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2018

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PREFACE

Managerial economics is the science of directing scarce resources to

manage cost effectively. Whether a market is local or global, the same
managerial economics apply.
Many of us who teach economics to business students believe that
training in economics not only helps business students better
understand and predict the economic forces shaping real-world
business decisions, but also serves to develop and strengthen overall
analytical skills of students of all majors.
The primary goal of this book has always been, and continues to be, to
teach students the economic way of thinking about business decisions.
Albedo School of Business Management is designing a standard
framework with integrated learning in managerial economics. Surely
this book will meet the requirement of economics students.
Your feedback and suggestions are always welcome
(mailto:[email protected] for suggestions and feedback) and will use it
to evaluate changes and make improvements in our Book.
ASBM Academics Team

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MANAGERIAL
ECONOMICS

ALBEDO SCHOOL OF BUSINESS MANAGEMENT

3rd FLOOR, REGENT COURT, IYYTIILMUKKU

CHITTOOR ROAD, ERNAKULAM – 682011,
Email: [email protected]
Website: www.asbmedu.org
Second A.S.B.M Edition, 2018

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TABLE OF CONTENTS

UNIT I (10 - 22)

1.1 MANAGERIAL ECONOMICS
1.1.1 Introduction
1.1.2 Definition
1.1.3 Meaning
1.2 SCOPE OF MANAGERIAL ECONOMICS
1.3 NATURE OF MANAGERIAL ECONOMICS
1.4 SIGNIFICANCE IN DECISION MAKING
1.5 FUNDAMENTAL CONCEPTS OF MANAGERIAL ECONOMICS
1.6 OBJECTIVES OF A FIRM

UNIT II (24 – 47)

2.1 LAW OF DEMAND
2.1.1 Assumption of law
2.1.2 Limitations/Exceptions of law of demand
2.1.3 Understanding law of demand using demand schedule
2.1.4 Understanding law of demand using demand curve
2.2 DETERMINANTS OF DEMAND
2.3 ELASTICITY OF DEMAND
2.3.1 Types of elasticity of demand
2.4 IMPORTANCE OF MANAGEMENT DECISION MAKING
2.4.1 Economic aspects of a market
2.4.2 Factors influencing management decisions
2.4.3 Use of Elasticity of Demand for Managerial Decision Making

UNIT III (49 - 59)

3.1 LAW OF SUPPLY

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3.1.1 Definition
3.1.2 Assumptions of law
3.2 SUPPLY ELASTICITY
3.3 PRODUCTION CONCEPT AND ANALYSIS
3.4 PRODUCTION FUNCTION
3.4.1 Production process
3.4.2 Factors of production
3.4.3 Cobb Douglas Production function
3.4.4 Short run Production function
3.4.5 Long run Production function
3.4.6 Measures of productivity
3.4.7 Assumptions of production function

UNIT IV (61 - 97)

4.1 SUPPLY ANALYSIS
4.1.1 Introduction
4.1.2 Meaning
4.1.3 Determinants of supply
4.1.4 Elasticity of supply
4.1.5 Kinds of supply & elasticity
4.1.6 Factors influencing supply elasticity
4.2 COST THEORY
4.2.1 The cost function
4.2.2 Theory of cost
4.3 COST-OUTPUT RELATIONSHIP
4.4 MARKET STRUCTURE & PRICING DECISIONS
4.5 CRITERIA FOR MARKET CLASSIFICATION

UNIT V (99 - 111)

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5.1 MARKET STRUCTURE : PERFECT COMPETITION

5.1.1 Features
5.1.2 Determination of price under Perfect Competition
5.2 MONOPOLY
5.2.1 Features
5.2.2 Pricing under Monopoly
5.3 PRICE DISCRIMINATION
5.4 NEW CONCEPTS OF MANAGERIAL ECONOMICS

REFERENCE 112

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SYLLABUS
UNIT I
Managerial economics
Managerial Economics -Introduction – Definition, Nature, Scope,
Significance in Decision Making, Fundamental concepts of Managerial
Economics, Objectives of a firm.

UNIT II
Law of Demand
Assumptions, Exceptions, Understanding Law of Demand using demand
schedule and demand curve - Determinants of demand - Elasticity of
demand – Importance of management decision making.

UNIT III
Law of Supply
Definition, Assumptions of law – Supply Elasticity – Production concept
and analysis – Production Function – production process, factors of
production, Short run and Long run production function, Measures of
productivity, Assumptions.

UNIT IV
Communication
Supply Analysis – Theory of Cost - Cost-output relationship - Market
structure and Pricing decisions– Various forms of markets - Criteria for
Market classification

UNIT V
Market Structure
Perfect Competition – Monopoly – Price Discrimination – New concepts
of Managerial Economics.

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MANEGERIAL ECONOMICS

AIM & OBJECTIVES OF MANAGERIAL

1.0
SCOPE OF MANAGERIAL ECONOMICS

NATURE OF MANAGERIAL ECONOMICS

FUNDAMENTAL CONCEPTS OF MANAGERIAL ECONOMICS

DEMAND ANALYSIS
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ELASTICITY OF DEMAND
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1.1 MANEGERIAL ECONOMICS

1.1.1 Introduction
Managerial economics is the science of directing scarce resources to
manage cost effectively. It consists of three branches: competitive
markets, market power, and imperfect markets. A market consists of
buyers and sellers that communicate with each other for voluntary
exchange. Whether a market is local or global, the same managerial
economics apply.
A seller with market power will have freedom to choose suppliers, set
prices, and use advertising to influence demand. A market is imperfect
when one party directly conveys a benefit or cost to others, or when
one party has better information than others.
An organization must decide its vertical and horizontal boundaries. For
effective management, it is important to distinguish marginal from
average values and stocks from flows. Managerial economics applies
models that are necessarily less than completely realistic. Typically, a
model focuses on one issue, holding other things equal.

1.1.2 Definition
“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.” – Spencer and
Seegelman.

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“Managerial economics is concerned with application of economic

concepts and economic analysis to the problems of formulating rational
managerial decision.” – Mansfield

1.1.3 Meaning
In simple terms, managerial economics means the application of
economic theory to the problem of management. Managerial
economics may be viewed as economics applied to problem solving at
the level of the firm.
Managerial economics generally refers to the integration of economic
theory with business practice. Economics provides tools managerial
economics applies these tools to the management of business.

1.2 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.
a) Demand Analysis and Forecasting: A business firm is an economic
organisation which is engaged in transforming productive resources

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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.
b) Cost and production analysis: A firm’s 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.
c) 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.
d) Profit management: Business firms are generally organized for
earning profit and in the long period, it is profit which provides the chief

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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.
e) Capital management: The problems relating to firm’s 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.

1.3 NATURE OF MANAGERIAL ECONOMICS

a) Managerial Economics is a Science
b) Managerial Economics requires Art
c) Managerial Economics for administration of organization
d) Managerial economics is helpful in optimum resource allocation
e) Managerial Economics has components of micro economics
f) Managerial Economics has components of macro economics
g) Managerial Economics is dynamic in nature

1.4 SIGNIFICANCE IN DECISION MAKING

Management is concerned with decision-making. Decision-making
needs a balance between simplification of analysis to be manageable
and complications for handling a variety of factors and objectives.

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Managerial economics accomplished several objectives. Moreover, it

also needs common sense and good judgement. Managerial economics
helps the decision-making process in the following ways:

1. Managerial economics presents those aspects of traditional

economics, which are relevant for business decision-making in real life.
It culls from economic theory the concepts, principles and techniques of
analysis, which have a bearing on the decision-making process. These
are, if necessary, adopted or modified with a view to enable the
manager take better decisions. Thus, managerial economics
accomplished the objective of building a suitable took kit from
traditional economics.

2. Managerial economics also incorporates useful ideas from other

disciplines such as psychology, sociology, etc; if they are found relevant
for decision-making. In fact, managerial economics takes the aid of
other academic disciplines having a bearing upon the business decisions
of a manager in view of the various explicit and implicit constraints
subject to which resource allocation is to be optimized.

3. Managerial economics helps in reaching a variety of business

decisions in a complicated environment such as what products and
services should be produced? What inputs and production techniques
should be used? How much output should be produced and at what
prices it should be sold? What are the best sizes and locations of new
plants? When should equipment be replaced? And how should the
available capital be allocated?

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4. Managerial economics makes a manager a more competent model

builder. Thus, he can capture the essential relationship, which
characterizes a situation while leaving out the cluttering details and
peripheral relationships.

5. At the level of the firm, where for various functional areas, functional
specialists or functional departments exist, such as finance, marketing,
personal, production, etc. Managerial economics serves as an
integrating agent by coordinating the different areas and bringing to
bear on the decisions of each department or specialist the implications
pertaining to other functional areas. It thus, enables business decision-
making not in watertight compartments but in an integrated
perspective, the significance of which lies in the fact that the functional
departments or specialists often enjoy considerable autonomy and
achieve conflicting goals.

6. Managerial economics takes cognizance of the interaction between

the firm and society and accomplishes the key role of business as an
agent in the attainment of social and economic welfare. It has come to
be raised that business, apart from its obligations to shareholders, has
certain social obligations. Managerial economics focuses attention on
those social obligations as constraints subject to which business
decisions are to be taken. It serves as an instrument in furthering the
economic welfare of the society through socially oriented business
decisions.

7. Managerial economics is helpful in making decisions such as the

following: What should be the product-mix? Which is the production
technique and the input-mix that is least costly? What should be the

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level of output and price for the product? How to take investment
decisions? How much should the firm advertise and how to allocate an
advertisement fund between different media? It has to concede that
good decisions require ability to analyze problems logically and clearly.

1.5 FUNDAMENTAL CONCEPTS OF MANAGERIAL ECONOMICS

There are seven fundamental concepts of managerial economics. The
concepts are:
a) The Incremental Concept: It is easy to describe incremental
reasoning. But it is very difficult to apply it. As T.J. Coyne has put it, “It
involves estimating the impact of decision alternatives on costs and
revenues, stressing the changes in total cost and total revenue that
result from changes in prices, products, procedures, investments or
whatever may be at stake in the decision”.
Two basic concepts lie at the heart of incremental analysis, viz.,
incremental cost and incremental revenue. The former refers to the
change in total cost resulting from a decision. Likewise, the latter may
be defined as the change in total revenue resulting from a decision.
b) The Concept 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

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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.
c) The Concept of Discounting Principle: 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
dollars into an equivalent number of present dollars. For instance, $1
invested today at 10% interest is equivalent to $1.10 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.
d) The Opportunity Cost Concept: 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.

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e) The Concept of Equi-marginal Principle: Marginal Utility is the

utility derived from the additional unit of a commodity consumed. The
laws of equi-marginal utility states that a consumer will reach the stage
of equilibrium when the marginal utilities of various commodities he
consumes are equal.
According to the modern economists, this law has been formulated in
form of law of proportional marginal utility. It states that the consumer
will spend his money-income on different goods in such a way that the
marginal utility of each good is proportional to its price, i.e.,
MUx / Px = MUy / Py = MUz / Pz
Where, MU represents marginal utility and P is the price of good.
Similarly, a producer who wants to maximize profit (or reach
equilibrium) will use the technique of production which satisfies the
following condition:
MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3
Where, MRP is marginal revenue product of inputs and MC represents
marginal cost.
Thus, a manger can make rational decision by allocating/hiring
resources in a manner which equalizes the ratio of marginal returns and
marginal costs of various use of resources in a specific use.
f) The Contribution Concept: The various concepts developed so far are
interdependent. For example, in measuring opportunity cost of capital
we use a discount factor by following the discounting principle. The
same thing is true of the contribution concept.
The contribution concept is often used in product- mix decisions, also in
pricing decisions. It is also applicable in make or buy decisions. Finally,
in a discussion on capital budgeting, it is usually discovered that the
cash flows estimated by financial analysis are closely related to the
contribution concept.

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g) The Concept of Negotiation Principle: Negotiations refer “to the part

of coming to terms in as friendly a manner as possible with a party who
represents interests that differ from one’s own.”
In fact, everything in the real commercial world is negotiable, such as
housing prices and terms and conditions of payment, equipment parts,
specifications, and prices. Likewise, a businessman contemplating
merger, acquisition, consolidation or other form of corporate takeover
is always in a position to negotiate a deal depending on his bargaining
strength.
In fact, each major commitment facing a firm can be negotiated. If a
negotiation is successful both the parties are happy. An example of this
is collective bargaining between the employer and the employee. An
intelligent businessman must understand the process by which
negotiation takes place.

1.6 OBJECTIVES OF A FIRM

The main objectives of firms are:
1. Profit maximisation
2. Profit satisficing
3. Sales maximisation
4. Increased market share/market dominance
5. Social/environmental concerns
6. Co-operatives

1. Profit Maximization

Usually, in economics, we assume firms are concerned with maximising

profit. Higher profit means:

 Higher dividends for shareholders.

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 More profit can be used to finance research and development.

 Higher profit makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers

2.Profit Satisficing

 In many firms, there is a separation of ownership and control.

Those who own the company (shareholders) often do not get
involved in the day to day running of the company.
 This is a problem because although the owners may want to
maximise profits, the managers have much less incentive to
maximise profits because they do not get the same rewards,
(share dividends)
 Therefore managers may create a minimum level of profit to
keep the shareholders happy, but then maximise other
objectives, such as enjoying work, getting on with other workers.
(e.g. not sacking them) This is the problem of separation
between owners and managers.
 This 'principle-agent' problem can be overcome, to some extent,
by giving managers share options and performance related pay
although in some industries it is difficult to

 measure performance.

2. Sales Maximization

Firms often seek to increase their market share – even if it means less
profit. This could occur for various reasons:

 Increased market share increases monopoly power and may

enable the firm to put up prices and make more profit in the long
run.
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 Managers prefer to work for bigger companies as it leads to

greater prestige and higher salaries.
 Increasing market share may force rivals out of business. E.g. the
growth of supermarkets have lead to the demise of many local
shops. Some firms may actually engage in predatory pricing
which involves making a loss to force a rival out of business.

3. Growth Maximization

This is similar to sales maximisation and may involve mergers and

takeovers. With this objective, the firm may be willing to make lower
levels of profit in order to increase in size and gain more market share.
More market share increases their monopoly power and ability to be a
price setter

4. Long-run Profit Maximization

In some cases, firms may sacrifice profits in the short term to increase
profits in the long run. For example, by investing heavily in new
capacity, firms may make a loss in the short run but enable higher
profits in the future.

5. Social/Environmental Concern

A firm may incur extra expense to choose products which don’t harm
the environment or products not tested on animals. Alternatively, firms
may be concerned about local community / charitable concerns.

 Some firms may adopt social/environmental concerns into part

of its branding. This can ultimately help profitability as the brand
becomes more attractive to consumers.

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 Some firms may adopt social/environmental concerns on

principal alone – even if it does little to improve sales/brand
image.

6. Co-operatives
Co-operatives may have completely different objectives to a typical PLC.
A co-operative is run to maximise the welfare of all stakeholders –
especially workers. Any profit the co-operative makes will be shared
amongst all members.

Review Questions:
1. Define managerial economics?
2. Explain the nature and scope of managerial economics?
3. Explain the significance in decision making?
4. Brief note on the fundamental concepts of managerial economics
5. What are the objectives of a firm?

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OPPORTUNITY COST

TIME PERSPECTIVE PRINCIPLE

ROLE OF MANAGERIAL ECONOMIST

IMPORTANCE OF MANAGEMENT DECISION

MAKING

MARKET STRUCTURE

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2.1 LAW OF DEMAND

The quantity of a commodity demanded in a given time period
increases as its price falls, ceteris paribus. (I.e. other things remaining
constant)
The law of demand states that, other things remaining the same, the
quantity demanded of a commodity is inversely related to its price. It is
one of the important laws of economics which was firstly propounded
by neo-classical economist, Alfred Marshall.
According to the law of demand, there is an inverse relationship
between price and quantity demanded, other things remaining the
same.
aw of demand expresses the functional relationship
D = f(P)
Where,
P is price and
D is quantity demanded of a commodity
Other things being equal, if a price of a commodity falls, the quantity
demanded of it will rise, and if the price of the commodity rises, its
quantity demanded will decline.
Defintion:
Alfred Marshal says that “the amount demanded increase with a fall in
price, diminishes with a rise in price”.
C.E. Ferguson says that “according to law of demand, the quantity
demanded varies inversely with price”.
Paul A. Samuelson says that “law of demand states that people will buy
more at lower prices and buy less at higher prices, other things
remaining the same”.

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2.1.1 Assumptions of the law

a) There is no change in income of consumers.
b) There is no change in the price of product.
c) There is no change in quality of product.
d) There is no substitute of the commodity.
e) The prices of related commodities remain the same.
f) There is no change in customs.
g) There is no change in taste and preference of consumers.
h) The size of population remains the same.
i) The climate and weather conditions are same.
j) The tax rates and other fiscal measures remain the same.

2.1.2 Limitations/ Expectation of law of demand

a) Inferior goods/ Giffen goods: Some special varieties of inferior goods
are termed as giffen goods. Cheaper varieties of goods like low priced
rice, low priced bread, etc. are some examples of giffen goods.
This exception was pointed out by Robert Giffen who observed that
when the price of bread increased, the low paid British workers
purchased lesser quantity of bread, which is against the law of demand.
Thus, in case of giffen goods, there is indirect relationship between
price and quantity demanded.
b) Goods having prestige value: This exception is associated with the
name of the economist, T.Velben and his doctrine of conspicuous
conception. Few goods like diamond can be purchased only by rich
people. The prices of these goods are so high that they are beyond the
capacity of common people. The higher the price of the diamond the
higher the prestige value of it.
In this case, a consumer will buy less of the diamonds at a low price
because with the fall in price, its prestige value goes down. On the other

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hand, when price of diamonds increase, the prestige value goes up and
therefore, the quantity demanded of it will increase.
c) Price expectation: When the consumer expects that the price of the
commodity is going to fall in the near future, they do not buy more
even if the price is lower.
On the other hand, when they expect further rise in price of the
commodity, they will buy more even if the price is higher. Both of these
conditions are against the law of demand.
d) Fear of shortage: When people feel that a commodity is going to be
scarce in the near future, they buy more of it even if there is a current
rise in price.
For example: If the people feel that there will be shortage of L.P.G. gas
in the near future, they will buy more of it, even if the price is high.
e) Change in income: The demand for goods and services is also
affected by change in income of the consumers. If the consumers’
income increases, they will demand more goods or services even at a
higher price.
On the other hand, they will demand less quantity of goods or services
even at lower price if there is decrease in their income. It is against the
law of demand.
f) Change in fashion: The law of demand is not applicable when the
goods are considered to be out of fashion. If the commodity goes out of
fashion, people do not buy more even if the price falls.
For example: People do not purchase old fashioned shirts and pants
nowadays even though they've become cheap. On the other hand,
people buy fashionable goods in spite of price rise.
g) Basic necessities of life: In case of basic necessities of life such as
salt, rice, medicine, etc. the law of demand is not applicable as the

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demand for such necessary goods does not change with the rise or fall
in price.

2.1.3 Understanding law of demand using demand schedule

This law can be explained with the help of demand schedule
and demand curve as presented below:
Demand Schedule is a tabular representation of various combinations
of price and quantity demanded by a consumer during a particular
period of time. An imaginary demand schedule is given below:

The above demand schedule shows negative relationship between price

and quantity demanded for a commodity. Initially, when a price of a
good is Rs.10 per kg, quantity demanded by the consumer is 10 kg. As
the price decrease from Rs.10 per kg to Rs.8 per kg and then to Rs.6 per
kg, quantity demanded by the consumer increases from 10 kg to 20 kg
and then to 30 kg respectively. Further, fall in price from Rs.6 per kg to
Rs.4 per kg and then to Rs.2 per kg, results in increase in quantity
demanded by the consumer from 30 kg to 40 kg and then to 50 kg,
respectively. Thus, from the above schedule we can conclude that there
is opposite inverse relationship in between price and quantity
demanded for a commodity.

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2.1.4 Understanding law of demand using demand curve

It is the graphical representation of demand schedule. In other words, it
is a graphical representation of the quantities of a commodity which
will be demanded by the consumer at various particular prices in a
particular period of time, other things remaining the same.
We can show, the above demand schedule through the following
demand curve:

In the figure above, price and quantity demanded are measured along
the y-axis and x-axis respectively. By plotting various combinations of
price and quantity demanded, we get a demand curve DD1 derived
from points A, B, C, D and E. This is a downward sloping demand curve
showing inverse relationship between price and quantity demanded.

2.2 DETERMINANTS OF DEMAND

When price changes, quantity demanded will change. That is a
movement along the same demand curve. When factors other than
price changes, demand curve will shift. These are the determinants of
the demand curve.

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1. Income:
A rise in a person’s income will lead to an increase in demand (shift
demand curve to the right), a fall will lead to a decrease in demand for
normal goods. Goods whose demand varies inversely with income are
called inferior goods (e.g. Hamburger Helper).
2. Consumer Preferences:
Favourable change leads to an increase in demand, unfavourable
change lead to a decrease.
3. Number of Buyers:
The more buyers lead to an increase in demand; fewer buyers lead to
decrease.
4. Price of related goods:
a. Substitute goods (those that can be used to replace each other): price
of substitute and demand for the other good are directly related.
Example: If the price of coffee rises, the demand for tea should
increase.
b. Complement goods (those that can be used together): price of
complement and demand for the other good are inversely related.
Example: if the price of ice cream rises, the demand for ice-cream
toppings will decrease.
5. Expectation of future:
a. Future price: consumers’ current demand will increase if they expect
higher future prices; their demand will decrease if they expect lower
future prices.
b. Future income: consumers’ current demand will increase if they
expect higher future income; their demand will decrease if they expect
lower future income.

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2.3 ELASTICITY OF DEMAND

In economics, the term elasticity means a proportionate (percentage)
change in one variable relative to a proportionate (percentage) change
in another variable. The quantity demanded of a good is affected by
changes in the price of the good, changes in price of other goods,
changes in income and changes in other factors. Elasticity is a measure
of just how much of the quantity demanded will be affected due to a
change in price or income.
Elasticity of demand is an important variation on the concept of
demand. Demand can be classified as elastic, inelastic or unitary.
An elastic demand is one in which the change in quantity demanded
due to a change in price is large. An inelastic demand is one in which
the change in quantity demanded due to a change in price is small.
The formula for computing elasticity of demand is:

(Q1 – Q2) / (Q1 + Q2)

---------------------------
(P1 – P2) / (P1 + P2)
If the formula creates a number greater than 1, the demand is elastic. In
other words, quantity changes faster than price. If the number is less
than 1, demand is inelastic.
In other words, quantity changes slower than price. If the number is
equal to 1, elasticity of demand is unitary. In other words, quantity
changes at the same rate as price.

2.3.1 Types of elasticity of demand

There are three quantifiable determinants of demand, Hence elasticity
of demand can be of three types:
 Price Elasticity of Demand

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 Income Elasticity of Demand

 Cross Elasticity of Demand
1) PRICE ELASTICITY OF DEMAND
Price Elasticity of demand is the degree of responsiveness of demand to
a change in its price. In technical terms it is the ratio of the percentage
change in demand to the percentage change in price.
The price elasticity of demand is measured by dividing the percentage
change in quantity demanded by the percentage change in price.
Thus,
Price Elasticity = Percentage change in quantity
demanded/Percentage change in price
Percentage change in quantity demanded
----------------------------------------------
Percentage change in price
In mathematical terms it can be represented as:
Ep =(∆q/∆p) (p/q)
ΔQ = change in quantity demanded
ΔP = change in price
P = price
Q = quantity demanded

For example:
Quantity demanded is 20 units at a price of Rs.500. When there is a fall
in price to Rs.400 it results in a rise in demand to 32 units. Therefore the
change in quantity demanded is 12 units resulting from the change in
price of Rs.100.
The Price Elasticity of Demand is = 500 / 20 x 12/100 = 3
The response of the consumers to a change in the price of a commodity
is measured by the price elasticity of the commodity demand.

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a) Elastic:
Relatively Elastic Demand (Ed >1) a small percentage change in price
leading to a larger change in Quantity demanded.
 The % change in quantity > % change in price.
 From the diagram below we see a small change in price brings
about a large change in the quantity demanded.
 This happens when there are many substitutes in the
marketplace.

b) Inelastic:
Relatively Inelastic Demand (Ed < 1) a change in price leads to a smaller
percentage change in quantity demanded.
 It is the reverse of elastic.
 The % change in quantity < % change in price.
 From the diagram below we see a large change in price brings
about a small change in the quantity demanded.
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 This happens when there are few substitutes in the marketplace,

and the good is an essential commodity.
 Thus even if prices go up, we cannot reduce consumption by a
lot.

c) Unit elasticity:
Unit Elasticity of Demand (Ed =1) the percentage change in quantity
demanded is the same as the percentage change in price that caused it.
 The % change in quantity = % change in price.
 From the diagram below we see a change in price brings about
an exact change in the quantity demanded.
 A 2% change in price brings about a 2% change in quantity
demanded

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a) Perfectly elastic:
Perfectly Elastic Demand (Ed = ∞) a small change in price will change
the quantity demanded by an infinite amount.
 The % change in price is zero.
 At the market going price P*, the quantity demanded is infinite.
 So by the formula of elasticity:
 Ed (perfectly elastic)
 = (% change in Qd) ÷ (% change in price)
 =∞÷0
 =∞

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b) Perfectly inelastic:
Perfectly Inelastic Demand (Ed = 0) the quantity demanded does not
change regardless of the percentage change in price.
 The % change in quantity is zero.
 At any price, the quantity demanded is the same.
 The consumption of this commodity is fixed, and not dependent
on price.
 Think of our oxygen consumption.
 Even if you charge a price, any price, the quantity consumed
cannot be changed
 So by the formula of elasticity:
 Ed (perfectly inelastic)
 = (% change in Qd) ÷ (% change in price)
 =0÷∞
 =0

2) INCOME ELASTICITY OF DEMAND

Income elasticity of demand measures the responsiveness of quantity
demanded to a change in income. It is measured by dividing the
percentage change in quantity demanded by the percentage change in
income.

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If the demand for a commodity increases by 20% when income

increases by 10% then the income elasticity of that commodity is said to
be positive and relatively high. If the demand for food were unchanged
when income increases, the income elasticity would be zero. A fall in
demand for a commodity when income rises results in a negative
income elasticity of demand.
Expression of Income Elasticity of Demand

Where, EY = Elasticity of demand

q = Original quantity demanded
∆q = Change in quantity demanded
y = Original consumer’s income
∆y= Change in consumer’s income

a) Positive income elasticity of demand (EY>0)

If there is direct relationship between income of the consumer and
demand for the commodity, then income elasticity will be positive. That
is, if the quantity demanded for a commodity increases with the rise in
income of the consumer and vice versa, it is said to be positive income
elasticity of demand. For example: as the income of consumer
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increases, they consume more of superior (luxurious) goods. On the

contrary, as the income of consumer decreases, they consume less of
luxurious goods.

b) Income elasticity greater then unity (EY > 1):

If the percentage change in quantity demanded for a commodity is
greater than percentage change in income of the consumer, it is said to
be income greater than unity. For example: When the consumer’s
income rises by 3% and the demand rises by 7%, it is the case of income
elasticity greater than unity.

In the given figure, quantity demanded and consumer’s income is

measured along X-axis and Y-axis respectively. The small rise in income
from OY to OY1 has caused greater rise in the quantity demanded
from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
income elasticity greater than unity.

c) Income elasticity equal to unity (EY = 1):

If the percentage change in quantity demanded for a commodity is
equal to percentage change in income of the consumer, it is said to be
income elasticity equal to unity. For example: When the consumer’s
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income rises by 5% and the demand rises by 5%, it is the case of income
elasticity equal to unity.

In the given figure, quantity demanded and consumer’s income is

measured along X-axis and Y-axis respectively. The small rise in income
from OY to OY1 has caused equal rise in the quantity demanded
from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
income elasticity equal to unity.

d) Income elasticity less then unity (EY < 1)

If the percentage change in quantity demanded for a commodity is less
than percentage change in income of the consumer, it is said to be
income greater than unity. For example: When the consumer’s income
rises by 5% and the demand rises by 3%, it is the case of income
elasticity less than unity.

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In the given figure, quantity demanded and consumer’s income is

measured along X-axis and Y-axis respectively. The greater rise in
income from OY to OY1 has caused small rise in the quantity demanded
from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
income elasticity less than unity.

e) Negative income elasticity of demand ( EY<0)

If there is inverse relationship between income of the consumer and
demand for the commodity, then income elasticity will be negative.
That is, if the quantity demanded for a commodity decreases with the
rise in income of the consumer and vice versa, it is said to be negative
income elasticity of demand. For example:
As the income of consumer increases, they either stop or consume less
of inferior goods.

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In the given figure, quantity demanded and consumer’s income is

measured along X-axis and Y-axis respectively. When the consumer’s
income rises from OY to OY1 the quantity demanded of inferior goods
falls from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
negative income elasticity of demand.

f) Zero income elasticity of demand ( EY=0)

If the quantity demanded for a commodity remains constant with any
rise or fall in income of the consumer and, it is said to be zero income
elasticity of demand. For example: In case of basic necessary goods such
as salt, kerosene, electricity, etc. there is zero income elasticity of
demand.

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In the given figure, quantity demanded and consumer’s income is

measured along X-axis and Y-axis respectively. The consumer’s income
may fall to OY1 or rise to OY2 from OY, the quantity demanded remains
the same at OQ. Thus, the demand curve DD, which is vertical straight
line parallel to Y-axis shows zero income elasticity of demand.

3) CROSS ELASTICITY OF DEMAND

The quantity demanded of a particular commodity varies according to
the price of other commodities. Cross elasticity measures the
responsiveness of the quantity demanded of a commodity due to
changes in the price of another commodity. For example the demand
for tea increases when the price of coffee goes up. Here the cross
elasticity of demand for tea is high. If two goods are substitutes then
they will have a positive cross elasticity of demand. In other words if
two goods are complementary to each other then negative income
elasticity may arise.
The responsiveness of the quantity of one commodity demanded to a
change in the price of another good is calculated with the following
formula.
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% change in demand for commodity A

Ec =
% change in price of commodity B
If two commodities are unrelated goods, the increase in the price of
one good does not result in any change in the demand for the other
goods. For example the price fall in Tata salt does not make any change
in the demand for Tata Nano.

2.4 IMPORTANCE OF MANAGEMENT DECISION MAKING

One has to observe the economic prospects of a particular industry
before venturing into it. Most of the people are not aware of the
existence of some businesses with fantastic economic characteristics
like high rate of return on invested capital, substantial profit margins
and consistent growth. How do you think Bill Gates and Warren Buffet
were able to make it on the Forbes top millionaires list? Successful
leaders focus on the economics of a business for decision making.

2.4.1 Economic Aspects of a Market

Managerial economics is a management science that gives you more
idea about the economic aspects of a market and how they affect your
decision making. This is very important because economic profits play a
crucial role in a market based economy., While above normal profits are
indicators of expansion and growth, below normal profits cautions you
about tightening or retrenchment. Business economics is comprised of
several tools of micro and macro-economic analysis which are useful in
management decision-making that act as facilitators to solve business
problems. Micro economic instruments used in this context include
demand analysis, production and cost analysis, breakeven analysis,

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theory of pricing, technical progress, location decisions and capital

budgeting .
2.4.2 Factors Influencing Management Decisions
The macroeconomic concepts that are directly or indirectly related to
management decisions include analysis of national income, business
cycles, monetary policy, fiscal policy, central banking, public finance,
economic growth, international trade, balance of payments,
protectionism, free trade, exchange rates and international monetary
system. The scope of management science is broad and is closely linked
with economic theory, decision sciences and accounting.
Traditional economics deals with theory and methodology of
management, while managerial or business economics applies these
theories to solve business problems. The tools and analytical techniques
are useful in providing optimal solutions to business problems.

c) Relationship with economics :

Managerial economics borrows concepts from economics to idealize
the strategic actions needed for decision making in a problem situation.
The analysis of micro and macroeconomic concepts adds valuable
information for the organization. Say, for example, national income
forecasting is an important aid for the analysis of business conditions
that in turn could be an invaluable contribution to forecast demand for
specific product groups. Theories of market structure can be analyzed
for market segmentation. Managers have the freedom to choose
between the decision alternatives that best suits the objectives of the
business enterprise. The challenge is to justify the alternative in terms
of cost and benefit.

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d) Relationship with decision sciences :

Decision models are created to format solutions for problem situations
and the process uses techniques such as, optimization, differential
calculus and mathematical programming. This also helps to analyze the
impact of alternative courses of action and evaluate the results of the
model. Economic models provide the organizations with the necessary
insight concerning value maximization
e) Relationship to Accounting
The accounting data and statements constitute the language of
business. The accounting profession has a significant impact on cost and
revenue information and classification. A manager therefore must be
familiar with the generation, interpretation and use of accounting data.
Accounting is also seen as a decision management tool and not as a
mere practice of book-keeping. The concepts and practices of
accounting can be well applied to improve the economic scope of a
project.
Economic theory is all about allocating scarce resources between
competing ends and managerial economics advocates rules for
improving managerial decisions and for efficiently achieving the goals of
an organization.

2.4.3 Use of Price Elasticity of Demand in Managerial Decision-making

The concept of price elasticity of demand has important practical
applications in managerial decision-making. A business man has often
to consider whether a lowering of price will lead to an increase in the
demand for his product, and if so, to what extent and whether his
profits would increase as a result thereof.
Here the concept of elasticity of demand becomes crucial.
In practice, an accurate estimate of the probable response of volume of

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sales to price changes is extremely difficult. Moreover, the cost of the

statistical analysis required may in some cases, exceed the benefit
especially when uncertainty is great or when the volume is too small to
provide a reason also return on the amount spend on research. The
subjective judgment of certain managers, beyond on years of
experience, sometimes exceeds in accuracy the best of the present
statistical techniques. Uses of price elasticity can be point out as below:

1. Price distribution: A monopolist adopts a price discrimination

policy only when the elasticity of demand of different consumers
or sub-markets is different. Consumers whose demand is
inelastic can be charged a higher price than those with more
elastic demand.
2. Public utility pricing: In case of public utilities which are run as
monopoly undertakings e.g. elasticity of water supply railways
postal services, price discrimination is generally practiced,
charging higher prices from consumers or users with inelastic
demand and lower prices in case of elastic demand.
3. Joint supply: Certain goods, being products of the same process
are jointly supplied, e.g. wool and mutton. Here if the demand
for wool is inelastic compared to the demand for mutton, a
higher price for wool can be charged with advantage.
4. Super Markets: Super-markets are a combined set of shops run
by a single organization selling a wide range of goods. They are
supposed to sell commodities at lower prices than charged by
shopkeepers in the bazaar. Hence, price policy adopted is to
charge slightly lower price for goods with elastic demand.

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5. Use of machine: Workers often oppose use of machines out of

fear of unemployment. Machines need not always reduce
demand for labor as this depends on price elasticity of demand
for the commodity produced. When machines reduce costs and
hence price of products, if the products demand is elastic, the
demand will go up, production will have to be increased and
more workers may be employed for the product is inelastic,
machines will lead to unemployment as lower prices will not
increase the demand.
6. Factor pricing: The factors having price inelastic demand can
obtain a higher price than those with elastic demand. Workers
producing products having inelastic demand can easily get their
wages raised.
7. International trade: (a) A country benefits from exports of
products as have price inelastic demand for a rise in price and
elastic demand for a fall in price. (b) The demand for imports
should be inelastic for a fall in price and elastic for a rise in price.
(c) While deciding whether to devalue a country’s currency or
not, price elasticity of demand for a country’s exports would be
an important factor to be taken into consideration. If the
demand is price elastic, it would lead to an increase in the
country’s exports and devaluation would fail to achieve its
objective.
8. Shifting of tax burden: It is possible for a business to shift a
commodity tax in case of inelastic demand to his customers. But
if the demand is elastic, he will have to bear the tax

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burden himself, otherwise demand for his goods will go down

sharply.
9. Taxation policy: Government can easily raise tax revenue by
taxing commodities which are price inelastic.

Review Questions:
1. Explain Law of Demand?
2. What are the exceptions of law of demand?
3. What are the determinants of demand?
4. Explain Elasticity of Demand and its Types?
5. What is the use of elasticity of demand for managerial decision
making?

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MEANING OF DEMAND

TYPES OF DEMAND

FACTORS AFFECTING DEMAND

LAW OF DEMAND--ELASTICITY OF DEMAND

CHANGE IN QUANTITY DEMANDED

PROFIT ANALYSIS--BREAK EVEN ANALYSIS

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3.1 LAW OF SUPPLY

The law of supply is a fundamental principle of economic theory which
states that, all else equal, an increase in price results in an increase in
quantity supplied. In other words, there is a direct relationship
between price and quantity: quantities respond in the same direction as
price changes. This means that producers are willing to offer more
products for sale on the market at higher prices by increasing
production as a way of increasing profits. In short, Law of Supply is a
positive relationship between quantity supplied and price and is the
reason for the upward slope of the supply curve.

3.1.1 Definition
"Other things remaining the same, if the price of a commodity increases
its quantity supplied increases and if the price of a commodity
decreases, quantity supplied also decreases".
There exists a direct and positive relationship between price and
quantity supplied of a commodity. The functional relationship between
quantity supplied and the price of a commodity can be expressed as:
Qs = f(P)
Where Qs = quantity supplied

P = price of commodity

3.1.2 Assumptions of law

The assumptions of the law of supply are as under:

1. No change in cost of production

It assumed that there is no change in cost of production because of the

profit decreases with the increase in cost of production and it causes
the decrease in supply. If price of a commodity decreases and cost of
production also decreases, at the same time, the quantity supplied does
not decrease and profit remains constant.
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2. No change in technology

It is also assumed that technique of production does not change. If

better methods of production are invented, profit increases at the
previous price. The sellers increase supply and law of supply does not
operate.

3. No change in climate

It is also assumed that there is no change in climatic situation. For

example, at any place flood or earth quake occurred. The supply of
goods decreases at that place at previously prevailing price.

4. No change in prices of substitutes

If the prices of substitutes of a commodity fall then the tendency of

consumers diverts to substitutes therefore, the supply of a commodity
falls without any change in price.

5. No change in natural resources

If the quantity of natural resources (minerals, gas, coal, oil etc)

increases, the cost of production decreases. It causes to increase in
quantity supplied.

6. No change in price of capital goods

The capital goods are raw material, machinery, tools etc. The cost of
production increases due to increase in prices of capital goods. It can
lead to decrease in quantity supplied.

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7. No change in political situation

The amount of investment is affected by the change in political

situation of a country. The production of goods decreases due to
decrease in investment.

8. No change in tax policy

It is also assumed that the taxation policy of government does not

change. The increase in taxes effects the investment and production
and supply of goods decreases.

3.2 SUPPLY ELASTICITY

Suppliers profit by selling goods and services at higher prices than their
cost to produce. The amount of profit is determined by the cost of the
factors of production to produce the product and on the suppliers'
efficiency in producing the product. Since higher prices facilitate earning
a profit, and since the amount of profit is also dependent on the
quantity sold, if increased demand raises prices, then suppliers will
respond by increasing their supply, since that will allow them to earn a
higher profit. Of course, this is merely the law of supply, but it does not
state how much supply will change when prices change. The elasticity of
supply measures the percentage change in the quantity of supply
compared to the percentage change in a supply determinant, much like
how the elasticity of demand is measured. Although the elasticity of
supply can be measured against several supply determinants, the most
important is the price. The price elasticity of supply measures the
percentage change in supply quantity compared to the percentage
change in the price, which, in turn, determines the change in total
revenue.

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Quantity Change
Percentage
Price Elasticity of Supply =

Price Change Percentage

The price elasticity of supply varies widely, depending not only on the
product or service, but also whether the price change occurs in a short
time or over a long time. If the supply changes little with a change in
price, then supplies are considered inelastic. Supply is elastic if there are
large changes in supply for a small change in price. If the percentage
change in price is equal, though opposite, to the percentage change in
quantity, then supply elasticity is unit elastic.
For instance, the supply of land is generally inelastic, because, as Will
Rogers once quipped, they're not making any more of the stuff. By
contrast, the supply of software is almost perfectly elastic since it costs
little to make and distribute copies of software.

3.4 PRODUCTION FUNCTION

Production is an important economic activity which satisfies the wants
and needs of the people. Production function brings out the
relationship between inputs used and the resulting output. A firm is an
entity that combines and processes resources in order to produce
output that will satisfy the consumer’s needs. The firm has to decide as
to how much to produce and how much input factors (labour and
capital) to employ to produce efficiently.

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Production function indicates the maximum amount of commodity ‘X’

to be produced from various combinations of input factors. It decides
on the maximum output to be produced from a given level of input, and
how much minimum input can be used to get the desired level of
output. The production function assumes that the state of technology is
fixed. If there is a change in technology then there would be change in
production function.
Q = f (Land, Labour, Capital, Organization)
Q = f (L, L, C, O)
The production manager’s responsibility is that of identifying the right
combination of inputs for the decided quantity of output. As a manager,
he has to know the price of the input factors and the budget allocation
of the organization. The major objective of any business organization is
maximizing the output with minimum cost. To achieve the maximum
output the firm has to utilize the input factors efficiently. In the long
run, without increasing the fixed factors it is not possible to achieve the
goal. Therefore it is necessary to understand the relationship between
the input and output in any production process in the short and long
run.

3.4.1 Production process

It is process by which the inputs or factors of production are
transformed into output. In a cement factory, inputs include labour of
its workers, raw materials such as limestone, sand, clay, and capital
invested in equipment required to produce cement. Output of cement
industry would be different varieties of cement.

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3.4.2 Factors of production

There are four factors of production, land, labour, capital and
organisation. All these are brought together in the process of
production to form a final output. Land represents natural resources
like land plots, minerals, water, oil, etc. Labour is considered to be an
integral part of the process of production. Both skilled and unskilled
labour is required by the firm. Capital represents physical capital in the
form of machinery, equipment, plants, factory and other physical
assets. Finally, organisation/entrepreneur brings all these factors of
production together to transform them into a finished product.

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a) Land: Land is heterogeneous in nature. The supply of land is fixed

and it is a permanent factor of production but it is productive only with
the application of capital and labour.
b) Labour: The supply of labour is inelastic in nature but it differs in
productivity and efficiency and it can be improved.
c) Capital: is a man made factor and is mobile but the supply is elastic.
d) Organization: the organization plans, , supervises, organizes and
controls the business activity and also takes risks.

3.4.3 Cobb Douglas Production Function

This is a function that defines the maximum amount of output that can
be produced with a given level of inputs. Let us assume that all input
factors of production can be grouped into two categories such as labour
(L) and capital (K).The general equilibrium for the production function is
Q = f (K, L)
There are various functional forms available to describe production. In
general Cobb-Douglas production function (Quadratic equation) is
widely used
Q = A Kα Lβ
Q = the maximum rate of output for a given rate of capital (K) and
labour (L).

3.4.4 Short Run Production Function

In the short run, some inputs (land, capital) are fixed in quantity. The
output depends on how much of other variable inputs are used. For
example if we change the variable input namely (labour) the production
function shows how much output changes when more labour is used. In
the short run producers are faced with the problem that some input
factors are fixed. The firms can make the workers work for longer hours

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and also can buy more raw materials. In that case, labour and raw
material are considered as variable input factors. But the number of
machines and the size of the building are fixed. Therefore it has its own
constraints in producing more goods.
In the long run all input factors are variable. The producer can appoint
more workers, purchase more machines and use more raw materials.
Initially output per worker will increase up to an extent. This is known
as the Law of Diminishing Returns or the Law of Variable Proportion.
To understand the law of diminishing returns it is essential to know the
basic concepts of production.

The Law of Diminishing Returns

The key to understanding the pattern for change in Q is
the phenomenon known as the law of diminishing returns. This law
states:
As additional units of variable input are combined with a fixed input, at
some point the additional output (i.e. marginal product) starts to
diminish.
Diminishing returns are illustrated in both the numerical example in
Table and the graph of these same numbers in Figure. As you examine
this information, think “Change” as you see the word
“marginal”. Therefore, the “Total product” of an input such as labor is
the change in output resulting from an additional units of input.
There are two key concerns of a practical nature that we advise readers
to keep in mind when considering the impact of the law of diminishing
returns in actual business situations. First, there is nothing in the law
that states when diminishing returns will start to take effect. The law
merely says that if additional units of a variable input are combined
with a fixed input, at some point, the marginal product of the input will

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start to diminish. Therefore, it is reasonable to assume that a manager

will only discover the point of diminishing returns by experience and
trial and error, Hindsight will be more valuable than foresight. Second,
when economists first stated this law, they made some restrictive
assumptions about the nature of the variable inputs being
used. Essentially, they assumed that all inputs added to the production
process were exactly the same in individual productivity. The only
reason why a particular unit of input’s marginal product would be
higher or lower than the other used was because of the order in which
it was added to the production process.

3.4.5 Long-Run Production Function

In the long run the fixed inputs like machinery, building and other
factors will change along with the variable factors like labour, raw
material etc. With the equal percentage of increase in input factors
various combinations of returns occur in an organization.
Returns to scale: the change in percentage output resulting from a
percentage change in all the factors of production. They are increasing,
constant and diminishing returns to scale.
Increasing returns to scale may arise: if the output of a firm increases
more than in proportionate to an increase in all inputs. For example the
input factors are increased by 50% but the output has doubled (100%).
Constant returns to scale: when all inputs are increased by a certain
percentage the output increases by the same percentage. For example
input factors are increased by 50% then the output has also increased
by 50 percentages. Let us assume that a laptop consists of 50
components we call it as a set. In case the firm purchases 100 sets they
can assemble 100 laptops but it is not possible to produce more than
100 units.

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Diminishing returns to scale: when output increases in a smaller

proportion than the increase in inputs it is known as diminishing return
to scale. For example 50% increment in input factors lead to only 20%
increment in the output.

3.4.6 Measures Of Productivity

a) Total production (TP): the maximum level of output that can be
produced with a given amount of input.
b) Average Production (AP): output produced per unit of input AP = Q/L
c) Marginal Production (MP): the change in total output produced by
the last unit of an input
d) Marginal production of labour = Δ Q / Δ L (i.e. change in the quantity
produced to a given change in the labour)
e) Marginal production of capital = Δ Q / Δ K (i.e. change in the
quantity produced to a given change in the capital)
3.4.7 Assumptions for Production Function
 Technology is assumed to be constant.
 It is related to a particular or specific period.
 It is assumed that the manufacturer is using the best technology.
 All inputs are divisible.
 Utilization for inputs at maximum level of efficiency
Review questions:

1. Define Law of Supply?

2. Explain assumptions of law of demand?
3. Explain Supply Elasticity?
4. Explain Factors of production?
5. Explain Short run and Long run Production Function?

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ASBM / ADBA/DBA/ME-V1 / 1 - 05.03.2018

SUPPLY ANALYSIS

PRODUCTION FUNCTION

COST THEORY

COST CONCEPTS

COST-OUTPUT RELATIONSHIP

MARKET STRUCTURE AND PRICING DECISIONS

CRITERIA FOR MARKET CLASSIFICATION

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4.1 SUPPLY ANALYSIS

4.1.1 Introduction
Supply is an independent economic activity but it is based on the
demand for commodities. The managers’ ability to make more profits
depends upon his ability to adjust the supply to the demand without
creating a surplus while at the same time not t creating a scarcity that
will spoil the image of the company in the eyes of the public. Supply is
also sometimes inelastic and sometimes elastic. The managers have to
take wise decisions to maximize the profits of the firm.
Supply of a commodity refers to the various quantities of the
commodity which a seller is willing and able to sell at different prices in
a given market at a point of time, other things remaining the same.
Supply is what the seller is able and willing to offer for sale. The
Quantity supplied is the amount of a particular commodity that a firm is
willing and able to offer for sale at a particular price during a given time
period.

4.1.2 Meaning
The supply of a commodity means the amount of that commodity which
producers are able and willingness to offer for sale at a given prices.
Prof.Bach:- “Supply is a schedule of amounts that will be offered for
sale at different prices during any time period, other factors remaining
same”

4.1.3 Determinants of Supply

a) The cost of factors of production: Cost depends on the price of
factors. Increase in factor cost increases the cost of production, and
reduces supply.

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b) The state of technology: Use of advanced technology increases

productivity of the organization and increases its supply.
c) External factors: External factors like weather influence the supply. If
there is a flood, this reduces supply of various agricultural products.
d) Tax and subsidy: Increase in government subsidies results in more
production and higher supply.
e) Transport: Better transport facilities will increase the supply.
f) Price: If the prices are high, the sellers are willing to supply more
goods to increase their profit.
g) Price of other goods: The price of other goods is more than ‘X’ then
the supply of ‘X’ will be increased.

4.1.4 Elasticity of Supply

Elasticity of supply of a commodity is defined as the responsiveness of a
quantity supplied to a unit change in price of that commodity.
ΔQs / Qs
Es = ------------------
ΔP / P
ΔQs = change in quantity supplied
Qs = quantity supplied
ΔP = change in price
P = price

4.1.5 Kinds Of Supply Elasticity

a) Price elasticity of supply: Price elasticity of supply measures the
responsiveness of changes in quantity supplied to a change in price.
b) Perfectly inelastic: If there is no response in supply to a change in
price. (Es = 0) Inelastic supply: The proportionate change in supply is
less than the change in price (Es =0-1)

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c) Unitary elastic: The percentage change in quantity supplied equals

the change in price (Es=1)
d) Elastic: The change in quantity supplied is more than the change in
price (Ex= 1- ∞)
e) Perfectly elastic: Suppliers are willing to supply any amount at a
given price (Es=∞)
The major determinants of elasticity of supply are availability of
substitutes in the market and the time period, Shorter the period higher
will be the elasticity.

4.1.6 Factors Influencing Elasticity Of Supply

a) Nature of the commodity: If the commodity is perishable in nature
then the elasticity of supply will be less. Durable goods have high
elasticity of supply.
b) Time period: If the operational time period is short then supply is
inelastic. When the production process period is longer the elasticity of
supply will be relatively elastic.
c) Scale of production: Small scale producer’s supply is inelastic in
nature compared to the large producers.
d) Size of the firm and number of products: If the firm is a large scale
industry and has more variety of products then it can easily transfer the
resources. Therefore supply of such products is highly elastic.
e) Natural factors: Natural calamities can affect the production of
agricultural products so they are relatively inelastic.
f) Nature of production: If the commodities need more workmanship,
or for artistic goods the elasticity of supply will be high.

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4.2 COST THEORY

Costs are very important in business decision-making. Cost of
production provides the floor to pricing. It helps managers to take
correct decisions, such as what price to quote, whether to place a
particular order for inputs or not whether to abandon or add a product
to the existing product line and so on.
Ordinarily, costs refer to the money expenses incurred by a firm in the
production process. But in economics, cost is used in a broader sense.
Here, costs include imputed value of the entrepreneur’s own resources
and services, as well as the salary of the owner-manager.

4.2.1 The Cost Function

The cost function expresses a functional relationship between total cost
and factors that determine it. Usually, the factors that determine the
total cost of production (C) of a firm are the output (0, the level of
technology (T), the prices of factors (Pf) and the fixed factors (F).
Symbolically, the cost function becomes
C=f (Q, T, Pf, F)
Such a comprehensive cost function requires multi-dimensional
diagrams which are difficult to draw. In order to simplify the cost
analysis, certain assumptions are made. It is assumed that a firm
produces a single homogeneous good (q) with the help of certain
factors of production. Some of these factors are employed in fixed
quantities whatever the level of output of the firm in the short run. So
they are assumed to be given.
The remaining factors are variable whose supply is assumed to be
known and available at fixed market prices. Further, the technology
which is used for the production of the good is assumed to be known
and fixed. Lastly, it is assumed that the firm adjusts the employment of

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variable factors in such a manner that a given output Q of the good q is

obtained at the minimum total cost, C.
Thus the total cost function is expressed as:
C=f (Q)
Which means that the total cost (C) is a function if) of output (Q),
assuming all other factors as constant. The cost function is shown
diagrammatically by a total cost (TC) curve. The TC curve is drawn by
taking output on the horizontal axis and total cost on the vertical axis.

It is a continuous curve whose shape shows that with increasing output

total cost also increases. The total cost function and the TC curve relate
total cost to output under given conditions. But if any of the given
conditions such as the technique of production change, the cost
function is changed.
For instance, if there is an improved technique of production, the cost
of production for any given output will be less than before which will
shift the new cost curve TС1below the old curve TC. On the other hand,
if the prices of factors rise, the cost of production will increase which
will shift the cost curve upwards from TC to TС2.
4.2.2 Theory of cost
The Traditional Theory of Costs
The traditional theory of costs analyses the behaviour of cost curves in
the short run and the long run and arrives at the conclusion that both

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the short run and the long run curves are U-shaped but the long-run
cost curves are flatter than the short-run cost curves.
(A) Firm’s Short-Run Cost Curves:
The short run is a period in which the firm cannot change its plant,
equipment and the scale of organisation. To meet the increased
demand, it can raise output by hiring more labour and raw materials or
asking the existing labour force to work overtime.
Short-Run Total Costs:
The scale of organisation being fixed, the short-run total costs are
divided into total fixed costs and total variable costs:
TC = TFC + TVC
Total Costs or TC:
Total costs are the total expenses incurred by a firm in producing a
given quantity of a commodity. They include payments for rent,
interest, wages, taxes and expenses on raw materials, electricity, water,
advertising, etc.
Total Fixed Costs or TFC:
Are those costs of production that do not change with output. They are
independent of the level of output. In fact, they have to be incurred
even when the firm stops production temporarily. They include
payments for renting land and buildings, interest or borrowed money,
insurance charges, property tax, depreciation, maintenance
expenditures, wages and salaries of the permanent staff, etc. They are
also called overhead costs.
Total Variable Costs or TVC:
Are those costs of production that change directly with output. They
arise when output increases, and fall when output declines. They
include expenses on raw materials, power, water, taxes, hiring of
labour, advertising etc., They are also known as direct costs.

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The relation between total costs, variable costs and fixed costs is
presented in Table 1, where column (1) indicates different levels of
output from 0 to 10 units. Column (2) indicates that total fixed costs
remain at Rs. 300 at all levels of output. Column (3) shows total variable
costs which are zero when output is nothing and they continue to
increase with the rise in output.
In the beginning they rise quickly, and then they slow down as the firm
enjoys economies of large scale production with further increases in
output and later on due to diseconomies of production, the variable
costs start rising rapidly. Column (4) relates to total costs which are the
sum of columns (2), and (3) i.e., TC – TFC + TVC. Total costs vary with
total variable costs when the firm starts production.

The curves relating to these three total costs are shown

diagrammatically in Figure 2. The TC curve is a continuous curve which
shows that with increasing output total costs also increase. This curve
cuts the vertical axis at a point above the origin and rises continuously
from left to right. This is because even when no output is produced, the
firm has to incur fixed costs.
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TO (1) TFC TVC TC (4) AFC AVC ATC MC (8)

(2) (3) (2+3) (5) (6) (7) (from
(2+1) (3+1) (5+6) 4)
or
(4+1)
Rs Rs Rs Rs Rs Rs Rs
0 300 0 300 300 0 300 -
1 300 300 600 300 300 600 300
2 300 400 700 150 200 350 100
3 300 450 750 100 150 250 50
4 300 500 800 75 125 200 50
5 300 600 900 60 120 180 100
6 300 720 1020 50 120 170 120
7 300 890 1190 42.9 127.1 170 170
8 300 1100 1400 37.5 137.5 175 210
9 300 1350 1650 33.3 150 183.3 470
10 300 2000 2300 30 200 230 650

The TFC curve is shown as parallel to the output axis because total fixed
costs are the same (Rs. 300) whatever the level of output. The TVC
curve has an inverted-S shape and starts from the origin О because
when output is zero, the TVCs are also zero. They increase as output
increases.
So long as the firm is using less variable factors in proportion to the
fixed factors, the total variable costs rise at a diminishing rate. But after
a point, with the use of more variable factors in proportion to the fixed
factors, they rise steeply because of the application of the law of

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variable proportions. Since the TFC curve is a horizontal straight line,

the TC curve follows the TVC curve at an equal vertical distance.
Short-Run Average Costs:
In the short run analysis of the firm, average costs are more important
than total costs. The units of output that a firm produces do not cost
the same amount to the firm. But they must be sold at the same price.
Therefore, the firm must know the per unit cost or the average cost.
The short-run average costs of a firm are the average fixed costs, the
average variable costs, and the average total costs.
Average Fixed Costs or AFC equal total fixed costs at each level of
output divided by the number of units produced:
AFC = TFC /Q
The average fixed costs diminish continuously as output increases. This
is natural because when constant total fixed costs are divided by a
continuously increasing unit of output, the result is continuously
diminishing average fixed costs. Thus the AFC curve is a downward
sloping curve which approaches the quantity axis without touching it, as
shown in Figure 3. It is a rectangular hyperbola.
Short-Run Average Variable Costs (or SAVC) equal total variable costs at
each level of output divided by the number of units produced:
SAVC = TVC/Q
The average variable costs first decline with the rise in output as larger
quantities of variable factors is applied to fixed plant and equipment.
But eventually they begin to rise due to the law of diminishing returns.
Thus the SAVC curve is U-shaped, as shown in Figure 3.

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Short-Run Average Total Costs (or SATC or SAC) are the average costs of
producing any given output.
They are arrived at by dividing the total costs at each level of output by
the number of units produced:
SAC or SATC = TC/Q TFC/Q + TVC/Q = AFC+ AVC
Average total costs reflect the influence of both the average fixed costs
and average variable costs. At first average total costs are high at low
levels of output because both average fixed costs and average variable
costs are large. But as output increases, the average total costs fall
sharply because of the steady decline of both average fixed costs and
average variable costs till they reach the minimum point.
This results from the internal economies, from better utilisation of
existing plant, labour, etc. The minimum point В in the figure represents
optimal capacity. As production is increased after this point, the
average total costs rise quickly because the fall in average fixed costs is
negligible in relation to the rising average variable costs.
The rising portion of the SAC curve results from producing above capac-
ity and the appearance of internal diseconomies of management,
labour, etc. Thus the SAC curve is U- shaped, as shown in Figure 3

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Why is SAC curve U-shaped?

The U-shape of the SAC curve can also be explained in terms of the law
of variable proportions. This law tells that when the quantity of one
variable factor is changed while keeping the quantities of other factors
fixed, the total output increases but after some time it starts declining.
Machines, equipment and scale of production are the fixed factors of a
firm that do not change in the short run. ’On the other hand, factors like
labour and raw materials are variable. When increasing quantities of
variable factors are applied on the fixed factors, the law of variable
proportions operates.
When, say the quantities of a variable factor like labour are increased in
equal quantities, production rises till fixed factors like machines,
equipment, etc. are used to their maximum capacity. In this stage, the
average costs of the firm continue to fall as output increases because it
operates under increasing returns.
Due to the operation of the law of increasing returns when the variable
factors are increased further, the firm is able to work the machines to
their optimum capacity. It produces the optimum output and its
average costs of production will be the minimum which is revealed by
the minimum point of the SAC curve, point В in Figure 3.
It the firm tries to raise output after this point by increasing the
quantities of the variable factors, the fixed factors like machines would
be worked beyond their capacity. This would lead to diminishing
returns. The average costs will start rising rapidly. Hence, due to the
working of the law of variable proportions the short-run AC curve is U-
shaped.
Short Run Marginal Cost:
A fundamental concept for the determination of the exact level of
output of a firm is the marginal cost.

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Marginal cost is the addition to total cost by producing an additional

unit of output:
SMC = ∆ТС/∆Q
Algebraically, it is the total cost of n + 1 units minus the total cost of n
units of output MCn = TCn+1 – TCn. Since total fixed costs do not change
with output, therefore, marginal fixed cost is zero. So marginal cost can
be calculated either from total variable costs or total costs. The result
would be the same in both the cases. As total variable costs or total
costs first fall and then rise, marginal cost also behaves in the same
way. The SMC curve is also U-shaped, as shown in Figure 3.
(B) Firm’s Long-Run Cost Curves:
In the long run, there are no fixed factors of production and hence no
fixed costs. The firm can change its size or scale of plant and employ
more or less inputs. Thus in the long run all factors are variable and
hence all costs are variable.
The long run average total cost or LAC curve of the firm shows the
minimum average cost of producing various levels of output from all-
possible short-run average cost curves (SAC). Thus the LAC curve is
derived from the SAC curves. The LAC curve can be viewed as a series of
alternative short-run situations into any one of which the firm can
move.
Each SAC curve represents a plant of a particular size which is suitable
for a particular range of output. The firm will, therefore, make use of
the various plants up to that level where the short-run average costs fall
with increase in output. It will not produce beyond the minimum short-
run average cost of producing various outputs from all the plants used
together.
Let there be three plants represented by their short-run average cost
curves SAC1 SAC2and SAC3 in Figure 4. Each curve represents the scale

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of the firm. SAС1depicts a lower scale while the movement from SAC2 to
SA С1 shows the firm to be of a larger size. Given this scale of the firm, it
will produce up to the least cost per unit of output. For producing ON
output, the firm can use SAC1or SAC2 plant.

The firm will, however, use the scale of plant represented by SAC 3since
the average cost of producing ON output is NB which is less than NA,
the cost of producing this output on the SAC2 plant. If the firm is to pro-
duce OL output, it can produce at either of the two plants. But it would
be advantageous for the firm to use the plant SA C 2 for the OL level of
output.
But it would be more profitable for the firm to produce the larger
output OM at the lowest average cost ME from this plant. However, for
output OH, the firm would use the SAС1plant where the average cost
HG is lower than HF of the SAC2 plant. Thus in the long-run in order to
produce any level of output the firm will use that plant which has the
minimum unit cost.
If the firm expands its scale by the three stages represented by
SAC1SAC2and SAC3 curves, the thick wave-like portions of these curves
form the long-run average cost curve. The dotted portions of these SAC

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curves are of no consideration during the long run because the firm
would change the scale of plant rather than operate on them.
But the long-run average cost curve LAC is usually shown as a smooth
curve fitted to the SAC curves so that it is tangent to each of them at
some point, as shown in Figure 5, where SAC1,SAC2, SAC3, SAC4 and
SAC5are the short-run cost curves. It is tangent to all the SAC curves but
only to one at its minimum point.
The LAC is tangent to the lowest point E of the curve SAC 3 in Figure 5 at
OQ optimum output. The plant SAC3 which produces this OQ optimum
output at the minimum cost QE is the optimum plant, and the firm
producing this optimum output at the minimum cost with this optimum
plant is the optimum firm. If the firm produces less than the optimum
output OQ, it is not working its plant to full capacity and if it produces
beyond it is overworking its plants. In both the cases, the plants
SAC2 and SAC4 have higher average costs of production than the plant
SAC3

The LAC curve is known as the “envelope” curve because it envelopes

all the SAC curves. According to Prof. Chamberlin, “It is composed of
plant curves; it is the plant curve. But it is better to call it a “planning”

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curve because the firm plans to expand its scale of production over the
long run.”
The long-run marginal cost (LMC) curve of the firm intersects SAC 1 and
LAC curves at the minimum point E.

The Modern Theory of Costs

The modem theory of costs differs from the traditional theory of costs
with regard to the shapes of the cost curves. In the traditional theory,
the cost curves are U-shaped. But in the modem theory which is based
on empirical evidences, the short-run SAVC curve and the SMC curve
coincide with each other and are a horizontal straight line over a wide
range of output. So far as the LAC and LMC curves are concerned, they
are L-shaped rather than U-shaped. We discuss below the nature of
short- run and long-run cost curves according to the modem theory.
(1) Short-Run Cost Curves:
As in the traditional theory, the short-run cost curves in the modem
theory of costs are the AFC, SAVC, SAC and SMC curves. As usual, they
are derived from the total costs which are divided into total fixed costs
and total variable costs.
But in the modem theory, the SAVC and SMC curves have a saucer-type
shape or bowl-shape rather than a U-shape. As the AFC curve is a
rectangular hyperbola, the SAC curve has a U-shape even in the modem
version. Economists have investigated on the basis of empirical studies
this behaviour pattern of the short-run cost curves.
According to them, a modern firm chooses such a plant which it can
operate easily with the available variable direct factors. Such a plant
possesses some reserve capacity and much flexibility. The firm installs
this type of plant in order to produce the maximum rate of output over
a wide range to meet any increase in demand for its product.

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The saucer-shaped SAVC and SMC curves are shown in Figure 7. To

begin with, both the curves first fall up to point A and the SMC curve
lies below the SAVC curve. “The falling part of the SAVC shows the
reduction in costs due to the better utilisation of the fixed factor and
the consequent increase in skills and productivity of the variable factor
(labour).

With better skills, the wastes in raw materials are also being reduced
and a better utilisation of the whole plant is reached.” So far as the flat
stretch of the saucer-shaped SAVC curve over Q:1Q2 range of output is
concerned, the empirical evidence reveals that the operation of a plant
within this wide range exhibits constant returns to scale.
The reason for the saucer-shaped SAVC curve is that the fixed factor is
divisible. The SAV costs are constant over a large range, up to the point
at which all of the fixed factor is used. Moreover, the firm’s SAV costs
tend to be constant over a wide range of output because there is no
need to depart from the optimal combination of labour and capital in
those plants that are kept in operation.
Thus there is a large range of output over which the SAVC curve will be
flat. Over that range, SMC and SAVC are equal and are constant per unit

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of output. The firm will, therefore, continue to produce within

Q1Q2 reserve capacity of the plant, as shown in Figure 7.
After point B, both the SAVC and SMC curves start rising. When the firm
departs from its normal or the load factor of the plant in order to obtain
higher rates of output beyond Q2, it leads to higher SAVC and SMC. The
increase in costs may be due to the overtime operations of the old and
less efficient plant leading to frequent breakdowns, wastage of raw
materials, reduction in labour productivity and increase in labour cost
due to overtime operations. In the rising portion of the SAVC curve
beyond point B, the SMC curve lies above it.
The short-run average total cost curve (SATC or SAC) is obtained by
adding vertically the average fixed cost curve (AFC) and the SAVC curve
at each level of output. The SAC curve, as shown in Figure 8, continues
to fall up to the OQ level of output at which the reserve capacity of the
plant is fully exhausted.

Beyond that output level, the SAC curve rises as output increases. The
smooth and continuous fall in the SAC curve upto the OQ level of
output is due to the fact that the AFC curve is a rectangular hyperbola
and the SAVC curve first falls and then becomes horizontal within the
range of reserve capacity. Beyond the OQ output level, it starts rising
steeply. But the minimum point M of the SAC curve where the SMC

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curve intersects it, is to the right of point E of the SAVC curve. This is
because the SAVC curve starts rising steeply from point E while the AFC
curve is falling at a very low rate.
(2) Long-Run Cost Curves:
Empirical evidence about the long-run average cost curve reveals that
the LAC curve is L-shaped rather than U-shaped. In the beginning, the
LAC curve rapidly falls but after a point “the curve remains flat, or may
slope gently downwards, at its right-hand end.” Economists have
assigned the following reasons for the L-shape of the LAC curve.
1. Production and Managerial Costs:
In the long run, all costs being variable, production costs and
managerial costs of a firm are taken into account when considering the
effect of expansion of output on average costs. As output increases,
production costs fall continuously while managerial costs may rise at
very large scales of output. But the fall in production costs outweighs
the increase in managerial costs so that the LAC curve falls with
increases in output. We analyse the behaviour of production and
managerial costs in explaining the L-shape of the LAC curve.

Production Costs:
As a firm increases its scale of production, its production costs fall
steeply in the beginning and then gradually. The is due to the technical
economies of large scale production enjoyed by the firm. Initially, these
economies are substantial. But after a certain level of output when all
or most of these economies have been achieved, the firm reaches the
minimum optimal scale or mini mum efficient scale (MES).
Given the technology of the industry, the firm can continue to enjoy
some technical economies at outputs larger than the MES for the
following reasons:

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(a) From further decentralisation and improvement in skills and

productivity of labour; (b) from lower repair costs after the firm reaches
a certain size; and
(c) By itself producing some of the materials and equipment cheaply
which the firm ne
eds instead of buying them from other firms.
Managerial Costs:
In modern firms, for each plant there is a corresponding managerial set-
up for its smooth operation. There are various levels of management,
each having a separate management technique applicable to a certain
range of output. Thus, given a managerial set-up for a plant, its mana-
gerial costs first fall with the expansion of output and it is only at a very
large scale output, they rise very slowly.
To sum up, production costs fall smoothly and managerial costs rise
slowly at very large scales of output. But the fall in production costs
more than offsets the rise in managerial costs so that the LAC curve falls
smoothly or becomes flat at very large scales of output, thereby giving
rise to the L-shape of the LAC curve.
In order to draw such an LAC curve, we take three short-run average
cost curves SAC1 SA С2, and SAC3representing three plants with the
same technology in Figure 9. Each SAC curve includes production costs,
managerial costs, other fixed costs and a margin for normal profits.
Each scale of plant (SAC) is subject to a typical load factor capacity so
that points A, В and С represent the minimal optimal scale of output of
each plant.

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By joining all such points as A, В and С of a large number of SACs, we

trace out a smooth and continuous LAC curve, as shown in Figure 9. This
curve does not turn up at very large scales of output. It does not
envelope the SAC curves but intersects them at the optimal level of
output of each plant.
2. Technical Progress:
Another reason for the existence of the L-shaped LAC curve in the
modern theory of costs is technical progress. The traditional theory of
costs assumes no technical progress while explaining the U-shaped LAC
curve. The empirical results on long-run costs confirm the widespread
existence of economies of scale due to technical progress in firms.
The period, between which technical progress has taken place, the long-
run average costs show a falling trend. The evidence of diseconomies is
much less certain. So an upturn of the LAC at the top end of the size
scale has not been observed. The L-shape of the LAC curve due to tech-
nical progress is explained in Figure 10.

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Suppose the firm is producing OQ1 output on LAC1curve at a per unit

cost of ОС1 If there is an increase in demand for the firm’s product to
OQ2,with no change in technology, the firm will produce OQ2 output
along the LAC1 curve at a per unit cost of ОС2. If, however, there is
technical progress in the firm, it will install a new plant having LAC 2 as
the long-run average cost curve. On this plant, it produces OQ2 output
at a lower cost OC2 per unit.
Similarly, if the firm decides to increase its output to OQ 3 to meet
further rise in demand technical progress may have advanced to such a
level that it installs the plant with the LAC3 curve. Now it produces
OQ3output at a still lower cost OC3 per unit. If the minimum points, L, M
and N of these U- shaped long-run average cost curves LAC1, LAC2 and
LAC3are joined by a line, it forms an L-shaped gently sloping downward
curve LAC.
3. Learning:
Another reason for the L-shaped long- run average cost curve is the
learning process. Learning is the product of experience. If experience, in
this context, can be measured by the amount of a commodity
produced, then higher the production is, the lower is per unit cost.

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The consequences of learning are similar to increasing returns. First, the

knowledge gained from working on a large scale cannot be forgotten.
Second, learning increases the rate of productivity. Third, experience is
measured by the aggregate output produced since the firm first started
to produce the product.
Learning-by-doing has been observed when firms start producing new
products. After they have produced the first unit, they are able to
reduce the time required for production and thus reduce their per unit
costs. For example, if a firm manufactures airframes, the fall observed
in long-run average costs is a function of experience in producing one
particular kind of airframe, not airframes in general.
One can, therefore, draw a “learning curve” which relates cost per
airframe to the aggregate number of airframes manufactured so far,
since the firm started manufacturing them. Figure 11 shows a learning
curve LAC which relates the cost of producing a given output to the
total output over the entire time period.
Growing experience with making the product leads to falling costs as
more and more of it is produced. When the firm has exploited all
learning possibilities, costs reach a minimum level, M in the figure.
Thus, the LAC curve is L-shaped due to learning by doing.

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Relation between LAC and LMC Curves:

In the modern theory of costs, if the LAC curve falls smoothly and
continuously even at very large scales of output, the LMC curve will lie
below the LAC curve throughout its length, as shown in Figure 12.

If the LAC curve is downward sloping up to the point of a minimum

optimal scale of plant or a minimum efficient scale (MES) of plant
beyond which no further scale economies exist, the LAC curve becomes
horizontal. In this case, the LMC curve lies below the LAC curve until the
MES point M is reached, and beyond this point the LMC curve coincides
with the LA С curve, as shown in Figure 13.

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4.3 COST-OUTPUT RELATIONSHIP

The cost of production depends on money forces and an understanding
of the functional relationship of cost to various forces will help us to
take various decisions. Output is an important factor, which influences
the cost.
The cost-output relationship plays an important role in determining the
optimum level of production. Knowledge of the cost-output
relation helps the manager in cost control, profit prediction, pricing,
promotion etc. The relation between cost and its determinants is
technically described as the cost function.
C= f (S, O, P, T ….)
Where;
C= Cost (Unit or total cost)
S= Size of plant/scale of production
O= Output level
P= Prices of inputs
T= Technology
Considering the period the cost function can be classified as (1) short-
run cost function and (2) long-run cost function. In economics theory,
the short-run is defined as that period during which the physical
capacity of the firm is fixed and the output can be increased only by
using the existing capacity allows to bring changes in output by physical
capacity of the firm.
a) Cost-Output Relationship in the Short-Run
The cost concepts made use of in the cost behaviour are Total
cost, Average cost, and Marginal cost. Total cost is the actual money
spent to produce a particular quantity of output. Total Cost is the
summation of Fixed Costs and Variable Costs.
TC=TFC+TVC

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Up to a certain level of production Total Fixed Cost i.e., the cost of

plant, building, equipment etc, remains fixed. But the Total Variable
Cost i.e., the cost of labor, raw materials etc., vary with the variation in
output. Average cost is the total cost per unit. It can be found out as
follows.
AC=TC/Q
The total of Average Fixed Cost (TFC/Q) keep coming down as the
production is increased and Average Variable Cost (TVC/Q) will remain
constant at any level of output.
Marginal Cost is the addition to the total cost due to the production of
an additional unit of product. It can be arrived at by dividing the change
in total cost by the change in total output.
In the short-run there will not be any change in Total Fixed C0st. Hence
change in total cost implies change in Total Variable Cost only.

Units Total Total Total Average Average Average

of fixed variable cost variable fixed cost
Output cost cost (TFC + cost cost (TC/Q)
Q TFC TVC TVC) (TVC / (TFC / AC
TC Q) AVC Q) AFC
0 - 60 - - -
1 60 20 80 20 60 80
2 60 36 96 18 30 48
3 60 48 108 16 20 36
4 60 64 128 16 15 31
5 60 90 150 18 12 30
6 60 132 192 22 10 32

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The above table represents the cost-output relationship. The table is

prepared on the basis of the law of diminishing marginal returns. The
fixed cost Rs. 60 May include rent of factory building, interest on
capital, salaries of permanently employed staff, insurance etc. The table
shows that fixed cost is same at all levels of output but the average
fixed cost, i.e., the fixed cost per unit, falls continuously as the output
increases. The expenditure on the variable factors (TVC) is at different
rate. If more and more units are produced with a given physical capacity
the AVC will fall initially, as per the table declining up to 3 rd unit, and
being constant up to 4th unit and then rising. It implies that variable
factors produce more efficiently near a firm’s optimum capacity than at
any other levels of output and later rises. But the rise in AC is felt only
after the start rising. In the table ‘AVC’ starts rising from the 5th unit
onwards whereas the ‘AC’ starts rising from the 6th unit only so long as
‘AVC’ declines ‘AC’ also will decline. ‘AFC’ continues to fall with an
increase in Output. When the rise in ‘AVC’ is more than the decline in
‘AFC’, the total cost again begin to rise. Thus there will be a stage where
the ‘AVC’, the total cost again begin to rise thus there will be a stage
where the ‘AVC’ may have started rising, yet the ‘AC’ is still declining
because the rise in ‘AVC’ is less than the droop in ‘AFC’.
Thus the table shows an increasing returns or diminishing cost in the
first stage and diminishing returns or diminishing cost in the second
stage and followed by diminishing returns or increasing cost in the third
stage.
The short-run cost-output relationship can be shown graphically as
follows.

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In the above graph the “AFC’ curve continues to fall as output rises an
account of its spread over more and more units Output. But AVC curve
(i.e. variable cost per unit) first falls and then rises due to the operation
of the law of variable proportions.
The behaviour of “ATC’ curve depends upon the behaviour of ‘AVC’
curve and ‘AFC’ curve. In the initial stage of production both ‘AVC’ and
‘AFC’ decline and hence ‘ATC’ also decline. But after a certain point
‘AVC’ starts rising. If the rise in variable cost is less than the decline in
fixed cost, ATC will still continue to decline otherwise AC begins to rise.
Thus the lower end of ‘ATC’ curve thus turns up and gives it a U-shape.
That is why ‘ATC’ curve are U-shaped. The lowest point in ‘ATC’ curve
indicates the least-cost combination of inputs. Where the total average
cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It

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is not be the maximum output level rather it is the point where per unit
cost of production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up
as follows:
a) If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.
b) When ‘AFC’ falls and ‘AVC’ rises
 ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in
‘AVC’.
 ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
 ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’
b) Cost-output Relationship in the Long-Run
Long run is a period, during which all inputs are variable including the
one, which are fixes in the short-run. In the long run a firm can change
its output according to its demand. Over a long period, the size of the
plant can be changed, unwanted buildings can be sold staff can be
increased or reduced. The long run enables the firms to expand and
scale of their operation by bringing or purchasing larger quantities of all
the inputs. Thus in the long run all factors become variable.
The long-run cost-output relations therefore imply the relationship
between the total cost and the total output. In the long-run cost-output
relationship is influenced by the law of returns to scale.
In the long run a firm has a number of alternatives in regards to the
scale of operations. For each scale of production or plant size, the firm
has an appropriate short-run average cost curves. The short-run
average cost (SAC) curve applies to only one plant whereas the long-run
average cost (LAC) curve takes in to consideration many plants.
The long-run cost-output relationship is shown graphically with the help
of “LCA’ curve.

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To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves.

In the above figure it is assumed that technologically there are only
three sizes of plants – small, medium and large, ‘SAC’, for the small size,
‘SAC2’ for the medium size plant and ‘SAC3’ for the large size plant. If
the firm wants to produce ‘OP’ units of output, it will choose the
smallest plant. For an output beyond ‘OQ’ the firm wills optimum for
medium size plant. It does not mean that the OQ production is not
possible with small plant. Rather it implies that cost of production will
be more with small plant compared to the medium plant.
For an output ‘OR’ the firm will choose the largest plant as the cost of
production will be more with medium plant. Thus the firm has a series
of ‘SAC’ curves. The ‘LCA’ curve drawn will be tangential to the entire
family of ‘SAC’ curves i.e. the ‘LAC’ curve touches each ‘SAC’ curve at
one point, and thus it is known as envelope curve. It is also known as
planning curve as it serves as guide to the entrepreneur in his planning
to expand the production in future. With the help of ‘LAC’ the firm
determines the size of plant which yields the lowest average cost of
producing a given volume of output it anticipates.

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4.4 MARKET STRUCTURE AND PRICING DECISIONS

Price determination is one of the most crucial aspects in economics.
Business managers are expected to make perfect decisions based on
their knowledge and judgment. Since every economic activity in the
market is measured as per price, it is important to know the concepts
and theories related to pricing. Pricing discusses the rationale and
assumptions behind pricing decisions. It analyses unique market needs
and discusses how business managers reach upon final pricing
decisions.

Market Structure
A market is the area where buyers and sellers contact each other and
exchange goods and services. Market structure is said to be the
characteristics of the market. Market structures are basically the
number of firms in the market that produce identical goods and
services. Market structure influences the behavior of firms to a great
extent. The market structure affects the supply of different
commodities in the market.
When the competition is high there is a high supply of commodity as
different companies try to dominate the markets and it also creates
barriers to entry for the companies that intend to join that market. A
monopoly market has the biggest level of barriers to entry while the
perfectly competitive market has zero percent level of barriers to entry.
Firms are more efficient in a competitive market than in a monopoly
structure.
a) Perfect Competition
Perfect competition is a situation prevailing in a market in which buyers
and sellers are so numerous and well informed that all elements of

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monopoly are absent and the market price of a commodity is beyond

the control of individual buyers and sellers
With many firms and a homogeneous product under perfect
competition no individual firm is in a position to influence the price of
the product that means price elasticity of demand for a single firm will
be infinite.

Pricing Decisions
 Determinants of Price Under Perfect Competition
Market price is determined by the equilibrium between demand and
supply in a market period or very short run. The market period is a
period in which the maximum that can be supplied is limited by the
existing stock. The market period is so short that more cannot be
produced in response to increased demand. The firms can sell only
what they have already produced. This market period may be an hour, a
day or a few days or even a few weeks depending upon the nature of
the product.
 Market Price of a Perishable Commodity
In the case of perishable commodity like fish, the supply is limited by
the available quantity on that day. It cannot be stored for the next
market period and therefore the whole of it must be sold away on the
same day whatever the price may be.

 Market Price of Non-Perishable and Reproducible Goods

In case of non-perishable but reproducible goods, some of the goods
can be preserved or kept back from the market and carried over to the
next market period. There will then be two critical price levels.
The first, if price is very high the seller will be prepared to sell the whole
stock. The second level is set by a low price at which the seller would

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not sell any amount in the present market period, but will hold back the
whole stock for some better time. The price below which the seller will
refuse to sell is called the Reserve Price.

b) Monopolistic Competition
Monopolistic competition is a form of market structure in which a large
number of independent firms are supplying products that are slightly
differentiated from the point of view of buyers. Thus, the products of
the competing firms are close but not perfect substitutes because
buyers do not regard them as identical. This situation arises when the
same commodity is being sold under different brand names, each brand
being slightly different from the others.
For example − Lux, Liril, Dove, etc.
Each firm is therefore the sole producer of a particular brand or
“product”. It is monopolist as far as a particular brand is concerned.
However, since the various brands are close substitutes, a large number
of “monopoly” producers of these brands are involved in a keen
competition with one another.

This type of market structure, where there is competition among a large

number of “monopolists” is called monopolistic competition.
In addition to product differentiation, the other three basic
characteristics of monopolistic competition are −
There are large number of independent sellers and buyers in the
market.
The relative market shares of all sellers are insignificant and more or
less equal. That is, seller-concentration in the market is almost non-
existent.

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There are neither any legal nor any economic barriers against the entry
of new firms into the market. New firms are free to enter the market
and existing firms are free to leave the market.
In other words, product differentiation is the only characteristic that
distinguishes monopolistic competition from perfect competition.

c) Monopoly
Monopoly is said to exist when one firm is the sole producer or seller of
a product which has no close substitutes. According to this definition,
there must be a single producer or seller of a product. If there are many
producers producing a product, either perfect competition or
monopolistic competition will prevail depending upon whether the
product is homogeneous or differentiated.
On the other hand, when there are few producers, oligopoly is said to
exist. A second condition which is essential for a firm to be called
monopolist is that no close substitutes for the product of that firm
should be available.

From above it follows that for the monopoly to exist, following things
are essential −
One and only one firm produces and sells a particular commodity or a
service.
There are no rivals or direct competitors of the firm.
No other seller can enter the market for whatever reasons legal,
technical, or economic.
Monopolist is a price maker. He tries to take the best of whatever
demand and cost conditions exist without the fear of new firms
entering to compete away his profits.

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The concept of market power applies to an individual enterprise or to a

group of enterprises acting collectively. For the individual firm, it
expresses the extent to which the firm has discretion over the price that
it charges. The baseline of zero market power is set by the individual
firm that produces and sells a homogeneous product alongside many
other similar firms that all sell the same product.
Since all of the firms sell the identical product, the individual sellers are
not distinctive. Buyers care solely about finding the seller with the
lowest price.
In this context of “perfect competition”, all firms sell at an identical
price that is equal to their marginal costs and no individual firm possess
any market power. If any firm were to raise its price slightly above the
market-determined price, it would lose all of its customers and if a firm
were to reduce its price slightly below the market price, it would be
swamped with customers who switch from the other firms.
Accordingly, the standard definition for market power is to define it as
the divergence between price and marginal cost, expressed relative to
price. In Mathematical terms we may define it as −
L= (P − MC)
------------
P

d) Oligopoly
In an oligopolistic market there are small numbers of firms so that
sellers are conscious of their interdependence. The competition is not
perfect, yet the rivalry among firms is high. Given that there are large
numbers of possible reactions of competitors, the behavior of firms
may assume various forms. Thus there are various models of
oligopolistic behavior; each based on different reactions patterns of
rivals.
Oligopoly is a situation in which only a few firms are competing in the
market for a particular commodity. The distinguishing characteristics of
oligopoly are such that neither the theory of monopolistic competition

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nor the theory of monopoly can explain the behavior of an oligopolistic

firm.

Two of the main characteristics of Oligopoly are briefly explained

below:
Under oligopoly the number of competing firms being small, each firm
controls an important proportion of the total supply. Consequently, the
effect of a change in the price or output of one firm upon the sales of its
rival firms is noticeable and not insignificant. When any firm takes an
action its rivals will in all probability react to it.
The behavior of oligopolistic firms is interdependent and not
independent or atomistic as is the case under perfect or monopolistic
competition.
Under oligopoly new entry is difficult. It is neither free nor barred.
Hence the condition of entry becomes an important factor determining
the price or output decisions of oligopolistic firms and preventing or
limiting entry of an important objective.

4.5 CRITERIA FOR MARKET CLASSIFICATION

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Generally, the market is classified on the basis of:

 Place,
 Time and
 Competition.
On the basis of Place, the market is classified into:
 Local Market or Regional Market.
 National Market or Countrywide Market.
 International Market or Global Market.
On the basis of Time, the market is classified into:
 Very Short Period Market.
 Short Period Market.
 Long Period Market.
 Very Long Period Market.
On the basis of Competition, the market is classified into:
 Perfectly Competitive Market Structure.
 Imperfectly Competitive Market Structure.
Both these market structures widely differ from each other in respect of
their features, price, etc. Under imperfect competition, there are
different forms of markets like monopoly, duopoly, oligopoly
and monopolistic competition.
 A monopoly has only one or a single (mono) seller.
 Duopoly has two (duo) sellers.
 Oligopoly has little or fewer (oligo) number of sellers.
 Monopolistic competition has many or several numbers of
sellers.

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Review questions:
1. Define supply analysis?
2. What are the determinants of supply?
3. Explain the elasticity of supply?
4. What are the factors influencing elasticity of supply?
5. What is cost theory? Explain its concepts?
6. Explain market structure and its pricing decisions?
7. Explain criteria for market classification?

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ASBM / ADBA/DBA/ME-V1 / 1 - 05.03.2018

NATIONAL INCOME

METHODS OF MEASURING NATIONAL

INCOME

BUSINESS ENVIRONMENT

CAPITAL BUDGETING

NEW CONCEPTS OF MANAGERIAL

ECONOMICS 96
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5.1 MARKET STRUCTURE : PERFECT COMPETITION

Market structure refers to the nature and degree of competition in the
market for goods and services. The structures of market both for goods
market and service (factor) market are determined by the nature of
competition prevailing in a particular market.
A perfectly competitive market is one in which the number of buyers
and sellers is very large, all engaged in buying and selling a
homogeneous product without any artificial restrictions and possessing
perfect knowledge of market at a time. In the words of A.
Koutsoyiannis, “Perfect competition is a market structure characterised
by a complete absence of rivalry among the individual firms.” According
to R.G. Lipsey, “Perfect competition is a market structure in which all
firms in an industry are price- takers and in which there is freedom of
entry into, and exit from, industry.”

5.1.1 Features
(1) Large Number of Buyers and Sellers:
The first condition is that the number of buyers and sellers must be so
large that none of them individually is in a position to influence the
price and output of the industry as a whole. The demand of individual
buyer relative to the total demand is so small that he cannot influence
the price of the product by his individual action.

Similarly, the supply of an individual seller is so small a fraction of the

total output that he cannot influence the price of the product by his
action alone. In other words, the individual seller is unable to influence
the price of the product by increasing or decreasing its supply.
Rather, he adjusts his supply to the price of the product. He is “output
adjuster”. Thus no buyer or seller can alter the price by his individual

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action. He has to accept the price for the product as fixed for the whole
industry. He is a “price taker”.

(2) Freedom of Entry or Exit of Firms:

The next condition is that the firms should be free to enter or leave the
industry. It implies that whenever the industry is earning excess profits,
attracted by these profits some new firms enter the industry. In case of
loss being sustained by the industry, some firms leave it.

(3) Homogeneous Product:

Each firm produces and sells a homogeneous product so that no buyer

has any preference for the product of any individual seller over others.
This is only possible if units of the same product produced by different
sellers are perfect substitutes. In other words, the cross elasticity of the
products of sellers is infinite.

No seller has an independent price policy. Commodities like salt, wheat,

cotton and coal are homogeneous in nature. He cannot raise the price
of his product. If he does so, his customers would leave him and buy the
product from other sellers at the ruling lower price.
The above two conditions between themselves make the average
revenue curve of the individual seller or firm perfectly elastic, horizontal
to the X-axis. It means that a firm can sell more or less at the ruling
market price but cannot influence the price as the product is
homogeneous and the number of sellers very large.

(4) Absence of Artificial Restrictions:

The next condition is that there is complete openness in buying and
selling of goods. Sellers are free to sell their goods to any buyers and

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the buyers are free to buy from any sellers. In other words, there is no
discrimination on the part of buyers or sellers.
Moreover, prices are liable to change freely in response to demand-
supply conditions. There are no efforts on the part of the producers, the
government and other agencies to control the supply, demand or price
of the products. The movement of prices is unfettered.

(5) Profit Maximisation Goal:

Every firm has only one goal of maximising its profits.

(6) Perfect Mobility of Goods and Factors:

Another requirement of perfect competition is the perfect mobility of

goods and factors between industries. Goods are free to move to those
places where they can fetch the highest price. Factors can also move
from a low-paid to a high-paid industry.

(7) Perfect Knowledge of Market Conditions:

This condition implies a close contact between buyers and sellers.

Buyers and sellers possess complete knowledge about the prices at
which goods are being bought and sold, and of the prices at which
others are prepared to buy and sell. They have also perfect knowledge
of the place where the transactions are being carried on. Such perfect
knowledge of market conditions forces the sellers to sell their product
at the prevailing market price and the buyers to buy at that price.

(8) Absence of Transport Costs:

Another condition is that there are no transport costs in carrying of
product from one place to another. This condition is essential for the
existence of perfect competition which requires that a commodity must
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have the same price everywhere at any time. If transport costs are
added to the price of the product, even a homogeneous commodity will
have different prices depending upon transport costs from the place of
supply.

(9) Absence of Selling Costs:

Under perfect competition, the costs of advertising, sales-promotion,

etc. do not arise because all firms produce a homogeneous product.

5.1.2 Determination of price under Perfect Competition

Dr. Alfred Marshall was the first economist who pointed out that the pricing
problem should be studied from the view point of time. He distinguished
three fundamental time periods in the determination of price:
(1) Market price.

(2) Short run normal price.

(3) Long run normal price.

Marshall has stated that it is wrong to say that demand alone or supply alone
determines price. It is both demand and supply which determine price. In the
words of Marshall:

"The shorter, the period which one considers, the greater must be the share
of our attention which is given to the influence of demand on value and
longer the period, the more important will be the influence of cost of
production on value".

Actual value at any time the market value as it is often called is often
influenced by passing events and is short lived than by those which work
persistently. But in the log run, these fitful and irregular causes in a large
measure efface one another influence so that in the long run persistent
causes dominate value completely. Stiller is right when he says that Marshall has
done a great service to economics by introducing time element in pricing.

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There are two well known approaches to pricing under perfect

competition:

1. Partial Equilibrium Approach

2. General Equilibrium Approach
1- Partial Equilibrium Approach:- In this approach we assume that the
prices of various commodities are independent and do not mutually
affect one another. This approach isolates the primary relation of
supply, demand and price in regard to a particular commodity. Thus in
this approach to pricing under perfect competition, demand for a
commodity is determined on the assumption that the prices of the
other commodities, prices of factors and production function remain
the same.

2- General Equilibrium Approach: this approach does not assume that

the prices of a good are determined independently of the prices of
other goods. It explains the mutual and simultaneous determination of
the prices of all goods and factors. Thus it looks at multi-market
equilibrium.
In the case of the inter-related goods, we have to resort to a general
equilibrium approach. According to Stonier and Hague, “if X and Y are
either strongly complementary or strongly competitive, a fall in the
price of X can have a substantial effect on the demand for Y. General
Equilibrium analysis attempts to take account of such relationship.”

Price Determination-General Statement: There was confliction

between various economists in the determination of the value or price.
Few economists were in favour of the force of demand while other was
in favour of the force of supply.
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5.2 MONOPOLY
Monopoly is a market situation in which there is only one seller of a
product with barriers to entry of others. The product has no close
substitutes. The cross elasticity of demand with every other product is
very low. This means that no other firms produce a similar product.
According to D. Salvatore, “Monopoly is the form of market
organisation in which there is a single firm selling a commodity for
which there are no close substitutes.” Thus the monopoly firm is itself
an industry and the monopolist faces the industry demand curve.

5.2.1 Features
The main features of monopoly are as follows:
1. Under monopoly, there is one producer or seller of a particular
product and there is no difference between a firm and an industry.
Under monopoly a firm itself is an industry.

2. A monopoly may be individual proprietorship or partnership or joint

stock company or a cooperative society or a government company.

3. A monopolist has full control on the supply of a product. Hence, the

elasticity of demand for a monopolist’s product is zero.

4. There is no close substitute of a monopolist’s product in the market.

Hence, under monopoly, the cross elasticity of demand for a monopoly
product with some other good is very low.

5. There are restrictions on the entry of other firms in the area of

monopoly product.
6. A monopolist can influence the price of a product. He is a price-
maker, not a price-taker.
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7. Pure monopoly is not found in the real world.

8. Monopolist cannot determine both the price and quantity of a

product simultaneously.
9. Monopolist’s demand curve slopes downwards to the right. That is
why, a monopolist can increase his sales only by decreasing the price of
his product and thereby maximise his profit. The marginal revenue
curve of a monopolist is below the average revenue curve and it falls
faster than the average revenue curve. This is because a monopolist has
to cut down the price of his product to sell an additional unit.

5.2.2 Pricing under Monopoly

A monopolist is the sole seller of a commodity. The aim of a monopolist
is to get maximum profits. Of course, everyone who enters business
aims at getting maximum profit. But there is no scope for getting
abnormal profit under competition for there are several number of
sellers. But the monopolist is the sole seller of a commodity. So he will
take advantage of the situation and try to get maximum profits. For, all
those who want the good should buy it only from him. They have no
other way. So in determining the price of a commodity, he will be
guided by only one motive, that is, to maximize his profits.
We know in a market, price is determined by the interaction of supply and demand.
Under monopoly too, the price of a good is determined by the
interaction of supply and demand, but in a different way. Under perfect
competition, there will be several number of sellers. But under
monopoly, the monopolist is the sole seller of a commodity. So he can
control the supply of his good. But he cannot control demand for there
are several number of buyers as in the case of competition.

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The aim of a monopolist is to maximize his profits. For that, he can do

one of the following two things. He can fix the price for his good and
leave the market to decide what output will be required. Or he can fix
the output and leave the price to be determined by the interaction of
supply and demand. In other words, he can fix the price or the output;
he cannot do both. The amounts he can sell at any given price depend
upon the conditions of demand for his good.

Just because the monopolist is the sole seller of the commodity, we

should not think he can fix whatever price he likes. Of course, he can do
it but he will not make profits. Benham has put it will in the following
lines: “The fortunate monopolist can fix what price he chooses, but if he
cannot sell enough, he doesn’t gain; he loses.” The monopolist,
therefore, has to study the conditions of supply and demand. He must
carefully estimate the demand for his goods. He has to see first whether
his commodity has got elastic demand or inelastic demand. If the
demand for the commodity is elastic, the monopolist cannot fix a very
high price because a rise in price may result in a fall of demand. So he
cannot sell much and he may not get large profits. In such a case, the
monopolist will fix a low price. If the good in question has inelastic
demand, the monopolist may fix a high price. It is so because even if the
price is high, there will not be a fall in demand. Then the monopolist will
get maximum profits by fixing a high price.
The monopolist should also study the conditions of supply. He must
estimate the cost of production for different quantities of his goods. If
his firm is producing under the conditions of the Law of Diminishing
costs, cost of production per unit will fall as output increases. Then the
monopolist will try to fix a low price and sell more units. Thereby he will

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try to get maximum profits. On the other hand, if his firm is working
under conditions of increasing costs, cost of production per unit will rise
as output increases. Under such circumstances, the monopolist will
generally restrict his output and sell his goods at a high price. Thereby
he will try to get maximum profits. Suppose his firm is working under
conditions of constant costs, the price he fixes will depend largely on
the conditions of demand for his goods.

5.3 PRICE DISCRIMINATION

Price discrimination means charging different prices from different
customers or for different units of the same product. In the words of
Joan Robinson: “The act of selling the same article, produced under
single control at different prices to different buyers is known as price
discrimination.” Price discrimination is possible when the monopolist
sells in different markets in such a way that it is not possible to transfer
any unit of the commodity from the cheap market to the dearer
market.
Price discrimination is, however, not possible under perfect
competition, even if the two markets could be kept separate. Since the
market demand in each market is perfectly elastic, every seller would
try to sell in that market in which he could get the highest price.
Competition would make the price equal in both the markets. Thus
price discrimination is possible only when markets are imperfect.

Different Types of Price Discrimination

1. First Degree Price Discrimination

This involves charging consumers the maximum price that they are
willing to pay. There will be no consumer surplus.

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2. Second Degree Price Discrimination

This involves charging different prices depending upon the quantity

consumed. For example:

 After 10 minutes phone calls become cheaper.

 Electricity is more expensive for the first number of units. For a
higher quantity of electricity consumed the marginal cost is
lower.
 Loyalty cards reward frequent buyers with discounts on future
products.

3. Third Degree Price Discrimination – ‘Group price discrimination’

This involves charging different prices to different groups of people. For

example:

 Student discounts,
 Senior citizen rail card
 Peak travel/ off-peak travel
 Cheaper prices by the time of the day (e.g. happy hour’s in pubs
– usually earlier on in evening where demand is lower.

5.4 NEW CONCEPTS OF MANAGERIAL ECONOMICS

The following figure tells the primary ways in which Managerial
Economics correlates to managerial decision-making.
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Managerial Economics can be defined as amalgamation of economic

theory with business practices so as to ease decision-making and future
planning by management. Managerial Economics assists the managers
of a firm in a rational solution of obstacles faced in the firm’s 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 firm’s 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.
Study of Managerial Economics helps in enhancement of analytical
skills, assists in rational configuration as well as solution of problems.
While microeconomics is the study of decisions made regarding the
allocation of resources and prices of goods and services,
macroeconomics is the field of economics that studies the behavior of
the economy as a whole (i.e. entire industries and economies).

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Managerial Economics applies micro-economic tools to make business

decisions. It deals with a firm.
The use of Managerial Economics is not limited to profit-making firms
and organizations. But it can also be used to help in decision-making
process of non-profit organizations (hospitals, educational institutions,
etc). It enables optimum utilization of scarce resources in such
organizations as well as helps in achieving the goals in most efficient
manner. Managerial Economics is of great help in price analysis,
production analysis, capital budgeting, risk analysis and determination
of demand.
Managerial economics uses both Economic theory as well
as Econometrics for rational managerial decision making. Econometrics
is defined as use of statistical tools for assessing economic theories by
empirically measuring relationship between economic variables. It uses
factual data for solution of economic problems. Managerial Economics
is associated with the economic theory which constitutes “Theory of
Firm”. Theory of firm states that the primary aim of the firm is to
maximize wealth. Decision making in managerial economics generally
involves establishment of firm’s objectives, identification of problems
involved in achievement of those objectives, development of various
alternative solutions, and selection of best alternative and finally
implementation of the decision.
Review questions:

1. What do you meant by national income

2. What are the concepts of national income
3. What are the methods of measuring national income
4. What do you meant by business environment
5. Define capital budgeting. Explain its methods
6. What are the new concepts of managerial economics

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REFERENCE:
1. Managerial Economics – Dr. Mukund Mahajan, Nirali Prakashan
2. Managerial Economics - Mote, Paul and Gupta, Nirali Prakashan
3. Managerial Economics - Varshney and Maheshwari
4. A study of Managerial Economics - D.Gopalkrishna
5. Managerial Economics - Gupta
6. Managerial Economics, 4th Ed. - Craig Peterson, Pearson
Education10. Managerial Economics, DM Mithani,
7. Himalaya
8. Economics For Managers , Hirschey – Thomson
9. https://www.tutorialspoint.com/managerial_economics/manage
rial_economics_overview.htm
10. http://www.managementstudyguide.com/managerial-
economics.htm
11. http://catalog.flatworldknowledge.com/bookhub/reader/5572
12. http://economydetail.blogspot.in/2010/02/concepts-of-national-
income.html
13. http://www.docsity.com/en/news/economics/demand-analysis-
definition-meaning/

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