Economics

Preface
Managerial economics, meaning the application of economic methods to the managerial
decision-making process, is a fundamental part of any business or management course. It
has been receiving more attention in business as managers become more aware of its
potential as an aid to decision-making, and this potential is increasing all the time. This is
happening for several reasons:

1. It is becoming more important for managers to make good decisions and to justify them,
as their accountability either to senior management or to shareholders increases.
2. As the number and size of multinationals increases, the costs and benefits at stake in the
decision-making process are also increasing.
3 In the age of plentiful data it is more imperative to use quantitative and rationally based
methods, rather than ‘intuition’.
4 The pace of technological development is increasing with the impact of the ‘new
economy’. Although the exact nature of this impact is controversial, there is no doubt that
there is an increased need for economic analysis because of the greater uncertainty and the
need to evaluate it.
5 Improved technologieshave also made it possible to develop more sophisticated methods
of data analysis involving statistical techniques. Modern computers are adept at ‘number-
crunching’, and this is a considerable aid to decision-making that was not available to most
firms until recent years.
As managerial economics has increased in importance, so books on the subject have
proliferated. Many of the more recent ones claim like this one to take a problem-solving
approach. We have found from our own teaching experience that, in spite of this, students
of the subject tend to have two main problems:
1 They claim to understand the theory, but fail to see how to put principles into practice
when faced with the kind of problems they find in the textbooks, even though these are
considerably simplified compared with real life Situations.
2 They fail to see the relevance of the techniques presented in the books in terms of
application to real-life situations. The two problems are clearly related. Textbook problems
are simplified, in terms of the amount of data and decision variables, to make them easier
for students to analyze. However, the result of this is that the module problems tend to fall
between two stools: they are still too difficult in some cases for students to tackle without
considerable help (the first problem), yet they are too simplified and abstract for students to
see how module methods can be applied to real-life situations (the second problem).

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This book attempts to overcome the considerable obstacles above. It adopts a user-friendly
problem-solving approach, which takes the reader in gradual steps from easy, very
simplified problems through increasingly difficult material to complex case studies.
Acknowledgements
1. CONTEXT

CHAPTER - MANAGERIAL ECONOMICS - AN

INTRODUCTION
1.1. Definition, Managerial Issues, Decision - Making
1.2. Scopes of Managerial Economics
CHAPTER II - FUNDAMENTAL ECONOMIC CONCEPTS
2.1. Equilibrium Analysis:
Supply and Demand
Relationships
2.2. Marginal Analysis
2.3. The Time Value of Money
CHAPTER III - OPTIMIZATION TECHNIQUES
3.1. Introduction
3.2. Types of Optimization Techniques
3.2.1. Differential Calculus
3.2.1.1. Applications of Differential Calculus to
Optimization Problems
3.2.1.2 Partial Differentiation and Multivariate
Optimization

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3.2.1.3. Constrained Optimization/lagrangian

multiplier technique
CHAPTER IV - THEORY OF DEMAND AND ITS APPLICATION

4.1. Meaning of Demand, Types of Demand, Demand

function
4.2. Elasticity’s of Demand, Importance of Elasticity
Measuring Demand Elasticity’s
4.3. Elasticity applications
CHAPTER V - DECISION MAKING UNDER RISK AND
UNCERTAINITY 5.1. The Nature of Decision Making
5.2 Meaning and Measurement of Risk
5.2.1. The Meaning of Risk
5.2.2. Risk and Probability Distributions
5.2.3. Risk and Expected values of an Investment
5.3. Approaches of incorporating Risk into Decision
Making Process
5.4. Decision Making Under Uncertainty
CHAPTER VI - THEORY OF PRODUCTION
6.1. Production Defined
6.2. The Production Function
6.3. Production Functions with one Variable Input

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6.4. Determining the Optimal Use of the Variable

Input
6.5. Production Functions with Two Variable Inputs
6.6. Determining the Optimal Combination of Inputs
6.7. Returns Scale
CHAPTER VII - THEORY OF COST
7.1. The Meaning and Measurement of Cost
7.2. Short-run Cost Functions
7.3. Long-run Cost Functions
7.4. Economies and Diseconomies of Scale
7.5. Breakeven Analysis and Operating Leverage-An
Application of Cost Theory
7.6. The Learning Curve
CHAPTER VIII- PRICING AND OUTPUT DECISIONS
8.1. Individual, Firm, and Market Demand Curves
8.2. Price-Output Determination Under Pure
Competition
8.3. Market Price Determination
8.4. Pure Monopoly
8.5. Monopolistic Competition
8.6. Oligopoly

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Economics

Chapter-1

Managerial Economics-An Introduction

1.1 Definition, Managerial Issues, Decision-Making
1.2 Scopes of Managerial Economics

Introduction:

“Managerial Economics” is economics applied in decision – making. It is that

branch of economics, which serves as a link between abstract theory and
managerial practice. It is based on economic analysis for identifying
problems, organizing information and evaluating alternatives.

WHAT IS MANAGERIAL ECONOMICS?

Managerial economics is the application of economic theory and quantitative methods

(mathematics and statistics) to the managerial decision-making process. Simply stated, managerial
economics is applied microeconomics with special emphasis on those topics of greatest interest and
importance to managers. The role of managerial economics in the decision-making process is
illustrated in Figure 1.1

Definitions of managerial economics:

1. Managerial economics is the use of economic modes of thought to analyze business situation.
-----MCNAIR & MERRIAM

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2. Managerial economics is the integration of economic theory with business practice for the
purpose of facilitating decision – making and forward planning by management.
----- SPENCER & SIEGEL MAN

3. Synthesis of microeconomic theory and quantitative methods to find optimal solutions to

managerial decision-making problems.
---- WATSON

To illustrate the scope of managerial economics, consider the case the owner of a company that
produces a product. The manner in which the firm owner goes about his or her business will
depend on the company’s organizational objectives. Is the firm owner a profit maximize or is
management more concerned something else, such as maximizing the company’s market share?
What specific conditions must be satisfied to optimally achieve these objectives? Economic theory
attempts to identify the conditions that need to be satisfied to achieve optimal solutions to these and
other management decision problems. As we will see, if the company’s organizational objective is
profit maximization then, according to economic theory, the firm should continue to produce
widgets up to the point at which the additional cost of producing an additional widget (marginal
cost) is just equal to the additional revenue earned from its sale (marginal revenue).To apply the
“marginal cost equals marginal revenue” rule, however, the firm’s management must first be able
to estimate the empirical relationships of total cost of widget production and total revenues from
widget sales. In other words, the firm’s operations must be quantified so that the optimization
principles of economic theory may be applied.

Objectives:

1. To introduce and define managerial economics.

2. To outline the types of issue which are addressed by managerial economics.
3. To explain the difference between positive and normative economics
4. To explain the relationship between managerial economics, economic theory
and the decision sciences.
5. To explain how managerial economics is related to other disciplines in
Business, such as marketing and finance
6. To identify the main subject areas in managerial economics, explain how
They are related to each other, and describe how they are organized and
Presented in the text.
7. To explain the methods used in the development of scientific theories and
show their relevance to managerial economics.
8. To explain how economic theory is presented from a pedagogical viewpoint,
and how this relates to the organization and presentation of the material in the text.

Scope of Managerial Economics:

Managerial Economics has a close connection with economic theory (micro-

economics as well as macro economics), operation research, statistics, mathematics and the
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theory of decision making. Managerial economics also draws together and relates ideas
from various functional areas of management like production, marketing, finance and
accounting, project management etc. a professional managerial economics has to integrate
concepts and methods from all these disciplines and functional areas in order to
understand and analyze practical managerial problems.

 Managerial Economics and Traditional Economics: In general the relation

between managerial economics and economics theory is very much like the relations
of engineering to physics and of medicine to biology. It is in fact the relation of an
applied field to its more fundamental and conceptual counterpart. Economics
provides certain basic concepts and analytical tools which are applied suitably to a
business situation.
Economics and managerial economics both deal with identical problems-
they both are connected with problems of scarcity and resource allocation. Since
labour and capital resources with a business firm are always limited, it must find
the best way in which to utilize them for achieving the set goals. For example, with
given resources the producer wishes to increase output of one good he will have to
reduce the output of the other goods. He, therefore, will have to decide about the
proportions in which different goods have to be produced to maximize his profits.
Further, while economists mainly concentrate on the study of types of markets,
managerial economist can get answers of the questions regarding the working of
market mechanism only when they analyze the problems from a broader
perspective of an economist.

 Managerial Economics and Operation Research: Both operation research

and managerial economics are concerned with taking effective decisions. Give the
firm’s objectives, both are concerned with what is the best way of achieving them.
The difference, however, is managerial economics is a fundamental academic
subject which seeks to understand and to analyze the problem of business decision
taking, while operation research is an activity carried out by functional specialists
within the firm to help the manager to do his job solving decision problems. This
explains the close links between operations research and managerial economics.
Like economic theory, operations research is also concerned with model building.
Models are generalized and scientifically analyzed relationships between various
factors relevant in a specified kind of situation. Though managerial economics and
operation research resort to model building, economic models are more general and
confined to broad economic decision making. Operation research models, on the
other hand, draw from various disciplines and are more job-oriented, though
situational. Some of the operations research models like queuing, linear
programming, etc., are widely used in managerial economics.
Operation research is often both expensive and slow process because it aims
at reaching accurate rather than rapid solutions. But the manager on the other
hand, must get results quickly and cheaply. Managerial economics comes to his
rescue here. Managerial economics provides the manager with the tools he needs to
carry out this ‘instant’ operation research. By using the knowledge which
managerial economics equips him with, he often reaches almost the same kind of

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solutions, as operations research would provide. And he will be able to do so more

quickly as is required by his job.
 Managerial economics and Mathematics: Mathematics provides us with a set
of tools which help in the derivation and exposition of economic analysis.
Mathematics is closely related to managerial economics. This is mainly because
managerial economics, besides being conceptual, is also metrical. It derives its
metrical property from the fact that that an important function of managerial
economics is to estimate and predict the relevant economic factors for decision-
making and forward planning. Mathematics is often preferred to a descriptive
analysis in such cases because the former possesses certain concepts and allows
operations for which no managerial economics. In as much as symbols and words
are really equivalents, it does not matter whether a mathematical or a descriptive
form is chosen to represent the problem. But it is generally believed that besides
being more manageable and having a greater scope of use, symbols are more
convenient to handle and to comprehend.
The main branch of mathematics which are generally used by a managerial
economist are geometry, algebra and calculus, while the main mathematical
concepts used or the logarithms and exponentials, vectors and determinants, input
or output tables, etc. Even operation research can be included as a part of
mathematical exercise in managerial economics.
 Managerial economics and Statistics: statistics is widely used by managerial
economists. Managerial economics aims at quantifying the past economic activity as
well as to predict its future course. This is needed for a correct judgment and
decision-making. For example, if a firm wants to decide about pricing its product, it
must have knowledge of the existing demand and production situations and also of
the likely changes in them so that an appropriate pricing policy can be decided. The
most useful aspect of statistics is that it can deal with uncertainty conditions which
the firm is generally found to face. Managerial economics heavily depend up on the
theory of probability to take care of such problems in decision-making.
 Managerial economics and the theory of decision making: The theory of
decision making is relatively new subject that has significant for managerial economics.
Much of economic theory is based on the assumption of single goal-maximization of
profit for the firm or maximization of utility of a consumer. It also usually rests on the
assumption of certainty (or perfect knowledge). In contrast, the theory of decision
making recognizes the multiplicity of goals and the pervasiveness of uncertainty in the
real world of management. The theory of decision making often replaces the notion of a
single optimum solution with the view of finding solutions that objectives. It probes
motivation, the relation of rewards and aspiration levels, and patterns of influence and
authority.
Making the Best Decision:
To establish appropriate decision rules, managers must understand the economic environment in
which they operate. For example, a grocery retailer may offer consumers a highly price-sensitive
product, such as milk, at an extremely low markup over cost—say, 1 percent to 2 percent—while
offering less price-sensitive products, such as nonprescription drugs, at markups of as high as 40
percent over cost. Managerial economics describes the logic of this pricing practice with respect to
the goal of profit maximization. Similarly, managerial economics reveals that auto import quotas

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reduce the availability of substitutes for domestically produced cars, raise auto prices, and create
the possibility of monopoly profits for domestic manufacturers. It does not explain whether
imposing quotas is good public policy; that is a decision involving broader political considerations.
Managerial economics only describes the predictable economic consequences of such actions.
Managerial economics offers a comprehensive application of economic theory and methodology to
management decision making. It is as relevant to the management of government agencies,
cooperatives, schools, hospitals, museums, and similar not-for-profit institutions as it is to the
management of profit-oriented businesses. Although this text focuses primarily on business
applications, it also includes examples and problems from the government and nonprofit sectors to
illustrate the broad relevance of managerial economics.
THE SUBJECT MATTER OF MANAGERIAL ECONOMICS - DECISION MAKING

Managerial Issues
Managerial issues are classified by two parts like………..

Managerial Issues

Operational Issues Environmental Issues

#Theory of demand #Issue related to macro economics

#Theory of production & Production
#Issue related to foreign trade
decision
#Analysis of market-Structure & pricing #Issue related to government policy
policy
#Profit Analysis & Profit Management
#Theory of capital&investment Page 9
decision.
Economics

Operational Issues:
1. Theory of demand: It is of vital importance for any firm to have an understanding of
the demand for its products. Demand relationships determine revenues and indirectly
affect output and costs; they thus have a fundamental impact on profits. An
understanding of demand is also relevant for planning purposes, involving production,
transportation, inventory, sales, marketing and finance functions. The identification of
factors affecting demand and the precise effects that these have is therefore a core
element in managerial economics.
2. Theory of Production & production decision:Allfirms are usually profit-oriented in
terms of their objectives and every one focused on the revenue side of the profit
equation by examining demand. We now need to examine the other side of the profit
equation by considering costs. However, just as we had to examine consumer theory in
order to understand demand, we must now examine production theory before we can
understand costs and cost relationships. In doing this we shall see that there are a
number of close parallels between consumer theory and production theory; there is a
kind of symmetry between them. At the end of the chapter we will consider the
importance of production theory for managerial decision-making, the focus of this
text. What is production theory? Essentially it examines the physical relationships
between inputs and outputs. By physical relationships we mean relationships in terms
of the variables in which inputs and outputs are measured: number of workers, tons of
steel, barrels of oil, megawatts of electricity, hectares of land, number of drilling
machines, number of automobiles produced and so on. Managers are concerned with
these relationships because they want to optimize the production process, in terms of
efficiency. Certain important factors are taken as given here: we are not considering
what type of product we should be producing, or the determination of how much of it
we should be producing. The first question relates to the demand side of the firm’s
strategy, while the second involves a consideration of both demand and cost, which is
examined in pricing. What we are considering is how to produce the product in terms
of the implications of using different input combinations at different levels of output.
For example, we can produce shoes in factories that make extensive use of automatic
machinery and skilled labour in terms of machine operators, or we can produce them
in factories employing more labor-intensive methods and unskilled labour. We cannot
say that one method or technology is better or more efficient than the other unless we
have more information regarding the relationships and costs of the inputs involved.
3. Analysis of market-structure and pricing policy: There are, perhaps, as many ways
to classify a firm’s competitive environment, or market structure, as there are industries.
Consequently, no single economic theory is capable of providing a simple system of rules for
optimal output pricing. It is possible, however, to categorize markets in terms of certain basic
characteristics that can be useful as benchmarks for a more detailed analysis of optimal
pricing behavior. These characteristics of market structure include the number and size
distribution of sellers, the number and size distribution of buyers, product differentiation, and
the conditions of entry into and exit from the industry. Pricing policy: For firms with market
power, price discrimination refers to the practice of tailoring a firm’s pricing practices to fit
specific situations for the purpose of extracting maximum profit. Price discrimination may
involve charging different buyers different prices for the same product or charging the same
consumer different prices for different quantities of the same product. Price discrimination

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may involve pricing practices that limit the consumers’ ability to exercise discretion in the
amounts or types of goods and services purchased. In whatever guise price discrimination is
practiced, it is often viewed by the consumer, when the consumer understands what is going
on, as somehow nefarious, or at the very least “unfair.”
4. Profit Analysis & Profit Management: In common parlance profit means the net
income of a businessman. It is calculated by deducting from the total receipts the total
expenditure incurred in a business venture. But profit in the above sense is not the
something as defined by economists. Economists. Regard profit as a factor-return like
wages, interest and rent. To them, profit is a return to the entrepreneur for the use of
his entrepreneurial ability. It becomes important to know what we mean by return for
entrepreneurial ability. Since the return for his routine management is wages, he must
do something other than routine management to earn profit. Essentially, there are two
things and entrepreneur does: 1. He decides when, where and how he is to use his
limited resources. 2. His second job is that of innovation. In attempting to make pot the
entrepreneur must search around for new methods of production, new ways of
business organization, new marketing techniques and approaches, and the like.
According to drucker, profit serves mainly the following three purposes: (i). it is an
index of performance of the firm. (ii). It is a premium to cover costs of staying in
business. (iii). It ensures supply of re-investible capital.
5. Theory of capital investment decision:Firms continually invest funds in assets and
these assets produce income and cash flows that the firm can then either reinvest in
more assets or pay to the owners. These assets represent the firm’s capital. Capital is
the firm’s total assets. It includes all tangible and intangible assets. These assets
include physical assets (such as land, buildings, equipment, and machinery), as well as
assets that represent property rights (such as accounts receivable, securities, patents,
copyrights). When we refer to capital investment, we are referring to the firm’s
investment in its assets. The term “capital” also has come to mean the funds used to
finance the firm’s assets. In this sense, capital consists of notes, bonds, stock, and
short-term financing. We use the term “capital structure” to refer to the mix of these
different sources of capital used to finance a firm’s assets. The firm’s capital
investment decision may be comprised of a number of distinct decisions, each referred
to as a project. A capital project is a set of assets that are contingent on one another and
are considered together. For example, suppose a firm is considering the production of
a new product. This capital project would require the firm to acquire land, build
facilities, and purchase production equipment. And this project may also require the
firm to increase its investment in its working capital—inventory, cash, or accounts
receivable. Working capital is the collection of assets needed for day-to-day operations
that support a firm’s long-term investments. The investment decisions of the firm are
decisions concerning a firm’s capital investment. When we refer to a particular
decision that financial managers must make, we are referring to a decision pertaining
to a capital project.

Environmental Issues:
1. Issue related to Macro Economics:As the name implies, macroeconomics looks at the big
picture. Macroeconomics is the study of entire economies and economic systems and
specifically considers such broad economic aggregates as gross domestic product, economic

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growth, national income, employment, unemployment, inflation, and international trade. In

general, the topics covered in macroeconomics are concerned with the economic environment
within which firm managers operate. For the most part, macroeconomics focuses on the
variables over which the managerial decision maker has little or no control but may be of
considerable importance in the making of economic decisions at the micro level of the
individual, firm, or industry. Definition: Macroeconomics is the study of aggregate economic
behavior. Macroeconomists are concerned with such issues as national income, employment,
inflation, national output, economic growth, interest rates, and international trade.
2. Issue related to foreign trade:Observing about foreign trade is very difficult to business
people. Because they have to solve so many things like…Every day changing export and
import conditions, Fluctuating trading rules, Getting the permission from GATT, ISO-9000,
ISO-14000, etc., in the present globalization condition every business concern facing high level
competition, prices are decreasing, and more quantity and quality items demanding by
people/customers. Technology and internet facilities also giving tuff competition to the
business people.
3. Issue related to government: every government wants to get Maximum wealth with the help
of high production and better utilization of resources and collection of taxes. In this aspect
governments are charging high taxes, penalties, more exchange duties, customs duties ect., by
this manner of the government business concerns are facing little bit trouble, because they are
unable to increase sale price of the product in the competitive market and insufficient
revenue sources to pay high charges to government.

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Chapter-2

Fundamental Economic Concepts

2.1 Equilibrium Analysis: Supply and demand relationships
2.2 Marginal Analysis
2.3 The time value of money
I. The Basic Notion of Supply & Demand
Supply-and-demand is a model for understanding the determination of the price of
quantity of a good sold on the market. The explanation works by looking at two different
groups – buyers and sellers – and asking how they interact.
II. Types of Competition
The supply-and-demand model relies on a high degree of competition, meaning that there
are enough buyers and sellers in the market for bidding to take place. Buyers bid against
each other and thereby raise the price, while sellers bid against each other and thereby
lower the price. The equilibrium is a point at which all the bidding has been done; nobody
has an incentive to offer higher prices or accept lower prices. Perfect competition exists
when there are so many buyers and sellers that no single buyer or seller can unilaterally
affect the price on the market. Imperfect competition exists when a single buyer or seller
has the power to influence the price on the market. The supply-and-demand model applies
most accurately when there is perfect competition. This is an abstraction, because no
market is actually perfectly competitive, but the supply-and-demand framework still
provides a good approximation for what is happening much of the time.
III. The Concept of Demand
Used in the vernacular to mean almost any kind of wish or desire or need. But to an
economist, demand refers to both willingness and ability to pay. Quantity demanded (Qd)
is the total amount of a good that buyers would choose to purchase under given conditions.
The given conditions include:
price of the good
income and wealth
prices of substitutes and complements
population
preferences (tastes)
expectations of future prices
We refer to all of these things except the price of the good as determinants of demand. We
could talk about the relationship between quantity demanded and any one of these things.
But when we talk about a demand curve, we are focusing on the relationship between
quantity demanded and price (while holding all the others fixed). The Law of Demand
states that when the price of a good rises, and everything else remains the same, the
quantity of the good demanded will fall. In short,

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Note 1: “everything else remains the same” is known as the “ceteris paribus” or “other
things equal” assumption. In this context, it means that income, wealth, prices of other
goods, population, and preferences all remain fixed. Of course, in the real world other
things are rarely equal. Lots of things tend to change at once. But that’s not a fault of the
model; it’s a virtue. The whole point is to try to discover the effects of something without
being confused or distracted by other things.
Note 2:Is the law of demand really a “law”? Well, there may be some exceedingly rare
exceptions. But by and large the law seems to hold.
Note 3: I will use the word “normal” to refer to any good for which the law of demand
holds. Please note that this is different from the book’s definition of normal. A Demand
Curve is a graphical representation of the relationship between price and quantity
demanded (ceteris paribus). It is a curve or line, each point of which is a price-Qd pair.
That point shows the amount of the good buyers would choose to buy at that price.
Changes in demand or shifts in demand occur when one of the determinants of demand
other than price changes. In other words, shifts occur “when the ceteris are not paribus.”
The demand curve’s current position depend on those other things being equal, so when
they change, so does the demand curve’s position.

Examples:
1. The price of a substitute good drops. This implies a leftward shift.
2. The price of a complement good drops. This implies a rightward shift.
3. Incomes increase. This implies a rightward shift (for most goods).
4. Preferences change. This could cause a shift in either direction, depending on
how preferences change.
Demand versus Quantity Demanded. Remember that quantity demanded is a specific
amount associated with a specific price. Demand, on the other hand, is a relationship
between price and quantity demanded, involving quantities demanded for a range of
prices. “Change in quantity demanded” means a movement along the demand curve.
“Change in demand” refers to a shift of the demand curve, caused by something other than
a change in price.
IV. The Concept of Supply
Used in the vernacular to mean a fixed amount, such as the total amount of petroleum in
the world. Again, economists think of it differently. Supply is not just the amount of
something there, but the willingness and ability of potential sellers to produce and sell it.
Quantity supplied (Qs) is the total amount of a good that sellers would choose to produce
and sell under given conditions. The given conditions include:
price of the good
prices of factors of production (labor, capital)
prices of alternative products the firm could produce
technology
productive capacity
expectations of future prices
We refer to all of these, with the exception of the price of the good, as determinants of
supply.

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When we talk about Supply, we’re talking about the relationship between quantity
supplied and the price of the good, while holding everything else constant. The Law of
Supply states that “when the price of a good rises, and everything else remains the same,
the quantity of the good supplied will also rise.” In short,

A Supply Curve is a graphical representation of the relationship between price and

quantity supplied (ceteris paribus). It is a curve or line, each point of which is a price-Qs
pair. That point shows the amount of the good sellers would choose to sell at that price.
Changes in supply or shifts in supply occur when one of the determinants of supply other
than price changes.
Examples:
1. The price of a factor of production rises. This would cause a leftward shift the supply
curve.
2. A rise in the price of an alternative good that could be provided with the same resources.
This implies a leftward shift of supply.
3. An improvement in technology. This leads to a rightward shift of supply. Supply versus
Quantity Supplied. Analogous to the demand versus quantity demanded distinction.
“Change in quantity supplied” means a movement along the supply curve. “Change in
supply” refers to a shift of the supply curve, caused by something other than a change in
price.

Equilibrium Analysis
Putting demand and supply together, we can find an equilibrium where the supply and
demand curve cross. The equilibrium consists of an equilibrium price P* and an
equilibrium quantity Q*. The equilibrium must satisfy the market-clearing condition,
which is Qd = Qs.

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In the m If price is below P*, at PL, then we have Qd> Qs. This is called “excess demand”
or “shortage.” The quantity that actually occurs will be Qs. For this quantity, buyers are
willing to pay much more than PL, so they’ll start bidding against each and raising the
price.

If price is below P*, at PH, then we have Qs >Qd. This is called “excess supply” or
“surplus.” The suppliers will start competing against each other for customers by lowering
the price.

Short-side rule: When there is a disequilibrium price, the actually quantity that gets sold is
given by Q = min{Qs,Qd}. This is implied by the requirement of voluntarism.

VI. Price Controls:

Price floors and price ceilings are government mandated prices that attempt to control the
price of a good or service. A price ceiling is usually imposed to keep down the price of
something perceived as too expensive. To have any effect, it must be imposed below the
market price. Example: Rent control on apartments.
What effect do we predict? As with any below-equilibrium price in the example above, we
xpect to get a shortage. But in this case, buyers can’t raise the price by bidding against each
other, because by law the price cannot rise. Using the short-side rule, we discover that rent
control actually reduces the amount of housing made available to the public. Ironically, the
price control may also raise the de facto price paid by consumers. From the demand curve,

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we can see that consumers would be willing to pay a very high price (much higher than the
price ceiling or even the market price) for the reduced quantity (Qs) available. They are
willing to pay this money if they can just find a way to do so – and they do, in the form of
bribes, key fees, rental agency fees, etc.
N.B.: If the price ceiling is imposed above the market price, it has no effect.
A price floor is usually imposed to keep up the price of something perceived as too cheap.
To have any effect, it must be set above the market price.
Example: Agricultural price supports.
These are imposed, usually, because farm lobbies have convinced the legislature that they
are not earning enough to stay in business. What effect do we predict? As with any above-
equilibrium price, we expect to get a surplus, this time persistent because sellers can’t bid
down the price. and
for many years, that’s exactly what the U.S. had. The government usually bought up the
surplus (and dumped it on 3rd World markets). Note: If the price floor is imposed below
the market price, it has no effect. Note: It’s easy to get confused if you’re not thinking
clearly. An effective price ceiling is below the market price, while an effective price floor is
above it. (Imagine a ceiling being too low and bumping your head, or a floor rising beneath
your feet.)

VII. Analyzing Changes in Market Equilibrium

Consider first a rightward shift in Demand. This could be caused by many things: an
increase in income, higher price of substitute, lower price of complements, etc. Such a shift
will tend to have two effects: raising equilibrium price, and raising equilibrium quantity.

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Example: Consider the market for rental housing, and suppose that a new factory or
industry opens up in the city, attracting more residents. Then there will be a rightward
shift in demand, driving up both price and quantity. Note: The price of housing does go up,
but not by as much as you might think, because the change in demand induces suppliers to
bring more housing to market. This can be seen in the movement along the Supply curve.

A leftward shift of demand would reverse the effects: a fall in both price and quantity. The
general result is that Demand shifts cause price and quantity to move in the same direction.
Now consider a rightward shift of supply (caused by lower factor price, better technology,
or whatever). This will tend to have two effects: raising equilibrium quantity, and lowering
quilibrium price.

Example: A new immigration policy allows lots of low-wage labor to enter the steel
business. The lower price of steel leads to a rightshift in the supply of cars, so the price of
cars falls and the quantity rises.
A leftshift of supply would reverse the effects, so the general result is that supply shifts tend
to cause price and quantity to move in opposite directions.
Now, what happens if both demand and supply both shift at once? In general, the two
changes have reinforcing effects on either price or quantity, and offsetting effects on the
other.
Example 1: The computer industry. Incredible improvements in technology, as well as the
entry of many new firms into the industry, have increased supply. Simultaneously, many
people have become very aware of the benefits of computers, and new software has made
computers more useful for a variety of projects, thereby increasing demand as well.
The increase in demand tends to increase both P and Q.
The increase in supply tends to lower P and raise Q.

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So both effects tend to raise quantity. But what happens to price? That depends on the
relative size of the two changes. Observation of the computer industry shows that prices
have actually fallen, so we can conclude that supply shifts have been relatively more
important than demand shifts in this market. A similar pattern emerges in many high-tech
products (CD players, DVD players).
A possible complication: Much technological change has been in the form of higher quality,
and consumers shift demand from lower quality to higher quality machines. This is not as
easy to think about in the supply-and-demand framework. The price of a new, cutting edge
computer has stayed about the same over time, at about $2000.
Example 2: Higher education. (This example may not be totally accurate historically, but it
demonstrates the point.) Supply has fallen because higher education is a labor-intensive
business, and educated labor (which has to be attracted from other industries) has become
much more expensive. Meanwhile, demand has increased because jobs for educated people
have become increasingly attractive relative to other jobs.
The increase in demand tends to increase both P and Q.
The decrease in supply tends to raise P while lowering Q.
So both forces tend to raise P, and that is confirmed by observation. But they work in
opposite directions on Q. Our knowledge of the market for higher education tells us that Q
has actually increased, meaning that the shift in demand has been relatively more
important. When analyzing situations where both supply and demand shift at once, don’t
let yourself be fooled by your graph. Your graph may appear to show clear changes in both
price and quantity. But we know that one variable will experience an offsetting effect.
Whether that variable appears to rise or fall depends entirely on how large you’ve drawn
the curve shifts. (Take the computer example above. If you drew the demand shift bigger
than the supply shift, you would mistakenly conclude that price should rise.) Unless you are
provided with additional information about the size of the shifts, you can only make a
prediction about one variable.

The algebraic approach to equilibrium.The algebraic approach to equilibrium

analysis is to solve, simultaneously, the algebraic equations for demand and supply. In the
example given above, the demand equation for good X was

and the supply equation for good X was

To solve simultaneously, one first rewrites either the demand or the supply equation as a
function of price. In the example above, the supply curve may be rewritten as follows:

Substituting this expression into the demand equation, one can solve for the equilibrium
price:

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Economics

The equilibrium price of good X is found to be $2. Substituting the equilibrium price of 2
into the rewritten supply equation for good X, one has:

The equilibrium quantity is found to be 4 units of good X.

Marginal Analysis:

A basic technique used in economics that analyzes small, incremental changes in key
variables. Marginal analysis is the primary analytical approached used in the study of
markets, production, consumption, business cycles, and economic policies. It not only
reflects how most economic decisions are made, it also lends itself to mathematical and
graphical analysis.
Approach utilizing such concepts as marginal revenue, marginal cost, and marginal profit
for economic decision making. For example, decisions for allocating scarce resources are
typically expressed in terms of the marginal condition(s) that must be satisfied in order to
attain an optimal solution. The familiar profit-maximizing rule of setting production or
sales volume at the point where "marginal revenue equals marginal cost" is one such
example.

Marginal analysis is based on a simple question often posed in the study of economics:
"What happens if something changes by one dollar, one unit, one person, or one
whatever?" For example, what happens to the quantity demanded of hot fudge sundaes if
the market rice',500,400)">market price increases by one cent? Or what happens to gross
domestic product if investment decreases by $1? Or what happens to the market price of
computers if one more computer supplier enters the industry?

Marginal Obsession:

The apparent economic obsession with marginal changes exists for at two notable reasons.

1. Incremental Decisions: One reason is that many economic decisions made in the
real world are made "at the margin." Duncan Thorley decides whether or not to eat
one more slice of pizza at the all-you-can-eat pizza lunch buffet after having eaten five
slices. Winston SmytheKennsington III decides whether or not to hire an additional
worker to the current staff. The Shady Valley City Council debates over adding an

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Economics

extra penny to their existing sales tax. These are marginal decisions, one and all, and
just the sort of phenomena investigated with marginal analysis.

2. Sophisticated Analysis:A second reason for using marginal analysis can best be
termed analytical sophistication. Economists frequently make use of high-powered
mathematical techniques, especially calculus, to create models of markets, consumer
behavior, production decisions, or the aggregate economy. Such high-powered
mathematical techniques not only lend themselves easily to analyzing incremental
changes, but also to building extremely complex models that use these incremental
changes to reveal interactions, implications,
and conclusions about the economy that are Slope and Marginal
often far from obvious. For example, such a
complex model might reveal how a financial
crises in Asia affects the construction of new
homes in California.

3. Marginal Slope:

The use of marginal analysis works nicely with

both mathematical and graphical analysis.
Marginal means incremental change. In simple
mathematical terms the slope parameter of an
equation captures the marginal change. In a graph,
the slope of a line captures a marginal change. In
effect, the term "marginal" is synonymous with
the term "slope."

Consider this simple equation that captures a linear relation between two variables X and
Y:

Y = a + bX
The key point of focus is the slope parameter, b. This equation indicates that each 1 unit
change in X results in a change in Y by the value of b. If b is 4, then an increase in X by 1
results in Y increasing by 4. The slope parameter b captures the marginal change in Y
resulting from a change in X.

Now consider a simple graph of a line such as Y = a + bX. It too captures marginal change
as the slope. This exhibit displays a positively-sloped line. The numerical value of the slope
of the line is 4. This value captures the marginal change in Y measured on the vertical axis
resulting from a change in X measured on the horizontal axis. An increase in X by 1 results
in Y increasing by 4.

Time Value of Money

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Economics

The basic idea of time value of money is that a birr today is worth more than a birr
tomorrow. This can be shown in many ways, many people find it easiest to understand if
they think in terms of something they already know: food. For example having the money
today allows you to buy some food immediately. Alternatively you may be willing to forgo
current consumption and wait until later to purchase your food. Thus you could lend your
“food money” to another with the promise of being paid back at some future time. Since
you are passing up food today you would demand a return sufficient to allow you to buy at
least as much food in the future that you are giving up now.

As we do not know the future this type of deal involves risks. For example the
borrower may decide to not pay you back. This is called default risk. Or the borrower may
pay you back but due to rising prices you can no longer purchase the same amount of food
as you had expected to be able to buy. As a result of these risks (you as a lender) would
require a higher interest rate to compensate for accepting the risks. However if you ask
for too high of interest rates you will not find any takers for your loan.

Present Value

The time value of money principle says that future birr are not worth as much as
birr today

In the vernacular what this means is that you are unwilling to make an interest free
loan. Fortunately we can compare present and future values with a rather simple equation.

1
PV  FV / (1  r ) t
This will give you the present value of a single future cash flow (CF). In fact for ease down
the road we will generally use CF instead of FV. Future Value (FV) will be reserved for
when we are actually solving for a future value. (For example how much will we have in 5
years). A simple Present value example follows:

What is the present value of $8,000 to be paid at the end of three years if the correct
(risk adjusted interest rate) is 11%?

2
PV  CF / (1  r )t
= 8,000/ (1.11)3

= 8,000/1.36

=$5,849

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Note that if you had so desired you could write this equation as

3 PV = CF * (1/(1+r)t )

Which would be:

PV = 8,000 * (1/1.11)3)

=8,000 * .7312

= $5,849

The second term in equation 3, (1/ (1+r) t), is known as the present value discount
factor or present value interest factor. It is usually abbreviated PVIF(r%, N periods). You
can find this number either mathematically or from present value tables. Specifically this
is the present value of a birr and can be found on table. (Note the higher the required
interest rate, i.e. the more risk, the lower the present value.)

Continuing our example, suppose that you were willing to make a loan where you
would get $8,000 back at the end of the third year, and $10,000 at the end of the fourth
year. What is the present value of this? Correct, you find the present value of each cash
flow and then add the present values. Thus,

PV = 8,000/(1.11)3 + 10000/(1.11)4

= $12,436.84

Generically, we can thus rewrite equation #2 as:

T
PV   CFt / (1  r ) t
4 t 1

Whereby we calculate the present value of each cash flow and then sum the present
values. As you can imagine this can get quite cumbersome if we had many future cash
flows. As a result many short cuts have been devised. Chief among these is when all of the
cash flows are identical. This we call an annuity. When we have an annuity we do not need
to add up each individual value but can use the present value (and later future value)
tables.

Examples of annuities include loan payments and certain long term contracts such
as pensions, leases, and certain sports contracts.

Example what is the present value of an annuity of $250 a year at the end of year for
6 years if interest rates are 12%?

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To solve this we could add each individual present value up, or can use the following
discount factor and then multiply by the cash flow.

1 1

5 PVIFA(r,n)=PVAF(r,n)=
r r (1  r ) n
Thus if interest rates are 12% and you will receive 6 payments, the discount factor is
4.114. Thus the Present Value (PV) of 6 payments of $250 if interest rates are 12% is

PV = PVAF(r,n) * CF

= 4.114 * $250

= $1,028.50

This answer will be the same whether you solve the problem mathematically, as we
just did, or using the table A2. (try it!)

An important assumption in using the annuity discount factors is that the cash flows
occur at the END of each year. If the cash flows are occurring at the beginning of each
year, the cash flows are called an annuity-due. Stop and think for a second what we are
doing in an annuity due. The first cash flow occurs today. Thus the present value of the
first cash flow is equal to the cash flow. One year from now you will receive another cash
flow. This second cash flow occurs at the same time (or technically 1 day later) than the
first cash flow of a regular annuity. To the present value of an annuity due is

6 PV = CF + PVAF (r,n-1) * CF

Using the above example but assuming the first payment is made today (rather
than in one year). we can value the cash flows using the annuity-due equation.

PV = 250 + PVAF(12%, 5)* CF

= 250 + 3.6048 * 250

= $1,151.20

Note that the present value is greater than before. Why? Because the payments
were all shifted up one year, thus allowing you (the lender) to reinvest sooner and make
more money. Alternatively if you were the borrower you are paying earlier so you lose
interest that you could have earned by keeping your money invested.

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Another shortcut that you will be responsible for is a perpetuity. A perpetuity is a

stream of cash flows that goes on forever. Or at least we assume it does. This may or may
not be a good assumption (why?-forever is a very long time!) but is very easy to use.

7 PV of a perpetuity = CF/r

Note the cash flow does not have a subscript. Why? Because the definition of a
perpetuity says that all cash flows are identical.

Example: To pay for a new highway the local government sells a perpetuity that
promises to pay $1000 a year from now until the end of time. If interest rates are 10%,
what is the most that you would be willing to pay to get these future cash flows?

PV = CF / r

= $1000 / (.1)

=$10,000

An interesting (this is interesting, right?!?!?!) extension of this is that you can also
value a growing perpetuity. This is a series of cash flows that grows at a constant rate. For
example suppose that the above perpetuity were promised to grow by 4% per year. Thus
this year you get $1000, the next year you get 1000(1.04)=$1,040 etc.

PV=CF1 / (r-g) where CF1 is the cash flow you will receive in one year.

Example: suppose you JUST received $1000 and now want to sell your growing
perpetuity. What is the least you should accept for the claim on these future cash flows if
the growth rate is 4% and the correct risk adjusted interest rate is 10%.

CF0 * (1  g )
PV =
rg
= $1,040/(.1-.04)

= $17,333

Future Value

Future Value is largely the same as present value but in reverse. The basic idea is
the same except here instead of determining what something is worth today, we want to
find out how much something is worth in the future. For example how much will I have if I
invest today?

The basic formula is

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8 FV =
PV * (1  r ) t
Example: you invest $1000 today at 10% in one year you will have
1000*(1.1)1=$1,100

In two years you will have 1,000*(1.1)2= 1,210. In three years you will have $1,331; this is
based on the implicit assumption of compound interest. This means you earn interest on
your interest. This is a powerful concept and can lead to very large amounts when you
have enough time periods over which to accumulate more interest.

Like in the present value discussion we also can use tables to determine a future
value factor. Table A3 gives us future value factors. These are abbreviated as FVIF(r,n).
Thus

FV= PV * (FVIF(r,n)) If r=10%, n=3

= $1,000 * 1.331 = $1,331 which is the same we calculated above.

We also have annuities when calculating future values. These are often used in retirement
planning. For example if you invest $1000 a year for three years how much will you have
at the end of three years? Use table A4. If r=10%, n=3 (as before)

FV= CF * (FVAF(r,n))

= $1000 * 3.3100

= $3,310.00

How is the future value of an annuity calculated? (that is where are the numbers
coming from?) Remember the future values for single payments at 10% for 1 and 2 years
these plus the last payment of $1000 sum to $3310. Still uncertain as to the logic? Draw a
timeline. Your first payment occurs at the end of year one and earns interest for two years
($1210), the second cash flow occurs at the end of the second year and earns interest for 1
year ($1100), while the third cash flow occurs at the end of the third year and therefore
earns no interest ($1000).

When planning your retirement you must account for inflation. We generally use the
nominal rate of interest. Thus although you may have a million dollars in the future, that
money will be worth less than a million dollars today. For evidence of the effects of
inflation consider that a $1 in 1940 is now worth only 8.5 cents (if we believe the CPI
numbers-but that is another stor

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CHAPTER III

OPTIMIZATION
TECHNIQUES
3.1. Introduction
3.2. Types of Optimization Techniques
3.2.1. Differential Calculus
3.2.1.1. Applications of Differential Calculus to Optimization
Problems
3.2.1.2 Partial Differentiation and Multivariate Optimization
3.2.1.3. Constrained Optimization/lagrgian multiplier technique
ECONOMIC OPTIMIZATION
Many problems in economics involve the determination of “optimal” solutions. For
example, a decision maker might wish to determine the level of output that would result in
maximum profit. The process of economic optimization essentially involve three steps:
 Defining the goals and objectives of the firm
 2. Identifying the firm’s constraints
 3. Analyzing and evaluating all possible alternatives available to the decision maker
In essence, economic optimization involves maximizing or minimizing some objective
function,which may or may not be subject to one or more constraints. Before discussing the
process of economic optimization, let us review the various techniques of expressing
economic and business relationships.

TYPES OF OPTIMIZATION TECHNIQUES:

Normative economic decision analysis involves determining the action that best achieves a
desired goal or objective. This means finding the action that optimizes (that is, maximizes
or minimizes) the value of an objective function. For example, in a price-output decision-

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making problem, we may be interested in determining the output level that maximizes
profits. In a production problem, the goal may be to find the combination of inputs
(resources) that minimizes the cost of producing a desired level of output. In a capital
budgeting problem, the objective may be to select those projects that maximize the net
present value of the investments chosen. There are many techniques for solving
optimization problems such as these. This chapter focuses on the use of differential calculus
to solve certain types of optimization problems. In another Chapter, linear programming
techniques, used in solving constrained optimization problems, are examined. Optimization
techniques are a powerful set of tools that are important in efficiently managing an
enterprise’s resources and thereby maximizing shareholder wealth.
In the above Para we defined the general form of a problem that managerial
economics attempts to analyze. The basic form of the problem is to identify the alternative
means of achieving a given objective and then to select the alternative that accomplishes
the objective in the most efficient manner, subject to constraints on the means. In
programming
terminology, the problem is optimizing the value of some objective function, subject to any
resource and/or other constraints such as legal, input, environmental, and behavioral
restrictions.

where Equation A.1 is the objective function and Equation A.2 constitutes the set of
constraints imposed on the solution. The xi variables, x1, x2, . . .,xn, represent the set of
decision variables, and y = f(x1, x2, . . ., xn) is the objective function expressed in terms of
these decision variables. Depending on the nature of the problem, the term optimize means
either maximize or minimize the value of the objective function. As indicated in Equation
A.2, each constraint can take the form of an equality (=) or an inequality (≤or ≥)
relationship.
Complicating Factors in Optimization:
Several factors can make optimization problems fairly complex and difficult to solve. One
such complicating factor is the existence of multiple decision variables in a problem.
Relatively simple procedures exist for determining the profit-maximizing output level for
the single-product firm. However, the typical medium- or large-size firm often produces a
large number of different products, and as a result, the profit-maximization problem for
such a firm requires a series of output decisions—one for each product. Another factor that
may add to the difficulty of solving a problem is the complex nature of the relationships
between the decision variables and the associated outcome. For example, in public policy
decisions on government spending for such items as education, it is extremely difficult to
determine the relationship between a given expenditure and the benefits of increased
income, employment, and productivity it provides. No simple relationship exists among the
variables. Many of the optimization techniques discussed here are only applicable to
situations in which a relatively simple function or relationship can be postulated between
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the decision variables and the outcome variable. A third complicating factor is the possible
existence of one or more complex constraints on the decision variables. For example,
virtually every organization has constraints imposed on its decision variables by the limited
resources—such as capital, personnel, and facilities—over which it has control. These
constraints must be incorporated into the decision problem. Otherwise, the optimization
techniques that are applied to the problem may yield a solution that is unacceptable from a
practical standpoint. Another complicating factor is the presence of uncertainty or risk. In
this chapter, we limit the analysis to decision making under certainty, that is, problems in
which each action is known to lead to a specific outcome. Other Chapter examines
methods for analyzing decisions involving risk and uncertainty. These factors illustrate the
difficulties that may be encountered and may render a problem unsolvable by formal
optimization procedures.

Constrained versus Unconstrained Optimization:

The mathematical techniques used to solve an optimization problem represented by

Equations A.1 and A.2 depend on the form of the criterion and constraint functions. The
simplest situation to be considered is the unconstrained optimization problem. In such a
problem no constraints are imposed on the decision variables, and differential calculus can
be used to analyze them. Another relatively simple form of the general optimization
problem
is the case in which all the constraints of the problem can be expressed as equali(=)
relationships. The technique of Lagrangian multipliers can be used to find the optimal
solution to many of these problems. Often, however, the constraints in an economic
decision-making problem take the form of inequality relationships (≤or ≥) rather than
equalities. For example, limitations on the resources—such as personnel and capital—of an
organization place an upper bound or budget ceiling on the quantity of these resources that
can be employed in maximizing (or minimizing) the objective function. With this type of
constraint, all of a given resource need not be used in an optimal solution to the problem.
An example of a lower bound would be a loan agreement that requires a firm to maintain a
current ratio(that is, ratio of current assets to current liabilities) of at least 2.00. Any
combination of
current assets and current liabilities having a ratio greater than or equal to 2.00 would
meet the provisions of the loan agreement. Such optimization procedures as the
Lagrangian multiplier method are not suited to solving problems of this type efficiently;
however, modern mathematical programming techniques have been developed that can
efficiently solve several classes of problems with these inequality restrictions.
Linear-programming problems constitute the most important class for which efficient
solution techniques have been developed. In a linear-programming problem, both the
objective and the constraint relationships are expressed as linear functions of decision
variables. Other classes of problems include integer-programming problems, in which some
(or all) of the decision variables are required to take on integer values, and quadratic
programming problems, in which the objective relationship is a quadratic function of the
decision variables. Generalized computing algorithms exist for solving optimization
problems that meet these requirements.

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The remainder of this chapter deals with the classical optimization procedures of
differential calculus. Lagrangian multiplier techniques are covered in the Appendix. Linear
programming is encountered in next chapter.

DIFFERENTIAL CALCULUS:

In this chapter, marginal analysis was introduced as one of the fundamental concepts of
economic decision making. In the marginal analysis framework, resource-allocation
decisions are made by comparing the marginal benefits of a change in the level of an
activity with the marginal costs of the change. A change should be made as long as the
marginal benefits exceed the marginal costs. By following this basic rule, resources can be
allocated efficiently and profits or shareholder wealth can be maximized. In the profit-
maximization example developed in Chapter 2, the application of the marginal analysis
principles required that the relationship between the objective (profit) and the decision
variable (output level) be expressed in either tabular or graphic form. This framework,
however, can become cumbersome when dealing with several decision variables or with
complex relationships between the decision variables and the objective. When the
relationship between the decision variables and criterion can be expressed in algebraic
form, the more powerful concepts of differential calculus can be used to find optimal
solutions to these problems.

Relationship between Marginal Analysis and Differential Calculus:

Initially, let us assume that the objective we are seeking to optimize, Y, can be expressed
algebraically as a function of one decision variable, X,
Y = f(X) [A.3]
Recall that marginal profit is defined as the change in profit resulting from a one-unit
change in output. In general, the marginal value of any variable Y, which is a function of
another variable X, is defined as the change in the value of Y resulting from a one-unit
change in X. The marginal value of Y, My, can be calculated from the change in Y, ∆Y, that
occurs as the result 0f a given change in X, ∆X :

When calculated with this expression, different estimates for the marginal value of Y may
be obtained, depending on the size of the change in X that we use in the computation. The
true marginal value of a function (e.g., an economic relationship) is obtained from
Equation A.4 when ∆X is made as small as possible. If ∆X can be thought of as a continuous
(rather than a discrete) variable that can take on fractional values,5 then in calculating My
by Equation A.4, we can let ∆X approach zero. In concept, this is the approach

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taken in differential calculus. The derivative, or more precisely, first derivative,6dY/dX, of

a function is defined as the limit of the ratio ∆Y/X as ∆X approaches zero; that is,

Graphically, the first derivative of a function represents the slope of the curve at a given
point on the curve. The definition of a derivative as the limit of the change in Y (that is, ∆Y)
as ∆X approaches zero is illustrated in Figure A.1(a). Suppose we are interested in the
derivative of the Y = f(X) function at the point X0. The derivative dY/dXmeasures the slope
of the tangent line ECD. An estimate of this slope, albeit a poor estimate, can be obtained
by calculating the marginal value of Y over the interval X0 to X2. Using Equation A.4, a
value of

is obtained for the slope of the CA line. Now let us calculate the marginal value of Y using
a smaller interval, for example, X0 to X1. The slope of the line C to B, which is equal to

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gives a much better estimate of the true marginal value as represented by the slope of the
ECD tangent line. Thus we see that the smaller the ∆X value, the better the estimate of the
slope of the curve. Letting ∆X approach zero allows us to find the slope of the Y =f(X) curve
at point C. As shown in Figure A.1(b), the slope of the ECD tangent line (and the Y = f(X)
function at point C) is measured by the change in Y, or rise, ∆Y, divided by the change in X,
or run, ∆X.

Process of Differentiation:

The process of differentiation—that is, finding the derivative of a function—involves

determining the limiting value of the ratio ∆Y/∆X as ∆X approaches zero. Before offering
some general rules for finding the derivative of a function, we illustrate with an example
the algebraic process used to obtain the derivative without the aid of these general rules.
The specific rules that simplify this process are presented in the following section .
Example…

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Rules of Differentiation:
Fortunately, we do not need to go through this lengthy process every time we want the
derivative of a function. A series of general rules, derived in a manner similar to the
process just described, exists for differentiating various types of functions.7 Constant
Functions A constant function can be expressed as
Y=a [A.12]
wherea is a constant (that is, Y is independent of X). The derivative of a constant function is
equal to zero:

[A.13]
For example, consider the constant function
Y =4
which is graphed in Figure A.2(a). Recall that the first derivative of a function (dY/dX)
measures the slope of the function. Because this constant function is a horizontal straight
line with zero slope, its derivative (dY/dX) is therefore equal to zero.

Power Functions:A power function takes the form of

[A.14]
wherea and b are constants. The derivative of a power function is equal to b times a, times
X raised to the (b - 1) power:

[A.15]
A couple of examples are used to illustrate the application of this rule. First, consider the
function
Y =2X

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which is graphed in Figure A.2(b). Note that the slope of this function is equal to 2 and is
constant over the entire range of X values. Applying the power function rule to this
example, where a =2 and b = 1, yields

Note that any variable to the zero power, e.g., X0, is equal to 1. Next, consider the function
Y =X2
which is graphed in Figure A.2(c). Note that the slope of this function varies depending on
the value of X. Application of the power function rule to this example yields (a=1, b=2):

As we can see, this derivative (or slope) function is negative when X ≤ 0, zero when X = 0,
and positive when X ≥0.

Sums of Functions:Suppose a function Y _ f(X) represents the sum of two (or more)
separate functions, f1(X), f2(X), that is,
Y = f1(X) =f2(X) [A.16]
The derivative of Y with respect to X is found by differentiating each of the separate
functions and then adding the results:

This result can be extended to finding the derivative of the sum of any number of functions.

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CHAPTER IV

THEORY OF DEMAND AND ITS APPLICATION

4.1. Meaning of Demand, Types of Demand, Demand function

4.2. Elasticity of Demand, Importance of Elasticity Concept. Measuring Demand

Elasticity

4.3. Elasticity applications

1. Demand Definition
The amount of a particular economic good or service that a consumer or group
of consumers will want to purchase at a given price. The demand curve is usually
downward sloping, since consumers will want to buy more as price decreases.
Demand for a good or service is determined by many different factors other than
price, such as the price of substitute goods and complementary goods. In extreme
cases, demand may be completely unrelated to price, or nearly infinite at a given
price. Along with supply, demand is one of the two keydeterminants of the market
price

2. Demand Meaning and Law of Demand

In economics, demand is the desire to own anything, the ability to pay for it,
and the willingness to pay. The term demand signifies the ability or the
willingness to buy a particular commodity at a given point of time.

Economists record demand on a demand schedule and plot it on a graph as a

demand curve that is usually downward sloping. The downward slope reflects the
relationship between price and quantity demanded: as price decreases, quantity
demanded increases. In principle, each consumer has a demand curve for any
product that he or she would consider buying, and the consumer's demand curve is
equal to the marginal utility (benefit) curve. When the demand curves of all

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consumers are added up, the result is the market demand curve for that product. If
there are no externalities, the market demand curve is also equal to the social utility
(benefit) curve.

Elements of the Law of Demand As Melvin and Boyes note the law of demand is
defined as:

1. The quantity of a well defined good or service that:

2. People are willing and able to buy.
3. During a particular period of time.
4. Decreases/increases as the price of that good or service rises/falls
5. All other factors remain constant.

Melvin and Boyes (2010)

Demand is a relationship between two variables price and quantity

demanded with all other factors that could affect demand being held constant.

'well defined'- The key phrase in the first element is “well defined”. The purpose
of the phrase is to ensure that we are examining the relationship between price and
quantity demanded for the same good. If we are interested in demand for a
particular good there is no reason to compare the relationship between the price of
the good and the change in quantity demanded of a different goods. Goods are well
defined if they share the same characteristics - brand, model, age, quality and
performance to name a few. For example a Cadillac CTS-V is a high performance
car manufactured by General Motors. The defining feature of the car is its engine a
a supercharged OHV 6.2 liter L V-8. The engine produces 556 horsepower and
551 lb·ft of torque. The enables the to go from zero to 60 in 3.9 seconds. The car
cost about 65,000.00. If we are interested in the demand for the CTS-V we need to
compare the price of a CTS-V to the quantity demanded for a CTS-V and not a
Ford Festive.

willing and able - to participate in the market a consumer must not only be
willing to buy a good she must be able to buy as well. For example, John
may want to buy a Cadillac CTS. However unless he has the cash or credit
to consummate the purchase his unrealized desires are irrelevant.
particular time period - demand measures the rate at which goods are
being purchased during a specified period of time. For example to say that
four thousand units are sold at a price of 65,000 does not tell us the level of
demand unless we specify the time period per day per week per month.

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nature of the relationship - this portion of the definition establishes that the
price and quantity demanded have a negative or inverse relationship along
the demand curve.
held constant ; there are innumerable factors other than price than can affect
the level of demand. Some of the more important are income, price of
related goods, number of buyers, expectations and tastes and preferences . To
focus on the cause and effect relationship between the good's own price and
the quantity of the good demanded all these other factors must be held
constant. To hold a variable constant means to freeze its value and not allow
it to change.
3. Demand schedule:

The demand schedule shows the quantity of goods that a consumer would be
willing and able to buy at specific prices under the existing circumstances. Some of
the more important factors affecting demand are the price of the good, the price of
related goods, tastes and preferences, income, and consumer expectations.

4. Factors affecting demand

Innumerable factors and circumstances could affect a buyer's willingness or ability

to buy a good. Some of the more common factors are:

A).Good's own price: The basic demand relationship is between potential

prices of a good and the quantities that would be purchased at those prices.
Generally the relationship is negative meaning that an increase in price will
induce a decrease in the quantity demanded. This negative relationship is
embodied in the downward slope of the consumer demand curve. The
assumption of a negative relationship is reasonable and intuitive. If the price
of a new novel is high, a person might decide to borrow the book from the
public library rather than buy it.Or if the price of a new piece of equipment
is high a firm may decide to repair existing equipment rather than replacing
it.

B). Price of related goods: The principal related goods are complements
and substitutes. A complement is a good that is used with the primary good.
Examples include hotdogs and mustard, beer and pretzels, automobiles and
gasoline. (Perfect complements behave as a single good.) If the price of the

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complement goes up the quantity demanded of the other good goes down.
Mathematically, the variable representing the price of the complementary
good would have a negative coefficient in the demand function. For
example, Qd = a - P - P g where Q is the quantity of automobiles demanded, P
is the price of automobiles and P g is the price of gasoline. The other main
category of related goods are substitutes. Substitutes are goods that can be
used in place of the primary good. The mathematical relationship between
the price of the substitute and the demand for the good in question is
positive. If the price of the substitute goes down the demand for the good in
question goes down.

C). Income: In most cases, the more income you have the more likely
you buy.

Tastes or preferences: The greater the desire to own a good the more likely
you are to buy the good. There is a basic distinction between desire and
demand. Desire is a measure of the willingness to buy a good based on its
intrinsic qualities. Demand is the willingness and ability to put one's desires
into effect. It is assumed that tastes and preferences are relatively constant.

D). Consumer expectations about future prices and income: If a

consumer believes that the price of the good will be higher in the future he is
more likely to purchase the good now. If the consumer expects that her
income will be higher in the future the consumer may buy the good now. In
other words positive expectations about future income may encourage
present consumption.

 This list is not exhaustive. All facts and circumstances that a buyer finds
relevant to his willingness or ability to buy goods can affect demand. For
example, a person caught in an unexpected storm is more likely to buy an
umbrella than if the weather were bright and sunny.

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5. Demand function and demand equation :The demand equation is the

mathematical expression of the relationship between the quantity of a good
demanded and those factors that affect the willingness and ability of a consumer to
buy the good. For example, Qd = f(P; Prg, Y) is a demand equation where Q d is the
quantity of a good demanded, P is the price of the good, P rg is the price of a related
good, and Y is income; the function on the right side of the equation is called the
demand function. The semi-colon in the list of arguments in the demand function
means that the variables to the right are being held constant as we plot the demand
curve in (quantity, price) space. A simple example of a demand equation is Q d =
325 - P - 30Prg + 1.4Y. Here 325 is the repository of all relevant non-specified
factors that affect demand for the product. P is the price of the good. The
coefficient is negative in accordance with the law of demand. The related good
may be either a complement or a substitute. If a complement, the coefficient of its
price would be negative as in this example. If a substitute, the coefficient of its
price would be positive. Income, Y, has a positive coefficient indicating that the
good is a normal good. If the coefficient was negative the good in question would
be an inferior good meaning that the demand for the good would fall as the
consumer's income increased. Specifying values for the non price determinants,
Prg = 4.00 and Y = 50, results in the demand equation Q = 325 - P - 30(4) +1.4(50)
or Q = 275 - P. If income were to increase to 55 the new demand equation would
be Q = 282 - P. Graphically this change in a non price determinant of demand
would be reflected in an outward shift of the demand function caused by a change
in the x intercept.

6. Demand curve: Main article: Demand curve The relationship of price and
quantity demanded can be exhibited graphically as the demand curve. The curve is
generally negatively sloped. The curve is two-dimensional and depicts the
relationship between two variables only: price and quantity demanded. All other
factors affecting demand are held constant. However, these factors are part of the
demand curve and influence the location of the curve. In many economics graphs,
such as that of the demand curve, the independent variable is plotted on the vertical
axis and the dependent variable on the horizontal axis. Consequently, the graphical
presentation is technically that of the equation P = f(Q) where f(Q) is the inverse
demand function, although the graph is referred to simply as the demand curve.

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7. Types of Demand Economics

i) Direct and Derived Demands

Direct demand refers to demand for goods meant for final consumption; it is the
demand for consumers’ goods like food items, readymade garments and houses.
By contrast, derived demand refers to demand for goods which are needed for
further production; it is the demand for producers’ goods like industrial raw
materials, machine tools and equipments.

Thus the demand for an input or what is called a factor of production is a derived
demand; its demand depends on the demand for output where the input enters. In
fact, the quantity of demand for the final output as well as the degree of
substituability/complementarty between inputs would determine the derived
demand for a given input.

For example, the demand for gas in a fertilizer plant depends on the amount of
fertilizer to be produced and substitutability between gas and coal as the basis for
fertilizer production. However, the direct demand for a product is not contingent
upon the demand for other products.

ii) Domestic and Industrial Demands

The example of the refrigerator can be restated to distinguish between the demand
for domestic consumption and the demand for industrial use. In case of certain
industrial raw materials which are also used for domestic purpose, this distinction
is very meaningful.

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For example, coal has both domestic and industrial demand, and the distinction is
important from the standpoint of pricing and distribution of coal.

iii) Autonomous and Induced Demand

When the demand for a product is tied to the purchase of some parent product, its
demand is called induced or derived.

For example, the demand for cement is induced by (derived from) the demand for
housing. As stated above, the demand for all producers’ goods is derived or
induced. In addition, even in the realm of consumers’ goods, we may think of
induced demand. Consider the complementary items like tea and sugar, bread and
butter etc. The demand for butter (sugar) may be induced by the purchase of bread
(tea). Autonomous demand, on the other hand, is not derived or induced. Unless a
product is totally independent of the use of other products, it is difficult to talk
about autonomous demand. In the present world of dependence, there is hardly any
autonomous demand. Nobody today consumers just a single commodity;
everybody consumes a bundle of commodities. Even then, all direct demand may
be loosely called autonomous.

iv) Perishable and Durable Goods’ Demands

Both consumers’ goods and producers’ goods are further classified into
perishable/non-durable/single-use goods and durable/non-perishable/repeated-use
goods. The former refers to final output like bread or raw material like cement
which can be used only once. The latter refers to items like shirt, car or a machine
which can be used repeatedly. In other words, we can classify goods into several
categories: single-use consumer goods, single-use producer goods, durable-use
consumer goods and durable-use producer’s goods. This distinction is useful
because durable products present more complicated problems of demand analysis
than perishable products. Non-durable items are meant for meeting immediate
(current) demand, but durable items are designed to meet current as well as future
demand as they are used over a period of time. So, when durable items are
purchased, they are considered to be an addition to stock of assets or wealth.
Because of continuous use, such assets like furniture or washing machine, suffer
depreciation and thus call for replacement. Thus durable goods demand has two
varieties – replacement of old products and expansion of total stock. Such demands
fluctuate with business conditions, speculation and price expectations. Real wealth
effect influences demand for consumer durables.

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v) New and Replacement Demands

This distinction follows readily from the previous one. If the purchase or
acquisition of an item is meant as an addition to stock, it is a new demand. If the
purchase of an item is meant for maintaining the old stock of capital/asset, it is
replacement demand. Such replacement expenditure is to overcome depreciation in
the existing stock.

Producers’ goods like machines. The demand for spare parts of a machine is
replacement demand, but the demand for the latest model of a particular machine
(say, the latest generation computer) is anew demand. In course of preventive
maintenance and breakdown maintenance, the engineer and his crew often express
their replacement demand, but when a new process or a new technique or anew
product is to be introduced, there is always a new demand.

You may now argue that replacement demand is induced by the quantity and
quality of the existing stock, whereas the new demand is of an autonomous type.
However, such a distinction is more of degree than of kind. For example, when
demonstration effect operates, a new demand may also be an induced demand. You
may buy a new VCR, because your neighbor has recently bought one. Yours is a
new purchase, yet it is induced by your neighbor’s demonstration.

vi) Final and Intermediate Demands

This distinction is again based on the type of goods- final or intermediate. The
demand for semi-finished products, industrial raw materials and similar
intermediate goods are all derived demands, i.e., induced by the demand for final
goods. In the context of input-output models, such distinction is often employed.

vii) Individual and Market Demands

This distinction is often employed by the economist to study the size of the buyers’
demand, individual as well as collective. A market is visited by different
consumers, consumer differences depending on factors like income, age, sex etc.
They all react differently to the prevailing market price of a commodity. For
example, when the price is very high, a low-income buyer may not buy anything,
though a high income buyer may buy something. In such a case, we may
distinguish between the demand of an individual buyer and that of the market
which is the market which is the aggregate of individuals. You may note that both
individual and market demand schedules (and hence curves, when plotted) obey

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the law of demand. But the purchasing capacity varies between individuals. For
example, A is a high income consumer, B is a middle-income consumer and C is in
the low-income group. This information is useful for personalized service or
target-group-planning as a part of sales strategy formulation.

viii) Total Market and Segmented Market Demands

This distinction is made mostly on the same lines as above. Different individual
buyers together may represent a given market segment; and several market
segments together may represent the total market. For example, the Hindustan
Machine Tools may compute the demand for its watches in the home and foreign
markets separately; and then aggregate them together to estimate the total market
demand for its HMT watches. This distinction takes care of different patterns of
buying behavior and consumers’ preferences in different segments of the market.
Such market segments may be defined in terms of criteria like location, age, sex,
income, nationality, and so on

x) Company and Industry Demands

An industry is the aggregate of firms (companies). Thus the Company’s demand is

similar to an individual demand, whereas the industry’s demand is similar to
aggregated total demand. You may examine this distinction from the standpoint of
both output and input.

For example, you may think of the demand for cement produced by the Cement
Corporation of India (i.e., a company’s demand), or the demand for cement
produced by all cement manufacturing units including the CCI (i.e., an industry’s
demand). Similarly, there may be demand for engineers by a single firm or demand
for engineers by the industry as a whole, which is an example of demand for an
input. You can appreciate that the determinants of a company’s demand may not
always be the same as those of an industry’s. The inter-firm differences with
regard to technology, product quality, financial position, market (demand) share,
market leadership and competitiveness- all these are possible explanatory factors.
In fact, a clear understanding of the relation between company and industry
demands necessitates an understanding of different market structures.

8. Different types of Elasticity of Demand

After knowing what is demand and what is law of demand, we can now come to
elasticity of demand. Law of demand will tell you the direction i.e. it tells you
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which way the demand goes when the price changes. But the elasticity of demand
tells you how much the demand will change with the change in price to demand to
the change in any factor.

Different types of Elasticity of Demand:

1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of Demand
4. Advertisement Elasticity of Demand

1. Price Elasticity of Demand:

We will discuss how sensitive the change in demand is to the change in price. The
measurement of this sensitivity in terms of percentage is called price Elasticity of
Demand. According to Marshall, Price Elasticity of Demand is the degree of
responsiveness of demand to the change in price of that commodity.

Types of Price Elasticity of Demands:

a) Perfectly Elastic
b) Perfectly Inelastic
c) Relatively Elastic
d) Relatively Inelastic
e) Unit Elasticity

Factors influencing Price Elasticity of Demand:

a) Nature of Commodity
b) Availability of Substitutes
c) Number of Uses
d) Durability of commodity
e) Consumer’s income

Practical significance of Price Elasticity of Demand:

a) Importance to the business
b) Important to Government

2. Income elasticity of demand:

In economics, the income elasticity of demand measures the responsiveness of the
quantity demanded of a good to the change in the income of the people demanding
the good. It is calculated as the ratio of the percent change in quantity demanded to
the percent change in income. For example, if, in response to a 10% increase in

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income, the quantity of a good demanded increased by 20%, the income elasticity
of demand would be 20%/10% = 2.

3. Cross elasticity of demand:

In economics, the cross elasticity of demand and cross price elasticity of demand
measures the responsiveness of the quantity demand of a good to a change in the
price of another good.

It is measured as the percentage change in quantity demanded for the first good
that occurs in response to a percentage change in price of the second good. For
example, if, in response to a 10% increase in the price of fuel, the quantity of new
cars that are fuel inefficient demanded decreased by 20%, the cross elasticity of
demand would be -20%/10% = -2.

4. Advertisement Elasticity of Demand:

The degree of responsiveness of quantity demanded to the change in the
advertisement expense of expenditure.
Ea= Change in quantity demanded x original advertisement expenses
Change in advertisement expenses original quantity demanded

Important factors influencing Advertisement:

1. Promotional elasticity of demand will be affected, depending on whether it is a
new product or the product with a growing market.
2. The amount a competitor reacts to the firm’s advertisement.
3. The time interval between the advertisement expensed or expenditure and the
unresponsiveness of the sales.
4. The influence of non-advertisement determinants of demands such as trends,
price, income etc.

Uses of Advertisement Elasticity of Demands:

1. It helps the manager to decide the advertisement expense. If the advertisement is
more than one, which means incremental revenue exceeds incremental expenses,
then increased expenditure on advertisement can be justified.
2. The fire should observe the saturation point, where advertisement pays nothing
or does not help in increasing sales revenue.

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8.1) Price elasticity of demand

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

Price elasticities are almost always negative, although analysts tend to ignore the
sign even though this can lead to ambiguity. Only goods which do not conform to
the law of demand, such as Veblen and Giffen goods, have a positive PED. In
general, the demand for a good is said to be inelastic (or relatively inelastic) when
the PED is less than one (in absolute value): that is, changes in price have a
relatively small effect on the quantity of the good demanded. The demand for a
good is said to be elastic (or relatively elastic) when its PED is greater than one (in
absolute value): that is, changes in price have a relatively large effect on the
quantity of a good demanded..

PED is derived from the percentage change in quantity (%ΔQd) and percentage
change in price (%ΔP).

Revenue is maximised when price is set so that the PED is exactly one. The PED
of a good can also be used to predict the incidence (or "burden") of a tax on that
good. Various research methods are used to determine price elasticity, including
test markets, analysis of historical sales data and conjoint analysis.

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Definition

PED is a measure of responsiveness of the quantity of a good or service demanded

to changes in its price.[1] The formula for the coefficient of price elasticity of
demand for a good is:

The above formula usually yields a negative value, due to the inverse nature of the
relationship between price and quantity demanded, as described by the "law of
demand".[3] For example, if the price increases by 5% and quantity demanded
decreases by 5%, then the elasticity at the initial price and quantity = −5%/5% =
−1. The only classes of goods which have a PED of greater than 0 are Veblen and
Giffen goods.[5] Because the PED is negative for the vast majority of goods and
services, however, economists often refer to price elasticity of demand as a
positive value (i.e., in absolute value terms).[4]

This measure of elasticity is sometimes referred to as the own-price elasticity of

demand for a good, i.e., the elasticity of demand with respect to the good's own
price, in order to distinguish it from the elasticity of demand for that good with
respect to the change in the price of some other good, i.e., a complementary or
substitute good.[1] The latter type of elasticity measure is called a cross-price
elasticity of demand.[6][7]

As the difference between the two prices or quantities increases, the accuracy of
the PED given by the formula above decreases for a combination of two reasons.
First, the PED for a good is not necessarily constant; as explained below, PED can
vary at different points along the demand curve, due to its percentage nature.[8][9]
Elasticity is not the same thing as the slope of the demand curve, which is
dependent on the units used for both price and quantity. [10][11] Second, percentage
changes are not symmetric; instead, the percentage change between any two values
depends on which one is chosen as the starting value and which as the ending
value. For example, if quantity demanded increases from 10 units to 15 units, the
percentage change is 50%, i.e., (15 − 10) ÷ 10 (converted to a percentage). But if
quantity demanded decreases from 15 units to 10 units, the percentage change is
−33.3%, i.e., (15 − 10) ÷ 15.[12][13]

Two alternative elasticity measures avoid or minimise these shortcomings of the

basic elasticity formula: point-price elasticity and arc elasticity.

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Point-price elasticity

One way to avoid the accuracy problem described above is to minimise the
difference between the starting and ending prices and quantities. This is the
approach taken in the definition of point-price elasticity, which uses differential
calculus to calculate the elasticity for an infinitesimal change in price and quantity
at any given point on the demand curve: [14]

In other words, it is equal to the absolute value of the first derivative of quantity
with respect to price (dQd/dP) multiplied by the point's price (P) divided by its
quantity (Qd).[15]

In terms of partial-differential calculus, point-price elasticity of demand can be

defined as follows:[16] let be the demand of goods as a
function of parameters price and wealth, and let be the demand for good .
The elasticity of demand for good with respect to price pk is

However, the point-price elasticity can be computed only if the formula for the
demand function, Qd = f(P), is known so its derivative with respect to price, dQd /
dP, can be determined.

Arc elasticity

A second solution to the asymmetry problem of having a PED dependent on which

of the two given points on a demand curve is chosen as the "original" point and
which as the "new" one is to compute the percentage change in P and Q relative to
the average of the two prices and the average of the two quantities, rather than just
the change relative to one point or the other. Loosely speaking, this gives an
"average" elasticity for the section of the actual demand curve—i.e., the arc of the
curve—between the two points. As a result, this measure is known as the arc
elasticity, in this case with respect to the price of the good. The arc elasticity is
defined mathematically as:[13][17][18]

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This method for computing the price elasticity is also known as the "midpoints
formula", because the average price and average quantity are the coordinates of the
midpoint of the straight line between the two given points. [12][18] However, because
this formula implicitly assumes the section of the demand curve between those
points is linear, the greater the curvature of the actual demand curve is over that
range, the worse this approximation of its elasticity will be. History

The illustration that accompanied Marshall's original definition of PED, the ratio of
PT to Pt

Together with the concept of an economic "elasticity" coefficient, Alfred Marshall

is credited with defining PED ("elasticity of demand") in his book Principles of
Economics, published in 1890. He described it thus: "And we may say generally:—
the elasticity (or responsiveness) of demand in a market is great or small according
as the amount demanded increases much or little for a given fall in price, and
diminishes much or little for a given rise in price".He reasons this since "the only
universal law as to a person's desire for a commodity is that it diminishes... but this
diminution may be slow or rapid. If it is slow... a small fall in price will cause a
comparatively large increase in his purchases. But if it is rapid, a small fall in price
will cause only a very small increase in his purchases. In the former case... the
elasticity of his wants, we may say, is great. In the latter case... the elasticity of his
demand is small."[ Mathematically, the Marshallian PED was based on a point-
price definition, using differential calculus to calculate elasticities.

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Determinants

The overriding factor in determining PED is the willingness and ability of

consumers after a price change to postpone immediate consumption decisions
concerning the good and to search for substitutes ("wait and look"). A number of
factors can thus affect the elasticity of demand for a good:

 Availability of substitute goods: the more and closer the substitutes

available, the higher the elasticity is likely to be, as people can easily switch
from one good to another if an even minor price change is made; There is a
strong substitution effect. If no close substitutes are available the
substitution of effect will be small and the demand inelastic.
 Percentage of income: the higher the percentage of the consumer's income
that the product's price represents, the higher the elasticity tends to be, as
people will pay more attention when purchasing the good because of its cost;
The income effect is substantial. When the goods represent only a negligible
portion of the budget the income effect will be insignificant and demand
inelastic,
 Necessity: the more necessary a good is, the lower the elasticity, as people
will attempt to buy it no matter the price, such as the case of insulin for
those that need it.
 Duration: for most goods, the longer a price change holds, the higher the
elasticity is likely to be, as more and more consumers find they have the
time and inclination to search for substitutes. When fuel prices increase
suddenly, for instance, consumers may still fill up their empty tanks in the
short run, but when prices remain high over several years, more consumers
will reduce their demand for fuel by switching to carpooling or public
transportation, investing in vehicles with greater fuel economy or taking
other measures. This does not hold for consumer durables such as the cars
themselves, however; eventually, it may become necessary for consumers to
replace their present cars, so one would expect demand to be less elastic.
 Breadth of definition of a good: the broader the definition of a good (or
service), the lower the elasticity. For example, Company X's fish and chips
would tend to have a relatively high elasticity of demand if a significant
number of substitutes are available, whereas food in general would have an
extremely low elasticity of demand because no substitutes exist.
 Brand loyalty: an attachment to a certain brand—either out of tradition or
because of proprietary barriers—can override sensitivity to price changes,
resulting in more inelastic demand.

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 Who pays: where the purchaser does not directly pay for the good they
consume, such as with corporate expense accounts, demand is likely to be
more inelastic.

Interpreting values of price elasticity coefficients

Perfectly inelastic demand[10]

Perfectly elastic demand

Elasticities of demand are interpreted as follows:

Value Descriptive Terms

Ed = 0 Perfectly inelastic demand
- 1 < Ed< 0 Inelastic or relatively inelastic demand
Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic
Ed = - 1
demand

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- ∞< Ed< - 1 Elastic or relatively elastic demand

Ed = - ∞ Perfectly elastic demand

A decrease in the price of a good normally results in an increase in the quantity

demanded by consumers because of the law of demand, and conversely, quantity
demanded decreases when price rises. As summarized in the table above, the PED
for a good or service is referred to by different descriptive terms depending on
whether the elasticity coefficient is greater than, equal to, or less than −1. That is,
the demand for a good is called:

 relatively inelastic when the percentage change in quantity demanded is less

than the percentage change in price (so that Ed> - 1);
 unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand
when the percentage change in quantity demanded is equal to the percentage
change in price (so that Ed = - 1); and
 relatively elastic when the percentage change in quantity demanded is
greater than the percentage change in price (so that Ed< - 1).

As the two accompanying diagrams show, perfectly elastic demand is represented

graphically as a horizontal line, and perfectly inelastic demand as a vertical line.
These are the only cases in which the PED and the slope of the demand curve
(∆P/∆Q) are both constant, as well as the only cases in which the PED is
determined solely by the slope of the demand curve (or more precisely, by the
inverse of that slope).

Effect on total revenue

See also: Total revenue test

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A set of graphs shows the relationship between demand and total revenue (TR) for
a linear demand curve. As price decreases in the elastic range, TR increases, but in
the inelastic range, TR decreases. TR is maximised at the quantity where PED = 1.

A firm considering a price change must know what effect the change in price will
have on total revenue. Generally any change in price will have two effects:

 theprice effect : an increase in unit price will tend to increase revenue, while
a decrease in price will tend to decrease revenue.
 thequantity effect : an increase in unit price will tend to lead to fewer units
sold, while a decrease in unit price will tend to lead to more units sold.

Because of the inverse nature of the relationship between price and quantity
demanded (i.e., the law of demand), the two effects affect total revenue in opposite
directions. But in determining whether to increase or decrease prices, a firm needs
to know what the net effect will be. Elasticity provides the answer: The percentage
change in total revenue is equal to the percentage change in quantity demanded
plus the percentage change in price. (One change will be positive, the other
negative.)

As a result, the relationship between PED and total revenue can be described for
any good:

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 When the price elasticity of demand for a good is perfectly inelastic (Ed = 0),
changes in the price do not affect the quantity demanded for the good;
raising prices will cause total revenue to increase.
 When the price elasticity of demand for a good is relatively inelastic (- 1 <
Ed< 0), the percentage change in quantity demanded is smaller than that in
price. Hence, when the price is raised, the total revenue rises, and vice versa.
 When the price elasticity of demand for a good is unit (or unitary) elastic (Ed
= -1), the percentage change in quantity is equal to that in price, so a change
in price will not affect total revenue.
 When the price elasticity of demand for a good is relatively elastic (- ∞< Ed<
- 1), the percentage change in quantity demanded is greater than that in
price. Hence, when the price is raised, the total revenue falls, and vice versa.
 When the price elasticity of demand for a good is perfectly elastic (Ed is −
∞), any increase in the price, no matter how small, will cause demand for the
good to drop to zero. Hence, when the price is raised, the total revenue falls
to zero.

Hence, as the accompanying diagram shows, total revenue is maximised at the

combination of price and quantity demanded where the elasticity of demand is
unitary.

It is important to realise that price-elasticity of demand is not necessarily constant

over all price ranges. The linear demand curve in the accompanying diagram
illustrates that changes in price also change the elasticity: the price elasticity is
different at every point on the curve.

Effect on tax incidence

When demand is more elastic than supply, producers will bear a greater proportion
of the tax burden than consumers will.

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Main article: tax incidence

PEDs, in combination with price elasticity of supply (PES), can be used to assess
where the incidence (or "burden") of a per-unit tax is falling or to predict where it
will fall if the tax is imposed. For example, when demand is perfectly inelastic, by
definition consumers have no alternative to purchasing the good or service if the
price increases, so the quantity demanded would remain constant. Hence, suppliers
can increase the price by the full amount of the tax, and the consumer would end
up paying the entirety. In the opposite case, when demand is perfectly elastic, by
definition consumers have an infinite ability to switch to alternatives if the price
increases, so they would stop buying the good or service in question completely—
quantity demanded would fall to zero. As a result, firms cannot pass on any part of
the tax by raising prices, so they would be forced to pay all of it themselves.

In practice, demand is likely to be only relatively elastic or relatively inelastic, that

is, somewhere between the extreme cases of perfect elasticity or inelasticity. More
generally, then, the higher the elasticity of demand compared to PES, the heavier
the burden on producers; conversely, the more inelastic the demand compared to
PES, the heavier the burden on consumers. The general principle is that the party
(i.e., consumers or producers) that has fewer opportunities to avoid the tax by
switching to alternatives will bear the greater proportion of the tax burden.

8.2) Income elasticity of demand

In economics, income elasticity of demand measures the responsiveness of the

demand for a good to a change in the income of the people demanding the good,
holding all prices constant. It is calculated as the ratio of the percentage change in
demand to the percentage change in income. For example, if, in response to a 10%
increase in income, the demand for a good increased by 20%, the income elasticity
of demand would be 20%/10% = 2.

Interpretation

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Inferior goods' demand falls as consumer income increases.

 A negative income elasticity of demand is associated with inferior goods; an

increase in income will lead to a fall in the demand and may lead to changes
to more luxurious substitutes.
 A positive income elasticity of demand is associated with normal goods; an
increase in income will lead to a rise in demand. If income elasticity of
demand of a commodity is less than 1, it is a necessity good. If the elasticity
of demand is greater than 1, it is a luxury good or a superior good.
 A zero income elasticity (or inelastic) demand occurs when an increase in
income is not associated with a change in the demand of a good. These
would be sticky goods.

Income elasticity of demand can be used as an indicator of industry health, future

consumption patterns and as a guide to firms investment decisions. For example,
the "selected income elasticities" below suggest that an increasing portion of
consumer's budgets will be devoted to purchasing automobiles and restaurant
meals and a smaller share to tobacco and margarine.

Mathematical definition

More formally, the income elasticity of demand, , for a given Marshallian

demand function for a good is

or alternatively:

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This can be rewritten in the form:

With income I, and vector of prices . Many necessities have an income elasticity
of demand between zero and one: expenditure on these goods may increase with
income, but not as fast as income does, so the proportion of expenditure on these
goods falls as income rises. This observation for food is known as Engel's law.

Selected income elasticities

 Automobiles 2.46[2]
 Books 1.44
 Restaurant Meals 1.40
 Tobacco 0.64
 Margarine -0.20
 Public Transportation -0.36[3]

Income elasticities are notably stable over time and across countries.

8.3) Cross elasticity of demand

In economics, the cross elasticity of demand or cross-price elasticity of demand

measures the responsiveness of the demand for a good to a change in the price of
another good. It is measured as the percentage change in demand for the first good
that occurs in response to a percentage change in price of the second good. For
example, if, in response to a 10% increase in the price of fuel, the demand of new
cars that are fuel inefficient decreased by 20%, the cross elasticity of demand

would be: .

Formula

The formula used to calculate the coefficient cross elasticity of demand is

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or:

Results for main types of goods

In the example above, the two goods, fuel and cars (consists of fuel consumption),
are complements; that is, one is used with the other. In these cases the cross
elasticity of demand will be negative, as shown by the decrease in demand for cars
when the price of fuel increased. Where the two goods are substitutes the cross
elasticity of demand will be positive, so that as the price of one goes up the demand
of the other will increase. For example, in response to an increase in the price of
carbonated soft drinks, the demand for non-carbonated soft drinks will rise. In the
case of perfect substitutes, the cross elasticity of demand is equal to positive
infinity. Where the two goods are independent, or, as described in consumer
theory, if a good is independent in demand then the demand of that good is
independent of the quantity consumed of all other goods available to the consumer,
the cross elasticity of demand will be zero: as the price of one good changes, there
will be no change in demand for the other good.

Two goods that Two goods that are Two goods that are
complement each other substitutes have a positive independent have a zero
show a negative cross cross elasticity of demand: cross elasticity of demand:
elasticity of demand: as the as the price of good Y as the price of good Y
price of good Y rises, the rises, the demand for good rises, the demand for good
demand for good X falls X rises X stays constant

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When goods are substitutable, the diversion ratio, which quantifies how much of
the displaced demand for product j switches to product i, is measured by the ratio
of the cross-elasticity to the own-elasticity multiplied by the ratio of product i's
demand to product j's demand. In the discrete case, the diversion ratio is naturally
interpreted as the fraction of product j demand which treats product i as a second
choice, measuring how much of the demand diverting from product j because of a
price increase is diverted to product i can be written as the product of the ratio of
the cross-elasticity to the own-elasticity and the ratio of the demand for product i to
the demand for product j. In some cases, it has a natural interpretation as the
proportion of people buying product j who would consider product i their "second
choice".

Selected cross price elasticities of demand

Below are some examples of the cross-price elasticity of demand (XED) for
various goods[2]:

Good Good with Price Change XED

Butter Margarine +0.81
Beef Pork +0.28
Entertainment Food -0.72

Chapter –V

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Decision Making Under Risk &

Uncertainty
5.1 The nature decision making
5.2 Meaning measurement of risk
5.3 Approaches of incorporating risk into decision making
5.4 Decision making under uncertainty
5.1 What is the nature of decision making-?
Most of the people answer would have been simple. They would have said the decision
making involves in three steps.

1. Define the problem and collect all relevant facts

2. State all possible courses of action and possible relatives
3. Weigh this information and decide upon the proper course of action

But the above answer is not satisfactory; here so many things people are not discussed.
According to Luce and raiffa organize decision making according to “whether a decision is
made by (1). An individual or (2) a group; and according to whether it is effected under
conditions of (a) certainty (b) risk, or (c) uncertainty.”

Drucker says “The most common source of mistakes in management decision is the
emphasis on finding right answer rather than the right question.”Drucker says that the
decisions That really matter are strategic and whatever their magnitude, complexity and
importance. They should never be taken problem solving.

Simons categorized decisions in to programmed and non programmed. Here what drucker
calls routine, simons calls programmed; Where druckercalls as strategic, simons identifies
as non programmed. concern in this paper is with individual decision making as viewed
with programmed (routine)/non programmed (strategic) co-intension.

In programmed decision making at least three techniques are used viz., (a). habit, (b).
standard operating procedure, (c). system approach.

In non programmed decision making we have to observe (a) finding occasions for decision
making (B) searching out alternative decisions (c) evaluating the various alternatives

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according to some choice criteria. (d) making the choice from alternative (e) following the
choice through to completion.

The economic nature of decision making:

Human wants are unlimited but resources are limited, which causes the concept of scarcity.
It become compulsory to human beings to take right decision to use limited resources to
solve unlimited wants , which is also called Economic problem.

"Economic problem" is the juxtaposition of productive resource scarcity against human

want insatiability. In attempting to resolve the economic problem, humans must make
choices in how to use their scarce resources as efficiently as possible in the satisfaction of
human wants. Making choices is the essence of decision making, and making decisions is
the central function of management. The management of any human activity is ultimately
an exercise in economizing. Managerial economics focuses upon the criteria for making
rational economic decisions in regard to the use of scarce resources. The following points
we have to observe for taking the economic decision.

1). The nature of the firm:The management of such commercial enterprises involves the
exercise of authority, usually from a top level of responsibility downward through
progressively lower levels of responsibility and function. The decisions made by the
manager of the enterprise encompass both the acquisition of scarce resources from outside
the enterprise, and the efficient allocation of those resources within the enterprise. Thus,
the management of a commercial enterprise ultimately is an exercise in economizing. The
motives, behavior, legitimacy of authority, criteria for successful decision making, and
consequences of operations constitute the heart of a study of managerial economics.

2). The Variety of Managerial Settings in the Modern Firm: Every business firm
has at least one office or plant, and many firms establish multiple places of business, each
of which must be directed by an office or plant manager. Such multiple sites may be
organized by function or by geographical region. Depending upon the mission of the office
or plant, multiple tiers of managerial responsibility and authority may be established at
each site. Managers at every site and at every tier are responsible for the efficient allocation
of the resources assigned to them.
Whatever the structure of a firm and its affiliated entities, any line or staff officer of the
firm, or any plant, division, or subsidiary manager, must make economic choices in the use
of the scarce resources that are assigned to his or her control. It is in this sense that
managerial decision making in any of its settings is ultimately an exercise in economizing.

3).Strategic and Tactical Decision Making:

Strategic management is concerned with the fundamental direction of the organization's
activity, i.e., the businesses that the organization intends to pursue and desired levels of

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achievement in those lines of business. Strategic decisions represent to solve long term
desires and goals of the organization. It concentrates the construct the base of development
and growth of the organization and very useful to Implementation of perfect plans and
views.

In military parlance, the term "tactic" is usually juxtaposed to "strategy" in referring to

an action that is taken "in the field" by a specific unit to accomplish a limited objective in
pursuit of a strategic goal of the organization. The term "tactic" and its various derivative
forms are rarely used in discussions of strategic management. However, decisions taken at
various levels in the administrative organization to implement an approved strategic
change are oriented toward specific objectives (such as a target volume of sales or share of
the market) rather than ultimate goals (such as a required return on investment in a
particular line of business), and are thus essentially tactical in nature. In a new venture,
goals and objectives may coincide, and strategic and tactical decision making may converge
in the mind of the founding entrepreneur.

4).The Nature of the Decision Problem: Managers may make a myriad of decisions
every day. Some of the decisions are trivial in the sense that the consequences of them do
not matter very much. The consequences of other decisions, for example, what employee
health insurance plan to adopt or whether to add or drop a product line from the
company's product mix, may be monumental.

We shall assume as an operating premise that human beings are basically interested in
their own welfare. Rational human behavior consists of trying to maximize the value of
some positive quantity, or to minimize the value of something perceived as having negative
connotations. Although human nature is culturally influenced, we shall also presume that
human beings are more-or-less materialistic, i.e., more is better than less, and hedonistic,
i.e., that pain and displeasure are to be avoided or minimized. We consider in previous
Chapter whether these behavior premises truly are viable foundations upon which to erect
models of managerial decision making.

5). Dimensions of the Decision Problem:

Multiple Goals. The decision maker may be confronted with a multiplicity of goals. Since it
is technically not possible to try to maximize simultaneously the values of multiple
conflicting goals, the decision maker has to choose one of the goals for primary pursuit.
The other goals, expressed as minimum or maximum acceptable values, can then be
regarded as constraints on the pursuit of the primary goal. The object of the decision is to
maximize the value of the primary goal, subject to realization of satisfactory levels of
subordinate goals. The mathematical modeling problems and possibilities with respect to
multiple goals are elaborated in Chapter 3(Optimal decision)

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Multiple Strategies. With respect to any single goal, a decision involves multiple possible
courses of action, or strategies. If there were no alternatives, no decision would be required
other than selecting the goal for pursuit. The deliberate approach to decision making
involves the identification of all possible courses of action and the benefits and costs likely
to result from each of the alternatives. The rational choice is the alternative that yields the
greatest relative positives or the largest sum of net benefits (positives less negatives), given
the decision maker's set of preferences.

Marginal Changes. In many cases, the choices are not mutually-exclusive alternative
courses of action; rather they involve more or less of the same course of action. The range
of possible alternatives includes larger or smaller quantities to be selected. Typically, the
decision problem is to select some quantity that is an alternative to the present one.
Assuming that the alternative quantities are arrayed from smallest to largest, or vice-versa,
choosing to shift from one to another involves additions to or subtractions from benefits or
costs. Economists speak of such additions and subtractions as incremental changes, or
marginal changes if they are the smallest possible changes that can be made. The rational
choice in such cases is to make a quantitative change that will yield the greatest marginal
benefit relative to marginal cost. The application of the calculus to marginal analysis is the
subject of Chapter 3(optimal decision).

Multiple Outcomes. Often the possible alternative courses of action can be identified, but
each decision alternative may have several outcome possibilities. If the decision maker can
in some meaningful sense assess the probability, p, of the occurrence of each possible
outcome, V, for each of the alternative courses of action, he may then compute the expected
value of each alternative, (1) EV = p 1V1 + p2V2 + ... + pkVk, (or) (1') EV =∑j=1,k (pjVj),
where EV is the expected value of the alternative, p is the probability of the outcome V for
each of the k possible outcomes of the alternative. The presumption here is that the sum of
the probabilities of the possible outcomes is 1.0. Each outcome may itself be a net difference
between benefit (b) and cost (c), or V = b - c. Other things remaining the same, the rational
decision then is the choice of the alternative that promises the largest expected value of
possible outcomes.
Risk.Other things may not be the same, however, if the range of outcome variability differs
from one alternative to another. It is typical for decision alternatives to have different
expected values, but even if two decision alternatives have approximately the same
expected values, one may have a wider range of possible outcome variability than the other.
Risk is inherent in the dispersion of possible outcomes about the mean of all such outcomes.

Imperfect Knowledge. Only rarely does a decision maker have perfect knowledge of a
decision environment, the possible alternative courses of action that may be taken, or the
range of outcomes that may result from each choice. Where multiple outcomes are possible,
a risky situation is said to exist if the decision maker can both identify all of the possible

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outcomes and meaningfully assess the probabilities of occurrence of each of the possible
outcomes. An uncertain situation occurs if the decision maker either cannot identify some
of the outcomes, or cannot meaningfully estimate the probabilities of their occurrence. The
decision maker may attempt to deal with uncertainty by seeking additional information
about outcomes or their probabilities of occurrence. But after all available information is
acquired and there is a persisting aura of uncertainty, the decision still has to be made.

Decision theorists have suggested a number of decision rules for situations involving
uncertainty, i.e., where outcomes cannot be identified or their probabilities of occurrence
cannot be meaningfully assessed. The two that seem to be most useful are the maximin and
the minimax regret decision rules. In the former, the objective is to identify the worst-case
outcomes of all of the decision strategies under consideration, and then choose the one that
yields the least-negative effects, i.e., the best of the worst-case scenarios. This is an
extremely conservative approach that is most appropriate to the need to avoid ultimate
failure of the enterprise. Its prime deficiency is that it considers only failure states, and
does not take into account the possibilities of success.

The minimax regret rule requires that the decision maker perceive the best possible
outcome of the decision strategies, and then compute the regret associated with all other
strategies as the difference between each and the best of the alternate strategies. The
strategy of choice then is the one that minimizes the regret that follows from failure to
select the best outcome.

The Time Dimension. Economists refer to a time frame during which some matters can
be changed (e.g., the number of workers employed), but others cannot (e.g., the size of
plant or the number of assembly lines) as the short run. Short-run decisions usually affect
the current situation or the immediate future. The long run is a period long enough so that
any- and everything can be changed. Long-run decisions usually have their impacts only
after the passage of some time, and do not affect current operations in any significant
sense. Most short-run decisions within the business enterprise are to increase or decrease
something already being done and thus require marginal comparisons of benefits and costs.
Long-run decisions usually affect the scale of the enterprise's operations, and often involve
starting something new or stopping some operation currently under way. Given the
sharpest possible contrast, short-run decisions are "more-or-less," whereas long-run
decisions are "go-no go" decisions.

Entrepreneurial Decisions. Finally, we may distinguish between managerial and

entrepreneurial decisions. The managerial context involves making relatively low-risk,
routine decisions in regard to processes that change in smooth, continuous fashion, about
which much can be known or discovered, and to which marginal analysis is applicable. In
contrast, the entrepreneurial decision is risk-laden because it involves innovative
discontinuities in operations, about which little can be known in advance, and to which

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marginal analysis is less likely to be applicable. As a general rule, short-run decisions are
often managerial in nature, whereas long-run decisions tend to be entrepreneurial.
Managerial decisions are matters of doing more or less of something already in process,
whereas entrepreneurial decisions involve starting or stopping activities or significantly
altering the structure, scope, or pace of extant processes.

5.2 Meaning and Measurement of Risk

5.2(A). Meaning of risk

The term risk may be traced back to classical Greek rizikon (Greek ριζα, riza),
[citation needed] meaning root, later used in Latin for "cliff".In the English language the
term risk appeared only in the 17th century, and "seems to be imported from continental
Europe. When the terminology of risk took ground, it replaced the older notion that
thought "in terms of good and bad fortune. The scientific approach to risk entered finance
in the 1960s with the advent of the capital asset pricing model and became increasingly
important in the 1980s when financial derivatives proliferated. It reached general
professions in the 1990s when the power of personal computing allowed for widespread
data collection and numbers crunching.

Defining the risk:

There are different definitions of risk for each of several applications. The widely
inconsistent and ambiguous use of the word is one of several current criticisms of the
methods to manage risk.

In one definition, "risks" are simply future issues that can be avoided or mitigated, rather
than present problems that must be immediately addressed.

The simple fact is that risk is always a probability issue. Possibility is a binary condition –
either something is possible, or it’s not – 100% or 0%. Probability reflects the continuum
between absolute certainty and impossibility. The key thing to keep in mind is that
establishing probabilities is not the same thing as foretelling the future.

In risk management, the term "hazard" is used to mean an event that could cause harm
and the term "risk" is used to mean simply the probability of something happening.

Financial risk is often defined as the unexpected variability or volatility of returns and thus
includes both potential worse-than-expected as well as better-than-expected returns.
References to negative risk below should be read as applying to positive impacts or
opportunity (e.g., for "loss" read "loss or gain") unless the context precludes this
interpretation.

Economic risk: Economic risks can be manifested in lower incomes or higher

expenditures than expected. The causes can be many, for instance, the hike in the price for

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raw materials, the lapsing of deadlines for construction of a new operating facility,
disruptions in a production process, emergence of a serious competitor on the market, the
loss of key personnel, technical changes, the change of a political regime, or natural
disasters. Etc.,.

Business risk: economic risk and business risk almost facing the same problems, here
business indicates the uncertainties in the business. Risk are non insurable, business
concerns always facing risk the because of some reasons like.. Market fluctuations,
Industry fluctuations, competition conditions, technology change, cost fluctuations, public
policies. etc.,

5.2(B). Risk and Probability Distributions

Defining Risk :Risk is fundamentally about uncertainty. In the context of finance it is

uncertainty about future payments of a financial instrument. More specifically, risk is not
just a concept, but a measure that can be quantified so the risks of different securities can
be compared. Risk depends on time horizon and risk is typically a relative measure,
meaning that risk is compared to some benchmark, such as a risk-free investment or the
risk of similar investments.

Probability:Probabilities measure the likelihood of certain events. A probability measure

is between 0 and 1. The closer the probability is to 1, the more likely an event is to occur.
The probabilities of all possible events must add to 1. For example, consider flipping a coin.
Here there are 2 possible outcomes: heads or tails. If the coin is fair, the probability of each
possible outcome is 1/2 or .5. So there are 2 outcomes, each with .5 probability and this of
course adds to 1.

Probability Distribution:
The probability of an event is the chance, or odds, that the incident will occur. If all
possible events or outcomes are listed, and if a probability is assigned to each event, the
listing is called a probability distribution. For example, suppose a sales manager observes
that there is a 70 percent chance that a given customer will place a specific order versus a
30 percent chance that the customer will not. This situation is described by the probability
distribution shown in Table 1-A. Both possible outcomes are listed in column 1, and the
probabilities of each outcome, expressed as decimals and percentages, appear in column 2.
Notice that the probabilities sum to 1.0, or 100 percent, as they must if the probability
distribution is complete. In this simple example, risk can be read from the probability
distribution as the 30 percent chance of the firm not receiving the order. For most
managerial decisions, the relative desirability of alternative events or outcomes is not
absolute. Amore general measure of the relation between risk and the probability
distribution is typically required to adequately incorporate risk considerations into the
decision-making process.
Suppose a firm is able to choose only one of two investment projects, each calling for an
outlay of $10,000. Assume also that profits earned from the two projects are related to the
general level of economic activity during the coming year, as shown in Table 1-B. This table

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is known as a payoff matrix because it illustrates the dollar outcome associated with each
possible state of nature. Both projects provide a $5,000 profit in a normal economy, higher
profits in an economic boom, and lower profits if a recession occurs. However, project B
profits vary far more according to the state of the economy than do profits from project A.
In a normal economy, both projects return $5,000 in profit. Should the economy be in a
recession next year, project B will produce nothing, whereas project Awill still provide a
$4,000 profit. If the economy is booming next year, project B’s profit will increase to
$12,000, but profit for project A will increase only moderately, to $6,000. Project A is
clearly more desirable if the economy is in recession, whereas project B is superior in a
boom. In a normal economy, the projects offer the same profit potential, and both are
equally desirable. To choose the best project, one needs to know the likelihood of a boom, a
recession, or normal economic conditions. If such probabilities can be estimated, the
expected profits and variability of profits for each project can be determined. These
measures make it possible to evaluate each project in terms of expected return and risk,
where risk is measured by the deviation of profits from expected values.
Table 1-A and Table 1-B(14.2)

Expected Value:
The expected value is the anticipated realization from a given payoff matrix and
probability distribution. It is the weighted-average payoff, where the weights are defined by
the probability distribution.
To continue with the previous example, assume that forecasts based on the current trend in
economic indicators suggest a 2 in 10 chance of recession, a 6 in 10 chance of a normal
economy, and a 2 in 10 chance of a boom. As probabilities, the probability of recession is
0.2, or 20 percent; the probability of normal economic activity is 0.6, or 60 percent; and the
probability of a boom is 0.2, or 20 percent. These probabilities add up to 1.0 (0.2 + 0.6 + 0.2
= 1.0), or 100 percent, and thereby form a complete probability distribution, as shown in
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Table 1-C. If each possible outcome is multiplied by its probability and then summed, the
weighted average outcomes is determined. In this calculation, the weights are the
probabilities of occurrence, and the weighted average is called the expected outcome.
Column 4 of Table 1-C. illustrates the calculation of expected profits for projects A and B.
Each possible profit level in column 3 is multiplied by its probability of occurrence from
column 2 to obtain weighted values of the possible profits. Summing column 4 of the table
for each project gives a weighted average of profits under various states of the economy.
This weighted average is the expected profit from the project.

The expected-profit calculation is expressed by the equation

Here, i is the profit level associated with the ith outcome, pi is the probability that
outcome I will occur, and n is the number of possible outcomes or states of nature. Thus,
E() is a weighted average of possible outcomes (the i values), with each outcome’s
weight equal to its probability of occurrence.

The expected profit for project A is obtained as follows:

Table 1-C

The results in Table 1-C. are shown as a bar chart in Figure 1-1. The height of each bar
signifies the probability that a given outcome will occur. The probable outcomes for project
A range from $4,000 to $6,000, with an average, or expected, value of $5,000. For project B,
the expected value is $5,400, and the range of possible outcomes is from $0 to $12,000. For
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simplicity, this example assumes that only three states of nature can exist in the economy:
recession, normal, and boom. Actual states of the economy range from deep depression, as
in the early 1930s, to tremendous booms, such as in the mid- to late 1990s, with an
unlimited number of possibilities in between. Suppose sufficient information exists to
assign a probability to each possible state of the economy and a monetary outcome in each
circumstance for every project. A table similar to Table 1-C.could then be compiled that
would include many more entries for columns 1, 2, and 3. This table could be used to
calculate expected values as shown, and the probabilities and outcomes could be
approximated by the continuous curves in Figure 1-2. Figure 1-2. is a graph of the
probability distribution of returns for projects A and B. In general, the tighter the
probability distribution, the more likely it is that actual outcomes will be close to expected
values. The more loose the probability distribution, the less likely it is that actual outcomes
will be close to expected values. Because project A has a relatively tight
Figure 1-1

Figure 1-2

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probability distribution, its actual profit is more likely to be close to its expected value than
is that of project B.
5.2(C). Risk and Expected values of investment

Absolute Risk Measurement:

Risk is a complex concept, and some controversy surrounds attempts to define and
measure it. Common risk measures that are satisfactory for most purposes are based on
the observation that tight probability distributions imply low risk because of the
correspondingly small chance that actual outcomes will differ greatly from expected values.
From this perspective, project A is less risky than project B. Standard deviation, shown as
_ (sigma), is a popular and useful measure of absolute risk. Absolute risk is the overall
dispersion of possible payoffs. The smaller the standard deviation, the tighter the
probability distribution and the lower the risk in absolute terms. To calculate standard
deviation using probability information, the expected value or mean of the return
distribution must first be calculated as

In this calculation, πi is the profit or return associated with the ith outcome; pi is the
probability that the ith outcome will occur; and E(π), the expected value, is a weighted
average of the various possible outcomes, each weighted by the probability of its
occurrence. The deviation of possible outcomes from the expected value must then be
derived:

The squared value of each deviation is then multiplied by the relevant probability and
summed. This arithmetic mean of the squared deviations is the variance of the probability
distribution

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Relative Risk Measurement

Problems sometimes arise when standard deviation is used to measure risk. If an
investment project is relatively expensive and has large expected cash flows, it will have a
large standard deviation of returns without being truly riskier than a smaller project.
Suppose a project has an expected return of $1 million and a standard deviation of only
$1,000. Some might reasonably argue that it is less risky than an alternative investment
project with expected returns of $1,000 and a standard deviation of $900. The absolute risk
of the first project is greater; the risk of the second project is much larger relative to the
expected payoff. Relative risk is the variation in possible returns compared with the
expected payoff amount. A popular method for determining relative risk is to calculate the
coefficient of variation. Using probability concepts, the coefficient of variation is

In general, when comparing decision alternatives with costs and benefits that are not of
approximately equal size, the coefficient of variation measures relative risk better than
does the standard deviation.
Other Risk Measures:

The standard deviation and coefficient of variation risk measures are based on the total
variability of returns. In some situations, however, a project’s total variability overstates its
risk. This is because projects with returns that are less than perfectly correlated can be
combined, and the variability of the resulting portfolio of investment projects is less than
the sum of individual project risks. Much recent work in finance is based on the idea that
project risk should be measured in terms of its contribution to total return variability for

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the firm’s asset portfolio. The contribution of a single investment project to the overall
variation of the firm’s asset port-folio is measured by a concept known as beta. Beta is a
measure of the systematic variability or covariance of one asset’s returns with returns on
other assets. The concept of beta should be employed when the returns from potential
investment projects are likely to greatly affect or be greatly affected by current projects.
However, in most circumstances the standard deviation and coefficient of variation
measures provide adequate assessments of risk.

Illustration 1. Consider a production unit which has tabulated its daily production over a
period of 200 days as follows:

Production per day (Nos): 300 400 500 600 700

Number of days : 20 50 90 30 10

Fro this data calculate the probability of a particular level of output and the expected value
of production-?

Solution:

Probability of level of output

Production Number of Number of Probability

per day(Nos) days days/200

300 20 20/200 0.10

400 50 50/200 0.25
500 90 90/200 0.45
600 30 30/200 0.15
700 10 10/200 0.05
200 1.00
It may be need that the sum of probability must equal unity.

We can now find the expected value of daily production as the sum of
output multiplied by the respective probability (as shown below).

Expected value of production

Production per Probability Expected

day(Nos) value=(Production x
probability)
300 0.10 30
400 0.25 100

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500 0.45 225

600 0.15 90
700 0.05 35
480

Decision using expected value method:

Illistration-2: Consider two production plans which generate output flow over time with
associated probabilities as follows:

Production Plan-1 Production

Plan-2

Out put Probability

flow(Rs.) Production plan- Probability
20,000 0.4 2
40,000 0.4 10,000 0.5
30,000 0.3 30,000 0.3
Which production plan is preferable-? 80,000 0.2

Solution:

Expected value of production plan 1 (EV1)

=(20,000x0.4)+(40,000x0.4)+(30000x0.3) = 8,000+16,000+9,000=33,000

Expected value of production plan 2(EV2)

=(10,000x0.5)+(30,000x0.3)+(80,000x0.2) = 5,000+9,000+16,000=30,000

Thus, by incorporating risk into calculation, we may conclude that production plan 1 is
preferable to production plan2 (though ignoring the element of risk would have led to the
reverse conclusion).

The Standard Deviation:

As is evident, the expected value is simply the average of all possible outcomes. In economic
literature risk is measured as the dispersion of possible outcomes around this average, viz.,
the expected value. The statistical concept of standards deviation is used as a yardstick that
reflects the variations of possible outcomes from its mean value. The standard deviation is
calculated as:

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Calculation of standard deviation

Cash flows (Xi) Probability (Pi) ( Xi-X) (X-X)2 (X-X)2pi

6,000 0.1 -4000 16,000,000 1,600,000

8,000 0.2 -2000 4,000,000 800,000
10,000 0.3 0 0 0
12,000 0.3 2,000 4,000,000 1,200,000
14,000 0.1 4000 16,00,000 1,600,000
50,000 1.0 5,200,000

5.3. Approaches of incorporating risk into decision making process

A decision maker in a risky situation applies two kinds of approaches… 1. Formulate

decision making approach, 2. Finding method approach.

In formulating approach a decision maker should have to develop a set of logical

rules which can provide an optimal solution. In finding method approach decision maker
must be able to compare the estimated value of additional information with the cost of
acquiring this additional information.

Analysis of risk process requires that a decision problem be divided into the following six
components:

1). Defining alternative set of actions: the decision-maker should be in position to : (a)
identify the set of alternative actions (denoted as a 1,a2,a3……): and (b) select from among
the set of feasible alternative actions.

2). Considering Environmental factors. These are those natural or economic factors that
affect The decision process but are them elves not effected by it. The environment is also
known as the states of nature. It depends up on such variable like prices, tax rates, rainfall,
fashions, regional economic cooperation of countries, export of good x by country A, etc.
states of nature are regarded as independent of actions and discrete in nature.(denoted as
θ1,θ2,θ3….).

3). Formulation of probabilities: If we denote a particular state of nature as I, we may write

its objective probability as p(θi). Thus there will be as many p(θ i)s as there are states of
nature. Since the probabilities are subjectively arrived by the decision maker, this can be
formulated in many ways. However, They must sum up to one when added over all states.
Since P(θi) are based on initial belief about the outcome, these are called prior
probabilities, which are eventually modified in the light of new and additional information.

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4). Stating the set of consequences: given the state of nature, each action will have a
consequence. Consequence of each can be measured in terms of profit. But money may not
be appropriate measure of whatever the producer is seeking maximize. For example,
consider two actions given exactly the same expected earnings. If one of the given constant
expected earnings while the expected earnings from the other action have large
fluctuations, the decision maker cannot treat the two actions equally regarding. To him the
the actions with study earnings is preferable to the other action in other words, he is said to
derive greater utility from one action compared to other. This example suggest the
existence of “return” other than the expected money outcome. This return is called “utility
function” which assigns utility to each consequence of his action.

Given the existence of utility function, we can find the shape of the utility function. In
practice utility often expressed as a function of earning or wealth. The utility of a given
action is then considered in the context of the resulting increase or decrease in wealth.

We know that given their mental makeup, the decision maker broadly fall into one of
the three categories. (1) Risk neutral, (2) Risk averse, (3) Riskpreferrer.

A decision maker is risk neutral if each added rupee of wealth gives him the same
additional utility. He is considered risk-averse if addition of each successive rupee to his
wealth gives him lesser utility than the earlier rupee. When addition of each successive
rupee to decision maker’s wealth gives him greater utility each time, he is consider risk –
preferrer.

5). Choice criterion: a decision maker must have a basis for selecting from among
alternatives. An objective function or a choice criterion states “what the decision maker
wishes to maximize (e.g. his utility)

6). Strategies: on the basis of the above mentioned five steps the decision maker can select
an appropriate action. But after evaluation, he may like to seek additional information
related to the problem so that either (i) the already arrived decision is reaffirmed as an
optimum decision, or (ii) in the light of the new information the initial estimates of the
probabilities are to be revised . note that the initial probability estimates are called prior
probabilities, while their revised estimates are called posterior probabilities. The decision
maker must have made the decision how to react to each possible bit of new information. If
this new information results from a forecast, then he must determine appropriate actions.
To be taken for each possible forecast. Such a set of action is called a strategy.

Method approach: in method approach 2 of the most popular methods for adjustment
are:

1). The risk adjusted discount rate (RADR): this is perhaps the most popular method. It is
similar to the capital asset pricing model used in determining cost of capital. According to
RADR method, the discount rate(r) for discounting the cash flows over time comprises: (a)
the risk free rate (Rf) and (b) the risk premium(Rp) : r= Rf+Rp

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The risk free rate generally taken as the short term government securities. The risk
premium (Rp) is based on a judgment as to the additional return sufficient to compensate
for additional risk. Suppose that a firm uses cost of capital of 15% for its average risk
projects, while the risk free rate is 10%, it implies that the risk premium is 5%. The firm
need not use 15% disount rate for all its projects. The discount may differ among a firms
subsidiaries/divisions, projects, products, marketing areas, etc., as each of them may
represent a different level of risk : discount rate(r) increases because Rp increases with
increase in riskiness.

Let us see how RADR is used in calculation of net present value. For example,
suppose a firm is planning to invest birr 3,10,000 and expects to earn birr 100,000 each
year for the next four year period. If the normal business risk requires 10% discount rate,
the net present value is……

Year Expected returns Discount rate (10%) Present values

1 1,00,000 0.9091 90,910
2 1,00,000 0.8264 82,640
3 1,00,000 0.7513 75,130
4 1,00,000 0.6830 68,300
Total p.value= 3,16,980

Discount rate 10% , if we convert into probable chance ie., 0.10

Discount value= (1/1+0.10)1 =0.9091, (/1+0.10)2 =0.8264,..……n

Net Present value = Total present value- Initial investment

=3,16,980-3,10,000 = 6,980

Now the proposal must be rejected discount rate relies heavily on judgment, it may suffer
from the element of subjectivity. But if companies have capable and vigilant staff, this
judgments are very often fairly accurate.

2).Certainty equipment approach: in the RADR method, risk is included in the calculation
of present value through the denominator of the discounting equation where as in the
certainty equaling approach a risk free discount rate is used in the denominator, while risk
is accounted for by modifying the numerator of the discounting equation.

A factor is applied to the cash flow to convert a risky flow into a riskless one. A smaller
cash flow that is riskless is preferred to the one that is risky. To convert risky cash flow into
riskless cash flow, we need to use an adjuster, called the certainty equivalent factor (α),
whose value lies between 0 and 1. When α=1, it implies that Decision maker feels that
project is risk free, and when α = 0, he feels project is too risky to be taken up. According
to certainty equivalent approach:

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n
NPV =∑ αt Rt / ( 1+i )
t =0

Rt= Risky cash flow in the tth time period

αt=The coefficient of certainty-equivalent for the tth time period,

i= Risk free interest rate. Here αt=rt*/rt

5.4 Risk versus uncertainty

Risk: Combination of the likelihood of an occurrence of a hazardous event or exposure(s)
and the severity of injury or ill health that can be caused by the event or exposure(s)

In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the
distinction between risk and uncertainty.

“ ... Uncertainty must be taken in a sense radically distinct from the familiar notion of
Risk, from which it has never been properly separated. The term "risk," as loosely
used in everyday speech and in economic discussion, really covers two things which,
functionally at least, in their causal relations to the phenomena of economic
organization, are categorically different. ... The essential fact is that "risk" means in
some cases a quantity susceptible of measurement, while at other times it is
something distinctly not of this character; and there are far-reaching and crucial
differences in the bearings of the phenomenon depending on which of the two is
really present and operating. ... It will appear that a measurable uncertainty, or
"risk" proper, as we shall use the term, is so far different from an un measurable
one that it is not in effect an uncertainty at all. We ... accordingly restrict the term
"uncertainty" to cases of the non-quantitive type. ”

Thus, Knightian uncertainty is immeasurable, not possible to calculate, while in the

Knightian sense risk is measureable.

Another distinction between risk and uncertainty is proposed in How to Measure Anything:
Finding the Value of Intangibles in Business and The Failure of Risk Management: Why It's
Broken and How to Fix It by Doug Hubbard.

Uncertainty: The lack of complete certainty, that is, the existence of more than one
possibility. The "true" outcome/state/result/value is not known.
Measurement of uncertainty: A set of probabilities assigned to a set of possibilities.
Example: "There is a 60% chance this market will double in five years"
Risk: A state of uncertainty where some of the possibilities involve a loss,
catastrophe, or other undesirable outcome.

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Measurement of risk: A set of possibilities each with quantified probabilities and

quantified losses. Example: "There is a 40% chance the proposed oil well will be dry
with a loss of $12 million in exploratory drilling costs".

In this sense, Hubbard uses the terms so that one may have uncertainty without risk but
not risk without uncertainty. We can be uncertain about the winner of a contest, but unless
we have some personal stake in it, we have no risk. If we bet money on the outcome of the
contest, then we have a risk. In both cases there are more than one outcome. The measure
of uncertainty refers only to the probabilities assigned to outcomes, while the measure of
risk requires both probabilities for outcomes and losses quantified for outcomes.

5.4(A). Decision Making under Uncertainty

1. Purpose: The purpose of this project is to give a tutorial level summary of "decisions
under uncertainty" and its application to product and system cost analysis. Included will
be the summary of the topic, a list of relevant sources with links, and an extended
bibliography. The depth and breadth of coverage should be equivalent to one class lecture.

2. Introduction:
Typically, personal and professional decisions can be made with little difficulty. Either the
best course of action is clear or the ramifications of the decision are not significant enough
to require a great amount of attention. On occasion, decisions arise where the path is not
clear and it is necessary to take substantial time and effort in devising a systematic method
of analyzing the various courses of action. [2,3]
When a decision maker must choose one among a number of possible actions, the ultimate
consequences of some if not all of these actions will generally depend on uncertain events
and future actions extending indefinitely far into the future. With decisions under
uncertainty, the decision maker must:
1. Take an inventory of all viable options available for gathering information, for
experimentation, and for action;
2. List all events that may occur;
3. Arrange all pertinent information and choices/assumptions made;
4. Rank the consequences resulting from the various courses of action;
5. Determine the probability of an uncertain event occurring.

Upon systematically describing the problem and recording all necessary data, judgments,
and preferences, the decision maker must synthesize the information set before him/her
using the most appropriate decision rules. Decision rules prescribe how an individual faced
with a decision under uncertainty should go about choosing a course of action consistent
with the individual’s basic judgments and preferences. This website will describe five such
decision rules commonly used in industry
 Hurwicz criterion;

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 Laplace insufficient reason criterion;

 Maximax criterion;
 Maximin criterion;
 Savage minimax regret criterion.
3. Decision Rules:

A tool commonly used to display information needed for the decision process is a payoff
matrix or decision table. The table shown below is an example of a payoff matrix. The A's
stand for the alternative actions available to the decision maker. These actions represent
the controllable variables in the system. The uncertain events or states of nature are
represented by the S's. Each S has an associated probability of its occurrence, denoted P.
(However, the only decision rule that makes use of the probabilities is the Laplace
criterion.) The payoff is the numerical value associated with an action and a particular
state of nature. This numerical value can represent monetary value, utility, or both. This
type of table will be used to illustrate each type of decision rule.

Actions\States S1 (P=.25) S2 (P=.25) S3 (P=.25) S4 (P=.25)

A1 20 60 -60 20
A2 0 20 -20 20
A3 50 -20 -80 20

Table 1: General Payoff Matrix style from Chankong [4]. This generic/hypothetical
example illustrates 3 different actions that can be taken, and 4 different possible, uncertain
states of nature with their respective payoff

1. Hurwicz criterion.
This approach attempts to strike a balance between the maximax and maximin criteria. It
suggests that the minimum and maximum of each strategy should be averaged using a and
1 - a as weights. a represents the index of pessimism and the alternative with the highest
average is selected. The index a reflects the decision maker’s attitude towards risk taking.
A cautious decision maker will set a = 1 which reduces the Hurwicz criterion to the
maximin criterion. An adventurous decision maker will set a = 0 which reduces the
Hurwicz criterion to the maximax criterion. [1] A decision table illustrating the application
of this criterion (with a = .5) to a decision situation is shown below.

Actions\States S1 S2 S3 S4 a = .5

A1 20 60 -60 20 0

A2 0 20 -20 20 0

A3 50 -20 -80 20 -15

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Table 2: Hurwicz criterion illustration (a = .5); Here the probability of each state is not
considered; results in a tie between the first two alternatives.
ii. Laplace insufficient reason criterion.
The Laplace insufficient reason criterion postulates that if no information is available
about the probabilities of the various outcomes, it is reasonable to assume that they are
equally likely. Therefore, if there are n outcomes, the probability of each is 1/n. This
approach also suggests that the decision maker calculate the expected payoff for each
alternative and select the alternative with the largest value. The use of expected values
distinguishes this approach from the criteria that use only extreme payoffs. This
characteristic makes the approach similar to decision making under risk. A table illustrates
this criterion below. [1]

Expected
Actions\States S1 (P=.25) S2 (P=.25) S3 (P=.25) S4 (P=.25)
Payoff:

A1 20 60 -60 20 10

A2 0 20 -20 20 5

A3 50 -20 -80 20 -7.5

Table 3: Laplace insufficiency illustration; Second alternative wins when expected payoff is
calculated between equiprobable states.
iii. Maximax criterion.
The maximax criterion is an optimistic approach. It suggests that the decision maker
examine the maximum payoffs of alternatives and choose the alternative whose outcome is
the best. This criterion appeals to the adventurous decision maker who is attracted by high
payoffs. This approach may also appeal to a decision maker who likes to gamble and who is
in the position to withstand any losses without substantial inconvenience. See the table
below for an illustration of this criterion. [1]

Actions\States S1 S2 S3 S4 Max Payoff

A1 20 60 -60 20 60

A2 0 20 -20 20 20

A3 50 -20 -80 20 50

Table 4: Maximax illustration; First alternative wins.

iv. Maximin criterion.
The maximin criterion is a pessimistic approach. It suggests that the decision maker
examine only the minimum payoffs of alternatives and choose the alternative whose
outcome is the least bad. This criterion appeals to the cautious decision maker who seeks to

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ensure that in the event of an unfavorable outcome, there is at least a known minimum
payoff. This approach may be justified because the minimum payoffs may have a higher
probability of occurrence or the lowest payoff may lead to an extremely unfavorable
outcome. This criterion is illustrated in the table below. [1]

Actions\States S1 S2 S3 S4 Min payoff

A1 20 60 -60 20 -60

A2 0 20 -20 20 -20

A3 50 -20 -80 20 -80

Table 5: Maximin illustration. Second alternative wins.

v. Savage minimax regret criterion.
The Savage minimax regret criterion examines the regret, opportunity cost or loss resulting
when a particular situation occurs and the payoff of the selected alternative is smaller than
the payoff that could have been attained with that particular situation. The regret
corresponding to a particular payoff Xij is defined as Rij = Xj(max) – Xij where Xj(max) is
the maximum payoff attainable under the situation Sj. This definition of regret allows the
decision maker to transform the payoff matrix into a regret matrix. The minimax criterion
suggests that the decision maker look at the maximum regret of each strategy and select the
one with the smallest value. This approach appeals to cautious decision makers who want
to ensure that the selected alternative does well when compared to other alternatives
regardless of what situation arises. It is particularly attractive to a decision maker who
knows that several competitors face identical or similar circumstances and who is aware
that the decision maker’s performance will be evaluated in relation to the competitors. This
criterion is applied to the same decision situation and transforms the payoff matrix into a
regret matrix. This is shown below. [1]

Actions\States R1 R2 R3 R4 Max Regret

A1 30 0 40 0 40

A2 50 40 0 0 50

A3 0 80 60 0 80

Table 5: Minimax illustration. First alternative wins.

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Chapter-6

Production
Theory
6.1 Production defined

6.2 The Production Function

6.3 Production function with one variable input

6.4 Production Function with two variable input

6.5 Determining the optimal Use of the Variable inputs

6.6 Returns scale

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6.1 Definition of Production

In microeconomics, production is the act of making things, in particular the act of making
products that will be traded or sold commercially. Production decisions concentrate on
what goods to produce, how to produce them, the costs of producing them, and optimizing
the mix of resource inputs used in their production. This production information can then
be combined with market information (like demand and marginal revenue) to determine
the quantity of products to produce and the optimum price to charge.
Production, in microeconomics is simply the conversion of inputs into outputs. It is an
economic process that uses resources to create a commodity that is suitable for exchange.
This can include manufacturing, storing, shipping, and packaging. Some economists define
production broadly as all economic activity other than consumption. They see every
commercial activity other than the final purchase as some form of production.
Production is a process, and as such it occurs through time and through space. Because it is
a flow concept, production is measured as a “rate of output per period of time”. There are
three aspects to production processes:
1. the quantity of the commodity produced,
2. the form of the good produced,
3. the temporal and spatial distribution of the commodity produced.
A production process can be defined as any activity that increases the similarity between
the pattern of demand for goods, and the quantity, form, and distribution of these goods
available to the market place.
Factors of Production:
The inputs or resources used in the production process are called factors by economists.
The myriad of possible inputs are usually grouped into four or five categories. These
factors are:
 Raw materials (natural capital)
 Labour services (human capital)
 Capital goods
 Land
Sometimes a fifth category is added, entrepreneurial and management skills, a subcategory
of labour services. Capital goods are those goods that have previously undergone a
production process. They are previously produced means of production. Some textbooks
use "technology" as a factor of production.
In the “long run” all of these factors of production can be adjusted by management. The
“short run” however, is defined as a period in which at least one of the factors of

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production is fixed. A fixed factor of production is one whose quantity cannot readily be
changed. Examples include major pieces of equipment, suitable factory space, and key
managerial personnel. A variable factor of production is one whose usage rate can be
changed easily. Examples include electrical power consumption, transportation services,
and most raw material inputs. In the short run, a firm’s “scale of operations” determines
the maximum number of outputs that can be produced. In the long run, there are no scale
limitations.
6.2 Production Function:
Production Function-Definition:In microeconomics, a production function expresses
the relationship between an organization's inputs and its outputs. It indicates, in
mathematical or graphical form, what outputs can be obtained from various amounts and
combinations of factor inputs. In particular it shows the maximum possible amount of
output that can be produced per unit of time with all combinations of factor inputs, given
current factor endowments and the state of available technology. Unique production
functions can be constructed for every production technology.
Alternatively, a production function can be defined as the specification of the minimum
input requirements needed to produce designated quantities of output, given available
technology. This is just a reformulation of the definition above.
The relationship is non-monetary, that is, a production function relates physical inputs to
physical outputs. Prices and costs are not considered.
The production Function an equation:
In its most general mathematical form, a production function is expressed as:
Q= f(X1,X2,X3...)
where:
Q= quantity of output
X1, X2, X3, etc.= factor inputs (such as capital, labour, raw materials, land, technology, or
management)
There are several ways of specifying this function. One is as an additive production
function:
Q= a + b X1 + c X2 + d X3
where a, b, c, and d are parameters that are determined empirically.
Another is as a Cobb-Douglas production function (multiplicative):
Q= aX1bX2c
Other forms include the constant elasticity of substitution production function (CES) which
is a generalized form of the Cobb-Douglas function, and the quadratic production function

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which is a specific type of additive function. The best form of the equation to use and the
values of the parameters (a, b, c, and d) vary from company to company and industry to
industry. In a short run production function at least one of the Xs (inputs) is fixed. In the
long run all factor inputs are variable at the discretion of management.
Production Function as a graph:
Any of these equations can be plotted on a graph. A typical (quadratic) production function
is shown in the following diagram. All points above the production function are
unobtainable with current technology, all points below are technically feasible, and all
points on the function show the maximum quantity of output obtainable at the specified
levels of inputs. From the origin, through points A, B, and C, the production function is
rising, indicating that as additional units of inputs are used, the quantity of outputs also
increases. Beyond point C, the employment of additional units of inputs produces no
additional outputs, in fact, total output starts to decline. The variable inputs are being used
too intensively (or to put it another way, the fixed inputs are under utilized). With too
much variable input use relative to the available fixed inputs, the company is experiencing
negative returns to variable inputs, and diminishing total returns. In the diagram this is
illustrated by the negative marginal physical product curve (MPP) beyond point Z, and the
declining production function beyond point C.

Quadratic Production Function

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From the origin to point A, the firm is experiencing increasing returns to variable inputs.
As additional inputs are employed, output increases at an increasing rate. Both marginal
physical product (MPP) and average physical product (APP) is rising. The inflection point
A, defines the point of diminishing marginal returns, as can be seen from the declining
MPP curve beyond point X. From point A to point C, the firm is experiencing positive but
decreasing returns to variable inputs. As additional inputs are employed, output increases
but at a decreasing rate. Point B is the point of diminishing average returns, as shown by
the declining slope of the average physical product curve (APP) beyond point Y. Point B is
just tangent to the steepest ray from the origin hence the average physical product is at a
maximum. Beyond point B, mathematical necessity requires that the marginal curve must
be below the average curve.

6.3&6.4 Production function with one and Two Variable:

The production function for a firm is the relationship between the quantities of inputs
per time period and the maximum output that can be produced.  It can be calculated for
one or more than one variable factors of production.   The one variable factor of
production function corresponds to the short-run during which at least one factor of
production is Fig. 7.1; The more than one variable factor function corresponds to either the
short- or the long-run Fig. 7.7;
 
1. One Variable Factor Production Function
Assuming that all but one factor of production are fixed, the production curve for total
output shows an initially rising section that peaks and then declines if additional variable
inputs are added Fig. 7.1;

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   No rational producer will go beyond the peak.  Why does the curve peak and then turn
down?  Congestion.  With fixed capital plant and equipment additional labour initially
increases output but eventually an additional worker simply gets in the way of other
workers and output actually declines.
As additional workers are added each contributes to output.  If we take total output at
each level of employment we can calculate both the average output per worker and the
marginal or additional output contributed by one more worker Fig. 7.2;

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.  As can be seen, the addition of a worker initially increases the average output per worker
but then the average declines as the marginal output per additional worker gradually
declines following the Law of Diminishing Marginal Returns: the marginal product of any
input will (eventually) fall as the employment of that input increases - assuming other factors
of production are held constant.
Given the production function for one variable factor, the average product can be
calculated as the slope of the line measuring the distance from the point of origin to the
total product curve Fig. 7.4; Similarly, marginal product can be measured as the slope of
the total product curve Fig. 7.5;

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2. Two Variable Factor Production Function

As with the consumer utility function for two goods and services, a production function
can be plotted for two variable factors of production, e.g. Q = f (k, l).  Factors can be
combined in different ways to generate the same level of output and graphed as an
isoquant, that is a curve showing equal levels of production for different combinations of
inputs Fig. 7.7;

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   The slope of an isoquant measures the Marginal Rate of Technical Substitution (MRTS)
or the rate at which one input can be exchanged for another while maintaining the same
level of output Fig. 7.8

.  The rate is measured as an absolute value, that is the rate if actually negative but it is
reported as a positive number.  It is analogous to the Marginal Rate of Substitution for the
consumer.  A straight line drawn from the origin intercepting higher and higher isoquants
marks a constant or fixed input ratio (K/L).
In the long-run a firm can increase the scale of its plant.  As it does so it may experience
constant, increasing or decreasing returns to scale Fig. 7.9;

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.  Increasing returns to scale reflects that, for example, doubling employment and capital
results in more than double the output.  Similarly, decreasing returns to scale reflects that
say a doubling of employment and capital results in less than double the output.  Constant
returns to scale reflects that a doubling of factors results in an exact doubling of output.
Economies or increasing returns of scale exist when the average cost falls as output
rises. Economies of scale are due to specialization and division of labour.  A related concept
is economies of team production involving specialization in mutually supportive tasks or
team production. Putting a designer together with an engineer and other specialists within
the firm may be cheaper and much more effective than trying to buy such services on the
market and then try to coordinate their various outputs.
On the other hand, diseconomies of scale occur when the average cost increases as
output rises. Diseconomies of scale can occur as a firm grows in size and complexity. Thus
some things are simply more cheaply done at a smaller scale of production, e.g. due to
congestion.  In fact, some industries are based on 'small scale' production, e.g. creative
products like art, advertising and R&D. These activities are often more efficiently
conducted in small rather than large firms. In entertainment and advertising the same
result can sometimes be achieved by creating special small scale production units while the
main administration of the enterprise handles marketing and other activities that benefits
from economies of scale.
The artist, for example, tends by nature to be a risk-taking entrepreneur who does not
readily submit to organizational goals.
In consequence, ... the artist functions as an independent entrepreneur ... or ... as a
member of a very small firm which he can dominate or in which he can preserve the
identity of his work. A few industries - the motion picture firms, television networks, the
large advertising agencies - must, by their nature, associate artists with rather complex
organization. All have a well-reported record of dissonance and conflict between the artists
and the rest of the organization... Frequently the problem is solved by removing actors,
actresses, scriptwriters, directors, composers, copywriters and creators of advertising

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commercials from the technostructure ... and reconstituting them in small independent
companies. The large firm then confines itself to providing the appropriate facilities for
producing and - more importantly - marketing, exhibiting or airing the product. Similarly
painters, sculptors, concert pianists and novelists function, in effect, as one-man firms or,
as in the case of rock, dance and folk music groups, as small partnerships and turn to
larger organizations to market themselves or their products (J.K. Galbraith, Economics
and the Public Purpose, Signet, 1973, 60).
Like consumer indifference curves that theoretically can be measured using revealed
preference, isoquants can be measured by collecting relevant evidence from the 'real'
world.

6.5 Determining the Optimal use of the variable input:

The determination of the profit-maximizing level of an input is, like the determination of
the profit-maximizing level of output, a mathematical problem if there is perfect knowledge
of the supply curves of resources, the production function, and the demand curve. It is
another application of the maximization principle, which says that the best level of an input
is that level for which its marginal benefit to the firm--the extra money the firm can obtain
by hiring or buying the input--just equals the marginal cost to the firm of hiring or buying
the input. In the jargon of economists, the marginal revenue product of an input should
equal the marginal resource cost.

The marginal resource cost depends only on the supply curve of the input. The marginal
revenue product is the extra revenue that the firm can obtain from hiring another unit of
the resource. It depends both on the extra output that the input produces and on the extra
revenue the firm can obtain from each extra unit produced. For example, if adding another
unit of an input can increase output by three, and selling an extra unit of output increases
revenues by $4.00, the marginal revenue product is $12.00. If it costs an extra $10.00 to hire
or buy the input, the firm will increase profit by $2.00 if it does buy or hire it. If the input
costs an extra $14.00, the firm will decrease profits by $2.00 by using it, and should
consider a reduction in the level of this particular input.

Because marginal revenue product equals the marginal product of a resource multiplied by
the marginal revenue of the output, the condition that marginal resource cost should equal
marginal revenue product, or:

MRC = MRP

can be written as

MRC = MP x MR = Marginal Product x Marginal Revenue

This formula can, with a bit of algebraic manipulation, be turned into the condition for
profit-maximizing output, or:

MR = MC = MRC/MP

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A simple numerical example shows the equivalence of the two approaches--by finding
optimal output or optimal input--to maximizing profits and the role of the three
constraints. Assume that a firm is a price taker both as a seller of output and as a buyer of
inputs, and that it can sell as much as it wants at a price of $2.10 per unit and buy as much
labor as it wants for $10.00 per unit. Assume also that the amount of capital is fixed at two,
that capital and labor are the only inputs, and that the firm faces the production function
discussed earlier.

Computation of the Best Input Level for the Firm

(1) (2) (5) (6) (7)
(3) (4)
Marginal Marginal Marginal Marginal Marginal
Labor Output
Revenue Product Resource Cost Product Revenue Cost
-- -- 0 0 -- -- --
$27.30 $10.00 1 (first) 13 (th) 13 $2.10 $.77
2
14.70 10.00 20 (th) 7 $2.10 1.43
(second)
12.60 10.00 3 (third) 26 (th) 6 $2.10 1.67
4
10.50 10.00 31 (st) 5 $2.10 2.00
(fourth)
8.40 10.00 5 (fifth) 35 (th) 4 $2.10 2.50

Columns 3 and 4 of this table show data taken from the production function. Column 5
shows the marginal product of labor, derived from columns 3 and 4. Column 2 shows the
marginal resource cost of labor, which comes from the assumption that the firm can buy as
much labor as it wants at $10.00 per unit. Column 6 shows marginal revenue, which comes
from the assumption that the firm can sell as much as it wants at $2.10 per unit of output.

To find the profit-maximizing amount of labor, the firm must compare the extra cost of
another unit of labor with the extra revenue that the extra labor adds. The extra cost is the
marginal resource cost, shown in column 2. The extra revenue is the marginal revenue
product, the value to the firm of the extra output that the additional labor produces.
Column 1 shows marginal revenue product, which is the product of marginal revenue and
marginal product (columns 5 and 6). By comparing the marginal revenue product to the
marginal resource cost, one can immediately see that the profit-maximizing amount of
labor is four. Hiring the fourth unit of labor adds $10.50 to revenue and $10.00 to cost, so
profits increase. Hiring a fifth unit adds less to revenue than to costs, $8.40 and $10.00
respectively, so it is not a profitable unit to hire. If the firm hires four units of labor, the
production function says that it will produce 31 units of output.

The previous section explained that to calculate profit-maximizing output, one needs to
compare marginal cost of output with marginal revenue. Column 6 of the table contains the
marginal revenue. To find the marginal cost of output, one must compute what it costs to
produce another unit. When the firm hires the first unit of labor, it adds 13 to output and
$10.00 to cost. However, we do not want to know what an extra 13 cost, but what an extra

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one costs. To find it, we divide the $10.00 into 13 equal parts, and call the result the extra
cost of producing one more. In other words, to get the marginal cost of output in column 7,
we need to divide the marginal resource cost by the marginal product.Comparing columns
6 and 7, one can immediately see that 31 is the profit-maximizing level of output. Producing
more or less will reduce profits. If the firm produces more than 31, it adds $2.00 in revenue
for each extra unit, but it also adds $2.50 in cost. If it produces less, it cuts costs, but not by
as much as it cuts revenues.Checking the production function at 31 units of output, one sees
that one needs four units of labor. Hence, finding profit-maximizing output and profit-
maximizing input are two different ways to arrange the information from the production
function, the supply of resources, and the demand for output. Both ways give identical
results.

6.6 Economies of Scale and Returns to Scale

Economies of scale in production means that production at a larger scale (more output) can
be achieved at a lower cost (i.e. with economies or savings). A simple way to formalize this
is to assume that the unit-labor requirement in production of a good is a function of the
level of output produced.

In the adjoining diagram we present a graph of the unit-labor requirement in steel

production as a function of the scale (level of output) of production. At production level
Q1S, the unit-labor requirement is given by a 1LS. If production were to rise to Q2S, then the
unit-labor requirement would fall to a2LS. This means that at the higher level of output, it
requires less labor (i.e. fewer resources or cost) per unit of output than it required at the
smaller scale.

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With a simple adjustment it is possible to show that economies of scale in production is

equivalent to increasing returns to scale. Increasing returns to scale in production means
that an increase in resource usage , by say x%, results in an increase in output by more
than x%. In the adjoining diagram we plot labor productivity in steel production when
production exhibits increasing returns to scale. [This graph is derived by plotting the
reciprocal of the unit-labor requirement (i.e. 1/aLS) for each output level in the above
diagram.]
Note that as output (scale) increases from Q1S to Q2S, labor productivity (given by the
reciprocal of the unit-labor requirement) also rises. In other words, output per unit of
labor input increases as the scale of production rises, hence increasing returns to scale.
Another way to characterize economies of scale is with a decreasing average cost curve.
Average costs, AC, are calculated as the total costs to produce output Q, TC(Q), divided by
total output. Thus AC(Q) = TC(Q)/Q. When average costs decline as output increases it
means that it becomes cheaper to produce the average unit as the scale of production rises,
hence economies of scale.
Economies of scale are most likely to be found in industries with large fixed costs in
production. Fixed costs are those costs that must be incurred even if production were to
drop to zero. For example fixed costs arise when large amounts of capital equipment must
be put into place even if only one unit is to be produced and if the costs of this equipment
must still be paid even with zero output. In this case the larger the output, the more the
costs of this equipment can be spread out among more units of the good. Large fixed costs
and hence economies of scale are prevalent in highly capital intensive industries such as
chemicals, petroleum, steel, automobiles etc. Economies of Scale and Perfect Competition
It is worth noting that the assumption of economies of scale in production can represent a
deviation away from the assumption of perfectly competitive markets. In most perfectly
competitive models, it is assumed that production takes place with constant returns to scale
(i.e. no economies). This means that the unit-cost of production remains constant as the
scale of production increases. When that assumption is changed, it can open up the
possibility of positive profits and strategic behavior among firms. Because there are
numerous ways to conceive of strategic interactions between firms, there are also numerous
models and results that could be obtained. To avoid some of these problems, a number of
models have been developed which retain some of the key features of perfect competition
while allowing for the presence of economies of scale as well

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Chapter-7

Cost Theory
7.1 Meaning and Measurement of Cost
7.2 Short run cost curves
7.3 Long run cost curves
7.4 Economies of scale
7.5 Break even Analysis
7.6 Learning curves
7.1 Meaning & Measurement of Cost
Something of value, usually an amount of money, given up in exchange for something else,
usually goods or services. All expenses are costs, but not all costs are expenses. (An expense
is the cost of resources used to produce revenue.) As a verb, cost means to estimate the
amount of money needed to produce a product or perform a service.

Measurement of cost:
When we study cost of production of any good or service, we observe that there are several
factors that influence the cost. Cost function expresses the relationship between cost and its
determinants, like the size of plant, level of output, input prices, technology etc. in a
mathematical from it can be expressed as, C= f(S,O,P,T……..)
Here, C= refers to cost (unit cost or total cost), S= refers to size of plant, P= denotes the
price of inputs used in production, T= refers to the nature of technology.
Let us discuss the main determinants of cost in detail:
 Size of plant: plant size is an important variable influencing cost. The relation
between scale of operations or size of plant to the unit cost is negative in the sense
that, as the former increases per unit cost decreases and vice versa. Such a
relationship gives step type downward sloping cost function, steps depending upon
the different sizes of plants taken into account. Such a cost gives primarily
engineering estimates of cost.
 Output level: level of output and total cost are obviously related total cost
increasing with increase in output. but average and marginal costs first decline and

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then increase with the increase in output. The average total cost or marginal cost
function are derived by relating the relevant costs with the level of capacity
utilization of given sized plant. Since such a cost function forms a U-shaped curve, a
quadratic or cubic function is more appropriate to use.
 Price of inputs.: obviously, changes in input prices influence costs, depending on the
selective usage of the input and relative changes in their prices. When a factor,
which is a major component in production, becomes relatively costly it raises the
cost significantly.
 Technology: technology is often quantified as capital-output ratio. Modern and
efficient technology is certainly cost saving and is, therefore, generally fund to have
higher capital output ratio.
 Managerial efficiency: Though cost is influenced a great deal by managerial
efficiency, it is difficult to quantify it. However, a change in cost at two points of
time may explain how organizational or managerial changes within the firm have
brought labour cost efficiency, provided it is possible to exclude the effect of other
factors.
It is believed that out of all the cost determinants the most important component is
the rate of output. It is therefore, assumed that the determinants other than the rate of
output are held constant while analyzing cost and constructing cost curves.
Note that the shape of cost curve is determined by the nature of underlying
production function, while the level of cost curve is affected by the input prices.

7.2 Short run Cost Curves

Ashort-run cost curve shows the minimum cost impact of output changes for a specific
plant size and in a given operating environment. Such curves reflect the optimal or least-
cost input combination for producing output under fixed circumstances. Wage rates,
interest rates, plant configuration, and all other operating conditions are held constant.
Any change in the operating environment leads to a shift in short-run cost curves. For
example, a general rise in wage rates leads to an upward shift; a fall in wage rates leads to a
downward shift. Such changes must not be confused with movements along a given short-
run cost curve caused by a change in production levels. For an existing plant, the short-run
cost curve illustrates the minimum cost of production at various output levels under
current operating conditions. Short-run cost curves are a useful guide to operating
decisions.
Short-Run Cost Categories
Both fixed and variable costs affect short-run costs. Total cost at each output level is the
sum of total fixed cost (a constant) and total variable cost. Using TC to represent total cost,
TFC for total fixed cost, TVC for total variable cost, and Q for the quantity of output
produced, various unit costs are calculated as follows:

 Total Cost = TC = TFC + TVC

 Average Fixed Cost = AFC = TFC/Q

 Average Variable Cost = AVC = TVC/Q

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 Average Cost = AC = TC/Q = AFC + AVC

 Marginal Cost = MC = ∆TC/∆Q

These cost categories are portrayed in Table 8.1. Using these data, it is possible to identify
the various cost relations as well as to examine cost behavior. Table 8.1 shows that AFC
declines

continuously with increases in output. AC and AVC also decline as long as they exceed MC,
but increase when they are less than MC. Alternatively, so long as MCis less than AC and
AVC, both average cost categories will decline. When MC is greater than AC and AVC, both
average cost categories will rise. Also note that TFC is invariant with increases in output
and that TVC at each level of output equals the sum of MC up to that output.
Marginal cost is the change in cost associated with a one-unit change in output. Because
fixed costs do not vary with output, fixed costs do not affect marginal costs. Only variable
costs affect marginal costs. Therefore, marginal costs equal the change in total costs or the
change in total variable costs following a one-unit change in output: MC = ∆TC/∆Q =
∆TVC/∆Q
Short-Run Cost Relations
Relations among short-run cost categories are shown in Figure 8.1. Figure 8.1(a) illustrates
total cost and total variable cost curves. The shape of the total cost curve is determined
entirely by the total variable cost curve. The slope of the total cost curve at each output
level is identical to the slope of the total variable cost curve. Fixed costs merely shift the
total cost curve to a higher level. This means that marginal costs are independent of fixed
cost. The shape of the total variable cost curve, and hence the shape of the total cost curve,
is determined by the productivity of variable input factors employed. The variable cost
curve in Figure 8.1 increases at a decreasing rate up to output level Q1, then at an
increasing rate. Assuming constant input prices, this implies that the marginal productivity
of variable inputs first increases, then decreases. Variable input factors exhibit increasing
returns in the range from 0 to Q1 units and show diminishing returns thereafter. This is a
typical finding. Fixed plant and equipment are usually designed to operate at a target
production level. Operating below the target output level results in some excess capacity. In

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the below-target output range, production can be increased more than proportionately to
increases in variable inputs. At above-target output levels, fixed factors are intensively
used, and the law of diminishing returns takes over. There, a given percentage increase in
variable inputs results in a smaller relative increase in output. The relation between short-
run costs and the productivity of variable input factors is also reflected by short-run unit
cost curves, as shown in Figure 8.1(b). Marginal cost declines over the range of increasing
productivity and rises thereafter. This imparts the familiar U-shape to average variable
cost and average total cost curves. At first, marginal cost curves also typically decline
rapidly in relation to the average variable cost curve and the average total cost curve. Near
the target output level, the marginal cost curve turns up and intersects each of the AVC and
AC short-run curves at their respective minimum points

7.3 Long run Cost curves

In the long run, the firm has complete input flexibility. All long-run costs are variable. A
long-run cost curve shows the minimum cost impact of output changes for the optimal
plant size in the present operating environment.

Long-Run Total Costs

Long-run cost curves show the least-cost input combination for producing output assuming
an ideal input selection. As in the case of short-run cost curves, wage rates, interest rates,

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plant configuration, and all other operating conditions are held constant. Any change in the
operating environment leads to a shift in long-run cost curves. For example, product
inventions and process improvements that occur over time cause a downward shift in long-
run cost curves. Such changes must not be confused with movements along a given long-run
cost curve caused by changes in the output level. Long-run cost curves reveal the nature of
economies or diseconomies of scale and optimal plant sizes. They are a helpful guide to
planning decisions. If input prices are not affected by the amount purchased, a direct
relation exists between longrun total cost and production functions. Aproduction function
that exhibits constant returns to scale is linear, and doubling inputs leads to doubled
output. With constant input prices, doubling inputs doubles total cost and results in a
linear total cost function. If increasing returns to scale are present, output doubles with less
than a doubling of inputs and total cost. If production is subject to decreasing returns to
scale, inputs and total cost must more than double to cause a twofold increase in output.
Aproduction function exhibiting first increasing and then decreasing returns to scale is
illustrated, along with its implied cubic cost function, in Figure 8.2. Here, costs increase less
than proportionately with output over the range in which returns to scale are
increasing but at more than a proportionate rate after decreasing returns set in. A direct
relation between production and cost functions requires constant input prices. If input
prices are a function of output, cost functions will reflect this relationship. Large-volume
discounts can lower unit costs as output rises, just as costs can rise with the need to pay
higher wages to attract additional workers at high output levels. The cost function for a
firm facing constant returns to scale but rising input prices as output expands takes the
shape shown in Figure 8.2. Costs rise more than proportionately as output increases.
Quantity discounts produce a cost function that increases at a decreasing rate, as in the
increasing returns section of Figure 8.2.

Long-Run Average Costs

Short-run cost curves relate costs and output for a specific scale of plant. Long-run cost
curves identify the optimal scale of plant for each production level. Long-run average cost
(LRAC) curves can be thought of as an envelope of short-run average cost (SRAC) curves.
This concept is illustrated in Figure 8.3, which shows four short-run average cost curves
representing four different scales of plant. Each of the four plants has a range of output
over which it is most efficient. Plant A, for example, provides the least-cost production
system for output in the range 0 to Q1 units; plant B provides the least-cost system for
output in the range Q1 to Q2; plant C is most efficient for output quantities Q2 to Q3; and
plant D provides the least-cost production process for output above Q3. The solid portion
of each curve in Figure 8.3 indicates the minimum long-run average cost for producing
each level of output, assuming only four possible scales of plant. This can be generalized by
assuming that plants of many sizes are possible, each only slightly larger than the
preceding one. As shown in Figure 8.4, the long-run average cost curve is then constructed
tangent to each short-run average cost curve. At each point of tangency, the related scale of
plant is optimal; no other plant can produce that particular level of output at so low a total
cost. Cost systems illustrated in Figures 8.3 and 8.4 display first economies of scale, then
diseconomies of scale. Over the range of output produced by plants A, B, and C in Figure
8.3, average costs are declining; these declining costs mean that total costs are increasing

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less than proportionately with output. Because plant D’s minimum cost is greater than that
for plant C, the system exhibits diseconomies of scale at this higher output level. Production
systems that reflect first increasing, then constant, then diminishing returns to scale result
in U-shaped long-run average cost curves such as the one illustrated in Figure 8.4. With a
U-shaped long-run average cost curve, the most efficient plant for each output level is
typically not operating at the point where short-run average costs are minimized, as can be
seen in Figure 8.3. Plant A’s short-run average cost curve is minimized at point M, but at
that output level, plant B is more efficient; B’s short-run average costs are lower. In
general, when economies of scale are present, the least-cost plant will operate at less than
full capacity. Here, capacity refers not to a physical limitation on output but rather to the
point at which short run average costs are minimized. Only for that single output level at
which long-run average cost is minimized (output Q* in Figures 8.3 and 8.4) is the optimal
plant operating at the minimum point on its short-run average cost curve. At any output
level greater than Q*, diseconomies of scale prevail, and the most efficient plant is
operating at an output level slightly greater than capacity. The number of competitors and
ease of entry is typically greater in industries with U-shaped long-run average cost curves
than in those with L-shaped or downward-sloping long-run average cost curves. Insight on
the competitive implications of cost/output relations can be gained by considering the
minimum efficient scale concept.

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7.3 Economies of scale

Economies of scale exist when long-run average costs decline as output expands.
Labor specialization often gives rise to economies of scale. In small firms, workers
generally do several jobs, and proficiency sometimes suffers from a lack of specialization.
Labor productivity can be higher in large firms, where individuals are hired to perform
specific tasks. This can reduce unit costs for large-scale operations. Technical factors can
also lead to economies of scale. Large-scale operation permits the use of highly specialized
equipment, as opposed to the more versatile but less efficient machines used in smaller
firms. Also, the productivity of equipment frequently increases with size much faster than
its cost. A500,000-kilowatt electricity generator costs considerably less than two 250,000-
kilowatt generators, and it also requires less fuel and labor when operated at capacity.
Quantity discounts give rise to money-related pecuniary economies through large scale
purchasing of raw materials, supplies, and other inputs. These economies extend to the cost
of capital when large firms have easy access to capital markets and can acquire funds at
lower rates. At some output level, economies of scale are typically exhausted, and average
costs level out and begin to rise. Increasing average costs at high output levels are often
attributed to limitations in the ability of management to coordinate large-scale
organizations. Staff overhead also tends to grow more than proportionately with output,
again raising unit costs. The current trend toward small to medium-sized businesses
indicates that diseconomies limit firm sizes in many industries.
Cost Elasticities and Economies of Scale
It is often easy to calculate scale economies by considering cost elasticities. Cost elasticity,
ЄC, measures the percentage change in total cost associated with a 1 percent change in
output. Algebraically, the elasticity of cost with respect to output is

Cost elasticity is related to economies of scale as follows:

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7.5 Break Even Analysis

In economics&business, specifically cost accounting, the break-even point (BEP) is the
point at which cost or expenses and revenue are equal: there is no net loss or gain, and one
has "broken even". A profit or a loss has not been made, although opportunity costs have
been paid, and capital has received the risk-adjusted, expected return.
For example, if a business sells less than 200 tables each month, it will make a loss, if it sells
more, it will be a profit. With this information, the business managers will then need to see
if they expect to be able to make and sell 200 tables per month.
If they think they cannot sell that much, to ensure viability they could:
Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control
of telephone bills or other costs)
Try to reduce variable costs (the price it pays for the tables by finding a new supplier)
Increase the selling price of their tables.
Any of these would reduce the break even point. In other words, the business would not
need to make so many tables to make sure it could pay its fixed costs.
The Break-Even Chart
In its simplest form, the break-even chart is a graphical representation of costs at various
levels of activity shown on the same chart as the variation of income (or sales, revenue)
with the same variation in activity. The point at which neither profit nor loss is made is
known as the "break-even point" and is represented on the chart below by the intersection
of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As
outputincreases, variable costs are incurred, meaning that total costs (fixed + variable) also
increase. At low levels of output, Costs are greater than Income. At the point of
intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.

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Fixed Costs:
Fixed costs are those business costs that are not directly related to the level of production
or output. In other words, even if the business has a zero output or high output, the level of
fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as
a result of investment in production capacity (e.g. adding a new factory unit) or through
the growth in overheads required to support a larger, more complex business.
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable Costs
Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-
related costs such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Directvariable costs are those which can be directly attributable to the production of a
particular product or service and allocated to a particular cost centre. Raw materials and
the wages those working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with
output. These include depreciation (where it is calculated related to output - e.g. machine
hours), maintenance and certain labour costs.
Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorising
business costs, in reality there are some costs which are fixed in nature but which increase
when output reaches certain levels. These are largely related to the overall "scale" and/or
complexity of the business. For example, when a business has relatively low levels of output
or sales, it may not require costs associated with functions such as human resource
management or a fully-resourced finance department. However, as the scale of the business
grows (e.g. output, number people employed, number and complexity of transactions) then
more resources are required. If production rises suddenly then some short-term increase in
warehousing and/or transport may be required. In these circumstances, we say that part of
the cost is variable and part fixed.
Limitations
 Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you
nothing about what sales are actually likely to be for the product at these various
prices.
 It assumes that fixed costs (FC) are constant. Although, this is true in the short run,
an increase in the scale of production is likely to cause fixed costs to rise.
 It assumes average variable costs are constant per unit of output, at least in the

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range of likely quantities of sales. (i.e. linearity)

 It assumes that the quantity of goods produced is equal to the quantity of goods sold
(i.e., there is no change in the quantity of goods held in inventory at the beginning of
the period and the quantity of goods held in inventory at the end of the period).
In multi-product companies, it assumes that the relative proportions of each product sold
and produced are constant (i.e., the sales mix is constant).
Margin of Safety
Margin of safety represents the strength of the business. It enables a business to know what
is the exact amount he/ she has gained or lost and whether they are over or below the break
even point.
margin of safety = (current output - breakeven output)
margin of safety% = (current output - breakeven output)/current output x 100
If P/V ratio is given then profit/ PV ratio
== In unit Break Even = FC / (SP − VC)
where FC is Fixed Cost, SP is Selling Price and VC is Variable Cost
7.6 The learning curve

There are many situations, not just in business but also in everyday life, where we learn
better ways of doing something over time. Examples are playing tennis, using a keyboard,
driving a car, or solving problems in managerial economics. In the workplace the factors
that are involved are increased familiarization with the tasks involved, improvements in
production methods, more efficient use of raw materials and machinery and fewer costly
mistakes. These factors are obviously interdependent. The improvement in performance
can be measured in a number of ways, depending on the situation,
but the most common are in terms of unit cost or unit time to produce a product. This
improvement is a function of experience, although when the concept was originally used in
the 1930s in the analysis of aircraft production, the reason proposed for the learning curve
effect was the learning by production workers, resulting in direct labour costs being
reduced. It was only later that additional benefits in terms of production methods and
indirect labour and other costs were considered. Hence, although the term experience
curve is often used interchangeably with learning curve, some economists claim that there
is some difference between the two concepts.4 Experience is normally
measured in terms of cumulative output, that is the total output since production of a
product began. Thus we can express the learning curve relationship as:

where U is some measure of unit cost and T represents cumulative output. It is important
to note that this function is fundamentally different from the normal cost functions
analysed so far, because of the nature of cumulative output. This means that the learning
curve is neither a short-run nor a long-run
cost function but can apply to any time horizon. Its effect is to cause the cost functions
considered so far to shift downwards over time. Weexpect the relationship to be an inverse

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one if we learn from experience, but everyday experience of the experience curve(!) tells us
that we tend to learn relatively quickly to begin with, and then our rate of learning slows
down because of the familiar law of diminishing returns. Thus we would normally expect
the situation that is shown in the following Figure

This indicates that the appropriate mathematical form of the relationship is a power
function: U ¼ aTb (6:18) where U is normally measured as the marginal cost of a unit. The
parameter b has a negative value, indicating an inverse relationship between marginal cost
and cumulative output. Learning curves are often described in terms of how a doubling of
cumulative output affects marginal cost; if such a doubling results in a 20 per cent
reduction in marginal cost it is said that the learning rate is 80 per cent. This learning rate
is given by 2b. The mathematical proof of this is as follows: let the initial cumulative
output¼T1 and the initial marginal cost¼U1; then the marginal cost of double the
output¼a(2T1)b¼2b(aTb 1)¼2b(U1). This means that every time cumulative output
doubles the marginal cost becomes 2b times what it was previously. Other aspects of
interpretation of the learning curve, its estimation and use in forecasting, and the results of
empirical studies, are discussed in the next chapter, along with a numerical example.

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Chapter-8

Pricing and Output

decisions
8.1 Individual, firm, market demand curves,

8.2 Price output determination under pure competition

8.3 Market price determination

8.4 Pure monopoly

8.5 Monopolistic competition

8.6 Oligopoly
8.1 Individual, Firm, Market Demand curves:

Individual Demand, Market Demand

The consumer equilibrium condition determines the quantity of each good the individual
consumer will demand. As the example above illustrates, the individual consumer's
demand for a particular good—call it good X—will satisfy the law of demand and can
therefore be depicted by a downward-sloping individual demand curve. The individual
consumer, however, is only one of many participants in the market for good X. The market

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demand curve for good X includes the quantities of good X demanded by all participants in
the market for good X. The market demand curve is found by taking the horizontal
summation of all individual demand curves. For example, suppose that there were just two
consumers in the market for good X, Consumer 1 and Consumer 2. These two consumers
have different individual demand curves corresponding to their different preferences for
good X. The two individual demand curves are depicted in Figure 1 , along with the market
demand curve for good X.

Figure 1

Derivation of the market demand curve from consumers' individual demand curves

The market demand curve for good X is found by summing together the quantities that
both consumers demand at each price. For example, at a price of $1, Consumer 1 demands
2 units while Consumer 2 demands 1 unit; so, the market demand is 2 + 1 = 3 units of good
X. In more general settings, where there are more than two consumers in the market for
some good, the same principle continues to apply; the market demand curve would be the
horizontal summation of all the market participants' individual demand curves.

8.2 Price output Determination under pure competition

Market characteristics described in the preceding section determine the level of
competition in the market for any good or service. This section focuses on the special
features of perfectly competitive markets and illustrates why perfect competition is
desirable from a social perspective

Characteristics of Perfectly Competitive Markets

Perfect competition exists when individual producers have no influence on market prices;
they are price takers as opposed to price makers. This lack of influence on price typically
requires
• Large numbers of buyers and sellers. Each firm produces a small portion of industry
output, and each customer buys only a small part of the total.
• Product homogeneity. The output of each firm is essentially the same as the output of any
other firm in the industry.

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• Free entry and exit. Firms are not restricted from entering or leaving the industry.
• Perfect dissemination of information. Cost, price, and product quality information is
known by all buyers and all sellers.
These basic conditions are too restrictive for perfect competition to be commonplace.
Although the stock market approaches the perfectly competitive ideal, imperfections occur
even there. For example, the acquisition or sale of large blocks of securities by institutional
investors clearly affects prices, at least in the short run. Nevertheless, because up to 1,000
shares of any stock can be bought or sold at the current market price, the stock market
approaches the ideal of a perfectly competitive market. Similarly, many industrial firms
must make output decisions without any control over price, and examination of a perfectly
competitive market structure provides insights into these operating decisions. Aclear
understanding of perfect competition also provides a reference point from which to analyze
monopolistic competition and oligopoly, as described in next topic.

Market Price Determination

Market prices in competitive industries are determined by aggregate supply and demand;
individual firms have no control over price. Total industry demand reflects an aggregation
of the quantities that individual firms will buy at each price. Industry supply reflects a
summation of the quantities that individual firms are willing to supply at different prices.
The intersection of industry demand and supply curves determines market price. Data in
Table 10.1 illustrate the process by which an industry supply curve is constructed. First,
suppose that each of five firms in an industry is willing to supply varying quantities at
different prices. Summing the individual supply quantities of these five firms at each price
determines their combined supply schedule, shown in the Partial Market Supply column.
For example, at a price of $2, the output supplied by the five firms are 15, 0, 5, 25, and 45
(thousand)
units, respectively, resulting in a combined supply of 90 (000) units at that price. With a
product price of $8, supply quantities become 45, 115, 40, 55, and 75, for a total supply by
the five firms of 330 (000) units. Now assume that there are actually 5,000 firms in the
industry, each with an individual supply schedule identical to one of the five firms
illustrated in the table. There are 1,000 firms just like each one illustrated in Table 10.1;
the total quantity supplied at each price is 1,000 times that shown under the Partial Market
Supply schedule. This supply schedule is illustrated in Figure 10.1. Adding the market
demand curve to the industry supply curve, as in Figure 10.2, allows one to determine the
equilibrium market price. Market price is found by equating market supply and market
demand to find the equilibrium price/output level. Using the curves illustrated in Figure
10.2, we have

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Although both the quantity demanded and supplied depend on price, a simple example
demonstrates the inability of individual firms to affect price. The total demand function in
Figure 10.2 is described by the equation
(10.1) Quantity Demanded = Q = 400,000 – 10,000P
or, solving for price,
(10.1a) $10,000P = $400,000 – Q
P = $40 – $0.0001Q
According to Equation 10.1a, a 100-unit change in Q would cause only a $0.01 change in
price. A $0.0001 price increase would lead to a one-unit decrease in total market demand; a
$0.0001 price reduction would lead to a one-unit increase in total market demand. The
demand curve shown in Figure 10.2 is redrawn for an individual firm in Figure 10.3. The
slope of the curve is –0.0001, the same as in Figure 10.2; only the scales have been changed.
The $7.80 intercept is the going market price as determined by the intersection of the
market supply and demand curves in Figure 10.2. At the scale shown in Figure 10.3, the
firm’s demand curve is seen to be, for all practical purposes, a horizontal line. Thus, it is
clear that under perfect competition, the individual firm’s output decisions do not affect
price in any meaningful way. Price can be assumed constant irrespective of the output level
at which the firm chooses to operate.

Firm Price/Output Decision

Profit maximization requires that a firm operate at the output level at which marginal
revenue and marginal cost are equal. With price constant, average revenue equals

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marginal revenue. Therefore, maximum profits result when market price is set equal to
marginal cost for firms in a perfectly competitive industry. In the example shown in Figure
10.4, the firm chooses to operate

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at output level Q*, where price (and hence marginal revenue) equals marginal cost, and
profits are maximized. A normal profit, defined as the rate of return necessary to attract
capital investment, is included as part of economic costs. Therefore, any profit shown in a
graph such as Figure 10.4 is defined as economic profit and represents an above-normal
rate of return. The firmincurs economic losses whenever it fails to earn a normal profit. A
firm might show a small accounting profit but be suffering economic losses because these
profits are insufficient to provide an adequate return to the firm’s stockholders. In such
instances, firms are unable to replace plant and equipment and will exit the industry in the
long run. In Figure 10.4 the firm produces and sells Q* units of output at an average cost of
C dollars; with a market price P, the firm earns economic profits of P – C dollars per unit.
Total economic profit, (P – C)Q*, is shown by the shaded rectangle PMNC. Over the long
run, positive economic profits attract competitors. Expanding industry supply puts
downward pressure on market prices and pushes cost upward because of increased
demand for factors of production. Long-run equilibrium is reached when all economic
profits and losses have been eliminated and each firm in the industry is operating at an
output that minimizes long-run average cost (LRAC). Long-run equilibrium for a firm
under perfect competition is graphed in Figure 10.5. At the profit-maximizing output, price
(or average revenue) equals average cost, so the firm neither earns economic profits nor
incurs economic losses. When this condition exists for all firms in the industry, new firms
are not encouraged to enter the industry nor are existing ones pressured into leaving it.
Prices are stable, and each firm is operating at the minimum point on its short-run average
cost curve. All firms must also be operating at the minimum cost point on the long-run
average cost curve; otherwise, they will make production changes, decrease costs, and
affect industry output and prices. Accordingly, a stable equilibrium requires that firms
operate with optimally sized plants.

Illustration of Price/Output Decisions:

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in Perfectly Competitive Markets The optimal price/output level for a firm in a perfectly
competitive market can be further illustrated using a more detailed example. Assume that
you are interested in determining the

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profit-maximizing activity level for the Hair Stylist, Ltd., a hairstyling salon in College
Park, Maryland. Given the large number of competitors, the fact that stylists routinely
tailor services to meet customer needs, and the lack of entry barriers, it is reasonable to
assume that the market is perfectly competitive and that the average $20 price equals
marginal revenue, P = MR = $20. Furthermore, assume that the firm’s operating expenses
are typical of the 100 firms in the local market and can be expressed by the following total
and marginal cost functions:
TC = $5,625 + $5Q + $0.01Q2
MC = $5 + $0.02Q
whereTC is total cost per month including capital costs, MC is marginal cost, and Q is the
number of hairstylings provided. The optimal price/output combination can be determined
by setting marginal revenue equal to marginal cost and solving for Q:
MR = MC
$20 = $5 + $0.02Q
$0.02Q = $15
Q = 750 hairstylings per month
At this output level, maximum economic profits are
π = TR – TC
= $20Q – $5,625 – $5Q – $0.01Q2
= $20(750) – $5,625 – $5(750) – $0.01(7502)
= $0
The Q= 750 activity level results in zero economic profits. This means that the Hair Stylist
is just able to obtain a normal or risk-adjusted rate of return on investment because capital
costs are already included in the cost function. The Q = 750 output level is also the point of
minimum average production costs (AC = MC = $20). Finally, with 100 identical firms in
the industry, industry output totals 75,000 hairstylings per month. Firm Supply Curve
Market supply curves are the sum of supply for individual firms at various prices. The
perfectly competitive firm’s short-run supply curve corresponds to that portion of the
marginal cost curve that lies above the average variable cost curve. Because P = MR under
perfect competition, the quantity supplied by the perfectly competitive firm is found at the
point where P = MC, so long as price exceeds average variable cost.
To clarify this point, consider the options available to the firm. Profit maximization always
requires that the firm operate at the output level at which marginal revenue equals
marginal cost. Under perfect competition, the firm will either produce nothing and incur a
loss equal to its fixed costs, or it will produce an output determined by the intersection of
the horizontal demand curve and the marginal cost curve. If price is less than average
variable costs, the firm should produce nothing and incur a loss equal to total fixed cost.
Losses will increase if any output is produced and sold when P <AVC. If price exceeds
average variable cost, then each unit of output provides at least some profit contribution to
help cover fixed costs and provide profit. The minimum point on the firm’s average
variable cost curve determines the lower limit, or cutoff point, of its supply schedule. This
is illustrated in Figure 10.6. At a very low price such as $1, MR = MC at 100 units of output.
The firm has a total cost per unit of $2 and a price of only $1, so it is incurring a loss of

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$1 per unit. This loss consists of a fixed cost component ($2.00 – $1.40 = $0.60) and a
variable cost component ($1.40 – $1.00 = $0.40). Thus, the total loss is Total Loss = (100
Units) _ ($0.60 Fixed Cost Loss + $0.40 Variable Cost Loss) = $100 If the firm simply shut
down and terminated production, it would not incur variable costs, and its loss would be
reduced to the level of fixed costs, or 100($0.60) = $60. Price fails to cover variable costs at
prices below $1.25, the minimum point on the AVC curve, so this is the lowest price at
which the firm will operate. Above $1.25, price more than covers variable costs. Even
though total costs are not covered at prices less than $2, it is preferable to operate when
$1.25 <P < $2 and earn at least some profit contribution to cover a portion of total fixed
costs rather than to shut down and incur losses equal to total fixed costs.

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8.3 Price Determination

Demandis the key determinant for market oriented company. Demand is the starting point
for all activities. Simply, the average customer will be demanding different product
quantities, depending on price. Law of the market says that demand and price are counter
proportional ( price increase leads to demand decrease and vice versa ).

Competition has a significant influence to price determination of market oriented

companies. Prices need to be adjusted in order to address the competition. Every company
should research market and competition, prior to launch of the new product. Survey
should include direct competitors but also the substitutes. Based on market survey and the
strength of the company the prices can be the same, lower or higher.

Costs – While demand and competition are external factor, the costs are internal. The costs
must be embedded in every stage of price determination process. There are several
methods of cost embedding into price:

1.) Costs Plus – company calculates the costs and increase price for the specific profit.

2.) Markup – price based on cost increased for amount of specific markup percentage.

3.) Target Return Method – calculated required markup, in order to achieve return on
investment.

4.) Profit Maximizing is the price where the marginal profit equals marginal cost.

5.) Breakeven Analysis – is the number of units sold that generates profit that can cover

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cost. This point does not have profit nor lost.

Life Cycle pricing approach analysis the current phase of product life in market.

1.) Entering phase usually requires higher sales prices in order to payback initial
development costs. Also customers are willing to pay more for a new product.

2.) Growth phase is bringing the market stabilization. Prices are more or less stabile.

3.) Saturation phase leads to price decline, due to competition entrance and loss of
consumer's interest

4.) Declining phase is the last part of product life cycle. Prices are still going down.

Sales Channels have the different shopping occasion. Consequently the pricing is adjusted
to sales channel. For example, the same products is cheaper in hypermarket than on petrol
station.
 
Government is usually do not interfere into price determination. Exceptionally it may limit
maximal prices for a certain products. Still, government is influencing pricing, since the
taxes & custom duties are the part of the price.

8.4 Pure Monopoly

1).Pure Monopoly  

 exists when a single firm is the sole producer of a product for which there are no
close substitutes

A. Characteristics

 Single Seller - a one producer of a specific product

 No Close Substitutes - no reasonable alternative products
 "Price Maker" - the firm exercises considerable control over price because it is
responsible for the quantity supplied.
 Totally Blocked Entry - no competitors because of economic, technological, legal
obstacles
 Advertising - monopolies may or may not advertise
o monopolist selling luxury good can advertise to increase demand
o monopolist selling utilities/necessities will not advertise

Examples

1. gas/electric companies

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2. water company
3. cable TV
4. telephone company
5. professional sports leagues
6. monopoly caused by geographic isolation  

2).Barriers to Entry

A)Economies of Scale

 natural monopoly - economies of scale that are so great that a good or service can
be produced by one firm at an average total cost lower than if produced by more
than one firm.
 New firms attempting to enter the industry as small-scale producers will have little
or no chance to survive and expand
 New small-scale entrants cannot realize the cost economies of the monopolist and
therefore cannot realize profits necessary for survival and growth
 New large-scale producers find it extremely difficult to secure enough startup
money and capital

B).Legal Barriers: Patent and Licenses

Patents

 Patents allow inventor from having the product usurped by rivals who have not
shared in the time, effort, and money put into the products development
 Patents give the inventor a monopoly position for the life of the patent
 Profits gained from a patent can further finance research required to develop new
patentable products .  Therefore, tremendous monopoly power can be obtained

Licenses

 Entry into an industry or occupation may require a government license

 Allows the government to create a public monopoly
 Examples: radio/TV stations, taxi cabs
 Ownership of Essential Resources
 Example: De Beers owns most of the world's known diamond mines

Implications:

 Monopolies are relatively rare

 Barriers to entry are rarely complete - meaning pure monopoly is relatively rare
 Technology may undermine existing monopoly power (e.g. email and postal service)
 Existing patent advantages can be circumvented by new and distinct, yet
substitutable products

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 New resources can be found  

Desirability

Comments on resource ownership, patents, and licensing imply undesirable connotations  

3).Monopoly Demand Curve

The demand curve in a monopoly is down-sloping - This implies that the monopolist
cannot sell more without lowering the price.

Price Exceeds Marginal Revenue

Marginal revenue is less than price for every level of output except for the first

Why?

1. Price cuts apply to both extra output sold as well as all other units of output, which
could have been sold at a higher price
2. The monopolist must lower price to boost sales

 When marginal revenue is positive - total revenue is increasing

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 When marginal revenue is negative - total revenue is decreasing  

4). Price Elasticity

 When demand is elastic, a decline in price will increase total revenue

 When demand is inelastic, a decline in price will reduce total revenue
 The profit-maximizing monopolist will always want to avoid the inelastic segment of
its demand curve
 By lowering price into inelastic range, total revenue will decline  

 Monopoly Output and Price Determination

MR = MC Rule - this tells us that maximum profit/minimum loss will occur if we produce
where MR = MC

How to determine economic profit:

 find quantity where MC = MR

 find the corresponding quantity on the demand curve
 draw a line down to the ATC curve
 draw a rectangle to the y-axis
 the area of this rectangle is economic profit  

Losses occur when ATC exceeds demand

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There is no supply curve in a monopoly. Why?

 There is no unique relationship between price and quantity supplied

 There is only one producer  

Misconceptions Concerning Monopoly Pricing

 The monopolist will not charge the highest price possible

 The monopoly will charge the price where total profit is greatest
 Monopolists want to maximize total profit, not unit profit

5).Economic Effects of Monopoly

Price, Output, and Efficiency

The monopolist will find it profitable to sell a smaller output and to charge a higher price
than would a competitive producer

Competitive markets seek to optimize allocative and productive efficiency.  Monopolistic

markets seek to optimize profits

Therefore, monopolies never achieve allocative or productive efficiency  

Income Distribution :Monopolists generally charge a higher price than a competitive firm
with the same costs.  Thus, monopolies earn much more economic profit

Thus, the owners of the monopolistic enterprise are enriched at the expense of society 

X-inefficiency :Occurs when a firm's actual costs of producing any output are greater than
the minimum possible costs.  For example, at quantity Q1, a produces at ATCx when it
could produce at ATCm.

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 Monopolists are sheltered from competitive forces by entry barriers.  Thus, this
allows X-inefficiency to occur
 In competitive markets, firms are continually under pressure from rivals.  Thus, X-
inefficiency does not occur 

Rent-seeking Expenditures

 Rent seeking behavior refers to activities designed to transfer income or wealth to a

particular firm or resource supplier at someone else's expense
 Example: Monopolies spend lots of money lobbying for legislation that allows
monopolies to hold their privileged position.  This increases costs, but not output. 
This is a rent-seeking expenditure  

Dynamic Efficiency

 Dynamic efficiency considers whether monopolists are more likely to develop more
efficient techniques over time than competitive firms.

The Competitive Model

 There is little or no technological progress in a purely competitive market because

there are no economic profits, which are a large incentive to produce new
technology.

The Monopoly Model

 "Does not promote advancement" view

o Because monopolies make a large economic profit, there is no incentive to
change the status quo.  As a result, firms do not develop new technology.
 "Does promote advancement" view
o Monopolies are more willing to develop new technology because doing so
lowers costs and expands profits.  Monopolies can develop new technology

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without the fear of competitors.  

Price Discrimination

 Price discrimination occurs when a given product is sold at more than one price,
and these price differences are not justified by cost differences
 Price discrimination is workable under three conditions

1. The seller possesses some degree of monopoly power

2. The seller must be able to segregate buyers into separate classes
3. The original purchaser cannot resell product or service

6). Consequences

1.       Monopolists that practice price discrimination get more profit

2.       Price-discriminating Monopolists produce more output

When a monopolist lowers the price, the reduced price applies only to
additional unit sold and not to prior units.  Hence, price and marginal
revenue are equal.  Therefore, the demand curve and marginal
revenue curves will coincide.  This allows the monopolist to produce
more output to receive maximum profit.

3.       More allocative efficiency is attained   

7). Regulated Monopoly

When the government regulates monopolies, there are two prices the government
can choose from.

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Socially Optimal Price: P = MC

 if government sets the price, the monopolist will choose its profit maximizing output
 there is allocative efficiency

"Fair-Return" Price: P = ATC

 firm will only realize a normal profit

8.5 Monopolistic Competition

The concept of Monopolistic Competition is concerned with the common form of a market
and its competitions. Monopolistic Competition is present in various industrial sectors such
as apparels, restaurants, footwear, food and in the service sectors as well

Monopolistically competitive markets: Distinctive features

A. In a monopolistically competitive market, there is abundance of both producers

and consumers.
B. The purchasing preferences of the customers are clearly expressed in a
monopolisticaly competitive market.
C. To survive in a monopolistically competitive market, each seller tries to distinguish
his products from that of other competitors, for increasing their saleabilities.
D. The entry and exit to a monopolistically competitive market is subject to certain
restrictions.
E. Here, the producers are endowed with considerable power to regulate the market
prices.
F. Monopolistic competitive market is essentially heterogeneous in nature.
G. Such market leads to the rise of non-price competitions.
H. At equilibrium, firms reach a zero economic profit situation where no firm enters
or exits the industry. A positive profit will imply increase in the number of firms in
the industry, and vice versa is the case for negative profit. This allow the firms to
exert substantial influence over the existing market by increasing the prices and not

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losing any consumer.

I. The production of goods in a monopolistically competitive market never act as
ideal substitutes, but as close substitutes .

The Short Run

In the short run, then, the monopolistically competitive firm faces limited competition.
There are other firms that sell products that are good, but not perfect, substitutes for the
firm's own product. In the words of British economist Joan Robinson, every firm has a
monopoly of its own product. When the product is differentiated, that means the firm has
some monopoly power -- maybe not much, if the competing products are close substitutes,
but some monopoly power, and that means we must use the monopoly analysis, as if Figure
1 below.

Figure 1: Monopolistic Competition

We see that, as usual in monopoly analysis, the marginal revenue is less than the price. The
firm will set its output so as to make marginal cost equal to marginal revenue, and charge
the corresponding price on the demand curve, so that in this example, the monopoly sells
1000 units of output (per week, perhaps) for a price of $85 per unit.

But this is just a short run situation. We see that the price is greater than the average cost
(which is $74 per unit, in this case) giving a profit of $11,000 per week. We remember too
that this is economic profit -- net of all implicit as well as explicit costs -- so this profitable
performance will attract new competition in the long run. What that means is that new
firms will set up, and existing firms will change their products, so that there will be more,
and closer, substitutes in the long run. That will shift the demand for this firm's profits
downward, and perhaps cause the cost curves to shift upward as well, squeezing the profit
margins.

The Long Run

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In monopolistic competition, when one firm or product variety is profitable, it will attract
more competition -- more substitutes and closer substitutes for the profitable product type.
Thus, demand will shift downward and (perhaps) costs will increase. This will go on as
long as the firm and its product type remain profitable. A new "long run equilibrium" is
reached when (economic) profits have been eliminated. This is shown in Figure 2:

Figure 2

In this example, the firm can break even by selling 935 units of output at a price of $76 per
unit. The profit -- zero -- is the greatest profit the firm can make, so profit is being
maximized (as usual) with the output that makes MC=MR.

Zero (economic) profit is also the condition for long run equilibrium in a p-competitive
industry. But this equilibrium is not the ideal that the long run equilibrium in a p-
competitive industry is. Many economists feel that the long run equilibrium in a
monopolistic industry has some problems:

Inefficiency

Notice that, either in the long run or in the short, the price is greater than marginal
cost. But the condition for efficient production is that price is equal to marginal
cost. Thus, an individual firm's output is less that would be efficient, according to
the traditional standard.

Excess capacity

We see that, in the long run, the firm is not producing at the bottom of its long run
average cost curve. Instead, it is operating on a scale that is smaller and less
efficient -- the firm has a capacity to produce more at a lower average cost. To put it
a little differently, each firm is serving a market that is too small, and there are too

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many firms, so that the product group as a whole has the capacity to serve more
customers than there are -- excess capacity.

Advertising and non price competition

A firm in a p-competitive industry will not advertise at all. Why should they? The
p-competitive firm can sell all it wants to sell, without cutting its price, so why spend
money to get more customers? But the monopolistically competitive firm cannot sell
all it wants without cutting its price, and advertising to get more customers may be
more profitable than cutting price. Thus, economists expect to see monopolistic
competition associated with advertising. Moreover, advertising seems to go along
with differentiated products, and as a profitable firm attracts more competition,
with more substitutes and closer substitutes for their product, the firm may feel that
it needs to spend more on advertising. (That's why the cost curve could be higher in
a long run equilibrium). In this context, advertising is seen as wasteful.

Of course, all of this is controversial. Some economists have been quite critical of the idea
of monopolistic competition from the start. Here are some responses the critics might make
to these points.

Inefficiency

While the hypothetical monopolistically competitive firm does operate inefficiently,

it doesn't miss efficiency by much. The deviation of marginal cost from marginal
price, and of the firm's production and price from the efficient, p-competitive
quantities could be only a few percent -- less than we can detect in practice. Thus,
despite the differentiation of products, the p-competitive theory may be a "good
enough" approximation, especially in the long run.

Excess capacity

Again, for concreteness, let's think of hairdressing as a typical instance of

"monopolistic competition." What this is telling us is that if some of the existing
hairdressing enterprises were combined, so that there would be fewer hairdressers
each serving a larger market, they could serve that market at a lower cost and
price. Perhaps; but some consumers would lose out, since they would have to go
further from their homes or offices to find the nearest hairdresser. More generally,
getting rid of "excess capacity" means sacrificing variety -- and that's a loss. Whose
favorite is to be eliminated?

Advertising and non price competition

Actually, advertising is common in most industries, however, competitive -- as a

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disequilibrium event. When price is a little above equilibrium, it makes sense for a
competitive firm to include advertising it its competitive mix; but when price
competition brings the price down to its equilibrium level, sellers no longer have
any reason to compete for buyers -- either by price cuts or advertising or any other
way. In the real world, a competitive industry is always reacting to changing events,
always moving toward the equilibrium -- but it may never stay there for very long.
And this advertising is useful, in keeping consumers up to date about their
opportunities. So it is not clear that monopolistically competitive advertising is
something to be concerned about.

As we have seen before, economic theory favors price competition, while nonprice
competition -- by advertising and other means -- is often seen as a mixed bag of good and
bad. But some economists claim that monopolistic competition promotes a particularly
unfortunate kind of nonprice competition. Here's the idea:

Increasing Product Differentiation

A monopolistically competitive firm faces competition from other products that are good
substitutes for its own product type. One way that it might be able to improve its profit
margins is by changing its product type so that the other products are less substitutable for
it. This is "increasing the differentiation of the product" or "(further) differentiating the
product," and may be accomplished by creating marketing, engineering redesign, or other
means.

How does "increasing the differentiation of the product" work in the model of
monopolistic competition? Thinking back to the section on elasticity, we recall

 The more and the closer substitutes there are for a product, the more elastic the
demand for that product is.

So, if the effort to differentiate the product is successful, the elasticity of demand for the
product will be decreased. In turn, we recall

 A less elastic demand is correlated with a steeper demand curve.

So we can visualize a more differentiated product as having a steeper demand curve.

That's the idea behind Figure 3:

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Figure 3

In the figure, the firm has succeeded in further differentiating its product, (starting from
the long-run equilibrium we saw before) without losing any of their customers. This
substitutes the lighter green New Demand curve for the old demand curve D. As a result,
referring to the new marginal revenue curve (which is not shown, to keep this complicated
diagram from being any more complicated) the firm will maximize profits by selling 642.5
units at $110 each for profits somewhat over $70,000 at an average cost of $90 per unit.
That compares with zero profits in the long run equilibrium on demand curve D -- not
bad!

But, of course, it is still a short run gain. In the long run, the new product type will attract
new competition, and profits will again be eroded. That's life in a competitive business.
Profits in the short run beats no profits at all.

All the same, let's take a look at the long run.

A. Drawbacks of the monopolistic competitive markets:

B. Monopolistic competitive markets are inefficient in handling the cost of the
regulating prices of each sold good. This is because the output of the
concerned firms involves substantial production costs.
C. Such markets are known for extensive promotions of advertisements for the
sake of developing brand names, making the consumers unnecessarily
spendthrifts. Moreover, this also increases the expenditure on unnecessary
advertising-related activities .

8.6 OLIGOPOLY:
A market structure characterized by a small number of large firms that dominate the
market, selling either identical or differentiated products, with significant barriers to entry
into the industry. This is one of four basic market structures. The other three are perfect
competition, monopoly, and monopolistic competition. Oligopoly dominates the modern

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economic landscape, accounting for about half of all output produced in the economy.
Oligopolistic industries are as diverse as they are widespread, ranging from breakfast
cereal to cars, from computers to aircraft, from television broadcasting to
pharmaceuticals, from petroleum to detergent.
Oligopoly is a market structure characterized by a small number of relatively large firms
that dominate an industry. The market can be dominated by as few as two firms or as
many as twenty, and still be considered oligopoly. With fewer than two firms, the industry
is monopoly. As the number of firms increase (but with no exact number) oligopoly
becomes monopolistic competition.

Because an oligopolistic firm is relatively large compared to the overall market, it has a
substantial degree of market control. It does not have the total control over the supply side
as exhibited by monopoly, but its capital is significantly greater than that of a
monopolistically competitive firm.

Relative size and extent of market control means that interdependence among firms in an
industry is a key feature of oligopoly. The actions of one firm depend on and influence the
actions of another. Such interdependence creates a number of interesting economic issues.
One is the tendency for competing oligopolistic firms to turn into cooperating oligopolistic
firms. When they do, inefficiency worsens, and they tend to come under the scrutiny of
government. Alternatively, oligopolistic firms tend to be a prime source of innovations,
innovations that promote technological advances and economic growth.

Like much of the imperfection that makes up the real world, there is both good and bad
with oligopoly. The challenge in economics is, of course, to promote the good and limit the
bad.

Characteristics

The three most important characteristics of oligopoly are: (1) an industry dominated by a
small number of large firms, (2) firms sell either identical or differentiated products, and
(3) the industry has significant barriers to entry.

 Small Number of Large Firms: An oligopolistic industry is dominated by a small

number of large firms, each of which is relatively large compared to the overall size
of the market. This generates substantial market control, the extent of market
control depending on the number and size of the firms.
 Identical or Differentiated Products: Some oligopolistic industries produce identical
products, while others produce differentiated products. Identical product
oligopolies tend to process raw materials or intermediate goods that are used as
inputs by other industries. Notable examples are petroleum, steel, and aluminum.
Differentiated product oligopolies tend to focus on consumer goods that satisfy the
wide variety of consumer wants and needs. A few examples of differentiated
oligopolistic industries include automobiles, household detergents, and computers.
 Barriers to Entry: Firms in a oligopolistic industry attain and retain market control

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through barriers to entry. The most common barriers to entry include patents,
resource ownership, government franchises, start-up cost, brand name recognition,
and decreasing average cost. Each of these make it extremely difficult, if not
impossible, for potential firms to enter an industry.

Behavior

Although oligopolistic industries tend to be diverse, they also tend to exhibit several
behavioral tendencies: (1) interdependence, (2) rigid prices, (3) nonprice competition, (4)
mergers, and (5) collusion.

 Interdependence: Each oligopolistic firm keeps a close eye on the activities of other
firms in the industry. Decisions made by one firm invariably affect others and are
invariably affected by others. Competition among interdependent oligopoly firms is
comparable to a game or an athletic contest. One team's success depends not only
on its own actions but on the actions of its competitor. Oligopolistic firms engage in
competition among the few.
 Rigid Prices: Many oligopolistic industries (not all, but many) tend to keep prices
relatively constant, preferring to compete in ways that do not involve changing the
price. The prime reason for rigid prices is that competitors are likely to match price
decreases, but not price increases. As such, a firm has little to gain from changing
prices.
 Nonprice Competition: Because oligopolistic firms have little to gain through price
competition, they generally rely on nonprice methods of competition. Three of the
more common methods of nonprice competition are: (a) advertising, (b) product
differentiation, and (c) barriers to entry. The goal for most oligopolistic firms is to
attract buyers and increase market share, while holding the line on price.
 Mergers: Oligopolistic firms perpetually balance competition against cooperation.
One way to pursue cooperation is through merger--legally combining two separate
firms into a single firm. Because oligopolistic industries have a small number of
firms, the incentive to merge is quite high. Doing so then gives the resulting firm
greater market control.
 Collusion: Another common method of cooperation is through collusion--two or
more firms that secretly agree to control prices, production, or other aspects of the
market. When done right, collusion means that the firms behave as if they are one
firm, a monopoly. As such they can set a
monopoly price, produce a monopoly Kinked-Demand Curve
quantity, and allocate resources as
inefficiently as a monopoly. A formal
method of collusion, usually found among
international produces is a cartel.

Kinked-Demand Curve

Short-run production activity of an oligopolistic

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firm is often illustrated by a kinked-demand curve, such as the one presented in the exhibit
to the right. A kinked-demand curve has two distinct segments with different elasticities
that join to form a kink. The primary use of the kinked-demand curve is to explain price
rigidity in oligopoly. The two segments are: (1) a relatively more elastic segment for price
increases and (2) a relatively less elastic segment for price decreases. The relative
elasticities of these two segments is directly based on the interdependent decision-making
of oligopolistic firms.

The kink of the demand curve exists at the current quantity (Qo) and price (Po).

 Because competing firms ARE NOT likely to match the price increases of an
oligopolistic firm, the firm is likely to loose customers and market share to the
competition. Small price increases result in relatively large decreases in quantity
demanded.
 However, because competing firms ARE likely to match the price decreases of an
oligopolistic firm, the firm is unlikely to gain customers and market share from the
competition. Large price decreases are needed to gain relatively small increases in
quantity demanded.

Each segment of the demand curve has its own marginal revenue segment. This actually
means that the marginal revenue curve facing an oligopolistic firm, labeled MR in the
exhibit, contains three distinct segments.

 Top Segment: The flatter top portion of the marginal revenue corresponds to the
more elastic demand generated by price increases.
 Bottom Segment: The steeper bottom portion of the marginal revenue corresponds
to the less elastic demand generated by price decreases.
 Middle Segment: The vertical middle segment connecting the top and bottom
segments that occurs at the output quantity Qo corresponds with the kink of the
curve.

The vertical segment is key to the analysis of short-run production by an oligopolistic firm.
It means that the firm can equate marginal revenue with marginal cost, and thus maximize
profit, even though marginal cost increases or decreases. If marginal cost increases a bit,
the profit-maximizing price and quantity remain at Po and Qo. If marginal cost decreases
a bit, the profit-maximizing price and quantity also remain Soft Drink Advertising
at Po and Qo.

Game Theory:

A technique often used to analyze interdependent behavior

among oligopolistic firms is game theory. Game theory
illustrates how the choices between two players affect the
outcomes of a "game." This analysis illustrates two firms
cooperating through collusion are better off than if they
compete.

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The exhibit to the right illustrates the alternative facing two oligopolistic firms, Juice-Up
and OmniCola, as they ponder the prospects of advertising their products.

 In the top left quadrant, if OmniCola and Juice-Up BOTH decide to advertise, then
each receives $200 million in profit.
 However, in the lower right quadrant, if NEITHER OmniCola or Juice-Up decide
to advertise, then each receives $250 million in profit. They receive more because
they do not incur any advertising expense.
 Alternatively, as shown in the lower left quadrant, if OmniCola advertises but
Juice-Up does not, then OmniCola receives $350 million in profit and Juice-Up
receives only $100 in profit. OmniCola receives a big boost in profit because its
advertising attracts customers away from Juice-Up.
 But, as shown in the top right quadrant, if Juice-Up advertises and OmniCola does
not, then Juice-Up receives $350 million in profit and OmniCola receives only $100
in profit. Juice-Up receives a big boost in profit because its advertising attracts
customers away from OmniCola.

Game theory indicates that the best choice for OmniCola is to advertise, regardless of the
choice made by Juice-Up. And Juice-Up faces EXACTLY the same choice. Regardless of
the decision made by OmniCola, Juice-Up is wise to advertise.

The end result is that both firms decide to advertise. In so doing, they end up with less
profit ($200 million each), than if they had colluded and jointly decided not to advertise
($250 million each).

The Bad of Oligopoly

Like much of life, oligopoly has both bad and good. The bads are that oligopoly: (1) tends
to be inefficient in the allocation of resources and (2) promotes the concentration, and thus
inequality, of income and wealth.

 Inefficiency: First and foremost, oligopoly does NOT efficiently allocate resources.
Like any firm with market control, an oligopoly charges a higher price and
produces less output than the efficiency benchmark of perfect competition. In fact,
oligopoly tends to be the worst efficiency offender in the real world, because perfect
competition does not exist, monopolistic competition inefficiency is minor, and
monopoly inefficiency has the potential for being so bad that it is inevitably subject
to corrective government regulation.
 Concentration: Another bad is that oligopoly tends to increase the concentration of
wealth and income. This is not necessarily bad, but it can be self-reinforcing and
inhibit pursuit of the microeconomic goal of equity. While the concentration of
wealth is not bad unto itself, such wealth can then be used (or abused) to exert
influence over the economy, the political system, and society, which might not be

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beneficial for society as a whole.

The Good of Oligopoly

With the bad comes a little good. The two most noted goods from oligopoly are (1) by
developing product innovations and (2) taking advantage of economies of scale.

 Innovations: Of the four market structures, oligopoly is the one most likely to
develop the innovations that advance the level of technology, expand production
capabilities, promote economic growth, and lead to higher living standards.
Oligopoly has both the motive and the opportunity to pursue innovation. Motive
comes from interdependent competition and opportunity arises from access to
abundant resources.
 Economies of Scale: Oligopoly firms are also able to take advantage of economies of
scale that reduce production costs and prices. As large firms, they can "mass
produce" at low average cost. Many modern goods--including cars, computers,
aircraft, and assorted household products--would be significantly more expensive if
produced by a large number of small firms rather than a small number of large
firms.

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