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AMF 103 Managerial Economics Book
AMF 103 Managerial Economics Book
AMF 103 Managerial Economics Book
PREFACE
This is an attempt to the integration of economic theory with business practices for
the purpose of facilitating Decision Making and Forward Planning by the
management. As economics provides as a set of concepts, these concepts furnish
us the tools and techniques of analysis. It is in this context economic analysis is an
aid to understand business practices in a given environment. As decision making
is a basic function of manager, economics is a valuable guide to the manager. In
the following we shall be discussing the decision making process of the
management and how managerial economics and its various tools and techniques
help a manager in this process.
Index
Business Forecasting
Demand Analysis
Cost Analysis
Production Analysis
Market Structure
CHAPTER I
CONTENTS:
1.1 Introduction
1.2 Decision Making Process
1.3 Management Decision Problems
1.4 Corporate Decision Making: Ford Introduces the Taurus
1.5 Types of Decision
1.6 Conditions Affecting Decision Making
1.7 The Steps of Decision Making
1.8 Selecting the Best Alternative
1.9 Implementing the Decision
1.10 Evaluating the Decision
1.11 Decision Making Model
1.11.1 The Classical Model
1.11.2 The Administrative Model
1.12 Decision Making Techniques
1.12.1 Marginal Analysis
1.12.2 Financial Analysis
1.13 Group Decision Techniques
1.13.1 Brainstorming
1.13.2 Nominal Group Technique
1.13.3 Delphi Group Technique
1.14 Decision Making Tools
1.14.1 Linear Programming
1.14.2Inventory Control
1.1 Introduction
Managerial Economics is the integration of economic theory with business
practices for the purpose of facilitating Decision Making and Forward Planning by
the management. As economics provides as a set of concepts, these concepts
furnish us the tools and techniques of analysis. The use of Economic Analysis is to
make business decisions involving the best use (allocation) of scarce resources.
Economic Theory helps managers to collect the relevant information and process
it in order to arrive at the optimal decision given the goals of a firm. A decision is
optimal if it brings the firm closest to its goals. It is in this context economic
analysis is an aid to understand business practices in a given environment. As
decision making is a basic function of manager, economics is a valuable guide to
the manager. In the following we shall be discussing the decision making process
of the management and how managerial economics and its various tools and
techniques help a manager in this process.
division be charged for engines it receives from another division? Should all the
parts be obtained from the upstream divisions, or other firms? All these decision
come under managerial decision taking process.
Managers make these decisions, and in order to obtain a clear understanding of the
decision making process, a classification system is useful. Three such systems are
available; each based on different types of decisions.
Organizational and personal decisions,
Basic and routine decisions
Programmed and non-programmed decisions.
be properly implemented.
Personal decisions are related to the managers as an individual, not as a member
of the organizations. Such decisions are not delegated to others because their
implementation does not require the support of organizational personnel. Deciding
to retire, taking a job offer from a competitive firm, or slipping out and spending
the afternoon on the golf course are all personal decisions.
A second approach is to classify decisions into basic and routine categories. Basic
decisions can be viewed a much more important than routine ones. They involve
long-range commitments, large expenditures of funds, and such a degree of
importance that a serious mistake might well jeopardize the well being of the
company. Selection of a product line, the choice of a new plant site, or a decision
to integrate vertically by purchasing sources of raw materials to complement the
current production facilities are all basic decisions.
Routine decisions are often repetitive in nature, having only a minor impact on the
firm. For this reason, most organizations have formulated a host of procedures to
guide the manager in handing these matters. Since some individuals in the
organization spend most of their time making routine decisions, these guidelines
are very useful to them.
Taking a cue from computer technology, decision could be classified as computer
technology programmed and non-programmed. These two types can be viewed on
a continuum, programmed being at one end and non-programmed at the other.
Programmed decisions correspond roughly to the routine decisions, with
procedures playing a key role. Non programmed decisions are similar to the
category of basic decisions, being highly novel, important, and unstructured in
nature. The value of viewing decision making in this manner is that it permits a
clearer understanding of the methods that accompany each type.
The first step in the decision-making process is identifying the problem. Problem
identification is probably the most critical art of the decision making process, for it
is what determines the direction that the decision making process takes, and,
ultimately, the decision that is made.
The second step in decision-making process is generating alternative solutions to
the problem. This step involves identifying items or activities that could reduce or
eliminate the difference between the actual situation and the desired situation. For
this step to be effective, the decision makers must allot enough time to generate
creative alternatives as well as ensure that all individuals involved in the process
exercise patience and tolerance of others and their ideas.
In the Pursuit of quick fix managers too often shortchange this step by failing to
consider more than one or two alternatives, which reduces the opportunity to
identify effective solutions. After generating a list of alternatives, the arduous task
of evaluating each of them begins. Numerous methods exist for evaluating the
alternatives, including determining the pros and cons of each; performing a cost-
benefit analysis for each alternative; and weighting factors important in the
decision, ranking each alternative relative to its ability to meet each factor, and
then multiplying cumulatively to provide a final value for each alternative.
The manager has incomplete information about the decision situation and
operates under a condition of risk or uncertainty.
The problem is not clearly defined, and the decision-maker has limited
knowledge of possible alternatives and their outcomes.
The decision-maker satisfies by choosing the first satisfactory alternative-
one that will resolve the problem situation by offering a good solution to the
problem.
called marginal physical product, provides a basis for determining whether or not
one new man will bring about profitable additional output.
1.12.2 Financial Analysis
The firms are supposed to safeguard their interest and avert the possibilities of risk
or try to minimize it. For this a firm needs to analyze the assets as well as
liabilities, efficiency of capital investment, choice of project and various vital
ratios. The cost benefit analysis ensures the firms to take prudent financial
decision.
regarding future demand and then attempt a solution. Three of the most common
assumptions made in determining optimal inventory size are: demand is known
with certainty; the lead time necessary for recording goods is also known with
certainty; and the inventory will be depleted at a constant rate. Now, the manager
has to decide if he or she wishes to use what can be labeled a trial-and -error
approach, or if he wants to employ an OR (Operations Research) tool known as
the economic order quantity formula which can be given by:
OQ = {2DA} vr
Where:
D = expected annual demand
A = Administrative costs per order
V = Value per item
r = Estimate for taxes, insurance and other expenses
The EOQ formula is used by many firms in solving inventory control problems.
However, it is only one of many mathematical techniques that lave been
developed to help the manager make decisions.
Many managers weight alternatives base don their immediate or short-run results,
but a decision- tree format permits a more dynamic approach because it makes
some elements explicit that are generally implicit in other analyses. A decision
tree is a graphic method that the manager. can employ in identifying the
alternative courses of action available to him in solving a problem; assigning
payoff corresponding to each act-event combination.
For example, consider the case of a firm that has expansion funds and must decide
what to do with them. After careful analysis, three alternatives identified:
Use the money to buy a new company
expand the facilities of the current firm
put the money in a saving account
And wait for better opportunities. In deciding which alternative is best, the
company has gathered all the available information and constructed the decision
tree.
In the figure there are four important components. One is the decision point,
represented by a square, which indicates where the decision maker must choose a
course of action. second is a chance point, represented by a circle, which indicates
where a chance event is expected, such as solid economic growth, stagnation, or
high inflation. A third is the branch, represented by a line flowing from the chance
points, which indicates an event and its likelihood such as 0.5 per solid growth,
0.3 for stagnation or 0.2 for high inflation. Finally, at the far right is a payoff
associated with the each branch. It is called a conditional payoff since its
occurrence depends on certain conditions. For example, in figure the conditional
ROI (Return on Investment) associated with buying a new firm and having solid
economic growth is 15 per cent, but this return is conditional on the two preceding
factors (buying the firm and having solid growth).
In building a decision tree, the company will start by identifying the three
alternatives, the probabilities and events associated with each alternative, and the
amount of return that can be expected from each. Having then constructed the tree,
the firm will roll back it from right to left, analyzing as it goes.
This analysis is conducted, first by taking the conditional ROls at the far right of
the tree and multiplying them by the probability of their occurrence. For example,
if the company buys a new firm and there is solid growth in the economy, as seen
in figure, it will obtain a 15 per cent ROL However, the probability of such an
occurrence is 0.5 Likewise, the probabilities associated with stagnant growth,
where the return will be 9 percent, and high inflation, where the return will be 3
percent, are .3 and .2 respectively. In order to determine the expected return
associated with buying a new firm, each of the conditional ROls is multiplied by
its respective probability and the products are then totaled. For alternative one,
buying the firm, the calculation is as follows:
Conditional ROI Probability Expected Return
15.0 0.5 7.5
9.0 0.3 2.7
3.0 .02 0.6
10.8
These expected returns are often placed over the chance points on the decision
tree. They can be determined only after the tree has been drawn and the analysis of
the branches has been conducted. The first alternative is the best, because it offers
the greatest expected return. In evaluating alternatives, decision these help the
manager identify both what can happen and the likelihood of its occurrence .In
building the tree we moved from left to right but in analyzing we moved from
right to left. In the final analysis the decision tree does not provide any definitive
answers. However, it does allow the manager to allow benefits against costs by
assigning probabilities to specific events and then ascertaining the respective
payoff.
Q.1. The Technique that employs a written survey to gather expert opinions from
a number of people without holding a group meeting is known as -
(a) Brainstorming
Q.3. Which sort of decision does not require the organizational support-
Q.5. The method of inventory valuation & thereupon decision making in which,
the cost of production is calculated on the assumption that the material which was
last to enter the inventory of the company was used first is
(a) LIFO
(b) FIFO
(c) F I LO
Q.7. Knowing the problem, its possible alternative solutions and their respective
outcomes in the decision making process of a manager refers to the condition of
(b) Certainty
Q.8. Prescriptive approach that outlines how managers should make decisions is
Q.9. The use of highly structured meeting agenda and restricted discussion or
interpersonal communication during the decision making process is known as
(b) Brainstorming,
Chapter-II
Business Forecasting
CONTENTS:
1.1 Introduction
1.2 Purpose and need of forecasting
1.2.1 Specific purposes of demand forecasting
1.3 Steps Involved in Forecasting
1.4 Period of forecasting
1.5 Levels of Forecasting
1.6 Methods of Forecasting
1.6.1Qualitative Forecast
1.6.1.1 Survey techniques
1.6.1.2 Opinion pools
1.6.2 Statistical Forecast
1.6.2.1 Trend projection method
1.6.2.2 Barometric methods
1.6.2.3 Regression method
1.6.2.4. Simultaneous equation method (Econometric Models)
1.6.2.5. Input Output Forecasting
1.7 Reasons for fluctuations in time series data
1.7.1 Cyclical fluctuations
1.7.2 Seasonal variation
1.7.3 Irregular and random variation
1.8 Smoothing Techniques
1.1 Introduction
Identification of objective
Determining the nature of goods under consideration.
Selecting a proper method of forecasting.
Interpretation of results.
1.6.1Qualitative Forecast
1.6.1.1 Survey techniques
Survey of business executives, plant and equipment, expenditure
plans. Basically compilation of expenditure plans of related
industries.
Survey of plans for inventory changes and sales expectations.
Survey of consumer expenditure plans.
Y = a + bX
Log d = -12.4 + 1.78 log y -1.22 log 0 + 2.20 log v + 0.8 log g + 1.62
log e
Y = National income
O = groundnut oil price
V = Vanaspati price
G = ghee price
E = egg, fish and meat price
The above equation is a demand forecast equation for groundnut oil
Ct = a1+b1GNPt+u1t
It =a2+b2IIt-1+U2t
Input output analysis and forecasting has many uses and applications. It is
used by the firm to forecast the raw material, labor and capital requirement
needed to meet the forecasted change in the demand for their product. The
shortcomings are that the direct and total coefficients are assumed to be
fixed and thus do not allow input substitution. Input output tables are
usually available with a time lag of many years and while the input output
coefficients do not change very rapidly they can become very biased.
Overestimation of demand
Underestimation of demand
One risk arises from entirely unforeseen events such as war, political
upheavals and natural disasters. The second risk arises from inadequate
analysis of the market.
Carefully defining the market for the product to include all potential
users of the market and considering the possibility of product
substitution.
(a) Carefully defining the market for the product to include all
potential users of the market and considering the possibility of
product substitution.
(b) Dividing total industry demand into its components and analyzing
each component separately.
(c) Forecasting the main driver or user of the product in each segment
of the market and projecting how they are likely to change in the
future.
CHAPTER III
DEMAND ANALYSIS
CONTENTS:
Conceptually, demand can be defined as the desire for a good backed by the
ability and willingness to pay for it. The desire without adequate purchasing
power and willingness to pay do not become effective demand and only an
effective demand matters in economic analysis and business decisions.
The demand for a commodity that arises on its own out of a natural desire to
consume or possesses a commodity independent of the demand of other
commodities, which may be substitute or complementary or on the raw
material side or on the product side, the demand for the product is termed as
independent. Commodities like tea and vegetables do come on absolute
terms. On the other hand if the demand for a product is tied to the demand
for some parent product, the demand is termed as derived demand.
Durable goods are those whose total utility is not exhausted in a single or
short run use. Such goods can be used repeatedly over a period of time.
Durable goods may be consumer goods as well as producer goods. The
demand for durable goods changes over a relatively longer period.
Perishable (non-durable) goods are defined as those which can be used only
once. Their demand is of two types. Replacement of old products and
expansion of existing stock. The demand for nondurable goods depends
largely on their prices, consumer income and is subject to frequent change.
Expectations
Master of Finance & Control Copyright Amity university India Page 46
AMF103 MANAGERIAL ECONOMICS
Population
Ep = expected prices
Ey = expected income
N = number of consumers
D = distribution of consumers
u = other factors
0.50 7.0
1.00 5.0
1.50 3.5
2.00 2.5
2.50 1.5
3.00 1.0
P P
Q Q
Linear Demand Non Linear Demand
Curve Curve
1.8 Shift of Demand Curve v/s Movement along the demand curve
Price Effect
Pfffff
e p @b1 A
Q
Which implies that the elasticity changes at the various points of the linear
demand curve?
If 0 < e p < 1, the demand is inelastic total expenditure total expenditure and
price change move in the same direction.
If 1< e p < 1 the demand is elastic, total expenditure and price change move
in the opposite direction.
The marginal revenue is related to the price elasticity with the formula
f g
1fff
MR p 1 @
e
Proof
The MR is
pQ dQ dP dP
MR d fffffffffff P ffffffffff Q ffffffffff P Q ffffffffff
dQ dQ dQ dQ
Rearranging we obtain
P dP
fffffffff ffffffffff
@
eQ dQ
Remember TR = P*Q
Basic Necessities Commodities like salt, food grains etc for which
demand is relatively inelastic and does not vary with income after a
point
The consumer is assumed to be rational. Given his income and the market
prices of the various commodities, he plans the spending of his income so
as to attain the highest possible satisfaction or utility. This is the axiom of
utility maximization. In order to attain this objective the consumer must be
able to compare the utility of the various baskets of goods which he can
buy with his income. There are two basic approaches to compare the
utilities, the cardinalist approach and the ordinalist approach.
The cardinal school stated that utility can be measured. Under certainty i.e.,
complete knowledge of market conditions and income levels over the
planning period utility can be measured in monetary units, called utils.
There are certain assumptions of cardinal utility theory.
Rationality of consumer
MU x Px
If there are more commodities, the condition for the equilibrium is the
equality of the ratios of the marginal utilities of the individual commodities
to their prices.
MU
ffffffffffffffff MU y MU n
x
ffffffffffffffff ffffffffffffffff
Px Py Pn
Rationality of consumer
Utility is ordinal
1.13.2.1Equilibrium of Consumer
The first condition is that the marginal rate of substitution be equal to the
ratio of commodity prices. This is necessary but not sufficient condition.
MU
ffffffffffffffff Pffffffff
MRS x ,y x
x
MU y P y
The second condition is that the indifference curve be convex to the origin.
This condition is fulfilled by the axiom of diminishing marginal rate of
substitution of x for y and vice versa.
The further away from the origin an indifference curve lies, the
higher the utility it denotes
(c) Horizontal
(d) Vertical
(c) No change
(b) Increases
(c) Decreases
(d) Fluctuates
(a) Increases
(b) Decreases
(d) Fluctuates
(a) Increases
(b) Decreases
(d) Undefined
MU
ffffffffffffffff
x Pffffffff
(b) < x
MU y P y
MU
ffffffffffffffff Px
(c) x
ffffffff
MU y P y
MU
ffffffffffffffff
x Pffffffff
(d) > x
MU y P y
(a) Q = 67
(b) Q = 72
(c) Q = 108
(d) Q = 81
CHAPTER IV
COST ANALYSIS
CONTENTS:
1.1 Introduction
1.2 Accounting Cost Concepts
1.2.1 Opportunity vs. Actual Cost
1.2.2 Explicit cost vs. implicit cost
1.3 Analytical Cost Concepts
1.3.1 Sunk vs. Incremental cost
1.3.2 Fixed and Variable Costs
1.3.3 Total, Average and Marginal Costs
1.3.3.1 Total Cost
1.3.3.2 Average cost
1.3.3.3 Marginal Cost
1.4 Properties of Short Run Cost Curves
1.5 Short-Run Output Decision
1.6 Long-Run Cost Function
1.6.1 Long Run Average Cost Curve
1.7 Economies and Diseconomies of Scale
1.7.1 Economies of Scale
1.7.1.1 Internal economies of scale
1.7.1.2 External economies of scale
1.7.2 Diseconomies of Scale
1.7.2.1 Internal diseconomies of scale
1.7.2.2 External diseconomies of scale
1.1 Introduction
Cost functions are derived functions from the production function which
describes the available efficient methods of production at any one time. The
cost of production is an important factor in almost all the business analysis
and decisions, especially those related to locating the weak points in
production management, minimizing the cost, finding the optimum level of
output, determination of price and dealers margin, estimation of the cost of
business operation. The cost concepts can be grouped under two categories
on the basis of their nature and purpose.
The opportunity cost may be defined as the expected returns from the
second best use of the resources which are foregone due to the scarcity of
resources. It is also called alternative cost. The concept of economic rent or
economic profit is associated with it. On the other hand actual Cost
considers only explicit cost, the out of pocket cost for items such as wages,
salaries, materials, and property rentals.
Explicit costs are cash expenses for the payment of wages, salaries,
material, license fee, insurance premium, depreciation charges and are
recorded in normal accounting practices. In contrast implicit costs are non
cash expenses. Opportunity cost is an important example of implicit cost.
The explicit and implicit costs together make the economic cost.
The sunk costs are those which cannot be altered, increased or decreased, by
varying the rate of output. A sunk cost is an expenditure that has been made
and cannot be recovered since it accord to the prior commitment.
Incremental cost is the change in cost tied to a managerial decision
associated with expansion of output or addition of new variety of product.
Fixed costs are those which are fixed in volume for a certain given output. It
does not vary with variation in the output for a certain scale. The fixed costs
include the cost of managerial and administrative staff, depreciation of fixed
assets, maintenance of land etc. Fixed costs are associated with the short
run. Variable costs are those which vary with the variation in the total
output. It include cost of raw material, cost of direct labor, running cost of
fixed capital such as fuel, repairs, routine maintenance etc.
X output
T technology
P f prices of factors
K fixed factors
TC TFC TVC
Average cost is obtained by dividing the total cost by the total output.
TC
ffffffffff
AC
Q
Average cost further can be categorized as average fixed cost (AFC) and
average variable cost (AVC).
TFC
fffffffffffffff
AFC
Q
TVC
fffffffffffffff
AVC
Q
Marginal cost is the change in the total cost for producing an extra unit of
output.
MC TC/Q
Marginal Cost
Curve
Short run cost curves get their shape from the marginal productivity
of the variable factor
Firm sets output at Q1, where MC=MR subject to checking the average
condition:
The long-run total cost curve describes the minimum cost of producing each
output level when the firm is free to vary all input levels. One of the first
decisions to be made by the owner/manager of a firm is to decide the scale
of operation (size of the firm).
In the Long Run, plant size is variable, and the firm is able to adjust
its scale of operations according to demand
Economies and diseconomies are associated with long run cost functions.
Economies of scale are advantages and diseconomies of scale are
disadvantages that arise due to the expansion of production scale and lead to
a fall and rise in the cost of production respectively.
Internal economies of scale are advantages that a firm gains from increasing
the scale of its own operations. Whereas external economies of scale are
advantages that a firm gains from the expansion and size of the industry as
whole industrial clusters. It is important to note that internal economies of
scale determine the shape of the LRAC curve while the position of this
curve depends on external economies such as change in technology and
changes of factor prices in the industry as a whole.
Technological advantage
Economies in marketing
Managerial economies
Managerial inefficiency
Labor inefficiency
1. Change in the total cost for producing an extra unit of output is know as
A: Incremental Cost
B: Marginal Cost
C: Variable cost
D: Both A & B
CHAPTER V
PRODUCTION ANALYSIS
CONTENTS:
1.1Production Function
1.2 Short Run Analysis
1.2.1 Marginal Product of Labor
1.2.2 Average Product of labor
1.3 Laws of Production
1.3.1 Law of variable proportions
1.3.2 Laws of Returns to Scale
1.3.2.1 Constant returns to scale
1.3.2.2 Increasing returns to scale
1.3.2.3 Diminishing Returns to Scale
1.4 Isoquant
1.5 Equilibrium of the Firm
1.6 Isocost
1.7 Isocost Curve and Optimal Combination of L and K
1.8 Production with Two (or more) Outputs-Economies of Scope
1.1Production Function
The creation of any good or service that has value to either producers or
consumers is termed as production. Production function is a technical
relation between factor inputs and outputs. It describes the laws of
proportion that is the transformation of factor inputs into outputs at any
particular time period. The production function includes all the technically
efficient methods of production.
b c
X f L, K, R, S, v, y
` a
X f L
Q
` a
f1 L
` a
f L
L
1.2 Short Run Analysis
Short Run is the period of time in which one (or more) of the factors of
production employed in a production process is fixed or incapable of being
varied. We usually assume Capital (K) to be fixed and analyze how output
varies with changes in Labor (L)
` a
X f L
The change in output resulting from a very small change in Labor keeping
all other factors constant.
MPL = X L
APL = X / L
MP = AP when AP is maximum
APL
MPL L
APL
L
MPL
Stage I Capital is Stage II Addition to
Underutilized and TP due to increase in Stage III Fixed Input capacity
Successive units of L continues to be is reached and additional L
L add greater positive but is falling causes output to decline
Amounts to TP with each unit
In the long run expansion of output may be achieved by varying all factors
by the same proportion or by different proportions. The laws of returns to
scale refer to the effects of scale relationship. Three types of returns to scale
are observed.
Specialization of labor
Inventory Economies
Managerial indivisibilities
Technical indivisibilities
Managerial inefficiency
Increased bureaucratic
Labor inefficiency
1.4 Isoquant
An isoquant is the locus of all the technically efficient methods or all the
combinations of factors of production for producing a given level of output
given the state of technology.
MP
fffffffffffffff
MRTS l ,k l
MP k
1.6 Isocost
The isocost line is the locus of all combinations of factors the firm can
purchase with a given monetary cost outlay. If a firm uses only L & K, the
total cost or expenditure of the firm can be represented by:
C wL rK
One can solve Optimization problem for the combination of inputs that
either minimizes total cost subject to a given constraint on output
OR
Optimal input Combination Depends on the relative prices of inputs and the
degree to which they can be substituted for each other represented by the
point of tangency between Isocost and Isoquant.
MP
fffffffffffffff wfffff
l
MP k r
Q.3 The law of variable proportions states that given at least one input
constant the marginal product of variable factor
(a) Increases
(b) Decreases
(d) Fluctuates
Isocost line
(c) When average product falls, marginal product also falls and lies
below
Average product
Isoquant
MP
fffffffffffffff
l wfffff
(b) <
MP k r
MP
fffffffffffffff wfffff
(c) l
MP k r
MP
fffffffffffffff w
(d) l
1 fffff
MP k r
CHAPTER VI
CONTENTS:
1.1 Introduction
1.2 Objectives of Pricing Policies
1.3 Factors affecting Pricing Policies
1.4 Price Forecasting
1.5 Prospective supply and demand
1.5.1 Prospective Supply
1.5.2 Prospective Demand
1.6 Pricing Methods
1.6.1 Introduction
1.6.1.1 Skimming Pricing
1.6.1.2 Penetration Pricing
1.6.2 Growth
1.6.3 Maturity
1.6.4 Saturation
1.6.5 Decline
1.7 The various Pricing methods are:
1.7.1 Cost-plus or full-cost pricing:
1.7.2 Rate of Return pricing
1.7.3 Marginal cost pricing
1.1 Introduction
Managerial decision making consists of a number of procedures at each
individual stage of the product manufacturing. They are related to the
product development depending on the market requirement, product
manufacturing, product distribution and marketing of the same to realize the
company's sales targets.
One of the important factors which assist the company in realizing its
profits through targeted sales is the Pricing Policy, it formulates. As a result
the method of the company's Pricing Policy plays an important role in the
Managerial decision making. Price, in fact, is the source of revenue which
the firm seeks to maximize. Also it is the most important device a firm can
use to expand its clientele base. The company should fix the price
reasonably because if the price is set too high, it may lead it to loose its
market share. On the other hand, if the price is set too low the company may
not recover its cost. so the right choice of the Price fixation would depend
on number of factors and wide variety of conditions prevailing in the
market. Moreover the pricing decisions have to be reviewed and formulated
from time to time.
Some of the factors which affect the choice of the pricing policies are:
Business Objectives: This relates to rate of growth, establishing and
increasing its market share and maintenance of control and finally
profit realization. All these concepts play an important role in pricing
policy formulation.
Competition level: It is important for a company to offer the product
which satisfies the wants and desires of the consumer than the one
which sells at the lowest price.
commodity and the willingness of the buyer to buy the commodity and their
purchasing power. An analysis of a price movement of a commodity over a
period of time will reveal certain fluctuation. These fluctuations and their
relationships are helpful in price forecasting. Some of the fluctuations
observed are:
Seasonal price variation: These are common in case of number of
commodities notably agricultural and food products such variations
would take place in markets having seasonal cycles. These variations
may take place due to seasonal fluctuation in the price of raw
materials also.
Cyclical price variation: During the business cycle, price of all
commodities would generally record fluctuations. So it becomes
essential to realize this effect on the commodities in different ways.
The general business conditions influence the commodity prices
through changes in the demand supply relationships in the market for
each individual commodity.
Cob -Web Cycle: These cycles occur on account of the cumulative
effect of the price expectations of the millions of independent
producers. When farmers expect higher prices in future, they plan
independently to producer more. Also new ones enter the field.
As a result, the aggregate output, when the future date arrives, is so
large that the price falls. When the prices fall, all the producers plan
to produce less, once they have suffered losses on the account of non-
materialization of their expected prices. This time the cumulative
effect of smaller output plan leads to the shortage of products which
in turn increases the prices.
1.6.1 Introduction
Research or engineering skills lead to the product development. There are
high promotional costs involved, volume of sales is low and there may be
heavy losses.
Pricing Policies in Introductory phase largely depend on the close
substitutes available in the market. Generally two kinds of pricing policies
are suggested,
1.6.1.1 Skimming Pricing: This pricing strategy is adopted when close
substitutes of a new product are not available in the market. To extract the
consumer surplus, setting up a very high price initially and then a
subsequent lowering of prices in a series of reduction.
1.6.2 Growth
Due to the cumulative effects of introduction stage the product begins to
make rapid sales gain. High and sharply rising profits may be witnessed.
Consumer satisfaction has to be ensured.
1.6.3 Maturity
Sales growth continue, but at a diminishing rate, because of the declining
number of the potential customers who remain unaware of the product or
have taken no action. Profit margin slips despite rise in the sale.
During Maturity stage, firm should move in the direction of Product
improvement and market segmentation.
1.6.4 Saturation
Sales reach and remain on a plate marked by the level of the replacement
demand. There is a little additional demand to be stimulated.
1.6.5 Decline
Sales begin to diminish absolutely as the customers begin to tire of the
product and the product is gradually edged out by better products or the
substitutes.
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The life cycle broadly gives the different stages through which a product
passes through. There are changes taking place in the price and promotional
elasticity of demand as also in the production and distribution cost of the
product. Pricing Policy, therefore, must be properly adjusted over the
various phases of the life cycle of the product.
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lower prices in order retain its market share. This may lead other firms to
reduce their prices leading to cut- throat competition. The price cut may be
up to such an extent that the fixed cost is not covered and thus a fair return
on the investment is not obtained.
Example: Nestle Tea is priced based on this method.
Bain explained why firms over a long period of time were keeping their
price at a level of demand where the elasticity was below unity, that is, they
did not charge the price which would maximize their revenue. Traditional
theory was concerned only with actual entry of the firms and not the
potential entry. Bain argued that in the long run because of the existence of
barrier to entry the price do not fall to the level of LAC. This behaviour can
be explained by assuming that there are barriers to entry and the existing
firms do not set the monopoly price but the limit price, i.e., the highest price
that the established firms believe they can charge without inducing entry.
The level at which limit will be set depends on the estimation of the costs of
the potential entrant, market elasticity of demand, shape and level of LAC,
size of the market and number of firms in the industry.
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hence every manufacturer wanting to enter this segment has to be Nescafe's line.
1.7.6 Team pricing
According to this method, the companies sometimes assign special roles to
the various products they sell. Some items may be used as promotional
items which are priced and advertised with prime purpose of attracting the
customers and other may be intended to make up for the low margin
obtained on the promotional items.
Example: Several retailers give free items with certain items. Pantaloon,
Allen Solly & Van Heusen are examples, for instance with a Van Heusen
Blazer you can choose Van Heusen tie for free.
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load price is charged during the peak-load period and a lower price is
charged during the off-peak period
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4. In which Pricing method, the firm adjusts its own price policy to
general pricing structure in the industry:
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9. In case certain goods are not sold within a reasonable time, the
retailer pulls the price down, it is known as
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CHAPTER VII
CONTENTS:
1.1 Introduction
1.2 Baumols Sales Revenue Maximization Theory
1.3 Marriss model of the managerial enterprise
1.4 Williamson Model of Managerial Discretion
1.5 Satisficing Behavior Theory of the Firm
1.1 Introduction
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= Profit Curve
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b c
U m f S, M, I d
Where
S staff expenditure
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M managerial emoluments
Id discretionary investment
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a) Sales maximization
b) Profit maximization
(a) MR > MC
(b) MR = MC
(c) MR < MC
(d) MR MC
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a) Always same
b) Always separate
c) Interdependent
b) (b) g gd gc
d) (d) g a
6 gd a
6 gc
a) Positively high
b) Positively low
c) Negatively high
d) Negatively low
a) Revenue maximization
b) Profit maximization
c) Investment maximization
d) Prices maximization
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CHAPTER VIII
MARKET STRUCTURE
CONTENTS:
1.1 Introduction
1.2 Meaning of market
1.3 Classification of Market Structure
1.3.1 Perfect Competition
1.3.1.1 Price Output Determination Under Perfect
Competition
1.3.1.2 Equilibrium in Short Run
1.3.1.3 Perfect Competition in the Long Run
1.3.1.4 Perfect Competition and Plant Size
1.3.1.5 Perfect Competition and the LR Supply Curve
1.3.1.6 Long Run Equilibrium
1.3.2 Monopoly Market
1.3.2.1 Why do Monopolies exist?
1.3.2.2 Equilibrium of the Firm
1.3.2.3 Price Discrimination
1.3.3 Monopolistic Competition
1.3.3.1 Structure
1.3.3.2 Short Run Equilibrium
1.3.3.3 Long Run Equilibrium
1.3.3.4 Efficiency under Monopolistic Competition
1.3.4 Oligopoly Market
1.3.4.1 Structure
1.3.4.2 Mutual Interdependence
1.3.4.3 Collusion is difficult if
1.3.4.4 Explicit Collusion Cartels
1.3.4.5 Sweezeys Model of Kinked Demand Curve
1.3.4.6 Price Stability with a Kinked Demand
Curve
1.3.4.7 Tacit Collusion: Price Leadership
1.3.4.7.1 Dominant Firm Price Leadership
1.3.4.7.2 Barometric Price Leadership
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1.1 Introduction
Maximization of output or optimization of cost or optimization of resource
allocation is only one aspect of the profit maximizing behavior of the firm.
Another and equally important aspect of Profit Maximization is to find the
price from the set of prices revealed by the demand schedule that is in
agreement with the profit maximization objective of the firm.
The profit maximizing price does not necessarily coincide with minimum
cost of production. Besides, the level of profit-maximizing price also
depends on the nature of competition prevailing in the market. Therefore,
while determining the price for its product, a firm has to take into account
the degree of competition.
A market is a group of people and firms which are in contact with one
another for the purpose of buying and selling some product. It is not
necessary that every member of the market be in contact with each other.
Market structure refers to the number and size distribution of buyers and
sellers in the market for a good or service. The market structure for a
product not includes firms and individuals currently engaged in Buying and
selling but also the potential entrants.
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Perfect Competition
Imperfect Competition
1.3.1 Perfect Competition
Characteristics of Perfect Competition:
Large number of small sellers and buyers: The number of buyer as
well as seller is so large that the share of each buyer in total market
demand and the share of each seller in total market supply is
insignificant and hence no individual buyer or seller can influence the
market price.
Homogeneous products: Products supplied by the firms are identical
and are regarded as perfect substitute to each other.
Perfect mobility of factors of production: For a market to be
perfectly competitive, the factors of production must be in the
position of moving freely into or out of the industry and from one
firm to another.
Free entry and free exit of the firms: No legal or otherwise
restrictions on the entry and exit of the firms.
Perfect dissemination of the information: to the buyers and sellers.
No government intervention and Absence of collusion.
Examples: Agricultural commodities and Stock market
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A Short run is a period in which firms can neither change their size nor quit,
nor can new firms enter the industry. Firms can increase (or decrease) the
supply of the product by increasing (or decreasing) the variable inputs.
Therefore, supply curve is elastic in short run.
The determination of market price in the short run is illustrated in the Fig.
4.1(a) and adjustment of output by the firms to the market price and firms
equilibrium are shown in Fig. 4.2(b). Fig. 4.1(a) shows the price
determination for the industry by the demand curve D and supply curve S at
the price OP. This price is fixed for all the firms in the industry. Given the
Price OP, an individual firm can produce and sell any quantity at this price.
To determine the profit maximizing output, firms cost curves are required
to be studied.
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The process of firms output determination and its equilibrium are shown in
the Fig 4.2(b). Profit maximizing condition for a firm is MR=MC. Since
price is fixed at OP, firms average revenue AR= OP and also if AR is
given, MR=AR. Firms upward sloping MC curve intersects MR
In the long run, entry and exit become possible. Why? Because potential
firms can buy fixed inputs and become actual firms. And existing firms can
sell off or stop renting their fixed inputs and go out of business.
Firms will choose to enter the industry if the existing firms in the industry
are making economic profits. The profits are an incentive to enter. As a
result the total market supply will increase and, therefore, the market supply
curve must shift to the right. It drives down the price on the market, thereby
reducing the profits of each firm.
Now the firms are making profits, but smaller profits than before. But if
there are still economic profits being made, more firms will enter. This must
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continue until there are no economic profits. What has to be true when
profits equal zero?
TR = TC
p*q = qATC
p* = ATC
So entry finally stops when firms are producing at their lowest average total
cost. Here is a diagram of the final, long-run equilibrium under perfect
competition:
What if typical firm is making losses? Then the reverse process will take
place. Firms will exit the market, causing a left shift of market supply,
causing a rise in market price, causing a reduction of losses. This continues
until losses are zero. Thus, Long Run competitive equilibrium consists of
two conditions:
p* = MC
p* = minimum ATC
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The first condition is caused purely by profit maximization, and its true in
both the SR and the LR. The second condition, however, is caused by entry
and exit in the LR. It wont necessarily be true in the SR.
These two conditions have important efficiency implications. Marginal-cost
pricing (p*= MC) means that consumers who buy the product face the true
opportunity cost of their choices. They will only buy the good if the value to
them is greater than the price, which represents the value of the resources
that went into making the product. Minimum average cost pricing (p* =
minimum ATC) means that the product is being made at the lowest average
cost possible, so that no resources are being wasted in its production.
The conclusion that firms make zero profit in the LR may seem odd, given
the profits that many firms earn in reality. What could explain the difference
between theory and reality? (1) Reality may differ from the perfectly
competitive model, and to that extent economic profits can be made. But
also, (2) the profits we generally hear about are accounting profits, not
economic profits. To find out whether these profitable firms are really
making economic profits, wed need more information about their implicit
costs.
Finally, (3) we may be observing short-run profits, not long-run profits.
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entrants into the industry in the usual fashion. So by the same arguments as
before, profits will eventually dissipate to zero. The price must be at the
bottom of the LRATC, not just the SRATC.
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pushing price back down (though possibly not as low as it was before).
Once profits are back to zero again, youre in a new long-run equilibrium.
Do this all again to find a third long run equilibrium, and then connect the
dots to get the long-run supply curve.
The interpretation of the LR supply curve is pretty much the same as the SR
supply
curve: it shows the willingness of producers to sell at each price. But the LR
supply
curve measures this willingness in the broadest sense, including all firms
that might
potentially supply this product.
Notice that the LR supply curve is flatter than the SR supply curve. This
must be so,
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since the LR supply curve takes into account the quantity responses of all
firms, not just the ones currently in the market, but potential firms as well. It
is even possible that the LR supply curve can be downward-sloping. Why?
Consider what must happen if entry and exit do not affect the cost curves of
individual firms. Then after all adjustment to a change in demand has taken
place, the market price must have returned to the lowest point on the
LRATC, which is exactly where it was before. So in this case, the LR
supply curve must be horizontal. We call this a constant--cost industry. This
is most likely to be the case when the industry in question constitutes only a
small portion of the demand for its inputs.
If the industry in question has a large impact on the markets for its inputs,
then the LR supply curve may slope upward or downward. If the effect of
entry into the industry is to bid up the price of inputs, so that a firms cost
curves rise as a result of the entry of new firms, then the market price after
adjustment will be higher than it was before. In this case, the LR supply
curve must be upward-sloping as in the picture above; this is called an
increasing-cost industry, which results from external diseconomies. On the
other hand, if entry into the industry creates a greater demand for inputs that
allows those inputs to be produced through mass production techniques
(i.e., at lower average cost), then the industry can benefit from lower costs
of production. In this case, the LR supply curve is downward-sloping. This
is called a decreasing-cost industry, which results from external economies.
They face a perfectly elastic demand curve Market prices change only if
demand and supply change
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P = MC = AC = MR
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1.3.3.1 Structure
Several firms in the market.
Producing differentiated products.
Free entry and exit.
Full and symmetric information.
Consumers have brand preference but can be induced to change
brands
Advertising often plays a big role in monopolistically competitive
markets
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industry's output. All of them market almost identical products. On the other
hand, passenger car industry with only three firms is characterized by
marked differentiation in products The nature of products is such that very
often one finds entry of new firms difficult. Oligopoly is characterized by
vigorous competition where firms manipulate both prices and volumes in an
attempt to outsmart their rivals. No generalization can be made about
profitability scenarios.
1.3.4.1 Structure
In an oligopoly there are very few sellers of the good.
The product may be differentiated among the sellers (e.g.
automobiles) or homogeneous (e.g. petrol).
Homogenous product Pure Oligopoly
Entry is often limited
by legal restrictions (e.g. banking in most of the world)
by a very large minimum efficient scale
by strategic behavior.
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(a) MR=MC.
(b) MR>MC
(c) MR<MC
(d) MC = AC
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(b) Cartel
(c) Horizontal
(d) Vertical
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BIBLIOGRAPHY
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