UNIT 1

 Management Theories – Frederick Taylor

The Father of Scientific Management, Frederick Taylor, attempted to use systematic study in
order to find the single best way of doing a task. He laid down the following four principles

I. Develop a science for each aspect of work. study and analyze it to find the single best
way to do the work.
II. Ensure that the selection of workers is based on a scientific methodology and not on
nepotism and favoritism. Also, train, teach and develop the workforce allowing them to
reach the optimum potential.
III. create an environment of cooperation with them to ensure the implementation of
scientific principles.
IV. Divide all work and responsibility equally between the workers and the management.

He also recommended the use of incentives for employee motivation.

management is an art of getting things done, by others.

One of the earliest scientists of management Henri Fayol has laid down 14 principles of
Management

 Management Theories – Max Weber and Henri Fayol

Max Weber introduced the idea of bureaucratic organizations to the world. , bureaucracy is the
exercise of control based on knowledge, expertise, and/or experience.

He proposed that organizations must adopt policies which are fair as opposed to favoritism-
based, professional managers must supervise the organization rather than company owners. some
principles to guide the management of an organization:

 Qualification-based hiring 
 Merit-based promotion – Managers decide on promotions and base their decisions on
experience or achievement.
 Chain of command – Organizations must have a structure wherein each position reports
and is accountable to a higher position. Also, create a complaints process to protect the
rights of workers in lower positions.
 Division of labor – Responsibilities, tasks, and authority is equally divided and clearly
defined.
 Impartiality – Regardless of the position or status of an employee, all rules and
regulations must apply to all members of the organization.
 Recording in writing – Record every single administrative act, decision, rule or
procedure in writing.
 Owners are not managers – The owners of a company should not manage it.
 Henri Fayol
The Father of Modern Management Theory, Henri Fayol, proposed a theory of general
management which is applicable to all types of fields and administration. He divided all
activities of an industrial enterprise in the following six groups:

1. Technical activities pertaining to production

2. Commercial activities (buying/selling)
3. Financial activities pertaining to the optimum utilization of capital
4. Accounting activities (final accounts, costs, statistics, etc.)
5. Security-related activities (protecting the premises)
6. Managerial activities
Of these, Fayol focused his work on describing and explaining managerial activities. He grouped
managerial functions around the activities of planning, organizing, commanding, coordinating,
and controlling. His14 principles of management:

1. Division of Work
2. Authority and Responsibility
3. Discipline
4. Unity of Command
5. Unity of Direction: If there are a group of tasks with a common objective, then there
must be a single head and a single plan.
6. Subordination: Individual interest is secondary to the general interest.
7. Remuneration
8. Centralization: The organization must decide about the amount of authority that the
higher levels would retain or dispersed in the organization.
9. Scalar Chain: The relations between the superiors and subordinates should be short-
circuited and not detrimental to the business.
10. Order: All employees and process must have an appointed place.
11. Equity: Managers must strive for equity and equality of treatment while dealing with the
employees, combination of kindness and justice.
12. Stability of Tenure of Personnel: Managers must try to reduce employee turnover.
13. Initiative: Managers must take initiatives.
14. Espirit de Corps: emphasis on teamwork and effective communication for achieving it.
  Key Roles in Management
Henri Fayol’s 14 principles of Management also segregated the function of management into
five distinct roles,

 Forecasting and Planning
 Organizing
 Commanding, Leading
 Coordinating
 Controlling

Behavioralists, Sociologists, and Psychologists

Many behavioralists believed that the study of management must concern itself with human
behavior in organizations, effectiveness of an organization relies on the quality of the
relationship among the people working in it. , manager’s ability to develop interpersonal
competence among its members.

behavioral approach to management drew attention to a lot of socio-psychological aspects like

the dynamics of organizational behavior, groups, organizational conflict, change, and techniques
of organizational development.

Systems Approach
The systems approach defines a system as a set of interdependent and inter-related parts arranged
meticulously to produce a unified whole, systems are of two types – Open and Closed. An open
system recognizes the dynamic interaction with the environment (suppliers, labor unions,
customers, etc.). in a closed system, the environment has no influence on it.

Difference between Administration and Management

Administration Management

Policy Making Policy Implementation

Legislative and largely determinative functions Executive and governing functions

Usually, administration concerns with planning Usually, management concerns with motivating
and organizing functions and controlling functions

Typically, the Board of Directors is concerned Personnel below the Directors are concerned
with the administration with the management

Objectives of Management

1. Economic objectives
(a) Earning Profit
b) Production of Goods
c) Creating Markets
d) Technological Development
2. Human Objectives
(a) Employees Welfare
b) Satisfaction of customers
(c) Shareholders satisfaction
3. Social objectives
(a) Availability of goods
b) Quality of goods and services
d) Creating job opportunities
(e) Natural resources

Importance of Management

1. Reduces Costs – It gets maximum output through least input by proper planning.
2. Establishes Equilibrium –  it enables the organization to sustain in a dynamic
environment.
3. Establishes Sound Organization – in relation to the objective of the company.for the
fulfillment of this, it sets up effective authority.

Management Skills

 Planning
 Controlling
 Organizing
 Leading
  Managerial Roles

Mintzberg categorized all activities into ten managerial roles performed over the course of a
day. These are as follows:

 Skills of an Effective Manager

Organizational Skills: The manager must be capable of organizing resources to utilize them

fully.
Technical Skills: knowledge about processes, equipment, techniques etc. and also the ability to
carry them out, about certain specific task or job.
Human Skills: This will include his ability to work, motivate, communicate, direct and
understand people.An effective manager has good ‘people skills’ and so is able to manage his
relations with all these people.

Conceptual Skills: involve understanding and visualizing the company as a whole, manager is
able to see and understand all the working parts of an organization and understand how these
pieces fall together, solve the problems he is faced with more creatively and effectively.
a few other qualities or skills a manager must have.

 Decision-making skills
 Administrative skills
 Behavioral skills
 Leadership Skills
 Analytical Skills
  Tasks and Responsibilities of Professional Managers
1. Envisioning Goals: visions and missions,
2. Managing Growth: There are both internal and external factors that are a threat to this
growth and survival of the firm.
3. Improving and Maintaining Efficiency: resources are not being wasted, efficiency has to
be effectively maintained.
4. Innovation: He must find new and creative solutions to the problems faced by the firm.
Innovation not only means having new ideas but also cultivating and implementing them.
5. Looking out for the competition: plan and prepare for the competition in the market.
6. Leadership
7. Change Management: to ensure the process of change is smooth
8. Choosing correct Information Technology

 Different experts have classified functions of management. According to George &

Jerry, “There are four fundamental functions of management i.e. planning, organizing,
actuating and controlling”.
According to Henry Fayol, “To manage is to forecast and plan, to organize, to command, & to
control”.
Whereas Luther Gullick has given a keyword ’POSDCORB’ where P stands for Planning, O
for Organizing, S for Staffing, D for Directing, Co for Co-ordination, R for reporting & B for
Budgeting.
But the most widely accepted are functions of management given by KOONTZ and
O’DONNEL i.e. Planning, Organizing, Staffing, Directing and Controlling.

1. Planning: According to KOONTZ, “Planning is deciding in advance - what to do,

when to do & how to do. It bridges the gap from where we are & where we want to be”.

2. Organizing: According to Henry Fayol, “To organize a business is to provide it with

everything useful or its functioning i.e. raw material, tools, capital and personnel’s”..
Organizing as a process involves:
1. Identification of activities.
2. Classification of grouping of activities.
3. Assignment of duties.
4. Delegation of authority and creation of responsibility.
5. Coordinating authority and responsibility relationships.

3. Staffing: According to Kootz & O’Donell, “Managerial function of staffing involves

manning the organization structure through proper and effective selection, appraisal &
development of personnel to fill the roles designed un the structure”. Staffing involves:
1. Manpower Planning (estimating man power in terms of searching, choose the
person and giving the right place).
2. Recruitment, Selection & Placement.
3. Training & Development.
4. Remuneration.
 5.Performance Appraisal.
6. Promotions & Transfer.
7. Directing: Supervision, Motivation, Leadership
4. Controlling

According to Theo Haimann, “Controlling is the process of checking whether or not

proper progress is being made towards the objectives and goals and acting if necessary,
to correct any deviation”.

According to Koontz & O’Donell “Controlling is the measurement & correction of

performance activities of subordinates in order to make sure that the enterprise
objectives and plans desired to obtain them as being accomplished.
Communication
It is a process of creating and sharing ideas, information, views, facts, feelings, etc. among the
people to reach a common understandingA manager may be highly qualified and skilled but if he
does not possess good communication skills, all his ability becomes irrelevant.

Communications Process

1. Sender
2. Message
3. Encoding:The message generated by the sender is encoded symbolically such as in the form
of words, pictures, gestures, etc. before it is being conveyed.
4. Media:It is the manner in which the encoded message is transmitted. The message may be
transmitted orally or in writing. The medium of communication includes telephone, internet,
post, fax, e-mail, etc.
5.Decoding:It is the process of converting the symbols encoded by the sender. After decoding
the message is received by the receiver.
6. Receiver
7. Feedback
8. Noise:It refers to any obstruction that is caused by the sender, message or receiver

Importance of Communication

1. The Basis of Co-ordination

2. Fluent Working
3. The Basis of Decision Making
4. Increases Managerial Efficiency
5. Increases Cooperation and Organizational Peace
6. Boosts Morale of the Employees

 Types of Communication

1. Formal Communication: flows through the official channels ,may take place between a
superior and a subordinate, a subordinate and a superior or among the same cadre employees or
managers,can be oral or in writing and are generally recorded and filed in the office.
further classified as Vertical communication and Horizontal communication.

Vertical Communication: flows vertically upwards or downwards through formal channels

Horizontal Communication: between one division and another. For example, a production
manager may contact the finance manager

 Types of communication networks in formal communication:

 Single chain:  flows from every superior to his subordinate through a single chain.
 Wheel:  all subordinates under one superior communicate through him only. They are
not allowed to talk among themselves.
 Circular:  communication moves in a circle. Each person is able to communicate with
his adjoining two persons only.
 Free flow:  each person can communicate with any other person freely.
 Inverted V:  a subordinate is allowed to communicate with his immediate superior as
well as his superior’s superior also. However, in the latter case, only ordained
communication takes place.
2. Informal Communication: without following the formal channels of communication, often
referred to as the ‘grapevine’ as it spreads throughout the organization and in all directions .it
spreads rapidly, often gets distorted and it is very difficult to detect the source of such
communication.
Types of Grapevine network:

 Single strand:  each person communicates with the other in a sequence.

 Gossip network:  each person communicates with all other persons on a non-selective
basis.
 Probability network: the individual communicates randomly with other individuals.
 Cluster Network:   the individual communicates with only those people whom he
trusts. Out of these four types of networks, the Cluster network is the most popular in
organizations.

Barriers to Communication

1. Semantic Barriers: concerned with the problems and obstructions in the process of encoding
and decoding of a message into words or impressions. such barriers result due to use of wrong
words, faulty translations, different interpretations, etc.

2. Psychological Barriers: Emotional or psychological factors ,The state of mind of both

sender and receiver of communication

3. Organizational Barriers: organizational structure, rules and regulations authority

relationships, highly centralized pattern, people may not be encouraged to have free
communication.
4. Personal Barriers:The personal factors of both sender and receiver ,If a superior thinks that a
particular communication may adversely affect his authority, he may suppress such
communication, Also, if the superiors do not have confidence in the competency of their
subordinates, they may not ask for their advice.
 7 C’s of communication:

1. Concise
2. Clear
3. Correct
4. Concrete: idea of being clear and particular. Concreteness is supported by figures and
facts.
5. Complete
6. Courteous: individual while sending the message should be polite, sincere, enthusiastic,
and reflective.
7. Coherent: messages that you send should be logical.

 Need and Characteristics for Communication

1. cannot be achieved through the one-way process. It is a two-way process. The

information and the ideas that you are conveying should also be heard and understood.

2.The communication is available at all levels of management and in all types of

organization

3. basic purpose for communication is to give and serve the information, and thus
influencing the actions of the others, nonverbal communication is also as important as the
verbal one

4. communication can be done through gestures, signs, and symbols as well

5. The communication done at an organizational level should be goal-oriented.

many sciences which are attached with the communication to make it more and more
effective.

 Johari Window
Each window in Johari window model signifies feelings, personal information, and motivation.
the main focus is on feedback. Accepting of feedback and conveying of this feedback is done
through this model.

This information which is known to self and unknown to others can be transferred through
socializing with others. While the part that is known to others but unknown to self is conveyed
through feedback

Johari Window Quadrant 1: Open Area or Arena

behaviour, feelings, emotions about the person is known to that person itself as well as the other
members in this group., communication occurs through a two-way process., person socializes
about himself with others and constantly receives feedback

open area through this group can be increased horizontally such that the blindspot area is reduced
and vertically it is increased so that the hidden and unknown areas of a person are reduced when
that person reveals about his feeling to the other person.

Johari Window Quadrant 2: Blindspot or BlindSelf

information on your personality is known to others but that information is not known to you.,
other people may interpret your personality different than you might have expected. For efficient
communication, this area must be reduced., One way to do it is through feedback that you get
from other members in the group.

Johari Window Quadrant 3: Hidden Area or Hidden Self

Hidden area is the information that you hide from others. Here, the information is known to you
but the others are unknown to this information., information might be personal to you so that you
are reluctant to share it with others. This includes secrets, past experiences, feelings, etc

Johari Window Quadrant 4: Unknown Areas or Unknown Self

information is unknown to you as well as the others. Generally, certain feelings, talents,
information, etc fall in this area.The person, as well as the group, is unaware about this till he or
she discovers it. One way to reduce this area is through open communication.
  Barriers To Effective Communication

 Linguistic Barriers
 Psychological Barriers: mental and psychological issues, Some people have stage fear,
speech disorders, phobia, depression etc.
 Emotional Barriers: A person who is emotionally mature will be able to communicate
effectively. people who let their emotions take over will face certain difficulties.
 Physical Barriers: noise, closed doors, faulty equipment used for communication, closed
cabins, etc.
 Cultural Barriers: Different cultures have a different meaning for several basic values of
society. Dressing, Religions or lack of them, food, drinks, pets, and the general behaviour will
change drastically from one culture to another.
 Organisational Structure Barriers.
 Attitude Barriers: They are the introverts or just people who are not very social. Others
like to be social or sometimes extra clingy.
 Perception Barriers: Different people perceive the same things differently.
 Physiological Barriers: Certain disorders or diseases or other limitations. The shrillness of
voice, dyslexia, etc 
 Technological barriers
 Socio-religious barriers: In a patriarchal society, a woman or a transgender may face many
difficulties and barriers while communicating.
  Decision Making – Concept, Process, Techniques and Tools:

Process of decision making:

1. Identify the problems.

2. Defining the objectives.
3. Making a pre decision (taking a decision about how to make a decision)
4. Generating alternatives.
5. Evaluating the alternatives solutions.
6. Choice to be made.
7. Implementation of the choosen alternatives.
8. Follow up (monitoring the effectiveness of any attempted solution)

Herbert Simon described activities associated with three major statges:

1) Intelligence activity: initial phase is the attempt to recognise , understand nature of
problem , search for possible causes.
2) Design activity: during second phase , alternative courses of action are developed,
constraints analysed.
3) Choice activity: choice among available and alternatives made at this stage.

Henry Mintzberg three phase model of decision making:

Types of managerial decisions:

1. Personal and organizational decisions

2. Routine and strategic decisions:
Strategic decisions are unique, most top management policy decisions, one-time
decisions involving long-range commitments of relative permanence or duration, or
those involving large investments. Eg
 Plant location
 Organisation structure 
 Wage negotiations, product line, etc. 
Routine decisions are the everyday, highly repetitive, management decisions which by
themselves have little impact on the overall organisation.Ex:
 An accountant's decision on a new entry
 A production supervisor’s decision to appoint a new worker
 3. Programmed and non programmed decisions: Programmed Decisions: Routine
/ Repetitive Decisions - Handled through Standard Operating Procedures

Non-programmed Decisions:   Unique / One-shot decisions - Must  be made by

managers  using available information and their own judgement.

4. Individual and group decisions.

5. Policy and operating decisions

how complex the problem is, and how much certainty of output. Considering these
two dimensions , four kinds of decision modes classified as:

1. Mechanistic: routine and repetitive in nature,

2. Analytical: involves a problem with a large number of decision variables ,

outcome of each decision alternative can be computed.

3. Judgemental: involves a problem with limited number of decision variables , but

outcomes of decision alternatives are unknown.

4. Adaptive: it involves a problem with large number of decision variables,

outcomes are not predictable, because of complexity and uncertainty of problems
decision makers are not able to agree on their nature or decision strategies.

Models of decision making:

1. Contingency model:
Beach & Mitchell felt that decision makers use three general decision strategies:
 Aided analytic: it employs some sort of formal model or formula or an aid such as
checklist.
 Unaided analytic: decision maker is very systematic in his approach , perhaps
follows some sort of model.
 No analytic: Decision makers chooses by habit or uses some simple rule of thumb
( better safe than sorry) to make the choice.

2. Economic man or Econologic model:

This model assumes that people are economically rational , attempt to maximise
outcomes , select the decision which has payoff among other alternatives.
 3. Administrative man model:
Presented by Simon , also called Bounded Rationality Model. This model assumes that
people while seeking best solution usually settle for much less because decisions they
confront demands greater information processing capabilities than they possess. This
model involves three steps:
 Sequential attention to alternatives solutions.
 Use of heuristics: it is a rule which guides search for alternatives into areas that
have high probability for yielding satisfactory solutions.
 Satisfying.

4. Implicit favourite model or Gamesman model:

This model deals primarily with non-programmed decisions (decisions that are novel
or Unique / One-shot decisions), made in intuitive fashion. By doing so, the individual
becomes convinced that he or she is acting in a rational fashion and making a logical,
reasoned decision on an important topic.

The implicit favourite model developed by Soelberg (1967),

5. Social man model.

DECISION MAKING UNDER DIFFERENT STATES OF NATURE:

1. Decision Under Certainty: When a manager knows the precise outcome associated
with each possible alternative or course of action.

2. Decision Under Risk: When a single action may result in more than one potential
outcome, but the relative probability of each outcome is known. For ex A quality control
inspector, for example, might determine the probability of number of `rejects' per production
run.
3. Decision Under Uncertainty: When a single action may result in more than one
potential outcome, but the relative probability of each outcome is unknown. Ex On a personal
level, the selection of a job from among alternatives is a career decision that incorporates a
great deal of uncertainty.

Identification of alternatives:
1, Brainstorming , developed by Alex F Osborn.., to produce as many ideas as possible.
2, Synectics, developed by William J J Gordan , members are selected from different
backgrounds and trainings.
3, Nominal grouping, developed by Andre Delbecq and Andrew Van de Ven , effective in
situations requiring high degree of innovation and idea generation.

Decision Making Tools:

1.SWOT Diagram.
2) Decision Making Diagram: are graphs that enable to map out the decision you have taken.
to estimate eventual actions based on the outcomes and risks.
3) Decision Matrix: is a technique that contains values that helps you to identify and analyze
the performance of the system. The elements of a decision matrix show results depend on
specific criteria.

4) Pareto Analysis: It is also known as 80/20 rule meaning, 20% of your activities will account
for 80% of your results. It is used for prioritizing possible changes by identifying the problems
and resolve them
5) Cause and Effect or Ishikawa Diagram: shows the causes of a particular event. It can be
used for product design and to check its quality to identify possible factors causing an overall
effect.

6) Force Field Analysis: enables you to examine your project. It provides a framework for
looking at the factors that influence a particular situation.
7) Strategy Map: is a diagram that can be used to document strategic business goals. ,is
created during the planning process of business. It is used as a primary material to check-in
and review meetings.
8) Break-even analysis: A break-even analysis helps you to determine at what stage a new
business product will be profitable. It's an economic calculation used to determine the number
of products or services you need to sell to cover your costs.
9) Pugh Matrix: is a diagram that is used to evaluate alternative solutions for business. It helps
you to determine which solutions are more valuable than the others. This method does not
require a massive amount of quantitative data.
10) Ratio Analysis: Ratio analysis is a term used for comparison of items available in the
financial statements of a business. It used to evaluate a number of problems with an entity,
like its liquidity, efficiency of operation, and more.
  Organisation Structure and Design – Types, Authority, Responsibility,
Centralisation, Decentralisation and Span of Control

organisation structure is a result of the organising process. The organisation structure consists of
the various jobs, departments and responsibilities in the enterprise coupled with the definition of
the extent of control, management and authority, is a framework within which managerial and
operating tasks are performed.

 Types of Organisation Structure

 Functional Structure: based on functions, similar jobs are integrated into functions and
major functions are categorised as departments handled by respective coordinating heads.
departments further consist of sections.
 Divisional Structure: integration of independent division, adopted in large and complex
enterprises which handle diverse products, because although an organisation produces a
homogeneous set of products, it can deal in a wide variety of differentiated products.

the organisation is divided into separate business units or divisions which are a bit
independent and multifunctional .Each unit has a divisional manager at the apex who
looks after all the operations within a division.

each division performs most of the functions like production, finance etc, each enterprise is
divided into various divisions which further adapt the functional structure.

PROCESS OF ORGANISATION:
1. Identification and Division of work
2. Departmentalisation
3] Assignment of Duties
4] Establishing Reporting Relationships

Importance of Organisation

1.Benefits of Specialisation
2.Clarity in Working Relationships
3. Optimum Utilisation of Resources
4. Effective Administration & Governance
5. Development of Personnel
6. Growth and Expansion

Types of Organisation

 Formal Organisation: rules and procedures that establish work relationships among the
employees, a clear boundary of authority and responsibility.
 Informal Organisation: informal organisation is fluid , no written or predefined rules for
it., it is a complex web of social relationships, it cannot be forced or controlled by the
management.

 DELEGATION:

delegation is the downward transfer of authority from a superior to a subordinate. 

Elements of Delegation

Authority
Responsibility
Accountability

Span of control

The Span of Control is the number of employees a manager can supervise as effectively as
possible. The addition of new hierarchical layers makes the organisational structure steeper.

A large Span of Control leads to a flatter organisational structure, which results in lower costs.
A small span of control creates a steeper organisational structure, which requires more
managers and which will consequently be more expensive for the organisation. It is therefore
useful for an organisation if its managers have a large span of control.

 Managerial Economics

it can be defined as amalgamation of economic theory with business practices so as to ease

decision-making and future planning by management, it assists the managers of a firm in a
rational solution of obstacles faced in the firm's activities.

Importance Of Managerial Economics

1. Useful in Business Organization

2. Helpful in Chalking Out Business Policies

3. Help in Business Planning

4. Helpful in Cost Control

5. Useful in Coordination of Business Activities

6.Useful In Demand for Casting

7. Helpful in Profit Planning and Control

8. Helpful for Business Prediction

9. Helpful in Price Determination

10. Helpful in Solutions of Business Taxation Problems

11. Useful in Understanding the Mechanism of Economic System

12. Helpful in Analysis of Effects of Government Policies

13. Attempt to Put Out the Friendly Business

14. Supporting the Manufacture and Use of Models

15. Useful in Showing the Path of Economic Well-Being

16. Gives the Right Direction

17. Maintains of Costs

18. Distribute Profit

19. Measurement of the Efficiency of the Firm

 Demand Theory?
Demand theory is an economic principle relating to the relationship between consumer
demand for goods and services and their prices in the market. As more of a good or service is
available, demand drops and so does the equilibrium price.

Demand theory highlights the role that demand plays in price formation, while supply-side
theory favors the role of supply in the market.

Supply-side theory is an economic theory built on the concept that increasing the supply of
goods leads to economic growth.

Alfred Marshall
In 1890, Alfred Marshall's Principles of Economics developed a supply-and-demand curve
that is still used to demonstrate the point at which the market is in equilibrium.

John Locke
Philosopher John Locke is credited with one of the earliest written descriptions of this
economic principle in his 1691 publication.

Sir James Steuart

Locke did not actually use the term "supply and demand," however. Its first appearance in
print came in 1767, with Sir James Steuart's Inquiry into the Principles of Political Economy. 

Adam Smith
Adam Smith dealt extensively with the topic in his 1776 epic economic work, The Wealth of
Nations. Smith, often referred to as the Father of Economics explained the concept of supply
and demand as an "invisible hand" that naturally guides the economy.
People demand goods and services in an economy to satisfy their wants, such as food,
healthcare, clothing, entertainment, shelter, etc. The demand for a product at a certain price
reflects the satisfaction that an individual expects from consuming the product. This level of
satisfaction is referred to as utility and it differs from consumer to consumer. The demand for
a good or service depends on two factors: (1) its utility to satisfy a want or need, and (2) the
consumer’s ability to pay for the good or service. 

Built into demand are factors such as consumer preferences, tastes, choices, etc.

When supply equals demand, prices are said to be in a state of equilibrium. When demand is
higher than supply, prices increase to reflect scarcity. Conversely, when demand is lower than
supply, prices fall due to the surplus.

The Law of Demand and the Demand Curve

Gives inverse relationship between price and demand for a good or service, as the price of a
commodity increases, demand decreases, provided other factors remain constant. and vice
versa .

The demand curve has a negative slope as it downward from left to right to reflect the inverse
relationship between the price of an item and the quantity demanded over a period of time.

An expansion or contraction of demand occurs as a result of the income effect or substitution

effect. When the price of a commodity falls, an individual can get the same level of
satisfaction for less expenditure, provided it’s a normal good. In this case, the consumer can
purchase more of the goods on a given budget. This is the income effect. The substitution
effect is observed when consumers switch from more costly goods to substitutes that
have fallen in price. As more people buy the good with the lower price, demand increases.

Sometimes, consumers buy more or less of a good or service due to factors other than price.
This is referred to as a change in demand, means shift in the demand curve to the right or left
following a change in consumers’ preferences, taste, income, etc. For example, a consumer
who receives an income raise at work will have more disposable income to spend on goods in
the markets, regardless of whether prices fall, leading to a shift to the right of the demand
curve.

Supply and Demand

supply and demand are related to each other and their relationship affects the price of goods
and services. when supply exceeds demand for a good or service, prices fall. When demand
exceeds supply, prices tend to rise.

There is an inverse relationship between the supply and prices of goods and services when
demand is unchanged. If there is an increase in supply for goods and services while demand
remains the same, prices tend to fall to a lower equilibrium price and a higher equilibrium
quantity of goods and services. If there is a decrease in supply of goods and services while
demand remains the same, prices tend to rise to a higher equilibrium price and a lower
quantity of goods and services.

The same inverse relationship holds for the demand of goods and services, when demand
increases and supply remains the same, the higher demand leads to a higher equilibrium price
and vice versa.
Supply and demand rise and fall until an equilibrium price is reached. For example, suppose a
luxury car company sets the price of its new car model at $200,000. While the initial demand
may be high, due to the company creating buzz for the car, most consumers are not willing to
spend $200,000 for an auto. As a result, the sales of the new model quickly fall, creating
an oversupply and driving down demand for the car. In response, the company reduces the
price of the car to $150,000 to balance the supply and the demand for the car to ultimately
reach an equilibrium price.

Marginal Utility Analysis

 Total Utility or Full Satiety – is the sum of utility derived from different units of
a commodity consumed by a consumer. Therefore, Total Utility = the sum total of all
marginal utility.

 Marginal Utility or Marginal Satiety – is the additional utility derived from the
consumption of an additional unit of a commodity. Therefore, Marginal Utility = the
addition made to the Total Utility by consuming one more unit of a commodity.

Assumptions of Marginal Utility Analysis

1] The Cardinal Measurability of Utility

it is measurable and quantifiable, ie you derive a utility of 10 units from consuming 1 unit of
commodity A and 5 from consuming 1 unit of commodity B. can analyze which commodity
offers better utility or satisfaction, money is the measuring rod of utility,

2] The constancy of the Marginal Utility of Money

when you are spending money on a commodity, the marginal utility of money remains constant
throughout.

3] The Hypothesis of Independent Utility

It states that the total utility that you get from a collection of goods is a simple sum total of the
separate utilities of each good.

The Law of Diminishing Marginal Utility

Alfred Marshall, British Economist defines the law of diminishing marginal utility as follows:
“The additional benefit which a person derives from a given increase in the stock of a thing
diminishes with every increase in the stock that he already has.”

as we consume more and more units of a good, the intensity of our want for the good decreases.
Eventually, it reaches a point where we no longer want it, hence marginal utility declines NOT
the total utility.

Relationship between Total and Marginal utility

1. As the total utility rises, the marginal utility diminishes

2. When the total utility is maximum, the marginal utility is zero.
3. As the total utility starts diminishing, the marginal utility becomes negative.
This shows how a consumer reaches equilibrium in case of a single commodity, a consumer
utilizes a commodity until its marginal utility becomes equal to the market price.

he derives maximum satisfaction by being in equilibrium in respect of the quantity of the

commodity.

In case of a fall in the price of the commodity, the equality between marginal utility and price
gets disturbed. Therefore, the consumer will consume more units of the good leading to a fall in
the marginal utility. He continues consuming until the equilibrium is achieved, in case of a rise in
the price of the commodity, he will consume less and achieve equilibrium too.

Limitations of the Law

The law of diminishing marginal utility applies only under certain assumptions:
1. Homogeneous units – The different units of a commodity are identical in all respects.
The income, taste, temperament, habit, etc. of the consumer remains unchanged.
2. Standard units of consumption – If a man is thirsty, then water should be given in units
of a glass. If you give him a spoonful of water, then the second spoon would conceivably
have higher utility than the first.
3. Continuous consumption –there is no gap between the consumption of two units.
4. Not applicable to prestigious goods –like gold, cash, etc. where a greater quantity can
increase the lust for it.
5. Related goods – If you don’t have sugar, then you will consume less tea, utility of
goods can be affected by the absence of related goods.

Indifference Curve?

It is a curve that represents all the combinations of goods that give the same satisfaction to the
consumer, hence the consumer prefers them equally.

Indifference Map
consumer is indifferent among the combinations lying on the same indifference curve. However,
he prefers the combinations on the higher indifference curves to those on the lower ones.

This is because a higher indifference curve implies a higher level of satisfaction. Therefore, all
combinations on IC1 offer the same satisfaction, but all combinations on IC2 give greater
satisfaction than those on IC1.

Marginal Rate of Substitution

This is the rate at which a consumer is prepared to exchange a good X for Y. Considers Peter’s
example , we have the following table:

Combination Food Clothing MRS

A 1 12 –

B 2 6 6

C 3 4 2

D 4 3 1
In this example, Peter initially gives up 6 units of clothing to get an extra unit of food. Hence, the
MRS is 6. Therefore, MRS of X for Y is the amount of Y whose loss can be compensated by a
unit gain of X, keeping the satisfaction the same.

1. As Peter gets more units of food, his intensity of desire for additional units of food
decreases.
2. Most of the goods are imperfect substitutes for one another. If they could substitute one
another perfectly, then MRS would remain constant.

Properties of an Indifference Curve or IC

1) An IC slopes downwards to the right

2) An IC is always convex to the origin
as Peter substitutes clothing for food, he is willing to part with less and less of clothing. This is
the diminishing marginal rate of substitution. The rate gives a convex shape to the indifference
curve. However, there are two extreme scenarios:

1. Two commodities are perfect substitutes for each other – In this case, the indifference
curve is a straight line, where MRS is constant.
2. Two goods are perfect complementary goods –ex , gasoline and water in a car. In such
cases, the IC will be L-shaped and convex to the origin.
Indifference curves never intersect each other
Two ICs will never intersect each other. Also, they need not be parallel to each other either.
Look at the following diagram:

Since A and B lie on IC1, the give the same satisfaction level. Similarly, A and C give the same
satisfaction level, as they lie on IC2. Therefore, we can imply that B and C offer the same level
of satisfaction, which is logically absurd.
A higher IC indicates a higher level of satisfaction as compared to a lower IC
A higher IC means that a consumer prefers more goods than not.

3)An IC does not touch the axis

If the curve touches either of the axes, then it means that he is satisfied with only one commodity
and does not want the other, which is contrary to our assumption.

Budget Line

Since a higher indifference curve represents a higher level of satisfaction, a consumer will try to
reach the highest possible IC to maximize his satisfaction. In order to do so, he has to buy more
goods and has to work under the following two constraints:

1. He has to pay the price for the goods and

2. He income is limited, restricting the availability of money for purchasing these goods

a budget line shows all possible combinations of two goods that a consumer can buy within the
funds available to him at the given prices of the goods. All combinations that are within his reach
lie on the budget line.

A point outside the line (point H) represents a combination beyond the financial reach of the
consumer. On the other hand, a point inside the line (point K) represents under-spending by the
consumer.

 Consumers Equilibrium
A consumer is in equilibrium when he derives maximum satisfaction from the goods and is in no
position to rearrange his purchases.

Assumptions
 The consumer has a fixed money income and wants to spend it completely on the goods
X and Y.
 The prices of the goods X and Y are fixed for the consumer.
 The goods are homogenous and divisible.
 The consumer acts rationally and maximizes his satisfaction.
In the following figure, we depict an indifference map with 5 indifference curves – IC1, IC2, IC3,
IC4, and IC5 along with the budget line PL for good X and good Y.

R, S, Q, T, and H cost the same to the consumer. In order to maximize his level of satisfaction,
the consumer will try to reach the highest indifference curve. Since we have assumed a budget
constraint, he will be forced to remain on the budget line.

From Fig. 1, we can see that R lies on a lower indifference curve – IC1. He can easily afford the
combinations S, Q, or T which lie on the higher ICs. Even if he chooses the combination H, the
argument is similar since H lies on the curve IC1 too.

The best choice is Q , it lies on his budget line and pts puts him on the highest possible
indifference curve, IC3. While there are higher curves, IC4 and IC5, they are beyond his budget.
Therefore, he reaches the equilibrium at point Q on curve IC3.

Notice that at this point, the budget line PL is tangential to the indifference curve IC3. Also, in
this position, the consumer buys OM quantity of X and ON quantity of Y.

Since point Q is the tangent point, the slopes of line PL and curve IC3 are equal at this point.
Further, the slope of the indifference curve shows a marginal rate of substitution of X for Y
(MRSxy) equal to MUxMUy.
Hence, at the equilibrium point Q,

MRSxy = MUxMUy = PxPy
Therefore, we can say that consumers equilibrium is achieved when the price line is tangential to
the indifference curve. Or, when the marginal rate of substitution of the goods X and Y is equal
to the ratio between the prices of the two goods.

Indifference curve :

Assumption

 Utility is cardinal.
 Consumer is rational.
 Goods consumed are substitutable.
 Availability of more goods is always better.
 A consumer will have transitivity in his choice. Suppose a consumer prefer item ‘A’
over ‘B’. Also, he chooses item ‘B’ over ‘C’. Then it must prefer item ‘A’ over ‘C’.
Properties of Indifference Curve

 The indifference curve has a negative slope.

 Indifferent curves do not intersect.
 They are convex from below, i.e., convex to the origin.
 An indifference curve that lies to the right of another, yields more utility.

Marginal Rate of substitution

It is the rate at which the consumer is willing to give up commodity ‘X’ for one more unit of
commodity ‘Y’. He tries to maintain the same level of satisfaction.

M.R.S. Y X = Δ X / Δ Y, on any point on the indifference curve.

The slope (d x2 / d x1) of the tangent at any point on an indifference curve is the rate at which
x1 must be substituted for x2 or vice versa.

The negative of the slope (− d x2 / d x1) is the marginal rate of substitution of x1 for x2.
Assumptions

 The consumer is logical and knowledgeable to consume every unit of goods.

 Goods are equal in size and shape.
 No time gap between consumption.
 No change in income, preference, taste, and fashion.
 Utility is cardinal.
 Marginal unit of money is constant.
Limitations
This law doesn’t apply to

 Dissimilar units.
 Unreasonable quantity.
 Unsuitable time period.
 Rare collections like coins, stamps etc.
 Change in taste and fashion of the consumer.
 Abnormal person.
 Changing the income of the consumer.
 Habitual goods.
 Durable and valuable goods.

Types of Marginal Rate of Substitution

1.Diminishing
One can obtain it if the consumer is willing to give up less and less unit of good Y for every
additional unit of good X.

2.Constant
if, for one more unit of Y, only one unit of X is given up. It is constant for perfect substitution.

3.Increasing
Suppose a consumer substitutes a commodity X for the other commodity Y at an increasing rate
to maintain the same level of satisfaction. In this case, one can obtain an increasing marginal rate
of substitution.

 Elasticity of Demand
A change in the price of a commodity affects its demand. or the degree of responsiveness of
demand by comparing the percentage price changes .

Determinants of Demand

1] Price of the Product

an increase in demand follows a reduction in price and a decrease in demand follows an increase
in the price of similar goods. An elastic demand implies a robust change quantity accompanied
by a change in price, an inelastic demand implies that volume does not change much even when
there is a change in price.

2] Income of the Consumers

Rising incomes lead to a rise in the number of goods demanded by consumers and vice versa.
This relationship between income and demand is not linear in nature. Marginal utility determines
the proportion of change in the demand levels.

3] Prices of related goods or services

 Complementary products – An increase in the price of one product will cause a decrease
in the quantity demanded of a complementary product. Example: Rise in the price of bread
will reduce the demand for butter.
 Substitute Product – An increase in the price of one product will cause an increase in the
demand for a substitute product. Example: Rise in price of tea will increase the demand for
coffee and decrease the demand for tea.
4] Consumer Expectations
Expectations of a higher income or expecting an increase in prices of goods will lead to an
increase the quantity demanded and vice versa.

5] Number of Buyers in the Market

As the number increases, the demand rises, irrespective of changes in the price of commodities.

 Exceptions to the Law of Demand

1. Law of Demand

all conditions being equal, as the price of a product increases, the demand for that product will
decrease, and as the price of a product decreases, the demand for that product will increase.

Exceptions to the Law of Demand

It holds true in most cases. The price keeps fluctuating until an equilibrium is created. However,
there are some exceptions to the law of demand. These include the Giffen goods, Veblen goods,
possible price changes, and essential goods.

Giffen Goods
Giffen Goods is a concept that was introduced by Sir Robert Giffen. These goods are goods that
are inferior in comparison to luxury goods. However, their unique characteristic is that as its
price increases, the demand also increases.

The Irish Potato Famine is a classic example of the Giffen goods. Potato is a staple in the Irish
diet. During the potato famine, when the price of potatoes increased, people spent less on luxury
foods such as meat and bought more potatoes to stick to their diet. So as the price of potatoes
increased, so did the demand.
Veblen Goods
concept that is named after the economist Thorstein Veblen, who introduced the theory of
“conspicuous consumption“. According to him , there are certain goods that become more
valuable as their price increases. If a product is expensive, then its value and utility are perceived
to be more, and hence the demand for that product increases.

And this happens mostly with precious metals and stones such as gold and diamonds and luxury
cars such as Rolls-Royce. As the price of these goods increases, their demand also increases
because these products then become a status symbol.

The expectation of Price Change

There are times when the price of a product increases and market conditions are such that the
product may get more expensive. In such cases, consumers may buy more of these products
before the price increases any further. Consequently, when the price drops or may be expected to
drop further, consumers might postpone the purchase to avail the benefits of a lower price.

For instance, in recent times, the price of onions had increased to quite an extent. Consumers
started buying and storing more onions fearing further price rise, which resulted in increased
demand.There are also times when consumers may buy and store commodities due to a fear of
shortage.

Necessary Goods and Services

People will continue to buy necessities such as medicines or basic staples such as sugar or salt
even if the price increases. The prices of these products do not affect their associated demand.

Change in Income
Sometimes the demand for a product may change according to the change in income. If a
household’s income increases, they may purchase more products irrespective of the increase in
their price, thereby increasing the demand for the product. Similarly, they might postpone buying
a product even if its price reduces if their income has reduced.

Elasticity of Demand
“it is the percentage change in quantity demanded divided by the percentage in one of the
variables on which demand depends.”

The variables on which demand can depend on are:

 Price of the commodity

 Prices of related commodities
 Consumer’s income, etc.
Let’s look at some examples:
a. The price of a radio falls from Rs. 500 to Rs. 400 per unit. As a result, the demand
increases from 100 to 150 units.
b. Due to government subsidy, the price of wheat falls from Rs. 10/kg to Rs. 9/kg. Due to
this, the demand increases from 500 kilograms to 520 kilograms.

 Types of Elasticity of Demand

Price Elasticity
The price elasticity of demand is the response of the quantity demanded to change in the price of
a commodity. It is assumed that the consumer’s income, tastes, and prices of all other goods are
steady. It is measured as a percentage change in the quantity demanded divided by the
percentage change in price.

Income Elasticity
The income elasticity of demand is the degree of responsiveness of the quantity demanded to a
change in the consumer’s income. Symbolically,

EI=Percentage change in quantity demanded/ Percentage change in income

Cross Elasticity
The cross elasticity of demand of a commodity X for another commodity Y, is the change in
demand of commodity X due to a change in the price of commodity Y. Symbolically,

 Price Elasticity of Demand

Price elasticity of demand measures how the change in a product’s price affects its associated
demand. Now you can measure the price elasticity of demand (PED) mathematically as follows:

Price Elasticity of Demand (PED) = % change in quantity demanded / % change in price

Coefficient of Price Elasticity
Economists measure the price elasticity of demand (PED) in coefficients. In response to the
change in price, demand for a product can be elastic, perfectly elastic, inelastic, or perfectly
inelastic based on the coefficient.

Now, you need to understand that since price and demand move in opposite directions, the
coefficient will have a negative value.

1.Perfectly Inelastic (PED = 0)

When the price elasticity of demand or PED is zero, then the demand is perfectly inelastic. That
is, there is no change in the quantity demanded in response to the change in price. The demand
curve remains vertical. Demand is completely unresponsive to the change in price.

2.Inelastic (PED is between 0 and 1)

If the percentage of change in demand is less than the percentage of change in price, then the
demand is inelastic. For instance, let us say that the price of a chocolate increases from Rs.10 to
Rs.20 and the associated demand decreases from ten chocolates to five chocolates. So now the
PED will be 50% divided by 100%, which is 0.5. Hence, the demand here is inelastic.

3.Elastic or Unit Elastic (PED = 1)

When the percentage of change in demand is the same as the percentage of change in price, then
the demand is unit elastic. For example, let us say that the price of a candy drops from Rs.10 to
Rs.5 and the demand increases from 10 candies to 15 candies. Here, the percentage of change in
demand is equal to the percentage of change in price (50% divided by 50%, which is 1).
4.Perfectly Elastic (PED > 1)
If the percentage of change in demand is more than the percentage of change in price, then the
demand is perfectly elastic. For instance, if a 10% increase in price causes a 20% drop in
demand, then the coefficient of PED is 3, which means that the demand is perfectly elastic.

 Factors that affect Price Elasticity

1] Number of Substitutes Available
If there are several substitutes or brands available for a product, then the elasticity of demand for
the product will be high because consumers can shift from one brand to another depending on
the change in price. Chocolates, for instance, Consumers can choose between several brands of
chocolates.

2] Price of Product in Relation to Income

Now when a household’s income changes, the demand for goods and services also varies in
response to the income. Hence, the demand for products and services  becomes elastic.

3] Cost of Substitution
In some cases, the result of changing from one brand to another may be quite high. For instance,
if a certain cable service has a lock-in period of deposit, then an existing consumer cannot
change to another service, although inexpensive, without losing the deposit. Hence, the demand
becomes inelastic.
4] Brand Loyalty
Sometimes, consumers are loyal to a specific product. In such cases, the price change in that
product will not affect its associated demand. Brand loyalty, therefore, makes the demand
inelastic.

5] Necessary Goods
Necessary goods such as medicines and petrol usually have an inelastic demand. As consumers
have to purchase these goods irrespective of the change in price, the demand remains
unresponsive.

 Income Elasticity of Demand

The income elasticity of demand measures how the change in a consumer’s income affects the
demand for a specific product. You can express the income elasticity of demand mathematically
as follows:

Income Elasticity of Demand (YED) = % change in quantity demanded / % change in

income

The higher the income elasticity of demand for a specific product, the more responsive it
becomes the change in consumers’ income.

The income elasticity of demand for a particular product can be negative or positive, or even
unresponsive.

Normal Goods and Luxuries

the coefficient for measuring income elasticity is YED.

When YED is more than zero, the product is income-elastic. Normal goods have positive YED.
That is, when the consumers’ income increases, the demand for these goods also increases.
However, normal goods can further be broken down into normal necessities and normal luxuries.
Normal necessities have a positive but low income-elasticity compared to luxurious goods.

YED for normal necessities is between 0 and 1. Normal necessities include basic needs such as
milk, fuel, or medicines.

change in price or change in consumers’ income do not affect the demand for necessary goods.
The percentage of change in the demand for these products is less in proportion to the percentage
of change in consumers’ income.

Luxuries, on the other hand, are highly income-elastic. Examples high-end electronics or
jewellery. For instance, if a consumer’s income increases, he/she may invest or purchase a high-
end mobile or an HD television.

The percentage of change in demand is more in proportion to the change in income.

Inferior Goods
YED is less than 0. If the consumers’ income increases, they demand less of these goods.
Inferior goods are called inferior because they usually have superior alternatives.

For instance, if a consumer’s income increases, then he/she might start taking a cab instead of
opting for public transport. Public transport, in this case, is an inferior good.

Consequently, when the incomes reduce and price of goods increases because of recession, then
the demand for inferior goods increases, thereby causing an outward swing of the demand curve.

 Demand Forecasting
It is a technique for estimation of probable demand for a product or services in the future. It is
based on the analysis of past demand for that product or service in the present market condition.
Demand forecasting should be done on a scientific basis and facts and events related to
forecasting should be considered.

Usefulness of Demand Forecasting

Demand plays a vital role in the decision making of a business. In competitive market
conditions, there is a need to take correct decision and make planning for future events related to
business like a sale, production, etc.

Demand is the most important aspect for business for achieving its objectives. Many decisions of
business depend on demand like production, sales, staff requirement, etc. Forecasting is the
necessity of business at an international level as well as domestic level.

Demand forecasting reduces risk related to business activities and helps it to take efficient
decisions. A good forecasting helps a firm in better planning related to business goals.
 Good forecast helps in appropriate production planning, process selection, capacity planning,
facility layout planning, and inventory management, etc.

Demand forecasting provides reasonable data for the organization’s capital investment and

expansion decision. It also provides a way for the formulation of suitable pricing and
advertisement strategies.

Following is the significance of Demand Forecasting:

 Fulfilling objectives of the business

 Preparing the budget
 Taking management decision
 Evaluating performance etc.

The Scope of Demand Forecasting

depends upon the operated area of the firm, present as well as proposed in the future.
Forecasting can be at an international level if the area of operation is international. If the firm
supplies its products and services in the local market then forecasting will be at local level.

The scope should be decided considering the time and cost involved in relation to the benefit of
the information acquired through the study of demand.

Types of Forecasting
There are two types of forecasting:

1. Based on Economy

i. Macro-level forecasting:  relating to the economy as measured by the Index of

Industrial Production(IIP), national income and general level of employment, etc.
ii. Industry level forecasting:  deals with the demand for the industry’s products as a
whole. For example demand for cement in India, demand for clothes in India, etc.
iii. Firm-level forecasting: It means forecasting the demand for a particular firm’s product.
For example, demand for Birla cement, demand for Raymond clothes, etc.

2. Based on the Time Period

i. Short-term forecasting:   It is done generally for six months or less than one year, is
generally useful in tactical decisions.
ii. Long-term forecasting casting:  for a longer period of time say, two to five years or
more. It gives information for major strategic decisions of the firm. For example,
expansion of plant capacity, opening a new unit of business, etc.
Methods of Demand Forecasting
1] Survey of Buyer’s Choice
in the short run, say a year, then the most feasible method is to ask the customers directly that
what are they intending to buy in the forthcoming time period. Thus, potential customers are
directly interviewed. This survey can be done in any of the following ways:

a. Complete Enumeration Method:  nearly all the potential buyers are asked about their
future purchase plans.
b. Sample Survey Method:  a sample of potential buyers are chosen scientifically and
only those chosen are interviewed.
c. End-use Method:  especially used for forecasting the demand of the inputs. Under this
method, the final users i.e. the consuming industries and other sectors are identified. The
desirable norms of consumption of the product are fixed, the targeted output levels are
estimated and these norms are applied to forecast the future demand of the inputs.
Hence, under this method the burden of demand forecasting is on the buyer, seller should take
decisions in the light of his judgment also.The customer may misjudge their demands which in
turn may mislead the survey. This method is suitable when goods are supplied in bulk
to industries but not in the case of household customers.

2] Collective Opinion Method

the salesperson of a firm predicts the estimated future sales in their region. The individual
estimates are aggregated to calculate the total estimated future sales. These estimates are
reviewed in the light of factors like future changes in the selling price, product designs, changes
in competition, advertisement campaigns, the purchasing power of the consumers, employment
opportunities, population, etc.

salesmen are closest to the consumers they are more likely to understand the changes in their
needs and demands. They can also easily find out the reasons behind the change in their tastes.

Therefore, a firm having good sales personnel can utilize their experience to predict the
demands. Hence, this method is also known as Salesforce opinion or Grassroots approach
method. However, this method depends on the personal opinions of the sales personnel and is not
purely scientific.

3] Barometric Method
This method is based on the past demands of the product and tries to project the past into the
future. The economic indicators are used to predict the future trends of the business. Based on
future trends, the demand for the product is forecasted. An index of economic indicators is
formed. There are three types of economic indicators, viz. leading indicators, lagging indicators,
and coincidental indicators.
The leading indicators are those that move up or down ahead of some other series. The lagging
indicators are those that follow a change after some time lag. The coincidental indicators are
those that move up and down simultaneously with the level of economic activities.

4] Market Experiment Method

the demand is forecasted by conducting market studies and experiments on consumer behavior
under actual but controlled, market conditions.

Certain determinants of demand that can be varied are changed and the experiments are done
keeping other factors constant. However, this method is very expensive and time-consuming.

5] Expert Opinion Method

Usually, market experts have explicit knowledge about the factors affecting demand. Their
opinion can help in demand forecasting. The Delphi technique, developed by Olaf Helmer is one
such method.

Under this method, experts are given a series of carefully designed questionnaires and are asked
to forecast the demand. They are also required to give the suitable reasons. The opinions are
shared with the experts to arrive at a conclusion. This is a fast and cheap technique.

6] Statistical Methods

a. Trend Projection Method:  sufficient amount of accumulated past data of the sales is
arranged chronologically to obtain a time series. Thus, the time series depicts the past trend
and on the basis of it, the future market trend can be predicted. It is assumed that the past
trend will continue in the future.
b. Regression Analysis: This method establishes a relationship between the dependent
variable and the independent variables. the quantity demanded is the dependent variable
and income, the price of goods, the price of related goods, the price of substitute goods, etc.
are independent variables. The regression equation is derived assuming the relationship to
be linear. Regression Equation: Y = a + bX. Where Y is the forecasted demand for a
product or service.

 Cross Elasticity of Demand

cross elasticity of demand is the responsiveness of demand for a product in relation to the change
in the price of another related product. The relevant word here is “related” product. Unrelated
products have zero elasticity of demand. An increase in the price of pulses will have no effect on
the demand for chocolates.

Cross Elasticity of Demand = % of the change in the demand for Product A / % of the change in
the price of product B

The cross elasticity of demand depends on whether the related product is a substitute product or a
complementary product.
Substitute and Complementary Products

Substitute Products
Substitute products are goods that are in direct competition. An increase in the price of one
product will lead to an increase in demand for the competing product. For instance, an increase
in the price of petrol will force consumers to go for diesel and increase the demand for diesel.
Now, the cross elasticity value for two substitute goods is always positive. The more close the
substitutes are in terms of use and quality, the more positive the cross elasticity of demand would
be.

However, if the related product is a weak substitute, then the demand will be less cross elastic,
but positive. That is, a change in the price of a product might not greatly affect the demand for its
substitute.

Substitute products have a positive cross elasticity of demand. As the

price for Y increases, the demand for substitute X also increases.

Complementary Products
Complementary goods, on the other hand, are products that are in demand together. An ideal
example would be coffee beans and coffee paper filters. If the price of coffee increases, then the
demand for filters would reduce because the demand for coffee will reduce. The cross elasticity
of demand for two complementary products is always negative.

Again, the stronger the complementary relationship between two products, the more negative the
cross elasticity coefficient would be.
  The shift of the Demand Curve
When there is a change in the quantity demanded of a particular commodity, at each possible
price, due to a change in one or more other factors, the demand curve shifts. The important
aspect to remember is that other factors like the consumer’s income and tastes along with the
prices of other goods, etc., which were expected to remain constant, changed.

This is the Shift of the Demand Curve. The demand curve can shift either to the left or the right,
depending on the factors affecting it.

The demanded quantities are plotted as demand curves DD and D’D’ as shown below:

From Fig. 2 above, we can clearly see that if the income changes, then a change in price shifts
the demand curve. In this case, the shift is to the right which indicates that there is an increase in
the desire to purchase the commodity at all prices.

Hence, we can conclude that with an increase in income the demand curve shifts to the right. On
the other hand, if the income falls, then the demand curve will shift to the left decreasing the
desire to purchase the commodity.
  Market – Meaning and Classification
Economists will describe a market as coming together of the buyers and sellers, i.e. an
arrangement where buyers and sellers come in direct or indirect contact to sell/buy goods and
services.It does not necessarily refer to a geographic location.

 A market is also not restricted to one physical or geographical location. It covers a

general wide area and the demand and supply forces of the region.
 There must be a group of buyers and sellers of the commodity to constitute a market.
And the relations between these sellers and buyers must be business relations.
 Both the sellers and buyers must have access to knowledge about the market. There
should be an awareness of the demand for products, consumer choices, and
preferences, fashion trends, etc.
 At any given time only one price can be prevalent in the market for the goods and
services. This is only possible in the existence of perfect competition.

 Classification of Markets

On the Basis of Geographic Location

 Local Markets buyers and sellers are limited to the local region or area. They usually
sell perishable goods of daily use since the transport of such goods can be expensive.
 Regional Markets: These markets cover a wider are than local markets like a district, or
a cluster of few smaller states
 National Market:  demand for the goods is limited to one specific country. Or the
government may not allow the trade of such goods outside national boundaries.
 International Market: When the demand for the product is international and the goods
are also traded internationally in bulk quantities,

On the Basis of Time

 Very Short Period Market:  for example the market for flowers, vegetables. Fruits etc.
The price of goods will depend on demand.
 Short Period Market: The market is slightly longer than the previous one. Here the
supply can be slightly adjusted.
 Long Period Market: Here the supply can be changed easily by scaling production. So
it can change according to the demand of the market.

On the Basis of Nature of Transaction

 Spot Market:  spot transactions occur, the money is paid immediately. There is no
system of credit
 Future Market: transactions are credit transactions. There is a promise to pay the
consideration sometime in the future.

On the Basis of Regulation

 Regulated Market: some oversight by appropriate government authorities to ensure

there are no unfair trade practices in the market. For example, the stock market is a highly
regulated market.
 Unregulated Market: This is an absolutely free market. There is no oversight or
regulation, the market forces decide everything

 Types of Market Structures

market structures essentially refer to the degree of competition in a market. There are other
determinants of market structures such as the nature of the goods and products, the number of
sellers, number of consumers, the nature of the product or service, economies of scale etc.
1] Perfect Competiton
there are a large number of buyers and sellers. All the sellers of the market are small sellers in
competition with each other. There is no one big seller with any significant influence on the
market. So all the firms in such a market are price takers.

There are certain assumptions as follows,

 The products on the market are homogeneous, i.e. they are completely identical
 All firms only have the motive of profit maximization
 There is free entry and exit from the market, i.e. there are no barriers
 And there is no concept of consumer preference

2] Monopolistic Competition
This is a more realistic scenario that actually occurs in the real world. In monopolistic
competition, there are still a large number of buyers as well as sellers. But they all do not sell
homogeneous products. The products are similar but all sellers sell slightly differentiated
products.

consumers have the preference of choosing one product over another. The sellers can also charge
a marginally higher price since they may enjoy some market power. So the sellers become the
price setters to a certain extent.

For example, the market for cereals is a monopolistic competition. The products are all similar
but slightly differentiated in terms of taste and flavours. Another such example is toothpaste.

3] Oligopoly
there are only a few firms in the market. While there is no clarity about the number of firms, 3-5
dominant firms are considered the norm, the buyers are far greater than the sellers.
The firms in this case either compete with another to collaborate together, They use their market
influence to set the prices and in turn maximize their profits. So the consumers become the
price takers. In an oligopoly, there are various barriers to entry in the market, and new firms
find it difficult to establish themselves.

4] Monopoly

In a monopoly type of market structure, there is only one seller, so a single firm will control the
entire market. It can set any price it wishes since it has all the market power. Consumers do not
have any alternative and must pay the price set by the seller.

Monopolies are extremely undesirable. Here the consumer loose all their power and market
forces become irrelevant. However, a pure monopoly is very rare in reality.

 Concepts of Total Revenue Average Revenue and Marginal Revenue

Total Revenue

A firm sells 100 units of a particular commodity for Rs. 10 each. If you were to calculate the
amount realized by the firm, the answer is simple – Rs. 1,000 (100 x 10). This is the total
revenue for the firm.

Hence, the total revenue refers to the amount of money realized by a firm on the sale of a
commodity.

TR = P x Q … where TR – Total Revenue, P – Price, and Q – Quantity of the commodity sold.

Average Revenue

Average revenue is simply the revenue earned per unit of the output, it is the price of one unit of
the output. Average revenue is expressed as follows:

AR=TR/Q

where AR – Average Revenue, TR – Total Revenue, and Q – Quantity of the commodity sold.
For example, a firm sells 100 units of a commodity and realizes a total revenue of Rs. 1,000.
Therefore, its average revenue is

AR=1000/100=Rs.10

Marginal Revenue

Marginal revenue (MR) is the change in total revenue resulting from the sale of an additional
unit of a commodity.
For example, consider a firm selling 100 units of a commodity and realizing a total revenue of
Rs. 1,000. Further, it realizes a total revenue of Rs. 1,200 after selling 101 units of the same
commodity. Therefore, the marginal revenue is Rs. 200.

Marginal revenue is also defined as the rate of change of total revenue resulting from the sale of
an additional unit of a commodity.

MR=ΔTR/ΔQ

MR – Marginal revenue, TR – Total revenue, Q – Quantity of the commodity sold, and Δ –

the rate of change.
Further, for one unit change in output, we have

MRn = TRn – TRn-1

Where,

 TRn – the total revenue when the sales are at the rate of ‘n’ units per period.
 TRn-1 – the total revenue when the sales are at the rate of (n-1) units per period.

Marginal Revenue, Average Revenue, Total Revenue and the Elasticity of Demand

It is important to note that the marginal revenue, average revenue and price elasticity
of demand are related to one another through the following formula:

MR=AR×(e–1)/e
where ‘e’ is the price elasticity of demand.

 If e = 1, then

MR=AR×(1–1)/1=0

 If e > 1, then MR is positive.

 If e < 1, then MR is negative.

Since price P equals AR we have, MR= P(1-1/e)

Behavioural Principles

Principle 1
“A firm should not produce at all if total revenue from its product does not equal or exceed its
total variable cost.”

Explanation: A firm produces products for profits. Therefore, if a firm does not better by
producing certain products, then it should rather not produce them. In a zero production scenario,
the firm will have an operating loss equal to its fixed costs. If the production adds more cost than
revenue to the firm, then it increases the loss of the firm.

Principle 2
“It is profitable for the firm to increase the output whenever the marginal revenue is greater than
the marginal cost. Ideally, the firm must continue expanding until the marginal revenue equals
the marginal cost. Also, apart from being equal, the marginal cost curve must cut the marginal
revenue curve from below.”

Explanation: According to this principle, if a unit of production adds more to the revenue than
to the cost, then the said unit increases the profits of the firm. On the other hand, if it adds more
to the cost than to the revenue, then the unit decreases the profits of the firm. The firm has
maximum profits at the point where the additional revenue from a unit equals its additional cost.

 Marginal Cost

Marginal cost is the change in the total cost that occurs when the quantity produced is
increased by one unit. It is the cost of producing one more unit of a good. When more goods
are produced, the marginal cost includes all additional costs required to produce the next unit.
For example, if producing one more car requires the building of an additional factory, the
marginal cost of producing the additional car includes all of the costs associated with building
the new factory. Marginal cost is the change in total cost divided by the change in output.

An example of marginal cost is evident when the cost of making one pair of shoes is $30. The
cost of making two pairs of shoes is $40. Therefore the marginal cost of the second shoe is
$40 -$30=$10.

 Marginal Revenue

Marginal revenue is the additional revenue that will be generated by increasing product sales
by one unit. In a perfectly competitive market, the price of the product stays the same when
another unit is produced. Marginal revenue is calculated by dividing the change in total
revenue by the change in output quantity.

For example, if the price of a good in a perfectly competitive market is $20, the marginal
revenue of selling one additional unit is $20.

 Marginal Cost-Marginal Revenue Perspective

Profit maximization is the short run or long run process by which a firm determines the price
and output level that will result in the largest profit. Firms will produce up until the point that
marginal cost equals marginal revenue.

This strategy is based on the fact that the total profit reaches its maximum point where
marginal revenue equals marginal profit. This is the case because the firm will continue to
produce until marginal profit is equal to zero, and marginal profit equals the marginal revenue
(MR) minus the marginal cost (MC).

producing up until the point of MR=MC is that if MR>MC, the firm should make more units:
it is earning a profit on each. If MR<MC, then the firm should produce less: it is making a loss
on each additional product it sells.
  Shut Down Case

Economic Shutdown

A firm will choose to implement a production shutdown when the revenue received from the
sale of the goods or services produced cannot cover the variable costs of production. In this
situation, a firm will lose more money when it produces goods than if it does not produce
goods at all.

Producing a lower output would only add to the financial losses, so a complete shutdown is
required.

If a firm decreased production it would still acquire variable costs not covered by revenue as
well as fixed costs . By stopping production the firm only loses the fixed costs.

Economic shutdown occurs when the marginal revenue is below average variable cost at the
profit-maximizing output. The goal of a firm is to maximize profits and minimize losses.
When a shutdown is required the firm failed to achieve a primary goal by not operating at the
level of output where marginal revenue equals marginal cost.

The Shutdown Rule

The shutdown rule states that “in the short run a firm should continue to operate if price
exceeds average variable costs. ”

When determining whether to shutdown , a firm has to compare the total revenue to the total
variable costs. If the revenue is greater than the variable cost (R>VC) then the firm is covering
it’s variable costs and there is additional revenue to partially or entirely cover the fixed costs.

But if the variable cost is greater than the revenue being made (VC>R) then the firm is not
even covering production costs and it should be shutdown immediately.

 The Supply Curve in Perfect Competition

The total revenue-total cost perspective and the marginal revenue-marginal cost perspective
are used to find profit maximizing quantities.
Cost Curve

In economics, a cost curve is a graph that shows the costs of production as a function of total
quantity produced. In a free market economy, firms use cost curves to find the optimal point
of production (minimizing cost).

By finding optimal point of production, firms can decide what output quantities are needed.
The various types of cost curves include total, average, marginal curves. Some of the cost
curves analyze the short run, others focus on the long run.

Profit Maximization

Profit maximization is the short run or long run process that a firm uses to determine the price
and output level that returns the greatest profit .

Graphing Profit Maximization

There are two ways in which cost curves can be used to find profit maximizing quantities: the
total revenue-total cost perspective and the marginal revenue-marginal cost perspective.

The total revenue-total cost perspective recognizes that profit is equal to the total revenue
(TR) minus the total cost (TC). The profit maximizing output is the one at which the profit
reaches its maximum.

The marginal revenue-marginal cost perspective says that for each unit sold, the marginal
profit equals the marginal revenue (MR) minus the marginal cost (MC).

If the marginal revenue is greater than the marginal cost, then the marginal profit is positive
and a greater quantity of the good should be produced.

And if the marginal revenue is less than the marginal cost, the marginal profit is negative and
a lesser quantity of the good should be produced.
Profit maximization is directly impacts the supply and demand of a product.

Short Run Firm Production Decision

Short Run Profit

In an economic market all production in real time occurs in the short run, where at least one
factor of production is fixed in amount while other factors are variable in amount.

Fixed costs have no impact on a firm’s short run decisions. However, variable costs and
revenues affect short run profits. In the short run, a firm could potentially increase output by
increasing the amount of the variable factors. An example of a variable factor being increased
would be increasing labor through overtime.

In the short run, a firm that is maximizing its profits will:

 Increase production if the marginal cost is less than the marginal revenue.
 Decrease production if marginal cost is greater than marginal revenue.
 Continue producing if average variable cost is less than price per unit.
 Shut down if average variable cost is greater than price at each level of output.

Short Run Shutdown vs. Long Run Exit

The goal of a firm is to maximize profits by minimizing losses , a firm will implement a
production shutdown when the revenue coming in from the sale of goods cannot cover the
variable costs of production.

The firm would experience higher loss if it kept producing goods than if it stopped production
for a period of time. Revenue would not cover the variable costs associated with production.
Instead, during a shutdown the firm is only paying the fixed costs.

A short run shutdown is designed to be temporary: it does not mean that the firm is going out
of business.

If market conditions improve, due to prices increasing or production costs falling, the firm can
restart production. When a firm is shut down in the short run, it still has to pay fixed costs and
cannot leave the industry. If market conditions do not improve a firm can exit the market.
Short Run Supply Curve

In a perfectly competitive market, the short run supply curve is the marginal cost (MC) curve
at and above the shutdown point. The portions of the marginal cost curve below the shutdown
point are no part of the supply curve because the firm is not producing in that range.

Market Differences Between Monopoly and Perfect Competition

Monopolies, as opposed to perfectly competitive markets, have high barriers to entry and a
single producer that acts as a price maker.

These are two extremes of market structures, but there are some similarities between firms in a
perfectly competitive market and monopoly firms. Both face the same cost and production
functions, both seek to maximize profit. The shutdown decisions are the same, and both are
assumed to have perfectly competitive factors markets.

However, there are several key distinctions.

In a perfectly competitive market, price equals marginal cost and firms earn an economic
profit of zero. In a monopoly, the price is set above marginal cost and the firm earns a positive
economic profit.

Perfect competition produces an equilibrium in which the price and quantity of a good is
economically efficient. Monopolies produce an equilibrium at which the price of a good is
higher, and the quantity lower, than is economically efficient. For this reason, governments
often seek to regulate monopolies and encourage increased competition.

 Marginal Revenue and Marginal Cost Relationship for Monopoly Production

For monopolies, marginal cost curves are upward sloping and marginal revenues are
downward sloping.

Profit Maximization

the goal of a firm is to maximize their profits. This means they want to maximize the
difference between their earnings, i.e. revenue, and their spending, i.e. costs. To find the profit
maximizing point, firms look at marginal revenue (MR) – the total additional revenue from
selling one additional unit of output – and the marginal cost (MC) – the total additional cost of
producing one additional unit of output.
When the marginal revenue of selling a good is greater than the marginal cost of producing it,
firms are making a profit on that product. a given good should continue to be produced if the
marginal revenue of one unit is greater than its marginal cost. Therefore, the maximizing
solution involves setting marginal revenue equal to marginal cost.

This is relatively straightforward for firms in perfectly competitive markets, in which marginal
revenue is the same as price.

Monopoly production is complicated by the fact that monopolies have demand curves and
MR curves that are distinct, causing price to differ from marginal revenue.

Monopoly: In a monopoly market, the marginal revenue curve and the demand curve are
distinct and downward-sloping. Production occurs where marginal cost and marginal revenue
intersect.

Perfect Competition: In a perfectly competitive market, the marginal revenue curve is

horizontal and equal to demand, or price. Production occurs where marginal cost and marginal
revenue intersect.

Monopoly Profit Maximization

The marginal cost curves faced by monopolies are similar to those faced by perfectly
competitive firms.

Most will have low marginal costs at low levels of production, Marginal costs get higher as
output increases.
For example, a pizza restaurant can easily double production from one pizza per hour to two
without hiring additional employees or buying more sophisticated equipment. When
production reaches 50 pizzas per hour, however, it may be difficult to grow without investing
a lot of money in more skilled employees or more high-tech ovens.

Profit Maximization Function for Monopolies

Monopolies set marginal cost equal to marginal revenue in order to maximize profit.

Monopolies have much more power than firms normally would in competitive markets, but
they still face limits determined by demand for a product. Higher prices mean lower sales.
Therefore, monopolies must make a decision about where to set their price and the quantity of
their supply to maximize profits.

They can either choose their price, or they can choose the quantity that they will produce and
allow market demand to set the price.

monopoly restricts output and charges a higher price than would prevail under competition.

This graph illustrates the price and quantity of the market equilibrium under a monopoly.

Monopoly Production Decision

To maximize output, monopolies produce the quantity at which marginal supply is equal to
marginal cost.

Monopoly Production

A pure monopoly has the same economic goal of perfectly competitive companies – to
maximize profit.

If we assume increasing marginal costs and input prices, the optimal decision for all firms is
to equate the marginal cost and marginal revenue of production.

a pure monopoly can – unlike a competitive market – alter the market price for its own
convenience: a decrease of production results in a higher price, rather than finding the point
where the marginal cost curve intersects a horizontal marginal revenue curve (which is
equivalent to good’s price), we must find the point where the marginal cost curve intersect a
downward-sloping marginal revenue curve.
Monopoly Production Point

Like non-monopolies, monopolists will produce the the quantity such that marginal revenue
(MR) equals marginal cost (MC).

However, monopolists have the ability to change the market price based on the amount they
produce since they are the only source of products in the market.

When a monopolist produces the quantity determined by the intersection of MR and MC, it
can charge the price determined by the market demand curve at the quantity. Therefore,
monopolists produce less but charge more than a firm in a competitive market.

Monopoly Production: Monopolies produce at the point where marginal revenue equals
marginal costs, but charge the price expressed on the market demand curve for that quantity of
production.

Monopoly Price and Profit

Monopolies can influence a good’s price by changing output levels, which allows them to
make an economic profit.

Monopolies, unlike perfectly competitive firms, are able to influence the price of a good and
are able to make a positive economic profit. While a perfectly competitive firm faces a single
market price, represented by a horizontal demand/marginal revenue curve, a monopoly has the
market all to itself and faces the downward-sloping market demand curve.

Graphically, one can find a monopoly’s price, output, and profit by examining the demand,
marginal cost, and marginal revenue curves.

Again, the firm will always set output at a level at which marginal cost equals marginal
revenue, so the quantity is found where these two curves intersect. Price, however, is
determined by the demand for the good when that quantity is produced. Because a monopoly’s
marginal revenue is always below the demand curve, the price will always be above the
marginal cost at equilibrium, providing the firm with an economic profit.
Monopoly Pricing: Monopolies create prices that are higher, and output that is lower, than
perfectly competitive firms. This causes economic inefficiency.

 Introduction to Determination of Prices

Factors affecting Determination of Prices

1] Product Cost
It includes the total of fixed costs, variable costs and semi-variable costs incurred through the
production, distribution, and selling of the product. Fixed costs refer to those costs which remain
fixed at all the levels of production or sales. For instance, rent, salary, etc.

Variable costs attribute to the costs which are directly related to the levels of production or sales.
For example, the costs of basic material, apprentice costs, etc. Semi-variable costs take
into account those costs which change with the level of activity but not in direct proportion.

2] The Utility and Demand

when the demand for a product is elastic, little variation in the price may result in large changes
in quantity demanded.While, when it is inelastic a change in the prices does not affect the
demand significantly. In addition, the buyer is ready to pay up to that point where he perceives
utility from the product to be at least equal to the price paid.

3] The extent of Competition in the Market

A firm can fix any price for its product if the degree of competition is low. However, when there
is competition in the market, the price is fixed after keeping in mind the price of the substitute
goods.

4] Government and Legal Regulations

the government intervenes and regulates the prices of the commodities. For this purpose, it
declares some products as indispensable products. For example, Life-saving drugs, etc.
5] Pricing Objectives
Profit Maximization, Obtaining Market Share Leadership, Surviving in a Competitive Market
and Attaining Product Quality Leadership are the pricing objectives of an enterprise.

6] Marketing Methods Used

A range of marketing methods such as circulation system, quality of salesmen, marketing, type
of wrapping, patron services, etc. also affects the price of manufactured goods.

 Perfect competition:

Profit Maximization: to maximize profits in a perfectly competitive market, firms set

marginal revenue equal to marginal cost (MR=MC). MR is the slope of the revenue curve
equal to the demand curve (D) and price (P). In the short-term, it is possible for economic
profits to be positive, zero, or negative. When price is greater than average total cost, the firm
is making a profit. When price is less than average total cost, the firm is making a loss in the
market.

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

Over the long-run, if firms in a perfectly competitive market are earning positive economic
profits, more firms will enter the market, which will shift the supply curve to the right. As the
supply curve shifts to the right, the equilibrium price will go down. As the price goes down,
economic profits will decrease until they become zero.

When price is less than average total cost, firms are making a loss. Over the long-run, if firms
in a perfectly competitive market are earning negative economic profits, more firms will leave
the market, which will shift the supply curve left. As the supply curve shifts left, the price will
go up. As the price goes up, economic profits will increase until they become zero.

Hence in the long-run, companies that are engaged in a perfectly competitive market earn zero
economic profits. The long-run equilibrium point for a perfectly competitive market occurs
where the demand curve (price) intersects the marginal cost (MC) curve and the minimum
point of the average cost (AC) curve.
Perfect Competition in the Long Run: In the long-run, economic profit cannot be
sustained. The arrival of new firms in the market causes the demand curve of each firm
to shift downward, bringing down the price, the average revenue and marginal revenue
curve. In the long-run, the firm will make zero economic profit. Its horizontal demand
curve will touch its average total cost curve at its lowest point.

The Demand Curve in Perfect Competition

A perfectly competitive firm faces a demand curve is a horizontal line equal to the equilibrium
price of the entire market.

In a perfectly competitive market the market demand curve is a downward sloping line,
reflecting the fact that as the price of an ordinary good increases, the quantity demanded
decreases. Price is determined by the intersection of market demand and market supply;
individual firms do not have any influence on the market price in perfect competition.

Once the market price has been determined by supply and demand , individual firms become
price takers. Individual firms are forced to charge the equilibrium price of the market or
consumers will purchase the product from the numerous other firms in the market charging a
lower price . The demand curve for an individual firm is thus equal to the equilibrium price of
the market.
Demand Curve for a Firm in a Perfectly Competitive Market: The demand curve for an
individual firm is equal to the equilibrium price of the market. The market demand
curve is downward-sloping.

The demand curve for a firm in a perfectly competitive market varies significantly from that of
the entire market. The market demand curve slopes downward, while the perfectly competitive
firm’s demand curve is a horizontal line equal to the equilibrium price of the entire market.
The horizontal demand curve indicates that the elasticity of demand for the good is perfectly
elastic. This means that if any individual firm charged a price slightly above market price, it
would not sell any products.

A strategy often used to increase market share is to offer a firm’s product at a lower price than
the competitors. In a perfectly competitive market, firms cannot decrease their product price
without making a negative profit. Instead, assuming that the firm is a profit-maximizer, it will
sell its goods at the market price.

Determination of Equilibrium Price

The price that makes demand equivalent to supply is called the equilibrium price, equilibrium
price is the point where the demand curve and supply curve intersect, at this point there is no
unsold stock left neither is any demand unfulfilled, known as the market clearing price, Stable
Equilibrium at this point .

Other things remaining the same, when the price falls below the equilibrium price, the demand
increases and supply decreases. There arises a shortage of goods which in turn increases the price
to equilibrium price.

Similarly, when the price rises above the equilibrium price, the demand decreases and supply
increases. There arises a surplus of goods which in turn decreases the price to equilibrium price.
Thus, the market restores the equilibrium price on its own.

However, Other factors such as the price of substitute goods, price of related goods, government
policies, competition in the market, etc. also play an important role in the determination of the
prices.

 National Income – Concept, Types and Measurement

It is the monetary value of its final services and goods produced by the residents of that country,
it includes the total investment expenditure, total consumption expenditure, net exports or
imports, total government expenditure. , it is the sum total of income everyone earns in India.

To determine the estimates of national income, there are three methods:

1. Product or production method: also known as value-added or the output method. the value
added by various services and production goods are measured.

For the value added of the goods to be observed, the expenditure that is incurred on the
intermediate goods is deducted from the goods itself. These intermediate goods include
unfinished goods which are purchased from the enterprises, raw materials, and the value of
output produced by that enterprise. This is the best simple method to calculate the national
income.

2.Income Method
This income in this method is obtained by adding up all the incomes of the people in the country.
Services like land and capital which produces its own services are included in this method.

The main component in this method is the service sector. in this method, the payments done
through transfer are not included in the national income. Further, illegal money like hawala
money or smuggling money is also not included.

3 Expenditure Method
this method includes all the expenditure done by the people in that country. The national income
in this method is calculated based on the total expenditures made on the services and goods
during the entirety of that year., it does not include the expenditure on the second-hand goods.
Thus, when the item or good is purchased again it is not included. Further, the expenditure on old
bonds and shares are also not included in this method.

 Types of National Income:

1) Gross National Income (GNP): It is most widely used measure of National Income. ,
Defined as value of all final goods and services produced during the specific period plus income
earned abroad by nationals minus income earned locally by foreigners.

GNP=GNI

2) Gross domestic product (GDP): Market value of all final goods and services produced in the
domestic economy during period of one year plus income earned locally by the foreigner minus
income earned abroad by national.

National output= National expenditure (aggregate demand)= National income

The concepts of GDP are similar to GNP , difference is , in GNP incomes earned by nationals in
foreign countries are added and incomes earned locally by foreigners are deducted from market
value of domestically produced goods and services.
But in GDP process is reversed incomes earned locally by foreigners are added and income
earned abroad by the nationals are deducted from the total value of domestically produced goods
and services.

GDP=C (consumption spending) + I ( investment by industries) + E (excess of export over

import) + G (government spending)

 (a)The expenditure method – Aggregate Demand (AD)

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

C- Household spending,I- Capital investment spending, G-Government spending

X-exports, M-imports

 (b) The income method ( adding together factor incomes)

GDP is sum of incomes earned through production of goods and services.

GDP ( by sum of factor incomes)= Income from people in jobs and in self employment (ie wages
and salaries) + Profits of private sector businesses + Rent income from ownership of land

Exclude items: Transfer payments like state pension, income support for low income families,
allowances and other welfare benefits, private transfer of money from one individual to other

Income not registered with tax authorities called shadow economy, also much activity not
recorded like subsistence farming & barter transactions. Hence published figures will be
inaccurate.

 (c) Net National Product (NNP)

It measures net output available for consumption by society ( consumers, producers,

government) , it is real measure of National income. NNP is same as National income at factor
cost and it measured at market price including direct taxes, Indirect tax is not part of actual cost
of production, NNP=GNP-Depreciation.

At market prices:

GNP=GNI

GDP=GNP-Depreciation

NNP=GNP-Depreciation
NDP=NNP-Net income from abroad.

At factor cost:

GNP at factor cost = GNP at market price – Net Indirect taxes

NNP at factor cost= NNP at market price – Indirect taxes

NDP at factor cost= NNP at market price – Net income from abroad

NDP at factor cost= NDP at market price – Net indirect taxes

NDP at factor cost= GDP at market price – Depreciation

 Factors affecting National income:

1)The stock of factors of production : like land , labour, capital and organization.

2) Enterprise 3) State of technical knowledge 4) Political stability.

 Theory of national income determination:

J M Keynes gave Keynesian theory of income, divided into 4 sectors:

Household sectors, firms or business sectors, government sectors, foreign sectors.

Based on following 3 model:

1)Two sector model by JM Keynes:

 There are only two sectors in economy households (with only consumption) and firms

(investment outlays)

 Households spent their entire factors income to consume all final goods and services.
 Firms hire factors of production from the households , they produce and sell final
goods and services to the households and they do not save.
 Economy is closed economy.

2) Circular flow of income and expenditure of two sector economy:

Factor payment = household income= household expenditure= total receipts of the firm= value
of output

Acc to Keynes, National income of a country is determined by two factors:

(a) Aggregate demand: is an ex-post concept, it implies effective demand which

equals actual expenditure. (AD – AS) model is derived from the basic circular
flow concept, which explain how income flows between households and firms,
means aggregate expenditure made by society per unit of time, AD consists of two
components:

1) Aggregate demand for consumer goods (c)

2) Aggregate demand for capital goods (I)

AD=C+I

(b) Aggregate supply (AS): defined as total value of goods and services produced and
supplied at a particular point of time. It comprises consumer goods, producer goods.
The national output is aggregate supply in the form of money value. The Keynesian
AS curve is drawn based on an assumption that total income is equal to total
expenditure,total income earned is fully spent .
(c) The correlation between income and exp is represented :
 AS= Aggregate income equals consumption (C) + Saving (S)

AS curve also called aggregate expenditure curve (AE)

• The consumption function shows the relationship between the level of consumption
expenditure and the level of income, C = f (Y)

Keynesian consumption concepts:

• APC=C/Y { average propensity to consume}

{The average propensity to consume (APC) is the ratio of consumption expenditures (C) to

disposable income (Y). }

• MPC= ∆C/∆Y { Marginal propensity to consume}

APS=S/Y { Average propensity to save}

MPS= ∆S/∆Y { Marginal propensity to save}

 • The slope of the consumption function (b) is called the marginal propensity to consume
(MPC), or the fraction of a change in income that is consumed, or spent.

• The fraction of a change in income that is saved is called the marginal propensity to save
(MPS), MPC+MPS=1

• The marginal propensity to save, MPS=ΔS/ ΔY

3)Three sector model including Household, business and Government sectors

4)Four sector model including foreign sector with three sector model

 INFLATION : It is the rate at which the general level of prices for goods and services
is rising and, consequently, the purchasing power of currency is falling.

It is classified into three types: Demand-Pull inflation, Cost-Push inflation, and

Built-In inflation.

Most commonly used inflation indexes are the Consumer Price Index (CPI) and the
Wholesale Price Index (WPI).

As prices rise, a single unit of currency loses value as it buys fewer goods and services.
This loss of purchasing power impacts the general cost of living for the common public
which ultimately leads to a deceleration in economic growth.

 Causes of Inflation
Rising prices are the root of inflation, can be attributed to different factors.

1) Demand-Pull Effect: Demand-pull inflation occurs when the overall demand for
goods and services in an economy increases more rapidly than the economy's
 production capacity. It creates a demand-supply gap with higher demand and lower
supply, results in higher prices.

For instance, when the oil producing nations decide to cut down on oil production, the
supply diminishes. It leads to higher demand, which results in price rises and
contributes to inflation.

Additionally, an increase in money supply in an economy also leads to inflation. With more
money available to individuals, leads to higher spending, increases demand and leads to price
rises.

Money supply can be increased by the monetary authorities either by printing and giving away
more money to the individuals, or by devaluing (reducing the value of) the currency. In all
such cases of demand increase, the money loses its purchasing power.
 2) Cost-Push Effect: Cost-push inflation is a result of the increase in the prices of
production process inputs.
Examples , increase in labour costs to manufacture a good or offer a service or increase
in the cost of raw material. These developments lead to higher cost for the finished
product or service and contribute to inflation.
ges

Such increase in costs are passed to consumers by firms by raising prices of products. Rising
wages leads to rising costs, hence rising prices. These rising prices prompt trade unions to
demand higher wages. Thus inflationary wage price spiral starts. This causes aggregate supply
curve to shift leftward.
AS1 is initial aggregate supply curve. Below full employment stage this AS curve is positive
sloping and at full employment stage it becomes perfectly inelastic.
E1 of AS1 and AD1 curves determine price level OP1. Now there is leftward shift of
aggregate supply curve AS2 with no change in aggregate demand causes price level to rise to
OP2 and output fall to OY2. With reduction in output unemployment rises. Further shift to
AS3 results higher price OP3 and lower aggregate output OY3. Hence CPI may arise even
below the full employment stage YF .
3) Built-In Inflation: It links to adaptive expectations. As the price of goods and services
rises, labour expects and demands more costs/wages to maintain their cost of living.
Their increased wages result in higher cost of goods and services, and this wage-price
spiral continues as one factor induces the other and vice-versa.

 Effect of inflation :
(a) On distribution of income and wealth:
 (i) Creditors and debtors: Borrowers gain & lenders lose because when debts are
repaid in rupee terms their real value declines, price level increase.

Borrower welcomes inflation, they have to pay less in real terms than when it was
borrowed

(ii) Bond & debentures holders : They earn fixed interest income, suffer reduction in
real income when price rise, the value of ones savings decline if interest rate falls
short of inflation rate.

(iii) Investors: People invests in share during inflation expected to gain since possibility
of earning business profits brightens. Higher profit induces owners to distribute
profit among investors.

(iv) Salaried people & wage earners: Anyone earning a fixed income is damaged by
inflation, real purchasing power of fixed income earners reduces.But people earning
flexible income may gain during inflation.

(v) Profit earners, speculators, and black marketers: profit earners gain, as prices of
their products rises, results profit. Speculators dealing in essential commodities
usually gain, black marketers also benefitted during inflation.

(b) On production & economic growth: Below full employment stage , inflation has
favourable effect on production. Prices rises, profits of businesses also rises, rising
profits of firms encourage larger investments, multiplier effect comes into operation
results in higher national output. Such effects are temporary.

Further inflation leads to fall in output, if cost push inflation there is no strict relation
between prices & output.

 Methods to control inflation:

Inflation is generally controlled by the Central Bank and/or the government. The main policy
used is monetary policy (changing interest rates). However, in theory, there are a variety of
tools to control inflation including:

1. Monetary policy – Higher interest rates reduce demand in the economy, leading to
lower economic growth and lower inflation.
2. Control of money supply – Monetarists argue there is a close link between the money
supply and inflation, therefore controlling money supply can control inflation.
3. Supply-side policies – policies to increase the competitiveness and efficiency of the
economy, putting downward pressure on long-term costs.
4. Fiscal policy – a higher rate of income tax could reduce spending, demand and
inflationary pressures.
5. Wage controls – trying to control wages could, in theory, help to reduce inflationary
pressures. However, apart from the 1970s, it has been rarely used.

 Monetary Policy

In a period of rapid economic growth, demand in the economy growing faster than its capacity
to meet it. This leads to inflationary pressures , firms respond to shortages and putting up the
price, called demand-pull inflation. Therefore, reducing the growth of aggregate demand (AD)
should reduce inflationary pressures.

The Central bank could increase interest rates. Higher rates make borrowing more expensive
and saving more attractive. This should lead to lower growth in consumer spending and
investment.

A higher interest rate should also lead to a higher exchange rate, which helps to reduce
inflationary pressure by:

 Making imports cheaper. (lower price of imported goods)

 Reducing demand for exports.
 Increasing incentive for exporters to cut costs..

Countries have also made Central Bank independent in setting monetary policy, independent
Central Bank will be free from political pressures to set low-interest rates before an election.

 Fiscal Policy

The government can increase taxes (such as income tax and VAT) and cut spending. This
improves the government’s budget situation and helps to reduce demand in the economy.

Both these policies reduce inflation by reducing the growth of aggregate demand. If economic
growth is rapid, reducing the growth of AD can reduce inflationary pressures without causing
a recession.
If a country had high inflation and negative growth, then reducing aggregate demand would be
more uninviting as reducing inflation would lead to lower output and higher unemployment.
They could still reduce inflation, but, it would be much more damaging to the economy.

 An increase in aggregate demand from AD1 to AD2 causes GDP to rise from Y1 to Y2,
firms employ more workers, unemployment falls.
 As economy gets closer to full capacity, we see increase in inflationary pressures. With
lower unemployment workers can demand higher wages, causes wage inflation, also
firms can put up price rises due to rising demand.
 In this situation we see falling unemployment but higher inflation.

{ PL--- Price level, LRAS- Long run aggregate supply}

 Wage Control

If inflation is caused by wage inflation (e.g. powerful unions bargaining for higher real
wages), then limiting wage growth can help to moderate inflation. Lower wage growth helps
to reduce cost-push inflation and helps to moderate demand-pull inflation. But it can be
difficult to control inflation through incomes policies, especially if the unions are powerful.

 Monetarism

Monetarism seeks to control inflation by controlling the money supply. Monetarists believe

there is a strong link between the money supply and inflation. If you can control the growth of
the money supply, then you should be able to bring inflation under control. Monetarists stress
policies such as:
 Higher interest rates (tightening monetary policy)
 Reducing budget deficit (deflationary fiscal policy)
 Control of money being created by the government
  Supply Side Policies

Often inflation is caused by persistent uncompetitiveness and rising costs. Supply-side policies
may enable the economy to become more competitive and help to moderate inflationary
pressures. For example, more flexible labour markets may help reduce inflationary pressure.

However, supply-side policies can take a long time, and cannot deal with inflation caused by
rising demand.

 Ways to Reduce Hyperinflation :

change currency: In a period of hyperinflation, conventional policies may be

unsuitable. Expectations of future inflation may be hard to change.  When people have
lost confidence in a currency, it may be necessary to introduce a new currency or use
another like the dollar (e.g. Zimbabwe hyperinflation)

(hyperinflation is very high and typically accelerating inflation. It quickly erodes the
real value of the local currency, as the prices of all goods increase. This causes people
to minimize their holdings in that currency as they usually switch to more stable foreign
currencies, often the US Dollar ) (Stagflation is an economic cycle in which
there is a high rate of both inflation and stagnation. Inflation occurs when the general
level of prices in an economy increases. Stagnation occurs when the production of
goods and services in an economy slows down or even starts to decline.)

 Ways to reduce Cost-Push Inflation

Cost-push inflation (e.g. rising oil prices can lead to inflation and lower growth. This is the
worst of both worlds and is more difficult to control without leading to lower growth.

 The Phillips Curve

The Phillips curve shows the inverse relationship between inflation and unemployment: as
unemployment decreases, inflation increases, The relationship, however, is not linear.
Graphically, the short-run Phillips curve traces an L-shape when the unemployment rate is on
the x-axis and the inflation rate is on the y-axis.

Theoretical Phillips Curve: The Phillips curve shows the inverse trade-off between inflation
and unemployment. As one increases, the other must decrease. In this graph, an economy can
either experience 3% unemployment at the cost of 6% of inflation, or increase unemployment
to 5% to bring down the inflation levels to 2%.

 Trade off between unemployment and inflation

The Phillips curve suggests there is a trade-off between inflation and unemployment, at least
in the short term. Other economists argue the trade-off between inflation and unemployment is
weak.

 Why is there a trade-off between Unemployment and Inflation?

 If the economy experiences a rise in AD, it will cause increased output.

 As the economy comes closer to full employment, we also experience a rise in inflation.
 However, with the increase in real GDP, firms take on more workers leading to a
decline in unemployment.
 Thus with faster economic growth in the short-term, we experience higher inflation and
lower unemployment.
Increase in AD causing inflation

If we get a rise in AD from AD1 to AD2 – we see a rise in real GDP. This rise in real output
creates jobs and a fall in unemployment. However, the rise in AD also causes a rise in the
price level from P1 to P2. (inflation) 

Phillips Curve Showing Trade-off between unemployment and inflation

In this Phillips curve, the increase in AD has caused the economy to shift from point A to
point B. Unemployment has fallen, but a trade-off of higher inflation.
If an economy experienced inflation, then the Central Bank could raise interest rates. Higher
interest rates will reduce consumer spending and investment leading to lower aggregate
demand. This fall in aggregate demand will lead to lower inflation. However, if there is a
decline in Real GDP, firms will employ fewer workers leading to a rise in unemployment.

 Monetarist View

The Phillips curve is criticised by the Monetarist view. Monetarists argue that increasing
aggregate demand will only cause a temporary fall in unemployment. In the long run, higher
AD only causes inflation and no increase in real GDP in the long term.

Monetarists argue LRAS is inelastic and therefore Phillips Curve looks like this:

 Monetarist Phillips Curve Diagram

{ LRPC- Long run Philip curve}

Rational expectation monetarists believe there is no trade-off even in the short-term. They
believe if the government or Central Bank increased the money supply, people would
automatically expect inflation, so there would be no improvement in real GDP.

 Monetarist view of AD/AS:

 Increse in AD causes temporary increase in real output Y1. After inflation expectations
increase , SRAS1 shifts left to SRAS2, we end up with higher inflation P3 and output of Y1.
This AD/AS model explains why we get a temporary fall in unemployment.

(i) Adaptive expectation monetarist argue there is only short term trade off between
unemployment and inflation.
(ii) Rational expectation monetarist argue there is no trade off , even in short term. Their
model suggests that workers see increase in AD as inflationary and so predict real
wages will remain the same.
 Falling Inflation and Falling Unemployment

In some periods, we have seen both falling unemployment and falling inflation. For example,
in the 1990s, unemployment fell, but inflation stayed low. This suggests that it is possible to
reduce unemployment without causing inflation.

If monetary policy is done well, you can avoid some of the boom and bust economic cycles
and enable sustainable low inflationary growth which helps reduce unemployment.
  Rising Inflation and Rising Unemployment

It is also possible to have a rise in both inflation and unemployment.

If there was a rise in cost-push inflation, the aggregate supply curve would shift to the left;
there would be a fall in economic activity and higher prices.
For example, during an oil price shock, it is possible to have a rise in inflation (cost-push) and
rise in unemployment due to lower growth. However, there is still a trade-off.
Central Bank can reduce the cost-push inflation through higher interest rates. However, it
would lead to an even bigger rise in unemployment.

 Monetarist vs Keynesian view

  Types of Inflation Indexes
Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale
Price Index (WPI)

 The Consumer Price Index

It examines the weighted average of prices of a basket of goods and services which are of
primary consumer needs. They include transportation, food, and medical care.

CPI is calculated by taking price changes for each item in the predetermined basket of goods
and averaging them based on their relative weight in the whole basket. The prices in
consideration are the retail prices of each item, as available for purchase by the individual
citizens. Changes in the CPI are used to assess price changes associated with the cost of living,
making it one of the most frequently used statistics for identifying periods of inflation or
deflation.
  The Wholesale Price Index
The WPI is another popular measure of inflation, which measures and tracks the changes in
the price of goods in the stages before the retail level. While WPI items vary from one country
to other, they mostly include items at the producer or wholesale level.

For example, it includes cotton prices for raw cotton, cotton yarn, and cotton clothing.
Although many countries and organizations use WPI, many other countries, including the
U.S., use a similar variant called the producer price index (PPI).

 The Producer Price Index

The producer price index is a family of indexes that measures the average change in selling
prices received by domestic producers of goods and services over time. The
PPI measures price changes from the perspective of the seller and differs from the CPI
which measures price changes from the perspective of the buyer.

Introduction to Business Ethics

Benefits of Adhering To Business Ethics:

Right Of Workers ,Easy Communication, Getting Across Complex Situations

Easy Evaluation, Increased Confidence, Fewer Errors, Better Public Image

Ethical Issues & Dilemma

Ethical dilemmas, also known as a moral dilemmas, are situations in which there is a
choice to be made between two options, neither of which resolves the situation in
an ethically acceptable fashion. In such cases, societal and personal ethical guidelines
can provide no satisfactory outcome for the chooser.

Corporate Governance

Value based organisation