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UNIVERSITY OF CALICUT
MASTER OF BUSINESS ADMINISTRATION
BUS 1C 07 MANAGERIAL ECONOMICS
Time: 60 Hours 4 credits
Course Objectives
1. To aquaint the student with the concepts and techniques of micro and macro
economics and
2. To enable them to apply this knowledge to business decisionmaking.

Module1
Managerial Economics definition, scope and importance, business decisions and concepts
ofmanagerial economics incremental concept, marginalism, equimarginal concept, the time
perspective, discounting principle, opportunity cost principle.

Module II
Utility and Demand Analysis concept and types of utility; Laws of demand; elasticity of
demand; demand forecasting techniques.

Module III
Production function production with one variable input, law of variable proportion;
production with two variable inputs; production isoquant; isocost lines; Estimating
production functions; cost concepts and break even analysis

Module IV
Market structure perfect and imperfect competition; monopoly, duopoly, oligopoly;
monopolistic competition, pricing methods under these competitive environments.

Module V
National income concepts and measurement; Business cycles and contra cyclical policies;
Economic planning and development models; Mahalnobis model; HarodKaldore model.

Books:
1. Paul .G. Keat, Philip.K.Y.Young, Sreejatha Banerjee, Managerial economics
Economic tools for todays Decision makers, Pearson education.
2. H.L.Ahuja. Managerial economics Analysis of managerial decision making, S.Chand,
New
Delhi
3. Adhikary,M: Business Economics, Excel Books, New Delhi 2000
4. DD Chaturvedi & SL Guptha, Managerial Economics, International Book House, 2012
5. DN Dwivedi, Managerial Economics, Vikas Publishing House, New Delhi, 2012

COURSE PLAN : NUMBER OF SESSIONS : 60

1. Managerial Economics Definition, Scope And Importance

2. Managerial Economics Definition, Scope And Importance
3. Business Decisions And Concepts Of Managerial Economics
4. Incremental Concept
5. Marginalism,
6. EquiMarginal Concept
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7. EquiMarginal Concept
8. The Time Perspective
9. Discounting Principle
10. Opportunity Cost Principle.

Module II

11. Utility
12. Demand Analysis
13. Concept And Types Of Utility
14. Laws Of Demand
15. Elasticity Of Demand
16. Elasticity Of Demand
17. Elasticity Of Demand
18. Demand Forecasting Techniques.
19. Demand Forecasting Techniques.
20. Demand Forecasting Techniques.
21. Test Paper

Module III

22. Production Function

23. Production Function
24. Production With One Variable Input
25. Law Of Variable Proportion
26. Production With Two Variable Inputs;
27. Production With Two Variable Inputs;
28. Production Isoquant
29. Isocost Lines;
30. Iso- Cost Iso -Quant
31. Cost Concepts
32. Cost Concepts
33. Break Even Analysis
34. Break Even Analysis
35. Break Even Analysis

Module IV

36. Market Structure

37. Market Structure
38. Perfect Competition;
39. Perfect Competition;
40. Monopoly
41. Monopoly
42. Duopoly
43. Oligopoly
44. Oligopoly
45. Monopolistic Competition,
46. Monopolistic Competition
47. Revision
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48. Test Paper

Module V

49. National income

50. concepts and measurement
51. concepts and measurement
52. Business cycles
53. contra cyclical policies;
54. Economic planning
55. Economic planning & development models
56. Mahalnobis model;
57. HarodKaldore model.
58. Revision
59. Revision
60. Test Paper

Examination 3 Hours for Full Course

Minimum Attendance Required 75%
Instructional Hours : 60

LECTURE NOTES/ INSTRUCTIONAL MATERIALS

Module1
Managerial Economics definition, scope and importance, business decisions and concepts
of managerial economics incremental concept, marginalism, equimarginal concept, the
time perspective, discounting principle, opportunity cost principle.

Managerial Economics : Definition, Nature, Scope

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

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

MANAGERIAL ECONOMICS : DEFINITION

Managerial Economics as defined by Edwin Mansfield

is "concerned with application of economic concepts and economic analysis to the problems
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of formulating rational managerial decision. Milton H.Spencer and Louis Siegelman say
Managerial economics is the integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning by management . It is
sometimes referred to as business economics and is a branch of economics that applies
microeconomic analysis to decision methods of businesses or other management units. As
such, it bridges economic theory and economics in practice. It draws heavily from
quantitative techniques such as regression analysis and correlation, calculus If there is a
unifying theme that runs through most of managerial economics, it is the attempt to optimize
business decisions given the firm's objectives and given constraints imposed by scarcity, for
example through the use of operations research, mathematical programming, game theory for
strategic decisions,[and other computational methods .

Managerial Economics assists the managers of a firm in a rational

solution of obstacles faced in the firms activities. It makes use of economic theory and
concepts. It helps in formulating logical managerial decisions. The key of Managerial
Economics is the micro-economic theory of the firm. It lessens the gap between economics in
theory and economics in practice. Managerial Economics is a science dealing with effective
use of scarce resources. It guides the managers in taking decisions relating to the firms
customers, competitors, suppliers as well as relating to the internal functioning of a firm. It
makes use of statistical and analytical tools to assess economic theories in solving practical
business problems.

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

economics bridging the gap between abstract theory and managerial practice. Haynes,
Mote and Paul.
Business Economics consists of the use of economic modes of thought to analyse business
situations. - McNair and Meriam
Business Economics (Managerial Economics) is the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by
management. - Spencerand Seegelman.
Managerial economics is concerned with application of economic concepts and economic
analysis to the problems of formulating rational managerial decision. Mansfield

Nature of Managerial Economics:

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

making and forward planning.

Decision making and forward planning go hand in hand with each other. Decision
making means the process of selecting one action from two or more alternative
courses of action. Forward planning means establishing plans for the future to carry
out the decision so taken.
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The problem of choice arises because resources at the disposal of a business unit
(land, labour, capital, and managerial capacity) are limited and the firm has to make
the most profitable use of these resources.

The decision making function is that of the business executive, he takes the decision
which will ensure the most efficient means of attaining a desired objective, say profit
maximisation. After taking the decision about the particular output, pricing, capital,
raw-materials and power etc., are prepared. Forward planning and decision-making
thus go on at the same time.

A business managers task is made difficult by the uncertainty which surrounds

business decision-making. Nobody can predict the future course of business
conditions. He prepares the best possible plans for the future depending on past
experience and future outlook and yet he has to go on revising his plans in the light of
new experience to minimise the failure. Managers are thus engaged in a continuous
process of decision-making through an uncertain future and the overall problem
confronting them is one of adjusting to uncertainty.

In fulfilling the function of decision-making in an uncertainty framework, economic

theory can be, pressed into service with considerable advantage as it deals with a
number of concepts and principles which can be used to solve or at least throw some
light upon the problems of business management. E.g are profit, demand, cost,
pricing, production, competition, business cycles, national income etc. The way
economic analysis can be used towards solving business problems, constitutes the
subject-matter of Managerial Economics.

Thus in brief we can say that Managerial Economics is both a science and an art.

Scope of Managerial Economics:

The scope of managerial economics is not yet clearly laid out because it is a developing
science. Even then the following fields may be said to generally fall under
Managerial Economics:
1. Demand Analysis and Forecasting
2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management
These divisions of business economics constitute its subject matter.
Recently, managerial economists have started making increased use of Operation Research
methods like Linear programming, inventory models, Games theory, queuing up theory etc.,
have also come to be regarded as part of Managerial Economics.
1.Demand Analysis and Forecasting: A business firm is an economic organisation which is
engaged in transforming productive resources into goods that are to be sold in the market. A
major part of managerial decision making depends on accurate estimates of demand. A
forecast of future sales serves as a guide to management for preparing production schedules
and employing resources. It will help management to maintain or strengthen its market
position and profit base. Demand analysis also identifies a number of other factors
influencing the demand for a product. Demand analysis and forecasting occupies a strategic
place in Managerial Economics.
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2.Cost and production analysis: A firms profitability depends much on its cost of production.
A wise manager would prepare cost estimates of a range of output, identify the factors
causing are cause variations in cost estimates and choose the cost-minimising output level,
taking also into consideration the degree of uncertainty in production and cost calculations.
Production processes are under the charge of engineers but the business manager is supposed
to carry out the production function analysis in order to avoid wastages of materials and time.
Sound pricing practices depend much on cost control. The main topics discussed under cost
and production analysis are: Cost concepts, cost-output relationships, Economics and
Diseconomies of scale and cost control.
3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a
business firm largely depends on the correctness of the price decisions taken by it. The
important aspects dealt with this area are: Price determination in various market forms,
pricing methods, differential pricing, product-line pricing and price forecasting.
4. Profit management: Business firms are generally organized for earning profit and in the
long period, it is profit which provides the chief measure of success of a firm. Economics
tells us that profits are the reward for uncertainty bearing and risk taking. A successful
business manager is one who can form more or less correct estimates of costs and revenues
likely to accrue to the firm at different levels of output. The more successful a manager is in
reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and
profit measurement constitute the most challenging area of Managerial Economics.
5. Capital management: The problems relating to firms capital investments are perhaps the
most complex and troublesome. Capital management implies planning and control of capital
expenditure because it involves a large sum and moreover the problems in disposing the
capital assets off are so complex that they require considerable time and labour. The main
topics dealt with under capital management are cost of capital, rate of return and selection of
projects.

Conclusion: The various aspects outlined above represent the major uncertainties which a
business firm has to reckon with, viz., demand uncertainty, cost uncertainty, price uncertainty,
profit uncertainty, and capital uncertainty. We can, therefore, conclude that the subject-matter
of Managerial Economics consists of applying economic principles and concepts towards
adjusting with various uncertainties faced by a business firm.

ROLE OF A MANAGERIAL ECONOMIST

A managerial economist helps the management by using

his analytical skills and highly developed techniques in solving complex issues of successful
decision-making and future advanced planning.

The role of managerial economist can be summarized as follows:

1. He studies the economic patterns at macro-level and analysis its significance to the
specific firm he is working in.
2. He has to consistently examine the probabilities of transforming an ever-changing
economic environment into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
5. He assists the management in the decisions pertaining to internal functioning of a firm
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such as changes in price, investment plans, type of goods /services to be produced,

inputs to be used, techniques of production to be employed, expansion/ contraction of
firm, allocation of capital, location of new plants, quantity of output to be produced,
replacement of plant equipment, sales forecasting, inventory forecasting, etc.
6. In addition, a managerial economist has to analyze changes in macro- economic
indicators such as national income, population, business cycles, and their possible
effect on the firms functioning.
7. He is also involved in advicing the management on public relations, foreign exchange,
and trade. He guides the firm on the likely impact of changes in monetary and fiscal
policy on the firms functioning.
8. He also makes an economic analysis of the firms in competition. He has to collect
economic data and examine all crucial information about the environment in which
the firm operates.
9. The most significant function of a managerial economist is to conduct a detailed
research on industrial market.
10. In order to perform all these roles, a managerial economist has to conduct an elaborate
statistical analysis.
11. He must be vigilant and must have ability to cope up with the pressures.
12. He also provides management with economic information such as tax rates,
competitors price and product, etc. They give their valuable advice to government
authorities as well.
13. At times, a managerial economist has to prepare speeches for top management.

INCREMENTAL CONCEPT /PRINCIPLE

Incremental analysis includes two concepts. Incremental cost &

Incremental revenue. IC is the additional cost incurred for additional output. In other words
changes in cost due to changes in level of output.Whereas IR is the additional revenue from
additional output or the changes in revenue due to changes in output.For every business
decisions there is IR and IC. In order to determine whether the decision is sound or not we
should compare the IC and IR of every decision.If the IR exceeds the IC, or IR is equal to IC
the decision can be assumed as a sound decision.

The incremental concept is closely related to the marginal costs and marginal revenues of
economic theory. Incremental concept involves two important activities which are as follows:

Estimating the impact of decision alternatives on costs and revenues.

Emphasising the changes in total cost and total cost and total revenue resulting from
changes in prices, products, procedures, investments or whatever may be at stake in
the decision.

The two basic components of incremental reasoning are as follows:

Incremental cost: Incremental cost may be defined as the change in total cost resulting
from a particular decision.
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Incremental revenue: Incremental revenue means the change in total revenue resulting
from a particular decision.

The incremental principle may be stated as under:

A decision is obviously a profitable one if:

It increases revenue more than costs

It reduces costs more that revenues.

It decreases some costs to a greater extent than it increases other costs

It increases some revenues more than it decreases other revenues

Some businessmen hold the view that to make an overall profit, they must make a profit on
every job. Consequently, they refuse orders that do not cover full cost (labour, materials and
overhead) plus a provision for profit. Incremental reasoning indicates that this rule may be
inconsistent with profit maximisation in the short run. A refusal to accept business below full
cost may mean rejection of a possibility of adding more to revenue than cost. The relevant
cost is not the full cost but rather the incremental cost. A simple problem will illustrate this
point.

IIIustration

Suppose a new order is estimated to bring in additional revenue of Rs. 5,000. The costs are
estimated as under:

Labour
Rs. 1,500

Material
Rs. 2,000

Overhead (Allocated at 120% of labour cost)

Rs. 1,800

Selling administrative expenses

(Allocated at 20% of labour and material cost)
Rs. 700

Total Cost
Rs. 6,000

The order at first appears to be unprofitable. However, suppose, if there is idle capacity,
which can be, utilised to execute this order then the order can be accepted. If the order adds
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only Rs. 500 of overhead (that is, the added use of heat, power and light, the added wear and
tear on machinery, the added costs of supervision, and so on), Rs. 1,000 by way of labour cost
because some of the idle workers already on the payroll will be deployed without added pay
and no extra selling and administrative cost then the incremental cost of accepting the order
will be as follows.

Labour
Rs. 1,000

Material
Rs. 2,000

Overhead
Rs. 500

Total Incremental Cost

Rs. 3,500

While it appeared in the first instance that the order will result in a loss of Rs. 1,000, it now
appears that it will lead to an addition of Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit.
Incremental reasoning does not mean that the firm should accept all orders at prices, which
cover merely their incremental costs. The acceptance of the Rs. 5,000 order depends upon the
existence of idle capacity and labour that would go unutilised in the absence of more
profitable opportunities. Earleys study of excellently managed large firms suggests that
progressive corporations do make formal use of incremental analysis. It is, however,
impossible to generalise on the use of incremental principle, since the observed behaviour is
variable.

INCREMENTAL PRINCIPLE

The incremental principle may be stated as under:

A decision is obviously a profitable one if
1. It Increases Revenue More Than Costs
2. It Decreases Some Costs To A Greater Extent Than It Increases Others
3. It Increases Some Revenues More Than It Decreases Others And
4. It Reduces Cost More Than Revenues

Why Should You Use Incremental Analysis?

Most often managers spend a lot of their precious time in studying all the data available on
the different choices, relevant or not. This leads to unnecessary wastage of productive time
that they could have effectively used elsewhere. Since the non-relevant costs have no play in
the final outcome of a decision, it doesnt make business sense to examine them.
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By using Incremental Analysis, managers can focus on the relevant costs to arrive at short-
term business/financial decisions quickly and more effectively.

You can use this simple approach to make decisions that fall under various categories such as:

Special order decisions While deciding whether to accept special orders with lower than
normal rates in order to book short-term profits

Limited resource decisions On choosing a product from a range of products for allocating
limited resources to its development or production

Make or buy decisions When you must decide whether to manufacture a product or
develop software in-house or procure it from an outside supplier

Sell, scrap or rebuild decisions Would you sell a product with its existing features and
capture the market, scrap the obsolete products with minimal loss or invest more on
enhancing its features?

You can easily make these kinds of short-term decisions with the help of Incremental
Analysis to achieve a smoother and less time-consuming decision-making process. Make sure
to gather the right financial information on the various alternatives and make sure it is
reliable for an error-free decision..

Managers across businesses normally prefer to use the Incremental Analysis technique as
against the full costing method because of its various benefits. It not only saves their time but
also gives accurate results that are sufficient to choose the best alternative with the
information available

EXPLAIN THE CONCEPT OF MARGINALISM IN ECONOMICS?

In economics the concept of margin means? The smallest amount of

something that is bought or sold. The study of marginal theories and relationships within
economics. The key focus of marginalism is how much extra use is gained from incremental
increases in the quantity of goods created, sold, etc. and how those measures relate to
consumer choice and demand.

The central concept of marginalism is that of marginal utility . Marginalism is a theory of

economics that attempts to explain the discrepancy in the value of goods and services by
reference to their secondary, or marginal, utility. The reason why the price of diamonds is
higher than that of water, for example, owes to the greater additional satisfaction of the
diamonds over the water. Thus, while the water has greater total utility, the diamond has
greater marginal utility. The theory has been used in order to explain the difference in wages
among essential and non-essential services, such as why the wages of an air-conditioner
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repairman exceed those of a childcare worker.Marginalism covers such topics as marginal

utility, marginal gain, marginal rates of substitution, and opportunity costs, within the context
of consumers making rational choices in a market with known prices.

Marginal utility
The marginal utility of a good or service is the utility of its marginal use. Under
the assumption of economic rationality, it is the utility of its least urgent possible use from the
best feasible combination of actions in which its use is included.

Marginal and Incremental Principle

This principle states that a decision is said to be rational and sound if given the
firms objective of profit maximization, it leads to increase in profit, which is in either of two
scenarios-

If total revenue increases more than total cost.

If total revenue declines less than total cost.

Marginal analysis implies judging the impact of a unit change in one variable on the other.
Marginal generally refers to small changes. Marginal revenue is change in total revenue per
unit change in output sold. Marginal cost refers to change in total costs per unit change in
output produced (While incremental cost refers to change in total costs due to change in total
output). The decision of a firm to change the price would depend upon the resulting
impact/change in marginal revenue and marginal cost. If the marginal revenue is greater than
the marginal cost, then the firm should bring about the change in price.

Incremental analysis differs from marginal analysis only in that it analysis the
change in the firm's performance for a given managerial decision, whereas marginal analysis
often is generated by a change in outputs or inputs. Incremental analysis is generalization of
marginal concept. It refers to changes in cost and revenue due to a policy change. For
example - adding a new business, buying new inputs, processing products, etc. Change in
output due to change in process, product or investment is considered as incremental change.
Incremental principle states that a decision is profitable if revenue increases more than costs;
if costs reduce more than revenues; if increase in some revenues is more than decrease in
others; and if decrease in some costs is greater than increase in others.

MARGINAL COST

Marginal Cost refers to the extra or additional cost of producing 1 extra unit of output

Calculation of Marginal Cost

OUTPUT (Q) TOTAL MARGINAL

COST(TC)Rs COST (MC)Rs

0 55

30
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1 85

25

2 110

20

3 130

30

4 160

50

5 210

Draw MC curve using the above table.

Marginal Cost
The marginal cost is the added expense of producing one more unit. Should you expand your
business? If so, what is the additional cost you entail to do so? Frequently, the marginal cost
can be computed. The added cost per square foot of expansion and the added cost of more
workers can be quantified. For a firm operating a call center, the cost of an additional station
and telephone line is the marginal cost. Marginal costs tend to rise the more a firm produces.
Resources may become more expensive, space gets tighter and good workers become more
difficult (and costly) to locate.

Marginal Revenue
Marginal revenue is the additional revenue that will be realized by selling one more unit. For
a pizza store, the marginal revenue is the price of one more pizza sold. In some cases,
marginal revenue may be more difficult to pin down. In the call center example, the marginal
revenue of an additional station will be the projected revenue that the new employee will
generate. In the absence of past experience, projected revenue may entail an uncertain
forecast.

Maximizing Profits
Economists tell us that a business can maximize its profit by producing at the level where
marginal revenue equals marginal cost.(MC=MR) As long as marginal revenue is greater
than marginal cost, it pays to produce more. Each added unit sold will add more to revenue
than to costs. But marginal costs rise and at high levels of production will exceed marginal
revenue. In this instance, it will pay for the firm to reduce production back to the level where
marginal revenue and marginal cost are equal. In every decision, the business owner must
weigh the profitability of the decision and consider the opportunity costs involved.
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OPPORTUNITY COST PRINCIPLE

Opportunity costs are cash outflows prevented by taking one course of

action instead of another. They include returns, which the entrepreneur could have earned in
alternative use of his services and capital.

By opportunity cost of a decision is meant the sacrifice of alternatives

required by that decision. If there are no sacrifices, there is no cost. According to Opportunity
cost principle, a firm can hire a factor of production if and only if that factor earns a reward in
that occupation/job equal or greater than its opportunity cost. Opportunity cost is the
minimum price that would be necessary to retain a factor-service in its given use. It is also
defined as the cost of sacrificed alternatives. For instance, a person chooses to forgo his
present lucrative job which offers him Rs.50000 per month, and organizes his own business.
The opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own
business

The concept of opportunity cost occupies a very important place in modern economic
analysis. The opportunity costs or alternative costs are the return from the second best
use of the firms resources which the firm forgoes in order to avail itself of the return
from the best use of the resources. To take an example, a farmer who is producing
wheat can also produce potatoes with the same factors. Therefore, the opportunity cost
of a quintal of wheat is the amount of the output of potatoes given up. Thus we find that
opportunity cost of anything is the next best alternative that could be produced instead
by the same factors or by an equivalent group of factors, costing the same amount of
money. Two points must be noted in this definition. Firstly, the opportunity cost of
anything is only the next best alternative foregone. Secondly, in the above definition is
the addition of the qualification or by an equivalent group of factors costing the same
amount of money.
The alternative or opportunity cost of a good can be given a money value. In order to
produce a good the producer has to employ various factors of production and have to
pay them sufficient prices to get their services. These factors have alternative uses.
The factor must be paid atleast the price they are able to obtain in the alternative uses.
Suppose a businessman can buy either a washing machine or a press machine with his
limited resources and suppose that he can earn annually Rs. 40,000 and 60,000
respectively from the two alternatives. A rational businessman will certainly buy a press
machine that gives him a higher return. But, in the process of earning Rs. 60,000 he
has foregone the opportunity to earn Rs. 40,000 annually from the washing machine.
Thus, Rs. 40,000 is his opportunity cost or alternative cost. The difference between
actual and opportunity costs is called economic rent or economic
profit. For example, economic profit from press machine in the above case is Rs.
60,000 Rs. 4000 = Rs. 20,000. So long as economic profit is above zero, it is rational
to invest resources in press machine.
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PRINCIPLE OF TIME PERSPECTIVE

According to this principle, a manger/decision maker should
give due emphasis, both to short-term and long-term impact of his decisions, giving apt
significance to the different time periods before reaching any decision. Short-run refers to a
time period in which some factors are fixed while others are variable. The production can be
increased by increasing the quantity of variable factors. While long-run is a time period in
which all factors of production can become variable. Entry and exit of seller firms can take
place easily. From consumers point of view, short-run refers to a period in which they
respond to the changes in price, given the taste and preferences of the consumers, while long-
run is a time period in which the consumers have enough time to respond to price changes by
varying their tastes and preferences.
Managerial economists are also concerned with the short run and the
long run effects of decisions on revenues as well as costs. The very important problem in
decision making is to maintain the right balance between the long run and short run
considerations.
For example;
Suppose there is a firm with a temporary idle capacity. An order for 5000 units comes to
managements attention. The customer is willing to pay Rs 4/- unit or Rs.20000/- for the
whole lot but not more. The short run incremental cost (ignoring the fixed cost) is only
Rs.3/-. There fore the contribution to overhead and profit is Rs.1/- per unit (Rs.5000/- for the
lot)
Analysis:

From the above example the following long run repercussion of the order is to be taken into
account:
1) If the management commits itself with too much of business at lower price or with a small
contribution it will not have sufficient capacity to take up business with higher contribution.
2) If the other customers come to know about this low price, they may demand a similar low
price. Such customers may complain of being treated unfairly and feel discriminated against.
In the above example it is therefore important to give due consideration to the time
perspectives. a decision should take into account both the short run and long run effects on
revenues and costs and maintain the right balance between long run and short run
perspective.

DISCOUNTING PRINCIPLE:
You use discounting principles to determine the value of something in the
future, compared to its present day value. The reasoning behind the discounting principle is that an
amount of money you have in your hands today is worth more than money you have the potential for
having at some future time.
The discounting principle requires you to look at the value of a sum of
money in the present day and compare it to the value of the money after an amount of time.
You need to do this if you are in a situation where you will use the money at a future date.
The value of the future amount of money is known as the present value. To find the present
value, you need to discount the amount of interest the money could earn if you were to place
it in an interest earning account.
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One of the fundamental ideas in Economics is that a rupee

tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make
between a gift of Rs.100/- today or Rs.100/- next year. Naturally he will chose Rs.100/-
today. This is true for two reasons-
i) The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present
opportunity is not availed of
ii) Even if he is sure to receive the gift in future, todays Rs.100/- can be invested so as to
earn interest say as 8% so that one year after Rs.100/- will become 108
According to this principle, if a decision affects costs and revenues in long-run, all
those costs and revenues must be discounted to present values before valid comparison of
alternatives is possible. This is essential because a rupee worth of money at a future date is
not worth a rupee today. Money actually has time value. Discounting can be defined as a
process used to transform future rupees into an equivalent number of present rupees. For
instance, Rs100 invested today at 10% interest is equivalent to Rs110 next year.

FV = PV*(1+r)t

Where, FV is the future value (time at some future time), PV is the present value (value at t0,
r is the discount (interest) rate, and t is the time between the future value and present value

Saving Money In a Bank

An example of when the discounting principle comes into play is saving money in a bank
account that earns interest. If you receive $100 from someone and place it in an account that
earns 10 percent interest yearly, you will have $110 in a year's time. But if you wanted to
have $100 next year in that same 10 percent interest account, you would need to deposit $90
in the account today.

Module II
Utility and Demand Analysis concept and types of utility; Laws of demand; elasticity of
demand; demand forecasting techniques.
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UTILITY

Utility, or usefulness, is the ability of something to satisfy needs or

wants. Utility is an important concept in economics and game theory, because it represents
satisfaction experienced by the consumer of a good. Not coincidentally, a good is something
that satisfies human wants and provides utility, for example, to a consumer making a
purchase. It was recognized that one can not directly measure benefit, satisfaction or
happiness from a good or service, so instead economists have devised ways of representing
and measuring utility in terms of economic choices that can be counted. The focus of
economics is to understand the problem of scarcity: the problem of fulfilling the unlimited
wants of humankind with limited and/or scarce resources. Because of scarcity, economies
need to allocate their resources efficiently. Underlying the laws of demand and supply is the
concept of utility, which represents the advantage or ful fillment a person receives from
consuming a good or service. Utility, then, explains how individuals and economies aim to
gain optimal satisfaction in dealing with scarcity.

Utility is an abstract concept rather than a concrete, observable quantity. The

units to which we assign an "amount" of utility, therefore, are arbitrary, representing a relative
value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from
consuming a given amount of goods or services in an economy. The amount of a person's
total utility corresponds to the person's level of consumption. Usually, the more the person
consumes, the larger his or her total utility will be. Marginal utility is the additional
satisfaction, or amount of utility, gained from each extra unit of consumption . Although total
utility usually increases as more of a good is consumed, marginal utility usually decreases
with each additional increase in the consumption of a good. This decrease demonstrates the
law of diminishing marginal utility.

Cardinal Utility

Cardinal utility states that the satisfaction the consumer derives by consuming goods and
services can be measured with numbers. Cardinal utility is measured in terms of utils (the
units on a scale of utility or satisfaction). According to cardinal utility the goods and services
that are able to derive a higher level of satisfaction to the customer will be assigned higher
utils and goods that result in a lower level of satisfaction will be assigned lower utils.
Cardinal utility is a quantitative method that is used to measure consumption satisfaction.

Ordinal Utility

Ordinal utility states that the satisfaction the consumer derives from the consumption of
goods and services cannot be measured in numbers. Rather, ordinal utility uses a ranking
system in which a ranking is provided to the satisfaction that is derived from consumption.
According to ordinal utility, the goods and services that offer the customer a higher level of
satisfaction will be assigned higher ranks and the opposite for goods and services that offer a
17

lower level of satisfaction. The goods that offer the highest level of satisfaction in
consumption will be provided the highest rank. Ordinal utility is a qualitative method that is
used to measure consumption satisfaction

Law Of Diminishing Marginal Utility.

According to Alfred Marshall, the law of diminishing marginal utility, the following happens:

During the course of consumption, as more and more units of a commodity are used, every
successive unit gives utility with a diminishing rate, provided other things remaining the
same; although, the total utility increases.

Explanation for the Law of Diminishing Marginal Utility:

We can briefly explain Marshalls theory with the help of an example. Assume that a
consumer consumes 6 apples one after another. The first apple gives him 20 utils (units for
measuring utility). When he consumes the second and third apple, the marginal utility of each
additional apple will be lesser. This is because with an increase in the consumption of apples,
his desire to consume more apples falls.

Therefore, this example proves the point that every successive unit of a commodity used
gives the utility with the diminishing rate.

We can explain this more clearly with the help of a schedule and diagram.

Schedule for Law of Diminishing Marginal Utility:

Unit of Consumption Marginal Utility Total Utility

1 20 20

2 15 35

3 10 45

4 05 50

5 00 50

6 -05 45

The schedule explains that with each additional unit consumed the marginal utility increases with a
diminishing rate. After the saturation point though, the utility starts to fall.

In the above table, the total utility obtained from the first apple is 20 utils, which keep on
increasing until we reach our saturation point at 5th apple. On the other hand, marginal utility
keeps on diminishing with every additional apple consumed. When we consumed the 6th
apple, we have gone over the limit. Hence, the marginal utility is negative and the total utility
falls.

With the help of the schedule, we have made the following diagram:
18

When the first apple is consumed, the marginal utility is 20. When the second apple is
consumed, the marginal utility increases by 15 utils, which is less than the marginal utility of
the 1st apple because of the diminishing rate. Therefore, we have shown that the utility of
apples consumed diminishes with every increase of apple consumed. Similarly, when we
consumed the 5th apple, we are at our saturation point. If we consume another apple, i.e. 6th
apple, we can see that the marginal utility curve has fallen to below X-axis, which is also
known as disutility.

Consumer Equilibrium through Utility

The term equilibrium is frequently used in economic analysis. Equilibrium means a state of
rest or a position of no change. It refers to a position of rest, which provides the maximum
benefit or gain under a given situation. A consumer is said to be in equilibrium, when he does
not intend to change his level of consumption, i.e., when he derives maximum satisfaction.
The Law of DMU can be used to explain consumers equilibrium in case of a single
commodity. Therefore, all the assumptions of Law of DMU are taken as assumptions of
consumers equilibrium in case of single commodity.

A consumer purchasing a single commodity will be at equilibrium, when he is buying such a

quantity of that commodity, which gives him maximum satisfaction. The number of units to
be consumed of the given commodity by a consumer depends on 2 factors:

1. Price of the given commodity;

2. Expected utility (Marginal utility) from each successive unit.

To determine the equilibrium point, consumer compares the price (or cost) of the given
commodity with its utility (satisfaction or benefit). Being a rational consumer, he will be at
equilibrium when marginal utility is equal to price paid for the commodity. We know,
marginal utility is expressed in utils and price is expressed in terms of money However,
marginal utility and price can be effectively compared only when both are stated in the same
units. Therefore, marginal utility in utils is expressed in terms of money.
19

Marginal Utility in terms of Money = Marginal Utility in utils/ Marginal Utility of one rupee
(MUM)

MU of one rupee is the extra utility obtained when an additional rupee is spent on other
goods. As utility is a subjective concept and differs from person to person, it is assumed that a
consumer himself defines the MU of one rupee, in terms of satisfaction from bundle of
goods.

Equilibrium Condition:
Consumer in consumption of single commodity (say, x) will be at equilibrium when:

Marginal Utility (MUx) is equal to Price (Px) paid for the commodity; i.e. MU = Price

i. If MUX > Px, then consumer is not at equilibrium and he goes on buying because benefit is
greater than cost. As he buys more, MU falls because of operation of the law of diminishing
marginal utility. When MU becomes equal to price, consumer gets the maximum benefits and
is in equilibrium.

ii. Similarly, when MUX < Px, then also consumer is not at equilibrium as he will have to
reduce consumption of commodity x to raise his total satisfaction till MU becomes equal to
price.

Consumer Equilibrium

Consumption Total Marginal Total Gain to

(units) Utility(Rs) Utility (Rs) Expenditure consumer
(Market price
=Rs3)
0 0 0 - -
1 4 4 3 1
2 7 3 6 1 (Equilibrium)
3 9 2 9 0
4 10 1 12 -2
5 10 0 15 -5
When the consumer buys one unit of a good at market price of Rs3 , he/she gains
utility worth Rs 4. In such case the consumer gains Re1 . when he buys 2 units ,the utility
gained is Rs 7 and total price paid is Rs 6. Again he gains Re 1. Next he purchases 3 units ,
the utility gained is Rs9 and the price paid is Rs9 . In such a case he does not gain anything.
If he buys further the total gain would become negative. It can be seen that MU is equal to
price 2 units of consumption. Consumption equilibrium is achieved when the consumer buys
2 units because at this point quantatity and utility gained is maximum and MU (Rs 3) is
equal to price (Rs3)

Law of Equi-Marginal Utility (for more than one good)

20

This law states that the consumer maximizing his total utility will allocate his income among
various commodities in such a way that his marginal utility of the last rupee spent on each commodity
is equal
Or The consumer will spend his money income on different goods in such a way that marginal utility
of each good is proportional to its price

In order to get maximum satisfaction out of the funds (money) we have, we carefully weigh the
satisfaction obtained from each rupee that we spend. If we find that a rupee spend in one direction has
greater utility than in another, we shall go non spending money, on the former ( first) commodity, till
the satisfaction derived from the last rupee spent in the two cases is equal. In other words, we
substitute some units of commodity of greater utility for some units of the commodity of less utility.

Let us discuss consumer equilibrium in case of 2 goods X and Y , whose prices are Px and Py
respectively. Consumers equilibrium is given as

MUx/Px= MUy/Py

The equation implies that a consumer reaches equilibrium when MU derived from each rupee spent
on 2 goods is same.

EQUI-MARGINAL PRINCIPLE

The Equimarginal Principle in Economics (Managerial Economics) states that different

courses of action should be pursued upto the point where all the courses give equal marginal
benefit per unit of cost. It claims that a rational decision-maker would certainly allocate or
hire resources in a fashion that the ratio of marginal returns and marginal costs of various
uses of a provided resource or of various resources in a given use is the same.

This principle is applicable to situations where a limited resource for example time, capital
or labor needs to be allocated among more than one independent uses. Taken along with the
Law of Diminishing Marginal Returns, it isnt difficult to see that an optimum solution should
indicate that the marginal returns for each of the feasible allocations are equivalent. Without a
doubt, if they were not, an improved allocation could possibly be attained by redistributing a
unit of resource from a use with smaller marginal returns to one with larger

Equi-marginal principle in managerial economics deals with the allocation of the available
resource among the alternative activities. According to equi-marginal principle, an input
should be allocated in such a way that the value added by the last unit is the same in all cases.

Suppose a firm has 100 units of labor at its disposal. The firm is engaged in four activities,
which need labor services, viz., A, B, C and D. It can enhance any one of these activities by
adding more labor but sacrificing in return the cost of other activities. If the value of the
marginal product is higher in one activity than another, then it should be assumed that an
optimum allocation has not been attained. Hence it would, be profitable to shift labor from
low marginal value activity to high marginal value activity, thus increasing the total value of
all products taken together.

For example, if the values of certain two activities are as follows:

21

Value of marginal product of labor for activity A = 20$ and, for activity B = 30$

In this case it will be profitable to shift labor from A to activity B thereby expanding activity
B and reducing activity A. The optimum will be reach when the value of the marginal product
is equal in all the four activities or, when in symbolic terms:

VMPLA = VMPLB = VMPLC = VMPLD

Where the subscripts indicate labor in respective activities

If the cost of project varies from project to project (COP), then resources are allocated that
MP per unit of cost of project(COP) is the same ie.

MpA =MpB=MpC=--------------------MpN

LAW OF DEMAND.

The law of demand is an economic law that states that consumers buy more of a
good when its price decreases and less when its price increases (ceteris paribus).The greater
the amount to be sold, the smaller the price at which it is offered must be in order for it to
find purchasers.Law of demand states that the quantity demanded of a commodity and its
price are inversely related, other things remaining constant. That is, if the income of the
consumer, prices of therelated goods, and tastes and preferences of the consumer remain
unchanged, the consumersdemand for the good will move opposite to the movement in the
price of the good."If the price of the good increases, the quantity demanded decreases, while
if price of the good decreases, its quantity demanded increases."

In other words, the law of demand states that the quantity demanded and the
price of a commodity are inversely related, other things remaining constant. If the income of
the consumer, prices of the related goods, and preferences of the consumer remain
unchanged, then the change in quantity of good demanded by the consumer will be
negatively correlated to the change in the price of the good.There are, however, some
possible exceptions to this rule (see Giffen goods and Veblen goods).

Graphical depiction
22

A demand curve is a graphical depiction that abides by the law of demand. It shows how the
quantity demanded of some product during a specified period of time will change as the price
of that product changes, holding all other determinants of the quantity demanded constant.
Price is measured on the vertical axis and quantity demanded on the horizontal axis.

There are two important things to note about the demand curve:

It is downward sloping indicating that between the price of a product and the
quantity demanded a negative or inverse relationship exists. In other words, as
the price declines the quantity demanded increases. This is indicated by a
downward movement along the demand curve. An increase in price decreases
the quantity demanded, and an upward movement along the demand curve
occurs.

The movement along a given demand curve due to a change in price is

referred to as "extension or contraction of demanded". As the price changes,
the quantity demanded change .But t lnhe term "change in demand" refers to a
shift of the demand curve because of factors other than price.

This increase and decrease in demand to price change is also called Extension and
Contraction of Demand..

1. Extension of Demand: This refers to rise in demand due to a fall in price of the
commodity. It is shown by a downwards movement on a given demand curve.

2. Contraction of Demand: This means fall in demand due to increase in price and can
be shown by an upwards movement on a given demand curve.

Assumptions

Every law will have certain limitation or exceptions. While expressing the law
of demand, theassumptions that other conditions of demand were unchanged. If remains
constant, the inverse relation may not hold well. In other words, it is assumed that the income
and tastes of consumers and the prices of other commodities are constant. This law operates
when the commoditys price changes and all other prices and conditions do not change. The
main assumptions are

1) Habits, tastes and fashions remain constant

2) Money, income of the consumer does not change.
3) Prices of other goods remain constant
23

4) The commodity in question has no substitute

5) The commodity is a normal good and has no prestige or status value.
6) People do not expect changes in the prices.
7) Quantity of the commodity remains constant.
8) State of wealth of consumer does not change.

Increase in Demand and Decrease in Demand

Usually demand curves are drawn based on the assumption except for price all other factors
remain the same. But there might be instances when demand may be affected by factors
other than price. This will result in the change in demand although the price will remain the
same. This change in demand may cause the demand curve to SHIFT inwards or outwards.

Shift of demand curve OUTWARDS shows an increase in demand at the same price
level. It is known as INCREASE IN DEMAND.

Shift of demand curve INWARDS shows that less is demanded at the same price
level. It is known as a FALL IN DEMAND.

Changes in demand imply the rise and fall due to factors other than price.

It means they occur without any change in price. They are of two types.

1. Increase in Demand: This refers to higher demand at the same price and results from
rise in income, population etc., this is shown on a new demand curve lying above the
original one.

2. Decrease in demand: It means less quantity demanded at the same price. This is the
result of factors like fall in income, population etc. this is shown on a new demand
lying below the original one.
 24

Individual Demand curve & Market demand Curve

The market demand curve is made up of all the individual demand curves
for a good. In general, the higher the price of an item, the less an individual consumer will
buy. Microeconomics is concerned with smaller-scale individual consumer behavior. But
since each consumer is different, one individual's behavior does not explain the entire market.
Macroeconomics attempts to understand the total market in a broader sense

Individual Demand Curve

The individual demand curve represents the quantity of a good that a

consumer will buy at a given price, holding all else constant. For example, consumer A might
buy zero oranges at $1 each, one orange at 75 cents each, and two at 50 cents each, while
consumer B might buy one at $1, two at 75 cents, and three at 50 cents. When charted on a
grid with price on the vertical axis and quantity purchased on the horizontal axis, these points
form the individual demand curves for consumers A and B.

Market Demand Curve

The market demand curve is the sum of all the individual demand curves in
the market. If the entire market consisted of only the two consumers mentioned above, the
total demand for oranges at a price of $1 would be one orange, because A would buy none
and B would buy one. At a price 50 cents, the market demand would be five oranges,
25

summing A's two oranges and B's three. For a single good, adding all the individual demand
curves of the millions of consumers in the market makes the total market demand curve.

Factors Affecting Demand

Price elasticity is the degree to which a change in price changes the quantity
demanded by the market. Necessities like electricity are price inelastic; a price change doesn't
greatly affect the quantity consumed. Nonessential goods like movie tickets are price elastic
because people can easily do without them. Another factor that affects demand for a good is
its relationship with other goods. For example, if the price of hot dogs increased dramatically
and demand decreased, demand for hot dog buns would also decrease, even if their price did
not change. This is known as a complementary relationship. A substitute relationship means
that as the price of one good goes up, consumers tend to buy another good in its place. For
example, people buy more used cars when the price of new cars increase

ELASTICITY OF DEMAND

What are the five types of elasticitys of demand?

The degree of responsiveness of quantity demanded of a commodity to the change in price is

called elasticity of demand. price elasticity of demand is popularly called elasticity of
demand. It is the rate of which quantity demanded changes in response to the change in price.
Elasticity of demand expresses the magnitude of change in quantity of a commodity.

Precisely stated, price elasticity demand is defined as the ratio of percentage change in
quantity demanded to a percentage change in price. Thus elasticity of demand can be
expressed in form of the following as price and quantity demanded move opposite.

Five cases of Elasticity of Demand:

1. Perfectly elastic demand

2. Perfectly inelastic demand

3. Relatively elastic demand

26

4. Relatively inelastic demand

5. Unitary elastic demand

1. Perfectly elastic demand:

The demand is said to be perfectly .elastic when a very insignificant change in price leads to
an infinite change in quantity demanded. A very small fall in price causes demand to rise
infinitely. Likewise a very insignificant rise in price reduces the demand to zero. This case is
theoretical which is never found in real life.

2. Perfectly inelastic demand:

The demand is said to be perfectly inelastic when a change in price produces no change in the
quantity demanded of a commodity. In such a case quantity demanded remains constant
regardless of change in price. The amount demanded is totally unresponsive of change in
price. The elasticity of demand is said to be zero.

3. Relatively more elastic demand:

27

The demand is relatively more elastic when a small change in price causes a greater change in
quantity demanded. In such a case a proportionate change in price of a commodity causes
more than proportionate change in quantity demanded. If price changes by 10% the quantity
demanded of the commodity change by more than 10% i.e. 25%. The demand curve in such a
situation is relatively flatter.

4. Relatively inelastic demand:

It is a situation where a greater change in price leads to smaller change in quantity demanded.
The demand is said to be relatively inelastic when a proportionate change in price is greater
than the proportionate change in quantity demanded. For example If price falls by 20%
quantity demanded rises by less than 20% i.e 15%.
28

5. Unitary elastic demand:

The demand is said to be unit when a change in price produces exactly the same percentage
change in the quantity demanded of a commodity. In such a situation the percentage change
in both the price and quantity demanded is the same. For example if the price falls by 25%
the quantity demanded rises by the same 25%. It takes the shape of a rectangular hyperbola.
Numerically elasticity of demand is said to be equal to 1.(ed = 1)

(To help you remember quantity is on top of price think of the football team QPR). The table
below shows a number of calculations of price elasticity of demand.

% change in price % change in quantity elasticity

10 20 2

50 25 0.5
29

7 28 4

9 3 0.33

The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate
of response of quantity demanded due to a price change. The formula for the Price Elasticity
of Demand (PEoD) is:

PEoD = (% Change in Quantity Demanded)/(% Change in Price)

Measurement of Price Elasticity of Demand

1. The Percentage Method

Price elasticity of demand (ep) = (Q/P) (P/Q)

This method is further known as ratio method, because we measure the ratio as: ep = %Q/
%P

Where,

%Q = percentage change in demand

%P = percentage change in price

2. Total Outlay Method

Marshall recommended the simplest technique to determine whether demand is elastic or
inelastic. According to his technique, in order to determine the demand elasticity, you have to
examine the change in total outlay of the consumer or total revenue of the firm.

Total Revenue (TR) = (Price (P) Quantity Sold (Q))

TR = (P Q)

Total Outlay Method

Price Quantity (in units) Total Outlay (or revenue) Elasticity of demand

Original 3 10 30 Unitary elasticity (price elasticity = 1)

Change 2 15 30

Original 3 10 30 Elastic demand (price elasticity > 1)

30

Price Quantity (in units) Total Outlay (or revenue) Elasticity of demand

Change 2 17 34

Original 3 10 30 Inelastic demand (price elasticity < 1)

Change 2 11 22

Cross Elasticity of Demand

This measures how sensitive consumer purchases of one product (X) are to a change in the
price of some other product (Y)

Substitute Goods

Cross elasticity of demand is positive

if the sales of product X moves in the
same direction as a change in the price of product Y

larger positive cross-elasticity coefficient = greater substitutability between the two

products

Complementary Goods

Cross elasticity is negative: increase in price of product X decreases the demand for
product Y

Larger negative cross-elasticity coefficient = greater complementarity between the

two goods

Independent Goods

Zero/near-zero cross elasticity = two products are unrelated

A change in one product's price has no effect on the other product's demand

Application

A product's substitutability, measured by the cross-elasticity coefficient, is important

in businesses and government because the demand for their products is directly
affected by the price of other products.

Income Elasticity of Demand:

Remember: income is a determinant of demand!
31

This measures the degree to which consumers respond to a change in their incomes by buying
more or less of a particular good.

Inferior Goods

A negative income-elasticity
coefficient represents an inferior good
(Ex. retread tires, cabbage, used
clothing).

A negative coefficient means that the income and quantity demanded move in
opposite directions. i.e. as the income increases, the demand for the good decreases
meaning it is inferior

Normal Goods

A positive income-elasticity coefficient represents a normal good; income and

quantity demanded move in same direction

Insights

Coefficients of income elasticity of demand provide insights into the economy and
helps explains why events are happening in the economy.

Practical Application of Price Elasticity of Demand

Price elasticity of demand (PED or Ed) is a measure used in economics to show the
responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its
price. More precisely, it gives the percentage change in quantity demanded in response to a
one percent change in price (ceteris paribus, i.e. holding constant all the other determinants of
demand, such as income). It was devised by Alfred Marshall.

Applications of price elasticity :

1.Inelastic demand for agricultural products helps to explain why bumper crops depress the
prices and total revenues for farmers.

2.Governments look at elasticity of demand when levying excise taxes. Excise taxes on
products with inelastic demand will raise the most revenue and have the least impact on
quantity demanded for those products
32

DEMAND FORECASTING

Demand forecasting is the activity of estimating the quantity of a product or service that
consumers will purchase. Demand forecasting involves techniques including both informal
methods, such as educated guesses, and quantitative methods, such as the use of historical
sales data or current data from test markets.

Explain in brief various methods of forecasting demand.

Demand forecasting seeks to investigate and measure the forces that determine sales for
existing and new products. Generally companies plan their business production or sales in
anticipation of future demand. Hence forecasting future demand becomes important. The art
of successful business lies in avoiding or minimizing the risks involved as far as possible and
face the uncertainties in a most befitting manner.

Methods of Forecasting:

Demand forecasting is a highly complicated process as it deals with the estimation of future
demand. It requires the assistance and opinion of experts in the field of sales management.
Demand forecasting, to become more realistic should consider the two aspects in a balanced
manner. Application of commonsense is needed to follow a pragmatic approach in demand
forecasting.

Broadly speaking, there are two methods of demand forecasting.

They are:
1) Survey methods and
2) Statistical methods
33

1) Survey Methods:

Survey methods help us in obtaining information about the future purchase plans of potential
buyers through collecting the opinions of experts or by interviewing the consumers. These
methods are extensively used in short run and estimating the demand for new products. There
are different approaches under survey methods. They are
1. Consumers interview method:
Under this method, efforts are made to collect the relevant information directly from the
consumers with regard to their future purchase plans. In order to gather information from
consumers, a number of alternative techniques are developed from time to time. Among
them, the following are some of the important ones.

a) Survey of buyers intentions or preferences:Under this method, consumer-buyers are

requested to indicate their preferences and willingness about particular products. They are
asked to reveal their future purchase plans with respect to specific items.

b) Direct Interview Method: this method, customers are directly contacted and interviewed.
Direct and simple questions are asked to them.

i. Complete enumeration method:Under this method, all potential customers are

interviewed in a particular city or a region.

ii. Sample survey method or the consumer panel method: Under this method, different
cross sections of customers that make up the bulk of the market are carefully chosen. Only
such consumers selected from the relevant market through some sampling method are
34

interviewed or surveyed.
2. Collective opinion method or opinion survey method:
Under this method, sales representatives, professional experts and the market
consultants and others are asked to express their considered opinions about the volume of
sales expected in the future.
3. Delphi Method or Experts Opinion Method ( given below)

4. End Use or Input Output Method:

Under this method, the sale of the product under consideration is projected on the basis of
demand surveys of the industries using the given product as an intermediate product.

2) Statistical Method:

It is the second most popular method of demand forecasting. It is the best available technique
and most commonly used method in recent years. Under this method, statistical,
mathematical models, equations etc are extensively used in order to estimate future demand
of a particular product. They are used for estimating long term demand. They are highly
complex and complicated in nature. Some of them require considerable mathematical
background and competence.
1. Trend Projection Method: (given below)

2. Economic Indicators:
Under this method, a few economic indicators become the basis for forecasting the sales of a
company. An economic indicator indicates change in the magnitude of an economic variable.
It gives the signal about the direction of change in an economic variable. This helps in
decision making process of a company.

Delphi Method or Experts Opinion Method:

Frequently business, governmental agencies and organizations are

faced with the problem of predicting or forecasting future events and relationships in order to
make appropriate and reasonable plans or changes. Several methods exist for forecasting, one
of which is called the Delphi technique. A forecasting or decision-making technique that
makes use of written questionnaires to eliminate the influence of personal relationships and
the domination of committees by strong personalities. Under this method, outside experts are
appointed. They are supplied with all kinds of information and statistical data. The
management requests the experts to express their considered opinions and views about the
expected future sales of the company. In a Delphi study, the development and administration
of questionnaires is interconnected. Note that multiple questionnaires are used. Participants in
a Delphi agree to receive and respond to a series of questionnaires, usually at least three
different rounds are used. The first questionnaire could take several forms, but would most
likely be one or two open-ended questions related to a broad problem or issue. The second
questionnaire is developed by the researcher based on the information collected during the
35

first round. Being certain steps are taken to eliminate the chance of research bias is important
throughout the Delphi process

Trend Projection Method

An old firm operating in the market for a long period will have the
accumulated previous data on either production or sales pertaining to different years. If we
arrange them in chronological order, we get what is called time series. It is an ordered
sequence of events over a period of time pertaining to certain variables. It shows a series of
values of a dependent variable say, sales as it changes from one point of time to another. In
short, a time series is a set of observations taken at specified time, generally at equal
intervals. It depicts the historical pattern under normal conditions. This method is not based
on any particular theory as to what causes the variables to change but merely assumes that
whatever forces contributed to change in the recent past will continue to have the same effect.
On the basis of time series, it is possible to project the future sales of a company.

Exponential smoothing

Exponential smoothing is a technique that can be applied to time

series data, either to produce smoothed data for presentation, or to make forecasts. The time
series data themselves are a sequence of observations. The observed phenomenon may be an
essentially random process, or it may be an orderly, but noisy, process. Whereas in the simple
moving average the past observations are weighted equally, exponential smoothing assigns
exponentially decreasing weights over time. Exponential smoothing is commonly applied to
financial market and economic data, but it can be used with any discrete set of repeated
measurements.

Exponential smoothing is also an averaging method that weights the most recent data more
strongly. As such, the forecast will react more to recent changes in demand. This is useful if
the recent changes in the data result from a change such as a seasonal pattern instead of just
random fluctuations (for which a simple moving average forecast would suffice).

Exponential smoothing is one of the more popular and frequently used forecasting
techniques, for a variety of reasons. Exponential smoothing requires minimal data. Only the
forecast for the current period, the actual demand for the current period, and a weighting
factor called a smoothing constant are necessary. The mathematics of the technique are easy
to understand by management. Virtually all POM and forecasting computer software
packages include modules for exponential smoothing. Most importantly, exponential
smoothing has a good track record of success. It has been employed over the years by many
companies that have found it to be an accurate method of forecasting.

The exponential smoothing forecast is computed using the formula

36

Linear Trend

A first step in analyzing a time series, to determine whether a

linear relationship provides a good approximation to the long-term movement of the series;
computed by the method of semi averages or by the method of least squares. Most naturally-
occurring time series in business and economics are not at all stationary (at least when plotted
in their original units). Instead they exhibit various kinds of trends, cycles, and seasonal
patterns. When trying to project an assumed linear trend into the future, we would like to
know the current values of the slope and intercept--i.e., the values that will give the best fit to
the next few periods' data. In statistics, linear regression is an approach to modeling the
relationship between a scalar dependent variable y and one or more explanatory variables
denoted X. The case of one explanatory variable is called simple regression. More than one
explanatory variable is multiple regression. (This in turn should be distinguished from
multivariate linea regression, where multiple correlated dependent variables are predicted,
rather than a single scalar variable.) Most applications of linear regression fall into one of the
following two broad categories:

1. Linear regression models are often fitted using the least squares approach. If the goal
is prediction, or forecasting, linear regression can be used to fit a predictive model to
an observed data set of y and X values

2. Linear regression analysis can be applied to quantify the strength of the relationship
between y and the Xj, to assess which Xj may have no relationship with y at all, and to
identify which subsets of the Xj contain redundant information about y.

Although linear trend models have their uses, they are often inappropriate for business and
economic data. Most naturally occurring business time series do not behave as though there
are straight lines fixed in space that they are trying to follow: real trends change their slopes
and/or their intercepts over time. The linear trend model tries to find the slope and intercept
that give the best average fit to all the past data, and unfortunately its deviation from the data
is often greatest near the end of the time series, where the forecasting action is!
37

A linear trend line relates a dependent variable, which for our purposes is demand, to one
independent variable, time, in form of a linear equation:

Moving Average Method

The moving-average method is not only useful in smoothing a

time series to see its trend; it is the basic method used in measuring the seasonal fluctuation,
described later in the chapter. In contrast to the least squares method, which expresses the
trend in terms of a mathematical equation the moving-average method merely smooths the
fluctuations in the data. This is accomplished by moving the arithmetic mean values
through the time series.

Advantages include: easy to use, quick, relatively inexpensive, andgood for short-run forecasts
Disadvantages include: not good for the long-run, does not react to variations that occur for a reason
(cycles and seasonal effects), and factors that cause changes are generally ignored

WORKED OUT EXAMPLE

The 3- and 5-month moving average forecasts for all the months of demand data are shown in
the following table. Actually, only the forecast for November based on the most recent
monthly demand would be used by the manager. However, the earlier forecasts for prior
months allow us to compare the forecast with actual demand to see how accurate the
forecasting method is--that is, how well it does.

Three- and Five-Month Averages

38

Least Square Method

The method of least square is more scientific as compared to the method of moving
averages.
It uses a straight line equation Y= a+ bX to fit the trend data

Note : The idea of a trend line is to reveal a linear relationship between two variables, x and y, in the
Y= a+ bX form. A statistical tool called regression analysis is required to calculate the best fit line
accurately. In simple linear regression, we predict scores on one variable from the scores on a second
variable. When there is only one predictor variable, the prediction method is called simple regression

Trend equation Y= a+ bX

To determine the value of of a & b the following two equations have to be solved
Y = Na + b X --------------------(1)
XY = a + b X2 ---------------------(2)
Where a= Y/ N
b = XY/ X2

The annual sales of a company is as follows.

Year 1991 1992 1993 1994 1995

Sales 45 56 58 46 75 (Rs 1000)

Year Sales 1993= 0) Estimated

Time- dev. Trend
2 Y=56 +5X
Y X X XY (Rs 000)
1991 45 -2 4 -90 46
1992 56 -1 1 -56 51
1993 58 0 0 0 56
1994 46 +1 1 46 61
1995 75 +2 4 150 66
n=5 Y =280 X =0 x2 = 10 XY =50

Trend equation Y= a+ bX

To determine the value of of a & b the following two equations have to be solved
Y = Na + b X --------------------(1)
XY = a + b x2 ---------------------(2)

Since X = 0 , the above equation will take the form of ( if midpoint is taken as the origin ,the
negative values in the first half and positive values in the second half of the series will cancel out each
other)
a= Y/ N
b = XY/ X2
a = 280/5= 56
b = 50/10 = 5
Y1991 = 56 + 5(-2) = 46
Y1992 = 56 + 5 (-1) =51
Y1993 = 56 + 5 (0) =56
39

Y1994 = 56 + 5 (1) = 61
Y1995 = 56 + 5 (2) = 66
Fore cast for the year 1996
Y1996 = 56 + 5 (3) = 71 ie. Rs 71000.00 . Fit st.line trend in a graph

Question 2 :
Year 1982 1983 1984 1985 1986 1987 1988
Production 800 900 920 830 940 990 920
( in 000 units)

Find out trend values and Fit a straight line trend to these figures graphically
Answer:
Trend values are 840, 860,880, 900,920,940, and 960 for the years 1982 to 1988
( Refer page 150 D. Gopalakrishna)

Utility of Forecasting:
Forecasting reduces the risk associated with business fluctuations which generally produce
harmful effects in business, create unemployment, induce speculation, discourage capital
formation and reduce the profit margin. Forecasting is indispensable and it plays a very
important part in the determination of various policies. In modem times forecasting has been
put on scientific footing so that the risks associated with it have been considerably minimised
and the chances of precision increased.

Module III

Production function production with one variable input, law of variable proportion;
production with two variable inputs; production isoquant; isocost lines; Estimating
production functions; cost concepts and break even analysis

Production : Meaning of Production

 40

In economics, production is the act of creating output, a goods

or service which has value and contributes to the utility of individuals. The act may or
may not include factors of production other than labour. Any effort directed toward the
realization of a desired product or service is a "productive" effort and the performance of such
act is production. The relation between the amount of inputs used in production and the
resulting amount of output is called the production function.

Production can be distinguished into three stages:

1. Primary producers directly extract natural resources.

2. Secondary producers process resources to turn them into intermediate goods.
3. Tertiary producers provide final goods or services to the consumer.

Production Function

A production function is a function that specifies the output of a firm, an

industry, or an entire economy for all combinations of inputs. This function is an assumed
technological relationship, based on the current state of engineering knowledge; it does not
represent the result of economic choices, but rather is an externally given entity that
influences economic decision-making.
Production function may be Capital Intensive or Labour Intensive. There are literally
millions of production functions and one specially designed for a specific location and
purpose would be useless anywhere else.
The production function is a mathematical expression which relates the quantity of factor
inputs to the quantity of outputs that result. We make use of three measures of production /
productivity. Total product is simply the total output that is generated from the factors of
production employed by a business. In most manufacturing industries such as motor vehicles,
freezers and DVD players, it is straightforward to measure the volume of production from
labour and capital inputs that are used. But in many service or knowledge-based industries,
where much of the output is intangible or perhaps weightless we find it harder to measure
productivityAverage product is the total output divided by the number of units of the
variable factor of production employed (e.g. output per worker employed or output per unit of
capital employed)Marginal product is the change in total product when an additional unit of
the variable factor of production is employed. For example marginal product would measure
the change in output that comes from increasing the employment of labour by one person, or
by adding one more machine to the production process in the short run.
ShortRun and LongRun Production
Our analysis of production and cost makes an important distinction between the short run and
the long run.In the short run one or more of the firms inputs is fixed; that is, they cannot be
varied. In the long run the firm can vary all of its inputs. There is no universal rule for
distinguishing between the short and long run; rather, the dividing line must be drawn on a
casebycase basis. For a petrochemical refinery, the short run might be any period less than
five years since it takes roughly this long to build a new refinery. For a fastfood chain, six
months (the time it takes to obtain zoning approvals and construct new restaurants) may be
the dividing line between the short and long run.
41

Inputs that cannot be changed in the short run are called fixed inputs. A firms production
facility is a typical example. In the long run, the firm could vary the size and scale of its
plant, whereas in the short run the size of this plant would be fixed at its existing capacity. If
a firm operates under restrictive, longterm labor contracts, its ability to vary its labor force
may be limited over the contract duration, perhaps up to three years. In this case, labor could
be a fixed input in the short run.

'Economies Of Scale'

The cost advantage that arises with increased output of a product. Economies
of scale arise because of the inverse relationship between the quantity produced and per-unit
fixed costs; i.e. the greater the quantity of a good produced, the lower the per-unit fixed cost
because these costs are shared over a larger number of goods. Economies of scale may also
reduce variable costs per unit because of operational efficiencies and synergies. Economies of
scale can be classified into two main types: Internal arising from within the company; and
External arising from extraneous factors such as industry size.

PRODUCTION WITH ONE VARIABLE INPUT : The law of returns

(LAW OF VARIABLE PROPORTION/ LAW OF DIMINISHING RETURNS)

The law of variable proportion is one of the fundamental laws of economics.

It is the generalized form of Law of Diminishing marginal return. The law of variable
proportion is the study of short run production function with some factors fixed and some
factors variable.In the short run the volume of production can be changed by altering variable
factors only. In the study of production function (variable proportion) the effect on output is
examined by varying factor proportions. When we increase the quantity of variable factors to
the combination of fixed factor, the proportion between fixed and variable factors change.
The change in factor proportion and its effect on output forms the subject- matter of the law
of variable proportions.

The ratio of variable factor to the fixed factor changes as the variable factors are increased in
the combination. Thus the main thing to be noted is the break of proportion between fixed
and variable factors of production. With disproportionate combination of factors, the returns
may initially increase then remain constant for sometime and ultimately diminishes.
Therefore, the law of variable proportion is called non-proportional returns.. The law of
variable proportions or diminishing returns has been stated by Benham in the following
manner."As the proportion of one factor in a combination of factors is increased, after a point,
first the marginal and then the average production of that factor will diminishing.

Marginal Product
Lets consider the production decisions of a firm.. In the short run, this capital input
is fixed. However, labor is a variable input; that is, the firm can freely vary its number of
42

workers. Table shows the amount of output obtainable using different numbers of workers.
(This information is reproduced from the earlier production function and expanded slightly.)
Notice that output steadily increases as the workforce increases, up to 7 workers. Beyond
that point, output declines. It appears that too many workers within a plant of limited size are
counterproductive to the task of producing parts. (Note : Labour increases, Capital remains
constant)

Number of Amount of Total Average Marginal

Workers (L) Capital(K) Product(TP) Product(APL) Product(MPL)
0 10 0 - -
1 10 10 10 10
2 10 30 15 20
3 10 60 20 30
4 10 80 20 20
5 10 95 19 15
6 10 108 18 13
7 10 112 16 4
8 10 112 14 0
9 10 108 12 -4
10 10 100 10 -8
10 10 388 3.88 2.0
The last column of Table lists the marginal product of labor (abbreviated MPL).
This marginal product is the additional output produced by an additional unit of labor, all
other inputs held constant. The marginal product increases upto 3rd labour and beyond that, it
decreases and reaches zero at 8th labour and becomes negative at 9th labour and beyond.
Mathematically, labors marginal product is MPL = dQ/dL. In other words, labors marginal
product is the change in output per unit change in labor input. The average product also
increases upto 3rd labour and is constant at 4th labour and it starts decreasing beyond 4th
labour

In our example, MPL first rises then declines. Why does MPL rise initially? With a small
workforce, the typical worker must be a jackofalltrades (and master of none). Increasing
the number of workers allows for specialization of laborworkers devoting themselves to
particular taskswhich results in increased output per worker. Furthermore, additional
workers can use underutilized machinery and capital equipment

Law of variable proportion is explained in the diagrams

(Figure 1 )
43

Figure 2
44

It is only one law of production which has three phases, increasing, diminishing and negative
production. This general law of production was named as the Law of Variable Proportions.

The Law of Variable Proportions which is the new name of the famous law of Diminishing
Returns has been defined by stigler in the following words. As equal increments of one input
are added, the inputs of other productive services being held constant, beyond a certain
point, the resulting increments of produce will decrease i.e., the marginal product will
diminish.According to Samuelson, An increase in some inputs relative to other fixed inputs
will in a given state of,technology cause outputto increase, but after a point, the extra output
resulting from the same addition of extra inputs will become less.

PRODUCTION WITH TWO VARIABLE INPUTS

In the short run, production function is explained with one variable factor
and other factors of productions are held constant. We have called this production function as
the Law of Variable Proportions or the Law of Diminishing returns.

In the long run, production function is explained by assuming all the factors of
production as variable. There are no fixed inputs in the long run. Here the production
function is called the Law of Returns to scale of production. As it is difficult to handle
more than two variables in graph, we therefore, explain the Laws of Returns according to
scale of production by assuming only two inputs i.e., capital and labour and Study how output
responds to their use. Production function is expressed as Q = f(K, L).

There are two methods which are used for explaining the laws of Returns to Scale

(i) Production function with two variable inputs.

(ii) Isoquant- Isocost Approach

These two methods are explained in brief.

THE LAW OF RETURNS TO SCALE

The law of returns ((Law of variable proportions) are often confused with the law
of returns to scale. There were three laws of returns (Law of variable proportions) mentioned
in the history of economic thought up till Alfred Marshalls time. The law of diminishing
returns operates in the short period. It explains the production behaviour of the firm with one
factor variable while other factors are kept constant. Whereas the laws of returns to scale
operates in the long period. It explains the production behaviour of the firm under the
45

conditions when both the inputs (labour and capital) are variable and they can be increased
proportionately and simultaneously.

The laws of Returns to scale is a set of three inter-related and chronological laws
(stages): Law of Increasing Returns to Scale, Law of Constant Returns to Scale, and Law of
Diminishing returns to Scale. If output increases by that same proportional change then there
are constant returns to scale (CRS). If output increases by less than that proportional change
in inputs, there are decreasing returns to scale (DRS). If output increases by more than that
proportional change in inputs, there are increasing returns to scale (IRS). In mainstream
microeconomics, the returns to scale faced by a firm are purely technologically imposed and
are not influenced by economic decisions or by market conditions (i.e., conclusions about
returns to scale are derived from the specific mathematical structure of the production
function in isolation).

The Laws of Return to Scale explains the behaviour of rate of increase in the
output/production to the subsequent increase in the inputs i.e. the factors of production in the
long run.In the long run all factors of production are variable and subject to change due a
given increase in size/scale .

The laws of Returns to scale is a set of three inter-related and chronological laws (stages)

1. Law of Increasing Returns to Scale

2. Law of Constant Returns to Scale

3. Law of Diminishing returns to Scale

Formal definitions
Formally, a production function is defined to have:

Constant returns to scale if (for any constant a greater than 0)

Increasing returns to scale if (for any constant a greater than 1)

Decreasing returns to scale if (for any constant a greater than 1)

where K and L are factors of productioncapital and labor, respectively

Dr. Marshall was of the view that the law of diminishing returns applies to agriculture and the
law of increasing returns to industry..
46

Example
When all inputs increase by a factor of 2, new values for output will be:

Twice the previous output if there are constant returns to scale (CRS)

Less than twice the previous output if there are decreasing returns to scale (DRS)

More than twice the previous output if there are increasing returns to scale (IRS)

Let us take a numerical example to explain the behavior of the law of returns to scale.

Table 1: Returns to Scale

Unit Scale of Production Total Returns Marginal Returns

1 1 Labor + 2 C 4 4 (Stage I - Increasing Returns)
2 2 Labor + 4 C 10 6
3 3 Labor + 6 C 18 8
4 4 Labor + 8 C 28 10 (Stage II - Constant Returns)
5 5 Labor + 10 C 38 10
6 6 Labor + 12 C 48 10
7 7 Labor + 14 C 56 8 (Stage III - Decreasing Returns)
8 8 Labor + 16 C 62 6
The data of table 1 can be represented in the form of Figure 3
47

RS = Returns to scale curve

RP = Segment; increasing returns to scale

PQ = segment; constant returns to scale

QS = segment; decreasing returns to scale

Explanation of Different Stages of Laws of Returns to Scale

1. The Increasing Returns to Scale: There are increasing returns to scale when a given
percentage increase in input leads to a greater relative percentage increase in output. In case
of increasing returns to scale, the production function is homogeneous of degree greater than
one.
Causes of Increasing Returns to Scale:

a.Internal economies of scale

b.Efficiency of labour and capital
c.Improvement in large scale operation
d.Division of labour and specialization
e.Use of better and sophisticated technology
f.Economy of organisation
g.External economies of scale
48

2.Constant Returns to Scale.There are constant returns to scale when a given percentage increase in
input leads to an equal percentage increase in output. It shows that if inputs are doubled then the
output also gets doubled. If inputs are trebled then the output also trebles

Causes of Constant Returns to Scale:

a)Internal economics of scale are equal to internal diseconomies of scale.
b)Balancing of external economics and diseconomies of scale
c)Factors of production are perfectly divisible substitutable, homogenous and their supply is perfectly
elastic at given prices.

3.Decreasing Returns to Scale.There are decreasing returns to scale when a given percentage
increase in input leads to a smaller percentage increase in output.

Causes of Decreasing Returns to Scale

a.Internal diseconomies of scale

b.External diseconomies of scale

c.Increase in business risk
d.Lack of entrepreneurial efficiency
e.Unhealtny management and organization
f.Imperfect factor substitutability
g.Transport bottlenecks and Marketing difficulties.
Returns to scale are important for determining how many firms will populate an
industry. When increasing returns to scale exist, one large firm will produce more cheaply than two
small firms. Small firms will thus have a tendency to merge to increase profits, and those that do not
merge will eventually fail. On the other hand, if an industry has decreasing returns to scale, a merger
of two small firms to create a large firm will cut output, raise average costs, and lower profits. In such
industries, many small firms should exist rather than a few large firms.

If business decision-makers lack information or are incompetent, the firm will not
make the best use of available resources. Or if morale is bad in a firm, people may work poorly and
produce less than they could. In either case, the firm will produce below the maximum that the
production function allows. Economist Harvey Liebenstein called losses of these sorts "X-
inefficiency." Although economists assume that the firm will be on the production function, a major
challenge of management is to make decisions so that the firm will be on or close to the production
function.

The Laws of Returns to Scale: Production Function with two variable

inputs : Isoquant-Isocost Approach
Long run is a period during which all factors of production can vary. Long run
relationship between inputs and output of a firm is explained by the Laws of returns to scale. The term
returns to scale arises in the context of a firm's Production Function.In the long run production
function, all factors are variable. Therefore in the long run output can be changed by changing all the
factors of production.A firm's production function could exhibit different types of returns to scale in
different ranges of output.Typically, there could be Increasing returns to scale,Constant returns to
scale and Diminishing returns to scale. In this section we will use the isoquants to analyse the input
output relationships under the condition that both the inputs (labour and Capital) are variable and their
quantity is changed proportionately and simultaneously.
49

The relationship between inputs such as capital, raw materials, land and labor
and outputs, or products, is called the production function. It shows the maximum output that
can be produced per unit of time using given quantities of input. Isoquant curves display
production functions graphically. They are composed of a set of points that represent
combinations of capital and labor yielding the same output. "Iso" means "equal", and "quant"
means "quantity." An isoquant curve is also called an equal product curve and a production
indifference curve.

Statement of the Law

"Other things being equal in the long run, as the firm increases the quantities of all factors
employed, the output may rise either more than proportionately, less than proportionately or
in exactly same proportion of the change in quantities of inputs.

Symbolically, the long run production function can be written as:

Two factor model: Q'x = f(L,K)

The laws of returns to scale can also be elucidated in stipulations of the Isoquant approach.
The laws of returns to scale refer to the effects of a change in the scale of factors upon
output in the long run when the combinations of factors are changed in some proportion. If
by increasing two factors say labour and capital in the same proportion, productivity
augments in exactly the same proportion there are invariable returns to the scale.

Increasing Returns to Scale

1. There may be indivisibilities in machines, management, labour, finance etc. A little

item of equipment or some activities have a minimum size and cannot be divided into
smaller units.

2. Increasing returns to scale also result from specialisation and division of labour, when
the scale of firm enlarges, there is a broader exposure for specialisation and division
of labour.

3. As the firm enlarges, it enjoys internal economies of production. It may be able to

install better machines, sell its products more easily, borrow money cheaply, procure
the services of more efficient manager and workers etc.

Decreasing Returns to Scale

1. Indivisible factors may become incompetent and less productive.

2. The firm experiences internal diseconomies. Business may become unwieldy and
produce problems of supervision and coordination. Large management creates
complexities of control and rigidities.

3. To these internal diseconomies are additional external diseconomies of scale. These

occur from higher factor price or from diminishing productivity of the factors.

Constant Returns to Scale

50

1. The returns to scale are invariable when internal economies enjoyed by a firm are
neutralised by internal diseconomies so that productivity amplifies in the same ration.

2. One more reason is the balancing of external economies and external diseconomies.

3. Invariable returns to scale also result when factors of production are perfectly
divisible, substitutable, standardised and their supplies are perfectly elastic at given
prices.

Thats why in the case of invariable returns to scale, the production function is homogeneous
of degree one.

ISOQUANT

An isoquant (isoproduct) is a curve on which the various combinations of labour and capital
show the same output. According to Cohen and Cyert, An isoproduct curve is a curve along
which the maximum achievable rate of production is constant. It is also known as a
production indifference curve or a constant product curve. Just as indifference curve shows
the various combinations of any two commodities that give the consumer the same amount of
satisfaction (iso-utility), similarly an isoquant indicates the various combinations of two
factors of production which give the producer the same level of output per unit of time.

Isoquant Properties

Negative Slope
Isoquant curves have a negative or downward slope. For a specific isoquant, the
amount of labor is always inversely related to the amount of capital used. So if capital
or labor is reduced, the other factor should be increased to maintain the same output.
Isoquants cannot slope upward.

No Intersection
Isoquants do not meet with each other or cross each other; they do not intersect.
Different isoquants are created for different outputs for the same production function.
Also, each isoquant relates to a particular rate of output. So an intersection of
isoquants would show that the same amounts of labor and capital with the same
efficiency can produce two different outputs. Similarly, isoquants cannot be tangential
to each other.

Convex Toward Origin

Isoquants are usually convex toward the origin. That means every isoquant becomes
flatter farther down its curve. As a result, the curve never can be parallel to the X or
the Y axis. The isoquant remains part of an oval. If you travel along the isoquant
downward and to the right, the values of labor and capital adjust with each other to
keep output constant. So successive increments of capital result in reduction of labor.
This is called the law of diminishing returns. As a result, the isoquant is convex
toward the origin.
51

Isoquant Map

A family of isoquants can be represented by an isoquant map, a graph combining

a number of isoquants, each representing a different quantity of output. Isoquants are also called equal
product curves. An isoquant map can also indicate decreasing or increasing returns to scale based on
increasing or decreasing distances between the isoquant pairs of fixed output increment, as output
increases. If the distance between those isoquants increases as output increases, the firm's production
function is exhibiting decreasing returns to scale; doubling both inputs will result in placement on an
isoquant with less than double the output of the previous isoquant. Conversely, if the distance is
decreasing as output increases, the firm is experiencing increasing returns to scale; doubling both
inputs results in placement on an isoquant with more than twice the output of the original isoquant

Producers Equilibrium: THE ECONOMICALLY EFFICIENT POINT OF

PRODUCTION

Choice of Optimal Factor Combination or Least Cost Combination of

Factors
A profit maximisation firm faces two choices of optimal combination of factors
(inputs): First, to minimise its cost for a given output; and second, to maximise its output for
a given cost. Thus the least cost combination of factors refers to a firm producing the largest
volume of output from a given cost and producing a given level of output with the minimum
cost when the factors are combined in an optimum manner.

Assumptions:
This analysis is based on the following assumptions:

1. There are two factors, labour and capital.

2. All units of labour and capital are homogeneous.

3. The prices of units of labour (w) and that of capital (r) are given and constant.

4. The cost outlay is given.

5. The firm produces a single product.

6. The price of the product is given and constant.

7. The firm aims at profit maximisation.

8. There is perfect competition in the factor market.

Given these assumptions, the point of least-cost combination of factors for a given level of
output is where the isoquant curve is tangent to an isocost line.
52

Explanation
There are only 2 factors of production, labour and capital. Combining labour and capital
produces output. The given table shows the same quantity of output that can be produced
with the different combinations of these 2 inputs.

Table showing different combinations of 2 inputs producing same level of output

Combinations Labour Capital Units of output

A 3 20 50

B 4 15 50

C 6 10 50

D 10 6 50

E 15 4 50

F 20 3 50

The above table , displayed in the form of a curve would look like (Figure4)
53

The Graphical representation of all the combinations of 2 inputs , producing same level of
output is called an isoquant curve.
An isoquant curve is always technically efficient.
ISOCOST

The Isocost Line

The isocost line is an important component when analysing producers behaviour. The isocost
line illustrates all the possible combinations of two factors that can be used at given costs and
for a given producers budget. In simple words, an isocost line represents a combination of
inputs which all cost the same amount.

Now suppose that a producer has a total budget of Rs 120 and and for producing a certain
level of output, he has to spend this amount on 2 factors A and B. Price of factors A and B are
Rs 15 and Rs. 10 respectively.

Combination Units of Units of Total expenditure

s Capital Labour

Price = Price = 100 ( in Rupees)

150Rs Rs

A 8 0 120

B 6 3 120

C 4 6 120

D 2 9 120

E 0 12 120

Figure 5
54

The isocost line shows all the possible combinations of two factors Labour and capital.

THE ECONOMICALLY EFFICIENT POINT OF PRODUCTION

Cost-Minimisation for a Given Output:

In the theory of production, the profit maximisation firm is in equilibrium when, given the
cost-price function, it maximises its profits on the basis of the least cost combination of
factors. For this, it will choose that combination which minimises its cost of production for a
given output. This will be the optimal combination for it.

The least cost combination of inputs for a given output occurs where the isocost curve is
tangent to the isoquant curve for that output.
This point can be found where the slopes of the theisoquant curve and isoquant line are equal.
And this is equal at the point of tangency.
Figure 6
55

The tangency point of Isoquant Map and isocost line gives us the equilibrium position E.
Isoquant map intersects the isocost line at 3 points x , E and Z
. x and z lie on the lower isoquant curve than E lies on and hence gives lesser utility than E.
So, E is the economically Efficient Point of Production

The point of tangency between the isocost line and the isoquant is an
important first order condition but not a necessary condition for the
producers equilibrium. There are two essential or second order conditions
for the equilibrium of the firm

1. The first condition is that the slope of the isocost line must
equal the slope of the isoquant curve.

2. The second condition is that at the point of tangency, the

isoquant curve must he convex to the origin.

Relation between Returns to Scale and Returns to a Factor (Law of Returns to Scale and Law of
Diminishing Returns):
Returns to a factor and returns to scale are two important laws of production. Both laws
explain the relation between inputs and output. Both laws have three stages of increasing,
decreasing and constant returns. Even then, there are fundamental differences between the
two laws. Returns to a factor relate to the short period production function when one factor is
varied keeping the other factor fixed in order to have more output, the marginal returns of the
variable factor diminish. On the other hand, returns to scale relate to the long period
production function when a firm changes its scale of production by changing one or more of
its factors.

The laws of returns to scale can also be explained in terms of the isoquant approach. The laws
of returns to scale refer to the effects of a change in the scale of factors (inputs) upon output
56

in the long-run when the combinations of factors are changed in some proportion. If by
increasing two factors, say labour and capital, in the same proportion, output increases in
exactly the same proportion, there are constant returns to scale. If in order to secure equal
increases in output, both factors are increased in larger proportionate units, there are
decreasing returns to scale. If in order to get equal increases in output, both factors are
increased in smaller proportionate units, there are increasing returns to scale.

Note : For reference only (Not in the syllabus)

. Law of Returns to Scale explained with the help of isoquants (see the following figures)

Increasing Returns to Scale:

Figure 24.11 shows the case of increasing returns to scale where to get equal increases in
output, lesser proportionate increases in both factors, labour and capital, are required.

Decreasing Returns to Scale:

Figure 24.12 shows the case of decreasing returns where to get equal increases in output,
larger proportionate increases in both labour and capital are required.

Constant Returns to Scale:

Figure 24.13 shows the case of constant returns to scale. Where the distance between the
isoquants 100, 200 and 300 along the expansion path OR is the same, i.e., OD = DE = EF. It
means that if units of both factors, labour and capital, are doubled, the output is doubled. To
treble output, units of both factors are trebled.
57

Questions

1. Explain Law of Variable Proportions / Explain production with

one variable input (Figure 1 &2 )

2. Explain Laws of Returns ( Figure 3)

3. Explain Isoquant Isocost approach Or Determine economic

efficiency point of production (Figure 4,5 and 6)

4. Explain production with two variable inputs ( Fig 3 &6)

Profit maximization (Explained in Theory of Markets)

In economics, profit maximization is the short run or long run process by

which a firm determines the price and output level that returns the greatest profit. There are
several approaches to this problem. The total revenuetotal cost perspective relies on the fact
that profit equals revenue minus cost and focuses on maximizing this difference, and the
marginal revenuemarginal cost perspective is based on the fact that total profit reaches its
maximum point where marginal revenue equals marginal cost.
58

ANALYSIS OF COSTS

Cost function

Cost function ( the output-cost relationship is the cost function of the

firm.)
Certain quantity of output can be produced by different input combinations. With
the input prices given, it will choose that combination of inputs which is least
expensive. So, for every level of output, the firm chooses the least cost input
combination.. and this output-cost relationship is the cost function of the firm.
or
In order to produce output, the firm chooses least cost input combinations. this
process of selecting and producing is called the cost function.

Cost Concepts Defined Cost is the value of the inputs used to produce its output; e.g. the firm
hires labor, and the cost is the wage rate that must be paid for the labor services Total cost
(TC) is the full cost of producing any given level of output, and it is divided into two parts:
Total fixed cost (TFC): it is the part of the TC that doesnt vary with the level of output Total
variable cost (TVC): it is the part of the TC that changes directly with the output
Average Costs Average total cost (ATC) is the total cost per unit of output
Average fixed cost (AFC) is the fixed cost per unit of output.(details given below)
Average variable cost (AVC) is the variable cost per unit of output
Marginal costs(MC): Marginal cost (incremental cost) is the increase in total cost resulting
from increasing the level of output by one unit .Since some of total costs are fixed costs,
which do not change as the level of output changes, marginal cost is also equal to the increase
in variable cost, that results when output is increased by one unit

Variable Costs and Fixed Costs

All the costs faced by companies can be broken into two main categories: fixed costs and
variable costs. Fixed costs are costs that are independent of output. These remain constant
throughout the relevant range and are usually considered sunk for the relevant range (not
relevant to output decisions). Fixed costs often include rent, buildings, machinery, etc. Cost
59

that do not change when production or sales levels do change, such as rent, property tax,
insurance, or interest expense. The fixed costs are summarized for a specific time period
(generally one month).

Variable costs are costs that vary with output. Generally variable costs increase at a constant
rate relative to labor and capital. Variable costs may include wages, utilities, materials used in
production, etc. In accounting they also often refer to mixed costs. These are simply costs that
are part fixed and part variable. An example could be electricity--electricity usage may
increase with production but if nothing is produced a factory still may require a certain
amount of power just to maintain itself. Variable costs are costs directly related to production
units. Typical variable costs include direct labor and direct materials. . The variable cost times
the number of units sold will equal the Total Variable Cost

Short-Run & Long-RunTotal Cost Function

The short-run and long-run total cost functions relate the cost per unit of
output against the quantity of goods produced. The long run is defined as the period of time
in which no factor units of production are fixed, while the short run involves at least one unit
of production as fixed. The difference between the long-run and short-run functions is that the
long run allows for a variety of capital to labor combinations, while the the short run
generally allows a very limited number of combinations.
"The short run is a period of time in which the quantity of
at least one input is fixed and the quantities of the other inputs can be varied. The long run is
a period of time in which the quantities of all inputs can be varied.There is no fixed time that
can be marked on the calendar to separate the short run from the long run. The short run and
long run distinction varies from one industry to another." The long run and the short run do
not refer to a specific period of time such as 3 months or 5 years. The difference between the
short run and the long run is the flexibility decision makers have. "The short run is a period
of time in which the quantity of at least one input is fixed and the quantities of the other
inputs can be varied. The long run is a period of time in which the quantities of all inputs
can be varied.Short Run: Some inputs variable, some fixed. New firms do not enter the
industry, and existing firms do not exit.Long Run: All inputs variable, firms can enter and
exit the market place.

Analysis of Costs
Quantit Fixe Variable Total Cost Margina Average Average Fixed Average
y d Cost(VC (TC=FC+VC l Cost Cost Cost per Variable Cost
Q cost ) ) (MC) (AC=TC/Q unit(AFC=F per
(FC) ) C/Q unit(AVC
=VC/Q)
0 55 0 55 Infinity Infinity Infinity
30
60

1 55 35 85 85 55 30
25
2 55 55 110 55 27.5 27.5
20
3 55 75 130 43.33 18.33 25
30
4* 55 105 160 40* 40* 13.75 26.25
50
5 55 155 210 42 11 31
70
6 55 225 280 46.66 9.16 37.5

Note: The starred MC= starred AC . The point where AC cuts MC in the diagram

ATC (Average Total Cost)/AC = Total Cost / quantity

AVC (Average Variable Cost) = Variable cost / Quantity

AFC (Average Fixed Cost) = Fixed cost / Quantity

Mathematically: Calculation of cost functions vary, although most tend to multilply the total
fixed units of production or costs and add them to the variable factors of production.

Total Cost
Total cost is the sum of total variable cost and the total fixed cost.

Fixed Cost - is the cost of fixed factors of production. Fixed Cost remains the
same in the short run.

Variable Cost - is the cost of variable factors of production. Variable Cost

increases with the increase in the quantity of production.
TC = TFC + TVC
61

( Fixed factors of production refers to the factors of production whose supply

cannot be increased in the short run. E.g. Land is a fixed factor of production in
the short run.

Variable factors of production refer to the factors of production whose supply

can be increased in the short run as well as long run.

Duration of short run and long run varies according to industry. For
some industries like steel plant 1 year is a short run, but for other
industries like plastic factory, 1 year is a long run.)

Average Fixed Cost is the total fixed cost divided by the quantity produced.
AFC = TFC/Q

Average Variable Cost is the total variable cost divided by the quantity
produced.
AVC = TVC/Q

Average Total Cost is the sum of average variable cost and average fixed cost.
or we can say, average cost is equal to the total cost divided by the number of
units produced.
ATC = TC/Q

Marginal Cost is the addition made to the total cost by producing 1 additional
unit of output.
Marginal Cost = Total cost of nth unit - Total cost of (n-1)th unit.
MC = TCn TCn-1 (e.g. MC of 6 th unit = Total cost of 6th unit Total cost of 5th
unit)

Marginal cost can also be defined as the change in total cost (TC) due to
change in quantity demanded(Q).
MC = TC/Q

BREAK EVEN ANALYSIS OR COST VOLUME PROFIT ANALYSIS

A calculation of the sales volume (in units) required to

just cover costs. A lower sales volume would be unprofitable and a higher volume would be
profitable. Break-even analysis focuses on the relationship between fixed cost, variable cost
(or cost per unit), and selling price (or selling price per unit).

Cost Volume Profit Analysis (Break Even Analysis)

Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that is concerned

with the effect of sales volume and product costs on operating profit of a business. It deals
with how operating profit is affected by changes in variable costs, fixed costs, selling price
per unit and the sales mix of two or more different products
 62

CVP analysis has following assumptions:

1 All cost can be categorized as variable or fixed.

2 Sales price per unit, variable cost per unit and total fixed cost are constant.

3 All units produced are sold.

CVP Analysis Formula

The basic formula used in CVP Analysis is derived from profit equation:

px = vx + FC +
Profit

In the above formula,

p is price per unit;
v is variable cost per unit;
x are total number of units produced and sold; and
FC is total fixed cost

Besides the above formula, CVP analysis also makes use of following concepts:

How to Do Break Even Analysis

Break-even analysis is a very useful cost accounting technique. It is part of a larger

analytical model called cost-volume-profit (CVP) analysis, and it helps you determine how many product
units your company needs to sell to recover its costs and start realizing profit. Learning how to do a break-
even analysis is a matter of following a few steps.

1. Determine your company's fixed costs. Fixed costs are any costs that don't depend
on the volume of production. Rent and utilities would be examples of fixed costs,
because you will pay the same amount for them no matter how many units you
produce or sell. Categorize all your firm's fixed costs for a given period and add them
together.
2. Determine your company's variable costs. Variable costs are those that will
fluctuate along with production volume. For example, a business that performs oil
changes will have to purchase more oil filters if they perform more oil changes, so the
cost of buying oil filters is a variable cost. In fact, because the company can expect to
buy 1 oil filter per oil change, this cost can be allocated to each oil change performed.
3. Determine the price at which you will sell your product. Pricing strategies are part
of the much more comprehensive marketing strategy, and can be fairly complex.
However, you know that your price will be at least as high as your production costs
(in fact, a lot of anti-trust legislation exists to outlaw selling below cost)
4. Calculate your unit contribution margin. The unit contribution margin represents
how much money each unit sold brings in after recovering its own variable costs. It is
calculated by subtracting a unit's variable costs from its sales price. Consider the
following example using an oil change business.
63

5. The sales price of an oil change is $40 (note that these calculations will work equally
well when expressed in other currencies). Each oil change has 3 costs associated with
it: purchasing a $5 oil filter, purchasing a $5 can of oil, and paying $10 in wages to
the technician performing the oil change. These are the variable costs associated with
an oil change.
6. The contribution margin for a single oil change is: 40 (5 + 5 + 10) or $20.
Providing an oil change to a customer brings the company $20 in revenue after
recovering its own variable costs
7. Calculate your company's break-even point. The break-even point tells you the
volume of sales you will have to achieve to cover all of your costs. It is calculated by
dividing all your fixed costs by your product's contribution margin.
8. Using the example above, imagine all of your company's fixed costs for a given
month are $2000. Therefore, the break-even point is: 2000 / 20 or 100 units. When
100 oil changes have been performed in a month, the company "breaks even."
9. Determine your expected profits or losses. Once you have determined the break-
even volume, you can estimate your expected profits. Remember that each additional
unit sold will produce revenue equal to its contribution margin. Therefore, each unit
sold above the break-even point will produce a profit equal to its contribution margin,
and each unit sold below the break-even point will generate a loss equal to its
contribution margin.
10. Using the example above, imagine your business provides 150 oil changes in a month.
Only 100 oil changes were needed to break even, so the additional 50 oil changes
generated a profit of $20 each, for a total of (50 * 20) or $1000.
11. Now imagine your business provided only 90 oil changes in a month. You didn't
achieve your break-even volume, so you sustained a loss. Each of the 10 oil changes
under your break-even volume generated a loss of $20, for a total of (10 * 20) or
$200.

Steps for Break Even Analysis

1. Determine your Companys Fixed Cost (FC)

2. Determine your Companys Variable Cost (VC)
3. Determine the price at which you will sell your product
4. Calculate your unit contribution margin
5. Calculate BEP
6. Determine your expected profit or loss
7. BEP can be calculated either in physical units or sales value (Rs)

Selling Price (per unit price)

The price that a unit is sold for. Sales Tax is not included the selling price and sales taxes paid
is not included as a cost. The Selling Price times the number of units sold equals the Total
Sales.

Break Even Point

The sales volume (express as units sold) at which the company breaks even. Profits are $0 at
the break even point. The break even point is calculated by the following formula: Break
Even Point = Fixed Costs / (selling price-variable costs).
64

Time Period

The fixed costs are summarized for a specific time period.

The per unit variable cost is not dependant on a specific period of time.

The per unit selling price is not dependant on a specific period of time.

The Break Even Point is expressed a the number of units, over a specific time period, that
must be sold to obtain a Net Profit of $0. The time period the units must be sold is always the
same as the time period of the fixed costs.

Typically the time period is Monthly, however it could be Yearly or even Hourly. For
example, a farmer seeking the break even on an annual corn crop would choose a yearly time
period. The farmer would add up the fixed costs for the whole year and the break even sales
volume would be expressed as a yearly sales volume.

The text that is written in the time period field is copied to the title of the Break Even Graph
and Break Even Report. If you leave the field blank then nothing will be copied.

Breakeven Analysis Formula

The breakeven analysis formula actually involves the use of several formulas. The first items
that are necessary for an analysis are the fixed costs, variable unit costs, expected unit sales
and unit price. Using the expected unit sales and variable unit costs you can compute the total
variable cost as:

(Total Variable Cost = Expected Unit Sales x Variable Unit Costs).

Once youve established the total variable cost you can calculate the total cost by adding it to
the fixed cost:

(Total Cost = Fixed Cost + Variable Cost).

Within the breakeven analysis you will also need to provide the total expected revenue. The
formula for this uses the expected unit sales multiplied by the unit price:

(Total Expected Revenue = Expected Unit Sales x Unit Price).

From the total revenue you can calculate the profit or loss. The final formula in a breakeven
analysis is the breakeven point. This is expressed using the fixed cost, unit price and variable
unit cost:
65

(Breakeven point = Fixed Costs / (Unit Sales Price Variable Costs))

This figure below is the graphical representation of the Break-Even formula.

The blue line running parallel to the X axis represents the total fixed costs. As you can
see, the fixed costs do not change as sales volume changes.

The red line represents the total variable costs. As you can see, the variable costs are
determined by sales volume.

The green line is the total costs. This is the sum of the variable costs and the fixed
costs.

The blue line is the total revenue. As you can see, the total revenue is also determined
by sales volume.

The vertical yellow line indicates the break-even point. You can see that it intersects
with the total revenue and total cost lines at the point in which they are equal.

Contribution Margin (CM)

Contribution Margin (CM) is equal to the difference between total

sales (S) and total variable cost or, in other words, it is the amount by which sales exceed
total variable costs (VC). In order to make profit the contribution margin of a business must
exceed its total fixed costs. In short:
66

CM = S VC

Unit Contribution Margin (Unit CM)

Contribution Margin can also be calculated per unit which is called Unit Contribution
Margin. It is the excess of sales price per unit (p) over variable cost per unit (v). Thus:

Unit CM = p v

Contribution Margin Ratio (CM Ratio)

Contribution Margin Ratio is calculated by dividing contribution margin by total sales or unit
CM by price per unit.

FORMULAE FOR BEP (COST-VOLUME PROFIT ANALYSIS)

1. BEP in Physical Units

BEP= TFC/P-AVC , where TFC is total fixed cost and P-AVC is marginal
contribution per unit

2. BES in Sales Value

BES= TFC/PV Ratio
BES= TFC x Price per unit/ P-AVC
BES= TFC/ Contribution Ratio
Where CR = TR-TVC/TR
PV Ratio =S-V/S x100

3. PV Ratio
PV Ratio= Change in Profit/Change in sales x 100
PV Ratio =Change in contribution/Change in sales x100
PV Ratio = S-V/S x100, where S= sales, V= variable cost
PV Ratio = TFC/BES

4. Margin of safety(MS)
MS= Total sales- BES
MS Ratio= Sales-BES/Sales
MS(as%) = Sales-BES/Sales x 100
MS= Profit /PV Ratio
MS= Profit /Contribution x Sales

5. Target Profit : Required Sales

Required Sales= TFC + Profit required/P-AVC
Required Sales = TFC + Profit /PV Ratio
6. Others
a) Fixed Cost = BES x PV Ratio
b) Fixed Cost =BEP x PV Ratio
c) Profit = Sales x PV Ratio FC
d) Profit = MS x PV Ratio
e) Profit = Contribution- FC
67

f) Profit= TR-TC
g) Contribution = Sales x PV Ratio
h) Contribution = FC+ Profit
i) Contribution = Sales- VC (Variable cost)
j) Contribution= S x PV Ratio

7. At Break Even point TR = TC

a) TR = TVC+ TFC
b) TR = TVC+TFC
c) TC= TVC+TFC
d) TVC= TC- TFC
e) TR= P x Q
f) (P x Q) = (AVC x Q) +TFC
g) (P x Q) (AVC x Q) = TFC
h) (AVC x Q) = TVC
i) P= Price
j) TVC = Total variable cost
k) AVC =Average variable cost
l) TFC= Total Fixed Cost
m) TC = Total cost
n) TR = Total revenue
o) Profit = TR-TC
p) Profit = TR-TVC- TFC
q) Profit = Q (P-AVC) -TFC

Module IV
Market structure perfect and imperfect competition; monopoly, duopoly, oligopoly;
monopolistic competition, pricing methods under these competitive environments.

Profits

Profit has a number of meanings in economics. At its most basic level, profit is the reward
gained by risk taking entrepreneurs when the revenue earned from selling a given amount of
output exceeds the total costs of producing that output. This simple statement is often
expressed as the profit identity, which states that:

Total profits = total revenue (TR) total costs (TC)

However, the concept of profit needs clarification because there is no standard definition of
what counts as a cost.

Normal profit

In markets which are perfectly competitive, the profit available to a single firm in the long
run is called normal profit. This exists when total revenue, TR, equals total cost, TC. Normal
profit is defined as the minimum reward that is just sufficient to keep the entrepreneur
supplying their enterprise. In other words, the reward is just covering opportunity cost - that
68

is, just better than the next best alternative. The accounting definition of profits is rather
different because the calculation of profits is based on a straightforward numerical calculation
of past monetary costs and revenues, and makes no reference to the concept of opportunity
cost. Accounting profit occurs when revenues are greater than costs, and not equal, as in the
case of normal profit.

To the economist, normal profit is a cost and is included in total costs of production.

Super-normal (economic) profit

If a firm makes more than normal profit it is called super-normal profit. Supernormal profit
is also called economic profit, and abnormal profit, and is earned when total revenue is
greater than the total costs. Total costs include a reward to all the factors, including normal
profit. This means that, when total revenue equals total cost, the entrepreneur is earning
normal profit, which is the minimum reward that keeps the entrepreneur providing their skill,
and taking risks.

The level of super-normal profits available to a firm is largely determined by the level of
competition in a market the more competition the less chance there is to earn super-normal
profits.

Marginal cost

A typical marginal cost curve with marginal revenue

Profit maximisation

Firms achieve maximum profits when marginal revenue (MR) is equal to marginal cost
(MC), that is when the cost of producing one more unit of a good or service is exactly equal
to the revenue derived from selling one extra unit.
69

Types of Market Systems

PERFECT COMPETITION

Perfect competition is a market system characterized by many different buyers and sellers. In
the classic theoretical definition of perfect competition, there are an infinite number of buyers
and sellers. With so many market players, it is impossible for any one participant to alter the
prevailing price in the market. If they attempt to do so, buyers and sellers have infinite
alternatives to pursue. An ideal market structure characterized by a large number of small
firms, identical products sold by all firms, freedom of entry into and exit out of the industry,
and perfect knowledge of prices and technology. This is one of four basic market structures.
The other three are monopoly, oligopoly, and monopolistic competition. Perfect competition
is an idealized market structure that is not observed in the real world. While unrealistic, it
does provide an excellent benchmark that can be used to analyze real world market
structures. In particular, perfect competition efficiently allocates resources.

Perfect competition a market structure characterized by a large number of firms so small

relative to the overall size of the market, such that no single firm can affect the market price
or quantity exchanged. Perfectly competitive firms are price takers. They set a production
level based on the price determined in the market. If the market price changes, then the firm
re-evaluates its production decision. This means that the short-run marginal cost curve of the
firm is its short-run supply curve.

Characteristics
Generally, a perfectly competitive market exists when every participant is a "price taker", and
no participant influences the price of the product it buys or sells. Specific characteristics may
include:

Infinite buyers and sellers An infinite number of 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.

Zero entry and exit barriers A lack of entry and exit barriers makes it
extremely easy to enter or exit a perfectly competitive market.

Perfect factor mobility In the long run factors of production are perfectly
mobile, allowing free long term adjustments to changing market conditions.

Perfect information - All consumers and producers are assumed to have

perfect knowledge of price, utility, quality and production methods of
products.

Zero transaction costs - Buyers and sellers do not incur costs in making an
exchange of goods in a perfectly competitive market.
70

Profit maximization - Firms are assumed to sell where marginal costs meet
marginal revenue, where the most profit is generated.

Homogenous products - The qualities and characteristics of a market good or

service do not vary between different suppliers.

Non-increasing returns to scale - The lack of increasing returns to scale (or

economies of scale) ensures that there will always be a sufficient number of
firms in the industry.

Property rights - Well defined property rights determine what may be sold, as
well as what rights are conferred on the buyer

Short run Equilibrium

In the short run, perfectly-competitive markets are not

productively efficient as output will not occur where marginal cost is equal to average cost
(MC=AC). They are allocatively efficient, as output will always occur where marginal cost is
equal to marginal revenue (MC=MR). In the long run, perfectly competitive markets are both
allocatively and productively efficient.

In perfect competition, any profit-maximizing producer faces a market price equal to its
marginal cost (P=MC). This implies that a factor's price equals the factor's marginal revenue
product. It allows for derivation of the supply curve on which the neoclassical approach is
based. This is also the reason why "a monopoly does not have a supply curve". The
abandonment of price taking creates considerable difficulties for the demonstration of a
general equilibrium except under other, very specific conditions such as that of monopolistic
competition.
71

In the short run, it is possible for an individual firm to make an economic profit. This
situation is shown in this diagram, as the price or average revenue, denoted by P, is above the
average cost denoted by C .

Long term equilibrium under perfect competition.

If firms are perfectly competitive, industry is making short term surplus

(profits), more firms will enter the industry. In the long run this will increase the market
supply of the product and reduces the market price as well as the profits until all firms in the
industry make a normal profit (break even ). However, in the long period, economic profit
cannot be sustained. The arrival of new firms or expansion of existing firms (if returns to
scale are constant) in the market causes the (horizontal) demand curve of each individual firm
to shift downward, bringing down at the same time the price, the average revenue and
marginal revenue curve. The final outcome is that, in the long run, the firm will make only
normal profit (zero economic profit). Its horizontal demand curve will touch its average total
cost curve at its lowest point.
72

Perfect Competition Long Run Equilibrium: Industry

It is the price at which total demand is exactly equal to total supply. Graphically it is the point
where DD curve and SS curve intersect each other.

Graph - Equilibrium Price Determination

73

In the above graphical diagram, the following points have been observed :-

1. On X axis, quantity demand and supplied per week has been given and on Y axis,
price has been given.

2. Buyers are purchasing more at lower price and vice versa. This negative relationship
is shown by downward sloping DD curve.

3. Sellers are selling more at higher price and vice versa. This positive relationship is
shown by upward sloping SS curve.

4. Rs. 30 is that price at which demand equates supply (300 units). So, Rs. 30 is an
equilibrium price and 300 units is an equilibrium quantity.

5. Suppose, price fails to Rs. 20/-, So this results into increase in demand (as per Law of
Demand) and decrease in supply (as per Law of Supply). Since DD > SS, i.e. because
of low supply, sellers will be dominant and competition will be among buyers, this
leads to rise in price level. (i.e. from Rs. 20 to Rs. 30) Again price will come back at
original level i.e. equilibrium price (Rs. 30).

6. Suppose, supply exceeds demand (DD < SS) now buyers become dominant and
competition will be among sellers. This leads to downfall in price. (i.e. from Rs. 40 to
Rs.30). Again price will come back to original level. i.e. equilibrium price (Rs. 30).

7. Such automatic adjustment by demand and supply forces will keep single price in
marker
74

Definition of 'Imperfect Competition'

mperfect competition is a competitive market situation where there are many sellers, but they
are selling heterogeneous (dissimilar) goods.

Definition: Imperfect competition is a competitive market situation where there are many
sellers, but they are selling heterogeneous (dissimilar) goods as opposed to the perfect
competitive market scenario. As the name suggests, competitive markets that are imperfect in
nature.

Description: Imperfect competition is the real world competition. Today some of the
industries and sellers follow it to earn surplus profits. In this market scenario, the seller
enjoys the luxury of influencing the price in order to earn more profits.

If a seller is selling a non identical good in the market, then he can raise the prices and earn
profits. High profits attract other sellers to enter the market and sellers, who are incurring
losses, can very easily exit the market.

There are four types of imperfect markets:

- Monopoly (only one seller) - Oligopoly (few sellers of goods) - Monopolistic competition
(many sellers with highly differentiated product) - Monopsony (only one buyer of a product)

MONOPOLY
A monopoly is the exact opposite form of market system as perfect
competition. In a pure monopoly, there is only one producer of a particular good or service,
and generally no reasonable substitute. In such a market system, the monopolist is able to
charge whatever price they wish due to the absence of competition, but their overall revenue
will be limited by the ability or willingness of customers to pay their price.Monopoly is an
extreme form of market structure. The word monopoly is derived from two Greek words-
Mono and Poly. Mono means single and Poly means 'seller'. Thus monopoly means single
seller. Monopoly is a firm of market organization for a commodity in which there is only one
single seller of the commodity.

In short monopoly is a form of market structure where there is a single seller producing a
commodity having no close substitute? Under monopoly there is no rival or competitors. The
degree of competition in monopoly is nil. Thus if the buyers is to purchase the commodity, he
can purchase it only from that seller. The seller dictates the price to consumers. Unlike perfect
competition a monopolist can fix up the price.As monopoly is a form of imperfect market
organization, there is no difference between firm and industry. A monopoly firm is said to be
an industry. Thus monopoly means the absence of competition. There are strong barriers to
entry into the industry. As a result, seller has full control over the supply of the commodity.

Features of Monopoly:

1. One seller and large number of buyers:

75

Monopoly is a form of imperfect market structure where there is only one seller of a product.
A monopoly firm may be owned by a person, a few numbers of partners or a joint stock
company. The characteristic feature of single seller eliminates the distinction between the
firm and the industry. A monopolist firm is itself 'the industry. Under monopoly there are
large numbers of buyers although the seller is one. No buyer's reaction can influence the
price.

2. No close substitute:

Under monopoly a single producer produces single commodities which have no close
substitute. As the commodity in question has no close substitute, the monopolist is at liberty
to change a price according to his own whimsy. Monopoly can not exist when there is
competition.

A firm is said, to be monopolist only when it is the single producer and supplier of the
product which have no close substitute. Under monopoly the cross elasticity of demand is
zero. Cross elasticity of demand shows a change in the demand for a good as a result of
change in the price of another good.

3. Strong barriers to the entry into the industry exist:

In a monopoly market there is strong barrier on the entry of new firms. Monopolist faces no
competition. As there is one firm no other rival producers can enter the market of the same
product. Since the monopolist has absolute control over the production and sale of the
commodity certain economic barriers are imposed on the entry of potential rivals.

4. Nature of demand curve:

In case of monopoly one firm constitutes the whole industry. The entire demand of the
consumers for a product goes to the monopolist. Since the demand curve of the individual
consumers lopes downward, the monopolist faces a downward sloping demand curve.

A monopolist can sell more of his output only at a lower price and can reduce the sale at a
high price. The downward sloping demand curve expresses that the price (AR) goes on
falling ns sales are increased. In monopoly AR curve slopes downward mid MR curve lies
below AR curve. Demand curve under monopoly la otherwise known as average revenue
curve.

The Monopolists Demand Curve

Be careful of saying that "monopolies can charge any price they like" -
this is wrong. It is true that a firm with monopoly has price-setting power and will look to
earn high levels of profit. However the firm is constrained by the position of its demand
curve. Ultimately a monopoly cannot charge a price that the consumers in the market will not
bear.
76

A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can take
the market demand curve as its own demand curve. A monopolist therefore faces a downward
sloping AR curve with a MR curve with twice the gradient of AR. The firm is a price maker
and has some power over the setting of price or output. It cannot, however, charge a price that
the consumers in the market will not bear. In this sense, the position and the elasticity of the
demand curve acts as a constraint on the pricing behaviour of the monopolist. Assuming that
the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as
shown in the diagram below.

Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run
equilibrium as shown in the diagram below.

The profit-maximising output can be sold at price P1 above the average cost AC at output Q1.
The firm is making abnormal "monopoly" profits (or economic profits) shown by the yellow
shaded area. The area beneath ATC1 shows the total cost of producing output Qm. Total costs
equals average total cost multiplied by the output

Price Discrimination

Price discrimination or price differentiation exists when sales

of identical goods or services are transacted at different prices from the same provider. In a
theoretical market with perfect information, perfect substitutes, and no transaction costs or
prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination
can only be a feature of monopolistic and oligopolistic markets, where market power can be
exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the
buyer at the lower price can arbitrage by selling to the consumer buying at the higher price
but with a tiny discount. However, product heterogeneity, market frictions or high fixed costs
(which make marginal-cost pricing unsustainable in the long run) can allow for some degree
of differential pricing to different consumers, even in fully competitive retail or industrial
77

markets. Price discrimination also occurs when the same price is charged to customers which
have different supply costs.

DUOPOLY

Duopoly (from the Greek duo, two, and polein, to sell) is a type of oligopoly. This kind
of imperfect competition is characterized by having only two firms in the market producing a
homogeneous good. For simplicity purposes, oligopolies are normally studied by analysing
duopolies. What strategies firms follow and their interactions are a key feature of this market
structure

A situation in which two companies own all or nearly all of the market for a
given product or service. A duopoly is the most basic form of oligopoly, a market dominated
by a small number of companies. A duopoly can have the same impact on the market as a
monopoly if the two players collude on prices or output. Collusion results in consumers
paying higher prices than they would in a truly competitive market and is illegal under U.S.
antitrust law.

MONOPOLISTIC COMPETITION
Monopolistic competition is a type of market system combining
elements of a monopoly and perfect competition. Like a perfectly competitive market system,
there are numerous competitors in the market. The difference is that each competitor is
sufficiently differentiated from the others that some can charge greater prices than a perfectly
competitive firm. An example of monopolistic competition is the market for music. While
there are many artists, each artist is different and is not perfectly substitutible with another
artist.

Characteristics features of Monopolistic Competition

The concept of monopolistic competition is more realistic than perfect

competition and pure monopoly. According to Chamberlain in real economic situation both
monopoly and competitive elements are present. Chamberlains monopolistic competition is
the blending of competition and monopoly. The most distinguishing feature of monopolistic
competition is that the products of various firms are not identical but different although they
are close substitutes for each other. Like perfect competition there are a large number of firms
but unlike perfect competition the firms produce differentiated products which are close
substitutes of each other.

Under monopolistic competition there is freedom of entry and exit. Thus under monopolistic
competition it is found that both the features of competition and monopoly are present. In
India, for example, we find the monopolistic competition. In India there are a number of
manufacturers producing different brands of tooth paste viz Colgate, Pepsodent. Promise,
Close-up, Prudent and Forhans etc.
78

The manufacturer of Colgate has got the monopoly of producing it. Nobody can produce and
sell tooth paste with the name Colgate. But at the same time he faces competition from other
manufactures of tooth paste as their products are close substitutes of Colgate tooth paste.
Thus we find that monopolistic competition is the real market structure than either pure
competition or monopoly.

Important features of monopolistic competition

1. Existence of large number of firms:

The first important feature of monopolistic competition is that there is a large number of
firms satisfying the market demand for the product. As there are a large number of firms
under monopolistic competition, there exists stiff competition between them. These firms do
not produce perfect substitutes. But the products are close substitute for each other.

(2) Product differentiations:

The various firms under monopolistic competition bring out differentiated products which are
relatively close substitutes for each other. So their prices cannot be very much different from
each other. Various firms under monopolistic competitors compete with each other as the
products are similar and close substitutes of each other. Differentiation of the product may be
real or fancied.

Real or physical differentiation is done through differences in materials used, design, color
etc. Further differentiation of a particular product may be linked with the conditions of his
sale, the location of his shop, courteous behaviour and fair dealing etc.

(3) Some influence over the price:

As the products are close substitutes of others any reduction of price of a commodity by a
seller will attract some customers of other products. Thus with a fall in price quantity
demanded increases. It therefore, implies that the demand curve of a firm under monopolistic
competition slopes downward and marginal revenue curve lies below it.

Thus under monopolistic competition a firm cannot fix up price but has influence over price.
A firm can sell a smaller quantity by increasing price and can sell more by reducing price.
Thus under monopolistic competition a firm has to choose a price-output combination that
will maximize price.

(4) Absence of firm's interdependence:

Under oligopoly, the firms are dependent upon each other and can't fix up price
independently. But under monopolistic competition the case is not so. Under monopolistic
competition each firm acts more or less independently. Each firm formulates its own price-
output policy upon its own demand cost.
79

(5) Non-price competition:

Firms under monopolistic competition incur a considerable expenditure on advertisement and

selling costs so as to win over customers. In order to promote sale firms follow definite
-methods of competing rivals other than price. Advertisement is a prominent example of non-
price competition.

The advertisement and other selling costs by a firm change the demand for his product. The
rival firms compete with each other through advertisement by which they change the
consumer's wants for their products and attract more customers.

(6) Freedom of entry and exit:

In a monopolistic competition it is easy for new firms to enter into an existing firm or to leave
the industry. Lured by the profit of the existing firms new firms enter the industry which
leads to the expansion of output. But there exists a difference.

Under perfect competition the new firms produce identical products, but under monopolistic
competition, the new firms produce only new brands of product with certain product
variation. In such a law the initial product faces competition from the existing well-
established brands of product.

Equilibrium under monopolistic competition

In the short run supernormal profits are possible, but in the long run new firms are attracted
into the industry, because of low barriers to entry, good knowledge and an opportunity to
differentiate.

Monopolistic competition in the short run :

At profit maximisation, MC = MR, and output is Q and price P. Given that price
(AR) is above ATC at Q, supernormal profits are possible (area PABC).
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As new firms enter the market, demand for the existing firms products becomes more elastic
and the demand curve shifts to the left, driving down price. Eventually, all super-normal
profits are eroded away.

Examples of monopolistic competition

Examples of monopolistic competition can be found in every high street.Monopolistically

competitive firms are most common in industries where differentiation is possible, such as:

The restaurant business

Hotels and pubs

General specialist retailing

Consumer services, such as hairdressing

The survival of small firms

The existence of monopolistic competition partly explains the survival of small firms in
modern economies. The majority of small firms in the real world operate in markets that
could be said to be monopolistically competitive.

The advantages of monopolistic competition

Monopolistic competition can bring the following advantages:

1. There are no significant barriers to entry ; therefore markets are relatively contestable.
81

2. Differentiation creates diversity, choice and utility. For example, a typical high street
in any town will have a number of different restaurants from which to choose.

3. The market is more efficient than monopoly but less efficient than perfect competition
- less allocatively and less productively efficient. However, they may be dynamically
efficient, innovative in terms of new production processes or new products. For
example, retailers often constantly have to develop new ways to attract and retain
local custom.

The disadvantages of monopolistic competition

There are several potential disadvantages associated with monopolistic competition,

including:

1. Some differentiation does not create utility but generates unnecessary waste, such as
excess packaging. Advertising may also be considered wasteful, though most is
informative rather than persuasive.

2. As the diagram illustrates, assuming profit maximisation, there is allocative

inefficiency in both the long and short run. This is because price is above marginal
cost in both cases. In the long run the firm is less allocatively inefficient, but it is still
inefficient.

OLIGOPOLY
An oligopoly is similar in many ways to a monopoly. The primary difference is that rather
than having only one producer of a good or service, there are a handful of producers, or at
least a handful of producers that make up a dominant majority of the production in the market
system. While oligopolists do not have the same pricing power as monopolists, it is possible,
without diligent government regulation, that oligopolists will collude with one another to set
prices in the same way a monopolist would.

Characteristic features of oligopolistic market

The term oligopoly is derived from two Greek words, Olegs and 'Pollen'. Olegs 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.
Oligopoly and oligopoly with product differentiation.
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Characteristics of Oligopoly:

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 an 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. 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 behaviour:

Another important feature of oligopoly is the analysis -of group behaviour. In case of perfect
competition, monopoly and monopolistic competition, the business firms are assumed to
behave in such a way as to maximize their profits. The profit-maximizing behaviour 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. As a result, the demand
curve facing an oligopolistic firm losses its determinateness.

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
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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.

Kinked demand curve under oligopoly

The kinked demand curve theory is an economic theory

regarding oligopoly and monopolistic competition. When it was created, the idea
fundamentally challenged classical economic tenets such as efficient markets and rapidly
changing prices, ideas that underlie basic supply and demand models. Kinked demand was an
initial attempt to explain sticky prices., "Kinked" demand curves and traditional demand
curves are similar in that they are both downward-sloping. They are distinguished by a
hypothesized convex bend with a discontinuity at the bend - the "kink." Therefore, the first
derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue
curve.An oligopolist faces a downward sloping demand curve but the elasticity may depend
on the reaction of rivals to changes in price and output. Assuming that firms are attempting to
maintain a high level of profits and their market share it may be the case that:

(a) rivals will not follow a price increase by one firm - therefore demand will be relatively
elastic and a rise in price would lead to a fall in the total revenue of the firm

(b) rivals are more likely to match a price fall by one firm to avoid a loss of market share. If
this happens demand will be more inelastic and a fall in price will also lead to a fall in total
revenue.

The kink in the demand curve at price P and output Q means that there is a discontinuity in
the firm's marginal revenue curve.

If we assume that the marginal cost curve in is cutting the MR curve then the firm is
maximising profits at this point.
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Module V
National income concepts and measurement; Business cycles and contra cyclical policies;
Economic planning and development models; Mahalnobis model; HarodKaldore model

CONCEPT AND MEANING OF NATIONAL INCOME

National Income is a measure of the total flow of earning of the factor-

owners through the production of goods and services. In simple words, it is the total amount
of income earned by the aggregate output.The total value of the level of aggregate output is
called Gross National Product or GNP. GNP is a measure of the total market value of all final
goods and services currently produced by all the citizens of a nation within a period, usually a
year

It Measures how much people produce.

It Counts current production only

It Counts the level of output with a market value.

It relies on the market prices of goods and services as a measure

METHODS OF MEASURING NATIONAL INCOME

There are mainly Three Approaches to measure GNP

Based on these 3 directions of Flows i.e. Flow of output, Flow of Income and a Flow of
Expenditure
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1. Output or value added approach

In this method, national income is measured as a flow of goods and services. We calculate
money value of all final goods and services produced in an economy during a year. Final
goods here refer to those goods which are directly consumed and not used in further
production process.

The total value of all final goods and services (i.e. outputs) can be found out by
adding up the total values of outputs produced at different stages of production .This method
it to avoid the so-called double-counting or an over-estimation of GNP. However, there are
difficulties in the collection and calculation of data obtained; caution should be taken to take
Final Goods not Intermediate goods as it will result in Double Counting.

2. Income approach
The Income approach tries to measure the total flows of income earned
by the factor-owners in the provision of final goods and services in a current period. There
are four types of factors of production and four types of factors incomes accordingly i.e.
Land, Labour, Capital, and Organization as Factors of Production and Rent, Wages, Interest
and Profit as Factor Incomes correspondingly.

National Income = Wages+ Interest Income + Rental Income +*Profit

The term* Profit can be further sub-divided into; profit tax; dividend to all those
shareholders; and retained profit (or retained earnings).

3. Expenditure approach

In this method, national income is measured as a flow of expenditure. GNP is sum-total of

private consumption expenditure. Government consumption expenditure, gross capital
formation (Government and private) and net exports (Export-Import). The income approach,
which is sometimes referred to as GDP(I), is calculated by adding up total compensation to
employees, gross profits for incorporated and non incorporated firms, and taxes less any
subsidies. The expenditure method is the more common approach and is calculated by adding
total consumption, investment, government spending and net exports.

Amount of Expenditure refers to all spending on currently-produced final goods and

services only in an economy. In an economy, there are three main agencieswhich buy goods
and services. These are:

Households, Firms and the Government

In Economics, we use the following

Terms:

C = Private Consumption Expenditure (of all Households)

I = Investment Expenditure (of all firms)

G = Government Consumption Expenditure (of the local government)

86

In an economy the entire output which is produced in a year is not fully

consumed by that economy as some goods are exported and in the similar way the domestic
consumption

(expenditure) may also include imports. Hence under the expenditure approach to measure
the

GNP ,the value of exports must be added to C, I and G whereas the values of imports must be

deducted from the above amount

Finally, we have:

GNP at market prices =C+I+G+X-M

(Where X-M = Exports Imports)

Gross Domestic Product (GDP)

We can only find the amount of outputs which are produced within the domestic
boundary of an economy in a specific period, say a year. To arrive at the value of GNP, Net
Factor Income Earned from Abroad (NFIA) has to be added to the GDP.

Income from abroad = income earned by local citizens form the provision of factors services
abroad

Income to abroad = income earned by foreign citizens form the provision of factors services
locally

Net Factor Income from abroad Income earned from abroad Income sent to abroad

GNP = GDP + Net Factor Income Earned from Abroad

GDP: Gross Domestic Product

The gross domestic product (GDP) is one the primary

indicators used to gauge the health of a country's economy. It represents the total dollar value
of all goods and services produced over a specific time period - you can think of it as the size
of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year.
For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has
grown by 3% over the last year

Measuring GDP is complicated (which is why we leave it to the economists), but at its most
basic, the calculation can be done in one of two ways: either by adding up what everyone
earned in a year (income approach), or by adding up what everyone spent (expenditure
method). Logically, both measures should arrive at roughly the same total.
87

National Income=C+G+I+(X-M)+NFIA-Depreciation-Indirect Taxes+Subsidies

GNP=C+I+G+(X-M)+NFIA

GDP=C+I+G+(X-M)

Difference between GNP &GDP

It is important to differentiate Gross Domestic Product from Gross
National Product (GNP). GDP includes only goods and services produced within the
geographic boundaries of India, regardless of the producer's nationality. GNP doesn't include
goods and services produced by foreign producers, but does include goods and services
produced by Indian . firms operating in foreign countries. The economy of India is the
eleventh largest in the world by nominal GDP and the third largest by purchasing power
parity (PPP).The country is one of the G-20 major economies and a member of BRICS. On a
per capita income basis, India ranked 140th by nominal GDP and 129th by GDP (PPP) in
2011, according to the IMF
Different Concepts National Income

National income is defined as the total value of all the goods and services
produced within a country plus income coming from abroad in a particular time period
usually 1 year. The main concepts of NI are: GDP, GNP, NNP, NI, PI, DI, and PCI. These
different concepts explain about the phenomenon of economic activities of the various sectors
of the various sectors of the economy.

Algebraic expression under product method is,

GDP=(P*Q)

where,
GDP=Gross Domestic Product
P=Price of goods and service
Q=Quantity of goods and service
denotes the summation of all values.

According to expenditure approach, GDP is the sum of consumption, investment, government

expenditure, net foreign exports of a country during a year.

Algebraic expression under expenditure approach is,

GDP=C+I+G+(X-M)

Where,
88

C=Consumption
I=Investment
G=Government expenditure
(X-M)=Export minus import

GDP includes the following types of final goods and services. They are:

Consumer goods and services.

Gross private domestic investment in capital goods.

Government expenditure.

Exports and imports.

Gross National Product (GNP)

Gross National Product is the total market value of all final goods and services produced
annually in a country plus net factor income from abroad. Thus, GNP is the total measure of
the flow of goods and services at market value resulting from current production during a
year in a country including net factor income from abroad. The GNP can be expressed as the
following equation:

GNP=GDP+NFIA (Net Factor Income from Abroad)

or, GNP=C+I+G+(X-M)+NFIA

Hence, GNP includes the following:

1. Consumer goods and services.

2. Gross private domestic investment in capital goods.
3. Government expenditure.
4. Net exports (exports-imports).
5. Net factor income from abroad.

BUSINESS CYCLE

The business cycle is the periodic but irregular up-and-down movements

in economic activity, measured by fluctuations in real GDP and other macroeconomic
variables. The term business cycle (or economic cycle or boom-bust cycle) refers to
fluctuations in aggregate production, trade and activity over several months or years in a
market economy. A business cycle is not a regular, predictable, or repeating phenomenon like
the swing of the pendulum of a clock. Its timing is random and, to a large degress,
unpredictable. Business cycles are the "ups and downs" in economic activity, defined in terms
of periods of expansion or recession. During expansions, the economy, measured by
indicators like jobs, production, and sales, is growingin real terms, after excluding the
effects of inflation.
89

The business cycle is the upward and downward movements of levels of gross domestic
product (GDP) and refers to the period of expansions and contractions in the level of
economic activities (business fluctuations) around its long-term growth trend.[2]

These fluctuations occur around a long-term growth trend, and typically involve shifts over
time between periods of relatively rapid economic growth (an expansion or boom), and
periods of relative stagnation or decline (a contraction or recession).

Business cycles are usually measured by considering the growth rate of real gross domestic
product. Despite being termed cycles, these fluctuations in economic activity can prove
unpredictable

The economy tends to experience different trends. These can be categorised as the trade cycle
and may feature boom, slump, recession and recovery

BOOM: A period of fast economic growth. Output is high due to increased demand,
unemployment is low. Business confidence may be high leading to increased investment.
Consumer confidence may lead to extra spending.
90

SLUMP: A period when output slows down due to a reduction in demand. Confidence may
begin to suffer.

RECESSION: A period where economic growth slows down and the level of output may
actually decrease. Unemployment is likely to increase. Firms may lose confidence and reduce
investment. Individuals may save rather than spend.

RECOVERY: A period when the economy moves between recession and a boom.

WHAT HAPPENS IN A BOOM?

- Businesses produce more goods

- Businesses invest in more machinery
- Consumers spend more money. There is a FEELGOOD FACTOR
- Less money is spent by the Government on unemployment benefits
- More money is collected by the Government in income tax and VAT
- Prices tend to increase due to extra demand (page)

WHAT HAPPENS IN A RECESSION?

- Businesses cut back on production

- Some businesses may go bankrupt
- Consumers spend less money. Fall in FEELGOOD FACTOR
- Individuals may lose their jobs
- More money is spent by the Govt on unemployment benefits
- Less money is collected by the Govt in income tax and VAT
- Prices start to fall
91

CONTRA CYCLICAL POLICIES

It refers to being or acting in opposition to an economic cycle eg.fiscal

policies. When any government uses the fiscal policy as an instrument for Economic stability
of the country, this fiscal policy should be contra-cyclic in nature. 1) The government can rise
the level of employment, income and economic activity by resorting to a deficit budgeting
(more expenditure than the income from taxes). this is called as an expansionary fiscal policy.
2) conversely, government can resort to the contractionary policy by contracting the
employment and income by the surplus budgeting (tax income is more than the
expenditures).To use the fiscal policy as an instrument for economic stability, the government
should keep in mind the above mentioned courses of actions in different economic scenarios
(Inflation and deflation). INFLATION. If for example there is an inflationary condition in a
country, the foremost step of the government should be to check the money in circulation at
its part. it should go for a surplus budgeting and therefore it will contract the employment and
reduce the disposable income with the public. If the step of government is the opposite one it
ll lead to severe price hike. DEFLATION. In deflationary condition the government should
induce more income into the market by stimulating the employment thereby resuming the
economic activity. If at this stage the government shows reluctance in resuming the economic
activity the economy of that particular nation will face depression, which is in no sense in the
92

favour of a nation. If a suitable fiscal policy is employed in Inflation and Deflation, these
fiscal policies are called as CONTRA-CYCLICAL FISCAL POLICIES.

ECONOMIC PLANNING

Historically, the idea of central economic planning was associated with the
criticism of capitalism as a system of anarchy and greed. Marxist critics did not give much
thought to how the economy would be run after capitalism had been abolished; most of them
professed to see no difficulty in organizing the society that would follow. When in 1917 the
new Soviet government found itself the owner of all the means of production, it had no
blueprint as to what to do next. The evolution of central economic planning in the Soviet
Union was largely a pragmatic affair; methods were tried and discarded, and new ones were
introduced. The decision in 1927 to undertake rapid and large-scale industrialization required
the centralizing of control, since only the government could undertake the task of marshaling
the productive resources of the country to achieve its ambitious aims

The process by which key economic decisions are made or influenced by central
governments. It contrasts with the laissez-faire approach that, in its purest form, eschews any
attempt to guide the economy, relying instead on market forces to determine the speed,
direction, and nature of economic evolution. Economic planning is a mechanism for
economic coordination contrasted with the market mechanism. There are various types of
planning procedures and ways of conducting economic planning. As a coordinating
mechanism for socialism and an alternative to the market, planning is defined as a direct
allocation of resources and is contrasted with the indirect allocation of the market.[1]

The level of centralization in decision-making in planning depends on the specific type of

planning mechanism employed. As such, one can distinguish between centralized planning
and decentralized planning.[2] An economy primarily based on central planning is referred to
as a planned economy. In a centrally planned economy the allocation of resources is
determined by a comprehensive plan of production which specifies output requirements.[3]
Planning may also take the form of directive planning or indicative planning.

Most modern economies are mixed economies incorporating various degrees of markets and
planning.A distinction can be made between physical planning (as in pure socialism) and
financial planning (as practiced by governments and private firms in capitalism). Physical
planning involves economic planning and coordination conducted in terms of disaggregated
physical units; whereas financial planning involves plans formulated in terms of financial
units.

DEVELOPMENT MODELS

We examine different models for economic growth. Growth in GDP is not the only
determinant of economic development, which in order to be measured effectively must
account for human welfare determinants such as life expectancy, literacy rates, child
mortality rates, distribution of income, and so on. However, it has been shown throughout
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history that economic growth, or the increase in real output and income, correlates directly
with improvements in development factors like those above.

The reason? Increases in national income usually mean at least some levels of improvement
in access to basic necessities for the average citizen in a developing country. Also, higher
incomes mean more savings, which means greater access to capital for investment by
entrepreneurs. More investment leads to greater productivity and rising incomes for those
who join the emerging industrial and service sectors that usually accompany economic
growth. Furthermore, rising incomes mean more tax revenue for governments, whose
spending on public goods like education, health care, and infrastructure result in real
improvements in standard of living for not just the emerging upper and middle classes, but
the poor as well

Of course, the following models can be observed to varying degrees among the worlds
developing economies today. Some of these models will fail to play out if the institutional
and political environment fails to create a stable atmosphere for savings and investment.
What you should notice, however, is the underlying importance of savings in all three
models. Poor countries suffering from low savings and, even worse, capital flight, are
doomed to a cycle of poverty, where funds for investment leading to productivity increases
are never made available due to instable institutions like banking and politics. To put a poor
country on a path towards economic growth and development, a strategy is needed. Such
strategies will be covered in a later post. For now, lets look at the models:

Harrod-Domar Growth Model:

The HarrodDomar model is an early post-Keynesian model of economic growth. It is used

in development economics to explain an economy's growth rate in terms of the level of
saving and productivity of capital. It suggests that there is no natural reason for an economy
to have balanced growth. The model was developed independently by Roy F. Harrod in 1939
and Evsey Domar in 1946 . Although the HarrodDomar model was initially created to help
analyse the business cycle, it was later adapted to explain economic growth. Its implications
were that growth depends on the quantity of labour and capital; more investment leads to
capital accumulation, which generates economic growth. The model carries implications for
less economically developed countries, where labour is in plentiful supply in these countries
but physical capital is not, slowing down economic progress. LDCs do not have sufficiently
high incomes to enable sufficient rates of saving; therefore, accumulation of physical-capital
stock through investment is low.

The model implies that economic growth depends on policies to increase investment, by
increasing saving, and using that investment more efficiently through technological advances.

The model concludes that an economy does not "naturally" find full employment and stable
growth rates
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The model suggests that the economys rate of growth depends on:

1. the level of saving

2. the productivity of investment

i.e. the capital output ratio

The Harrod-Domar model was

developed to help analyse the
business cycle. However, it was later
adapted to explain economic
growth. It concluded that:

Economic growth depends on

the amount of labour and
capital.

As LDCs often have an abundant supply of labour it is a lack of physical capital that
holds back economic growth and development.

More physical capital generates economic growth.

Net investment leads to more capital accumulation, which generates higher output and
income.

Higher income allows higher levels of saving

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MAHALANOBIS MODEL

The FeldmanMahalanobis model is a model of economic development, created

independently by Soviet economist G. A. Feldman in 1928, and Indian statistician Prasanta
Chandra Mahalanobis in 1953. Mahalanobis became essentially the key economist of India's
Second Five Year Plan, becoming subject to much of India's most dramatic economic
debates.

The essence of the model is a shift in the pattern of industrial investment towards building up
a domestic consumption goods sector. Thus the strategy suggests in order to reach a high
standard in consumption, investment in building a capacity in the production of capital goods
is firstly needed. A high enough capacity in the capital goods sector in the long-run expands
the capacity in the production of consumer goods. The distinction between the two different
types of goods was a clearer formulation of Marxs ideas in Das Kapital, and also helped
people to better understand the extent of the trade off between the levels of immediate and
future consumption. These ideas were however first introduced in 1928 by Feldman, an
economist working for the GOSPLAN planning commission; presenting theoretical
arguments of a two-department scheme of growth. There is no evidence that Mahalanobis
knew of Feldmans approach, being kept behind the borders of the USSR.

The model was created as an analytical framework for Indias Second Five Year Plan in 1955
by appointment of Prime Minister Jawaharlal Nehru, as India felt there was a need to
introduce a formal plan model after the First Five Year Plan (19511956). The First Five Year
Plan stressed investment for capital accumulation in the spirit of the one-sector Harrod
Domar model. It argued that production required capital and that capital can be accumulated
through investment; the faster one accumulates, the higher the growth rate will be. The most
fundamental criticisms came from Mahalanobis, who himself was working with a variant of it
in 1951 and 1952. The criticisms were mostly around the models inability to cope with the
real constraints of the economy; its ignoring of the fundamental choice problems of planning
over time; and the lack of connection between the model and the actual selection of projects
for governmental expenditure. Subsequently Mahalanobis introduced his celebrated two-
sector model, which he later expanded into a four-sector version.

KALDOR GROWTH MODEL

Nicholas Kaldor in his essay titled A Model of Economic Growth,

originally published in Economic Journal in 1957, postulates a growth model, which follows
the Harrodian dynamic approach and the Keynesian techniques of analysis. In his growth
model, Kaldor attempts "to provide a framework for relating the genesis of technical progress
to capital accumulation", whereas the other neoclassical models treat the causation of
technical progress as completely exogenous.

According to Kaldor, "The purpose of a theory of economic growth is to show the nature of
non-economic variables which ultimately determine the rate at which the general level of
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production of economy is growing, and thereby contribute to an understanding of the

question of why some societies grow so much faster than others."

The basic properties of Kaldor's growth model are as follows:

1. Short period supply of aggregate goods and services in a growing economy is

inelastic and not affected by any increase in effective monetary demand. As it is based
on the Keynesian assumption of "full employment".

2. The technical progress depends on the rate of capital accumulation. Kaldor postulates
the "technical progress function", which shows a relationship between the growth of
capital and productivity, incorporating the influence of both the factors. Where the
capital-output ratio will depend upon the relationship of the growth of capital and the
growth of productivity.

3. Wages and profits constitute the income, where wages comprise salaries and earnings
of manual labour, and profits comprise incomes of entrepreneurs as well as property
owners. And total savings consist of savings out of wages and savings out of profit.

Compiled by Dr.P.S.Mohana Kumar : 9946662723