NATIONAL OPEN UNIVERSITY OF NIGERIA

COURSE CODE : BHM 303

COURSE TITLE: MANAGERIAL ECONOMICS

MANAGERIAL ECONOMICS
(THE COURSE GUIDE) THE NEED Managerial Economics as a course required for effective resource management was put in place due to the following developments in the global business environment: (a) Growing complexity of business decision ma!ing processes" (b) #ncreasing need for the use of economic logic$ concept$ theories$ and tools of economic analysis in the process of decision ma!ing" (c) %apid increases in the demand for professionally trained managerial manpower" &hese developments have made it necessary that every manager aspiring for good leadership and achievement of organi'ational ob(ectives be equipped with relevant economic principles and applications" )nfortunately$ a gap has been observed in this respect among today*s managers" #t is therefore the aim of this course to bridge such gap" THE COURSE OBJECTIVES +n completion of the requirements of this course$ students and managers ali!e will be expected to: 1" )nderstand the relative importance of Managerial Economics, -" .now how the application of the principles of managerial economics can aid in the achievement of business ob(ectives, /" )nderstand the modern managerial decision rules and optimi'ation techniques, 0" 1e equipped with tools necessary in the analysis of consumer behaviours$ as well as in forecasting product demand, 2" 1e equipped with the tools for analy'ing production and costs, 3" )nderstand and be able to apply latest pricing strategies, THE COURSE STRUCTURE &his course will be presented in modules$ each of which is designed to achieve specific managerial ob(ectives" #n a nutshell the course contents are as follows:

MODULE 1: Basic Principles in the Application of Mana erial Econo!ics 1.1 Int !"#$t%!n (a) 4efinition of Managerial Economics (b) Economic 5nalysis and 1usiness 4ecisions (c) 6cope of Managerial Economics (d) Managerial Economics and Gap between &heory and 7ractice (e) 1.& O'()$t%*)+ !, - B#+%n)++ F% . 1" Meaning and &heories of 7rofit -" 7rofit maximi'ation as a 1usiness +b(ective /" 6ales$ Growth %ate$ and Maximisation of )tility function as business ob(ectives 0" 8ong %un 6urvival$ Mar!et 6hares$ and Entry 7revention 1.3 C!n+t -%n)" O/t%.%+-t%!n (a) &he 6ubstitution Method (b) 8agrangian Multiplier Method MODULE ": Decision Anal#sis &.1 Int !"#$t%!n &.& D)$%+%!n An-01+%+ 1" 9ertainty and )ncertainty in 4ecision 5nalysis -" 5nalysis of the 4ecision 7roblem /" Expected Monetary :alue 4ecision 0" 4ecision Ma!ing #nvolving 6ample #nformation 2" &ime 7erspective in 1usiness 4ecisions MODULE 3: An-01+%+ !, M- 2)t D).-n"3 D).-n" F#n$t%!n+3 D).-n" An-01+%+ -n" D).-n" F! )$-+t%n4 3.1 Int !"#$t%!n 3.& An-01+%+ !, M- 2)t D).-n" 1" 4efinition of Mar!et 4emand -" &ypes of 4emand /" 4eterminants of Mar!et 4emand
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3.3 D).-n" F#n$t%!n+ 1" 8inear 4emand ;unction -" <on 8inear 4emand ;unction /" Multi :ariate or 4ynamic 4emand ;unction 3.5 E0-+t%$%t1 !, D).-n" (a) +wn 7rice Elasticity (b) 9ross Elasticity (c) #ncome Elasticity (d) 5dvertisement Elasticity (e) Elasticity of 7rice Expectation 3.6 D).-n" F! )$-+t%n4 1" &he ;orecasting &echniques MODULE $: Pro%&ction an% Cost Anal#sis 5.1 Int !"#$t%!n 5.& T7) T7)! 1 !, P !"#$t%!n -" &he 7roduction ;unction /" +ptimal #nput 9ombinations 0" #nput 7rice 9hanges and the +ptimal 9ombinations 5.3 T7)! 1 !, C!+t -n" B )-28E*)n An-01+%+ 1" &he 1usiness 9ost 9oncepts -" &he &heory of 9ost: 9ost +utput %elations /" Economies and 4iseconomies of 6cale 0" 1rea! Even 5nalysis: 8inear 9ost and %evenue ;unctions 2" 1rea! Even 5nalysis: <on 8inear 9ost and %evenue ;unctions = MODULE ': Mar(et Str&ct&re an% Pricin Decisions 6.1 Int !"#$t%!n 6.& P %$) D)t) .%n-t%!n Un") P) ,)$t C!./)t%t%!n (a) 7ricing in Mar!et 7eriod (b) 7ricing in the 6hort %un (c) 7ricing in the 8ong %un

6.3 P %$) D)t) .%n-t%!n Un") P# ) M!n!/!01 1" Monopoly 7ricing and +utput 4ecision in the 6hort %un -" Monopoly 7ricing and +utput 4ecision in the 8ong %un

RE9UIRED TE:T 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) Si*th E%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)

Dr On#e!aechi On+e

MANAGERIAL ECONOMICS UNIT 1: AND IMPORTANCE OF MANAGERIAL ECONOMICS C!nt)nt 1"> #ntroduction -"> +b(ectives /"> 4efinition and #mportance of Managerial Economics /"1 4efinition of Managerial Economics /"- #mportance of Managerial Economics /"/ 6cope of Managerial Economics /"0 Managerial Economics and Gap between &heory and 7ractice /"2 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &he discovery of managerial economics as a separate course in management studies has been attributed to three ma(or factors: /" &he growing complexity of business decision ma!ing processes$ because of changing mar!et conditions and the globali'ation of business transactions" 0" &he increasing use of economic logic$ concepts$ theories$ and tools of economic analysis in business decision ma!ing processes" 2" %apid increase in demand for professionally trained managerial manpower" #t should be noted that the recent complexities associated with business decisions has increased the need for application of economic concepts$ theories and tools of economic analysis in business decisions" &he reason has been that ma!ing appropriate business decision requires clear understanding of existing mar!et conditions mar!et fundamentals and the business environment in general" 1usiness decision ma!ing processes therefore$ requires intensive and extensive analysis of the mar!et conditions in the product$ input and financial mar!ets" Economic theories$ logic and tools of analysis have been developed for the analysis and prediction of mar!et behaviours" &he application of economic concepts$ theories$ logic$ and analytical tools in the assessment and prediction of mar!et conditions and business environment has proved to be a significant help to business decision ma!ers all over the globe" &.0 O'()$t%*)+ 5t the end of this unit$ you will be expected to: 1" an understanding of the meaning and importance of managerial economics -" the relevant phases in business decision ma!ing processes

/" familiar with the scope of Managerial Economics 0" 1e able to discuss freely how managerial economics can fill the gap between theory and practice 3.0 -n" I./! t-n$) !, M-n-4) %-0 E$!n!.%$+ 3.1 D),%n%t%!n !, M-n-4) %-0 E$!n!.%$+ Managerial economics has been generally defined as the study of economic theories$ logic and tools of economic analysis$ used in the process of business decision ma!ing" #t involves the understanding and use of economic theories and techniques of economic analysis in analy'ing and solving business problems" Economic principles contribute significantly towards the performance of managerial duties as well as responsibilities" Managers with some wor!ing !nowledge of economics can perform their functions more effectively and efficiently than those without such !nowledge" &a!ing appropriate business decisions requires a good understanding of the technical and environmental conditions under which business decisions are ta!en" 5pplication of economic theories and logic to explain and analyse these technical conditions and business environment can contribute significantly to the rational decision ma!ing process" 3.& I./! t-n$) !, M-n-4) %-0 E$!n!.%$+ #n a nutshell$ three ma(or contributions of economic theory to business economics have been enumerated: 1" -" /" B&il%in of anal#tical !o%els that help to recogni'e the structure of managerial problems$ eliminate the minor details that can obstruct decision ma!ing$ and help to concentrate on the main problem area" Ma(in a,aila-le a set of anal#tical !etho%s for business analyses thereby$ enhancing the analytical capabilities of the business analyst" Clarification of the ,ario&s concepts &se% in -&siness anal#sis) enabling the managers avoid conceptual pitfalls"

3.&.1 E$!n!.%$ An-01+%+ -n" B#+%n)++ D)$%+%!n+ 1usiness decision ma!ing basically involves the selection of best out of alternative opportunities open to the business organi'ation" 4ecision ma!ing processes involve four main phases$ including: Phase One: 4etermining and defining the ob(ective to be achieved" Phase .+o: 9ollection and analysis of information on economic$ social$

political$ and technological environment" 7hase &hree: #nventing$ developing and analy'ing possible course of action 7hase ;our: 6electing a particular course of action from available alternatives" <ote that phases two and three are the most crucial in business decision ma!ing" &hey put the manager*s analytical ability to test and help in determining the appropriateness and validity of decisions in the modern business environment" 7ersonal intelligence$ experience$ intuition and business acumen of the manager need to be supplemented with quantitative analysis of business data on mar!et conditions and business environment" #t is in fact$ in this area of decision ma!ing that economic theories and tools of economic analysis ma!e the greatest contribution in business" #f for instance$ a business firm plans to launch a new product for which close substitutes are available in the mar!et$ one method of deciding whether or not this product should be launched is to obtain the services of a business consultant" &he other method would be for the decision ma!er or manager to decide" #n doing this$ the manager would need to investigate and analyse the following thoroughly: (a) production related issues, and$ (b) sales prospects and problems" Aith regards to production$ the manager will be required to collect and analyse information or data on: (c) (d) (e) (f) (g) (h) available production techniques, cost of production associated with each production technique, supply position of inputs required for the production process, input prices, production costs of the competitive products, and$ availability of foreign exchange$ if inputs are to be imported"

%egarding the sales prospects and problems$ the manager will be required to collect and analyse data on: (a) general mar!et trends, (b) the industrial business trends, (c) ma(or existing and potential competitors$ as well as their respective mar!et shares, (d) prices of the competing products, (e) pricing strategies of the prospective competitors, (f) mar!et structure and the degree of competition, and$ (g) the supply position of complementary goods" &he application of economic theories in solving business problems helps in facilitating decision ma!ing in the following ways:

/irst) it can give clear understanding of the various necessary economic concepts$ including demand$ supply$ cost$ price$ and the li!e that are used in business analysis" Secon%) it can help in ascertaining the relevant variables and specifying the relevant data" ;or example$ in deciding what variables need to be considered in estimating the demand for two different sources of energy$ petrol and electricity" .hir%) it provides consistency to business analysis and helps in arriving at right conclusions" 3.3 S$!/) !, M-n-4) %-0 E$!n!.%$+ Managerial economics comprises both micro and macro economic theories" Generally$ the scope of managerial economics extends to those economic concepts$ theories$ and tools of analysis used in analysing the business environment$ and to find solutions to practical business problems" #n broad terms$ managerial economics is applied economics" &he areas of business issues to which economic theories can be directly applied is divided into two broad categories: 1" +perational or internal issues, and$ -" Environment or external issues" Operational pro-le!s are of internal nature" &hese problems include all those problems which arise within the business organi'ation and fall within the control of management" 6ome of the basic internal issues include: (f) choice of business and the nature of product (what to produce), (g) choice of si'e of the firm (how much to produce), (h) choice of technology (choosing the factor combination), (i) choice of price (product pricing), (() how to promote sales, (!) how to face price competition, (l) how to decide on new investments, (m) how to manage profit and capital, and$ (n) how to manage inventory" &he microeconomic theories dealing with most of these internal issues include$ among others: 0" &he theor# of %e!an%) which explains the consumer behaviour in terms of decisions on whether or not to buy a commodity and the quantity to be purchased" 2" .heor# of Pro%&ction an% pro%&ction %ecisions0 &he theory of production or theory of the firm explains the relationship between inputs and output" 3" Anal#sis of Mar(et str&ct&re an% Pricin theor#0 7rice theory explains how prices are determined under different mar!et conditions" @" Profit anal#sis an% profit !ana e!ent0 7rofit ma!ing is the most common business ob(ective" ?owever$ ma!ing a satisfactory profit is not always

guaranteed due to business uncertainties" 7rofit theory guides firms in the measurement and management of profits$ in ma!ing allowances for the ris! premium$ in calculating the pure return on capital and pure profit$ and for future profit planning" B" &heory of capital and investment decisions" 9apital is the foundation of any business" #t efficient allocation and management is one of the most important tas!s of the managers$ as well as the determinant of the firm*s success level" 6ome of the important issues related to capital include: choice of investment pro(ect, assessing the efficiency of capital, and$ the most efficient allocation of capital" En,iron!ental iss&es are issues related to the general business environment" &hese are issues related to the overall economic$ social$ and political atmosphere of the country in which the business is situated" &he factors constituting econo!ic en,iron!ent of a country include: 1" &he existing economic system -" General trends in production$ income$ employment$ prices$ savings and investment$ and so on" /" 6tructure of the financial institutions" 0" Magnitude of and trends in foreign trade" 2" &rends in labour and capital mar!ets" 3" Government*s economic policies" @" 6ocial organi'ations$ such as trade unions$ consumers* cooperatives$ and producer unions" B" &he political environment" C" &he degree of openness of the economy" Managerial economics is particularly concerned with those economic factors that form the business climate" #n macroeconomic terms$ managerial economics focus on business cycles$ economic growth$ and content and logic of some relevant government activities and policies which form the business environment" 3.5 M-n-4) %-0 E$!n!.%$+ -n" G-/ ')t;))n T7)! 1 -n" P -$t%$) .he Gap -et+een .heor# an% Practice #t is a general !nowledge that there exists a gap between theory and practice in the world of economic thin!ing and behaviour" 1y implication$ a theory which appears logically sound might not be directly applicable in practice" &a!e for instance$ when there are economies of scale$ it seems theoretically sound that when inputs are doubled$ output will be more or less doubled$ and when inputs are tripled$ output would be more or less tripled" &his theoretical conclusion may not hold in practice" Economic theories are highly simplistic because they are propounded on the basis of economic models based on simplifying assumptions" &hrough economic models$

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economists create a simplified world with its restrictive boundaries from which they derive their conclusions" 5lthough economic models are said to be an extraction from the real world$ the closeness of this extraction depends on how realistic the assumptions of the model are" #t is a general belief that assumptions of economic models are unrealistic in most cases" &he most common assumption of the economic models$ as you may recall$ is the ceteris paribus assumptions (that is all other things being constant or equal)" &his assumption has been alleged to be the most unrealistic assumption" &hough economic theories are$ no doubt$ hypothetical in nature$ in their abstract form however$ they do loo! divorced from reality" 5bstract economic theories cannot be simply applied to real life situations" &his however$ does not mean that economic models and theories do not serve useful purposes" Microeconomic theory$ for example$ facilitates the understanding of what would be a complicated confusion of billions of facts by constructing simplified models of behaviour that are sufficiently similar to the actual phenomenon to be of help in understanding them" #t cannot$ nevertheless$ be denied the fact that there is a gap between economic theory and practice" &he gap arises from the fact that there exists a gap between the abstract world of economic models and the real world" #t suffices to say that although economic theories do not directly offer custom made solutions to business problems$ they provide a framewor! for logical economic thin!ing and analysis" &he need for such a framewor! arises because the real economic world is too complex to permit consideration of every bit of economic facts that influence economic decisions" Economic analysis presents the business decision ma!ers with a road map, it guides them to their destinations$ and does not ta!e them to their destinations" Managerial economics can the gap between theory real world business decisions" &he managerial economic logic and tools of analysis guide business decision ma!ers in: 1" identifying their problems in the achievement -" collecting the relevant data and related facts, /" processing and analysing the facts, 0" drawing the relevant conclusions, 2" determining and evaluating the alternative means of achieving the goal, and$ 3" ta!ing a decision" Aithout the application of economic logic and tools of analysis$ business decisions may li!ely be irrational and arbitrary" #rrationality is highly counter productive" 3.6 S)0,8A++)++.)nt E<) $%+) 4iscuss the important phases of business decision ma!ing processes

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5.0 C!n$0#+%!n &his unit has been able to expose you to what managerial economics is all about and why it is necessary to have it for effective business decisions" Managerial Economics comprises both micro and macro economic theories" #ts scope extends to those economic concepts$ theories$ and tools of analysis used in the analysis of business environment$ and to find solutions to practical business problems" 6.0 S#..- 1 &o put some light to the understanding and appreciation of managerial economics as a tool of business analysis$ the unit focused on the following issues: 1" Economic analysis and business decisions$ where it was pointed out that business decision ma!ing basically involves the selection of best out of alternative opportunities open to the business enterprise" -" 6cope of Managerial Economics$ where we learned that the scope of managerial economics extends to some economic concepts and tools used in analysing the business environment in order to see! for solutions to practical business problems" /" Managerial Economics and the gap between theory and practice$ where it was pointed out that there exists a gap between theory and practice in the world of economic thin!ing and behaviour" Managerial economics can bridge this gap through logic and tools of analysis that guide business decision ma!ers" =.0 T#t! 8M- 2)" A++%4n.)nt Ahy is the understanding of the principles of Managerial Economics necessary for a business managerD >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

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UNIT &: MEANING AND THEORIES OF PROFIT C!nt)nt 1"> #ntroduction -"> +b(ectives /"> &he &heory of 7rofit /"1 &heories of 7rofit /"- Monopoly 7rofit /"/ 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &he term profit means different things to different people" 1usinesspeople$ accountants$ tax collectors$ employees$ and economists have their individual meaning of profit" #n its general sense$ profit is regarded as income accruing to equity holders$ in the same sense as wages accrue to the wor!ers, rent accrues to owners of rentable assets, and$ interest accrues to the money lenders" &o the accountant$ Eprofit* means the excess of revenue over all paid out costs$ such as manufacturing and overhead expenses" #t is more li!e what is referred to a Enet profit*" ;or practical purposes profit or business income refers to profit in accounting sense" Economist*s concept of profit is the pure profit or Eeconomic profit*" Economic profit is a return over and above the opportunity cost, that is$ the income expected from the second alternative investment or use of business resources" this unit$ emphasis will be placed on the various concepts of profit" &.0 O'()$t%*)+ 1y the time you must have gone through this unit$ you will be able to: 1" 4efine profit and differentiate between 5ccounting profit and pure Economic profit" -" familiar with the different theories of profit" /" what is meant by monopoly profit" 3.0 T7) T7)! %)+ !, P !,%t 1efore exposing you to the theories of profit$ it will be helpful for you to distinguish between two often misunderstood profit concepts: the 5ccounting profit and the Economic profit" .he Acco&ntin Profit 5ccounting profit may be defined as follows: 5ccounting 7rofit F a F &% G (w H r H # H m)

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where &% F &otal %evenue, w F wages and salaries, r F rent, i F interest, and m F cost of materials" Iou can observe that when calculating accounting profit$ it is only the explicit or boo! costs that are considered and subtracted from the total revenue (&%)"

.he Econo!ic or P&re Profit )nli!e accounting profit$ economic profit ta!es into account both the explicit costs and implicit or imputed costs" &he implicit or opportunity cost can be defined as the payment that would be necessary to draw forth the factors of production from their most remunerative alternative use or employment" Opportunity cost is the income is the income foregone which the business could expect from the second best alternative use of resources" &he foregone incomes referred to here include interest$ salary$ and rent$ often called transfer costs0 Economic profit also ma!es provision for (a) insurable ris!s$ (b) depreciation$ (c) necessary minimum payment to shareholders to prevent them from withdrawing their capital investments" Economic profit may therefore be defined as Eresidual left after all contractual costs$ including the transfer costs of management$ insurable ris!s$ depreciation$ and payments to shareholders have been met" &hus$ Economic or 7ure 7rofit F e F &% G E9 G #9 where E9 F Explicit 9osts, and$ #9 F #mplicit 9osts" <ote that economic profit as defined by the above equation may necessarily not be positive" #t may be negative since it may be difficult to decide beforehand the best way of using the business resources" 7ure profit is a short term phenomenon" #t does not exist in the long run under perfectly competitive conditions" 3.1 T7)! %)+ !, P !,%t &he unsettled controversy on the sources of profit has led to the emergence of various theories of profit in economics" &he following discussions summarise the main theories" 3.1.1 ?-02) @+ T7)! 1 !, P !,%t: P !,%t -+ R)nt !, A'%0%t1 +ne of the widely !nown theories of profit was stated by ;" 5" Aal!er who theorised Eprofit* as the rent of Jexceptional abilities that an entrepreneur may possessK over others" ?e believes that profit is the difference between the earnings of the least and the most efficient entrepreneurs" Aal!er assumes a state of perfect competition$ in which all firms are presumed equal managerial ability" #n Aal!er*s view$ under perfectly competitive

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conditions$ there would be no pure or economic profit and all firms would earn only marginal wages$ which is popularly !nown in economics as 1nor!al profit10 3.1.& C0- 2@+ D1n-.%$ T7)! 1 &he L" 1" 9lar!*s theory is of the opinion that profits arise in a dynamic economy$ not in a static economy" 5 static economy is defined as the one in which there is absolute freedom of competition, population and capital are stationary, production process remains unchanged over time, goods continue to remain homogeneous, there is freedom of factor mobility, there is no uncertainty and no ris!, and if ris! exists$ it is insurable" #n a static economy therefore$ firms ma!e only the Enormal profit* or the wages of management" 5 dynamic economy on the other hand$ is characteri'ed by the following generic changes: (i) population increases, (ii) increase in capital, (iii) improvement in production technique, (iv) changes in the forms of business organi'ations, and$ (v) multiplication of consumer wants" &he ma(or functions of entrepreneurs or managers in a dynamic environment are in ta!ing advantage of the generic changes and promoting their businesses$ expanding sales$ and reducing costs" &he entrepreneurs who successfully ta!e advantage of changing conditions in a dynamic economy ma!e pure profit" ;rom 9lar!*s point of view$ pure profit exist only in the short run" #n the long run$ competition forces other firms to imitate changes made by the leading firms$ leading to a rise in demand for factors of production" 9onsequently$ production rise$ thus reducing profits$ especially when revenue remains unchanged" 3.1.3 H-;0)1@+ R%+2 T7)! 1 !, P !,%t &he ris! theory of profit was initiated by ;" 1" ?awley in 1BC/" 5ccording to ?awley$ ris! in business may arise due to such reasons as obsolescence of a product$ sudden fall in the mar!et prices$ non availability of crucial raw materials$ introduction of better substitutes by competitors$ ris! due to fire$ war and the li!e" %is! ta!ing is regarded as an inevitable accompaniment of dynamic production$ and those who ta!e ris! have a sound claim of a separate reward$ referred to as Eprofit*" ?awley simply refers to profit as the price paid by society for assuming business ris!" ?e suggests that businesspeople would not assume ris! without expecting adequate compensation in excess of actuarial value$ that is$ premium on calculable ris!" 3.1.5 An%47t@+ T7)! 1 !, P !,%t ;ran! .night treated profit as a residual return to uncertainty bearing$ not to ris! bearing as in the case of ?awley*s" .night divided ris! into calculable and non calculable ris!s" 9alculable ris!s are those ris!s whose probability of occurrence can be statistically estimated on the basis of available data" Examples of these types of ris!s are ris!s due to

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fire$ theft$ accidents$ and the li!e" 9alculable ris!s are insurable" &hose areas of ris! in which the probability of its occurrence is non calculable$ such as certain elements of production cost that cannot be accurately calculated$ are not insurable" 3.1.6 S$7#./)t) @+ Inn!*-t%!n T7)! 1 !, P !,%t &he innovation theory of profit was developed by Loseph 5" 6chumpeter" 6chumpeter was of the opinion that factors such as emergence of interest and profits$ recurrence of trade cycles are only incidental to a distinct process of economic development, and certain principles which could explain the process of economic development would also explain these economic variables or factors" 6chumpeter*s theory of profit is thus embedded in his theory of economic growth" #n his explanation of the process of economic growth$ 6chumpeter began with the state of stationary equilibrium$ characterised by equilibrium in all spheres" )nder conditions of stationary equilibrium$ total receipts from the business are exactly equal to the total cost outlay$ and there is no profit" 5ccording to the 6chumpeter*s theory$ profit can be made only by introducing innovations in manufacturing technique$ as well as in the methods of supplying the goods" of innovation include: 1" #ntroduction of new commodity or a better quality good, -" #ntroduction of new method of production, /" +pening of a new mar!et, 0" 4iscovery of new sources of raw material, and$ 2" +rganising the industry in an innovative manner with the new techniques" 3.& M!n!/!01 P !,%t +bserve that the profit theories presented above were propounded in the bac!ground of the existence of perfect competition" 1ut as conceived in the theoretical models$ perfect competition is either non existent or is a rare phenomenon" 5n extreme opposite of perfect competition is the existence of monopoly in the mar!et" &he term monopoly characterises a mar!et situation in which there is a single seller of a commodity that does not have close substitutes" Monopoly arises due to such factors as: (i) economies of scale, (ii) sole ownership, (iii) legal sanction and protection, and$ (iv) mergers and acquisition" 5 monopolist can earn pure or Emonopoly* profit and maintain it in the long run by using its monopoly powers$ including: (i) powers to control price and supply, (ii) powers to prevent entry of competitors by price cutting, and$ (iii) monopoly power in certain input mar!ets"

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3.3 S)0,8A++)++.)nt E<) $%+) 4iscuss the basic difference between accounting profit and economic profit" #n your personal opinion$ which of the different theories of profit you learned from this unit do you thin! is more businessli!e and whyD 5.0 C!n$0#+%!n &his unit has presented another important aspect in the understanding and application of managerial economics: the meaning and theories of profit" &hough it was observed that profit means different things to different people$ you should bear in mind that$ for practical purposes$ profit or business income refers to profit in accounting sense" &he Economist*s concept of profit is the pure profit defined as a return over and above the opportunity cost" &here are several important theories of profit among which are: the Aal!er*s theory, the 9lar!*s dynamic theory, ?awley*s theory, .night*s theory, and$ the 6chumpeter*s #nnovation theory" 6.0 S#..- 1 &his unit serves as an important bac!ground to the study of managerial economics" #t has presented the basic definitions of profit$ both in business accounting and economic terms" #n accounting terms$ profit has been defined simply as the difference between revenue from sales and explicit or out of poc!et costs" #n economic terms$ profit was defined as the return over and above the opportunity costs$ that is$ the income expected from the second alternative investment or use of business resources" Economic profit ma!es provision for insurable ris!s$ depreciation$ necessary minimum payment to shareholders to prevent them from withdrawing their capital investments" #t is also defined as Ethe residual left after all contractual costs$ including transfer costs of management$ insurable ris!s$ depreciation$ and payments to shareholders have been met" &he discussions on the theory of profits have exposed you to the different important theories of profit$ including: the Aal!er*s theory which refers to profit as rent of ability, the 9lar!*s dynamic theory which assumes that profits arise in a dynamic economy$ not in a static economy, the ?awley*s ris! theory$ which refers to profit as the price paid by society for assuming business ris!, the .night*s theory which loo!s at profit as a residual return to uncertainty bearing$ not to ris! bearing as in ?awley*s theory, and$ 6chumpeter*s innovation theory$ which is embedded in his theory of economic growth" 6chumpeter believes that profit can only be made by introducing innovations in manufacturing techniques$ as well as in the methods of supplying the goods produced" =.0 T#t! 8M- 2)" A++%4n.)nt Enumerate the ma(or areas of business decision ma!ing in business" +utline the reason it might be important to distinguish between accounting profit and economic or pure profit" >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

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UNIT 3: PROFIT MA:IMISATION AS A BUSINESS OBJECTIVE C!nt)nt 1"> #ntroduction -"> +b(ectives /"> 7rofit Maximisation +b(ective /"1 &he 7rofit Maximising 9onditions /"- 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &he conventional economic theory assumes that profit maximisation is the only ob(ective of business firms" 7rofit maximisation forms the basis of conventional price theory" #t is the most reasonable$ analytical$ and Eproductive* business ob(ective" &his unit begins by familiari'ing you with the necessary and sufficient conditions for profit maximisation$ followed by in depth presentations and business examples" &.0 O'()$t%*)+ 5t the end of this unit$ you will be expected to: 1" the reason a firm sets its ob(ective to be that of profit maximisation -" the necessary and sufficient conditions for profit maximisation" /" problems involving profit maximisation" 3.0 M-<%.%+-t%!n O'()$t%*) 7rofit maximisation ob(ective helps in predicting the behaviour of business firms in the real world$ as well as in predicting the behaviour of price and output under different mar!et conditions" &here are some theoretical profit maximising conditions that we must have in our finger tips" are presented below: 3.1 T7) P !,%t8M-<%.%+%n4 C!n"%t%!n+ Ae first define profit as: F &% G &9$ (/"1"1) where &% F &otal %evenue F )nit price (7) x Muantity (M) F 7M$ and$ &9 F &otal cost F :ariable 9ost (:9) H ;ixed 9ost (;9)" &here are two ma(or conditions that must be fulfilled for equation (/"1"1) to be a maximum profit: (i) the first order (or necessary) condition$ and (ii) the second order (or supplementary) condition" &he first2or%er con%ition requires that at a maximum profit$ marginal revenue (M%) must equal marginal 9ost (M9)" <ote that by the term Emarginal revenue*$ we mean the

1B

revenue obtained from the production and sale of one additional unit of output$ while Emarginal cost* is the cost arising from the production of the one additional unit of output" &he secon%2or%er con%ition requires that the first order condition must be satisfied under the condition of decreasing marginal revenue (M%) and increasing marginal cost (M9)" ;ulfillment of this two conditions ma!es the second order condition the sufficient condition for profit maximi'ations" &he first and second order conditions can be illustrated as in figure /"1 below: F%4# ) 3.1: M- 4%n-0 C!n"%t%!n+ !, P !,%t M-<%.%+-t%!n M9 M% 71 7M% M9 +utput (M) M1 M5s you can see in figure /"1$ the first order condition is satisfied at points 71 and 7-$ where M% F M9" the second order condition is satisfied only at point 7-$ where technically$ the second derivative of the profit function is negative" 1y implication$ at this point$ the total profit curve has turned downward after having reached its pea!" #n technical terms$ the profit maximising conditions can be formulated as follows: Given profit (N) F &% G &9 to be maximi'ed$ let: &% F f(M) and$ &9 F f(M) where M F quantity produced and sold" &hen F ;(M) f(M)&% G f(M)&9 (/"1"-)

&he first order condition requires that the first derivative of equation (/"1"-) should be 'ero$ so that: d F d&% G d&9 F > dM dM dM Iou can observe that this condition holds only when: d&% F d&9 dM dM or (/"1"/)

1C

M% F M9" &o get the second order condition$ we ta!e the second derivative of the profit function to get: d- F d-&% G d-&9 dM- dM- dM(/"1"0)

&he second order condition requires that equation (/"1"0) is negative$ so that: d-&% d-&9 O > dM- dMor d-&% O d-&9 dMdMEquation (/"1"2) may also be written as: 6lope of M% O 6lope of M9$ since the left hand side of equation (/"1"2) represents the slope of M% and the right hand side represents the slope of M9" &his implies that at the optimum point of profit maximisation$ marginal cost (M9) must intersect the marginal revenue (M%) from below" Ae conclude that maximum profit occurs where the first and second order conditions are satisfied" E<-./0) 6uppose that the unit price of a commodity is defined by: 7 F 1>> G -M (/"1"3) &hen$ &% F 7M F (1>> G -M) M (/"1"@) F 1>>M G -M6uppose also that the total cost of producing this commodity is defined by the cost function: &9 F 1>> H >"2M(/"1"B) Iou are required to apply the first order condition for profit maximisation and determine the profit maximising level of output" 5ccording to the first order condition$ profit is maximi'ed where: M% F M9$ (/"1"2)

->

+r d&% F d&9 dM dM Given equations (/"1"@) and (/"1"B)$ we get: M% F d&% F 1>> G 0M dM M9 F d&9 F 1M F M dM #t follows that profit is maximi'ed where: M% F M9 +r 1>> G 0M F M 6olving for M in equation (/"1"11)$ we get: 1>> F 2M 2M F 1>> M F 1>>P2 F ->" &he output level of -> units satisfies the first order condition" 8et us see if it satisfies the second order condition" %ecall that the second order condition requires that: d-&% G d-&9 O > dM- dMor dM% G dM9 O > dM dM or d(1>> G 0M) G d(M) O > dM dM 0 1F 2O> (/"1"11) (/"1"C) (/"1"1>)

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&hus the second order condition is also satisfied at the output level of -> units" therefore conclude that the profit maximising level of output in this problem is -> units" &o determine the maximum profit$ you will substitute -> for M in the original profit function" &hus$ the maximum profit will be: &% G &9 F 1>>M G -M- G (1> H >"2M-) F 1>>M G -"2M- G 1> F 1>>(->) G -"2(->)- G 1> F ->>> G 1>>> G 1> F CC>" Ae conclude that the maximum profit is <CC> only" 3.& S)0,8A++)++.)nt E<) $%+) Examine critically profit maximisation as the ob(ective of business firms and discuss the alternative ob(ectives of business firms" 5.0 C!n$0#+%!n 7rofit maximisation has been the prime ob(ective of classical business organi'ations" &o maximise profit$ certain conditions must be met$ the first being that at optimum profit maximising point$ the firm*s marginal revenue must equal marginal cost" 6econd$ to ensure that maximum profit is attained$ the second derivative of the profit function is expected to be less than 'ero" 6.0 S#..- 1 &his unit informs you that profit maximisation ob(ective helps in predicting the behaviour of business firms in the real world$ as well as in predicting the behaviour of price and output under different mar!et conditions" the discussions$ you noted that profit can basically be defined as the difference between revenue and costs" maximi'e profit$ marginal revenue is equated with marginal cost" Ae refer to this as the first order condition" &he second order condition requires that the first order condition must be satisfied under the condition of decreasing marginal revenue (M%) and increasing marginal cost (M9)" =.0 T#t! 8M- 2)" A++%4n.)nt 5ssuming the unit price of a commodity is defined by: 7 F C> G -q$ and the cost function is given as: 9 F 1> H >"2 q-$ 1" 4etermine the profit maximising level of output and the unit price"

--

-"4etermine the cost minimising level of output >.0 R),) )n$)+ 1" 4wivedi$ <" (->>-) Mana erial Econo!ics) si*th e%ition 4elhi: :i!as 7ublishing ?ouse 8td)" -" E" ;" and 7aul$ %" 6" (1C@3)$ Intro%&ctor# Mathe!atical Anal#sis for St&%ents of B&siness an% Econo!ics) "n% e%ition (%eston :irginia: %eston 7ublishing 9ompany)

UNIT 5: OTHER BUSINESS OBJECTIVES

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C!nt)nt 1"> #ntroduction -"> +b(ectives /"> +ther %elevant 1usiness +b(ectives /"1 6ales$ Growth %ate$ and Maximisation of )tility ;unction as 1usiness +b(ectives /"- 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n 5part from profit maximisation$ as you all !now$ business firms have the following ob(ectives: 1" Maximisation of 6ales revenue -" Maximisation of the growth rate /" Maximisation of manager*s utility function 0" Ma!ing satisfactory rate of profit 2" 8ong run survival of the firm 3" Entry prevention and ris! avoidance" #n this unit$ we discuss these other business ob(ectives with the aim of acquainting you with the several reasons an entrepreneur will choose to be in business" &.0 O'()$t%*)+ ?aving gone through this unit$ you will be able to: 1" more informed on ob(ectives of a business organisation -" the techniques of maximising revenue$ output$ and minimising costs /" able to ma!e effective decisions for business expansion and growth" 3.0 R)0)*-nt B#+%n)++ O'()$t%*)+ 3.1 S-0)+3 G !;t7 R-t)3 -n" M-<%.%+-t%!n !, Ut%0%t1 F#n$t%!n -+ B#+%n)++ O'()$t%*)+ 3.1.1 S-0)+ R)*)n#) M-<%.%+-t%!n -+ B#+%n)++ O'()$t%*) #t was one famous economist$ A" L" 1aumol$ who introduced the hypothesis of 6ales %evenue maximisation as an alternative to the profit maximisation ob(ective" 1aumol*s reason for the introduction of this hypothesis is the usual dichotomy between business ownership and management$ especially in large corporations" &his dichotomy$ according to 1aumol$ gives managers some opportunity to set their personal goals other than profit maximisation goal which business owners pursue" the opportunity$ managers would want to maximise their own utility function" 5nd$ the most plausible factor in managers* utility functions is the maximisation of sales revenue" 1aumol lists the factors that explain the managers* pursuance of this goal as follows:

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/irst) salary and other monetary benefits of managers tend to be more closely related to sales revenue than to profits" Secon%) ban!s and other financial institutions loo! at sales revenue while financing business ventures" .hir%) trend in sales revenue is a readily available indicator of a firm*s performance" /o&rth) increasing sales revenue enhances manager*s prestige while profits go to the business owners" /ifth) managers find profit maximisation a difficult ob(ective to fulfill consistently over time and at the same level" 7rofits fluctuate with changing economic conditions" /inall#) growing sales tend to strengthen competitive spirit of the firm in the mar!et$ and vice versa. 3.1.2 Technique of Total Revenue Maximisation As noted earlier, total revenue (TR) can be defined by TR = PQ (3.1.1)

where P refers to unit rice and Q refers to !uantity sold. The o ti"isation roble" here is to find the value of Q that "a#i"ises total revenue. The rule for "a#i"isin$ total revenue is that total revenue will be "a#i"i%ed at the level of sales (Q) for which "ar$inal (&R) = '. (n other words, the revenue fro" the sale of the "ar$inal unit of the roduct "ust be e!ual to %ero at the oint of "a#i"u" revenue. The "ar$inal revenue (&R) is the first derivative of the total revenue (TR) function. )or e#a" le, we want to find the level of Q for which revenue will be "a#i"i%ed if the rice function is $iven by* P = +'' , +Q Then by e!uation (3.1.1), TR = PQ = (+'' , +Q)Q = +''Q , +Q&ar$inal revenue (&R) = dTR = +'' , 1'Q dQ (3.1.3) (3.1..) (3.1.-)

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/ettin$ e!uation (3.1..) e!ual to %ero accordin$ to the rule, we $et* +'' , 1'Q = ' solvin$ for Q in e!uation (3.1.+), we $et* +'' = 1'Q or, 1' Q = +'' Q = +'. This indicates that the revenue0"a#i"isin$ level of out ut is +' units. The "a#i"u" total revenue can be obtained by substitutin$ +' for Q in the total revenue function, TR = +''Q , +QThus, TR = +''(+') , +(+')= -+,''' , 1-,+'' = 11-,+''. 3.1.3 Technique of Output Maximisation: Minimisation of Average Cost The o ti"u" si%e of the fir" is the si%e "ini"ises the avera$e cost of roduction. This is also referred to as the "ost efficient si%e of the fir". 2nowled$e of the o ti"u" si%e of a fir" is very i" ortant for future lannin$ under three i" ortant conditions* First, a business erson lannin$ to set u a new roduction unit would li3e to 3now the o ti"u" si%e of the lant for future lannin$. This issue arises because, as the theory of roduction indicates, the avera$e cost of roduction in "ost roductive activities decreases to a certain level of out ut and then be$ins to increase. Second, the fir"s lannin$ to e# and their scale of roduction would li3e to 3now the "ost efficient level of the econo"ies of scale so that they can be able to lan the "ar3etin$ of the roduct accordin$ly. Third, business eo le wor3in$ under co" etitive business environ"ent are faced with a $iven "ar3et rice. Their rofit therefore, de ends on their ability to reduce their unit cost of roduction. And, $iven the technolo$y and in ut rices, (3.1.+)

-3

the ros ect of reducin$ unit cost of roduction de ends on the si%e of roduction. The roble" decision "a3ers face under this condition is how to find the o ti"u" level of out ut or the level of out ut that "ini"ises the avera$e cost of roduction. As i" lied earlier, under $eneral roduction conditions, the o ti"u" level of out ut is the one that "ini"ises the avera$e cost (A4), where the avera$e cost can be defined as the ratio between total cost (T4) and !uantity roduced (Q). Thus, A4 = T4 Q /u ose the total cost function of a fir" is $iven by* (3.1.7) (3.1.6)

T4 = 1'' 5 6'Q 5 .Qthen, A4 = T4 = 1'' 5 6'Q 5 .QQ Q

= 1'' 5 6' 5 .Q (3.1.8) Q The roble" here is to find the value of Q that "ini"ises the avera$e cost, as re resented in e!uation (3.1.8). The Minimisation Rule. 9i3e the "a#i"isation rule, the "ini"i%ation rule is that the derivative of the function to be "ini"ised "ust be e!ual to %ero. (t follows that the value the value of out ut (Q) that "ini"ises avera$e cost (A4) can be obtained by ta3in$ the first derivative of the A4 function and settin$ it e!ual to %ero and solvin$ for Q. Thus, in the current e#a" le, dA4 = d(1''Q01 5 6' 5 .Q) = 01'' 5 . dQ dQ Q/ettin$ e!uation (-.3.:) e!ual to %ero, we $et* 01'';Q- 5 . = ' 01'';Q- = 0. 0.Q- = 01'' Q- = 1'';. = -+ (3.1.:)

-@

Q = <-+ = + Thus, the level of out ut that "ini"ises avera$e cost is + units. 3.1.5 M-<%.%+-t%!n !, F% .@+ G !;t7 R-t) -+ -n A0t) n-t%*) O'()$t%*) 5ccording to %obin Marris$ managers attempt to maximise a firm*s balanced growth rate, sub(ect to managerial and financial constraints" Marris defines firm*s balanced growth rate (G) as: G F G4 F G9 (/"1"->)

where G4 and G9 are growth rate of demand for the firm*s product and growth rate of capital supply to the firm$ respectively" 6imply stated$ a firm*s growth rate is said to be balanced when demand for its product and supply of capital to the firm increase at the same rate" Marris translated these two growth rates into two utility functions: (i) manager*s utility function ()m)$ and (ii) business owner*s utility function ()o)$ where: )m F f(salary$ power$ (ob security$ prestige$ status)" )o F f(output$ capital$ mar!et share$ profit$ public esteem)" (/"1"-1) (/"1"--)

&he maximisation of business owner*s utility ()o) implies maximisation of demand for the firm*s product or growth of the supply of capital" 3.1.6 M-<%.%+-t%!n !, M-n-4) %-0 Ut%0%t1 F#n$t%!n -+ -n A0t) n-t%*) O'()$t%*) +" E" Ailliamson propounded the hypothesis of maximisation of managerial utility function" ?e argues that managers have the freedom to pursue ob(ectives other than profit maximisation" Managers see! to maximise their own utility function sub(ect to a minimum level of profit" 5ccording to Ailliamson$ manager*s utility function can be expressed as: ) F f(6$ M$ #4) where 6 F additional expenditure on staff M F managerial emoluments #4 F discretionary investments 5ccording to the hypothesis$ managers attempt to maximise their utility function sub(ect to a satisfactory profit" 5 minimum profit is necessary to satisfy the shareholders or else the manager*s (ob security will be at sta!e" 3.1.= L!n48 #n S# *%*-0 -n" M- 2)t8+7- ) -+ - B#+%n)++ O'()$t%*) (/"1"-/)

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." A" %othschild proposed the hypothesis of long run survival and mar!et share goals" 5ccording to the hypothesis$ the primary goal of the firm is long run survival" +ther economists suggest that attainment and retention of a constant mar!et share is an additional ob(ective of the firms" Managers therefore$ see! to secure their mar!et share and long run survival" &he firms may see! to maximise their long run profit$ which may not be certain" 3.1.> Ent 18/ )*)nt%!n -n" R%+28-*!%"-n$) -+ B#+%n)++ O'()$t%*) +ther alternative ob(ectives of business firms as suggested by economists are the prevention of entry of new firms and ris! avoidance" #t is argued that the motive behind entry prevention may be any or all of the followings: (a) profit maximisation in the long run, (b) securing a constant mar!et share, and$ (c) avoidance of ris! caused by unpredictable behaviour of new firms" &he advocates of profit maximisation as business ob(ective argue$ however$ that only profit maximising firms can survive in the long run" can achieve all other subsidiary ob(ectives and goals easily only if they can maximise their profits" 5nother argument is that prevention of entry may be the ma(or ob(ective in the pricing policy of the firm$ particularly in the case of limit pricing" the motive behind entry prevention is to secure a constant share in the mar!et$ which is compatible with profit maximisation" 3.& S)0,8A++)++.)nt E<) $%+) +utline the ma(or reasons a manager must !now the ob(ectives of a business firm$ apart from profit maximisation" 5. C!n$0#+%!n Ae have discovered from this unit that$ apart from profit maximisation$ business firms have the following ob(ectives: Maximisation of 6ales revenue Maximisation of the growth rate Maximisation of manager*s utility function Ma!ing satisfactory rate of profit 8ong run survival of the firm Entry prevention and ris! avoidance" &he advocates of profit maximisation as business ob(ective argue$ however$ that firms can achieve all other subsidiary ob(ectives and goals easily only if they can maximise their profits" 5nother important argument has been that prevention of entry may be the ma(or ob(ective in the pricing policy of the firm$ particularly in the case of limit pricing" 1ut the motive behind entry prevention is to secure a constant share in the mar!et$ which is compatible with profit maximisation" 6.0 S#..- 1

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&his unit stress the point that managers often set their personal goals different from profit maximisation$ the goal usually pursued by business owners" 6ome good examples of such manager ob(ectives are sales$ growth rate$ and maximisation of utility function" &he factors explaining this include the fact that: /irst) salary and other monetary benefits of managers tend to be more closely related to sales revenue than to profits" Secon%) ban!s and other financial institutions loo! at sales revenue while financing business ventures" .hir%) trend in sales revenue is a readily available indicator of a firm*s performance" /o&rth) increasing sales revenue enhances manager*s prestige while profits go to the business owners" /ifth) managers find profit maximisation a difficult ob(ective to fulfill consistently over time and at the same level" 7rofits fluctuate with changing economic conditions" /inall#) growing sales tend to strengthen competitive spirit of the firm in the mar!et$ and vice versa. +ther similar ob(ectives include: ma!ing satisfactory profit rate$ long run survival of the firm$ and entry prevention and ris! avoidance" .nowledge of these other business ob(ectives is essential for management decisions" =. T#t! 8M- 2)" A++%4n.)nt+ 5part from the business ob(ectives discussed in this unit$ can you enumerate and discuss briefly other business ob(ectives you can thin! ofD >. 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT 6: OPTIMISATION C!nt)nt 1"> #ntroduction -"> +b(ectives /"> &he 9onstrained +ptimisation &echniques

/>

/"1 9onstrained +ptimisation by 6ubstitution Method /"- 9onstrained +ptimisation by 8agrangian Multiplier Method /"/ 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &he maximisation and minimi'ation techniques as referred to and discussed the previous units are generally referred to in economics as &nconstraine% optimisation or minimisation$ as the case may be" are unconstrained in the sense that firms are assumed to operate under no constraints on their activities" #n the real business world however$ firms face serious resource constraints" &hey need$ for example$ to maximise output with given quantity of capital and labour time" &he techniques used to optimise the business ob(ective(s) under constraints are referred to as constraine% opti!isation techni3&es0 &he three common techniques of optimisation include: 4i5 Linear Pro ra!!in ) 4ii5 constraine% opti!isation -# s&-stit&tion) and 4iii5 La ran ian !&ltiplier0 &he linear programming technique has a wide range of applications and should be a sub(ect in itself$ usually discussed in detail under quantitative techniques in economics" &his discussion will attempt to summarise the two other important techniques$ that is$ constrained optimisation by substitution and 8agrangian multiplier" &.0 O'()$t%*)+ 5t the end of this unit$ you will be expected to: 1" )nderstand the meaning and importance of constrained optimisation -" the applicable techniques in constrained optimisation /" able to apply optimisation principles in business decisions 3.0 T7) C!n+t -%n)" O/t%.%+-t%!n T)$7n%B#)+ &here are basically two mostly used optimisation techniques including: the substitution method, and$ the 8agrangian multiplier method 3.1 C!n+t -%n)" O/t%.%+-t%!n '1 S#'+t%t#t%!n M)t7!" &his technique will be illustrated in two ways: (i) constrained profit maximisation problem$ and (ii) constrained cost minimisation problems" 3.1.1 C!n+t -%n)" P !,%t M-<%.%+-t%!n 8et the profit function of an hypothetical firm be given as: F f(Q$ I) F 1>>Q G -Q- G QI H 1B>I G 0IAhere Q and I represent two products" (/"1"1)

/1

Ae wish to maximise equation (/"1"1) sub(ect to the constraint that the sum of the output of Q and I be equal to /> units" &hat is$ Q H I F /> 6olving by the substitution method$ we obtain as follows: ;irst note that the process of the substitution method involves two steps 1" express one of the variables (Q or I in this case) in terms of the other and solve the constraint equation for one of them (Q or I)$ and -" substitute the solution obtained into the ob(ective function (that is$ the function to be maximi'ed or the profit function) and solve the outcome for the other variable" S!0#t%!n Given the constraint equation /"1"-)$ we solve for the values of Q and I in terms of one another to obtain: Q F /> G I +r I F /> G Q 1y substituting the value of Q into the profit equation (/"1"1)$ we obtain: F 1>>(/> G I) G -(/> G I)- G (/> G I)I H 1B>I G 0IF />>> G 1>>I G -(C>> G 3>I H I-) G />I H I- H 1B>I G 0IF />>> G 1>>I G 1B>> H 1->I G -I- G />I H I- H 1B>I G 0IF 1->> H 1@>I G 2I(/"1"/) Equation (/"1"/) can now be maximised by obtaining the first derivative and setting it equal to 'ero and solving for I: d F 1@> G 1>I F > dI 6olving equation (/"1"0) for I$ we get: 1>I F 1@> I F 1@" 6ubstituting 1@ for I into the constraint equation (/"1"-)$ we get: Q H 1@ F /> (/"1"0) (/"1"-)

/-

Q F 1/ #t follows that the optimum solution for the constrained profit maximisation problem is Q F 1/ units and I F 1@ units" values of Q and I satisfy the constraint" Expressed differently$ the firm maximises profit by producing and selling 1/ units of product Q and 1@ units of product I" &he maximum profit under the given constraint can now be obtained by substituting the above values of Q and I into the profit function$ equation (/"1"1): (, I) F (13, 1@) F 1>>(1/) G -(1/)- G (1/)(1@) H 1B>(1@) G 0(1@)F -$302" &hus$ the maximum profit under constraint is <-$302" can be shown that maximum profits under constraints is less than maximum profits without constraints" 3.1.& C!n+t -%n)" C!+t M%n%.%+-t%!n Ae now apply the substitution method to the problem of constrained cost minimisation" 6uppose the cost function of a firm producing two goods$ Q and I$ is given by: 9 F -Q- G QI H /Iand the firm must meet a combined order of /3 units of the two goods" problem is to find and optimum combination of the products Q and I that minimises the cost of production" 5lternatively stated$ we Minimise 6ub(ect to 9 F -Q- G QI H /IQ H I F /3 (/"1"2) (/"1"3)

5gain$ substitution method requires that the constraint equation (/"1"3) is expressed in terms of any of the two goods$ Q and I$ and then substituted into the objective function (equation (/"1"2))" Q in terms of I$ we get: Q F /3 G I (/"1"@)

6ubstituting equation (/"1"@) for Q in the ob(ective function$ you get: 9 F -(/3 G I)- G (/3 G I)I H /IF -(1-C3 G @-I H I-) G /3I H I- H /IF -2C- G 100I H -I- G /3I H I- H /IF -2C- G 1B>I H 3I-

(/"1" B)

5ccording to the optimisation rule$ for the now ob(ective function (equation (/"1"B)) to be minimised$ the first derivative must be equal to 'ero$ vi':

//

d9 F 1B> H 1-I F > dI

(/"1"C)

6olving for I in equation (/"1"C)$ we get the value of I as follows: 1-I F 1B> I F 12 6ubstituting this value into the constraint equation (/"1"3)$ you get: Q H 12 F /3 Q F -1 &hus$ the optimum solution demands that -1 units of Q and 12 units of I minimise the cost of meeting the combined order of /3 units (that is$ -1 H 12 F /3 units)" minimum cost of producing -1 units of Q and 12 units of I can be obtained as follows$ using equation (/"1"2)$ the ob(ective function: Minimum 9ost F -Q- G QI H /IF -(-1)- G (-1)(12) H /(12)F BB- G /12 H 3@2 F 1$-0&hus$ the minimum cost of producing the combined order is <1$-0-" 3.& C!n+t -%n)" O/t%.%+-t%!n '1 L-4 -n4%-n M#0t%/0%) M)t7!" &he lagrangian method is most useful in solving complex optimisation problems" #n this discussion$ we summarise this method using two illustrations: 2" a constrained profit maximisation problem$ and 3" a constrained cost minimisation problem 3.&.1 C!n+t -%n)" P !,%t M-<%.%+-t%!n Ae refer to the profit function of equation (/"1"1)$ with some constraint imposed$ so that we: Maximse (, I) F 1>>Q G -Q- G QI H 1B>I G 0I6ub(ect to Q H I F /> (/"-"1) (/"-"-)

&he basic approach of the 8agrangian method is to combine the ob(ective function and the constraint equation to form a 8agrangian function" is then solved using partial first order derivatives"

/0

&he 8agrangian function is formulated simply by: ;irst$ setting the constraint equation (/"-"-) equal to 'ero: Q H I G /> F > 6econd$ multiplying the resulting equation by (Gree! letter$ JlambdaK): ( H I G />)" 5dding this to the ob(ective function$ we get the 8agrangian function as: R F 1>>Q G -Q- G QI H 1B>I G 0I- H ( H I G />) (/"-"/)

Equation (/"-"/) is the 8agrangian function with three un!nowns$ Q$ I$ and . values of these un!nowns that maximise R will also maximi'e 7rofit (N)" Gree! letter$ , is referred to as the 8agrangian multiplier" #t measures the impact of a small change in the constraint on the ob(ective functions" Ae are now required to maximise R (equation (/"-"/)" do this$ we first obtain the partial derivatives of R with respect to Q$ I$ and and set each equal to 'ero to satisfy the first order condition for optimisation" &his will give rise to a simultaneous equation system in three un!nowns$ Q$ I$ and as indicated below: R F 1>>Q G -Q- G QI H 1B>I G 0I- H ( H I G />) R F 1>> G 0Q G I H F > R F Q H1B> G BI H F > (/"-"0) (/"-"2)

R F Q H I G /> F > (/"-"3) 6olving for Q$ I$ and in the above simultaneous equation system$ you obtain the values of Q$ I$ and that maximise the ob(ective function in equation (/"-"1)" )sing the necessary technique of solving simultaneous equation systems$ you obtain the solutions: Q F 1/ I F 1@$ and$ F /1" &he value of implies that if output is increased by 1 unit$ that is$ from /> to /1 units$ profit will increase by about </1$ and if output is decreased from /> to -C units$ profit will decrease by about </1" 3.&.& C!n+t -%n)" C!+t M%n%.%+-t%!n

/2

6uppose a firm has to supply a combined order of 2>> units of products Q and I" (oint cost function for the two products is given by: 9 F 1>>Q- H 12>I(/"-"@)

6ince the quantities to be produced of Q and I are not specified in the order$ the firm is free to supply Q and I in any combination" &he problem is therefore$ to find the combination of Q and I that minimises cost of production$ sub(ect to the constraint$ Q H I F 2>>" we are required to: Minimise 6ub(ect to 9 F 1>>Q- H 12>IQ H I F 2>> (/"-"B)

&he 8agrangian function can be formulated as in equation (/"-"C) below: Rc F 1>>Q- H 12>I- H (500 G Q G I) 5s before$ the first order partial derivatives yield: Rc F ->>Q F > Rc F />>I F > Rc F 2>> G Q G I F > (/"-"C) (/"-"1>) (/"-"11) (/"-"1-)

5gain$ solving the above simultaneous equations for Q$ I$ and , we get the solution to the cost minimisation problem" ;or simplicity$ substract equation (/"-"11) from equation (/"-"1>)$ you get: ->>Q (/>>I ) F > ->>Q G />>I F > ->>Q F />>I Q F 1"2I 6ubstituting 1"2I for Q in equation (/"-"1-)$ we get: 2>> G 1"2I G I F > 2>> G -"2I F > /3 (/"-"1/)

-"2I F 2>> I F ->> 6ubstituting I F ->> into the constraint equation (/"-"B)$ you get: Q H ->> F 2>> Q F />>" #t follows that the solution to the minimisation problem is that Q F />> and I F ->> will minimise the cost of producing the combined 2>> units of the products Q and I" &he minimum cost is obtained by using the ob(ective function (equation (/"-"@)) as follows: 9 F 1>>Q- H 12>IF 1>>(/>>)- H 12>(->>)F C$>>>$>>> H 3$>>>$>>> F 12$>>>$>>> &hus the minimum cost of supplying the combined 2>> units of products Q and I is <12 million" 3.3 S)0,8A++)++.)nt E<) $%+) 1riefly discuss what you understand by constrained optimisation" ?ow would you interpret the lagrangian multiplier" 5.0 C!n$0#+%!n &his unit has presented the basic principles of constrained optimisation$ with special emphasis on profit maximisation and cost minimisation" 5mong the various techniques of constrained optimisation$ the ones that are used most of the time are: (i) the substitution method, and$ (ii) the 8agrangian multiplier method"

6.0 S#..- 1 &he techniques used to optimise the business ob(ective(s) under constraints are referred to as constraine% opti!isation techni3&es0 &he three common techniques of optimisation include: 4i5 Linear Pro ra!!in ) 4ii5 constraine% opti!isation -# s&-stit&tion) and 4iii5 La ran ian !&ltiplier0 &he linear programming technique has a wide range of applications and should be a sub(ect in itself$ usually discussed in detail under

/@

quantitative techniques in economics" &his unit has attempted to outline the two other important techniques$ that is$ constrained optimisation by substitution and 8agrangian multiplier" 1oth techniques were illustrated by profit maximisation and cost minimisation problems" )nder the 8angrangian method$ a very important multiplier$ the 8angrangian multiplier$ S$ was introduced" &he value of S would imply that if a business firm increases output by 1 unit$ all things being equal$ profit will increase by <1$ and vice versa" =.0 T#t! 8M- 2)" A++%4n.)nt &he 1 7roducts 7lc produces two products$ Q and I" company is given by: F 1>Q G Q- G QI H 1BI G -I&he company is under the obligation to produce a minimum combined output of 0> units" ;ind the number of units that will be produced of the products Q and I$ sub(ect to the total of 0> units$ that maximises profit" )se the 8agrangian multiplier method" >.0 R),) )n$)+ 1" 4wivedi$ <" (->>-) Mana erial Econo!ics) si*th e%ition 4elhi: :i!as 7ublishing ?ouse 8td)" -" ?aessuler$ E" ;" and 7aul$ %" 6" (1C@3)$ Intro%&ctor# Mathe!atical Anal#sis for St&%ents of B&siness an% Econo!ics) "n% e%ition (%eston :irginia: %eston 7ublishing 9ompany) &he profit function of this

UNIT =: ANALYSIS C!nt)nt 1"> #ntroduction -"> +b(ectives /"> 4ecision 5nalysis

/B

/"1 9ertainty and )ncertainty in 4ecision 5nalysis /"- 5nalysis of the 4ecision 7roblem /"/ 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n =ecision analysis is the "odern a roach to decision "a3in$ both in econo"ics and in business. (t can be defined as the lo$ical and !uantitative analysis of all the factors influencin$ a decision. The analysis forces decision "a3ers to assu"e so"e active roles in the decision0"a3in$ rocess. >y so doin$, they rely "ore on rules that are consistent with their lo$ic and ersonal behaviour than on the "echanical use of a set of for"ulas and tabulated robabilities. The ri"ary ai" of decision analysis is to increase the li3elihood of $ood outco"es by "a3in$ $ood and effective decisions. A $ood decision "ust be consistent with the infor"ation and references of the decision "a3er. (t follows that decision analysis rovides decision0"a3in$ fra"ewor3 based on available infor"ation on the business environ"ent, be it a sa" le infor"ation, ?ud$"ental infor"ation, or a co"bination of both. 5s you may have noticed in unit 2$ optimisation techniques are regarded as the most important techniques in the managerial decision ma!ing processes" optimisation technique is generally defined as the technique used in finding the value of the independent variable(s) that maximises or minimises the value of the dependent variable" &.0 O'()$t%*)+ 5t the end of this unit$ you will be able to: 1" -" /" 0" 2" )nderstand what decision analysis is all about .now how you can ma!e business decisions under conditions of uncertainty 5nalyse decision problems with a view to providing solutions" )se sample information in ma!ing business and economic decisions 1e informed about time perspective in business decisions"

3. !ecision Anal"sis &ost decision0"a3in$ situations involve the choice of one a"on$ several alternatives actions. The alternative actions and their corres ondin$ ayoffs are usually 3nown to the decision0"a3er in advance. A ros ective investor choosin$ one invest"ent fro" several alternative invest"ent o ortunities, a store owner deter"inin$ how "any of a certain ty e of co""odity to stoc3, and a co" any e#ecutive "a3in$ ca ital0bud$etin$ decisions are so"e e#a" les of a business decision "a3er selectin$ fro" a "ultitude of a "ultitude of alternatives. The decision "a3er however, does not 3now which alternative which alternative

/C

will be best in each case, unless he;she also 3nows with certainty the values of the econo"ic variables that affect rofit. These econo"ic variables are referred to, in decision analysis, as states of nature as they re resent different events that "ay occur, over which the decision "a3er has no control. The states of nature in decision roble"s are $enerally denoted by s i (i = 1, -, 3, @, 3), where 3 is the nu"ber of or different states of nature in a $iven business and econo"ic environ"ent. (t is assu"ed here that the states of nature are "utually e#clusive, so that no two states can be in effect at the sa"e ti"e, and collectively e#haustive, so that all ossible states are included within the decision analysis. The alternatives available to the decision "a3er are denoted by ai (i = 1, -, 3, @, n), where n is the nu"ber of available alternatives. (t is also $enerally assu"ed that the alternatives constitute a "utually e#clusive, collectively e#haustive set. 3.1 Certaint" an# $ncertaint" in !ecision Anal"sis Ahen the state if nature, si, whether 3nown or un3nown, has no influence on the outco"es of $iven alternatives, we say that the decision "a3er is o eratin$ under certainty. Btherwise, he;she is o eratin$ under uncertainty. =ecision "a3in$ under certainty a ears to be si" ler than that under uncertainty. Cnder certainty, the decision "a3er si" ly a raises the outco"e of each alternative and selects the one that best "eets his;her ob?ective. (f the nu"ber of alternatives is very hi$h however, even in the absence of uncertainty, the best alternative "ay be difficult to identify. 4onsider, for e#a" le, the roble" of a delivery a$ent who "ust "a3e 1'' deliveries to different residences scattered over 9a$os "etro olis. There "ay literally be thousands of different alternative routes the a$ent could choose. Dowever, if the a$ent had only 3 sto s to "a3e, he;she could easily find the least0cost route. =ecision "a3in$ under uncertainty is always co" licated. (t is the robability theory and "athe"atical e# ectations that offer tools for establishin$ lo$ical rocedures for selectin$ the best decision alternatives. Thou$h statistics rovides the structure for reachin$ the decision, the decision "a3er has to in?ect his;her intuition and 3nowled$e of the roble" into the decision0"a3in$ fra"ewor3 to arrive at the decision that is both theoretically ?ustifiable and intuitively a ealin$. A $ood theoretical fra"ewor3 and co""onsense a roach are both essential in$redients for decision "a3in$ under uncertainty. To understand these conce ts, consider an investor wishin$ to invest 11'',''' in one of three ossible invest"ent alternatives, A, >, and 4. (nvest"ent A is a /avin$s Plan with returns of 6 ercent annual interest. (nvest"ent > is a $overn"ent bond with ..+ ercent annual interest. (nvest"ents A and > involve no ris3s. (nvest"ent 4 consists of shares of "utual fund with a wide diversity of available holdin$s fro" the securities "ar3et. The annual return fro" an

0>

invest"ent in 4 de ends on the uncertain behaviour of the "utual fund under varyin$ econo"ic conditions. The investors available actions (aiE ( = 1, -, 3, .) are as follows a1* =o not invest a-* /elect invest"ent A the 6F ban3 savin$s lan. a3* /elect invest"ent >, the ..+ F $overn"ent bond. a.* /elect invest"ent 4, the uncertain "utual fund Bbserve that actions a1 to a3 do not involve uncertainty as the outco"es associated with the" do not de end on uncertain "ar3et conditions. Bbserve also that action a - do"inates actions a1 and a3. (n addition, action a1 is clearly inferior to the ris30free ositive $rowth invest"ent alternatives a - and a3 as it rovides for no $rowth of the rinci al a"ount. Action a. is associated with an uncertain outco"e that, de endin$ on the state of the econo"y, "ay roduce either a ne$ative return or a ositive return. Thus there e#ists no a arent do"inance relationshi between action a . and action a-, the best a"on$ the actions involvin$ no uncertainty. /u ose the investor believes that if the "ar3et is down in the ne#t year, an invest"ent in the "utual fund would lose 1' ercent returnsE if the "ar3et stays the sa"e, the invest"ent would stay the sa"eE and if the "ar3et is u , the invest"ent would $ain -' ercent returns. The investor has thus defined the states of nature for his;her invest"ent decision0"a3in$ roble" as follows* s1* The "ar3et is down. s-* The "ar3et re"ains unchan$ed. s3* The "ar3et is u . A study of the "ar3et co"bined with econo"ic e# ectations for the co"in$ year "ay lead the investor to attach sub?ective robabilities of '.-+, '.-+, and '.+', res ectively, the the states of nature, s1, s-, and s3. The "a?or !uestion is then, how can the investor use the fore$oin$ infor"ation re$ardin$ invest"ents A, >, and 4, and the e# ected "ar3et behaviour serves as an aid in selectin$ the invest"ent that best satisfies his;her ob?ectivesG This !uestion will be considered in the sections that follow. 3.2 Anal"sis of the !ecision %ro&lem (n roble"s involvin$ choices fro" "any alternatives, one "ust identify all the actions that "ay be ta3en and all the states of nature whose occurrence "ay influence decisions. The action to ta3e none of the listed alternatives whose outco"e is 3nown with certainty "ay also be included in the list of actions. Associated with each action is a list of ayoffs. (f an action does not involve ris3, the ayoff will be the sa"e no "atter which state of nature occurs.

01

The ayoffs associated with each ossible outco"e in a decision roble" should be listed in a payoff table, defined as a listin$, in tabular for", of the value ayoffs associated with all ossible actions under every state of nature in a decision roble". The ayoff table is usually dis layed in $rid for", with the states of nature indicated in the colu"ns and the actions in the rows. (f the actions are labeled a1, a-, @, an, and the states of nature labeled s1, s-, @, s3, a ayoff table for a decision roble" a ears as in table 3.-.1 below. 1ote that a ayoff is entered in each of the n3 cells of the ayoff table, one for the ayoff associated with each action under every ossible state of nature. Ta&le 3.2.1: The %a"off Ta&le 'TAT( O) *AT$R( ACT+O* a1 aa3 . . . an (xample The "ana$in$ director of a lar$e "anufacturin$ co" any is considerin$ three otential locations as sites at which to build a subsidiary lant. To decide which location to select for the subsidiary lant, the "ana$in$ director will deter"ine the de$ree to which each location satisfies the co" anyHs ob?ectives of "ini"isin$ trans ortation costs, "ini"isin$ the effect of local ta#ation, and havin$ access to an a" le ool of available se"i0s3illed wor3ers. 4onstruct a ayoff table and ayoff "easures that effectively ran3 each otential location accordin$ to the de$ree to which each satisfies the co" anyHs ob?ectives. 'olution 9et the three otential locations be sites A, >, and 4. To deter"ine a ayoff "easure to associate with each of the co" anyHs ob?ectives under each alternative, the "ana$in$ director sub?ectively assi$ns a ratin$ on a ' , to , 1' scale to "easure the de$ree to which each location satisfies the co" anyHs ob?ectives. )or each ob?ective, a ' ratin$ indicates co" lete dissatisfaction, while a 1' ratin$ indicates co" lete dissatisfaction. The results are resented in table 3.-.- below* s1 ss3 @ s3

0-

Ta&le 3.2.2: Ratings for three alternative plant sites for a Manufacturing Compan" ALTERNATIVE COMPAN O!"ECTIVE /ite A /ite > /ite 4 Trans ortation 4osts 6 . 1' Ta#ation 4osts 6 : + Aor3force Pool 7 6 . To co"bine the co" onents of ayoff, the "ana$in$ director as3s hi"self, what are the relative "easures of i" ortance of the three co" any ob?ectives ( have considered as co" onents of ayoffG /u ose the "ana$in$ director decides that "ini"isin$ trans ortation costs is "ost i" ortant and twice as i" ortant as either the "ini"i%ation of local ta#ation or the si%e of wor3force available. De;she thus assi$ns a wei$ht of - to the trans ortation costs and wei$hts of 1 each to ta#ation costs and wor3force. This will $ive rise to the followin$ ayoff "easures* Payoff (/ite A) = 6(-) 5 6(1) 5 7(1) = -+ Payoff (/ite >) = .(-) 5 :(1) 5 6(1) = -3 Payoff (/ite 4) = 1'(-) 5 +(1) 5 .(1) = -: 3.3 'elf,Assessment (xercise Enumerate the ma(or areas of business decision ma!ing" ?ow does the study of managerial economics help a business manager in decision ma!ingD -. Conclusion &his unit focuses on business decision analysis" &he idea is that the most plausible way of ma!ing business decisions is to loo! at and analyse business opportunities$ variables$ and challenges" &o help you carry out these important tas!s$ the unit presents important discussions on: 1" and uncertainty in decision analysis -" of decision problems .. 'ummar" This unit infor"s you that "ost decision0"a3in$ situations involve the choice of one a"on$ several alternatives actions. The alternative actions and their corres ondin$ ayoffs are usually 3nown to the decision0"a3er in advance. Ahen the state if nature, si, whether 3nown or un3nown, has no influence on the outco"es of $iven alternatives, you will say that the decision "a3er is o eratin$ under certainty. Btherwise, he;she is o eratin$ under uncertainty. =ecision "a3in$ under certainty a ears to be si" ler than that under uncertainty. Cnder certainty, the decision "a3er si" ly a raises the outco"e of each alternative and selects the one that best "eets his;her ob?ective.

0/

(n roble"s involvin$ choices fro" "any alternatives, one "ust identify all the actions that "ay be ta3en and all the states of nature whose occurrence "ay influence decisions. The action to ta3e none of the listed alternatives whose outco"e is 3nown with certainty "ay also be included in the list of actions. Associated with each action is a list of ayoffs. (f an action does not involve ris3, the ayoff will be the sa"e no "atter which state of nature occurs. /. Tutor,Mar0e# Assignment )or each of the followin$ business decision0"a3in$ roble"s, list the actions available to the decision "a3er and the states of nature that "i$ht result to affect the ayoff* (a) The re lace"ent of "anually o erated ac3a$in$ "achines by a fully auto"ated "achineE (b) The leasin$ of a co" uter by a co""ercial ban3 o rocess chec3s and handle internal accountin$E (c) The e# ansion of the "ar3et of a brewery fro" a two0state "ar3et to either a four0state "ar3et or a seven0state "ar3etE (d) The assi$n"ent of seven secretaries to seven e#ecutivesE and, (e) The invest"ent of a co" any ension fund. 1. References 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT >: E:PECTED MONETARY VALUE DECISIONS3 DECISION8 MAAING INVOLVING SAMPLE INFORMATION3 AND TIME PERSPECTIVE IN BUSINESS DECISIONS Content

00

1.' (ntroduction -.' Bb?ectives 3.' (" ortant )eatures of >usiness =ecision0&a3in$ Processes 3.1 I# ected &onetary Jalue =ecisions 3.- =ecision &a3in$ (nvolvin$ /a" le (nfor"ation 3.3 Ti"e Pers ective in >usiness =ecisions 3.. /elf0Assess"ent I#ercise ..' 4onclusion +.' /u""ary 6.' Tutor0&ar3ed Assi$n"ent 7.' References 1. +ntro#uction As you noted in unit 6, decision analysis rovides you with decision0"a3in$ fra"ewor3 based on available infor"ation on the business environ"ent, in the for" of either sa" le infor"ation or ?ud$"ent infor"ation or both. (n this unit, we e#a"ine the i" ortant features of business decision "a3in$ as they relate to e# ected "onetary values, availability of sa" le infor"ation, and ti"e ers ective. 2. O&2ectives Davin$ $one throu$h this unit, you will be able to* 1. Dave additional levera$e in decision "a3in$ rocesses -. >e infor"ed on how to "a3e e# ected "onetary value decisions 3. Cse sa" le infor"ation in rofitable business decisions .. Cnderstand and ta3e into consideration ti"e ers ectives in business lannin$. 3. +mportant )eatures of 3usiness !ecision,Ma0ing %rocesses 3.1 (xpecte# Monetar" 4alue !ecisions A decision0"a3in$ rocedure, which e" loys both the ayoff table and rior robabilities associated with the states of nature to arrive at a decision is referred to as the E#pected Monetary Value decision rocedure. 1ote that by prior probability we "ean robabilities re resentin$ the chances of occurrence of the identifiable states of nature in a decision roble" rior to $atherin$ any sa" le infor"ation. The e#pected $onetary %alue decision refers to the selection of available action based on either the e# ected o ortunity loss or the e# ected rofit of the action. =ecision "a3ers are $enerally interested in the opti$al $onetary %alue decisions. The o ti"al e# ected "onetary value decision involves the selection of the action associated with the "ini"u" e#pected opportunity loss or the action associated with the "a#i"u" e#pected profit, de endin$ on the ob?ective of the decision "a3er.

02

The conce t of e# ected "onetary value a lies "athe"atical e# ectation, where o ortunity loss or rofit is the rando" variable and the rior robabilities re resent the robability distribution associated with the rando" variable. The expected opportunity loss is co" uted by* E&Li' ( )all * Li*P&s*', &i ( +, ,, -, n'

where 9i? is the o ortunity loss for selectin$ action ai $iven that the state of nature, s?, occurs and P&s*' is the rior robability assi$ned to the state of nature, s?. The expected profits for each action is co" uted in a si"ilar way* E&.i' ( )all * .i*P&s*' where Ki? re resents rofits for selectin$ action ai (xample >y recordin$ the daily de"and for a erishable co""odity over a eriod of ti"e, a retailer was able to construct the followin$ robability distribution for the daily de"and levels* Ta&le 3.1.1: %ro&a&ilit" !istri&ution for the !ail" !eman# s? P&s*' 1 '.+ '.3 '.3 '.' . or "ore The o ortunity loss table for this de"and0inventory situation is as follows*

Ta&le 3.1.2: The Opportunit" 5oss Ta&le /tate of 1ature, =e"and Action, (nventory s1(1) s-(-) s3(3) a1(1) a-(-) a3(3) ' . 3 ' 6 3 '

Ae are re!uired to find the inventory level that "ini"ises the e# ected o ortunity loss.

03

'olution Liven the rior robabilities in the first table, the e# ected o co" uted as follows* E&Li' ( )*(+/Li*P&s*', for eac0 in%entory le%el, I ( +, ,, /. The e# ected o

ortunity loss are

ortunity losses at each inventory level beco"e*

E&L+' ( '('.+) 5 3('.3) 5 6('.-) = 1-.1' E&L,' ( -('.+) 5 '('.3) 5 3('.-) = 11.6' E&L/' = .('.+) 5 -('.3) 5 '('.-) = 1-.6' (t follows that in order to "ini"i%e the e# ected o ortunity loss, the retailer should stoc3 - units of the erishable co""odity. This is the o ti"al decision. !ecision Ma0ing +nvolving 'ample +nformation 3.2 (n discussin$ rior robabilities, recall it was noted that rior robabilities are ac!uired either by sub?ective selection or by co" utation fro" historical data. 1o current infor"ation describin$ the robability of occurrence of the states of nature was assu"ed to be available. (n "any cases, observational infor"ation or other evidence are available to the decision "a3er either for urchase or at the cost of e# eri"entation. )or e#a" le, a retailer whose business de ends on the weather "ay consult a "eteorolo$ist before "a3in$ decisions, or an investor "ay hire a "ar3et consultant before investin$. &ar3et surveys carried out before the release of a new roduct re resent another area in which the decision "a3er "ay see3 additional infor"ation. (n each of these e#a" les, the decision "a3er atte" ts to ac!uire infor"ation relative to the occurrence of the states of nature fro" a source other than that fro" which the rior robabilities were co" uted. Ahen such infor"ation are available, !aye1s La2 can be e" loyed to revise the rior robabilities to reflect the new infor"ation. These revised robabilities are referred to as posterior probabilities. >y definition, the posterior probability re resented sy"bolically by P&s34#' is the robability of occurrence of the state of nature s 3, $iven the sa" le infor"ation, #. This robability is co" uted by* P&s 34#' ( P&#4s3'P&s3' )all iP&#4si'P&si'

0@

The robabilities, P&#4si' are the conditional robabilities of observin$ the observational infor"ation, #, under the states of nature, s i, and the robabilities P&si' are the rior robabilities. The e# ected "onetary value decisions are for"ulated in the sa"e way as before, e#ce t that the osterior robabilities are used instead of rior robabilities. (f the ob?ective is to "ini"i%e the e# ected o ortunity loss, the !uantity is co" uted for each action ai. The e# ected o ortunity loss in this case is co" uted by* E&Li' ( )all I Li*P&si4#' I ( +, ,, /,-,n (xample (t is 3nown that an asse"bly "achine o erates at a + ercent or 1' ercent defective rate. Ahen runnin$ at a 1' ercent defective rate, the "achine is said to be out of control. (t is then shut down and read?usted. )ro" ast e# erience, the "achine is 3nown to run at + ercent defective rate :' ercent of the ti"e. A sa" le of si%e n = -' has been selected fro" the out ut of the "achine, and y = - defectives have been observed. >ased on both the rior and sa" le infor"ation, what is the robability that the asse"bly "achine is in control (runnin$ at + ercent defective rate)G 'olution The states of nature in this e#a" le relates to the asse"bly "achine defective rates. Thus the states of nature include* s1 = '.'+, and s- = '.1' with the assu"ed rior robabilities of occurrence of '.:' and '.1'. Ae are re!uired to use these rior robabilities, in line with the observed sa" le infor"ation, to find the osterior robability associated with the state of nature, s1. (n this roble", the Me# eri"ental infor"ation, #N is the observation of y = defectives fro" a sa" le of n = -' ite"s selected fro" the out ut of the asse"bly "achine. Ae need to find the robability that the e# eri"ental infor"ation, #, could arise under each state of nature, s i. This can be done by referrin$ to the bino"ial robability distribution table found in the a endi#. Cnder the state of nature s1 = '.'+, we obtain* P&#45.56' ( P&n ( ,5, y (,45.56' ( 5.7,6 8 5.9/: ( 5.+;7 (fro" the bino"ial distribution table) Cnder the state of nature, s- = '.1', we obtain* P&#45.+5' ( P&n ( ,5, y ( ,45.+5' = '.677 , '.3:- = '.-8+ (fro" the bino"ial distribution table). Ae now e" loy the >ayeHs 9aw to find the osterior robability that the "achine is in control (s1) based on both the rior and e# eri"ental infor"ation. To "a3e

0B

the wor3 easy, we use the 4olu"nar a illustrated below*

roach to the use of >ayeHs 9aw as

s1 s-

Ta&le 3.2.1: Columnar Approach to $se of 3a"e6s 5a7 (1) (-) (3) (.) (+) /tate of Prior, I# eri"ental Product, Posterior, 1ature, P&si' (nfor"ation, P&si'P&#4si' P&si4#' si P&#4si' '.'+ '.:' '.18: '.17'1 '.86 '.1' '.1' '.-8+ '.'-8+ '.1. 1.'' '.1:86 1.'' 9oo3in$ at colu"n (.), we observe the roduct of the entries in colu"ns (-) and (3). These values "easure the *oint probabilities. The su" of the entries in colu"n (.) is the ter" in the deno"inator of the for"ula for >ayeHs 9aw and "easures the $ar<inal probability of observin$ the e# eri"ental infor"ation, #. The osterior robabilities, colu"n (+), are obtained by ta3in$ each entry in colu"n (.) and dividin$ by the su" of the entries in colu"n (.). Iven thou$h we found that 1' ercent of the ite"s in the sa" le is defective (that is, - out of the -' ite"s is defective), the osterior robability that the "achine is runnin$ at the 1' ercent defective rate (runnin$ out of control) is only '.1., which is a little $reater than the rior robability that the "achine is out of control ('.1'). (t follows that the robability that the "achine is not runnin$ out of control is '.86. 3.3 Time %erspective in 3usiness !ecisions All business decisions are ta3en with so"e ti"e ers ective. Ti"e ers ective refers to the duration of ti"e eriod e#tendin$ fro" the relevant ast to foreseeable future, ta3en into consideration while "a3in$ a business decision. The relevant ast refers to the eriod of ast e# erience and trends which are relevant for business decisions with lon$0run i" lications. >ear in "ind that all business decisions do not have the sa"e ti"e ers ective. /o"e have short0 run re ercussions, and therefore, involve short0run ers ective. )or instance, a decision re$ardin$ buildin$ inventories of finished roduct involves a short0run ti"e ers ective. There are "any business decisions which have lon$0run re ercussions such as, invest"ent in land, buildin$, "achinery, e# ansion of the scale of roduction, introduction of a new roduct, invest"ent abroad, and the li3e. =ecisions on such business issues "ay not be rofitable in the short0run, but "ay rove very rofitable in the lon$0run. >usiness decisions "a3ers "ust therefore, assess and deter"ine the ti"e ers ective of business ro ositions well in advance and "a3e decisions accordin$ly. =eter"ination of ti"e ers ective is very si$nificant, es ecially

0C

where forecastin$, lannin$, and ro?ections are involved. =ecision0"a3ers "ust decide on an a ro riate future eriod for ro?ectin$ the value of a $iven business variable. Btherwise, ro?ections "ay rove "eanin$less fro" business analysis oint of view and decisions based thereon "ay result in oor ay0offs. )or instance, in a business decision re$ardin$ the establish"ent of an institute of entre reneurshi , ro?ectin$ a short0run de"and and ta3in$ a short0run ti"e ers ective will not be wise. 3.- 'elf,Assessment (xercise Live the ?ustification for usin$ an e# ected "onetary value ob?ective in decision roble"s. 5.0 C!n$0#+%!n &o beef up your understanding of business decision ma!ing this unit has examined the important features of decision ma!ing in business$ including: 1" monetary value decisions -" involving sample information /" perspective in business decisions 6.0 S#..- 1 =ecision "a3ers are $enerally interested in the opti$al $onetary %alue decisions. The o ti"al e# ected "onetary value decision involves the selection of the action associated with the "ini"u" e#pected opportunity loss or the action associated with the "a#i"u" e#pected profit, de endin$ on the ob?ective of the decision "a3er. All business decisions are ta3en with so"e ti"e ers ective. Ti"e ers ective refers to the duration of ti"e eriod e#tendin$ fro" the relevant ast to foreseeable future, ta3en into consideration while "a3in$ a business decision. The relevant ast refers to the eriod of ast e# erience and trends which are relevant for business decisions with lon$0run i" lications. =.0 T#t! 8M- 2)" A++%4n.)nt A business erson is tryin$ to decide whether to ta3e one of two contracts or neither one. De;she has si" lified the situation and feels it is sufficient to i"a$ine that the contracts rovide the alternatives shown in the followin$ table*

Contract A %rofit %ro&a&ilit" 11'',''' '.-' +',''' '..' ' '.3' 03',''' '.1'

Contract 3 %rofit %ro&a&ilit" 1.',''' 1',''' 01',''' '.3' '..' '.3'

2>

(a) Ahich contract should the business erson select if he;she wishes to "a#i"i%e his;her e# ected rofitG (b) Ahat is the e# ected rofit associated with the o ti"al decisionG >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT C: ANALYSIS OF MARAET DEMAND C!nt)nt 1"> #ntroduction -"> +b(ectives /"> 5nalysis of Mar!et 4emand /"1 4efinition of Mar!et 4emand

21

/"- &ypes of 4emand /"/ 4eterminants of Mar!et 4emand /"0 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n This unit discusses the "eanin$ of "ar3et de"and, ty es of de"and, deter"inants of "ar3et de"and, the de"and functions, elasticities of de"and, and techni!ues of de"and forecastin$. This is in reco$nition of the fact that the analysis of "ar3et de"and for a business fir"Hs roduct lays an i" ortant role in business decision "a3in$. (n addition, for a fir" to succeed in its o erations, it "ust lan for future roduction, the inventories of raw "aterials, advertise"ents, and sales outlets. (t follows that the 3nowled$e of the "a$nitude of the current and future de"and is indis ensable. The analysis of "ar3et de"and enables business e#ecutives 3now* 6. the factors deter"inin$ the si%e of consu"er de"and for their roductsE 7. the de$ree of res onsiveness of de"and to chan$es in its deter"inantsE 8. the ossibility of sales ro"otion throu$h "ani ulation of ricesE :. res onsiveness of de"and to advertise"ent e# endituresE and, 1'. o ti"u" levels of sales, inventories, and advertise"ent e# enditures. 2. O&2ectives At the end of this unit, you should be able to* 1. 2now what the "ar3et de"and is all about -. Cnderstand the various ty es of de"and 3. >e fa"iliar with the deter"inants of de"and 3.0 An-01+%+ !, M- 2)t D).-n" 3.1 D),%n%t%!n !, M- 2)t D).-n" &he mar!et demand of any product is the sum of individual demands for the product at a given mar!et price in a given time period" <ote that the individual demand for the product per unit of time at a given price is the quantity demanded by an individual" 5 hori'ontal summation of individual demand schedule gives rise to the !ar(et %e!an% sche%&le0 ;or example$ assume three consumers$ Q$ I$ and R of a given commodity$ say commodity 5" the individual demands by the consumers$ Q$ I$ and R be represented as in table /"1 below$ the mar!et demand schedule$ that is$ the aggregate of individual demands by the three consumers at different prices$ as indicated$ is shown by the last column of the table"

2-

T-'0) 3.1.1: T7) M- 2)t D).-n" S$7)"#0) P %$) !, A 9#-nt%t1 !, A D).-n")" '1: : Y D 1> 2 1 > B @ > 3 1> 0 1 0 10 3 -> 1> 0 > -@ 12 B

M- 2)t D).-n" 3 C 12 -/0 2>

3.& T1/)+ !, D).-n" &he ma(or types of demand encountered in business decisions are outlined below" 3.&.1. In"%*%"#-0 -n" M- 2)t D).-n". &he quantity of a commodity an individual is willing and able to purchase at a particular price$ during a specific time period$ given hisPher money income$ hisPher taste$ and prices of other commodities$ such as substitutes and complements$ is referred to as the in%i,i%&al %e!an% for the commodity" 5s illustrated in table /"1 above$ the total quantity which all the consumers of the commodity are willing and able to purchase at a given price per time unit$ given their money incomes$ their tastes$ and prices of other commodities$ is referred to as the !ar(et %e!an% for the commodity" 3.&.&. ,! ,% .@+ -n" In"#+t 1@+ P !"#$t. &he quantity of a firm*s product that can be sold at a given price over time is !nown as the demand for the firm*s product" &he sum of demand for the products of all firms in the industry is referred to as the mar!et demand or industry demand for the product" 3.2.3 A#t!n!.!#+ -n" D) %*)" D).-n". 5n autonomous demand or direct demand for a commodity is one that arises on its own out of a natural desire to consume or possess a commodity" &his type of demand is independent of the demand for other commodities" 5utonomous demand may also arise due to demonstration effect of a rise in income$ increase in population$ and advertisement of new products" &he demand for a commodity which arises from the demand for other commodities$ called Eparent products is called derived demand. 4emand for land$ fertili'ers and agricultural tools$ is a derived demand because these commodities are demanded due to demand for food" #n addition$ demand for bric!s$ cement$ and the li!e are derived demand from the demand for house and other types of buildings" #n general$ demand for producer goods or industrial inputs is a derived demand" 3.2.- D).-n" ,! D# -'0) -n" N!n8D# -'0) G!!"+. 4urable goods are those goods for which the total utility or usefulness is not exhaustible in the short run use" 6uch goods can be used repeatedly over a period of time" 4urable consumer goods include houses$ clothing$ shoes$ furniture$ refrigerator$ and the li!e"

2/

4urable producer goods include mainly the items under Efixed assets*$ such as building$ plant$ machinery$ and office furniture" &he demand for durable goods changes over a relatively longer period than that of the non durable goods" &he demand for non durable goods depends largely on their current prices$ consumers* income$ and fashion" #t is also sub(ect to frequent changes" 4urable goods create replacement demand$ while non durable goods do not" #n addition$ the demand for non durable goods change linearly$ while the demand the demand for durable goods change exponentially as the stoc! of durable goods changes" 3.&.6. -n" L!n48t) . D).-n". Short2ter! %e!an% refers to the demand for goods over a short period" &he type of goods involved in the short term demand are most fashion consumer $oods, $oods used seasonally, inferior substitutes for su erior $oods durin$ scarcities. /hort0 ter" de"and de ends "ainly on the co""odity rice, rice of their substitutes, current dis osable income of the consumers$ the consumers* ability to ad(ust their consumption pattern$ and their susceptibility to advertisement of new products" &he lon 2ter! %e!an% refers to the demand which exists over a long period of time" 9hanges in long term demand occur only after a long period" Most generic goods have long term demand" &he long term demand depends on the long term income trends$ availability of better substitutes$ sales promotion$ consumer credit facility$ and the li!e" 3.3 D)t) .%n-nt+ !, M- 2)t D).-n" ;or corporate managers at large and specifically$ the mar!eting managers$ it is highly important to understand the factors affecting the mar!et demand for their products" &his understanding is required for analysing and estimating demand for the products" &hough there are several factors affecting mar!et demand for a product$ the most important are: 1" Price of the pro%&ct or the o+n price 4Po50 &his is the most important determinant of demand for a product" &he own price of a product and the quantity demanded of it are inversely related so that$ TMo U > T7o -" Price of the relate% oo%s) s&ch as s&-stit&tes an% co!ple!ents 4Ps an% Pc5 Ahen two goods are substitutes for each other$ the change in price of one affects the demand for the other in the same direction" #f goods Q and I are substitute goods$ then an increase in the price of Q will give rise to an increase in the demand for I" <ote that changes in the price of related goods cause shifts in the demand for the goods" 9hanges in demand are illustrated graphically as rightward shifts (for increase) and leftward shifts (for decrease) in the demand for the products" 5s shown below$ 5n increase in the price of good Q will shift the demand for good I to the right and shift that of good Q to the left" F%4# ) 3.3.1: S7%,t+ %n D).-n" P< P1

20

4x Q 6ymbolically$ 4x F f(7y), T4xPT7y U > 4y F f(7x), T4yPT7x U >

4y I

Ahen two goods are complements for each other$ one complements the use of another" 7etrol and car a complement goods" #f an increase in the price of one good causes a decrease in demand for the other$ the goods are said to be complements" &hus if the demand function for a car (4c) in relation to petrol price (7p) is specified by: 4c f(7p)$ T4cPT7p O >" /" Cons&!er1s Inco!e &his is the ma(or determinant of demand for any product since the purchasing power of the consumer is determined by the disposable income" Managers need to !now that income demand relationship is of a more varied nature than those between demand and its other determinants" &he relationship between demand for commodity Q$ for example$ and the consumer*s income$ say I$ !eeping other factors constant$ can be expressed by a demand function: 4x F f(I)$ and T4xPTI U >" Iou should note that consumer goods of different nature have different relationships with income of different categories of consumers" &he manager needs$ therefore$ to be completely aware of the goods they deal with and their relationship with consumer*s income$ particularly with respect to the assessment of both existing and prospective demand for a product" %egarding income demand analysis$ consumer goods and services are grouped under four broad categories: i" Essential Cons&!er Goo%s 4ECG50 Goods and services in this category are referred to as Ebasic needs*$ and are consumed by all persons in a society" 6uch goods and services include food grains$ salt$ vegetable oil$ coo!ing$ fuel$ housing$ and minimum clothing" &he demand for such goods and services increase with increases in consumer*s income$ but only up to a certain limit$ even though the total expenditure may increase in accordance with the quality of goods consumed$ all things being equal" &he relationship between goods and services of this category and consumer*s income is shown by the curve E9G in figure /"/"- below" F%4# ) 3.3.&: In$!.)8D).-n" R)0-t%!n+7%/+ 9onsumer*s

22

#ncome (I) I#G I1 > Q1

E9G

<G

8G

QMuantity 4emanded (Q)

ii" Inferior Goo%s 4IG50 #nferior and superior goods are widely !nown to both buyers and sellers" Economists define inferior goods as goods in which their demands decrease as consumer*s income increases$ beyond a certain level of income" &he relationship between income and demand for an inferior good is illustrated by curve #G in figure /"/"- above" 4emand for such goods rises only up to a certain level of income$ say (+I1)$ and declines as income increases beyond this level" iii" Nor!al Goo%s 4NG50 #n economic terms$ normal goods are goods demanded in increasing quantities as consumer*s income rises" of normal goods are clothing$ furniture$ and automobiles" &he type of relationship between income and demand for normal goods is shown by curve <G in figure /"/"- above" in the figure that up to a certain level of income$ say I1$ the relationship between income and demand for all types of goods is similar" &he difference is only in terms of the degree of relationship" &he relationship becomes distinctively different beyond the income level (I1)" iv" L&*&r# an% Presti e Goo%s0 such goods that add to the pleasure and prestige of the consumer without enhancing his or her earning fall in the category of luxury goods" 7restige goods are special category of luxury goods$ examples$ rare paintings and antiques$ prestigious schools$ and the li!e" 4emand for such goods arises beyond a certain level of consumer*s income" 7roducers of such goods$ while assessing the demand for their product$ need to consider the income changes in the richer section of the society" &he income demand relationship for this category of goods is shown by curve 8G in figure /"/"-" $0 .astes an% Preferences 9onsumers* tastes and preferences play important role in the determination of the demand for a product" &astes and preferences generally depend on life style$ social customs$ religious values attached to a commodity$ habit of the people$ age and sex of the consumers$ and the li!e" 9hanges in these factors tend to change consumers* tastes and preferences" '0 E*pen%it&res0 5dvertisement costs are incurred while attempting to promote sales" #t helps in increasing product demands in at least four ways: (a) by informing the potential consumers about the product*s availability,

23

(b) by showing the product*s superiority over the rival product, (c) by influencing consumer*s choice against the rival product, and$ (d) by setting new fashions and changing tastes" &he impact of these causes upward shifts in the demand for the product" things being equal$ as expenditure on advertisement increases$ it is expected that volume of sales will increase" &he relationship between sales (6) and advertisement outlays (54) can be expressed by the function: 6 F f(54)$ and T6PT54 U >" relationship is indicated in figure /"/"/ below: F%4# ) 3.3.3 A"*) t%+).)nt -n" S-0)+ :olume of 6ales (I) 6ales curve

>

5dvert" Expenditure (<)

&he relationship as shown by figure /"/"/ is based on the following assumptions: (a) 9onsumers are fairly sensitive and responsive to various modes of advertisement (b) &he rival firms do not react to the advertisement made by the firm$ (c) &he level of demand has not reached the saturation point and advertisement ma!es only marginal impact on demand for a product$ (d) 5dding of advertisement cost to the product price does not ma!e the price prohibitive for consumers$ compared to the price of substitutes" 60 E*pectations0 consumers* expectations about the future product prices$ income$ and supply position of goods play significant role in the determination of demand for goods and services in the short run" rational consumer who expects a high rise in the price of a nonperishable commodity would buy more of it at the high current price with a view to avoiding the pinch of the high price rise in the future" &his partly explains the high demand for fuel during periods of expected increase of pump price of fuel in <igeria" +n the contrary$ if a rational consumer expects a fall in the price of goods hePshe purchases$ hePshe would postpone the purchase of such goods with a view to ta!ing advantage of lower prices in the future" is especially the case for non essential goods" behaviour tends to reduce the current demand for goods whose prices are expected to decrease in the future" 5n expected increase in income would similarly increase current demand for goods and services" ;or instance$ a corporate announcement of bonuses or upward revision of salary scales would induce increases in current demand for goods and services" 70 Effect0 Ahenever new commodities or models of commodities are introduced in the mar!et$ many households buy them not because of their genuine need for them but because their neighbours have purchased them" &his type of purchase arises out of such feelings (ealousy$ competition$ and equality in the peer group$ social

2@

inferiority$ and the desire to raise once social status" 7urchases based on these factors are the result of what economists refer to as Edemonstration effect* or the E1and Aagon effect*" &hese effects have positive impacts on commodity demand" +n the contrary$ when a commodity becomes a thing of common use$ some rich people decrease their consumption of such goods" &his behaviour is referred to in economics as the Esnob effect*" &his has negative impact on the demand for the commodity concerned" +ther determinants of demand for commodities include Consumer-Credit facility, the population of consumers, and income distribution. 3.5 S)0,8A++)++.)nt E<) $%+) 1riefly discuss the reason it is important for a manager to understand the various types of demand" 5.0 C!n$0#+%!n &his unit has defined a product*s mar!et demand as the sum of individual demands for the product" addition$ you were informed that a hori'ontal sum of individual demand schedule will result in the mar!et demand schedule" &he unit presents five different types of demand: (i) individual and mar!et demand, (ii) demand for firm*s and industry product, (iii) autonomous and derived demand, (iv) demand for durable and non durable goods, and$ (v) short term and long term demand" Iou also learned that the determinants of demand include: the product*s own price, price of related goods, consumer tastes, consumer income, consumer expectations, and others" 6.0 S#..- 1 &he mar!et demand of any product is the sum of individual demands for the product at a given mar!et price in a given time period" &he individual demand for the product per unit of time at a given price is the quantity demanded by an individual" &he quantity of a commodity an individual is willing and able to purchase at a particular price$ during a specific time period$ given hisPher money income$ hisPher taste$ and prices of other commodities$ such as substitutes and complements$ is referred to as the in%i,i%&al %e!an% for the commodity" 5n autonomous demand or direct demand for a commodity is one that arises on its own$ out of a natural desire to consume or possess a commodity" &his type of demand is independent of the demand for other commodities" 5utonomous demand may also arise due to demonstration effect of a rise in income$ increase in population$ and advertisement of new products" 4urable goods are those goods for which the total utility or usefulness is not exhaustible in the short run use" 6uch goods can be used repeatedly over a period of time" &he

2B

demand for durable goods changes over a relatively longer period than that of the non durable goods" 9onsumer goods of different nature have different relationships with income of different categories of consumers" &he manager needs$ therefore$ to be completely aware of the goods they deal with and their relationship with consumer*s income$ particularly with respect to the assessment of both existing and prospective demand for a product" =.0 T#t! 8M- 2)" A++%4n.)nt Explain with practical examples the following demand concepts: 1" demand -" demand /" or 1and Aagon effect on demand >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT E: DEMAND FUNCTIONS C!nt)nt 1"> #ntroduction -"> +b(ectives /"> &he 4emand functions /"1 8inear 4emand function /"- <onlinear 4emand ;unction

2C

/"/ Multi :ariate or 4ynamic 4emand ;unction /"0 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n Mathematically$ we can define a function as a symbolic representation of relationship between dependent and independent variables" 5 demand function states the relationship between the demand for a product (the dependent variable in this case) and its determinants (the independent variables)" #t is the nature of demand price relationship that determines the form of a demand function" &he three most common forms of demand functions are the linear %e!an% f&nction) non2linear %e!an% f&nction and the !&lti2,ariate or %#na!ic %e!an% f&nction0 of these forms will be presented briefly in the following discussions" &.0 O'()$t%*)+ ?aving gone through the discussions in this unit$ you should be able to: 1" informed about the theoretical demand functions -" the differences between the various types of demand functions /" the principles behind modeling of demand for goods and services 3.0 T7) D).-n" ,#n$t%!n+ &he various types of demand functions relevant to our discussions include: 1" 8inear 4emand function, -" non linear demand function, and$ /" multivariate or dynamic demand function" Each of these demand functions has specific roles to play in decision ma!ing involving the demand for a firm*s product" 3.1 L%n)- D).-n" ,#n$t%!n 5 demand function is said to be linear when its graph results in a straight line" &he general form of a linear demand function is presented in equation (/"1"1) below: (/"1"1) 4x F a b7x Ahere a F the demand intercept or the quantity demanded at a 'ero price$ b F the slope of the demand function or the rate at which quantity demanded of product Q changes with respect to the price (7x)" slope is defined by T4xPT7x &he graphical form of this demand function is illustrated in figure /"1"1 below" F%4# ) 3.1.1: L%n)- D).-n" F#n$t%!n 7rice (7x)

3>

a 4x F a b7x

>

Muantity (4x)

&he price function can easily be obtained from the demand function (equation /"1"1) in the following way: 4x F a G b7x b7x F a G 4x 7x F a G 4x F a G 14x b bb (/"1"-)

3.& N!n0%n)- D).-n" F#n$t%!n 5 demand function is said to be nonlinear or curvilinear when the slope of the of the demand function$ T7PT4$ changes along the demand curve" 5 nonlinear demand function yields a demand curve unli!e the demand line yielded by a linear demand function as in figure /"1"1 above" 5 nonlinear demand function is of the form of a power function as given in equation (/"-"1) below" (/"-"1) 4x F a7x b Iou should note that the exponent of the 7rice variable 7x$ that is$ b$ in the nonlinear demand function (equation (/"-"1) is referred to as the price elasticity of demand" &he nonlinear demand function can be s!etched as in figure /"-"1 below" F%4# ) 3.&.1: N!n0%n)- D).-n" F#n$t%!n 7rice 7x 4x F a7x b > Muantity 4emanded (4x) 3.3 M#0t%8V- %-t) ! D1n-.%$ D).-n" F#n$t%!n &he demand functions discussed above are classified as single variable demand functions$ and$ as such$ referred to as short term demand functions" the long run$ neither the individual nor the mar!et demand for a given product is determined by anyone of its determinants alone$ because other determinants do not remain constant" &he long run demand for a product depends on the composite impact of all its determinants

31

operating simultaneously" #t follows that in order to estimate the long term demand for a product$ all the relevant determinants must be ta!en into account" &he long run demand functions describe the relationship between a demand for a product (the dependent variable) and its determinants (the independent variables)" 4emand functions of this type are referred to as multi-variate or dynamic demand functions" 9onsider the demand for product Q$ (4x)$ which depends on such variables as its own price (7x)$ consumer*s income (I)$ price of its substitutes (7s)$ price of the complementary goods (7c)$ consumer*s taste (&)$ and advertisement expenditure (5)$ the functional form can be written as: 4x F f(7x$ I$ 7s$ 7c$ &$ 5) (/"/"1)

#f the relationship between the demand (4x) and the quantifiable independent variables$ 7x$ I$ 7s$ 7c$ and 5$ is of a linear form$ then the estimable form of the demand function is formulated as: 4x F a H b7x H cI H d7s H e7c H g5 (/"/"-)

where Ea* is a constant and parameters b$ c$ d$ e" and g are the coefficients of relationship between the demand for product Q (4x) and the respective independent variables" ;or the mar!et demand function for a product$ other independent variables such as si'e of the population (<)$ and a measure of income distribution$ the Gini coefficient (G) may be included in equation (/"/"-)" 3.5 S)0,8A++)++.)nt E<) $%+)B %),01 present the ma(or determinant of the form of a firm*s demand function" 5.0 C!n$0#+%!n Iou can define a demand function as a symbolic representation of relationship between the demand for a product and its determinants" Ahen established$ this relationship can help you predict what will happen to the demand for your product when the determinants of the demand changes" demand function can ta!e any of the following forms: (i) linear, non linear, or multivariate"

6.0 S#..- 1 Iou have learned from this unit that: 1" is extremely important for a manager to understand the relationship between product*s demand and its determinants" -" is the nature of demand price relationship that determines the form of the demand function for a product" /" &he ma(or forms of demand function include:

3-

(i) &he linear demand function represented by the equation: 4x F a b7x (ii) 5 nonlinear demand function which is of the form of a power function given as: 4x F a7x b (iii) &he multivariate or dynamic demand function$ which ta!es into account all the relevant determinants of demand" =.0 T#t! 8M- 2)" A++%4n.)nt Iou are required to discuss$ with relevant examples$ the various forms of a demand function" R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT 10: ELASTICITY OF DEMAND C!nt)nt 1"> #ntroduction -"> +b(ectives /"> Elasticity of 4emand /"1 +wn G7rice Elasticity of 4emand

3/

/"- 9ross Elasticity of 4emand /"/ 4eterminants of 7rice elasticity of demand /"0 Measuring 7rice Elasticity of 4emand from a 4emand ;unction /"2 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n ;rom the managerial point of view$ the !nowledge of the nature of relationship between product*s demand and its determinants is not sufficient" Ahat is more important is the degree of responsiveness of demand to changes in its determinants" &his degree of responsiveness of demand to changes in its determinants is referred to as the elasticity of demand for the product in question" &he concept of elasticity of demand plays significant role in pricing decisions" #n practical business decisions$ firms would li!e to pass cost increases over to the consumers through price increases" 1ut whether increase in price as a result of rising cost is beneficial to the firm will depend on: 2" the price elasticity of demand for the product, and$ 3" the price elasticity of demand for its substitutes %aising the price may be beneficial if: (i) demand for a product is less elastic, and$ (ii) demand for its substitute is much less elastic" &his unit discusses the various methods of measuring price elasticity of demand" &he concepts of price elasticities of demand mostly used in business decisions are: 4i5 O+n2 Price Elasticit#) 4ii5 Cross2Price Elasticit#) &.0 O'()$t%*)+ 5t the end of this unit$ you must have: 1" able to define the elasticity of demand -" the different types of demand elasticities used in business decisions /" 8earned how to apply the concepts of demand elasticities in ma!ing production and distribution decisions" 3.0 !, D).-n" &he elasticity of demand concepts are presented as follows: 3.1 O;n FP %$) E0-+t%$%t1 !, D).-n" &he own price elasticity of demand is generally defined as the degree of responsiveness of demand for a commodity to changes in its own price" More precisely$ it is the

30

percentage change in quantity demanded as a result of one percent change in the price of the commodity" &he wor!ing definition is as follows: ep 7ercentage change in quantity demanded (M) 7ercentage change in price (7) where ep stands for own price elasticity" ;rom this definition$ a general formula for the calculation of the coefficient of own price elasticity is derived as follows: ep TM V T7 F TM x 7 M 7 M T7 F TM x 7 T7 M (/"1"1)

where M F original quantity demand$ 7 F original price$ TM F change in quantity demanded (new quantity G original quantity)$ T7 F change in price (new price G original price)" <ote that since the term$ TMPT7$ is the slope of the demand function$ a minus sign ( ) is generally inserted in the formula (/"1"1) before the fraction with a view to ma!ing the elasticity coefficient a non negative value" &he own price elasticity can be measured between two points on a demand curve (for arc elasticit#5 or on a point ( for point elasticit#50 3.1.1 A $ E0-+t%$%t1 5n arc elasticity measures the elasticity of demand between any two finite points on a given demand line or curve" of elasticity between points 5 and 1 in figure /"3 below$ for example$ is referred to as arc elasticity" Movement from point 5 to 1 indicates a fall in the commodity price from say$ <1>Punit to <BPunit$ so that T7 F <(1> G B) F <-" decrease in price is assumed to cause an increase in quantity demanded from say$ 2> to 3> units$ so that TM F 2> G 3> F 1> units" &he elasticity from 5 to 1 can be computed by substituting these values into the elasticity formula to get: ep TMPT7 " 7oPMo (7o F original price, Mo F original quantity) F 1>P- x 1>P2> F 1 (the case of unitary elasticity) &he elasticity of 1 (unitary elasticity) implies that 1 percent decrease in price of the commodity results in 1 percent increase in quantity demanded" F%4# ) 3.1.1: A $ E0-+t%$%t1 ,! - L%n)- D).-n" F#n$t%!n

32

7rice /> (7x) -> 5 1> B 2 > 1> -> /> 0> 2> Muantity (Mx) 1 4x

3>

@>

#t is important to note that one problem associated with the use of arc elasticity is that the elasticity coefficient changes along the demand line or curve as the direction of price change is reversed$ say from price decrease to price increase in our present example" &o confirm this$ try re computing the arc elasticity if price rises from <BPunit to <1>Punit$ instead" 3.1.& P!%nt E0-+t%$%t1 7oint elasticity is the elasticity of demand at a finite point on a demand line or a demand curve" ;or example$ at the point 9 or 4 on the linear demand line$ M<$ of figure /"1"-$ you will calculate the point elasticity" &his is not the same as the arc elasticity between points 9 and 4" F%4# ) 3.1.&: P!%nt E0-+t%$%t1 ,! - L%n)- D).-n" F#n$t%!n 7rice (7) M % 9 4 > < M Muantity (M) 5 movement from point 4 towards 9 would imply change in 7rice (T7) becoming smaller and smaller$ such that point 9 is almost approached" 5t this point$ the change in price is infinitesimally small" &he measurement of elasticity for an infinitesimally small change in price is same as measurement of elasticity at a point" 7oint elasticity is measured by the following formula: 7oint elasticity (ep) F (7PM)(dMPd7)

33

&he derivative$ dMPd7$ is reciprocal of the slope of the demand line or demand curve$ that is$ 1Pd7PdM" 3.1.3 P!%nt )0-+t%$%t1 !n - N!n8L%n)- D).-n" C# *). #t is worthy of note that the ratio T4PT7 in respect of a non linear demand curve (function) is different at each point on the curve" follows that the technique used in measuring point elasticity on a linear demand function (line) can not be directly applied" &o measure point elasticity on a non linear demand curve$ the chosen point is first transformed or imposed on a linear demand line" &his can be done by drawing a tangent line through the chosen point on the non linear curve" figure /"1"/$ suppose for example$ you want to measure elasticity on the non linear demand curve$ 44$ at point 9$ you need to draw a line M< tangent to the curve through the point$ 9" the line M< passes through the same point$ 9 as the non linear demand curve$ 44$ the slope of the line and the demand curve at point 9 is the same" &hus$ the elasticity of the demand curve at point 9 will be equal to that of the line at this point" &he elasticity of the line at point 9 can be computed as: ep F 7 " dM M d7 F 9M " M< F M< >M 9M >M F%4# ) 3.1.3: M)-+# %n4 E0-+t%$%t1 !n N!n8L%n)- D).-n" C# *) 7 M 9 % 4 < > M Muantity 3.&: C !++8E0-+t%$%t1 !, D).-n" &he cross elasticity (or cross price elasticity) can be defined as the degree of responsiveness of demand for a commodity to the changes in price of its substitutes and complementary goods" formula for measuring the cross elasticity of demand for a commodity$ Q$ can be written as: Ex$i F 7ercentage change in quantity demanded of Q (Mx) 7ercentage change in the price of i (7i) F 7i " TMx (/"-"1) 4

3@

Mx T7i where i refers to either substitutes to commodity Q or its complementary goods" &he cross elasticity of demand can be used to identify substitute and complementary goods for a given commodity" #f the cross price elasticity between two goods is positive$ the two goods may be considered as substitutes to one another" &he greater the cross price elasticity coefficient$ the closer the substitute" 6imilarly$ if the cross price elasticity is negative$ the two goods may be considered as complements" &he higher the negative cross elasticity coefficient$ the higher the degree of complementarity" &he concept of cross elasticity is important in pricing decisions" #f the cross elasticity in response to the price of substitutes is greater than 1$ it would not be advisable to increase the price" %educing the price$ instead may prove beneficial" #f the price of the complementary good is rising$ it would be beneficial to reduce the price of the commodity" 3.3 D)t) .%n-nt+ !, P %$)8)0-+t%$%t1 !, ").-n" &he price elasticity of demand varies between 'ero and infinity (> W ep W X)" &he price elasticity of demand for a product within this range will depend on the following factors: 1. of S&-stit&tes for the pro%&ct0 is one of the most important determinants of the price elasticity of demand for a product" higher the degree of closeness between the commodity and its substitutes$ the greater the price elasticity of demand for the commodity" &. of the Co!!o%it#0 9ommodities can be grouped as luxuries$ comforts$ and necessities" &he demand for luxury goods is more price elastic than the demand for necessities and comforts" &his is so because the consumption of luxury goods can be dispensed with or postponed when their prices rise" +n the other hand$ the consumption of necessities cannot be postponed and hence$ their demand is price inelastic" 9omforts have more elastic demand than necessities$ and less elastic demand than luxuries" 3. in the .otal Cons&!ption0 &he proportion of income which consumers spend on a particular commodity influences the elasticity of demand for such commodity" &he larger the proportion of income spent on a commodity$ the greater will be the elasticity of demand for such commodity$ and vice versa. 5. factor in a%8&st!ent of Cons&!ption pattern0 7rice elasticity of demand depends on the time consumers need to ad(ust their consumption pattern to a new price" &he longer the ad(ustment time$ the greater the price elasticity of demand 6. of Co!!o%it# Use0 &he range of uses of a given commodity can affect the elasticity of demand for such commodity" &he wider the range of use of a product$ the higher the elasticity of demand for such product" Electricity$ for example$ has a wide

3B

range of use including$ lighting$ coo!ing$ and industrial activities" &he demand for electricity therefore has greater elasticity" 3.5 M)-+# %n4 P %$)8E0-+t%$%t1 !, D).-n" , !. - D).-n" F#n$t%!n. &he price elasticity of demand for a product can be measured directly from the demand function" Ae loo! at this from the perspective of the 8inear demand function$ as well as the non linear demand function" 4i5 Price2Elasticit# fro! a Linear De!an% /&nction0 ;or a given linear demand function$ you can measure the price elasticity by first ta!ing the first derivative with respect to the price variable$ 7$ (dMPd7)$ if price is the independent variable$ or with respect to the quantity variable$ M$ (d7PdM)$ if quantity is the independent variable" &he result will the be multiplied by the price quantity ratio (7PM) for the first case$ and the quantity price ratio (MP7) for the second case" a linear demand function: M F -1> G >"17$ the point elasticity can be measured for any price by using: dM " 7 d7 M ;or 7 F <2Punit$ the price elasticity would be: >"1(7PM)$ since d(-1> G >"17) F >"1 d7 Given that 7 F 2 (as specified above)$ we solve for M in the demand function to get: M F -1> G >"1(2) F -1> G >"2 F ->C"2 &herefore$ the required price elasticity of demand becomes$ ep >"1(2P->C"2) F >">>-" 4ii5 Price2Elasticit# fro! a Non2Linear De!an% /&nction0 &he computation of price elasticity from a non linear demand function follows the same process as that of the linear demand function" &he only difference is in the nature of the demand function" #f a non linear demand function is given by: M F a7 b$ then$ ep F dM " 7 d7 M where dM F ba7 b 1 d7 &he price elasticity of demand can therefore be expressed as: (/"0"1)

3C

ep ba7 b 1(7PM) F ba7 b M 6ince M F a7 b$ by substitution$ you get: (/"0"-) ep F ba7 b F b b a7 $ 5ccording to equation (/"0"-)$ when a demand function is of a multiplicative or power form$ the price elasticity coefficient equals the power of the variable 7" implies that price elasticity for multiplicative demand function remains constant$ regardless of a change in the commodity price" 3.6 S)0,8A++)++.)nt E<) $%+) 4efine the own price and cross price elasticities of demand and explain how one differs from the other 5.0 C!n$0#+%!n &his unit points out the importance of measuring price elasticies of demand" #t began by defining$ with simple examples$ own price elasticity of demand and cross price elasticity of demand" +ther information you can gather from the unit are (i) the determinants of price elasticity of demand, and$ (ii) how to measure price elasticity of demand from the demand function" 6.0 S#..- 1 &he own price elasticity of demand is generally defined as the degree of responsiveness of demand for a commodity to changes in its own price" More precisely$ it is the percentage change in quantity demanded as a result of one percent change in the price of the commodity" &he own price elasticity can be measured between two points on a demand curve (for arc elasticit#5 or on a point ( for point elasticit#50 &he cross elasticity (or cross price elasticity) can be defined as the degree of responsiveness of demand for a commodity to the changes in price of its substitutes and complementary goods" &he cross elasticity of demand can be used to identify substitute and complementary goods for a given commodity" #f the cross price elasticity between two goods is positive$ the two goods may be considered as substitutes to one another" &he greater the cross price elasticity coefficient$ the closer the substitute" 6imilarly$ if the cross price elasticity is negative$ the two goods may be considered as complements" &he higher the negative cross elasticity coefficient$ the higher the degree of complementarity" &he determinants of a commodity*s price elasticity of demand include: availability of substitutes, nature of the commodity, weightage of the total consumption, time factor in ad(ustment of consumption pattern, and$ range of commodity use"

@>

=.0 T#t! 8M- 2)" A++%4n.)nt 6uppose the demand function for a product is given by: Md F 2>> G 27$ compute the: (d) quantity demanded at the unit price of <1> (e) price to sell ->> units (f) price for 'ero demand (g) quantity demanded at 'ero price (h) the own price elasticity of demand at the price for which ->> units are sold"" >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT 11: PRICE ELASTICITY3 REVENUES3 AND INCOME ELASTICITY OF DEMAND C!nt)nt

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1"> #ntroduction -"> +b(ectives /"> %elationships 1etween 7rice elasticity$ %evenues$ and #ncome Elasticity of 4emand /"1 7rice Elasticity and &otal %evenue /"- #ncome Elasticity of 4emand /"/ 5dvertisement or 7romotional Elasticity of 6ales /"0 Elasticity of 7rice Expectations /"2 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &his unit examines some important applications of price elaticity of demand$ especially in the areas of total revenue and marginal revenue from the sale of goods and services" #t also extends the discussions of elasticity to those of income$ advertisement$ and price expectations" &.0 O'()$t%*)+ 1y the end of this unit$ you should be able to: 1" your understanding of elasticity of demand -" how demand elasticity$ revenue$ and income are related /" the concept of demand elasticity to sales forecasts and planning" 3.0 R)0-t%!n+7%/+ B)t;))n P %$) )0-+t%$%t13 R)*)n#)+3 -n" In$!.) E0-+t%$%t1 !, D).-n" 3.1 P %$)8E0-+t%$%t1 -n" T!t-0 R)*)n#) 5 revenue maximising firm would be interested in !nowing whether increasing or decreasing the commodity price would maximise revenue" &he price elasticity of demand for the firm*s product at different price levels would provide the answer this question" &he answer would come from the fact that if ep U 1$ then decreasing the price will increase the total revenue$ and if ep O 1$ then increasing the price will increase the total revenue" &he relationship between price elasticity (ep) and total revenue (&%) is sumarised in table /"1"1 below"

T-'0) 3.1.1: P %$)8E0-+t%$%t13 P %$)8C7-n4)3 -n" C7-n4) %n T!t-0 R)*)n#) Elasticit# If Price: .hen .otal Coefficient Re,en&e 9ill: #ncreases #ncrease ep F >

@-

ep O 1 ep F 1 ep U 1 ep F X

4ecreases #ncreases 4ecreases #ncrease 4ecrease #ncrease 4ecrease #ncrease 4ecrease

4ecrease #ncrease 4ecrease <o change <o change 4ecrease #ncrease 4ecrease to 'ero #nfinite increase$ depending on si'e of the mar!et

3.1.1 P %$)8E0-+t%$%t1 -n" M- 4%n-0 R)*)n#) <ote that Marginal %evenue (M%) is the first derivative of the total revenue (&%) function$ and that &% F 7M (7 F unit price, M F quantity sold)" &he relationship between price elasticity$ M%$ and &% is shown by the following derivations: 6ince &% F 7"M$ M% F d(7"M) F 7 H Md7 (the product rule of differentiation) dM dM F 7 1 H M " dM 7 dM <ote that in equation (/"/"@"/):: M " dM F 1Pep 7 d7 1y substituting G 1Pep into equation (/"1"1)$ you get: M% F 7Y1 G 1PepZ (/"1"1)

(/"1"-)

Given this relationship between Marginal %evenue (M%) and price elasticity of demand (ep)$ the deciding manager can easily !now whether it will be beneficial to change the price" ;rom equation (/"1"-)$ you can deduce that if ep F 1$ M% F >" follows that change in price will not affect the total revenue (&%)" #f ep O 1$ M% O >$ &% decreases when price decreases$ and &% increases when price increases" 5nd if ep U 1$ M% U >$ &% increases when price decreases$ and vice versa.

3.&: In$!.)8E0-+t%$%t1 !, D).-n" &he income elasticity of demand can be defined as the degree of responsiveness of demand to changes in the consumer*s income" <ote that unli!e the price elasticity of demand$ which is always negative due to the negative slope of the demand function$ the

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income elasticity of demand is always positive" &his is because of the positive relationship between demand and the consumer*s income" &his is the case however$ for normal goods" the case of inferior goods$ the income elasticity of demand is always negative" &his is so because the demand for inferior goods decreases with increases in consumer*s income$ and vice versa" &he income elasticity of demand for a commodity$ say Q can be computed by: (/"-"1) ey I " TMx Mx Ahere$ ey F income elasticity of demand, I F consumer*s income, Mx F quantity demanded of commodity Q" 5s noted above$ for all normal goods$ the income elasticity is positive" ?owever$ the degree or magnitude of elasticity varies in accordance with the nature and type of commodities" 9onsumer goods of the three categories: necessities) co!forts) and l&*&ries have different elastiticies" &he general pattern of income elasticities of different !inds of goods for increase in income and their effects on sales is given in table /"-"1 below for managers to ta!e note: T-'0) 3.&.1: M-4n%t#") !, In$!.)8E0-+t%$%t1 ,! "%,,) )nt C-t)4! %)+ !, G!!"+ Cons&!er Goo%s Coefficient of Effect on Sales Inco!e2Elasticit# Essential Goods 8ess than proportionate 8ess than 1 or unity change in sales (ey O 1) 9omforts 5lmost proportionate 5lmost equal to unity change in sales (ey [ 1) 8uxuries More than proportionate Greater than unity increase in sales (ey U 1) +wn price and cross elasticities of demand are specifically significant in the pricing of products aimed at the maximisation of short run revenues" of products is highly significant in long run planning and management of production$ especially during the period of business cycles" &he concept of income elasticity can be used in the estimation of future demand$ provided that the rate of increase in income and income elasticity of demand for the given product are !nown" can be useful in forecasting demand for expected changes in consumers* personal incomes$ other things remaining the same" .nowledge of income elasticity of demand is also helpful in the avoidance of over and under production" 3.3 A"*) t%+).)nt8 ! P !.!t%!n-08E0-+t%$%t1 !, S-0)+ #t is a !nown fact that expenditure on advertisements and on other sales promotion activities help in promoting sales$ but not in the same magnitude or degree at all levels of sales" concept of advertisement elasticity is found useful in the determination of

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optimum level of advertisement expenditure" &his concept assumes a greater significance in deciding advertisement expenditure than other decision variables" &his is so especially when the government imposes restriction on advertisement cost (as is the case in most developed economies)$ or there is competitive advertising by the rival firms" 1y definition$ advertisement elasticity of sales is the degree of responsiveness of sales to changes in advertisement expenditures" #t can be computed by the formula: (/"/"1) e5 F T6 " 5 T5 6 where 6 F sales, T6 F change in sales, 5 F initial advertisement cost, and$ T5 F additional expenditure on advertisement &he advertisement elasticity of sales varies between 'ero and infinity" &hus$ > W e5 W X 6ome values of the advertisement elasticity of sales can be interpreted according to table /"/"1 below: T-'0) 3.3.1: Int) / )t-t%!n !, A"*) t%+).)nt8E0-+t%$%t1 !, S-0)+ Elasticit# 4eA5 Interpretation 6ales do not respond to advertisement expenditure e5 F > #ncrease in total 6ales is less than proportionate to the increase > O e5 O1 in advertisement expenditure 6ales increase in proportion to the increase in expenditure on e5 F 1 advertisement 6ales increase at a higher rate than the rate of increase in e5 U 1 advertisement expenditure" 6ome of the i!portant factors affectin the a%,ertise!ent2elasticit# of sales can be outlined as follows: (i) .he le,el of total sales0 sales increase$ the advertisement elasticity of sales decreases" (ii) A%,ertise!ent -# ri,al fir!s0 a highly competitive mar!et$ the effectiveness of advertisement by a firm is determined by the relative effectiveness of advertisement by the rival firms (iii) C&!&lati,e effect of past a%,ertise!ents0 doses of advertisement expenditures do have cumulative effect on the promotion of sales$ and this may considerably increase the advertisement elasticity of sales"

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+ther factors affecting the advertisement elasticity of sales are those factors demand for the product$ including change in products price; consumers income; growth of substitute goods and their prices. 3.5 E0-+t%$%t1 !, P %$)8E</)$t-t%!n+ 4uring the period of price fluctuations$ consumer*s price expectations play a significant role in determining demand for a given commodity" &he price expectation elasticity refers to the expected change in future price as a result of changes in current prices of a given product" elasticity of price expectation is defined and measured by the following formula: ex T7f " 7c T7c 7f where 7c and 7f are current and future prices$ respectively" &he coefficient ex is a measure of expected percentage change in future price due to a 1 percent change in current price" ex U 1 implies that future change in price will be greater than the current change in price$ and vice versa. ex F 1 implies that the future change in price will be equal to the change in current price" &he concept of elasticity of price expectation is very useful in future pricing policies" ;or instance$ if ex U 1$ sellers will be able to sell more in the future at higher prices" 5ccordingly$ businesspeople may determine their future pricing policies" 3.6 S)0,8A++)++.)nt E<) $%+) Ahat are the possible consequences of a large scale firm placing its product in the mar!et without having estimated the demand for its productD 5.0 C!n$0#+%!n &his unit has exposed you further to the concepts and applications of elasticity of demand" Iou have observed the important relationship between price elasticity of demand and revenue$ and the relationship between price elasticity of demand and marginal revenue" &hese relationships will help you in your pricing decisions$ especially when your business ob(ective is to maximise sales revenue" Iou also learned that consumers* price expectations play significant roles in determining the demand for your commodity" &his is especially the case for periods of general price fluctuations" (/"0"1)

6.0 S#..- 1 &he points made by this unit can be summarised by you as follows: 1" revenue maximising firm would be interested in !nowing whether increasing or decreasing the commodity price would maximise revenue" &he price elasticity of

@3

demand for the firm*s product at different price levels would provide the answer this question" &he answer would come from the fact that if ep U 1$ then decreasing the price will increase the total revenue$ and if ep O 1$ then increasing the price will increase the total revenue" -" income elasticity of demand can be defined as the degree of responsiveness of demand to changes in the consumer*s income" &he income elasticity of demand is always positive$ especially for normal goods" #n the case of inferior goods$ the income elasticity of demand is always negative" &his is so because the demand for inferior goods decreases with increases in consumer*s income$ and vice versa" /" concept of advertisement elasticity is found useful in the determination of optimum level of advertisement expenditure" &his concept assumes a greater significance in deciding advertisement expenditure than other decision variables" 0" the period of price fluctuations$ consumer*s price expectations play a significant role in determining demand for a given commodity" &he price expectation elasticity refers to the expected change in future price as a result of changes in current prices of a given product" =.0 T#t! 8M- 2)" A++%4n.)ntG%*)n the demand function: Md F 1- G 7 (a) )sing some hypothetical figures for Md and 7$ present the demand and marginal revenue (M%) schedules (b) 7lot the average revenue (5%) and M% schedules (c) ;ind the marginal revenue when 7 F 1-$ 1>$ 3$ and 0 (d) Estimate the elasticity coefficient of the demand curve$ when the total revenue is at its maximum" >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT 1&: DEMAND FORECASTING C!nt)nt 1"> #ntroduction

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-"> +b(ectives /"> 4emand ;orecasting /"1 4emand ;orecasting &echniques /"- 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &he term demand forecasting in our context simply means predicting the future demand for a product" regarding future demand is essential for scheduling and planning production$ acquisition of raw materials$ acquisition of finance$ and advertising" ;orecasting is most useful where large scale production is involved and production requires long gestation period" &.0 O'()$t%*)+ Ahen you go through this unit$ you will be able to: 1" about how to forecast demand for your products -" at your finger tips the latest forecasting techniques /" models that can aid you in forecasting demand 3.0 D).-n" F! )$-+t%n4 3.1 D).-n" F! )$-+t%n4 T)$7n%B#)+ &here are many techniques employed in demand forecasting$ but of most important in our discussions are the S&r,e# and Statistical methods" 3.1. 1 T7) S# *)1 T)$7n%B#)+ 6urvey techniques are used where the purpose is to ma!e short run demand forecasts" &his technique uses consumer surveys to collect information about their intentions and future purchase plans" #t involves: (i) survey of potential consumers to elicit information on their intentions and plans, (ii) opinion polling of experts$ that is$ opinion survey of mar!et experts and sales representatives, &he methods used in conducting the survey of consumers and experts include: Cons&!er S&r,e# Metho%s 4%irect inter,ie+s50 4irect interview of the potential consumers may be in the form of: (a) Complete Enumeration. this case$ almost all the consumers or users of the product in question are contacted to ascertain their future of purchasing the product" quantities indicated by the consumers are added together to obtain the probable demand for the product" for example$ a ma(ority of n out of m households in a given

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geographical location indicate the quantity$ (q) they will be willing to purchase of a commodity$ then the total probable demand (4p) may be obtained as: 4p F q1 H q- H q/ H \ H qn where q1$ q-$ q/$ \ n$ represent demand by individual households" &his method can$ however$ be useful for products whose consumers are concentrated in a certain locality" #t may not be physically possible for cases where the mar!et is widely dispersed" (b) ample urvey. #n a sample survey$ only few potential consumers and users of the products are selected as respondents from the relevant mar!et" &he survey may ta!e the form of either direct interview or mailed questionnaire to the sample consumers" +n the basis of information obtained thereof$ the probable demand (4p) can be estimated by the simple formula: 4p F ?% (?$ 54) ?6 where ?% F number of households indicating demand for the product ?6 F the number of households surveyed ? F the census number of households from the relevant mar!et" 54 F average expected demand as indicated by the households survey F total quantity of demand indicated V number of households" &hough this method is widely used for forecasting demand$ it has limitations similar to those of the complete enumeration method" (c) !he End-"se #ethod. method of forecasting demand has a considerable theoretical and practical importance$ especially in forecastin %e!an% for inp&ts0 method involves four basic stages: Sta e 1: &his stage requires that all the possible users of the product in question be identified and listed" Sta e ": &he second stage involves fixing suitable technical norms of consumption$ expressed either per unit of production of the complete product or$ in some cases$ per unit of investment or per capita use" Sta e :: ?aving established the technical norms of consumption for the different industries and other end uses of the product$ the third step is the application of the norms" &his requires the !nowledge of the desired or targeted levels of output of the individual industries for the reference year$ and also the li!ely development in other economic activities for which the product is used"

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Sta e $: &he final stage in the end use method of demand forecasting involves the aggregation of the product wise or use wise content of the item for which the demand is to be forecast" %esult of this aggregation gives the estimate of demand for the product as a whole for the terminal year in question" Opinion Poll Metho%s0 &hese methods aim at collecting opinions of those possessing !nowledge of the mar!et$ such as the sales representatives$ sales executives$ professional mar!eting experts$ and mar!eting consultants" &he opinion poll methods include: (a) &he Expert +pinion method, (b) 4elphi method, and$ (c) Mar!et 6tudies and Experiments !he E$pert-Opinion #ethod. &his method involves the use of sales representatives in the assessment of demand for the product in the areas$ 6tates or cities they represent" sales representatives are expected to !now the future purchasing plans of consumers they transact business with" estimates of demand thus obtained from the different sales representatives at different areas$ 6tates and cities are added up to get the overall probable demand for the product in question" !he %elphi #ethod. method of demand forecasting is an extension of the simple expert opinion poll method" #t is used to consolidate the divergent expert opinions and to arrive at a compromise estimate of future demand" #n the 4elphi method$ the experts are provided with some information on estimates of forecasts of other experts$ along with the underlying assumptions" #t will then be the consensus of the experts about the forecasts that will become the final forecast for the future demand" #ar&et tudies and E$periments. &his method requires that firms first select some areas of representative mar!ets$ about four cities with similar features in terms of population$ income level$ cultural and social bac!ground$ occupational distribution$ and consumer preferences and choices" &his is followed by mar!et experiments involving changing prices$ advertisement expenditures$ and other controllable variables in the demand function$ all things being equal" &hese variables are changed over time$ either simultaneously in all the mar!ets or in selected mar!ets" ?aving introduced these changes$ the consequent changes in demand over a period of time are then recorded" 1ased on these data$ elasticity coefficients are then computed$ and these coefficients are used to assess the forecast demand for the product" 3.1.&. St-t%+t%$-0 T)$7n%B#)+ &he statistical techniques of demand forecasting use historical (or time series)$ and cross section data for estimating long term demand for a product" &he techniques are found more reliable than those of the survey techniques" &hey include: (i) the &rend 7ro(ection techniques, (ii) the 1arometric techniques, and$ (iii) the Econometric techniques" +ur discussions will$ however$ concentrate on the Econometric techniques as these are more superior and reliable than the &rend 7ro(ection and 1arometric techniques"

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.he Econo!etric .echni3&es0 &he Econometric techniques include: (i) %egression method, and$ (ii) 6imultaneous Equation method" 3.1.3T7) R)4 )++%!n M)t7!". %egression analysis is found to be the most popular method of demand estimation andPor forecasting" #t combines economic theory and statistical techniques of estimation" &he economic theory specifies the determinants of demand and the nature of the relationship between the demand for a product and its determinants" #t helps in ascertaining the general form of demand function" techniques on the other hand are employed in estimating the values of the parameters in the estimated equation" #n regression models$ the quantity to be forecast in the demand function is the dependent variable$ and the determinants of demand are the independent or e$planatory variables" #n specifying the demand functions for various commodities$ the forecaster may come across many commodities whose demand depends$ at large$ on a single independent variable" ;or instance$ suppose the demand for sugar in a given geographical area is found to depend largely on the population$ then the demand function for sugar will be referred to as a sin le2,aria-le demand function" 1ut if it is found that demand functions for fruits and vegetables depend on a number of variables such as$ their own prices$ substitutes$ household income$ population$ and the li!e$ then such demand functions are referred to as !&lti2,aria-le demand functions" &he single regression equation is used for single variable demand functions$ while the multi variable equation is used for multi variable demand functions" single variable and multi variable regressions are outlined below" .he Si!ple or Bi,ariate Re ression .echni3&e 5s mentioned earlier$ in a simple regression technique$ a single independent variable is used in estimating the statistical value of the dependent variable or the variable to be forecast" &his technique is similar to trend fitting$ though$ in trend fitting$ the independent variable is time$ t$ while in the case of simple regression$ the chosen independent variable is the single most important determinant of demand" 6uppose we want to forecast the demand for sugar$ for example$ for particular periods on the basis of some past data$ we would estimate the regression equation of the form: I F a H bQ (/"1"1)

where I represents the quantity of sugar to be demanded, and$ Q represents the single variable$ population$ and a and b are constants" &he parameters a and b can be estimated$ using the past data$ by solving the following corresponding linear quations for a and b:

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]Ii F na H b]Qi ]QiIi F a]Qi H bQi-

(/"1"-) (/"1"/)

&he procedures for calculating the terms in equations (/"1"-) and (/"1"/) can be illustrated by the following example" 9onsider the following hypothetical past data on the demand for sugar for the years ->>> to ->>3: T-'0) 3.1.1: D).-n" ,! S#4Iear 7opulation Muantity of sugar demanded (millions) (>>>*s) ->>> ->>1 ->>->>/ ->>0 ->>2 ->>3 1> 112 -> -2 /> 0> 0> 2> 3> @> B> C> 1>>

)sing this hypothetical data$ we can calculate the terms as shown in table /"1"- below: T-'0) 3.1.&: C-0$#0-t%!n !, T) .+ !, t7) L%n)- EB#-t%!n+ %n S%./0) R)4 )++%!n Iear 7opulation Muantity of sugar (Qi) (Ii) QiQiIi ->>> 1> ->>1 1->>12 ->>/ -> ->>0 -2 ->>2 /> ->>3 0> nF@ ]Qi F 120> 2> 3> @> B> C> 1>> ]Ii F 0C> 1>> 100 --2 0>> 3-2 C>> 13>> ]Qi- F /CC0 0>> 3>> C>> 10>> ->>> -@>> 0>>> ]QiIi F 1->>>

6ubstituting the related values from table /"1"- into equations (/""1"-) and (/"1"/)$ we get: 0C> F @a H 12-b 1->>> F 12-a H /CC0b (/"1"0) (/"1"2)

6olving simultaneously for a and b in the above equations$ we obtain: a F -@"00, b F 1"C3" these values into the regression equation (/"/"11)$ the estimated regression equation becomes: I F -@"00 H 1"C3Q (/"1"3)

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Aith the regression equation (/"1"3)$ the demand for the commodity concerned can be easily forecast for any period provided that the figure for the population or any single determinant of demand is !nown" the population for the year ->>B is pro(ected to be 1>> million then the demand for sugar$ according to our example$ would be estimated using the regression equation as: I F -@"00 H 1"C3(1>>) F -@"00 H 1C3> F --/$00> units" &he simple regression technique is based on the following assumptions: 0" the independent variable will continue to grow at the estimated growth rate$ 1"C3 according to regression equation (/"1"3), 2" the relationship between the dependent and independent variables will continue to remain the same in the future as in the past" .he M&lti2;ariate Re ression .echni3&e &he technique is used in cases where the demand for a commodity is determined to be a function of many independent variables$ or where the explanatory variables are greater than one" analysis in this technique is referred to as multiple regression analysis" &he procedure of multiple regression analysis involves the following steps: tep One' pecification of the independent or e$planatory variables, that is$ the variables that explain the variations in demand for the commodity in question" variables are identified from the determinants of demand as listed earlier" tep !wo' Collection of time-series data on the independent variable. the necessary data on both the dependent (the demand for the commodity) and independent variables (the determinants of demand) are collected" tep !hree' pecification of the (egression E)uation. &he reliability of the demand forecast depends to a large extent on the form of regression equation and the degree of consistency of the explanatory variables in the estimated demand function" &he greater the degree of consistency$ the higher will be the reliability of the estimated demand function and vice versa. &he final step is to employ the necessary statistical technique in estimating the parameters of the regression equation" 6ome common forms of multi variate demand functions are as follows: *. !he +inear ,unction. &he linear demand function is where the relationship between the demand and its determinants is formulated by a straight line" &he most common type of this equation is of the form: Mx F ^ G b7x H cI H d7s H L5 (/"1"@)

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where Mx F quantity demanded of commodity Q, 7x F unit price of commodity Q, I F consumer*s income, 7s F price of substitute good, 5 F advertisement expenditure, ^ is a constant (or the demand intercept)$ and b$ c$ d$ and ( are the parameters (or regression coefficients) expressing the relationship between demand and 7x$ I$ 7s$ and 5$ respectively" #n linear demand functions$ quantity demanded is assumed to change with changes in independent variables at a constant rate" &he parameters are estimated by using the least squares method" ?aving estimated the parameters$ the demand can be easily forecast if data on the independent variables for the reference period are available" -. !he .ower ,unction. #n the linear functions of demand$ the marginal effects on demand of independent variables are assumed to be constant and independent of changes in other variables" #t is assumed$ for instance$ that the marginal effect of a change in own price is independent of change in income or other independent variables" &here may$ however$ be cases in which it is intuitively or theoretically found that the marginal effect of the independent variables on demand is neither constant nor independent of the values of all other variables included in the demand function" ;or example$ the effect of an increase in the price of sugar on demand may be neutralised by a rise in consumer*s income" #n such cases$ a multiplicative or Epower* form of the demand function$ considered to be the most logical form$ is used for estimating the demand of a commodity" &he power form of the demand function is given by: Mx F ^7xbIc7sd5( (/"1"B)

&he algebraic form of multiplicative demand function can be transformed into a log linear form for simplicity in estimation as follows: 8og Mx F log ^ G b log 7x H c log I H d log 7s H ( log 5 (/"1"C)

&his can be estimated using the least squares regression technique" &he estimated function can easily be used in forecasting the future demand for the given commodity" 3.1.5T7) S%.#0t-n)!#+ EB#-t%!n+ M)t7!" &his method of demand forecasting involves the estimation of several simultaneous equations" &hese equations are$ generally$ behavioural equations$ mathematical identities$ and mar!et clearing equations" 4emand forecasting using econometric models of simultaneous equations enables the forecaster ta!e into account the simultaneous interaction between dependent and independent variables" &he simultaneous equations method is a complete and systematic approach to forecasting in general" #t uses sophisticated mathematical and statistical tools which are beyond the scope of the present discussions" effect$ our discussions here will be restricted to the basic steps in the application of this method of forecasting"

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&he first step is to develop a complete model and specify the behavioural assumptions regarding the variables included in the model" &he variables included in the model are referred to as (i) endogenous variables$ and (ii) exogenous variables" &he en%o eno&s ,aria-les are variables whose values are determined within the model" Endogenous variables are included in the model as dependent variables or variables to be explained by the model" &hese variables are often referred to in econometrics as Econtrolled* variables" <ote that the number of e)uations in the model must e)ual the number of endogenous variables. E*o eno&s ,aria-les are those whose values are determined outside the model" &hey are referred to as inputs of the model" &he purpose of a given model will determine whether a variable is endogenous or exogenous" variables are also loo!ed at as Euncontrolled variables" &he secon% step is to collect the necessary data on both endogenous and exogenous variables" #f you find that data is not available$ they can be generated from available primary or secondary sources" ?aving developed the model$ and the necessary data collected$ the thir% step is to estimate the model using the appropriate method$ and the two-stage least-s)uares method to predict the values of the exogenous variables" /inall#) the model is solved for each endogenous variable in terms of exogenous variables" 1y plugging the values of exogenous variables into the equations$ the ob(ective value can be calculated and prediction made" &he simultaneous equation method is theoretically superior to the simple regression method" &he main advantage of the method is that it is capable of capturing the influence of dependency of the variables" &he ma(or limitation is non availability of adequate data" &he following example illustrates the simultaneous equation method" 5 simple macroeconomic model is given below: It F 9t H #t H Gt H Qt (/"1"1>)

where$ It F Gross <ational 7roduct (G<7) 9t F &otal consumption expenditure #t F Gross 7rivate #nvestment Gt F Government expenditure Qt F <et Export (Q G M)$ where Q represents Export$ and M$ #mport" 6ubscript t represents a given time unit" Equation (/"/"->) is an identity that can be explained with a system of simultaneous equations$ such as:

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9t F a H bIt #t F -> Gt F 1> Qt F 2

(/"1"11) (/"1"1-) (/"1"1/) (/"1"10)

#n the above system of equations$ It and 9t are the endogenous variables$ and #t$ Gt$ and Qt$ are exogenous variables" Equation (/"1"11) is a regression equation that needs to be estimated" Equations (/"1"1-) to (/"1"1) show the values of exogenous variables determined outside the model" 6uppose you want to predict the values of It and 9t simultaneously$ and that when you estimated equation (/"1"11) you get: 9t F 1>> H >"@2It (/"1"12)

)sing this equation$ the value of It can be determined as: It F 9t H #t H Gt H Qt F 1>> H >"@2It H -> H 1> H 2 F >"@2It H 1/2 It G >"@2It F 1/2 >"-2It F 1/2 It F 1/2P>"-2 F 20>" )sing this value of It$ you can evaluate the value of 9t as follows: 9t F 1>> H >"@2It F 1>> H >"@2(20>) F 1>> H 0>2 F 2>2" #t follows that the predicted values will be: It F 20> 9t F 2>2 It F 2>2 H -> H1> H 2 F 20>" <ote that the above example of econometric model is an extremely simplified model" #n actual practice$ the econometric models are generally very complex" 3.& S)0,8A++)++.)nt E<) $%+) 4iscuss the necessary steps in the application of the simultaneous equation method of forecasting

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5.0 C!n$0#+%!n Iou must have learned some useful forecasting techniques from this unit" Iou also learned that the term demand forecasting simply means predicting the future demand for a product" regarding future demand is essential for scheduling and planning production$ acquisition of raw materials$ acquisition of finance$ and advertising" ;orecasting is most useful where large scale production is involved and production requires long gestation period" 6.0 S#..- 1 5mong the numerous techniques employed in demand forecasting$ the most important of them are the S&r,e# and Statistical techniques" &he survey techniques are used where the purpose is to ma!e short run demand forecasts" technique uses consumer surveys to collect information about their intentions and future purchase plans" #t involves: (i) survey of potential consumers to elicit information on their intentions and plans, and$ (ii) opinion polling of experts$ that is$ opinion survey of mar!et experts and sales representatives" &he statistical techniques use historical (or time series)$ and cross section data for estimating long term demand for a product" &he techniques are found more reliable than those of the survey techniques" &hey include: (i) the &rend 7ro(ection techniques, (ii) the 1arometric techniques, and$ (iii) the Econometric techniques" +ur discussions$ however$ concentrated on the Econometric techniques as these are more superior and reliable than the &rend 7ro(ection and 1arometric techniques" =.0 T#t! 8M- 2)" A++%4n.)nt 5n Economic %esearch 9entre has published data on the Gross 4omestic 7roduct (G47) and the 4emand for refrigerators as presented below: <ear: &000 &001 &00& &003 &005 &006 &00= GDP 4N1 -illions5: -> --2 -@ /> // /2 Refri erators 4!illions5: 2 3 B B C 1> 1(a) Estimate the regression equation$ % F a H bI where % F refrigerators (in millions)$ and I F G47 (in <*billions) (b) ;orecast the demand for refrigerators for the years ->>@$ ->>B$ and ->>C$ if the %esearch 9entre pro(ected the G47 for ->>@$ ->>B$ and ->>C to be <0> billion$ <2billion$ and <32 billion$ respectively

>.0 R),) )n$)+ 1" 4wivedi$ <" (->>-) Mana erial Econo!ics) si*th e%ition 4elhi: :i!as 7ublishing ?ouse 8td)"

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-" E" ;" and 7aul$ %" 6" (1C@3)$ Intro%&ctor# Mathe!atical Anal#sis for St&%ents of B&siness an% Econo!ics) "n% e%ition (%eston :irginia: %eston 7ublishing 9ompany)

UNIT 13: THE THEORY OF PRODUCTION C!nt)nt 1"> #ntroduction -"> +b(ectives

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/"> &he &heory of 7roduction /"1 &he 7roduction ;unction /"- 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n <o matter the ob(ective of any business organisation$ achievement of efficiency in production or cost minimisation for a given production activity appear to be one of the prime concern of the managers" 5s a matter of fact$ the survival of a business firm in a competitive environment depends on its ability to produce at competitive costs" ;irms are$ therefore$ mandated to either minimise costs of production or maximise output from a given quantity of inputs" #n the manager*s effort to minimise production costs$ the fundamental questions he or she faces are: (f) ?ow can production be optimi'ed or costs minimisedD (g) Ahat will be the beaviour of output as inputs increaseD (h) ?ow does technology help in reducing production costsD (i) ?ow can the least cost combination of inputs be achievedD (() Given the technology$ what happens to the rate of return when more plants are added to the firmD &he theory of production attempts to provide theoretical answers to these questions$ through abstract models built under hypothetical conditions" #t follows that$ though production theories may not provide solutions to the real life business problems$ it can provide tools and techniques for the analysis of production conditions and for finding solutions to the practical business problems" #n this unit$ we present the theory of production" #n unit 10$ the discussions will be extended to other important aspects of production$ including economies of scale and optimal input combinations" &.0 O'()$t%*)+ 5t the end of this unit$ should be able to: 1" the relationships between production and the factors of production -" answers to the fundamental questions managers as! themselves in their efforts to minimise costs of production" /" the basic forms of production functions 0" efficient production decisions 3.0 T7) T7)! 1 !, P !"#$t%!n 7roduction theory generally deals with quantitative relationships$ that is$ technical and technological relationships between inputs$ especially labour and capital$ and between inputs and outputs"

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5n inp&t is a good or service that goes into the production process" 5s economists refer to it$ an input is simply anything which a firm buys for use in its production process" o&tp&t) on the other hand$ is any good or service that comes out of a production process" Economists classified inputs as (i) labour, (ii) capital, (iii) land, (iv) raw materials, and$ (v) time" &hese variables are measured per unit of time and hence referred to as flow variables" #n recent times$ entrepreneurship has been added as part of the production inputs$ though this can be measured by the managerial expertise and the ability to ma!e things happen" #nputs are classified as either fi*e% or ,aria-le inputs" ;ixed and variable inputs are defined in both economic sense and technical sense" economic sense, a fixed input is one whose supply is inelastic in the short run" technical sense, a fixed input is one that remains fixed (or constant) for certain level of output" 5 variable input is one whose supply in the short run is elastic$ example$ labour$ raw materials$ and the li!e" )sers of such inputs can employ a larger quantity in the short run" &echnically$ a variable input is one that changes with changes in output" the long run$ all inputs are variable" 3.1 T7) P !"#$t%!n F#n$t%!n 7roduction function is a tool of analysis used in explaining the input output relationship" #t describes the technical relationship between inputs and output in physical terms" #n its general form$ it holds that production of a given commodity depends on certain specific inputs" #n its specific form$ it presents the quantitative relationships between inputs and outputs" 5 production function may ta!e the form of a schedule$ a graph line or a curve$ an algebraic equation or a mathematical model" &he production function represents the technology of a firm" 5n empirical production function is generally so complex to include a wide range of inputs: land$ labour$ capital$ raw materials$ time$ and technology" &hese variables form the independent variables in a firm*s actual production function" 5 firm*s long run production function is of the form: (/"1"1) M F f(8d$ 8$ .$ M$ &$ t) where 8d F land and building, 8 F labour, . F capital, M F materials, & F technology, and$ t F time" ;or sa!e of convenience$ economists have reduced the number of variables used in a production function to only two: capital (.) and labour (8)" &herefore$ in the analysis of input output relations$ the production function is expressed as: M F f(.$ 8) (/"1"-) Equation (/"1"-) represents the algebraic or mathematical form of the production function" #t is this form of production function which is most commonly used in production analysis"

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5s implied by the production function (equation (/"1"-))$ increasing production$ M$ will require . and 8$ and whether the firm can increase both . and 8 or only 8 will depend on the time period it ta!es into account for increasing production$ that is$ whether the firm is thin!ing in terms of the short run or in terms of the long run. Economists believe that the supply of capital (.) is inelastic in the short run and elastic in the long run" in the short run firms can increase production only by increasing labour$ since the supply of capital is fixed in the short run" the long run$ the firm can employ more of both capital and labour$ as the supply of capital becomes elastic over time" #n effect$ there exists two types of production functions: &he short run production function, and$ &he long run production function 3.1.1 T7) S7! t8 -n" L!n48R#n P !"#$t%!n F#n$t%!n+ &he short2r&n production function$ often referred to as the sin le ,aria-le pro%&ction f&nction) can be written as: M F f(8) (/"1"/)

#n the lon 2r&n) both capital (.) and labour (8) is included in the production function$ so that the long run production function can be written as: M F f(.$ 8) (/"1"0)

5 production function is -ase% on the follo+in ass&!ptions: (i) perfect divisibility of both inputs and output, (ii) there are only two factors of production G capital (.) and lacour (8), (iii) limited substitution of one factor for the other, (iv) a given technology, and$ (v) inelastic supply of fixed factors in the short run" 5ny changes in the above assumptions would require modifications in the production function" &he two most important forms of production functions used in economic literature in analysing input output relationships are the Cobb-%ouglas production function and the Constant Elasticity of ubstitution /CE 0 production function" +ur interest at this level will be limited to the 9obb 4ouglas production function"

3.1.& T7) C!''8D!#40-+ P !"#$t%!n F#n$t%!n &he 9obb 4ouglas production function is of the following general form:

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M F 5.a8b where a and b are positive fractions"

(/"1"2)

&he 9obb 4ouglas production function is often used in its following form: M F 5.a8(1 a) (/"1"3)

P !/) t%)+ !, t7) C!''8D!#40-+ P !"#$t%!n F#n$t%!n 5 power function of the 9obb 4ouglas type has the following important properties: /irst) the multiplicative form of the power function (/"1"2) can be transformed into its log linear form as: log M F log 5 H a log . H b log 8 (/"1"@) #n its logarithmic form$ the function becomes simple to handle and can be empirically estimated using linear regression techniques" Secon%) power functions are homogeneous and the degree of homogeneity is given by the sum of the exponents a and b as in the 9obb 4ouglas function" #f a H b F 1$ then the production function is homogeneous of degree 1 and implies constant returns to scale" .hir%) a and b represent the elasticity coefficient of output for inputs$ . and 8$ respectively" &he output elasticity coefficient (_) in respect of capital can be defined as proportional change in output as a result of a given change in .$ !eeping 8 constant" &hus$ _! F `MPM F `M" . `.P. `. M (/"1"B)

1y differentiating the production function$ M F 5.a8b$ with respect to . and substituting the result into equation (/"1"B)$ the elasticity coefficient$ _!$ can be derived: `M F a5. (a 1)8b `. 6ubstituting the values for M (equation (0"2)) and `MP`. into equation (/"1"B)$ you get: _! a 5. (a 1)8b Y Fa #t follows that the output coefficient for capital$ .$ is Ea*" same procedure may be applied to show that Eb* is the elasticity coefficient of output for labour$ 8" . Z 5.a8 b

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/o&rth) the constants a and b represent the relative distributive share of inputs . and 8 in the total output$ M" &he share of . in M is given by: `M " . `. 6imilarly$ the share of 8 in M can be obtained by: `M " 8 `8 &he relative share of . in M can be obtained as: `M " ." 1 a `. M and the relative share of 8 in M can be obtained as: `M " 8 " 1 b `8 M ;inally$ the 9obb 4ouglas production function in its general form $ M F .a8(1 a)$ implies that at 'ero cost$ there will be 'ero production" 6ome of the necessary concepts in production analysis can be easily derived from the 9obb 4ouglas production function as shown below: 1" 7roducts of 8 (578) and . (57.): 578 F 5 (.P8) (1 a) 57. F 5 (8P.)1 -" 7roducts of 8 (M78) and . (M7.): M78 F a(MP8) M7. F (1 G a)MP. /" %ate of &echnical 6ubstitution of 8 for . (M%&6 8$.): M%&6 8$. F M78 F a " . (1 a) 8 M7. <ote the M%&6 8$. is the rate at which a marginal unit of labour$ 8$ can be substituted for a marginal unit of capital$ . (along a given isoquant) without affecting the total output" 3.& S)0,8A++)++.)nt E<) $%+) ?ow does 9obb 4ouglas production function differ from the standard short run production functionD

5.0 C!n$0#+%!n &his unit points out that production theory deals with quantitative relationships$ otherwise !nown as technical and technological relationships between inputs$ especially labour and capital$ and between inputs and outputs"

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5n inp&t has been defined as a good or service that goes into the production process" economic terms$ an input is simply anything which a firm buys for use in its production process" o&tp&t) on the other hand$ is any good or service that comes out of a production process" Economists classified inputs as (i) labour, (ii) capital, (iii) land, (iv) raw materials, and$ (v) time" &hese variables are measured per unit of time and hence referred to as flow variables" #n recent times$ entrepreneurship has been added as part of the production inputs$ though this can be measured by the managerial expertise and the ability to ma!e things happen" &he unit discusses two ma(or forms of production functions: (i) the short and long run production functions, and$ (ii) the 9obb 4ouglas production function" 6.0 S#..- 1 &he unit notes that production function is a tool of analysis used in explaining the input output relationship" #t describes the technical relationship between inputs and output in physical terms" #t suggests that production of a given commodity depends on certain specific inputs" 5 production function may ta!e the form of a schedule$ a graph line or a curve$ an algebraic equation or a mathematical model" &he production function represents the technology of a firm" 5n empirical production function is generally so complex to include a wide range of inputs: land$ labour$ capital$ raw materials$ time$ and technology" &hese variables form the independent variables in a firm*s actual production function" 5 firm*s long run production function is of the form: 5 production function is -ase% on the follo+in ass&!ptions: (i) perfect divisibility of both inputs and output, (ii) there are only two factors of production G capital (.) and lacour (8), (iii) limited substitution of one factor for the other, (iv) a given technology, and$ (v) inelastic supply of fixed factors in the short run" &he two most important forms of production functions used in economic literature in analysing input output relationships are the Cobb-%ouglas production function and the Constant Elasticity of ubstitution /CE 0 production function" &he unit however$ focused on the 9obb 4ouglas form of production function" &he 9obb 4ouglas production function is of the following general form: M F 5.a8b where a and b are positive fractions" &he 9obb 4ouglas production function is often used in its following form:

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M F 5.a8(1 a) ;our important properties of the 9obb 4ouglas production function was discussed in detail in the unit" of which is that the powers a and - in the above production function (the first equation) represent the elasticity coefficient of output for . and 8 respectively" =.0 T#t! 8M- 2)" A++%4n.)nt Given the 9obb 4ouglas production function: M F 1>>.>"08>"3$ derive mathematically the output elasticities of capital (.) and labour (8)$ respectively" >.0 R),) )n$)+ 1" 4wivedi$ <" (->>-) Mana erial Econo!ics) si*th e%ition 4elhi: :i!as 7ublishing ?ouse 8td)" -" E" ;" and 7aul$ %" 6" (1C@3)$ Intro%&ctor# Mathe!atical Anal#sis for St&%ents of B&siness an% Econo!ics) "n% e%ition (%eston :irginia: %eston 7ublishing 9ompany)

UNIT 15: DEGREES OF PRODUCTION FUNCTIONS3 ECONOMIES OF SCALE3 RETURNS3 AND OPTIMAL INPUT COMBINATIONS

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C!nt)nt 1"> #ntroduction -"> +b(ectives /"> 4egrees of production ;unction$ Economies of scale$ %eturns to scale$ and +ptimal #nput 9ombinations /"1 4egree of 7roduction ;unctions and %eturns to 6cale /"- Economies and 4iseconomies of 6cale /"/ +ptimal #nput 9ombinations /"0 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &his unit discusses four important production concepts that a manager must !now in order to be in the hem of affairs in any production decision" the unit title indicates$ these concepts include: (i) degrees of production functions, (ii) economies of scale in production, (iii) returns to scale, and$ (iv) optimal input combinations" &.0 O'()$t%*)+ ?aving gone through this unit$ you should be able to: 1" more informed on the issues involving production decisions than ever" -" efficient and effective" /" the managerial implications of economies and diseconomies of scale in production" 3.0 D)4 ))+ !, / !"#$t%!n F#n$t%!n3 E$!n!.%)+ !, +$-0)3 R)t# n+ t! +$-0)3 -n" O/t%.-0 In/#t C!.'%n-t%!n+ 3.1 D)4 )) !, P !"#$t%!n F#n$t%!n+ -n" R)t# n+ t! S$-0) &he famous laws of returns to scale can be explained through production functions" 5ssume generally a production function involving two variables capital (.) and labour (8)$ and one commodity$ Q" production function may be expressed in the form: Mx F f(.$ 8) (/"1"1)

Mx denotes the quantity produced of commodity Q" 5ssume also that the production function is ho!o eneo&s) that is$ when all inputs are increased in the same proportion$ the proportion can be factored out mathematically" #f when all inputs are increased by a certain proportion (say$ !) and output increases by the same proportion (!)$ the production function is said to be homogeneous of degree 1" production function of homogeneous of degree 1 is expressed as follows: !Mx F f(!.$ !8) F !(.$ 8) (/"1"-)

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5 homogeneous production function of degree 1 implies constant ret&rns to scale0 Equation (/"1"-) indicates that increases in the inputs . and 8 by a multiple of !$ will increase output$ Mx$ by the same multiple$ !$ implying constant returns to scale" <ote that increasing inputs$ say . and 8 in the same proportion may result in increasing or diminishing returns to scale" 6imply stated$ it is li!ely that increases in all the inputs in certain proportion may not result in increase in output in the same proportion" #f all the inputs are doubled$ for example$ output may not be doubled$ it may increase by les than or more than double" #n this case$ the production function can be expressed as: hMx F f(!.$ !8) (/"1"/)

where h denotes h times increase in output$ Mx$ as a result of ! times increase in inputs$ . and 8" proportion$ h may be greater than !$ equal to !$ or less than !" touches on the three la+s of ret&rns to scale: (i) #f h F !$ production function reveals constant returns to scale (ii) #f h U !$ production function reveals increasing returns to scale (iii) #f h O !$ the production function reveals decreasing returns to scale" +bserve that in the production function$ equation (/"1"-)$ ! has an exponent equal to 1 (that is$ ! F !1)$ hence$ it is of homogeneous of degree 1" general$ the exponent of ! can ta!e the letter r$ where r a 1" production function is therefore$ said to be homogeneous of degree r when if all the inputs are multiplied by !$ output increases by a multiple of .r" is$ if$ f(!.$ !8) F .r(.$ 8) F !rM (/"1"0)$ then the production function (equation$ /"1"0) is homogeneous of degree r" ;rom this production function$ the laws of returns to scale can again be derived as follows: (i) #f ! U 1$ and r O 1$ production function reveals decreasing returns to scale (ii) #f ! U 1$ and r U 1$ production function reveals increasing returns to scale (iii) #f ! U 1$ and r F 1$ production function reveals constant returns to scale" 9onsider the following multiplicative form of a production function: M F .>"-28>"2> (/"1"2) #f . and 8 are multiplied by !$ and output increases by a multiple of h$ then hM F (!.)>"-2(!8)>"2>" factoring out !$ you get: hM F !>"-2 H >"2>Y.>"-28>"2>Z F !>"@2Y.>"-28>"2>Z (/"1"3)

5ccording to equation (0"10)$ h F !>"@2 and r F >"@2$ implying that r O 1$ and$ h O !" follows that the production function (equation$ /"1"2) shows decreasing returns to scale"

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9onsider another production function of the form: M F f(.$ 8$ Q) F .>"@2 81"-2 Q>"2> (/"1"@)

Multiplying .$ 8$ and Q by !$ M increases by a multiple of h: hM F (!.)>"@2 (!8)1"-2 (!Q)>"2> 5gain factoring out !$ you get: hM F !(>"@2H1"-2H>"2>)Y.>"@2 81"-2 Q>"2>Z F !-"2Y.>"@2 81"-2 Q>"2>Z +bserve that in this case$ h F !-"2 and r F -"2$ so that h U !" production function (equation$ /"1"@) depicts increasing returns to scale" 3.& E$!n!.%)+ -n" D%+)$!n!.%)+ !, S$-0) #t can be shown that 8ong run average cost decreases with the expansion of production scale up to a certain optimum level$ and then begins to rise" &his behaviour of the long run average cost is cost by the economies and diseconomies of scale" Economies of scale gives rise to cost savings$ while diseconomies of scale leads to cost increases" and diseconomies of scale determine also the returns to scale in production" #ncreasing returns to scale operates until economies of scale are greater than the economies of scale" Ahen economies of scale and diseconomies of scale are in balance$ returns to scale are constant" #n the discussions that follow$ we examine the various !inds of economies and diseconomies of scale" 3.&.1 E$!n!.%)+ !, S$-0). Economies of scale are of two different categories: (i) #nternal or %eal economies, and$ (ii) External or 7ecuniary Economies" i" Internal Econo!ies0 or Ereal economies* arise from the expansion of the plant si'e of the firm and are internali'ed" &his implies that internal economies are exclusively available to the expanding firm" #nternal economies are often classified under the categories: (a) Economies in production, (b) Economies in mar!eting, (c) Managerial economies, and$ (d) Economies in transport and storage" Economies in .roduction. in production arise from two basic sources: (a) technological advantages, and$ (b) advantages of division of labour and speciali'ation"

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Economies in #ar&eting. Economies in mar!eting arise from large scale purchase of raw materials and other material inputs$ as well as large scale selling of the firm*s own products" Economies in mar!eting the firm*s own product are associated with: (a) economies in advertisement cost, (i) economies in large scale distribution through wholesalers, and (c) other large scale economies" #anagerial Economies. arise from (a) speciali'ation in management, and$ (b) mechani'ation of managerial functions" Economies in !ransport and torage costs arise from full utili'ation of transport and storage facilities" ii" E*ternal or Pec&niar# Econo!ies of Scale0 &hese !ind of economies of scale accrue to the expanding firms from the advantages arising outside the firm$ from the input mar!et$ for example" 7ecuniary economies accrue to the large si'e firms in the form of discounts and concessions on: (i) large scale purchase of raw materials, (ii) large scale acquisition of external finance, (iii) massive advertisement campaigns, (iv) large scale hiring of means of transport and warehouse$ and the li!e" 3.&.& D%+)$!n!.%)+ !, S$-0) 4iseconomies of scale represent disadvantages that arise due to the expansion of scale of production$ leading to a rise in production cost" &his may be internal or e$ternal. i" Internal Disecono!ies of Scale0 Economies of scale has some limit$ which is reached when the advantages of division of labour and managerial staff have been fully exploited, excess plant capacity, excess warehouse capacity, excess transport and communication capacity$ and the li!e" 4ii5 E*ternal Disecono!ies of Scale0 &hese are the disadvantages that originate outside the firm: in the input mar!ets$ and due to natural constraints$ especially in agriculture and extractive industries" Aith the expansion of the industry$ for example$ the discounts and concessions that are available on bul! purchases of inputs$ as well as concessions on finance will eventually come to an end" demand for inputs also put pressure on the input mar!ets leading to increase in input prices that will further lead to rises in production costs" 3.3 O/t%.-0 In/#t C!.'%n-t%!n+ Economists are of the opinion that profit maximising firms see! to minimise costs for a given level of output$ or to maximise its output for a given total cost" &he two ma(or instruments in the maximisation of output are the Iso3&ants c&r,es and Isocost line) often referred to as the -&% et constraint line0 logic of isoquant tells you that a given level of output can be produced with different input combinations" Given the input prices$ however$ only one of the input combinations would be the least cost combination" &he least cost combination represents the input combination for which the budget

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constraint line is tangent to the isoquant curve" &his is the point for which the slope of the budget constraint line equals the slope of the isoquant curve$ as indicated by figure /"/"1 below" F%4# ) 3.3.1: L)-+t8C!+t C!.'%n-t%!n !, In/#t+ . .o .b #soquant 7b Mo #socost

> 8b 8 8o 5ccording to figure 0"1$ the least cost combination of the inputs$ capital (.) and labour (8) is at the point (7b) for which the isocost line$ .o8o is tangent to the isoquant curve$ Mo" this point$ the optimal combination of capital (.) and labour (8) is +.b of . and +8b of 8" &his combination is optimal since it satisfies the least cost criterion: (/"/"1) M78 F 78 M7. 7. (/"/"-) +r M78 F M7. 78 7. where M78 and M7. are marginal products of labour and capital$ respectively$ and 78 and 7. are prices of labour and capital$ respectively" &he above least cost criterion can be translated in values terms by multiplying the marginal productivities of capital (M7.) and labour (M78) each by the product price (7) to obtain the marginal revenue product of labour (M%78) and the marginal revenue product of capital (M%7.)$ and ta!ing ratios to get: (/"/"/) M78"7 F M%78 M7."7 M%7. Equation (/"/"/) can be related to the ratio of input prices as follows: 78 F M%78 7. M%7. (/"/"0) +r$ M%78 F M%7. 78 7. #t can be inferred from equation (/"/"0) that least cost or optimum input combination requires that the marginal revenue productivity ratio of factors should be equal to their price ratios$ or that the marginal revenue productivity and factor price ratios of all the inputs must be equal"

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E,,)$t !, C7-n4)+ %n In/#t P %$)+ !n t7) O/t%.-0 C!.'%n-t%!n !, In/#t+ 9hanges in input prices affect the optimal combination of inputs at different magnitudes$ depending on the nature of input price change" #f all input prices change in the same proportion$ the relative prices of inputs (that is the slope of the budget constraint or isocost line) remain unaffected" 1ut when input prices change at different rates in the same direction$ or change at different rates in the opposite direction$ or price of only one input changes while the prices of other inputs remain constant$ the relative prices of the inputs will change" &his change in relative input prices changes both the input combinations and the level of output" change in input combinations is as a result of the substitution effect of change in relative prices of inputs" 5 change in relative prices of inputs would imply that some inputs have become cheaper in relation to others" minimising firms attempt to substitute relatively cheaper inputs for the more expense ones" refers to the s&-stit&tion effect of relative input price changes" /"/"1 &he effect of change in input prices on optimal input combinations is illustrated by figure /"/"- below" F%4# ) 3.3.&: S#'+t%t#t%!n E,,)$t !, C7-n4)+ %n In/#t P %$)+ . .o* .K ./ ..1 > 81 88o Eo E#1 8/ 8o* 8K 8 #E1

Ae assume that$ given the price of capital (7!) and price of labour (78)$ and the total resources as indicated by the isocost line$ .K8o$ the representative firm*s optimum input combination is given by point Eo in figure /"/"-" that 78 decreases (7! remaining constant)$ resulting in a new isocost$ .K8K$ which is tangent to the isoquant$ #- at point E-" this point$ the firm*s new optimum combination of inputs becomes +.1 H +8/" follows that the decrease in price of labour (78) has given rise to the reduction of capital input by the amount .1.- and increment of labour input by 818/" change in the input combination is referred to as the price effect of the decrease in the price of labour" price effect is composed of substitution and budget effects$ where the substitution effect is represented by the difference between price effect and budget effect" &hus$ 6ubstitution effect F 7rice effect G 1udget effect" ;rom figure -$ the 7rice effect F 818/$ and$

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1udget effect F 8186ubstitution effect F 818/ G 818- F 8-8/ Ae conclude therefore$ that a firm*s input combination changes with a change in the price of a given input$ all things being equal" #n this illustration$ the firm employs more of the cheaper input (8) and less of the more expensive one (.)" level of output also changes$ as you can infer from figure /"/"-" 3.5 S)0,8A++)++.)nt E<) $%+) Aith the appropriate diagram$ discuss the effect of a decrease in the price of labour input on the optimal input combination$ assuming a production function involving capital (.) and labour (8)" 5.0 C!n$0#+%!n 6ome of the important production concepts learned from this unit involve: degrees of production function, economies and diseconomies of scale, returns to scale, and$ optimal input combinations" Ae learned that Economies of scale are of two different categories: (i) #nternal or %eal economies, and$ (ii) External or 7ecuniary Economies" 4iseconomies of scale represent disadvantages that arise due to the expansion of scale of production$ leading to a rise in production cost" &his may be internal or e$ternal. 6.0 S#..- 1 5 production function is said to be ho!o eneo&s of %e ree 1 if when all inputs are increased by a certain proportion$ output is increased by the same proportion" ;or instance$ if when all inputs are increased by a certain proportion (say$ !) and output increases by the same proportion (!)$ the production function is said to be homogeneous of degree 1" homogeneous production function of degree 1 implies constant ret&rns to scale0 general$ given the production function: hMx F f(!.$ !8) where h denotes h times increase in output$ Mx$ as a result of ! times increase in inputs$ . and 8" proportion$ h may be greater than !$ equal to !$ or less than !" touches on the three la+s of ret&rns to scale: (i) #f h F !$ production function reveals constant returns to scale (ii) #f h U !$ production function reveals increasing returns to scale (iii) #f h O !$ the production function reveals decreasing returns to scale" Economies of scale gives rise to cost savings$ while diseconomies of scale leads to cost increases" Economies and diseconomies of scale determine also the returns to scale in production" #ncreasing returns to scale operates until economies of scale are greater than the economies of scale" Ahen economies of scale and diseconomies of scale are in balance$ returns to scale are constant"

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&he least cost combination of inputs is also the optimal input combinations" &his is the combination of inputs for which the marginal revenue products of the inputs are equal" =.0 T#t! 8M- 2)" A++%4n.)nt 4etermine whether the following production functions show constant$ increasing$ or decreasing returns to scale: (a) M F 8 >"3> . >"0> (b) M F 2. >"2 8 >"/ (c) M F 08 H -. >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT 16: THE THEORY OF COST C!nt)nt 1"> #ntroduction -"> +b(ectives /"> &he &heory of 7roduction 9osts

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/"1 &he 1usiness 9ost 9oncepts /"- 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n 1usiness decisions are generally ta!en based on the monetary values of inputs and outputs" <ote that the quantity of inputs multiplied by their respective unit prices will give the monetary value or the cost of pro%&ction0 7roduction cost is an important factor in all business decisions$ especially those decisions concerning: (a) the location of the wea! points in production management, (b) cost minimisation (c) finding the optimal level of output, (d) determination of price and dealers* margin, and$ (e) estimation of the costs of business operation" #n this unit$ we present briefly the cost concepts applicable to business decisions" &.0 O'()$t%*)+ 5t the end of this unit$ you will be expected to: 1" familiar with the theory of production costs -" the costs of business operation /" production costs 0" plausible costing decisions" 3.0 T7) T7)! 1 !, P !"#$t%!n C!+t+ 3.1 T7) B#+%n)++ C!+t C!n$)/t+ &he cost concepts are theoretically grouped under two over lapping categories: (i) 9oncepts used for accounting purposes, and$ (ii) 5nalytical cost concepts used in economic analysis of business activities" 3.1.1 A$$!#nt%n4 C!+t C!n$)/t+ &he accounting cost concepts include: 10 Cost an% Act&al or E*plicit Cost0 +pportunity cost can be seen as the expected returns from the second best use of an economic resource which is foregone due to the scarcity of the resources" scholars refer to opportunity cost as alternative cost. &here would be no opportunity cost if the resources available to the society were unlimited" 5ssociated with the concept of opportunity cost is the concept of econo!ic rent or econo!ic profit0 Economic rent is the excess of earning from investment over and above the expected profit" &he business implication of this concept is that investing in a given pro(ect will be preferred so long as its economic rent is greater than 'ero or positive"

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5dditionally$ if firms !now the economic rent of various alternative uses of their resources$ it will aid them in the choice of the best investment avenue" &he actual or explicit costs are those out of poc!et costs of labour$ materials$ machine$ plant building and other factors of production" -" an% /&ll Costs0 the expenses incurred to carry out a business are referred to as business costs" &hese are similar to actual or real costs$ and include all the payments and contractual obligations made by the firm$ together with the boo! cost of depreciation on plant and equipment" 1usiness costs are those used in calculating business profits and losses and for filing returns for income tax and for other legal purposes" /&ll costs include business costs$ opportunity costs and normal profit$ while normal profit represents a necessary minimum earning in addition to the opportunity cost$ which a firm must receive to remain in business" :0 an% I!plicit=I!p&te% Costs0 &hese are costs falling under business costs and are those entered in the boo!s of accounts" for wages and salaries$ materials$ insurance premium$ depreciation charges are examples of e$plicit costs. &hese costs involve cash payments and are recorded in accounting practices" &hose costs that do not involve cash outlays or payments and do not appear in the business accounting system are referred to as implicit or imputed costs" costs are not ta!en into account while calculating the loss or gains of the business$ though they form an important consideration in whether or not a factor will be continued in use for the day to day operations of the business" explicit and implicit costs together (explicit H implicit costs) form the econo!ic cost0 $0 an% Boo( Costs0 Expenditure items that involve cash payments or cash transfers$ both recurring and non recurring$ are referred to in economics as out-ofpoc&et costs. the explicit costs including wages$ rent$ interest$ cost of materials$ maintenance$ transport expenditures$ and the li!e are in this classification" +n the contrary$ there exists some actual business costs which do not involve cash payments$ but a provision is made in the boo!s of account and they are ta!en into account while finali'ing the profit and loss accounts" 6uch costs are !nown as boo& costs. &hese are somehow$ payments made by a firm to itself" 3.1.& An-01t%$-0 C!+t C!n$)/t+ U+)" %n E$!n!.%$ An-01+%+ !, B#+%n)++ A$t%*%t%)+. &he analytical cost concepts include: 3" ;ixed and :ariable 9osts @" &otal$ 5verage$ and Marginal 9osts B" 6hort %un and 8ong %un 9osts C" #ncremental 9osts and 6un! 9osts

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1>" ?istorical and %eplacement 9osts 11" 7rivate and 6ocial 9osts 10 an% ;aria-le Costs0 ,i$ed costs are those costs that are fixed in volume for a certain level of output" &hey do not vary with output" &hey remain constant regardless of the level of output" ;ixed costs include: (i) 9ost of managerial and administrative staff, (ii) 4epreciation of machinery, (iii) 8and maintenance$ and the li!e" ;ixed costs are normally short term concepts because$ in the long run$ all costs must vary" 1ariable Costs are those that vary with variations in output" include: (i) 9ost of raw materials, (ii) %unning costs of fixed capital$ such as fuel$ repairs$ routine maintenance expenditure$ direct labour charges associated with output levels, and (iii) the 9osts of all other inputs that may vary with the level of output" "0 A,era e) an% Mar inal Costs0 &he !otal Cost /!C0 refers to the total expenditure on the production of goods and services" #t includes both explicit and implicit costs" explicit costs themselves are made up of fixed and variable costs" a given level of output$ the total cost is determined by the cost function" &he 2verage cost /2C0 is obtained by dividing total cost (&9) by total output (M)" 59 F &9 (/"1"1) M #arginal Cost /#C0 is the addition to total cost on account of producing one additional unit of a product" #t is the cost of the marginal unit produced" cost of output can be computed as &9n G &9n 1$ where n represents the current number of units produced$ and n 1 represents the previous number of units produced" M9 can also be computed by the following relationship: M9 F 9hange in &9 F c&9 (/"1"-) 9hange in M cM #f the total cost (&9) is in a functional form$ M9 can be computed by the derivative: M9 F d&9 (/"1"/) dM :0 an% Lon 2R&n Costs0 Costs are costs which change as desired output changes$ si'e of the firm remaining constant" &hese costs are often referred to as variable costs" +ong-(un costs, on the other hand are costs incurred on the firm*s fixed assets$ such as plant$ machinery$ building$ and the li!e" #n the long run$ all costs become variable costs as the si'e of the firm or scale of production increases" 7ut differently$ long run costs are associated with changes in the si'e and type of plant" $0 Costs an% S&n( Costs0 9onceptually$ incremental costs are closely related to the concept of marginal cost$ but with a relatively wider connotation" Ahile

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marginal cost refers to the cost of extra or one more unit of output$ incremental cost refers to the total additional cost associated with the decision to expand output or to add a new variety of product" &he concept of incremental cost is based on the fact that$ in the real world$ it is not practicable to employ factors for each unit of output separately due to lac! of perfect divisibility of inputs" #ncremental costs also arise as a result of change in product line$ addition or introduction of a new product$ replacement of worn out plant and machinery$ replacement of old technique of production with a new one$ and the li!e" &he un& costs are those costs that cannot be altered$ increased or decreased$ by varying the rate of output" instance$ once management decides to ma!e incremental investment expenditure and the funds are allocated and spent$ all preceding costs are considered to be the sun! costs since they accord to the prior commitment and cannot be reversed or recovered when there is a change in mar!et conditions or a change in business decisions" '0 an% Replace!ent Costs0 3istorical cost refers to the cost an asset acquired in the past$ whereas$ replacement cost refers to the outlay made for replacing an old asset" &hese concepts derive from the unstable nature of price behaviour" Ahen prices become stable over time$ other things being equal$ historical and replacement costs will be at par with each other" 60 an% Social Costs0 7rivate and social costs are those costs which arise as a result of the functioning of a firm$ but neither are normally reflected in the business decisions nor are explicitly borne by the firm" 9osts in this category are borne by the society" #t follows that the total cost generated in the course of doing business may be divided into two categories: (i) those paid out by the firm, and$ (ii) those not paid or borne by the firm$ including the use of resources that are freely available plus the disutility created in the process of production" 9osts under the first category are !nown as private costs. &hose of the second category are !nown as e$ternal or social costs" of such social costs include: water pollution from oil refineries$ air pollution costs by mills and factories located near a city$ and the li!e" ;rom a firm*s point of view$ such costs are classified as e$ternal costs, and from the society*s point of view$ they are classified as social costs. &he relevance of the concept of social costs is more pronounced in the cost benefit analysis of the overall impact of a firm*s operation in the society as a whole$ and in wor!ing out the social cost of private gains" 3.& S)0,8A++)++.)nt E<) $%+) ?ow do incremental and sun! costs differ from marginal costs" 5.0 C!n$0#+%!n &his unit focused on the general cost concepts" &he cost concepts are theoretically grouped under two over lapping categories: (i) 9oncepts used for accounting purposes, and$

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(ii) 5nalytical cost concepts used in economic analysis of business activities" &he accounting cost concepts include: (i) +pportunity costs and explicit costs (ii) 1usiness and full costs (iii) Explicit and imputed costs (iv) +ut of poc!et and 1oo! costs &he analytical cost concepts include: 1-" ;ixed and :ariable 9osts 1/" &otal$ 5verage$ and Marginal 9osts 10" 6hort %un and 8ong %un 9osts 12" #ncremental 9osts and 6un! 9osts 13" ?istorical and %eplacement 9osts 1@" 7rivate and 6ocial 9osts 6.0 S#..- 1 &he unit*s discussions can be summarised as follows: ;irst$ opportunity cost can be seen as the expected returns from the second best use of an economic resource which is foregone due to the scarcity of the resources" scholars refer to opportunity cost as alternative cost. &here would be no opportunity cost if the resources available to the society were unlimited" 5ssociated with the concept of opportunity cost is the concept of econo!ic rent or econo!ic profit0 Economic rent is the excess of earning from investment over and above the expected profit" &he business implication of this concept is that investing in a given pro(ect will be preferred so long as its economic rent is greater than 'ero or positive" 6econd$ all the expenses incurred to carry out a business are referred to as business costs" &hird$ those costs that do not involve cash outlays or payments and do not appear in the business accounting system are referred to as implicit or imputed costs" ;ourth$ &he analytical cost concepts used in economic analysis of business activities include: (i) ;ixed and :ariable 9osts" costs are those costs that are fixed in volume for a certain level of output" 1ariable Costs are those that vary with variations in output" (ii) &otal$ 5verage$ and Marginal 9osts" (iii) 6hort %un and 8ong %un 9osts" hort-(un Costs are costs which change as desired output changes$ si'e of the firm remaining constant" &hese costs are often referred to as variable costs" +ong-(un costs, on the other hand are costs incurred on the firm*s fixed assets$ such as plant$ machinery$ building$ and the li!e" (iv) #ncremental 9osts and 6un! 9osts" 4ncremental costs are closely related to the concept of marginal cost$ but with a relatively wider connotation" Ahile marginal cost refers to the cost of extra or one more unit of output$ incremental cost refers to the total additional cost associated with the decision to expand output or to add a new variety of product" &he un& costs are those costs that cannot be altered$

1>B

increased or decreased$ by varying the rate of output" (v) ?istorical and %eplacement 9osts" 3istorical cost refers to the cost an asset acquired in the past$ whereas$ replacement cost refers to the outlay made for replacing an old asset" (vi) 7rivate and 6ocial 9osts" and social costs are those costs which arise as a result of the functioning of a firm$ but neither are normally reflected in the business decisions nor are explicitly borne by the firm" 9osts in this category are borne by the society" =.0 T#t! 8M- 2)" A++%4n.)nt 1riefly present what you thin! are the ma(or differences between accounting costs and economic costs" >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT 1=: THE THEORY OF COST: COST8OUTPUT RELATIONS C!nt)nt 1"> #ntroduction -"> +b(ectives /"> 9ost +utput %elations /"1 &he 9ost ;unctions

1>C

/"- 9ost Minimisation /"/ +utput +ptimisation in the 6hort %un /"0 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &he theory of costs basically deal with costs in relation to output changes" other words$ they deal with cost output relations" &he basic economic principle states that total cost increases with increase in output. ?owever$ what is important from a theoretical and marginal point of view is not the absolute increase in total cost$ but the direction of change in the average cost (59) and the marginal cost (M9)" &he direction of changes in 59 and M9 will depend on the nature of the cost function" #n this unit$ we examine in detail the cost output relations" &.0 O'()$t%*)+ ?aving gone through this unit$ you will be expected to: 1" your !nowledge of the theory of costs -" the theoretical cost output relations /" cost functions in the minimisation of costs of production" 3.0 C!+t8O#t/#t R)0-t%!n+ 5 cost function is a symbolic statement of the technological relationship between the cost and output" cost functions ta!e the following form: 9 F &9 F f(M)$ and U >$ where M represents output level" #n addition$ the specific form of the cost function depends on the time framewor! for cost analysis: short or long run" there exists short run cost function and long run cost function" 5ccordingly$ cost output relationship are analysed in short run and long run framewor!s"

3.1 T7) C!+t F#n$t%!n+ 3.1.1 T7) S7! t8R#n C!+t F#n$t%!n. 9ost output relations are normally determined by the cost function and are exhibited by cost curves" shape of cost curves depends on the nature of the cost function which are derived from actual cost data" 9ost functions may ta!e a variety of forms$ yielding

11>

different !inds of cost curves$ including linear, )uadratic, and cubic cost curves arising from the corresponding functions" &he functions are as illustrated below: 10 Cost /&nction0 5 linear cost function is of the form: &9 F 9 F a H bM where a F &otal ;ix 9ost (&;9) bM F &otal :ariable 9ost (&:9) (/"1"1)

&he 5verage and Marginal cost functions can be obtained from the &otal 9ost ;unction (equation /"1"1) as follows: 5verage 9ost (59) &9 F a H bM F aPM H b M M Marginal 9ost (M9) F d&9 F b dM "0 Cost /&nction0 quadratic cost function is of the form: &9 F 9 F a H bM H M(/"1"-)

;rom the quadratic cost function (equation /"1"-)$ we can obtain the 5verage and Marginal cost functions as follows: 59 F &9 F a H bM H M- aPM H b H M M M M9 F d&9 F b H -M dM Example$ if &9 F 9 F 12> H 1>M H M&hen$ 59 F 12> H 1>M H MM F 12>PM H 1> H M M9 F d&9 F 1> H -M dM :0 Cost /&nction0 &he cubic cost function is of the form: &9 F 9 F a H bM G cM- H dM/ (/"1"/)

111

&he corresponding 5verage 9ost (59) and Marginal 9ost (M9) functions can be derived as: 59 F &9 F a H bM G cM- H dM/ M M F aPM H b G cM H dMM9 F d&9 F b G -cM H /dMdM 5ssume that the cost function is empirically and explicitly estimated as: &9 F 1> H 3M G >"CM- H >">2M/ 5nd$ &:9 F 3M G >"CM- H >">2M/ (/"1"0) (/"1"2)

1ased on equations /"1"0 and /"1"2$ the &9 and &:9$ respectively is calculated for M F 1 to 1> and presented in table /"1"1$ and graphically illustrated in figure /"1"1" T-'0) 3.1.1: C!+t8O#t/#t R)0-t%!n+ 9 FC TVC TC (1) (&) (3) (5) > 1> >"> 1>">> 1 1> 2"12 12"12 1> B"B> 1B"B> / 1> 11"-2 -1"-2 0 1> 1-"B> --"B> 2 1> 1/"@2 -/"@2 3 1> 10"0> -0"0> @ 1> 12">2 -2">2 B 1> 13">> -3">> C 1> 1@"22 -@"22 1> 1> ->">> />">> AFC (6) 1>">> 2">> /"// -"2> -">> 1"3@ 1"0/ 1"-2 1"11 1">> AVC (=) 2"12 0"0> /"@2 /"-> -"@2 -"0> -"12 -">> 1"C2 -">> AC (>) 12"12 C"0> @">B 2"@> 0"@2 0">@ /"2B /"-2 /">3 /">> MC (C) 2"12 /"32 -"02 1"22 >"C2 >"32 >"32 >"C2 1"22 -"02

)sing equations (/"1"0) and (/"1"2)$ you can derive the behavioural equations for the average fixed cost (5;9)$ average variable cost (5:9)$ average total cost (5&9)$ and marginal cost (M9) follows: 5;9 F ;9PM F 1>PM 5:9 F &:9PM F 3M G >"CM- H >">2M/ F 3 G >"CM H >">2MM

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5&9 F &9PM F 1> H 3M >"CM- H >">2M/ M F 1>PM H 3 G >"CM H >">2MM9 F d&9 F 3 G 1"BM H >"12MdM 3.& C!+t M%n%.%+-t%!n #n its simplest form$ the critical value of output (M) in respect of the average variable cost (5:9) is the value that minimises average variable cost" &he average variable cost will be at its minimum when its rate of change dd(5:9)e F >" can be accomplished by differentiating the 5:9 dM function with respect to output (M)" form our examples$ 5:9 F 3 G >"CM H >">2Md(5:9) F >"C H >"1>M dM 6etting this equal 'ero$ you get: >"C H >"1>M F > >"1>M F >"C MF C #t follows that critical value of output (M) in respect of the average variable cost is C units" ;rom table /"1"1$ we observe that at the output level M F C$ the minimum average variable cost is <1"C2" &he same argument can be made for average total cost (5&9)" Given the 5&9 function$ you can set the derivative with respect to M d (d(5&9) e F >$ dM and solve for M to obtain the level of output that minimises average total cost"

3.3 O#t/#t O/t%.%+-t%!n %n t7) S7! t8R#n &he optimum level of output in the short run is the level of output for which the average cost (59) of production equals the marginal cost (M9)" &hat is$ for optimum output$ 59 F M9 in the short run"

11/

6uppose the short run cost function is given by: 9 F ->> H 2M H -M59 F ->> H 2M H -MM F ->>PM H 2 H -M M9 F d9 F 2 H 0M dM (/"/"-) (/"/"/) (/"/"1)

1y using 59 F M9 at optimum$ and solving for M$ you will obtain the optimum level of output" &hus$ ->> 2 H -M F 2 H 0M M ->>PM F -M -M- F ->> M- F 1>> M F 1> &hus the optimum level of output in this example is 1> units" 3.5 S)0,8A++)++.)nt E<) $%+) &he shape of cost curves depends on the nature of the cost function which are derived from actual cost data" 4iscuss" 5.0 C!n$0#+%!n &his unit has exposed you to the principles of cost output relations" Iou must have learned that short run cost functions are of different categories: (i) the linear cost function, (ii) the quadratic cost function, and$ (iii) the cubic cost function" 5lso$ an important learning from the unit is the procedures for cost minimisation" 6.0 S#..- 1 Iou may have learned from this unit that 9ost output relations are normally determined by the cost function and are exhibited by cost curves" shape of cost curves depends on the nature of the cost function which are derived from actual cost data" 9ost functions may ta!e a variety of forms$ yielding different !inds of cost curves$ including linear, (59 F M9)

110

)uadratic, and cubic cost curves arising from the corresponding functions" Aith respect to the minimisation of production cost$ you learned that #n its simplest form$ the critical value of output (M) in respect of the average variable cost (5:9) is the value that minimises average variable cost" average variable cost will be at its minimum when its rate of change dd(5:9)e F >" dM ;inally$ you were informed that the optimum level of output in the short run is the level of output for which the average cost (59) of production equals the marginal cost (M9)" &hat is$ for optimum output$ 59 F M9 in the short run" =.0 T#t! 8M- 2)" A++%4n.)nt Given the cost function: 9 F 1>>> H 1>M1P- H M H -M-$ derive the average and marginal cost functions" 2 units of output$ what are the average and marginal costs" >.0 R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT 1> : LONG8RUN COST8OUTPUT RELATIONS AND BREAA8 EVEN ANALYSIS C!nt)nt 1"> #ntroduction

112

-"> +b(ectives /"> &he 8ong %un 9ost +utput %elations and 1rea! Even 5nalysis /"1 &he 8ong %un 9ost +utput %elations /"- 1rea! Even 5nalysis: 8inear 9ost and %evenue ;unctions" /"/ 1rea! Even 5nalysis: <on 8inear 9ost and %evenue ;unction /"0 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n 1y definition$ the long run is a period for which all inputs change or become variable" &his is based on the assumption that in the long run$ supply of all inputs$ including those held constant in the short run$ becomes elastic" ;irms are therefore$ now in a position to expand the scale of production by increasing all inputs" follows that the long run cost output relations imply the relationship between the changing scale of a firm and the firm*s total output$ whereas in the short run$ this relationship is essentially one between the total output and the variable costs such as$ labour and raw materials" #n this unit$ we discuss the long run cost output relations especially with specific reference to the firm*s brea! even conditions" &.0 O'()$t%*)+ 5t the end of this unit you will be able to: 1" more familiar with issues on cost output relations -" long run cost and output decisions /" your optimum plant si'e 3.0 T7) L!n48R#n C!+t8O#t/#t R)0-t%!n+ -n" B )-28E*)n An-01+%+ 3.1 T7) L!n48R#n C!+t8O#t/#t R)0-t%!n+ &he long-run cost curve /+!C0 is composed of a series of short run cost curves" is shown by figure /"1"1 below:

F%4# ) 3.1.1: T7) L!n48R#n T!t-0 C!+t C# *) (LTC) L.C &otal cost (9) S.C:

113

S.C" S.C1

M1

M-

M/

+utput (M)

;igure /"1"1 assumes that the firm has only one plant$ with the corresponding short run cost curve given by S.C1$ the firm decides to add two more plants with associated two more short run cost curves given by S.C" and S.C:" long run total cost curve (8&9) is then drawn through the minimum of the short run cost curves$ S.C1$ S.C"$ and S.C:0 &he +ong-(un 2verage Cost Curve /+2C0 is derived by combining the short run average cost curves (659s)" is as drawn in figure /"1"- below: F%4# ) 3.1.&: T7) L!n48R#n A*) -4) C!+t C# *) 59

6591 659/ 91 96599/ LAC

M1

M-

M/

+utput (M)

&he long run average cost curve (859) is drawn through the short run average cost curves$ 6591$ 659-$ and 659/$ as indicated by figure /"1"-" 859 curve is also !nown in economics as the >En,elope C&r,e1 or >Plannin C&r,e1 as it serves as a guide to the entrepreneur in plans to expand production"

11@

#t is obvious from the 8&9 in figure /"1"1$ that the long run cost output relations is similar to the short run cost output relations" Aith subsequent increases in output$ 8&9 first increases at a decreasing rate$ and then at an increasing rate" 5s a result$ 859 initially decreases until the optimum utili'ation of the second plant capacity$ and then it begins to increase" &hese cost output relations follow the Elaws of returns to scale"* &hat is$ when the scale of the firm expands$ unit production cost initially decreases$ but ultimately increases$ as shown in figure /"1"-" decrease in unit cost is attributed to the internal and external economies and the eventual increase in cost$ to the internal and external diseconomies" 3.1.1 O/t%.#. P0-nt S%G) -n" L!n48R#n C!+t C# *)+. &he short run cost curves are extremely helpful in the determination of the optimum utili5ation of a given plant, or in the determination of the least cost output level" 8ong run cost curves$ on the other hand$ can be used to show how a firm can decide on the optimum si5e of the firm. 9onsequently$ the optimum si'e of the firm is one which ensures the most efficient utili'ation of the resources" practical terms$ the optimum si'e of a firm is one in which the long run average cost (859) is minimised" 3.& B )-28E*)n An-01+%+: L%n)- C!+t -n" R)*)n#) F#n$t%!n+. &raditionally$ the basic ob(ective of any business firm is to maximi'e profit" maximum profit does not necessarily coincide with the minimum cost$ according to the traditional theory of the firm" <evertheless$ firms plan their production activities much better if the level of production for which total cost and total revenue brea! even is !nown" implies the profitable and non profitable range of production" &he brea&even analysis, or what is often referred to as profit contribution analysis is an important analytical technique used in studying the relationship between total cost$ total revenue$ and total profits and losses over the whole range of stipulated output" &he brea! even analysis is a technique of previewing profit prospects and a tool of profit planning" #t integrates cost and revenue estimates to ascertain the profits and losses associated with different levels of output" #n order to exemplify the brea! even analysis under linear cost and revenue conditions$ you can assume a linear cost function and a linear revenue function as follows: 9ost function: 9 F 1>> H 1>M (/"-"1) (/"-"-)

%evenue function: % F 12>M

&he cost function (equation /"-"1) implies a total fixed cost (&;9) of <1>>" variable cost varies at a constant rate of <1> per unit in response to increases in output" revenue function (equation /"-"-) implies that the mar!et price for the firm*s product is <12 per unit of sale"

11B

Given equations /"-"1 and /"-"-$ the brea! even output can be computed algebraically in the following way: 5t the brea! even point$ &otal %evenue (%) &otal 9ost (9)$ so that in this example$ 12M F 1>> H 1>M 2M F 1>> M F ->" #t follows that the brea! even level of output is -> units" result can be illustrated graphically in figure /"-"1 below" F%4# ) 3.&.1: B )-28E*)n An-01+%+: L%n)- F#n$t%!n+ 9ost and %evenue &% +perating 2>> 0>> 8oss e &9 />> ->> d 1>> 2> 1> -> /> 0> +utput &;9

+perating 7rofit &:9

3.3 B )-28E*)n An-01+%+: N!n8L%n)- C!+t -n" R)*)n#) F#n$t%!n &he brea! even analysis under non linear cost and revenue functions is best demonstrated by the following graph" shown in figure /"/"1 below$ the total fixed cost (&;9) line shows the fixed cost at +;$ and the vertical distance between &9 and &;9 measures the total variable cost (&:9)" curve$ &%$ shows the total sales or total revenue at different output levels and at different prices" vertical distance between the &% and &9 measures the profit or loss for various levels of output" Iou will observe from figure /"/"1 that the &% and &9 curves intersect each other at two points$ 71 and 7-"$ where &% F &9" &hese represent the lower and upper brea! even points" ;or the whole range of output between +M1 (corresponding to the brea! even point$ 71) and +M- (corresponding to the brea! even point$ 7-)$ &% U &9" &his implies that a firm producing more than +M1 and less than +M- will be ma!ing profits" differently$ the profitable range of output lies between +M1 and +M- units of output" 7roducing less or more than these limits will give rise to losses"

11C

F%4# ) 3.3.1: B )-28E*)n An-01+%+: N!n8L%n)- F#n$t%!n+ TC &9 &% 7&%

71 ; + M1 M+utput &;9

T7) P !,%t V!0#.) (PV) R-t%!. &he 7: ratio is another useful tool for finding the 1rea! Even 7oint (1E7) of sales$ especially for multi purpose firms" &he 7: ratio is defined by the following formula: 7: %atio F 6 G : x 1>> 6 Ahere 6 F 6elling price, and$ : F average :ariable cost" ;or instance$ if the selling price$ 6 F <2 per unit$ and average variable cost$ : F <0 per unit$ then: 7: %atio F 2 G 0 x 1>> 2 F -> percent &he 1rea! even point (1E7) in sales value is calculated by dividing the fixed expenses (;) by the 7: ratio" &hus$ 1E7 (6ales value) F ;ixed Expenses F ;P6 : 7: %atio 6

3.5 S)0,8A++)++.)nt E<) $%+) 4escribe briefly how a firm can decide on its optimum plant si'e using the long run cost curve"

1->

5.0 C!n$0#+%!n Iou may have learned from this unit that the long run in any business life is very important and must be ta!en as such" long run has been defined as a period for which all inputs change or become variable" &his is based on the assumption that in the long run$ supply of all inputs$ including those held constant in the short run$ becomes elastic" #n addition$ the short run cost curves are extremely helpful in the determination of the optimum utili5ation of a given plant, or in the determination of the least cost output level" 8ong run cost curves$ on the other hand$ can be used to show how a firm can decide on the optimum si5e of the firm. ;inally$ the unit informs you that the brea&-even analysis, or what is often referred to as profit contribution analysis is an important analytical technique used in studying the relationship between total cost$ total revenue$ and total profits and losses over the whole range of stipulated output" 6.0 S#..- 1 +ur discussion in the unit can be summarised in the following statements: 1" managers must plan for the long run administration of costs revenues and profits" &his is so because in the long run$ firms will be in a position to expand the scale of production by increasing all inputs" -" the long run$ with increases in output$ the total cost of production first increases at a decreasing rate$ and then at an increasing rate" 5s a result$ the long run average cost initially decreases until the optimum utili'ation of the new plant capacity$ and then it begins to increase" &hese cost output relations follow the Elaws of returns to scale"* /" ;irms are assumed to plan their production activities much better if the level of production for which total cost and total revenue brea! even is !nown" &his implies the profitable and non profitable range of production" &he brea! even analysis$ or what is often referred to as profit contribution analysis is an important analytical technique used in studying the relationship between total cost$ total revenue$ and total profits and losses over the whole range of stipulated output" &he brea! even analysis is a technique of previewing profit prospects and a tool of profit planning"

=.0 T#t! 8M- 2)" A++%4n.)nt &he profit and loss data of an enterprise for a given period are as follows: <aira (<)

1-1

<et 6ales 9ost of goods sold: :ariable 9ost ;ixed 9ost Gross 7rofit 6elling 9osts: :ariable 9ost ;ixed 9ost <et 7rofit

1>>$>>> 0>$>>> 1>$>>> 2>$>>> 1>$>>> 2$>>> /2$>>>

(d) 9ompute the brea! even level of output" (e) Ahat is your forecast of the profit for a sales volume of <13>$>>>D 5t what sales volume would a net profit of <22$>>> be earnedD >. R),) )n$)+ 4wivedi$ 4" <" (->>-) Mana erial Econo!ics) si*th e%ition (<ew 4elhi: :i!as 7ublishing ?ouse 8td)"

UNIT 1C: MARAET STRUCTURE AND PRICING DECISIONS C!nt)nt 1"> #ntroduction -"> +b(ectives

1--

/"> Mar!et 6tructure and 7ricing 4ecisions /"1 7rice 4etermination )nder 7erfect 9ompetition /"- 7rice 4etermination )nder 7ure Monopoly /"/ Monopoly 7ricing and +utput 4ecision in the 8ong %un" /"0 6elf 5ssessment Exercise 0"> 9onclusion 2"> 6ummary 3"> &utor Mar!ed 5ssignment @"> %eferences 1.0 Int !"#$t%!n &he mar!et structure will determine a firm*s ability to ma!e pricing decisions or its degree of freedom in the determination of product prices" on the mar!et structure$ the degree of freedom varies between 'ero and one" &his degree of freedom implies the extent to which a firm is free or independent of the rival firm in setting product prices" higher the degree of competition$ the lower the firm*s degree of freedom in ma!ing decisions about product prices" &he reverse is also true" )nder perfect co!petition) a large number of firms compete against one another" #t follows that the degree of competition under perfect competition is close to one" 9onsequently$ a firm*s discretion in determining the price of its product is close to 'ero" &he firm has to accept the price determined by the mar!et forces of demand and supply" 5s the degree of competition decreases$ a firm*s control over the product prices and its discretion in pricing decisions increases" )nder !onopolistic co!petition) where the degree of competition is less than one$ the firm has some discretion in product pricing" )nder oligopolistic mar!et structure$ the degree of competition is low$ the firm*s control over pricing decisions increases" &he firms therefore$ have control over the price of their products and can exercise their discretion in pricing decisions$ especially where product differentiation is prominent" &.0 O'()$t%*)+ 5t the end of this unit$ you will be able to: 1" acquainted with the basic principles of pricing -" how to ma!e pricing decisions under different mar!et conditions /" consumer price expectations in an effective and efficient manner"

3.0 M- 2)t St #$t# ) -n" P %$%n4 D)$%+%!n+ 3.1 P %$) D)t) .%n-t%!n Un") P) ,)$t C!./)t%t%!n #n a perfectly competitive mar!et$ commodity prices are determined by the mar!et forces of demand and supply" #n other words$ mar!et prices are determined by the mar!et

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demand and mar!et supply$ where the mar!et demand refers to the industry demand as a whole: this is the sum of quantity demanded by each individual consumer or user of the product at different prices" mar!et supply is the sum of quantity supplied by individual firms in the industry" &he mar!et price is determined for the industry and the individual firms and consumers ta!e the mar!et price as given" &his is the reason sellers under a perfectly competitive mar!et is referred to as price ta(ers0 &he main problem facing a profit maximising firm is therefore$ not to determine the price of its product but to ad(ust its output its output to the mar!et price so that profit is maximised" &he determination of commodity as well as services price under perfectly competitive conditions are often analysed under three different time periods: (i) the mar!et period or very short-run; (ii) short run, and$ (iii) long run" 3.1.1 P %$%n4 %n M- 2)t P) %!". #n mar!et period$ it is assumed the total output of a given product is fixed" Each firm in the industry has a stoc! of commodity or services to be sold" stoc! of goods and services in the industry ma!es the industry supply" Aith the assumption of fixed stoc! of goods and services$ the industry supply curve is perfectly inelastic$ as indicated by the line 6M in figure /"1"1 below" this condition of inelasticity$ the price is determined solely by the condition of demand" 6upply in this case is an inactive agent of price determination as it is fixed at some level of output$ M" F%4# ) 3.1.1: D).-n" 8 D)t) .%n)" P %$) %n M- 2)t P) %!" 6 7rice (7) 7471 41 > M Muantity (M) 6imilarly$ given a fixed demand for a product or services$ you will have the case of supply determined rather than demand determined price" &his is illustrated in figure /"1"- below" F%4# ) 3.1.&: S#//018D)t) .%n)" P %$) %n t7) M- 2)t P) %!" 7 61 671

1-0

7M1 M-

4 +utput (M)

Pricin in the Short2R&n0 1y definition$ a short run refers to the period in which firms can neither change their si'e nor quit$ nor can new firms enter the industry" Ahile in the mar!et period$ supply is absolutely fixed$ in the short run$ it is possible to increase or decrease the supply by increasing or decreasing the variable inputs" #n the short run$ therefore$ supply curve is elastic" &he determination of mar!et price in the short run is illustrated by figures /"1"/ (a) and /"1"/ (b)" /"1"/ (a) shows the determination of output based on mar!et determined price in figure /"1"/ (b)" mar!et price is fixed for all the firms in the industry" /i &re :010:: Pricin in the Short2r&n Un%er Perfect Co!petition0 %$ 9 M9 7 6 7roft 5:9 E 7b 7b F M9 4

qb /ir! 4a5

q In%&str# 4-5

Given the industry price$ 7b$ firms will maximise profit by equation 7b to its marginal cost$ M9" can be seen from the equilibrium point E in figure /"1"/ (a)" 5t this point$ the optimal output for the individual firm is indicated by the output level$ qb" Pricin in the Lon 2R&n0 #n the long run the firm can ad(ust its si'e or quit the industry" <ew firms can also enter the industry" #f the mar!et price is such that 5verage %evenue (5%) U 8ong run 5verage 9ost (859)$ firms will ma!e economic or super-normal profit" 5s a result$ new firms will enter the industry$ causing a rightward shift in the supply curve" 6imilarly$ if 5% O 859$ firms will begin to ma!e losses" this case$ marginal firms will exit the industry$ causing a leftward shift in the supply curve" rightward shift in the supply curve pulls down the mar!et price and its leftward shift pushes it up" &his process continues until price is so determined that 5% F 859 and firms will now earn only normal profit" &he long run price determination and output (or si'e) ad(ustment by an individual firm are presented in figures /"1"0 (a) and /"1"0 (b) below" 6uppose that the long run demand curve is represented by 48, the short run supply is 61$ and price is determined at 71"

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this price$ firms ad(ust their output to the point$ M$ the equilibrium point$ where 71 F 5%1 F M%1 F 8M9" enables firms to ma!e economic profit of M6 per unit of output" &his super normal profit lures new firms into the industry" 9onsequently$ the industry supply curve shifts rightward to 6-$ causing a fall in price to 7-" this price$ firms are in a position to cover only the long run marginal cost (8M9) at the output q-" this point they will be ma!ing losses because 5% O 859" incurring losses cannot survive in the long run" 6uch firms will thus quit the industry" 5s a result$ total industry production decreases$ causing a leftward shift in the supply curve$ to the position of 6o$ for example$ with the corresponding mar!et price at 7o" existing firms then ad(ust their outputs to the new mar!et price at the output qo" this output$ firms are in a position to ma!e only normal profit$ where 7> F 5% F M% F 8M9 F 859$ the industry equilibrium position or point" 5t this point$ no firm is in a position to ma!e economic profit$ nor does a firm ma!e losses" F%4# ) 3.1.5: P %$%n4 %n t7) L!n48R#n Un") P) ,)$t C!./)t%t%!n 7 (a) (b) 8M9 859 61 6o 7 671 71 71 F 5%1 FM%1 7o 748 > #ndustry M qqo q1 ;irm q 3.& P %$) D)t) .%n-t%!n Un") P# ) M!n!/!01 &he term p&re !onopol# connotes absolute power to produce and sell a product with no close substitute" 5 monopoly mar!et is one in which there is only on seller of a product having no close substitute" &he cross elasticity of demand for a monopolist*s product is either 'ero or negative" 5 monopoli'ed industry refers to a single-firm industry" 3.&.1 M!n!/!01 P %$%n4 -n" O#t/#t D)$%+%!n %n t7) S7! t8R#n. 5s in the case of perfect competition$ pricing and output decision under monopoly are based on revenue and cost conditions" &he cost conditions (59 and M9 curves) are same for both perfect competition and pure monopoly" &he difference is basically in the revenue conditions (5% and M% curves)" &his is so because$ unli!e the competitive firm$ a monopoly firm faces a downward sloping demand curve" 5 monopolist can reduce its product price and sell more$ and raise its product price and still retain some customers" Ahen a demand curve slopes downward$ the associated marginal revenue (M%) curve lies below the average revenue (5%) curve$ and the slope of the M% curve is two times the slope of the 5% curve" &he revenue and cost conditions faced by a monopoly firm in the short run are presented in figure /"-"1 below" monopoly average and marginal revenue curves are represented by 5% and M% curves$ respectively" &he short run average and marginal 7o 7M

7o F 5% F M% F 8M9 7- F 5%- F M%-

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cost curves are represented by 659 and 6M9 curves$ respectively" &he price and output decision rule for a profit maximising monopolist is same as that of a firm under perfect competition" &he profit maximising monopoly firm chooses a price output combination at which M% F 6M9" Given the monopolist*s cost and revenue curves in figure /"-"1$ its M% and 6M9 intersect each other at point E" 5n ordinate drawn from point E to the Q axis determines the profit maximising level of output for the firm at Mb" this output$ firms* M% F 6M9" the demand curve$ 5% F 4$ the output$ Mb can be sold in a given time at only one price$ 7b" follows that the determination of output simultaneously determines the price for the monopoly firm" ;or any given price$ the unit and total profits are also simultaneously determined" &his defines the equilibrium condition for the monopoly firm" F%4# ) 3.&.1: S7! t8R#n P %$) D)t) .%n-t%!n )nder Monopoly 7$ 9$ % 659 6M9 7b E (M% F 6M9) 5% F 4 M% Mb +utput (M)

.he Al e-raic Deter!ination of Monopol# Price an% O&tp&t 6uppose demand and cost functions for a monopoly firm are given as: 4emand function: M F 1>> G >"-7 7rice function: 9ost function: 7 F 2>> G 2M 9 F 2> H ->M H M(/"-"1) (/"-"-) (/"-"/)

&he problem is to determine the profit maximising level of output and price" &his can be solved in the following way" %ecall that profit is maximised at an output for which M% F M9" &he first step is therefore to find M% and M9 using the demand and cost functions as given in equations (/"-"1) and (/"-"/)$ and formulate the revenue function using equations (/"-"-): &otal %evenue (%) F 7M$ so that$ % F (2>> G 2M) M F 2>>M G 2M(/"-"0)

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M% F d% F 2>> G 1>M dM 6imilarly$ M9 F d9 F -> H -M dM Equating M% to M9$ the profit maximising condition$ we get: M% F 2>> G 1>M M9 F -> H -M$ and$ 2>> G 1>M F -> H -M 0B> F 1-M Mb F 0>" #t follows that the profit maximising level of output is Mb F 0> units" &he profit maximising price can be obtained by substituting Mb F 0> in the price function$ equation (/"-"-) to get: 7b F 2>> G 2(0>) F />>" &hus$ the profit maximising price$ 7b F </>>" Aith these information$ the total (maximum) profit can be calculated as follows: 7rofit (f) F % G 9 F 2>>M G 2M- G (2> H ->M H M-) F 2>>M G 2M- G 2> G ->M G MF 0B>M G 3M- G 2> 6ubstituting for M F 0>$ we obtain: g F 0B>(0>) G 3(0>)- G 2> F 1C->> G C3>> G 2> F C22>"

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&hus$ the maximum profit (fb) F <C$22>" 3.3 M!n!/!01 P %$%n4 -n" O#t/#t D)$%+%!n %n t7) L!n48R#n. &he decision rules guiding optimal output and pricing in the long run is same as in the short run" the long run however$ a monopolist gets an opportunity to expand the si'e of its firm with the aim of enhancing the long run profits" of the plant si'e may$ however$ be sub(ect to such conditions as: (a) the mar!et si'e, (b) expected economic profit, and$ (c) ris! of inviting legal restrictions" 5ll things being equal$ the equilibrium monopoly price and output determination in the long run is illustrated by figure /"/"1 below" to the figure /"/"1$ the 5% and M% curves show the mar!et demand and marginal revenue conditions facing the monopolist" &he long run average cost (859) and the long run marginal cost (8M9) curves indicate the long run cost conditions" 5s you can observe from figure /"/"1$ the monopolist*s 8M9 and M% intersect at point 7$ where output is represented as Mb" represents the profit maximising level of output" the 5% curve$ the price at which the output$ Mb is represented by 7b" follows that$ in the long run$ the monopolist output will be Mb and price$ 7b" &his output price combination will maximise the long run profit" &he total profit is shown by the shaded area" F%4# ) 3.3.1: M!n!/!01 EB#%0%' %#. %n t7) L!n48R#n. 7$ %$ 8M9 859 9osts 7b

5% F 4 M% M Mb

3.5 S)0,8A++)++.)nt E<) $%+) 1(a) 4istinguish between mar!et period$ short run$ and short run" the consideration of period affect the pricing policy of a firmD (b) 9an a monopolist charge any price for its productD Give reasons for your answer" 5.0 C!n$0#+%!n

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&he mar!et structure will determine a firm*s ability to ma!e pricing decisions or its degree of freedom in the determination of product prices" on the mar!et structure$ the degree of freedom varies between 'ero and one" &he main problem facing a profit maximising firm is not to determine the price of its product but to ad(ust its output to the mar!et price so that profit is maximised" &he determination of commodity as well as services price under perfectly competitive conditions are often analysed under three different time periods: (i) the mar!et period or very short-run; (ii) short run, and$ (iii) long run 5s with perfect competition$ pricing and output decision under monopoly are based on revenue and cost conditions" cost conditions (59 and M9 curves) are same for both perfect competition and pure monopoly" &he difference is basically in the revenue conditions (5% and M% curves)" 6.0 S#..- 1 Iou have (ust been informed by this unit that: 1" a perfectly competitive mar!et$ commodity prices are determined by the mar!et forces of demand and supply" -" determination of commodity as well as services price under perfectly competitive conditions are often analysed under three different time periods: (i) the mar!et period or very short-run; (ii) short run, and$ (iii) long run" /" 5s in the case of perfect competition$ pricing and output decision under monopoly are based on revenue and cost conditions" 5 monopoly price is basically determined by equating marginal revenue (M%) to marginal cost (M9)" 0" decision rules guiding optimal output and pricing in the long run is same as in the short run" the long run however$ a monopolist gets an opportunity to expand the si'e of its firm with the aim of enhancing the long run profits" is sometimes sub(ect to such conditions as: (d) the mar!et si'e, (e) expected economic profit, and$ (f) ris! of inviting legal restrictions"

=.0 T#t! 8M- 2)" A++%4n.)nt 5 monopoly firm wishes to supply two different mar!ets$ 1 and -$ with the corresponding demand functions given as: 71 F 2>> G M1 1) 7- F />> G M- (Mar!et -)

1/>

71 and 7- represent the prices charged in mar!ets 1 and -$ respectively$ and M1 and M- are quantities sold in mar!ets 1 and -$ respectively" &he cost function is given by: 9 F 2>$>>> G 1>>M ;ind: (a) &he profit maximising output for the monopolist (b) 5llocation of output between the two mar!ets (c) &he price charged in each of the two mar!ets (d) &he total or maximum profit" >.0 R),) )n$)+ 1" 4wivedi$ <" (->>-) Mana erial Econo!ics) si*th e%ition 4elhi: :i!as 7ublishing ?ouse 8td)" -" E" ;" and 7aul$ %" 6" (1C@3)$ Intro%&ctor# Mathe!atical Anal#sis for St&%ents of B&siness an% Econo!ics) "n% e%ition (%eston :irginia: %eston 7ublishing 9ompany)

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