
actual practice. Similarly, there is no pure monopoly in reality.
Imperfect competition covers all other forms of market structures ranging from highly
competitive to less competitive in nature. Traditionally, oligopoly and monopolistic
competition are categorized as the most realistic forms of market structures under
imperfect competition.

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An industry is in equilibrium in the short run when there is no tendency for its total
output to expand or contract, i.e., the output of the industry is steady.
The short-period market price and its determining factors, viz., short demand and
short-period supply, are in equilibrium. When the quantity demanded is equal to total
quantity supplied, at the equilibrium short run market price, the market is cleared so
there is no reason for the market price to change in the short run.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. Which market is a simple and convenient form of market structure to understand
and analyze?

a) Perfect market b) Imperfect market

c) Both of them d) None of them

2. According to Marshall, which are the time periods of varying duration?

a) Market period b) Short period

c) Long period d) All of them

3.___________ competition refers to the market structure where competition among
the sellers and the buyers prevails in its most perfect form.

a) Perfect b) Imperfect

c) Both d) none of them

4. Under perfect competition, there is a ___________ruling market price.

a) Single b) Short period

c) Long period d) none of them

5. The market period is a very _________period.

a) Market period b) Short period

c) Long period d) none of them

GLOSSARY
Perfect competition : Perfect competition refers to the market
structure where competition among the sellers
and the buyers prevail in its most perfect form.
In a perfectly competitive market, a single
market price prevails for a commodity, which is
determined by the forces of total demand and
total supply in the market.

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 Pure Competition : Pure competition is a market situation where
there are a large number of independent Sellers
offering identical products. It means it is a term
for an industry where competition is stagnant
and relatively on-competitive.
Imperfect competition : Imperfect competition covers all other forms of
market structures ranging from highly
competitive to less competitive in nature..

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.economicsdiscussion.net/perfect-competition/perfect-
competition-with-7-assumptions/5230
8. https://www.economicsdiscussion.net/articles/market-forms-pure-
competition-perfect-competition-and-imperfect-competition/1685
9. https://www.youtube.com/watch?v=Aqn7BPMvhCY

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) d 3) a 4) a 5) b

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Unit 10

MONOPOLISTIC COMPETITION
STRUCTURE

Overview

Learning Objectives

10.1 Meaning of Monopolistic Competition

10.2 Features of Monopolistic Competition

10.3 Foundation of Monopolistic competition model

10.4 Price and Output Determination in short Run

10.5 Price and Output Determination in long Run

10.6 Analysis of selling cost and firm’s equilibrium

10.7 Critical appraisal of Chamberlin’s theory of Monopolistic Competition

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

Suggested Readings

OVERVIEW
Monopolistic competition is a type of imperfect competition where that many
producers sell products that are differentiated from one another as goods but not
perfect substitutes. In the monopolistic competition, a firm takes the prices charged
by its rivals as given and ignores the impact of its own prices on the prices of other
firms.
The long-run characteristics of a monopolistically competitive market are almost the
same as a perfectly competitive market. Two differences between the two are that
monopolistic competition produces heterogeneous products and that monopolistic
competition involves a great deal of non-price competition ,which is based on subtle
product differentiation. A firm making profits in the short run will nonetheless only
break even in the long run because demand will decrease and average total cost will
increase. This means in the long run; a monopolistically competitive firm will make
zero economic profit.

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LEARNING OBJECTIVES

After reading this unit, you should be able to,

• describe the monopolistic competition market and its features

• explain the foundation of monopolistic competition model

• discuss the price and output determination under monopolistic competition

• analyse the selling cost and firm’s equilibrium

• appraise the Chamberlin’s theory of Monopolistic Competition.

10.1 MEANING OF MONOPOLISTICCOMPETITION

Monopolistic competition is a market structure quite similar to perfect competition in
that vigorous price competition among a large number of firms and individuals is
present.
Monopolistic competition is the market situation mid-way between the extremes of
perfect competition and monopoly, and displaying features of the both. In such
situation’s firms are free to enter a highly competitive market where several
competitors offer products that are close substitutes and, therefore, prices are at the
level of average costs. Some consumers have a preference for one product over
another that is strong enough to make them keep buying it even when its price
increases, thus giving its producer a small amount of market power. Monopolistic
situation is a common situation in all free markets.

10.2 FEATURES OF MONOPOLISTIC COMPETITION

Following are the features of a monopolistic competitive market:

i) Large number of firms

Monopolistic competition is characterized by large number of firms producing
close substitutes but not identical product. Each firm must control a small yet
significant portion of the market share such that by substantially extending or
restricting its own sales, it is not able to affect the sales of any other individual
seller. This condition is the same as in perfect market.

ii) There is product differentiation

No seller has full control over the market supply. Each seller produces very close
substitute products. The product is neither identical nor markedly different. Since
every seller produces slightly differentiated product, each seller has minor control
over the price. Unlike perfect market conditions, the firm is a price –maker to
some extent. That is, a firm can change the price slightly, though not much. The
control over price will depend on the degree of product differentiation.

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iii) Absence of Inter-dependence
Existence of a large number of firms insures the condition too large and too small.
Thus, the individual firm’s supply is small constituent of total supply. Therefore,
individual firm has limited control over price level. Similarly, each firm can decide
,its price or output policies independently through price discrimination, any action
by one firm may not invite reaction from rival firms.

iv) Selling cost

Competitive advertisement is an essential feature of monopolistic competition.
Selling cost becomes an integral part of the marketing of firms when product is
differentiated. It is necessary to tell the buyers about the superiority of the product
and induce the customer to buy the products. However, the presence of many
close substitutes limits the price-setting ability of individual firms, and drives
profits down to a normal rate of return in the long-run. As in the case of perfect
competition, above-normal profits are only possible in the short-run before rivals
are able to take effective countermeasures. Examples of monopolistically
competitive market structures include abroad range of industries producing
clothing, consumer financial services, professional services, restaurants, and so
on.
v) Free entry and exit
Under monopolistic competition, new firm firms can exit. There are no restrictions
on entry or exit of the small size of firms. Existence of super normal profit attracts
entry loss, business firms to quit the market.
10.3 FOUNDATION OF MONOPOLISTIC COMPETITIONMODEL
A monopolistically competitive market has features that represent a cross between a
perfectly competitive market and a monopolistic market (hence the name). The
following are some of the main assumptions of the model:
Many, firms produce in monopolistically competitive industry. This assumption is
similar to that found in amodelof0020perfect competition.
Each firm produces a product that is differentiated (i.e., different in character)from all
other products produced by the other firms in the industry. Thus one firm might
produce a red toothpaste with a spearmint taste, and another might produce white
toothpaste with wintergreen taste. This assumption is similar to a monopoly market
that produces a unique (or highly differentiated) product.
The differentiated products are imperfectly substitutable in consumption. This means
that if the price of one good were to rise, some switch their purchases to another
product within the industry. From the perspective of a firm in the industry, it would face
a downward-sloping demand curve for its product, but the position of the demand
curve would depend on the characteristics and prices of the other substitutable

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products produced by other firms. This assumptions intermediate between the
perfectly competitive assumption in which goods are perfectly substitutable and the
assumption in a monopoly market in which no substitution is possible.
Consumer demand for differentiated products is sometimes described using two
distinct approaches: the love-of-variety approach and the ideal variety approach. The
love-of-variety approach assumes that each consumer has a demand for multiple
varieties of a product over time. A good example of this would be restaurant meals.
Most consumers who eat out frequently will also switch between restaurants, one day
eating at a Chinese restaurant, another day at a Mexican restaurant, and so on. If all
consumers share the same love of variety, then the aggregate market will sustain
demand for many varieties of goods simultaneously. If a utility function is specified
that incorporates a love of variety, then the wellbeing of any consumer is greater the
larger the number of varieties of goods available. Thus the consumers would prefer
to have twenty varieties to choose from rather than ten.
The ideal variety approach assumes that each product consists of a collection of
different characteristics. For example, each automobile has a different color, Interior
and exterior design, engine features, and so on. Each consumer is assumed to have
different preferences over these characteristics. Since the final product consists of a
composite of these characteristics, the consumer chooses a product closest to his or
her ideal variety subject to the price of the good. In the aggregate, as long as
consumers have different ideal varieties, the market will sustain multiple firms selling
similar products. Therefore, depending on the type of consumer demand for the
market, one can describe the monopolistic competition model as having consumers
with heterogeneous demand (ideal variety) or homogeneous demand(love of variety).
There is free entry and exit of firms in response to profits in the industry. Thus firms
making positive economic profits act as a signal to others to open up similar firms
producing similar products. If firms are losing money (making negative economic
profits), then, one by one, firms will drop out of the industry. Entry or exit affects the
aggregate supply of the product in the market and forces economic profit to zero for
each firm in the industry in the long run. (Note that the long run is defined as the period
of time necessary to drive the economic profit to zero.) This assumption is identical to
the free entry and exit assumption in a perfectly competitive market.
There are economies of scale in production (internal to the firm). This is incorporated
as a downward-sloping average cost curve. If average costs fall when firm output
increases, It means that the per-unit cost falls with an increase in the scale of
production. Since monopoly markets can arise when there are large fixed costs in
production and since fixed costs result in declining average costs, the assumption of
economies of scale is similar to a monopoly market.
These main assumptions of the monopolistically competitive market show that the
market is intermediate between a purely competitive market and a purely monopolistic

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market. The analysis of trade proceeds using a standard depiction of equilibrium in a
monopoly market. However, the results are reinterpreted in light of these
assumptions. Also, it is worth mentioning that this model is a partial equilibrium model
since there is only one industry described and there is no interaction across markets
based on an aggregate resource constraint.

10.4 PRICE AND OUTPUT DETERMINATION IN SHORT RUN

In monopolistic competition, every firm has a certain degree of monopoly power i.e.
every firm can take initiative to set a price. Here, the products are similar but not
identical, therefore there can ever be a unique price but the prices will be in a group
reflecting the consumers’ tastes and preferences for differentiated products. In this
case the price of the product of the firm is determined by its cost function, demand,
its objective and certain government regulations, if there are any. As the price of a
particular product of a firm reduces, it attracts customers from its rival groups (as
defined by Chamberlin). Say for example, if ‘Samsung ‘TV reduces its price by a
substantial amount or offers discount, then the customers from the rival group who
have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung ‘TV sets. As discussed
earlier, the demand curve is highly elastic but not perfectly elastic and slopes
downwards. The market has many firms selling similar products, therefore the firm’s
output is quite small as compared to the total quantity sold in the market and so its
price and output decisions go unnoticed. Therefore, every firm acts independently and
for a given demand curve, marginal revenue curve and cost curves, the firm
maximizes profit or minimizes loss when marginal revenue is equal to marginal cost.
Producing an output of selling at price P maximizes the profits of the firm.

In the short run, a firm may or may not earn profits. The equilibrium point for the firm
is at price P and quantity Q and is denoted by point A. Here, the economic profit is
given as area PAQR. The difference between this and the monopoly cases that here
the barriers to entry are low or weak and therefore new firms will be attracted to enter.
Fresh entry will continue to enter as long as there are profits. As soon as the super
normal profit is competed away by new firms, equilibrium will be attained in the market
and no new firms will be attracted in the market. This is the situation corresponding to
the long run and is discussed in the next section.

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10.5 PRICE AND OUTPUT DETERMINATION IN LONG RUN
The difference between monopolistic competition and perfect competition is that in
monopolistic competition the point of tangency is downward sloping and does not
occur at minimum of the average cost curve and this is because the demand curve is
downward sloping.
Under monopolistic competition in the long run we see that LRAC is the long run
average cost curve and LRMC the long run average marginal curve. Let us take a
hypothetical example of a firm in a typical monopolistic situation where it is making
substantial amount of economic profits.
Here it is assumed that the other firms in the market are also making profits. This
situation would then attract new firms in the market. The new firms may not sell the
same products but will sell similar products. As a result, there will be an increase in
the number of close substitutes available in the market and hence the demand curve
would shift downwards since each existing firm would lose market share. The entry of
new firms would continue as long as there are economic profits. The demand curve
will continue to shift downwards till it becomes tangent to LRAC at a given price P1
and output at Q1 as shown in the Figure 10.1.At this point of equilibrium, an increase
or decrease in price would lead to losses. In this case the entry of new firms would
stop, as there will not be any economic profits.

Figure.10.1 Demand Curve

Due to free entry, many firms can enter the market and there may be a condition
where the demand falls below LRAC and ultimately suffers losses resulting in the exit
of the firms. Therefore under the monopolistic competition free entry and exit must
lead to a situation where demand becomes tangent to LRAC, the price becomes equal
to average cost and no economic profit is earned. It can thus be said that in the long
run the profits peter out completely. One of the interesting features of the
monopolistically competitive market is the variety available due to product
differentiation. Although firms in the long run do not produce at the minimum point of
their average cost curve, and thus there is excess capacity available with each firm,

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economists have rationalized this by attributing the higher price to the variety
available. Further, consumers are willing to pay the higher price for the increased
variety available in the market.

10.6 ANALYSIS OF SELLING COST AND FIRM’S EQUILIBRIUM

Selling costs play the key role in monopolistic competition and oligopoly. Under these
market forms, the firms have to compete to promote their sale by spending on
advertisements and publicity.
Moreover, producer has not to decide about price and output and he also keeps in
view how to maximize the profit.
Thus, cost on advertisement publicity and salesmanship ads to the demand of the
product. We do not find perfect competition or monopoly in the real world but
monopolistic competition or oligopoly. In short, selling costs is a broader concept than
the advertisement expenditures. Advertisement expenditures are part of selling costs.
In selling costs we include the salaries of sales persons, allowances to retailers to
display the products etc. besides the advertisements. Advertisement expenditure
includes costs incurred for advertising in newspapers and magazines, televisions,
radio, cinema slides etc. It was Chamberlin who introduced the analysis of selling
costs and distinguished it from the production costs. The production costs include all
those expenses which are spent on the manufacturing of the commodity, its
transportation cost of handling, storing and delivering of the commodity to actual
customers because these add utilities to a commodity.
On the other hand, all selling costs include all expenditures in order to raise demand
for a commodity. In short, selling costs are those which are made to create the
demand for the product. Transport costs should not be included in selling costs; rather
these should be included in the production costs. Transport costs actually do not
increase the demand; it only helps in meeting the demand of the consumers.
In the same fashion, high rents are not the part of selling costs. High rents are paid
so as to meet the already existing demand of the people. According to Edward H.
Chamberlin, “Those costs which are made to adopt the product to the demand are
costs of production; those made to adopt the demand to product are costs of selling.”

Definitions
“Selling costs are costs incurred in order to alter the position or shape of the demand
curve for the product.” E.H. Chamberlin
“Selling costs may be defined as costs necessary to persuade a buyer to buy one
product rather than another or to pay from one seller rather than another.” Meyers

Assumptions

Basically, the concept of selling cost is based on the following two assumptions:

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 1. Buyers do not have any perfect knowledge about the different types of product.

2. Buyers demand and tastes can be changed.

10.7 CRITICAL APPRAISAL OF CHAMBERLIN’S THEORY OF MONOPOLISTIC
COMPETITION
Edward Hastings Chamberlin (b. 1899) in 1933 published The Theory of Monopolistic
Competition as a reorientation of the theory of value, designed to base it on a
synthesis of monopolistic and competitive theories. He argues that the old idea of
monopoly and competition as alternative is wrong; and that most situations are
composites in which elements of both monopoly and competition are combined. But
he asserts that the correct procedure is to start from the theory of monopoly. This, he
thinks, has the merit of eliminating none of the competitive elements, since these
operate through the demand for the monopolist’s product; while on the contrary the
alternative assumption of competition rules out the monopoly elements.
Thus, in taking monopoly as a starting point, Chamberlin’s approach is similar to that
of Cournot. But, while with Cournot the transition to perfect competition takes place
only on a scale of numbers of competitors, with Chamberlin it takes place also on a
scale of substitution of products. Any producer whose product is significantly different
from the products of others has some monopoly of it, subject to the competition of
substitutes. He considers each producer in an industry as having some monopoly in
his own product. If he be the sole seller of a unique product, he has a pure monopoly.
If there be two sellers of similar products, the situation is one of “duopoly”. If there be
several, an “oligopoly” exists. The condition may range through various degrees of
oligopoly to pure competition, under which there are so many sellers of a highly
standardized product that anyone could sell all his product without affecting the
demand. Pure competition is found only under the dual condition of (a) a large
number, and (b) a perfectly standardized product. The usual condition Chamberlin
considers being in the intermediate area, in which some element of “monopoly “exists,
and which he calls “monopolistic competition.”
Economic inertia and friction are “imperfections “which he does not consider as part
of “monopolistic competition.”
Thus Chamberlin’s thought centers on the product. Each producer, under
“monopolistic competition,” faces competition from “substitute” products which are not
identical and which are sold by other concerns with various price policies, and sales
expenses. These merely limit his “monopoly” of his own product.
The individual demand curve (or sales) for one seller’s product is then regarded as
affected by the market policies of other individual sellers whose products are partial
substitutes. Total sales of the partly competing group of substitute products are
treated as limiting the sales of the product of any one seller. Under “pure “competition
(many sellers and a completely standardized product) a horizontal demand curve

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(average revenue) would exist for each individual competitor’s product. This would
mean identical prices. Chamberlin argues that “pure” competition would force all
individual competitors to treat differential advantages, or rents, as costs, the same as
other costs.
Chamberlin emphasizes the effect of judgments by one seller concerning his rivals’
policies, possible retaliation, etc. He also argues that selling costs such as advertising
are not part of the cost of production, but are incurred to increase the sales of the
given product; and thus they affect the demand curve. Through-out, his basic idea is
that, no matter how slight, any differentiation of a seller’s product gives him to that
extent a monopoly. And all these conditions, commonly found in competitive markets,
are either “impurities” in the nature of monopoly elements, or are associated with such
elements. They make “pure” competition impossible.
To Chamberlin, actual “competition”1 includes the effort of competitors to increase
their monopoly powers.

Figure.10.2.Demand Curve

DD’= demand curve (avg. rev.)

PP’= avg. cost of production, including a “minimum profit” (charge required to attract
capital and enterprise) and all “rents”

FF’= avg. total cost, including fixed uniform selling costs

AR= price

EHRR’= profit (above “minimum”)

OA= quantity sold

pp’=marginal cost of production

Did’=marginal revenue

Q= intersection of pp’ and did’

And the essence of “monopoly,” and therefore of “monopolistic competition, "is seen
as lying-in differences

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 (1) Differences in price policy,

(2) Differences in nature of product, and

(3) Differences in such sales effort as advertising outlays.

It is a contribution of Chamberlin’s to have developed the second and third of these
variables as arising out of the mixture of monopoly and competition. Chamberlin starts
with a single firm and develops the idea of monopoly price and competitive prices as
determined by the intersection of revenue or sales curves with expense curves. Either
the marginal revenue curve, or the average revenue curve (from which it is derived),
maybe used to determine the monopoly output and price, the former by intersecting
the rising marginal cost curve, the latter by the familiar Marshalling method of fitting
the maximum profit area between it and the average cost curve, which includes rents
or differentials and thus equals the average price.
The analysis with respect to all three variables then is extended beyond the firm to
groups of sellers, which may be taken as corresponding to conventional “industries,”
depending on how broadly a “class of product” is conceived in a particular case. The
group is analyzed, first under the assumption of symmetry (all its members assumed
to have uniform cost and demand curves). Then some consideration is given to what
might hap-pen if a “diversity of conditions” existed. If selling costs are not great, and
if they reduce the slope of the sellers’ demand curves, increasing them may result in
a lower price. Variations in product may lead to either smaller or larger outputs. Group
equilibrium (with “alert” competitors) must result in the optimum with respect to all the
variables, and no profits above a necessary minimum for every producer.
The conclusion is drawn that under monopolistic competition the equilibrium price is
higher, and the volume of output probably (not necessarily) lower, than under pure
competition. The net profits of enterprise, however, may or may not be higher than
under pure competition because of the expense which is required to maintain the
monopoly elements and which is often increased by multiplication of substitute
products surrounding the monopolist. Chamberlin argues that monopolistic
competition need not bring higher profits to the marginal firm in a given industry.
Instead, it may allow the existence of a larger number of firms making normal profits.

LET US SUM UP
Monopolistic competition is a market structure quite similar to perfect competition in
that vigorous price competition among a large number of firms and individuals is
present.
Monopolistic competition is characterized by large number of firms producing close
substitutes but not identical product. Each firm must control a small yet significant
portion of the market share such that by substantially extending or restricting its own

135
sales, it is not able to affect the sales of any other individual seller. This condition is
the same as in perfect market.
Under monopolistic competition in the long run we see that LRAC is the long run
average cost curve and LRMC the long run average marginal curve. Let us take a
hypothetical example of a firm in a typical monopolistic situation where it is making
substantial amount of economic profits.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. What is Monopolistic Competition?

a) It is characterized by large number of firms producing close
Substitutes but not identical product.
b) It is a market structure where only a few large rivals are responsible for
the bulk, if not all, industry output.

c) Both (a) and (b)

d) None of the above

2. What is a marketing process that showcases the differences between Products?

a) Product differentiation
b) It is characterized by large number of firms producing close
substitutes but not identical product
c) It is a market structure where only a few large rivals are
responsible for the bulk, if not all, industry output.
d) None of the above

3.__________competition is a market structure quite similar to perfect

Competition in that vigorous price competition among a large number

Of firms and individuals is present.

a) Monopolistic b) Oligopoly

c) Duopoly d) None of the above

4. Under monopolistic competition, there are no restrictions on entry or

Exit of the ___________of firms.

a) Large size b) Small size

c)Medium size d) none of the above

5.__________looks to make a product more attractive by contrasting its

Unique qualities with other competing products.

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 a) Resource allocation b) Deductive methods

c) Differentiation d) Pricing

GLOSSARY

Monopolistic : Monopolistic competition is a market structure

competition quite similar to perfect competition in that
vigorous price competition among a large number
of firms and individuals is present.

Product Differentiation : Product differentiation is a marketing process that

showcases the differences between products.
Differentiation looks to make a product more
attractive by contrasting its unique qualities with
other competing products.

Selling costs : Products under monopolistic competition are

spending huge amounts on advertising and
publicity. Much of this expenditure is wasteful from
the social point of view. The producer can reduce
the price of the product instead of spending on
publicity.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand & Sons
Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts &
Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial Economics,
Sultan Chand & Sons, New Delhi.
7. https://www.yourarticlelibrary.com/economics/7-most-important-features-of-
monopolistic-competition/9154
8. https://www.economicsdiscussion.net/monopolistic-competition/chamberlins-
model-of-monopolistic-competition/5369

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) a 3) a 4) b 5) c

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Unit 11

OLIGOPOLY MARKET
STRUCTURE

Overview

Learning Objectives

11.1 Oligopoly

11.2 Oligopoly Market

11.3 Characteristics of Oligopoly

11.4 Causes of Oligopoly

11.5 Effects of Oligopoly

11.6 Price determination under oligopoly

11.7 Price Determination Models of Oligopoly

11.8 Game theory approach to oligopoly

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings
Answers to Check Your Progress

OVERVIEW
An oligopoly is a market structure in which a few firms dominate. When a market is
shared between a few firms, it is said to be highly concentrated. Although only a few
firms dominate, it is possible that many small firms may also operate in the market.

LEARNING OBJECTIVES

After reading this unit you will be able to,

• list out the characteristics of Oligopoly market

• explain the Duopoly model

• elaborate the Oligopoly models

• apply game theory approach to oligopoly.

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11.1 OLIGOPOLY
According to Mrs. John Robinson, “Oligopoly is a market situation that is in between
monopoly and perfect competition in which the number of sellers is more than one but
is not so large that the market price is not influenced by any one of them”.
According to Prof.George J. Stigler, “Oligopoly is a market situation in which a firm
determines its marketing policies on the basis of expected behavior of close
competitors”.
According to Prof.Stoneur and Hague, “Oligopoly is different from monopoly on one
hand in which there is a single seller, on the other hand, it differs from perfect
competition and monopolistic competition also in which there is a large number of
sellers. In other words, while describing the concept of oligopoly, we include the
concept of a small group of firms”.
11.2 OLIGOPOLYMARKET
Oligopoly is a market structure where only a few large rivals are responsible for the
bulk, if not all, industry output. As in the case of monopoly, high to very high barriers
to entry are typical. Under oligopoly, the price/output decisions of firms are interrelated
in the sense that direct reactions from leading rivals can be expected. As a result, the
decision-making of individual firms is based, in part, on the likely response of
competitors.
The term oligopoly is derived from two Greek words, Oleg’s and ‘Pollen’. Oleg’s
means a few and Pollen means to sell thus. Oligopoly is said to prevail when there
are few firms or sellers in the market producing and selling a product. Oligopoly is
often referred to as “competition among the few”. In brief oligopoly is a kind of
imperfect market where there are a few firm in the market, producing either and
homogeneous product or producing product which are close but not perfect
substitutes of each other.
There is no such border line between a few and many. Usually oligopoly is understood
to prevail when the numbers of sellers of a product are two to ten. Oligopoly is of two
types-oligopoly without product differentiation or pure.

11.3 CHARACTERISTICS OFOLIGOPOLY

1. Interdependence: The firms under oligopoly are interdependent in making
decision. They are interdependent because the number of competition is few
and any change in price & product etc. by a firm will have a direct influence on
the fortune of its rivals, which in turn retaliate by changing their price and output.
Thus under oligopoly a firm not only considers the market demand for its
product but also the reactions of other firms in the industry. No firm can fail to
take into account the reaction of other firms to its price and output policies.

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 There is, therefore, a good deal of interdependences of the firm under
oligopoly.
2. Importance of advertising and selling costs: The firms under oligopolistic
market employ aggressive and defensive weapons to gain a greater share in
the market and to maximise sale. In view of this firms have to incur a great deal
on advertisement and other measures of sale promotion. Thus advertising and
selling cost play a great role in the oligopolistic market structure. Under perfect
competition and monopoly expenditure on advertisement and other measures
is unnecessary. But such expenditure is the life-blood of an oligopolistic firm.
3. Group behavior: Another important feature of oligopoly is the analysis of group
behavior. In case of perfect competition, monopoly and monopolistic
competition, the business firms are assumed to behave in such away also
maximize their profits. The profit-maximizing behavior on his part may not be
valid. The firms under oligopoly are interdependent as they are in a group.
4. Indeterminateness of demand curve: This characteristic is the direct result
of the interdependence characteristic of an oligopolistic firm. Mutual
interdependence creates uncertainty for all the firms. No firm can predict the
consequence of its price-output policy. Under oligopoly a firm cannot assume
that its rivals will keep their price unchanged if he makes charge in its own
price. The demand curve as is well known, relates to the various quantities of
the product that could be sold it different levels of prices when the quantity to
be sold is itself unknown and uncertain the demand curve can’t be definite and
determinate.
5. Elements of monopoly: There exist some elements of monopoly under
oligopolistic situation. Under oligopoly with product differentiation each firm
controls a large part of the market by producing differentiated product. In such
a case it acts in its sphere as a monopolist in lining price and output.
6. Price rigidity: Under oligopoly there is the existence price rigidity. Prices lend
to be rigid and sticky. If any firm makes a price-cut it is immediately retaliated
by the rival firms by the same practice of price-cut. There occurs a price-war in
the oligopolistic condition. Hence under oligopoly no firm resorts to price-cut
without making price-output decision with other rival firms. The net result will
be price -finite or price-rigidity in the oligopolistic condition.

11.4 CAUSES OFOLIGOPOLY

1. Economies of Scale: The firms in the industry, with heavy investment, using
improved technology and reaping economies of scale in production, sales,
promotion, etc., will compete and stay in the market.

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2. Barrier to Entry: In many industries, the new firms cannot enter the industry
as the big firms have ownership of patents or control of essential raw material
used in the production of an output. The heavy expenditure on advertising by
the oligopolistic industries may also be a financial barrier for the new firms to
enter the industry.
3. Merger: If the few firms in the industry smell the danger of entry of new firms,
they then immediately merge and formulate a joint policy in the pricing and
production of the products. The joint action of the few big firms discourages the
entry of new firms into the industry.
4. Mutual Interdependence: As the number of firms is small in an oligopolistic
industry, therefore, they keep a strict watch of the price charged by rival firms
in the industry. The firm generally avoids price ware and tries to create
conditions of mutual interdependence.

11.5 EFFECTS OFOLIGOPOLY

1. Small output and high prices: As compared with perfect competition,
oligopolistic sets the prices at higher level and output at low level. Restriction
on the entry: Like monopoly, there is a restriction on the entry of new firms in
an oligopolistic industry.
2. Prices exceed Average Cost: Under oligopoly, the firms fixed the prices at
the level higher than the AC. The consumers have to pay more than it is
necessary to retain the resources in the industry. In other words, the economy’s
productive capacity is not utilized in conformity with the consumers’
preferences.
3. Lower efficiency: Some economists argued that there is a low level of
production efficiency in oligopoly. There is no tendency for the oligopolists to
build optimum scales of plant and operate them at the optimum rates of output.
However, the Schumpeterian hypothesis states that there is high tendency of
innovation and technological advancement in oligopolistic industries. As a
result, the product cost decreases with production capacity enhancement. It will
offset the loss of consumer surplus from too high prices.
4. Selling Costs: In order to snatch markets from their rivals, the oligopolistic
firms may engage in aggressive and extensive sales promotion effort by means
of advertisement and by changing the design and improving the quality of their
products.
5. Wider range of products: As compared with pure monopoly or pure
competition, differentiated oligopoly places at the consumers’ disposal a wider
variety of commodities.

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 6. Welfare Effect: Under oligopoly, vide sums of money are poured into sales
promotion to create quality and design differentiations. Hence, from the point
of view of economic welfare, oligopoly fares fairly badly. The oligopolist push
on-price competition beyond socially desirable limits.

11.6 PRICE DETERMINATION UNDER OLIGOPOLY

The price and output behavior of the firms operating in oligopolistic orduopolistic
market condition can be studied under two main heads:

1. Price and Output Determination under Duopoly

a. If an industry is composed of two giant firms each selling identical or
homogenous products and having half of the total market, the price and output
policy of each is likely to affect the other appreciably, therefore there is every
likelihood of collusion between the two firms. The firms may agree on a price,
or divide the total market, or assign quota, or merge themselves into one unit
and form a monopoly or try to differentiate their products or accept the price
fixed by the leader firm, etc.
b. In case of perfect substitutes the two firms may be engaged in price
competition. The firm having lower costs, better goodwill and clientele will drive
the rival firm out of the market and then establish monopoly.
c. If the products of the duopolists are differentiated, each firm will have a close
watch on the actions of its rival firms. The firm good quality product with lesser
cost will earn abnormal profits. Each firm will fix the price of the commodity and
expand output in accordance with the demand of the commodity in the market.

2. Price and Output Determination under Oligopoly

a. If an industry is composed of few firms each selling identical or homogenous
products and having powerful influence on the total market, the price and
output policy of each is likely to affect the other appreciably, therefore they will
try to promote collusion.
b. In case there is product differentiation, an oligopolistic can raise or lower his
price without any fear of losing customers or of immediate reactions from his
rivals. However, keen rivalry among them may create condition of
monopolistic competition.

11.7 PRICE DETERMINATION MODELS OF OLIGOPOLY

1. Kinky Demand Curve

The kinky demand curve model tries to explain that in non-collusive oligopolistic
industries there are not frequent changes in the market prices of the products. The
demand curve is drawn on the assumption that the kink in the curve is always at the
ruling price. The reason is that a firm in the market supplies a significant share of the

142
product and has a powerful influence in the prevailing price of the commodity. Under
oligopoly, a firm has two choices:
a) The first choice is that the firm increases the price of the product. Each firm in
the industry is fully aware of the fact that if it increases the price of the product,
it will lose most of its customers to its rival. In such a case, the upper part of
demand curve is more elastic than the part of the curve lying below the kink.
b) The second option for the firm is to decrease the price. In case the firm lowers
the price, its total sales will increase, but it cannot pushup its sales very much
because the rival firms also follow suit with a price cut. If the rival firms make
larger price cut than the one which initiated it, the firm which first started the
price cut will suffer a lot and may finish up with decreased sales. The
oligopolists, therefore avoid cutting price, and try to sell their products at the
prevailing market price. These firms, however, compete with one another on the
basis of quality, product design, after sales services, advertising, discounts,
gifts, warrantees, special offers, etc.

Figure.11.1 Marginal Revenue Curve

In the above diagram, we shall notice that there is a discontinuity in the marginal
revenue curve just below the point corresponding to the kink. During this
discontinuity the marginal cost curve is drawn. This is because of the fact that
the firm is in equilibrium at output ON where the MC curve is intersecting the
MR curve from below. The kinky demand curve is further explained in the
following diagram:

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 Figure.11.2 Kinky Demand Curve
In the above diagram, the demand curve is made up of two segments DB and
BD’. The demand curve is kinked at point B. When the price is Rs. 10 per unit,
a firm sells 120 units of output. If a firm decides to charge Rs. 12 per unit, it
loses a large part of the market and its sales come down to 40 units with a loss
of80 units. In case, the producer lowers the price to Rs. 4 per unit, its competitors
in the industry will match the price cut. Its sales with a big price cut of Rs. 6
increase the sale byonly40 units. The firm does not gain as its total revenue
decreases with the price cut.

2. Price Leadership Model

Underprice leadership, one firm assumes the role of a price leader and fixes the
price of the product for the entire industry. The other firms in the industry simply
follow the price leader and accept the price fixed by him and adjust their output to
this price. The price leader is generally a very large or dominant firm or firm with
the lowest cost of production. It often happens that price leadership is established
as a result of price warning which one firm emerges as the winner.
In oligopolistic market situation, it is very rare that prices are set independently
and there is usually some understanding among the oligopolists operating in the
industry. This agreement maybe either tacit or explicit.

Types of Price Leadership

There are several types of price leadership. The following are the principal types:
a) Price leadership of a dominant firm, i.e., the firm which produces the bulk
of the product of the industry. It sets the price and rest of the firms simply
accepts this price.
b) Barometric price leadership, i.e., the price leadership of an old,
experienced and the largest firm assumes the role of a leader, but undertakes
also to protect the interest of all firms instead of promoting its own interests
as in the case of price leadership of a dominant firm.
c) Exploitative or Aggressive price leadership, i.e., one big firm built its
supremacy in the market by following aggressive price leadership. It compels
other firms to follow it and accept the price fixed by it. In case the other firms
show any independence, this firm threatens them and coerces them to follow
its leadership.

Price Determination under Price Leadership

There are various models concerning price-output determination underprice
leadership on the basis of certain assumptions regarding the behavior of the price

144
 leader and his followers. In the following case, there are few assumptions for
determining price-output level underprice leadership
a) There are only two firms A and B and firm A has a lower cost of production
than the firm B.
b) The product is homogenous or identical so that the customers are indifferent
as between the firms.
c) Both A and B have equal share in the market, i.e., they are facing the same
demand curve which will be the half of the total demand curve.

In the above diagram, MCa is the marginal cost curve of firm A and MCb is the
marginal cost curve of firm B. Since we have assumed that the firm A has a lower cost
of production than the firm B, therefore, the MCa is drawn below MCb.
Now let us take the firm A first, firm A will be maximizing its profit by selling OM level
of output at price MP, because at output OM the firm A will be in equilibrium as its
marginal cost is equal to marginal revenue at point E. Whereas the firm will be in
equilibrium at point F, selling ON level of output at price NK, which is higher than the
price MP. Two firms have to charge the same price in order to survive in the industry.
Therefore, the firm B has to accept and follow the price set by firm A. This shows that
firm A is the price leader and firm B is the follower.
Since the demand curve faced by both firms is the same, therefore, the firm B will
produce OM level of output instead of ON. Since the marginal cost of firm B is greater
than the marginal cost of firm A, therefore, the profit earned by firm B will be lesser
than the profit earned by firm A.

11.8 GAME THEORY APPROACH TO OLIGOPOLY

Game theory is concerned with predicting the outcome of games of strategy in which
the participants (for example two or more businesses competing in a market) have
incomplete information about the others’ intentions
Game theory analysis has direct relevance to the study of the conduct andbehavior
of firms in oligopolistic markets for example the decisions that firms must take over
pricing and levels of production, and also how much money to invest in research and
development spending.

145
Costly research projects represent a risk for any business but if one firm invests in
R&D, can arrival firm decide not to follow? They might lose the competitive edge in
the market and suffer a long term decline in market share and profitability.
The dominant strategy for both firms is probably to go ahead with R&D spending. If
they do not and the other firm does, then their profits fall and they lose market share.
However, there are only a limited number of patents available to be won and if all of
the leading firms in a market spend heavily on R&D, this may ultimately yield a lower
total rate of return than if only one firm opts to proceed.

The Prisoner’s Dilemma

The classic example of game theory is the Prisoner’s Dilemma, a situation where two
prisoners are being questioned over their guilt or innocence of a crime.
They have a simple choice, either to confess to the crime (thereby implicating their
accomplice) and accept the consequences, or to deny all involvement and hope that
their partner does likewise.

Nash Equilibrium
Nash Equilibrium is an important idea in game theory .This describes any situation
where all of the participants in a game are pursuing their best possible strategy given
the strategies of all of the other participants.
In a Nash Equilibrium, the outcome of a game that occurs is when player takes
the best possible action given the action of player B, and player B takes the best
possible action given the action of player A.

LET US SUM UP
An oligopoly is a market structure in which a few firms dominate. When a market is
shared between a few firms, it is said to be highly concentrated. Although only a few
firms dominate, it is possible that many small firms may also operate in the market.
Oligopoly is a market structure where only a few large rivals are responsible for the
bulk, if not all, industry output. As in the case of monopoly, high to very high barriers
to entry are typical. Under oligopoly, the price/output decisions of firms are interrelated
in the sense that direct reactions from leading rivals can be expected. As a result, the
decision-making of individual firms is based, in part, on the likely response of
competitors.
The kinky demand curve model tries to explain that in non-collusive oligopolistic
industries there are not frequent changes in the market prices of the products. The
demand curve is drawn on the assumption that the kink in the curve is always at the
ruling price. The reason is that a firm in the market supplies a significant share of the
product and has a powerful influence in the prevailing price of the commodity.

146
Under price leadership, one firm assumes the role of a price leader and fixes the price
of the product for the entire industry. The other firms in the industry simply follow the
price leader and accept the price fixed by him and adjust their output to this price. The
price leader is generally a very large or dominant firm or afirm with the lowest cost of
production. It often happens that price leadership is established as a result of price
warring which one firm emerges as the winner.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. What is a market structure where only a few large rivals are responsible for the
bulk, if not all, industry output?

a) Oligopoly b) Duopoly

c) Pure competition d) All the above

2. The term oligopoly is derived from two Greek words ___________

a) Oleg’s b) ‘Pollen’

c) Both a and b d) None of the above

3. Bertrand, a French Mathematician developed his own model of duopoly in the
year___________

a) 1883 b) 1884

c) 1885 d) 1886

4. Edge worth developed his model of duopoly in the year___________

a) 1897 b) 1884

c) 1885 d) 1886
5. ___________ is a market structure where only a few large rivals are responsible
for the bulk, if not all, industry output.

a) Oligopoly b) Duopoly

c) Pure competition d) All the above

GLOSSARY

Oligopoly : An oligopoly is a market structure in which a few

firms dominate. When a market is shared between
a few firms, it is said to be highly concentrated.
Although only a few firms dominate, it is possible

147
 that many small firms may also operate in the
market.

Kinky demand curve : The kinky demand curve model tries to explain that
in non-collusive oligopolistic industries there are not
frequent changes in the market prices of the
products. The demand curve is drawn on the
assumption that the kink in the curve is always at
the ruling price.

Price leadership : Under price leadership, one firm assumes the role
of a price leader and fixes the price of the product
for the entire industry. The other firms in the industry
simply follow the price leader and accept the price
fixed by him and adjust their output to this price.

Oligopolistic market : In oligopolistic market situation, it is very rare that

prices are set independently and there is usually
some understanding among the oligopolists
operating in the industry. This agreement maybe
either tacit or explicit.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.youtube.com/watch?v=P0hAiUwU7Ss
8. https://www.youtube.com/watch?v=wYc51ezZDX0
9. https://www.economicsdiscussion.net/oligopoly/price-leadership-under-
oligopoly-with-diagram/3778

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) a 4) a 5) a

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Unit 12

PRICING
STRUCTURE

Overview

Learning Objectives

12.1 Methods of Pricing

12.2 Factors affecting Pricing Decision

12.3 Differential Pricing

12.4 Government Intervention and Pricing

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
In the preceding unit, you have been exposed to the meaning and the structure of
the market. In this unit, we shall analyse the methods of pricing. Pricing of the product
by firms is very important aspect of Managerial Economics, since firm’s revenue
mainly depends on its pricing policy. The chief function of the firm is pricing. Pricing
depends on cost of production. Price affects profit which in turn the business. Pricing
explains how prices are determined under different market structures. The manager
is required to have a thorough knowledge of profit. He has to determine suitable price
policies. The success or failure of a firm mainly depends on accurate price decisions.
A correct pricing policy makes the firm to the successful, while an incorrect pricing
policy leads to its failure.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• analyse the various methods of pricing

• explain the factors affecting pricing

• discuss the differential pricing.

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12.1 METHODS OF PRICING

a) Full Cost Pricing

Full Cost Pricing is the most common method used for pricing. This method is also
known as ‘Cost Plus Pricing’. Full cost pricing is a practice of adding a certain
percentage of total cost of production to average cost. That is, the selling price of
the product is equal to the cost of production plus anticipated profit. According to
Joel Dean, there are three methods of computing the cost. They are:

(i) the actual costs

(ii) the expected costs and

(iii) the standard cost.

Actual Cost is the cost incurred in the production of an article. It is the historical
cost for the latest available period which includes recent wages, material prices
etc.
Expected Cost is a forecast of actual cost for the pricing period on the basis of
expected prices, output etc.
Standard Cost refers to a normal cost determination at some normal rate of
output with normal efficiency.

Illustration
Suppose the cost of production of a product is Rs.10. If the management decides
to have a mark of 10 per cent as profit, then Re.1 is the addition to the cost.
Hence, the price per unit of the product is Rs.11.
Advantages

1. Full cost pricing is a very simple method.

2. Full cost prices are regarded as fair from the point of view of the
consumers.
3. It enables the firm to make up price lists even before the actual production
begins.

4. It eliminates frequent price fluctuations.

5. It is particularly suitable for industries where there is price leadership.

6. It reduces the costs of decision making.

7. When businessmen are uncertain about the demand conditions for their
product, this method is a safe and secure method.

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 Limitations

1. This method ignores completely the market demand.

2. It fails to reflect competitive forces.

3. It is useless for the industries whose products are perishable.

4. This method uses only average cost instead of marginal cost. So this
method is not relevant.

5. This method neglects the future cost.

6. Inefficiency during initial stages of producers is not considered and finally
the ultimate consumers suffer.

b) Marginal Cost Pricing

Both under Cost Plus Pricing and Rate of Return Pricing, the prices of products
are determined on the basis of total costs (Variable + Fixed Costs). But under
Marginal Cost Pricing, fixed costs are ignored and price is determined on the basis
of marginal costs or variable costs. Marginal cost pricing implies the practice of
fixing price just to cover the marginal cost incurred in the production of a
commodity. That is, according to marginal cost pricing, the price of the products
should be equal to marginal cost. Marginal cost is the additional cost made to
total cost by increasing one more unit of output.

Advantages

1. This method enables the firms to face competition.

2. It accurately reflects future costs than current costs.

3. It enables a producer to develop an aggressive pricing policy.

4. It is more useful for pricing over the life cycle of a product.
5. It is extremely useful in setting the price of a product produced according
to special orders or for exports.

6. This method is highly useful for public utility undertakings.

Limitations
1. When the executives are not fully aware of this method, they could not
explain the use of this method to the management.
2. During the period of recession, a firm using this method may reduce its
price which will lead to cut-throat competition.
3. This policy neglects the importance of long period. That is, this policy
holds good only when the problem is of a short period only.

151
c) Rate of Return Pricing
This method of pricing is only a refinement of the Full Cost Pricing. Under this
method, the price is determined on the basis of rate of return on investment.
According to this method, the producer considers a pre-determined target rate of
return on capital invested. The rate of return is to be translated into a per cent
mark-up on cost as profit margin. The profit margin is determined on the basis of
normal rate of production. The total cost of a year’s normal production is
estimated and regarded as standard cost. The mark-up percentage of profit
margin is obtained by multiplying capital turn over by the goal rate of return.

Illustration
Suppose the capital turn over I is 0.6 and the goal rate of return I is 12 per cent
on invested capital. Then,
Mark-up Profit Margin = CxR

= 0.6 x 12

= 7.2 per cent.

d) Going Rate Pricing

The Going Rate Pricing is opposite to Full Cost Pricing. Going rate pricing implies
that though the firm has the power to fix up its own price for the product, it will not
do so, but instead it tries to adjust its own price policy with the general pricing
structure prevailing in the industry. This means the firm which practices going rate
pricing policy does not have a price policy of its own; instead, it imitates the price
fixed by others in the industry.

This pricing policy is adopted under the following conditions:

(i) When costs are difficult to measure.
(ii) The adoption of going rate pricing will avoid price war among rival firms,
particularly in oligopolistic market.

(iii) This method avoids unnecessary troubles in calculating actual costs.

The Going rate pricing is usually happening in oligopoly.

Advantages

The following are the important advantages of going rate pricing:

1. This method helps in avoiding cut-throat competition among the firms.

2. This method is a rational pricing method, when costs are difficult to measure.
3. This method is less trouble-some and less costly. Because, exact calculation
of costs and demand is not necessary.

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 4. This method is suitable to avoid price hazards in oligopoly market.

e) Customary Pricing
When a price prevails for a long period of time, the same price becomes to be a
fixed price for a given commodity. For this situation, there is no deliberate action
on the part of the sellers / producers. Consumers are accustomed to that price
and hence consider it as a rigid price. Such prices are said to be ‘Customary
Price’. In other words, customary pricing refers to charging a price which has
prevailed for a long time. In case, if the firm increases the price, the demand
changes immediately. Thus, there is high degree of elasticity for the product.
Suppose if the firm decreases the price from the customary prices, there will not
be much difference in demand. When demand is slack, producers aim to reduce
the supply rather than reduce the price of the product.

f) Administered Price
The term Administered Price was introduced by J.M. Keynes for the prices
charged by a monopolist. A monopolist being a price maker administers the price
of his product. According to the Indian Economists like L.K. Jha and Malcolm
Adiseshiah, administered price for a commodity is the one which is decided and
arbitrarily fixed by the Government. It is not allowed to be determined by the
market forces of demand and supply. The administered prices are fixed by the
Government to prevent price fluctuations, black marketing, shortages in supply
etc. The Government may adopt administered prices for the commodities like
steel, cement, fertilizers etc. The objective of administered prices is to prevent
sudden rise in their prices and to ensure reasonable prices to the users. If the
prices of these commodities are allowed to rise or fall, the production of final
commodities is affected. The administered prices are fixed on the basis of the
cost of production plus a certain amount of profit.

Characteristics of Administered Prices

The following are the important characteristics of administered prices:

1. They are fixed by the Government.

2. They are statutory, i.e., they are legally enforced by the Government.

3. They are regulatory in nature.

4. They are meant as corrective measures.

5. They are outcome of the price policy of the Government.

g) Skimming Price
For the products that represents a drastic departure from accepted ways of
performing a service, a policy of relatively high prices have coupled with heavy
promotional expenditure in the early stages of the market development and lower

153
 prices at later stages has proved successful for many products. Therefore,
skimming price is the price where the initial price is high. Whenever a firm
introduces a new product, it spends a huge sum of money on advertisements.
The firm may put the product in attractive packages. Therefore, to cover all these
costs, the firm fixes a highest possible price. When it has no rivals, a high price
is fixed for the product. When the new firms enter into the market, then the price
is reduced.

Conditions for the Success of Skimming Prices

The following are the important reasons for the success of the skimming price.
1. The demand is likely to be more inelastic in the early stages than in the later
stages.

2. The cross elasticity is usually very low.

3. The initial advertisement elasticity is very high.

h) Penetration Price
Penetration Price is the reverse of the skimming price policy in which price is
lowered right from the beginning to penetrate the market as quickly as possible.
This policy is intended to maximize the profit in the long-run. Therefore, the firms
adopting the penetration price policy set a low price of the product in the initial
stage. It is due to the fact that the consumers may buy the product at a low price.
As the product catches the market, price is gradually raised up. The objective of
the penetration pricing policy is to keep the rivals away from entering into the
market with substitute products. The low price of the products prevents
competition.

Conditions for the Success of Penetration Price

The success of the penetration price policy requires the existence of the following
conditions in the market:

1. The short run demand for the product has elasticity greater than unity.

2. The economies of large scale production are available to the firm.

3. The market for the product is large.

4. The product should have a high cross elasticity in relation to rival products.

5. The product can be easily purchased by the mass of consumers.

i) Peak Load Pricing

Peak Load Pricing implies the practice of raising the price above the average
variable cost during high demand periods and reducing it towards average
variable cost during low demand periods. For example, the demand for electricity

154
 is high during the day time and low during night time. It is high in a cold country
and low in a hot country. Similarly, the demand for telephone is more during day
time and low during night time. Since these services are not storable, the capacity
to be installed should depend upon that maximum demand, i.e., peak load
demand. Hence, in the case of electricity and telephone, the prices are high for
the peak load period and low for low demand period.

Advantages
1. It depresses peak demand and thereby reduces the total resources needed to
satisfy consumers’ demand.
2. It stimulates peak consumption during slack periods and allows more efficient
155maximization of existing facilities.

12.2 FACTORS AFFECTING PRICING DECISION

The factors affecting pricing decision can be divided into two groups. They are: a)
Internal Factors b) External Factors

a) Internal Factors
Internal factors are generally within the control of the organization. They are
sometimes referred to as “Built-in-Factors” that affect the pricing decision. These
factors include the following:

a) Cost
The most important factor which affects pricing decision is the cost of
production. In the past, the price fixing was a simple affair; just add up all the
costs incurred and divided the final Figure (i.e., total cost) by the number of
units produced. Adding necessary profits with the cost of production would
give the price at which the products are to be sold.
The main defect with this approach is that it disregards the external factors like
demand, competition. Whatever be the cost of production, there is a price at
which the consumer is willing to buy. Furthermore, finding the cost of
production is not so simple today on account of indirect costs.

b) Objectives
Many firms have various objectives and pricing contributes its share in
achieving such objectives. These objectives may be 155maximization sales
revenue, 155maximization market share, maintaining an image, maintaining
stable price etc.

155
b) External Factors
External factors are generally beyond the control of an organization. These
factors include demand, competition, distribution channels, suppliers of raw
materials, economic conditions etc.

a) Demand
The market demand for a product also affects pricing decision. If the demand for
a product is inelastic, high prices may be fixed. On the other hand, if the demand
is elastic, lower prices must be fixed than that of the competitors.

b) Competition
Competition is a crucial factor that influences pricing decision. No producer is free
to fix the price for his product without considering competition, unless he is a
monopolist. A firm can fix the price equal to or lower than that of the competitors,
provided the quality and size of the product are not lower than that of the
competitors.

c) Distribution Channels
The distribution channels also sometimes affect the price. The consumer knows
only the retail price. But there are middlemen working in the channel of distribution
between the manufacturer and the consumer. Each one of them has to be paid
for the services rendered. This compensation must be included in the ultimate
price.

d) Supply of Raw Materials

The suppliers of raw materials also affect the pricing decision. For example, if the
price of cotton goes up, the price of cloths goes up. Hence, scarcity or abundance
of the raw materials also determines the price.

e) Economic Conditions
The inflationary or deflationary tendency affects pricing. During recession period,
the prices are reduced to a sizeable extent to maintain the level of turnover. On
the other hand, the prices are increased in boom period to cover the increasing
cost of production and distribution.
Hence, legal restraints, Government interference such as control of prices, levying
of taxes, etc., are other factors which also affect the pricing decision.

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12.3 DIFFERENTIAL PRICING
It means charging of different prices from different consumers for the same commodity
at the same time.

12.3.1 Degrees of Differential Pricing

i. First Degree Discrimination

The seller charges different prices for each commodity bought by the same
buyer.

ii. Second Degree Discrimination

The seller charges different prices for blocks of units instead of each item.

iii. Third Degree Discrimination

The seller divides the buyers into different groups keeping in view their income,
location and kinds of uses of the commodity and charge different prices from each
group.

12.3.2 Bases for Price Differentials

The main bases for price differentials are:

• The trade status of the buyer

• The amount of his purchase

• The location of the purchases

• The promptness of payment

• The time of purchase

• The personal situation

12.3.3 Conditions for Differential Pricing

The following are the conditions for differential pricing:

• The seller categorizes the buyers according to their income, location, taste
etc.
• The seller must be able to divide the total market into various sub-markets.

• The seller must prevent the resale of goods from lower to the high priced
market.

12.3.4 Goals of Differential Prices

The producer will have the following goals in adopting differential prices:

157
 • Implementation of marketing strategy to reach a particular sector of the market
through price differentials.
• Differential pricing is adopted to achieve profitable market segmentation, if legal
and competitive considerations permit it.
• Differential prices help to attract new customers.

• Differential prices are major device for selective adjustment to competitive

situations.
• Allowing seasonal discounts reduce the overall production costs by encouraging
off season purchases.

12.4 GOVERNMENT INTERVENTION AND PRICING

Often Governments intervene with the normal process of price determination by fixing
prices either above equilibrium level or below it.The Government should take the
following steps to make this intervention effective or difficulties in price fixing:
i. Examples of attempts to fix prices above an equilibrium level are minimum wage
legislation and price support policies. When Government step is to fix a
minimum price much above the equilibrium price, consumers curtail their
consumption.
On the other hand, farmers are encouraged to increase their production under
the incentive of high prices. As a result, there is disequilibrium between the
demand and supply. There are two ways to maintain prices at a higher level.
a) The Government can buy large quantities to make up the difference
between quantity supplied and quantity demanded.

b) The Government can ask the farmers to cut their output.

ii. Efforts to set maximum prices below the equilibrium level are shown by price
control.
The Government would have to adopt both or either of the following measures:
a) Introduction of Rationing.

b) Payment of subsidy to the producers

LET US SUM UP
In this unit, we have seen the methods of pricing and factors affecting pricing decision.
Further in this unit, we have analyzed the differential pricing and Government
intervention and pricing. Differential pricing means charging of different prices from
different consumers for the same commodity at the same time.

158
CHECK YOUR PROGRESS

Choose the Correct Answer

1. The practice of adding a certain percentage of total cost to average

Cost is ___________

a) Marginal cost pricing b) Full cost pricing

c) Rate of return pricing d) Administered price

2. The practice of fixing price just to cover the marginal cost is ___________

a) Marginal cost pricing b) Full cost pricing

c) Rate of return pricing d) Average cost pricing

3. The charging of different prices from different consumers for the same

Commodity at the same time is called ___________

a) Marginal cost pricing b) Full cost pricing

c) Rate of return pricing d) Differential Pricing

4. The seller charges different prices for blocks of units instead of each

Item is ___________

a) First Degree Discrimination b) Full cost pricing

c) Second Degree Discrimination d) Differential Pricing

5. The seller charges different prices for each commodity bought by the
Same buyer___________

a) First Degree Discrimination b) Full cost pricing

c) Second Degree Discrimination d) Differential Pricing

GLOSSARY

Full cost pricing : Full Cost Pricing is the most common method used
for pricing. This method is also known as ‘Cost plus
pricing’. Full cost pricing is a practice of adding a
certain percentage of total cost of production to
average cost.

Penetration price : Penetration Price is the reverse of the skimming

price policy in which price is lowered right from the
beginning to penetrate the market as quickly as
possible. This policy is intended to maximize the
profit in the long-run. Therefore, the firms adopting

159
 the penetration price policy set a low price of the
product in the initial stage.

Marginal cost pricing : Both under Cost Plus Pricing and Rate of Return
Pricing, the prices of products are determined on
the basis of total costs (Variable + Fixed Costs).
But under Marginal Cost Pricing, fixed costs are
ignored and price is determined on the basis of
marginal costs or variable costs.

Skimming price : For the products that represent a drastic departure

from accepted ways of performing a service, a
policy of relatively high prices coupled with heavy
promotional expenditure in the early stages of
market development and lower prices at later
stages has proved successful for many products.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand & Sons
Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts &
Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial Economics,
Sultan Chand & Sons, New Delhi.
7. https://www.toppr.com/guides/fundamentals-of-economics-and-
management/forms-of-market/pricing-strategies/
8. https://www.youtube.com/watch?v=DMtezEw7VrQ

ANSWERS TO CHECK YOUR PROGRESS

1) b 2) a 3) d 4) c 5) a

160
 BLOCK 4

PROFIT & COST VOLUME ANALYSIS

Unit 13: Profit

Unit 14: Cost Volume Profit Analysis

161
Unit 13

PROFIT
STRUCTURE

Overview

Learning Objectives

13.1 Concept of Profit

13.2 Profit Planning

13.3 Profit Control

13.4 Measurement of Profit

13.5 Profit Maximization

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Success or failure of any firm depends on profit. A business firm is always profit
motivated. Profit seeking is the motive force of any business. Market economy is,
thus, profit oriented. Reasonable profit is the reward of the entrepreneur for his
entrepreneurial ability. As such, a rational profit policy is important for a modern
business. Hence profit planning is indispensable for a successful firm. Therefore,
profit maximization is the basic objective of each firm. In this unit, let us discuss the
meaning of profit, profit planning, profit control, measurement of profit and profit
maximization.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define the concept of profit

• explain the concept of profit planning and profit maximization

• analyse the measurement of profit.

162
13.1 CONCEPT OF PROFIT
Profit is the remuneration paid to the entrepreneur for his service (or for the use of his
ability). In other words, profit is the amount left with the entrepreneur after he has
made payments for all the other factors (land, labour and capital) used by him in the
production.

13.2 PROFIT PLANNING

Profit is indispensable for the health and well-being of the business. Hence, in the
operation of the firm, profit planning is considered as a vital operation. Towards that,
a firm considers the expected demand for its product and measures needed to reduce
the cost for increasing profit margin. Hence, appropriate profit planning is necessary
for a firm to realize a high level of profit.

Methods of Profit Planning

To maximise the profit, a firm can use any of the following or more than one method
in its managerial operations:

a) Profit Budget Method

The profit budget method is an annual profit plan prepared by a business firm in order
to estimate the anticipated profit. It is based on the income statement of the firm
relating to the previous year. The firm has to forecast its estimated demand for its
product, price of the product, cost of production of the product for the forthcoming
year. Finally, the expected profit for the forthcoming year is calculated. The profit
budget deals with the activities like production and marketing of the product, getting
and administrating the number of labour required, purchase and storage of raw
materials, securing the required finance etc.
One more aspect of budget is control aspect. Effective control of activities is essential.
Hence, a systematic check on operations is needed to have implementation of budget.

b) Break Even Analysis

The Break Even Analysis studies the relationship between cost of production, volume
of output, sales, revenue and profit. The impact of level of output on costs, revenues
and profits can be studied through this analysis.

c) Rate of Return on Investment Method

To measure the profitability, the rate of return on invested capital can be used. The
rate of return on investment is defined as the quotient (ratio) of the after tax earnings
plus interest charges on bonds to total long term committed funds of the firm.

Therefore,

163
Rate of Return on Investment =
Current Value of Investment − Cost of Investment
Cost of Investment
Normally, the marginal rate of return is used for taking marginal decisions. When the
marginal rate of return is found to be equal to the marginal cost of capital, a firm can
introduce a new product. This method is used as a standard method of measuring
the performance of the business firm.

13.3 PROFIT CONTROL

The use of the profit incentive and profit accounting in the measurement and control
of executive performance in large business enterprises is another managerial aspect
of profits. Perhaps the major internal threat to vitality in the big corporation is
bureaucratic deviation.
Keith Powlison has pointed out three common deviationist tendencies that appear
when the profit motive is attenuated:
1. More energy is spent in expanding sales volume and product lines than in
raising profitability, the valid company objective.
2. Subordinates spend too much time and money doing jobs to perfection
regardless of cost and usefulness. This is particularly common among staff
men who don’t understand or appreciate the insignificance of that last digit in
their estimates and projections.
3. Lower management’s insecurity feelings become barricaded by expensive
overstocking and playing-safe tactics, since there is no reward for imaginative
ventures that can possibly offset the perils of making a mistake.
Companies that have become concerned about this problem have sought methods of
measuring and rewarding executive performance that will guard against this
hardening of the profit seeking arteries. Such plans have two characteristics in
common.
1. The first is realignment of the managerial organization to shift the basic
breakdown of operating responsibility from a functional basis.
2. The second common trait is reorientation of accounting reports to conform to
the areas of executive responsibility. Each executive is given a profit goal for
his operation and his performance is appraised on the basis of periodic profit
and loss statements, as well as subordinate budgetary controls.
This kind of managerial decentralization and control-by-profits has important
advantages for the big company.

164
13.4 MEASUREMENT OF PROFIT
The measurement of the amount of profit earned by a firm during a given period is not
simple. Even in the accounting sense, measurement of profits is not an easy task.
There is a wide variety of generally accepted accounting principles which provide for
different methods of treatment for certain items of revenue or expenditure. They are:

a) Depreciation

b) Valuation of Stock

c) Treatment of Deferred Expenses and

d) Capital Gains and Losses.

a) Depreciation
During the process of production, equipments and machines are used and hence
they are gradually worn out. Some machines may also become obsolete. Hence,
a certain part of the income must be used for the replacement of worn out and
obsolete machines. This amount is called “Depreciation” by the accountants. In
order to measure the true income of a business, this depreciation is made against
the annual income of the business.
Methods of Measuring Depreciation
There are a number of methods of measuring depreciation. The following three
methods are commonly accepted:

i) The Straight Line Method

ii) The Declining Balance Method

iii) The Sum of the Year’s Digits Method

i) The Straight Line Method
This method is simple and is most commonly used method of depreciation.
Under this method, an asset is supposed to wear out evenly during its normal
life. Hence, depreciation is provided on a uniform basis regardless of the fact
that the asset depreciates more rapidly at some stages of its life. The amount
of annual depreciation is obtained by dividing the initial cost of the assets by
the estimated life in years, assuming that there is no scrap value (residual
value of the asset). If the asset has an estimated scrap value, the scrap
value has to be deducted from the initial cost before dividing it by the estimated
life in years. This method is known as the ‘Straight Line Method’ because of
the successive values of depreciation is plotted against the life time of the
asset, as the fall in a straight line. The formula to calculate depreciation under
the straight-line method is:
D = (F-S)/n

165
 where,
D= Annual Depreciation
F= Original value of the Asset
S= Scrap value of the Asset
n= Life of the Asset in years.
Illustration
Suppose an asset has an original value of Rs. 9,000 with a scrap value of
Rs.900 and the life of the asset is 9 years. The depreciation charge on this
asset will be:

D = Rs. 990
Under the “Working Hours Method”, the life of the asset is expressed
in terms of working hours, rather than in years. Under this method,
depreciation is calculated by dividing the initial cost less scrap value by the
number of working hours.
Illustration
Suppose an asset has a working life of 12000 hours whose original cost is
Rs.40,000 and its scrap value is Rs.4000. The depreciation per working hour
will be:

= Rs.3 per working hour

ii) The Declining Balance Method

Under this method, depreciation is provided on a uniform rate on the written
down value of the asset at the beginning of the year. If the cost of the asset
is Rs.10,000 and the rate of depreciation is 20 per cent, the depreciation for
the first year would be Rs.2,000 (20 per cent of Rs.10,000 i.e., 20/100 x
10,000). The written down value of the asset at the beginning of the second
year would be Rs.8,000 (10,000 – 2000). Then the depreciation for the second
year would be Rs.1,600 (20 per cent of Rs.8,000, i.e., 20/100 x 8000) and the
value of the asset at the beginning of the third year would be Rs.6,400
(Rs.8,000 – Rs.1,600). Then the depreciation for the third year would be
Rs.1,280 (20 per cent of Rs.6,400, i.e., 20/100 x 6400).
Thus, the depreciation amount will show a declining trend of Rs.2,000 for the
first year, Rs.1,600 for the second year and Rs.1,280 for the third year. Under
this method, the written down value however small, will never be zero. Hence,
the asset is assumed to have some scrap value.

The formula for determining the fixed rate of depreciation is as follows:

d = 100

where,

166
 d = Percentage of Depreciation

s = Scrap Value

c = Initial cost of the Asset

n = Estimated Life of the Asset in Years.

The method of computing the fixed rate of depreciation as described above is
rather complicated. A similar and more widely used method is to use a uniform
percentage which is double the reciprocal of the estimated life.

Uniform Rate or d = 2 (…….)

The basic idea behind the use of this method is to provide for a more or less
uniform total cost of operation of the asset over different years of its life. On
the other hand, under this method, depreciation is higher in earlier part of the
life of the asset, but it declines progressively in the later years. The
combined effect is that the total charge in the profit and loss account for the
asset concerned is more or less equated over different years.

iii) The Sum of the Year’s Digits Method

The basic idea of this method is similar to that of the Declining Balance
Method, i.e., to provide for a uniform total cost of operation of the asset. The
amount of depreciation in the beginning of the life of the asset is higher and it
progressively declines with the passage of time. The variable rate of
depreciation is calculated as follows:
(i) Each digit of the years of the usual life of the asset is added up and
the resulting Figure is the denominator of the fraction to find out the
depreciation rate.
(ii) The numerator of the fraction for each year is the expected life of the
asset in that particular year and this declines by one, each year.
Thus, the depreciation rate is composed of a varying numerator and
an unvarying denominator. And this rate is applied each year to the
assets original cost.

Illustration
The sum of the year’s digit method can be explained by a simple illustration.
Suppose the original cost of an asset is Rs.10,000, its scrap value is Rs.1,000
and its expected life is 5 years. In the beginning, the asset has an expected
life of 5 years, one year later it has an expected life of 4 years and so on.
Thus the expected life periods of the asset are 5, 4, 3, 2 and 1 years. The
sum of these expected life periods is 15 (5+4+3+2+1) years which will be the
common denominator of the annual rates. The numerators are 5/15, 4/15,
3/15, 2/15 and 1/15 respectively. The original value of the asset is Rs.10,000

167
 and the scrap value is Rs.1,000 and hence the depreciation charge should be
made for Rs.9,000 (Rs.10,000 – 1,000).
The calculation of annual depreciation, accumulated depreciation and book
value of the asset by the sum of the year’s digits method is shown in Table
11.1.

Age of Rate of Annual Accumulated Book

the Depreciation Depreciation Depreciation Value
Assets of the
in the Asset
Asset

1 5/15 or 33 3,000 3,000 7,000

1/3%

2 4/15 or 26 2,400 5,400 4,600

3/8%

3 3/15 or 20% 1,800 7,200 2,800

4 2/15 or 13 1,200 8,400 1,600

1/3%

5 1/15 or 6 2/3% 600 9,000 1,000

Depreciation and Profit

From this, we can understand that the amount of profit of a firm depends on the
method of depreciation adopted. With the same machine, equipment, building,
etc., different firms can show different amounts of depreciation and consequently,
different amounts of profit.
b) Valuation of Stock
In business, the valuation of stock will influence the profit. The method adopted
to calculate the valuation of stock will have the impact on the profit. There are
three common methods of valuation of stocks. They are:

i) First in First Out Method (FIFO)

ii) Last in First Out Method (LIFO)

iii) Weighted Average Method.

i) First In First Out Method (FIFO)

This method assumes that the raw materials purchased first will always be
the used first. Hence, when the earlier purchases have been consumed, the
later purchases will be used, i.e., first in stock should go out first and the

168
 stock acquired very recently will be used later. As a result, the inventory is
supposed to consist of goods purchased most recently.

ii) Last In First Out Method (LIFO)

This method assumes that the raw materials purchased very recently will be
used in production. Under this method, the prices of the most recently
purchased stocks become the costs of raw materials in current production.
As a result, the inventory (the closing stock) earlier is supposed to consist of
goods purchased earlier. Cost of goods sold under LIFO approximates their
replacement cost.

iii) Weighted Average Method.

This method assumes that it is not possible to identify the cost of goods
purchased at different times at different prices. Since the cost of one unit of
good in the stock cannot be distinguished from the cost of another, the goods
in the stock are priced at an average of the cost of each purchase, weighted
by the quantity purchased at that cost. As a result, inventory also gets
valued at the average cost.

Illustration
The above three methods of valuation of stock can be explained with a
simple illustration.
Suppose a firm purchases 500 kg of raw materials at different times at
different prices as per the details given below:

Purchased on February 7th :100 kg @ Rs.2.25= Rs.225

Purchased on June 19th:150 kg @ Rs.2.50= Rs.375

Purchased on June 21st:250 kg @ Rs.2.75= Rs.687.50
Suppose, on September 11, the stores department issued a quantity of 200
kg of the raw materials to the production department. Then the calculation
of value of stock on hand under the three methods are:
Under FIFO method, the raw material issued to the production department
(200 kg) will be valued at Rs.475 (100 kg @ Rs.2.25 = Rs.225 plus
100 kg @ Rs.2.50 = Rs.250) and the stock will be valued at Rs.812.50 (50
kg @ Rs.2.50 = Rs.125 plus 250 kg @ Rs.2.75 = Rs. 687.50). According to
this method, the first acquired should go out first.
Under LIFO method, the raw materials issued to the production department
will be valued at Rs.550 (200 kg @ Rs.2.75) and the stock will be valued at
Rs.737.50 (50 kg @ Rs.2.75 = Rs.137.50 plus 150 kg @ Rs.2.50 = Rs.375

169
 plus 100 kg @ Rs.2.25 = Rs.225). Under this method, recently procured
materials should be issued first.
Under Weighted Average Method, the raw materials issued will be valued at
Rs.515.

X Quantity of Raw materials Issued

x 200=Rs.515 and the stock will be valued at Rs.772.50

x Remaining Stock

x (500 – 200)

x 300 = Rs.772.50
Thus, it will be seen that the value of the stock is different under different
methods.
c) Treatment of Deferred Expenses and
The firm will have intangible fixed assets. This intangible fixed asset can be
classified into two categories, namely,
(i) those having a limited life, i.e., Patents and Copy right, Licenses and
Permits etc., and
(ii) those having no such limited life, e.g., Trade Marks, Goodwill,
Preliminary Expenses etc.
Businessmen prefer to write off the intangible assets during their life time, because
they are having a limited life. Sometimes, the businessmen prefer to write off
these intangible assets even before their useful life expires. For example, this
type is provided by copyrights. The copyrights have a legal life equal to author’s
life plus 50 years thereafter. But publications rarely have an active market for
such a long period. It is therefore, considered advisable to write off the cost of
copyright against the income from the first edition.
The treatment of intangible fixed asset with no limited life is more complicated
because of the following reasons:
(i) There is a difference of opinion, whether the assets should be written off at
all or not.
(ii) If they have to be written off, what should be the period for their
amortization? This amortization may be done either gradually or by an
immediate write off.
For example, this type is provided by “Goodwill”. The goodwill should be written
off immediately upon or after acquisition, because goodwill is a fancy asset which
has no place in the balance sheet. This is the conservative view which is not

170
 wholly commendable because sometimes goodwill is based on certain important
factors giving decisive advantage to the firm. In that case, a more rational view
would be to write off the goodwill over an appropriate period of time. And there is
always room for difference of opinion on what is an appropriate time.
Regarding preliminary expenses of the firm, it is regarded as a permanent asset.
Because, they are expected to benefit the company so long as it continues in
operation. But, the conservative view is that they are a sheer loss and therefore,
they must be written off as soon as possible. Accountants have regarded the
preliminary expenses as deferred charge on profits to be written off during the
early of the company’s life, say 5 to 7 years.

d) Capital Gains and Losses.

The conservative companies may decide not to include capital gains in the current
profit. At the same time, they would like to write off capital losses from the current
profits of the year in which the loss occurs. On the other hand, a company may
decide to include the capital gains in the profits of the year in which capital gains
may occur. So far as capital losses are concerned, it may decide to write off, out
of retained earnings. Thus, the amount of profit would also be affected by the
treatment of capital gains and losses. It would be lower in the case of conservative
companies than in the case of non-conservative companies.

13.5 PROFIT MAXIMISATION

Profit maximization is the basic objective of each firm. Because, the success of a firm
is based on the volume of profit earned by it. Most firms want to limit short-run profits
in order to maximize long-run profit. All activities of the firms are to limit the size of
the profit in the short-run by the following ways:
1. Firms often aim at becoming leader in their respective industries even if it means
higher costs and lower profit. In such firms, profit 171 maximization is
subordinated to industry leadership.
2. When a firm aims at 171maximization profits, it attracts competitors to enter the
field and share the market. To avoid such competitors, a firm may follow a policy
of profit restriction rather than a policy of profit 171maximization.
3. High profits are often regarded as an index of monopoly power. They may
create an impression that the firm is exploiting the consumers. Hence,
Government may investigate into its profits. Therefore, the firms may decide to
aim less than the maximum profits.
4. A policy of profit restraint rather than profit 171maximizations may be followed
in order to maintain goodwill of the customers.
5. Much management give greater importance to financial soundness of a firm and
hence prefer liquidity to profit maximization. This is because; profit maximization

171
 often enters into the new areas of production involving a huge investment in
fixed assets and consequent reduction in liquidity.
6. Profit maximization may involve an element of risk. Business executives may
avoid such risks because in case of failure, they may loss their job, status and
image.
7. If the firm maximizes its profit, trade unions will demand high wages, which
increases the costs and also creates management problems. Thus, to avoid
such problems and to maintain good labour relations, profit control is imperative.

LET US SUM UP
In this unit, we have defined the concept of profit. Profit is the reward paid to the
entrepreneur for his service. Profit planning is indispensable for a successful firm.
We have also discussed the meaning and methods of profit planning, namely, Profit
budget method, Break Even Analysis and Rate of return on investment. In this unit,
we have analyzed the measurement of profit and profit maximization, because profit
maximization is the sole objective of each firm.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. The relationship between cost of production, volume of output, sales,

revenue and profit is called ___________

a) Profit planning b) Profit control

c) Profit budget d) Break Even Analysis

2.______________ is the remuneration paid to the entrepreneur for his

service.

a) Profit b) Profit control

c) Profit budget d) Break Even Analysis

3._______________is an annual profit plan prepared by a business firm

in order to estimate the anticipated profit.

a) Profit planning b) Profit control

c) Profit budget d) Break Even Analysis

4.To measure the ____________, the rate of return on invested capital can be used.

a) Break Even Analysis b) Profit control

c) Profitability d) Break Even Analysis

5. The method adopted to calculate the valuation of stock will have the

172
impact on the ___________

a) Profit b) Profit control

c) Profit budget d) Break Even Analysis

GLOSSARY

Profit : Profit is the remuneration paid to the entrepreneur

for his service (or for the use of his ability)

Profit planning : Profit is indispensable for the health and well-

being of the business. Hence, in the operation of
the firm, profit planning is considered as a vital
operation.

Profit control : The use of the profit incentive and profit

accounting in the measurement and control of
executive performance in large business
enterprises is another managerial aspect of profits.
Perhaps the major internal threat to vitality in the
big corporation is bureaucratic deviation.

Depreciation : During the process of production, equipment's and

machines are used and hence they are gradually
worn out. Some machines may also become
obsolete. Hence, a certain part of the

Valuation of stock : In business, the valuation of stock will influence

the profit. The method adopted to calculate the
valuation of stock will have the impact on the
profit.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand & Sons
Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts &
Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.

173
 6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial Economics,
Sultan Chand & Sons, New Delhi.
7. https://corporatefinanceinstitute.com/resources/accounting/types-
depreciation-methods/
8. https://www.economicsdiscussion.net/profit/profit-maximization-model-of-a-
firm-with-diagram/6129

ANSWERS TO CHECK YOUR PROGRESS

1) d 2) a 3) c 4) c 5) a

174
Unit 14

COST VOLUME PROFIT ANALYSIS

STRUCTURE

Overview

Learning Objectives

14.1 Introduction

14.2 Meaning of Break-Even Analysis

14.3 Break Even Point

14.4 Determination of BEP

14.5 Assumptions

14.6 Managerial Uses of Break-Even Analysis

14.7 Limitations of Break-Even Analysis

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
In the preceding unit, we have seen the profit planning and profit control. Profit
maximization is the basic objective of each firm, for which Cost Volume Profit Analysis
is essential. Hence, in this unit let us discuss this analysis in an elaborate manner.
This analysis has considerable significance for economic research, business decision
making, company management and public policy. This analysis is also useful to
understand the financial relationship among cost, revenue and the rate of output.
Capital budgeting is also necessary for a successful firm.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• define Break-Even Point and Capital Budgeting

• examine the Break-Even Analysis

• explain the managerial uses of BEA

• analyse the evaluation techniques for the appraisal of projects.

175
14.1 INTRODUCTION
Mathematical techniques are now considered as an effective aid towards solving
management problems. Business executives and others are supposed to have a
good knowledge of mathematical techniques. In this topic, we deal in an elementary
way with the important mathematical technique, Break Even Analysis, which is used
for managerial decision making.

14.2 MEANING OF BREAK EVEN ANALYSIS

The Break-Even Analysis studies the relationship between the volume and cost of
production on the one hand and the revenue and profits obtained from the sales on
the other hand.

14.3 BREAK-EVEN POINT (BEP)

The Break-Even Point (BEP) is the point at which the total revenue is equal to the
total cost and consequently the net profit is equal to zero. That level or point is said
to be ‘No-Profit, No-Loss’ point

BREAK-EVEN CHART
A Break-Even Chart is the graphic form of the relationship between production and
sales or profits. Figure 12.1 illustrates the break-even chart.

Figure. 14.1 Break-Even Chart

In Figure 14.1, X axis represents output and Y axis represents total cost / total
revenue. Both the Total Cost (TC) and the Total Revenue (TR) curves are shown as
linear.TR curve is linear because of the assumption of constant variable costs. TR
curve is drawn as a straight line from the origin because every unit of output
contributes constant amount to total revenue.TC curve is also a straight line starting
from Y axis because total cost includes fixed and variable costs. In the chart, ‘B’ is
the break-even point at which TR equals TC at OQ level of output. So the net profit is
zero at this level of output OQ. That is OQ is the level of output where the firm makes
neither profit nor loss. Below the break-even point, total cost is more than total
revenue and the firm would suffer a loss. Above the break-even point, total revenue

176
exceeds total cost and the firm would make profit. Since profit or loss occurs between
cost and revenue lines, the space between them is known as the “Profit Zone” (to the
right of the BEP) and the “Loss Zone” (to the left of the BEP).
The Break-Even Chart can also be represented in an alternative form (Figure: 14.2)
where the contribution to fixed cost (contribution margin) and profits is clearly
depicted.

Figure. 14.2 The Break-even Chart (Alternative Form)

14.4 DETERMINATION OR CALCULATION OF BEP

The BEP is determined either in physical units or in money terms (i.e., in terms of
sales value of total output).
(i) BEP in terms of physical units

This method is useful for a firm that produces a single product.

In this method, we use AR and AC concepts instead of TR and TC. Then, the BEP
is to be found out at a level of output where AR is equal to AC. AR is nothing but
price. So AR or price must cover the AVC in full and part of FC. The difference
between the selling price and variable cost per unit (AVC) is the “Contribution
Margin”. BEP can be found out at a point of output, where the total “Contribution
Margin” is equal to TFC. The following formula can be used to find BEP:
TFC
BEP =
P −AVC

where,

BEP = the break-even point

TFC = the total fixed cost

P = the selling price

AVC = the average variable cost

177
 Obviously, P–AVC measures the contribution margin per unit.

Examples
1. An establishment is producing only one product. It sells at Rs.7.50 per unit. The
Fixed Cost is Rs.40,000 and Variable Cost is Rs.3.50 per unit. How
many units must be produced to Break-Even and how many units of the product
must be produced to get a profit of Rs.10,000? What would be the profit if
12,000 units are produced?

Solution

Break-Even Point (in units) = 10,000 Units.

BEP (units) to earn a profit of

Rs.10,000 = 12,500 units.

Profit at sales of 12,000 units = TR – TVC – TFC

=PQ – (AVC) Q – TFC

= 7.5 x 12,000 –(3.5x12000)

- 40,000

=90,000 – 42,000 – 40,000

= 90,000 – 82,000

= Rs.8,000.
2. Suppose the Fixed Cost of a factory is Rs.6,012 and the Variable Cost isRs.3 per
unit and the selling price is Rs.9 per unit. Find out the Break- Even Point.
Solution
BEP = 1002 units.
Answer
The Break-Even Point is reached, when the factory sells 1002 units.

TR = PQ = Rs.9 x 1002 = 9018

TC = TFC + TVC = 6012 + (1002 X 3)

= 6012 + 3006 = Rs.9,018

Hence, [Net Profit is 0 TR – TC = 9018 – 9018 = 0].

(ii) BEP in terms of sales value

This method is used when a firm is engaged in multi-products. Under this method,
TR and TC concepts are used. The BEP is determined in terms of money or sales
value. The difference between the total sales value (TR) and Total Variable Cost

178
 (TVC) is called ‘Contribution Ratio’. Then the formula to calculate BEP is as
follows:
Total Fixed Cost
BEP = ContributionRatio

The formula to find out the ‘Contribution Ratio’ is as follows:

TR−TVC
Contribution Ratio (CR) = TR

Examples
1. A firm incurs a Fixed Cost of Rs.40,00 and Variable Cost of Rs.10000.The
total sales receipts is Rs.15000. Determine the BEP.
Solution
TR−TVC
CR = TR
15000−1000 1
= =3
15000
=
TFC 4000 4000 x 3
BEP = = 1 = 1 =12000
CR ⁄3

Answer
The Break-Even Point is reached when the firm’s sales value is Rs.12,000.
2. The Fixed Cost of a factory is Rs.6,000 per year. The Variable Cost is
Rs.12,000. The sales value is Rs.18,000. Find out the Break-Even Point.
Solution
TR−TVC
CR = TR
18000−12000
= 18000
1
=3

BEP =6,000 x 3

= Rs.18, 000.

Answer

The Break-Even Point is reached when the firm’s sales value is Rs.18,000.

14.5 ASSUMPTIONS OF BREAK-EVEN ANALYSIS

The Break-Even Analysis is based on the following assumptions.

1. The total cost can be classified into fixed cost and variable cost. It
ignores semi-variable cost.
2. The volume of sales and volume of production are equal. So, there is
no closing stock.

179
 3. The selling price remains constant.

4. The variable costs vary proportionately with volume.

5. It assumes constant technology and no improvement in labour
efficiency.

6. The factor prices remain unaltered.

7. Both the total cost and total revenue are assumed to be linear.

14.6 MANAGERIAL USES OF BREAK-EVEN ANALYSIS

The following are the important managerial uses of the Break-Even Analysis:

i) Safety Margin
The Break-Even Analysis is useful to calculate ‘Safety Margin’. Safety Margin
refers to the extent to which the firm can afford a decline in sales before it starts
incurring loss. Safety Margin can be calculated by using the following formula:
Sales−BEP
Safety Margin= × 100
Sales

Example
The sales volume of a firm is 45000 units and the BEP is 27000 units. Find the
Safety Margin.

Solution
45000−27000
Safety Margin = x 100
45000
18000
= x 100
45000

= 0.4 x 100= 40

ii) Target Profit

The Break-Even Analysis is also useful to determine the volume of sales needed
to secure a target profit. The formula to calculate the target sales volume is:
TFC−Target Profit
Target Sales Volume = Contribution Margin

Example
If Total Fixed Cost of a firm is Rs.36,000, selling price is Rs.6 per unit and
Variable Cost per unit is Rs.3, find out the volume of sales to achieve a profit
target of Rs.9,000.

Solution
TFC−Target Profit
Target Sales Volume = Contribution Margin

180
 Contribution Margin= Price – AVC

=6–3=3

Therefore,
36000−9000
Target Sales Volume = 3

= 9000

iii) Change in Price

Whenever the firm reduces the price, there will be a reduction in the Contribution
Margin. This means that, to remain at the same level of profit, the firm has to
increase its output. The following formula can be used to calculate the increase
in volume of output in order to maintain the same level of profits.
TFC−Target Profit
New Sales Volume = Contribution Margin

Example
If Total Fixed Cost of a firm is Rs.9,000, profit target is Rs.27,000, selling price is
Rs.12 per unit and Variable Cost is Rs.3 per unit. Suppose the firm decides to
reduce the price from Rs.12 to Rs.9, find the new sales volume to maintain the
same level of profit.

Solution
TFC−Target Profit
Target Sales Volume = Contribution Margin

Contribution Margin= Price – AVC

= 12 – 3 = 9

Therefore,
9000 −27000
Target Sales Volume =
9

=- 2000
If the firm decides to reduce the price from Rs.12 to Rs.9

Contribution Margin= Price – AVC

=9–3=6

Therefore,
9000 −27000
New Sales Volume =
6
−18000
= 6

= - 3000.

181
iv) Change in Costs
The impact of an increase in Variable Cost is to push up the total cost. As a
result, Contribution Margin declines. This decline in the Contribution Margin will
shift the Break-Even Point downwards. Likewise, a fall in the Variable Cost
increases the Contribution Margin and the Break-Even Point moves upwards.
When Variable Cost changes, the business executive has to decide about the
new price or the new sales volume to maintain the previous level of profit.

The formulae to calculate the new sales volume and the new sales price are:

1. The New Sales Volume=

2. New Sales Price = Present Selling Price + New Variable
Cost – Present Variable Cost
Example
The Contribution Margin is Rs.9,000, the present selling price is Rs.9 and the
present Variable Cost is Rs.3. If the Variable Cost per unit rises from Rs.3 to
Rs.6, find the new sales volume and new selling price.

Solution
New Sales Volume =
= 3,000 units
New Selling Price =Present Selling Price + New
Variable Cost – Variable Cost
= 9 + 6 – 3= Rs.12.

v) Make or Buy Decision

The Break-Even Analysis also helps to decide whether components which are
part of their finished products should be manufactured by themselves or bought
from outside firms.

Example
A manufacturer of bicycle buys a certain part of a bicycle at Rs.90 each. If
he decides to manufacture it himself, his Fixed Cost would be Rs.36,000 and the
Variable Cost per unit is Rs.60. Find out the Break-Even Point.

Solution
TFC
BEP =𝑃−𝐴𝑉𝐶
36000
= 90−60
36000
= 30

= 1,200 units

182
 The manufacturer can produce the parts himself, if he needs more than 1,200
units. If his requirement is less than 1,200 units, it is better to buy from outside
firms.

vi) Advertising Decisions

The Break-Even Analysis helps the management to examine the effects of
different levels of advertising expenditure and different modes of advertisement

14.7 LIMITATIONS OF BREAK-EVEN ANALYSIS

Even though the BEA has many managerial uses, it has several limitations. They are:
1. It assumes that profit is a function of output only. But the firm may increase
profit without increasing its output, by adopting a new technique which cuts
costs.
2. In BEA, everything is assumed to be constant. But costs and revenues may
change over a period of time.
3. The BEA is based on accounting data. It neglects imputed costs, takes the
arbitrary depreciation estimates and considers the inappropriate allocation
of overhead costs.
4. The BEA assumes cost and revenue functions are linear. In fact, the linearity
of cost and revenue functions are real only for a limited range of output.
5. The Break-Even Chart cannot be drawn for the firm’s producing and selling
multiple products.
6. The BEA assumes that the volume of production and volume of sales are equal.
But they may not be equal always.
7. It is very difficult to handle selling cost such as, advertisement and sales
promotion in a Break-Even Chart.

LET US SUM UP
In this unit, we have introduced the concept of Break Even Point. Break Even point is
the point at which the total revenue equals total cost and consequently the net profit
is equal to zero. That point is said to be “No-Profit, No-Loss” point. The Break Even
Analysis studies the relationship between the volume and cost of production on the
one hand and the revenue and profits obtained from the sales on the other hand.
Capital Budgeting is the planning of expenditure for assets, which will yield a series
of returns over future time periods.

183
CHECK YOUR PROGRESS

Choose the correct answer

1.The Break-Even Analysis is useful to calculate___________

a) Safety Margin b) Target Profit

c) Change in Price d) Change in Costs

2. Break Even Point is also called ___________

a) Safety Margin b) Target Profit

c) Change in Price d) Cost Volume and Profit analysis

3.The total cost can be classified into fixed cost and___________

a) Safety Margin b) Target Profit

c) Variable Cost d) Change in Costs

4. Break-Even Analysis helps the management to examine the effects of

different levels of___________

a) Safety Margin b) Target Profit

c) Variable Cost d) advertising expenditure

5. Whenever the firm reduces the price, there will be a reduction in the

___________Margin

a) Safety Margin b) Target Profit

c) Contribution d) advertising expenditure

GLOSSARY
Break Even point : The Break-Even Point (BEP) is the point at
which the total revenue is equal to the total cost
and consequently the net profit is equal to zero.
That level or point is said to be ‘No-Profit, No-
Loss’ point
Safety margin : The Break-Even Analysis is useful to calculate
‘Safety Margin’. Safety Margin refers to the
extent to which the firm can afford a decline in
sales before it starts incurring loss.
Advertising Decisions : The Break-Even Analysis helps the
management to examine the effects of different
levels of advertising expenditure and different
modes of advertisement.

184
SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.investopedia.com/terms/b/breakevenpoint.asp
8. https://www.yourarticlelibrary.com/accounting/break-even-point/break-
even-point-meaning-assumptions-uses-and-limitations/65309

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) d 3) c 4) d 5) c

185
 BLOCK 5
NATIONAL INCOME

Unit 15: National Income

Unit 16: Fiscal Policy

Unit 17: Monetary Policy

186
Unit 15

NATIONAL INCOME
STRUCTURE
Overview
Learning Objectives

15.1 Meaning of National Income

15.2 Definition of National Income

15.3 National Income Concepts

15.4 Measurement of National Income

15.5 Importance of National Income Estimate

15.6 Difficulties Encountered in the Estimation of National Income

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
National Income is an important indicator of economic development of any country.
Hence, it is imperative to know the meaning, concepts, measurement and difficulties
encountered in the estimation. Business cycles and unemployment affects national
income, and in turn, retard economic development of developing countries. Hence, if
any developing country wants to attain economic development, first it has to take
necessary measures to increase national income. In order to increase national
income, the developing country should know the causes for the economic factors like
business cycles and unemployment and take necessary steps to solve these
problems.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• describe the concepts of National Income, unemployment and business cycles

• classify different National Income concepts.

187
15.1 MEANING OF NATIONAL INCOME
National Income means aggregate income of a country during a given period, usually
one year

15.2 DEFINITION OF NATIONAL INCOME

According to the National Income Committee of India, “A national income estimate
measures the volume of commodities and services turned out during a given period
counted without duplication”.

15.3 NATIONAL INCOME CONCEPTS

i) Gross National Product (GNP)

It is the total value of all final goods and services produced in the country in one
year.

ii) Net National Product (NNP)

When we subtract depreciation charges for renewals and repairs from GNP, we
obtain Net National Product.

NNP at market prices = GNP at market prices – Depreciation

iii) Net National Income at Factor Cost

It is the sum total of all income payments made to the factors of production. The
sum total of goods and services are produced by the co-operation of factors of
production. Hence, the money value of the goods and services is to be
distributed among the factors of production. Therefore, national income may also
be regarded as the total of income received by the factors of production used in
production. So, Net National Income at Factor Cost shows the income actually
received by the factors of production. Hence,

NNI at Factor Cost = NNI at Market Price + Subsidies

- Indirect Taxes – Government Earned Profits

iv) Personal Income

It is the total of income received by all persons from all sources. It consists of
wages and salaries, interest, rent and dividends received by individuals including
the corporate bodies. It also includes the mixed incomes of self-employed
persons like farmers and shop keepers and all transfers received from public
authorities such as pension. Therefore,
Personal Income = National Income – Undistributed Profits of
Companies - Corporate income tax- Social
Security Contribution + Transfer Payments

188
v) Disposable Income
It is obtained by deducting personal direct taxes from the personal income. The
personal taxes are in the form of income tax, wealth tax, expenditure tax
and professional tax. Hence, disposable income denotes the actual income
which can be used by the individuals. Therefore,

Disposable Income = Personal Income – Personal Taxes

vi) Per capita Income

It is obtained by dividing the national income by total population. Therefore,

National Income
Per capita Income = Total Population

15.4 MEASUREMENT OF NATIONAL INCOME

i) The Product Method

According to this method, national income is calculated by adding together
the net value of all goods and services produced in a country during one year.

ii) The Income Method

According to this method, national income is estimated by adding together all
incomes accruing to the factors of production in the form of rent, wage, profit and
interest.

iii) The Expenditure Method

According to this method, national income is estimated by adding together the
consumption expenditure, gross private domestic investment, state purchase of
goods and services and net foreign investment.

iv) Social Accounting Method

All economic transactions of a country are classified into Productive Enterprises,
Financial Intermediaries and Final Consumers. Each sector will maintain
accounts of their receipts and payments. By totaling these accounts, the national
income is estimated.

15.5 IMPORTANCE OF NATIONAL INCOME ESTIMATE

• National income estimates are the most important tools for economic planning.
A country cannot frame a plan without having a prior knowledge of the trends in
national income.
• National income Figure enables us to have an idea of the inflationary and
deflationary gaps.

189
 • Modern Governments try to prepare their budgets within the framework of
national income data.
• National income estimates show how national expenditure is divided between
consumption expenditure and investment expenditure.
• With the help of national income estimates of various countries, we can compare
the standards of living of people of these countries.
• National income Figure enables us to know the relative roles of public and
private sectors in the economy.
• National income estimates reveal the contributions made by various sectors of
the economy such as agriculture, industry, trade etc.
• National income estimates help us to find out the distribution of national
income among different categories of income such as rent, wage, profit and
interest.
• By comparing national income estimates over a period of time, we can know
whether the economy is growing or stagnant or declining.
15.6 DIFFICULTIES ENCOUNTERED IN THE ESTIMATION OF NATIONAL
INCOME
• The definition of ‘Nation’ itself is a problem in the estimation of national
income. For example, national income does not refer to income produced
within the country alone. But, income earned from other countries is also
included.
• Commodities and services having money value are included in the national
income, but there are goods and services performed for love and kindness
are having economic value but have no money value. Whether these services
should be included in national income and how to measure their money value.
• Another difficulty is regarding the method to be used in the estimation of national
income.
• Yet another difficulty is the non-availability of statistical data.

• A very important difficulty is inadequacy of efficient and trained personnel’s.

• People of developing countries like India are illiterate and they do not keep
proper accounts. Even, if they keep any accounts, they are highly unreliable.
• One more difficulty is that of transfer payments. A person receives income, a
part of it may have been received as interest payment on Government loans.
This part is in the nature of transfer payments and may be taken either as the
income of the individual or of the Government.

190
 • Another important difficulty is “Double Counting”. Double counting implies
the possibility of a commodity like raw material being included in national
income more than twice. For example, a former sells wheat to mill-owner, the
mill-owner further sells the wheat flour to a wholesaler who further sells it to a
retailer and who in turn sells it to the consumers. If we calculate it at every
stage, its money value will increase.
• Income earned through illegal activities like gambling, smuggling, illicit
extraction of liquor is not included in the national income.

LET US SUM UP
National income is an uncertain term which issued interchangeably with national
dividend, national output and national expenditure. On this basis, national income has
been defined in a number of ways. National income means the total value of goods
and services produced annually in a country.
National income is the total net value of all goods and services produced within a
nation over a specified period of time, representing the sum of wages ,profits, rents,
interest, and pension payments to residents of the nation. It is the total amount of
income earned by the citizens of a nation.
The National Income Unit of the Central Statistical Organization (CSO)estimates a
major part of the national incomes by the product method, e.g., in sectors like
agriculture, animal husbandry, forestry, fishing, mining and factory establishments.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. The amount obtained by deducting personal taxes from the personal income is
called___________

a) Disposable income b) Personal income

c) Per capita income d) National income

2.__________ means aggregate income of a country during a given period, usually
one year.

a) Disposable income b) Personal income

c) Per capita income d) National income

3.The total value of all final goods and services produced in a country in one year is
called _________

a) Disposable income b) Personal income

c) GNP d) National income

191
4._________ method, national income is calculated by adding together the net value
of all goods and services produced in a country during one year.

a) Product b) Supply

c) Income d) None of the above

5.___________ method, national income is estimated by adding together all incomes
accruing to the factors of production in the form of rent, wage, profit and interest.

a) Product b) Supply

c) Income d) None of the above

GLOSSARY
National income : National income is an uncertain term
which is used interchangeably with
national dividend, national output and
national expenditure. On this basis,
national income has been defined in a
number of ways. National income means
the total value of goods and services
produced annually in a country.
Gross Domestic Product : Gross Domestic Product (GDP) is the
total market value of all final goods and
services currently produced within the
domestic territory of a country in a year.
Gross National Product : Gross National Product is the total
market value of all final goods and
services produced in a year.GNP
includes net factor income from abroad
whereas GDP does not.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.

192
 6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.economicsdiscussion.net/national-income/4-main-concepts-
of-national-income/17241
8. https://www.economicsdiscussion.net/national-income/measure/how-to-
measure-national-income-top-3-methods/12678

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) d 3)c 4)a 5)c

193
Unit 16

FISCAL POLICY
STRUCTURE

Overview

Learning Objectives

16.1 Fiscal policy

16.2 Objectives of fiscal policy of India

16.3 Fiscal policy and economic growth

16.4 Fiscal policy and full employment

16.5 Fiscal policy and Social justices

16.6 Fiscal policy and Economic stabilization

16.7 Role of fiscal policy in developing countries.

Let Us Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Fiscal policy is a part of general economic policy of the government, which is primarily
concerned with budget receipts and the expenditure of the government. Fiscal policy
explains the tax and expenditure policy of the government. It encompasses two
separate but related decisions, public expenditures and the level and structure of
taxes. The amount of public outlay, the incidence and effects of taxation and the
relation between expenditure and revenue exert a significant impact upon free
enterprise economy.

LEARNING OBJECTIVES

After completing this unit, you should be able to

• define fiscal policy

• list out the objectives of fiscal policy

• discuss fiscal policy and economic growth.

194
16.1 INTRODUCTION
Fiscal policy is defined as the conscious attempt of the government to achieve certain
macro-economic goals of policy by altering the volume and pattern of its revenue and
expenditures and the balance between them. The major economic goals of fiscal
policy are to maintain a high average level of employment and business activity, to
minimize fluctuations in employment activity, prevent inflation and to produce and
promote economic growth.
The fiscal policy is used to control inflation through making deliberate changes in
government revenue and expenditure to influence the level of output and prices. It is
a budgetary policy. Fiscal policy is the use of government taxes and spending to alter
macroeconomic outcomes of the country. During the great depression of the 1930s
people were out of work, they were unable to buy goods and services therefore
government had to increase, to regulate macroeconomic values and money supply.
The use of government spending and taxes to adjust aggregate demand is the
essence of fiscal policy. The simplest solution to the demand shortfall would be to
increase government spending. The government increases it’s spending through
construction of tanks, schools, highways. This increased spending is a fiscal stimulus.
Economic stability is a macro goal of the fiscal policy of a country whether developed
or developing. By economic stabilization it means; controlling recession or depression
and price stability.

16.2 OBJECTIVES OF FISCAL POLICY OF INDIA

1. To maintain economic stability in the country

2. To bring Price stability

3. To achieve full employment

4. To provide social justice

5. To promote export and introduce import substitution

6. To mobilize more public revenue

7. To reallocate available resources

8. To achieve balanced regional growth.

Instruments:
The major instruments to be used to control inflation and to achieve the above said
objectives are

(i) Taxation

(ii) Public borrowings

(iii) Deficit financing.

195
Fiscal policy deals with the government expenditure and its composition. Government
expenditures are classified into two categories as capital expenditure and
consumption expenditure. The spending on construction of road, dams and others are
called as capital expenditure. Government expenditure on consumption of goods and
services are called as consumption expenditure. The interest paid by the government
against the borrowings or national debt is called as interest payment. Governments’
transfer of money from one sector to other is called Transfer of payments.

16.3 FISCAL POLICY AND ECONOMIC GROWTH

Developed economies aim at attaining full employment through long term fiscal policy.
Keynesian analysis of fiscal policy is considered as short-term view whereas post
Keynesian economists like Hanson, Harrod and Domer have tried to extend
Keynesian analysis to a more comprehensive long-term theory of income and
employment. Therefore, the main objective of long-term fiscal policy in developed
country is conceived to be the maintenance of a steady growth of full employment
income without inflation or deflation in order to avoid secular stagnation or secular
inflation.
According to Harrod and Domer, investment plays a vital role in the process of
economic growth. In the process of secular growth, along run dis-equilibrium may
occur in a mature economy. The reason behind this dis-equilibrium may be the income
does not grow at a rate just sufficient to ensure full capacity use of a growing capital
stock. Thus, the objective of growth and full employment in the long run is associated
with problem of enlarging capacity through investments in capital goods sector.
Therefore, in the long run, employment is the function of the rate of growth, investment
and income.
But the role of fiscal policy in a developing country is different because this type of
countries is caught in the grip of vicious circle of poverty, and quite obviously the aim
and objective of long-term fiscal policy in the countries should be breaking the vicious
circle of poverty. Rapid economic growth is the long-term objective of fiscal policy in
poor countries and thereby to break the circle.
Fiscal policy aims at fulfilling following objectives while used as a means of
encouraging economic growth:
• Providing revenue to public enterprises.

• Imposition of additional taxes

• Realizing and channelizing the potential resources into productive projects.

• Direct physical control.

• Increase in the rate of taxation.

• Public dept.

196
 • Deficit financing.

• To promote investment into socially desirable channels.

• Inducing and stimulating private investment.

To change the direction and pattern of investment and production so that general
economic welfare is improved and to level the gap of the distribution of wealth and
income. (reframe the highlighted sentence)

16.4 FISCAL POLICY AND FULL EMPLOYMENT

According to Keynes, public finance is a compensatory finance which should aim at
full employment and to maintain it. To attain this let us see some of the suggestions
made by Keynes-
a) Deficit budget: Budgetary policy should be designed to Figure deflation and
unemployment. A deficit budget will bring about expansionary effects in a
stagnant economy.
b) Tax Policy for Stimulation: The tax policy should be designed in such way that
it stimulates consumption and investment both. To affect this, indirect taxes
should be brought to minimum so that purchasing power of the people should
increase and effective demand increases. Direct taxes should also follow the
same policy so as to step up investment
c) Compensatory Public Spending: Compensatory public expenditure and public
sector investment play a vital role in attaining full employment in the present-day
public policy. Public expenditure and public works like road construction,
buildings, parks, school, colleges, hospitals, canals etc. This will stimulate
effective demand and volume of employment.
d) Public debt management: Efficient and effective public debt management can
be used for achieving full employment. This can happen when public expenditure
is partly financed through public borrowings. Government should follow cheap
money policy so that burden of public debt will not be much. Government should
borrow from the people with whom money remains idle.
Democratic governments aim at providing maximum social welfare which can be
attained through providing social justice which lie in equitable distribution of income
and wealth. Fiscal policy can serve as an effective means of achieving this much
desired objective through expenditure, tax and debt policy. Therefore, budget policy
should aim at re-distribution of wealth by taxing more to the rich and by providing free
medical, education, housing and other social up liftment measures.

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16.5 FISCAL POLICY AND SOCIAL JUSTICES

Anti-Depressionary Fiscal Policy

Keynes advocated the effectiveness of fiscal policy to overcome depression.
According to Keynes, depression is the consequence of deficiency in effective
demand and that can be overcome by a deficit budget policy.

A deficit budget policy during depression follows the following strategies -

1) Reduction in direct taxes.

2) Increases in public expenditure and

3) Repayment of public debt

These strategies will tend to increase the flow of total expenditure and thereby the
size of effective demand which as per Keynes, pull out a country from the state of
depression.
Expenditure could be increased through two different prescriptions-pump
priming and compensatory spending.
Pump priming refers to that initial public expenditure which helps to initiate and revive
economic activity in a depressed economy. The idea is aimed at increasing private
investment through public expenditure.
Compensatory spending on the other hand, refers to government expenditure which
is undertaken with the idea of compensating the decline in private investment.
Depression brings down the private investment because of the low marginal efficiency
of capital, whose automatic revival is not possible. Thus, the government having no
other alternative than to resort to public investment fills the gap in private investment.

Deficit Financing
Keynes’ another suggestion to raise the effective demand is deficit financing which
means the government spends more than its revenue and thereby relying on
unbalanced budget. It rises public spending because the public have extra purchasing
power in their hand and consequently effective demand rises.

Fiscal Policy during Inflation

The economy which has initiated economic growth makes huge investment to
construct social overhead capital, infrastructure of the economy and development of
heavy industries which all have a long gestation period, and returns are not
immediate, shortage of consumption goods are felt. This leads to rise in prices. This
demand pull inflation causes wages to go up and resultantly cost push inflation is
generated. This vicious circle of inflation has to be checked through appropriate fiscal
measures. Therefore, in order to arrest the inflation, fiscal policy should aim at curbing

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the flow of expenditure, particularly consumption expenditure and reduce the demand.
Hence a surplus budget policy will help which may have the following prescriptions.
i) Increases in direct taxes to squeeze the purchasing power of the people and
reduce their consumption expenditure.

ii) Reduction in public expenditure and

iii) Attempt to increase public debt by issuing bonds etc., to seize people’s
purchasing power.

16.6 FISCAL POLICY AND ECONOMIC STABILIZATION

Economic stability is a macro- goal of the fiscal policy of a country whether developed
or developing. By economic stabilization it means -Controlling recession or
depression and Price stability as well as Checking inflation or deflation.

16.7 ROLE OF FISCAL POLICY IN DEVELOPING COUNTRIES.

The role of fiscal policy in the developing countries has to be different from that of in
developed countries for the obvious reason that the task of fiscal policy in developing
country is or ought to be rapid economic growth.

Objective of Fiscal Policy in Developing Countries

i. Capital Formation: Fiscal policy in the developing countries aims at the
formation of high rate of capital. Private capital is generally shy in these countries
and so the government has to fill up this lacuna.
ii. Allocation of Resources: Another objective of fiscal policy in a poor country is
to divert existing resources from unproductive sectors to productive socially more
desirable projects.
iii. Social Justice: Equitable distribution of wealth and income in the society is
another important objective of the fiscal policy. Though, equitable distribution of
wealth and income and economic growth-are two paradoxical issues. Hence
difficulty arises. Equitable distribution reduces aggregate savings as the
propensity to consume of the poor people is high and the propensity to save of
the rich people reduces. Socialism brings social justice but not growth. Hence,
government has to choose between capitalistic system suitable for high growth
or socialism.

LET US SUM UP
Fiscal policy is an important and integral part of modern public finance. It is related to
government spending, taxation, borrowing and management public debt. Therefore,
fiscal policy comprises, budget instruments and government transactions designed to
further general economic development and allied objectives.

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It operates through both taxation and expenditure programs of the government.
Obviously, fiscal policy relates itself with aggregative effects of public expenditure and
taxation on income, output and employment.

CHECK YOUR PROGRESS

Choose the Correct Answer

1. Equitable distribution of wealth and income in the society is another

important objective of ___________

a) Fiscal policy b) Deficit budget

b) Deficit financing d) All of them

2. ___________ which means the government spends more than its

revenue and thereby relying on unbalanced budget

a) Deficit budget b) Deficit financing

b) Fiscal policy d) All of them

3. A___________ will bring about expansionary effects in a stagnant economy

a) Deficit budget b) Production Budget

b) Purchase budget d) All of them

4. ___________ is defined as the conscious attempt of the government to achieve
certain macro-economic goals of policy by altering the volume and pattern of its
revenue and expenditures and the balance between them

a) Deficit budget b) Production Budget

c) Fiscal Policy d) All of them

5. Fiscal policy in the developing countries aims at the formation of high rate of capital
___________

a) Rate of Interest b) Rate of Capital

c) Profit d) Income

GLOSSARY
Fiscal Policy : Fiscal policy is defined as the conscious attempt
of the government to achieve certain macro-
economic goals of policy by altering the volume
and pattern of its revenue and expenditures and
the balance between them.
Deficit budget : Budgetary policy should be designed to
Figurants deflation and unemployment. A deficit

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 budget will bring about expansionary effects in
a stagnant economy.
Deficit Financing : Keynes’ another suggestion to raise the
effective demand is deficit financing which
means the government spends more than its
revenue and thereby relying on unbalanced
budget. It rises public spending because the
public have extra purchasing power in their
hand and consequently effective demand rises.
Capital Formation : Fiscal policy in the developing countries aims at
the formation of high rate of capital. Private
capital is generally shy in these countries and so
the government has to fill up this lacuna.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And Cases,
Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L. 19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://www.economicsdiscussion.net/fiscal-policy/top-8-objectives-of-
fiscal-policy/4694
8. https://www.yourarticlelibrary.com/policies/role-of-fiscal-policy-in-
developing-countries/26320

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) b 3) a 4) a 5) b

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Unit 17

MONETERY POLICY
STRUCTURE

Overview

Learning Objectives

17.1 Meaning of the Monetary Policy

17.2 Neutrality of Money

17.3 Price Stability and Control of Business Cycles

17.4 Full Employment

17.5 Monetary Policy and Economic Growth

Let US Sum Up

Check your Progress

Glossary

Suggested Readings

Answers to Check Your Progress

OVERVIEW
Monetary policy plays a vital role in shaping the economy of a country because money
and credit influence tremendously the course, nature and volume of economic
activities. A keenly and appropriately weaved monetary policy can significantly aid
economic growth by adjusting the money supply according to the needs of economic
growth by directing the flow of funds into desired channels. Apart from that, monetary
policy can make available the institutional credit to the much desired and required
economic pursuit more appropriately, in the present-day management of the
economy, monetary policy plays an extremely important role of stabilizing the
economy.

LEARNING OBJECTIVES

After completing this unit, you should be able to,

• discuss monetary policy

• explain the neutrality of money.

17.1 MEANING OF THE MONETARY POLICY

Monetary policy is an important tool in the hands of the monetary authority (more often
central bank of the country) to regulate the flow of money in the economy according

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to needs at a particular point of time. Through this tool, the monetary authority
achieves many macroeconomic goals. The need for monetary policy is felt because
money can’t manage itself. Monetary management itself therefore, the main issue of
monetary policy.
According to Prof.Wrightsman, the deliberate effort by the central bank to control the
money supply and credit condition for the purpose of achieving certain broad
economic objectives. (Something needs to be added, sentence incomplete).
In the Indian context, monetary policy comprises those decisions of the government
and the Reserve Bank of India which directly influence the volume and composition
of money supply, the size and distribution of credit, the level and structure of interest
rates, and the direct and indirect effects of these monetary variables upon related
factors such as savings and investment and determination of output, income and
price.
Monetary policy is only a means to an end and not an end in itself. Monetary policy
has to be structured and operated within the institutional framework of the money
market of the country. Credit control measures and decisions are the constituent
elements of a monetary policy.
In a developing economy there are two factors of monetary policy-Positive and
Negative. In its positive aspect, it sets out the promotional role of central banking in
improving the savings ratio and expanding credit for facilitating capital formation. In
its negative approach, it implies a regulatory phase of restricting credit expansion, and
its allocation according to the absorbing capacity of the economy.

17.2 NEUTRALITY OF MONEY

According to some economists like Wicks Steed, Hayek and Robertson the best
monetary system is one in which money is neutral. Money should be a passive factor.
It should not be allowed to interfere with economic forces like productive efficiency,
real cost of production and consumer preferences. Therefore, according to them
money should facilitate exchange alone. The quantity of money should be controlled
in such a way that the total output, the total transactions and prices of goods and
services being exactly what they would be in an efficient barter economy.

It implies that the monetary authority must keep the quantity of money perfectly stable.
The neutral money concept has been criticized severely by many economists as
follows:
• It is based on the out-dated concept of quantity theory of money - The critics have
discarded the concept of neutrality of money as an outdated concept which can’t
be practiced in the modern day management of the economy.
• Neutrality can’t guarantee price stability - In modern economy in which
technological and scientific developments play a vital role in increasing

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 production and under such conditions quantity of money is kept fixed, it would
only lead to deflationary conditions.
• Neutral money policy not suitable during depression- During depression when
prices are falling neutral money policy will not hold good. There is the need to
have active money policy during depression.
• Contradictory and impractical - The concept of neutral monetary policy and the
very purpose for which it is suggested are not only contradictory but also
impractical. This is based on concept of laissez - faire philosophy and existence
of perfect competition, have been rejected long back in modern dynamic
economy.
Therefore, as a conclusion it can be said that a neutral money policy can’t check the
occurrence of business cycle in an economy and that money has come to stay as an
active element in a modern economy.

17.3 PRICE STABILITY AND CONTROL OF BUSINESS CYCLES

In Normal cases, capitalism has inborn characteristics of fluctuations in prices and
cyclical variations among other disadvantages of monetary system under capitalism.
Therefore, according to Cassel and Keynes and others, a more important aim of
monetary policy is to achieve and maintain price stabilization and normal business
activity through regulating the credit appropriately.

Arguments in favour of Price Stabilization

• Smooth production and distribution: Price instability create difficult problem
of production and distribution, affecting differently different sections of the
community. Precisely, there are innumerable evil aspects of inflation or
deflation.
• Eliminates the Evils of Inflation and Deflation: Both inflation and deflation
bring reduction in social welfare and hardships to individuals. Inflation reduces
purchasing power and thereby reduces economic welfare, deflation brings fall
in production, employment and income and thereby hardships. Therefore,
stability of price can prevent these evils.
• It eliminates socio-economic disturbances: Changes in price level cause
disturbances in economic relationships within a country and among countries as
well. This may bring dire economic and social consequences to all concerned.
Therefore, price stabilization is prescribed to eliminate these disturbances.
• It Leads to Economic Stabilization: By eliminating cyclical fluctuations price
stability leads to economic stabilization. Apart from the above, price stabilization
leads to equity in distribution and economic welfare also.

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Arguments against price stabilization
• Price stability is opposed generally following grounds

• It is a Vague Policy- The concept of price stabilization is vague and thereby it is

difficult to determine the price level to be selected for stabilization.
• Obstructs Economic Growth - Price stabilization as the potentials of hindering
economic development, as it will remove much of the price incentives to the
business community and as such productive activity will suffer from stagnation.
• It is not suited for a dynamic economy.

• It ignores the importance of relative prices and changes in working of the market
economy.
• It also has the potentials to adversely affect economic relations.

• It is impractical.

• In fact, a mild inflation of the magnitude of 2 to 3 percent is suggested for the

smooth growth and economic development of an economic.

17.4 FULL EMPLOYMENT

Most economists considered attainment of full employment as for most and ideal
objective of monetary policy after the publication of “General Theory” of Keynes. Thus,
the use of monetary policy for promoting full employment is of recent origin. Many
modern economists are of the view that, economic stabilization can be combined with
the objective of having a full level of employment. By encouraging saving and
investment, monetary policy can play an effective role in realizing its objective of full
employment. Many modern economists feel that the proper aim of a monetary policy
is neither price stability nor neutrality of money, but optimum utilization of resource full
employment level.

17.5 MONETARY POLICY AND ECONOMIC GROWTH

Economic growth is undoubtedly the primary goal of any country. Therefore, monetary
policy is taken into help for achieving this goal. Though, till recently many economists
considered monetary policy as a short-term policy primarily aimed at full employment
and mitigating cyclical fluctuations and not concerned with economic growth.
However, recreantly it has been realized by the economists and the managers of the
economy that mere achieving full employment is not enough but the economy should
aim at achieving continuous and faster economic growth for providing a high standard
of living to the people. Some economists like Howard Ellis, are strongly opposed of
the idea of the role monetary policy is economic growth because they fear inflation.
Still there are economists like Whittlesey, who strongly support the role of monetary
policy in economic growth and argue that since economic growth is the primary aim
of the general economic policy which is a part of the general economic policy, there

205
is no reason why monetary policy should not be directed to achieve this objective.
Monetary policy can contribute to the achievement of economic growth in two ways-

1) Management of aggregate demand

It is expected from the monetary authority to keep the aggregate demand for
money in balance with the aggregate supply of goods and services. For this, a
flexible monetary policy is required. A tight or dear restrictive money policy will
have to be applied when there is excess demand on the economy threatening to
raise prices and create conditions of unsustainable boom. Contrary to that are
expansionary or cheap credit policy has to be followed when there deficiency a of
aggregate demand and supply is in excess casing a fall in prices, production,
employment and income.
It is argued that a tight money policy impedes while an easy money policy
promotes economic growth. But both are extremist views whereas the truth lies in
the mid-way. A tight money policy is not conductive to growth when it is applied at
a wrong time. In a situation when demand is deficient and resources are
unemployed, an easy money policy is most suitable. But if it is carried beyond the
limit, it will generate inflationary pressure and to control it. A tight money policy
would be need. Therefore, a flexible monetary policy has been advocated to
achieve economic growth with price stability. Precisely, monetary policy can assist
in promoting economic growth by maintaining reasonable price stability and
optimum use of economic resources in an economy.

2) Encouragement to saving and investment

Monetary authority can help economic development by creating favorable
environment for saving and investment which is the backbone of the economic
growth. For this monetary policy should aim at price stabilization. Price stability
encourages saving and investment. Saving being the main source of capital
formation, when saving increases under favorable circumstances,
capital formation can also be accelerated which in turn accelerate economic
growth.

Exchange Rate Stability and Equilibrium in the Balance of Payments

A smooth operation of international trade depends upon exchange rate stability
and this in turn brings confidence internationally. Instability in exchange rate might
lead to undesirable effects such as weakening of the currency in the world market,
speculation and even flight of capital.
The objectives of exchange stability of a monetary policy could easily achieve
equilibrium in the balance of payments of a country under the gold standard.
Traditionally, countries that have faced disequilibrium in their balance of payment,
have used monetary policy for correcting it.

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 Following are the ways through which a restrictive monetary policy tends to reduce
country’s balance of payments deficit: -
• It forces domestic demand downwards and thereby reduces the demand for
imports and of domestic goods.
• Fall of domestic demand ease down the pressure of inflation which makes
imported article less attractive. At the same time exports become more
attractive.
• Under dear money policy, higher interest rates make it less attractive for
foreign countries to borrow from the deficit country and induce them to invest
there.

LET US SUM UP
Monetary policy refers to all such decisions and measures of the monetary authorities,
state and central bank, influencing money supply and credit situation in the monetary
system as a whole with a view to full fill certain macro-economic goals.
Monetary policy basically deals with two aspects of credit- 1) The cost of credit and
2) The availability of credit. Monetary policy involves three major steps- 1) Choice of
objectives 2) Implementation of the policy and 3) Relationship between action and
steps. Major objectives of monetary policy include–Neutrality of money, exchange
rate stability, price stability, full employment and economic growth.

CHECK YOUR PROGRESS

Choose the Correct Answer:

1. ___________ should be a passive factor

a) Money b) Cost
c) Investment d) Pricing
2. Price stability encourages saving and___________
a) Money b) Cost

c) Investment d) Pricing
3. Both inflation and ___________bring reduction in social welfare and hardships to
individuals.

a) Deflation b) Cost

c) Investment d) Pricing

4. Economic growth is undoubtedly the___________ goal of any country

a) Primary b) Secondary

c) Investment d) Pricing

207
5. Changes in___________level cause disturbances in economic

relationships within a country and among countries as well.

a) Price b) Secondary

c) Investment d) Cost

GLOSSARY

Monetary policy : Monetary policy is an important tool in the hands of

the monetary authority (more often central bank of
the country) to regulate the flow of money in the
economy according to needs at a particular point of
time. Through this tool, the monetary authority
achieves many macroeconomic goals.

Neutrality of Money : According to some economists like Wicks Steed,

Hayek and Robertson the best monetary system is
one in which money is neutral. Money should be a
passive factor.

Economic growth : Economic growth is undoubtedly the primary goal of

any country. Therefore, monetary policy is taken into
help for achieving this goal. Though, till recently many
economists considered monetary policy as a short-
term policy primarily aimed at full employment and
mitigating cyclical fluctuations and not concerned
with economic growth.

SUGGESTED READINGS
1. Dewett, K K&Navalur,M H (2006), Modern Economic Theory, S. Chand
Publishing, New Delhi.
2. Mehta, P.L. (1997) “Managerial Economics",5th Edition Sultan Chand &
Sons Publications.
3. Mehta, P L,(2016), Managerial Economics Analysis , Problems And
Cases, Sultan Chand & Sons, New Delhi .
4. Mote,V, Samuel Paul , Gupta,G.(2017),Managerial Economics : Concepts
& Cases, Tata McGraw-Hill Publishing Company Limited, New Delhi.
5. Sankaran,S. Dr.3rd Editions (2012), Business Economics, Margham
Publications, Chennai.
6. Varshney, R.L., Maheshwari,K.L.19th Edition (2014), Managerial
Economics, Sultan Chand & Sons, New Delhi.
7. https://corporatefinanceinstitute.com/resources/economics/neutrality-of-
money/

208
 8. https://www.thebalancemoney.com/what-is-monetary-policy-objectives-
types-and-tools-3305867

ANSWERS TO CHECK YOUR PROGRESS

1) a 2) c 3) a 4) a 5) a

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