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UNIT- I
Managerial Economics
Introduction( Nature and scope of managerial economics)
CONTENTS
1.01: INTRODUCTION
1.02: DEFINITIONS OF ECONOMICS
1.03: MICRO AND MACRO ECONOMICS
1.01: INTRODUCTION (ORIGIN OF ECONOMICS)
One can. trace the roots of economics in the 3rd century B.C. Kautilya, also
known as Chanakya, Minister at Chandragupta Mourya’s court, authored
Arthashstra.
In that book in addition to discussing at length the state craft, he discussed

the methods of revenue mobilization. In 6th and 7th century A.D, Greek
philosophers also used the word economics in their writings in a crude
manner. They discussed economics as part of political economy and not as
a separate entity. The word ‘economics’ evolved out of Greek words
‘Okino Mikos’ which implies household activity. In a way, the Greeks
associated economics as the management of household activity.
1.02: DFINITIONS OF ECONOMICS
The era of modern economics was rooted in the writings of Adam Smith.In
economics literature Adam Smith is generally considered as the ‘father of
economics’.Adam Smith published “An inquiry into the nature and
causes of wealth of nations” passionately called as “wealth of nations” and
“epic on economics” in the year 1776. In that book, he stated explicitly that
‘self-interest’ is the basic motivational force behind growth of economies
as well as individuals.
In the later part of 19th century Alfred Marshall of Cambridge School

proposed welfare definition of economics. He published “Principles of
Economics” in the 1890. In that book he emphasized the discussion of
‘welfare- centric human activity’ as the heart and soul of economics.
Marshall stated that “economics is a study of mankind in the ordinary

business of life.
According to Marshall, economics is on the one side a study of wealth and

on the other and most important side a study of human welfare.
“Welfare is for man and not man is for wealth”.
Lionel Robbins disagreed with Marshall’s description of economics as the

study of human welfare and proposed his understanding of economics in
the form of a book titled “An Essay on the Nature and Significance of
Economic Science” in the year 1935.
He defined economics as “the positive science which studies human

behavior as a relationship between ends and scarce means which have
alternative uses”.
Economics is the study of social behaviour guiding in the allocation of

scarce resources to meet the unlimited needs and desires of the individual
members of a given society.Economics seeks to understand those
individuals interact within the social structure to address key questions
about the production and exchange of goods and services.
DEFINITIONS OF MANAGERIAL ECONOMICS:
McNair and Meriam defined managerial economics as “the application of
economic modes of thought to analyse business situations”.
1.03: MICRO AND MACRO ECONOMICS
The subject matter of economics has been broadly classified into two parts. They
are(1). Micro economics (2). Macro economics. We shall try to understand these
two parts of economics in detail.
1.03.1: MICRO ECONOMICS:
This part of economics studies the behavior of individual units such as
Purchase pattern of a consumer at different prices
Supply pattern of a producer at different prices
Profit maximization by a producer
Utility maximization by a consumer
1.03.2: MACRO ECONOMICS
Macro economics is the study of aggregates. It deals with the behavior of the
whole economy. It studies the behavior of macro economic aggregates such as
National income, National output, Employment, Unemployment,Aggregate
savings , investment, exports, imports, general price level. Since it studies the
behavior of aggregates, macro economics also called as aggregate economics or
employment theory or theory of income determination.
Micro Economics Macro economics

S.no
1 The Greek term Micro means Small. The Greek term Macro means
large/aggregate.
2 It studies individual units like It is branch of economics which deals with

individual household, consumer, economy as a whole instead of individual
industry,firms,price of product. aspect.*Total Consumption *Total
*Purchase pattern of a consumer at Investment *National Income *employment
different prices.
*supply pattern of a producer at
different prices.
3 It study a problem of It study a problem of all.

individual.Ex:study of tree Ex: study of forest.
MODULE-2: NATURE OF MANAGERIAL ECONOMICS
2.01: INTRODUCTION
2.02: MEANING AND NATURE OF MANAGERIAL ECONOMICS
2.03: ECONOMICS vs MANAGERIAL ECONOMICS
2.04: MEANING OF ECONOMIC THEORY
2.01: INTRODUCTION:
The part of micro economics applied to study the behavior of business firm
is called as managerial economics. It is the branch of economics which
serves as a link between abstract theory and managerial practice.
Managerial economics is based on identifying problems, organizing

information and evaluating alternatives. Traditionally, the problem of
optimal decision by firms and individuals has been studied in micro
economic theory. Managerial economics as a separate branch owes its
origin to the growing dissatisfaction with the economic theory in providing
solutions to the problems faced by business firms.
2.02: MEANING AND NATURE OF MANAGERIAL ECONOMICS:
Managerial economics is basically related to the decision making by a

business
firm. For example the decisions pertaining to:
1. What to produce?
2. How to produce?
3. How much to produce?
4. What is the break-even level of output?
5. Where to locate the firm?
6. Where to get raw material?
7. Where to procure finances?
8. How many skilled and semi skilled personnel to be employed?
9. What should be the volume of promotional expenditures?
10. What is the kind of marketing strategy to be adopted?
11. What is the price at which commodity is to be placed in the market?
12. How to place the commodity in the market?
13. Is there any need for product differentiation?
14. Whether to expand the firm or not?
15. How to face competition in domestic and world markets?
16. Whether to merge the firm or take over other firms to reap economies of
scale?.
This is not the end of the list. The decision problems of potential entrant
differs from established firms. For example: the decision problem of a new
entrant is how to survive in the market?. Where as the decision problem of
an established firm is, how to acquire dominant position in the market?.
2.03: ECONOMICS vs MANAGERIAL ECONOMICS
The decisions of business firms are some way or other related to

economics. The concern of economics is with economic problem and its
identification, description, explanation and finally finding out a solution, if
possible. An economic problem is a problem of choice. The problem of
choice arises because of limited resources, which have alternative uses.In
the sense that, at the same time these resources are to be used to satisfy
unlimited wants. Had the resources such as labour, capital, money, raw
materials and other inputs not been in short supply i.e. scarce, there would
have been no problem of choice. Scarcity is the birth place of all economic
problems. Whatever the decisions that the management arrives at, these
decisions must help the firm to attain its goal of either profit maximization,
revenue maximization, output maximization or cost minimization.
The study of managerial economics helps the management executives to

arrive at optimal or efficient decisions, when confronted with the allocation
of limited resources among unlimited alternative uses. But the fact is that,
managerial economics does not provide ready made solutions to day-to-
day problems of business firms. It helps the management, like a tool-kit in
the hands of a technician. After knowing the problem, the technician will
take out a specific tool to rectify the defect. In the same way a management
executive can use the knowledge of managerial economics to solve decision
problems.
EX: A finance manager selects the sources and uses of funds.
* A production manager chooses the optimum product mix, aiming at

minimizing cost or maximizing output.
* Marketing manager strives to maximize sales revenue through proper

market segmentation.
*A personnel manager chooses the right staffing pattern.
*A purchase manager chooses the quality of raw material given the cost.
This implies that all managers select one thing or the other from among a
set of alternatives.
2.04: MEANING OF ECONOMIC THEORY:
Economic theory deals with a number of concepts and principles like

demand, supply, cost, production, profit, competition, trade cycles etc.
Economics with the help of allied subjects namely statistics, mathematics,
econometric s, operations research can solve or at least throw some light
upon the problems of business management. The way economic analysis
used to solve business problems constitutes the subject matter of
managerial economics.
NATURE & CHARACTERISTICS OF MANAGERIAL
ECONOMICS:
1 Managerial economics is basically micro in character. It

examines the decision problems of business firms.
2. To provide solutions to business problems it uses concepts

and principles of micro economics.
3. Managerial economics is pragmatic in its approach and

optimistic in arriving at optimal decisions under uncertain
conditions.
4. Managerial economics is normative in character and not

positive. It belongs to normative economics. It is concerned with
ethical/value judgments of decisions.
It is also concerned with the discussion of what should be or

what ought to be the optimal decision keeping in mind the
resource constraint and objectives of the business firm. In fact, it
is prescriptive in character.
5. Managerial economics, though basically micro in character, also

examines concepts of macro economics for example: national
income, trade cycles, industrial policies, tax policies, foreign
trade, etc.
Scope of Managerial Economics:
MODULE-4: FUNDAMENTAL CONCEPTS
1. SCARCITY:
This is one of the fundamental concepts of managerial economics that influences
decisions of business firms to a large extent. scarcity is the root cause of all
economic problems. It is a fact that the resources at the disposal of functional
managers are limited.
For example: production manager may face scarcity of quality raw material, the
marketing manager may face scarcity of sales force and the finance manager may
face scarcity of funds to take up expansion activity. Not only the managers of
business firms but also the finance minister of a country generally faces scarcity
problem due to the expenditure exceeding the revenue. Thus scarcity is a
universal phenomenon.
Example: Supply of resource (the resources at the disposal of a firm) 50 workers
and rupees 1 crore and demand for resource (quantity of resources required) 100
workers and rupees 2 crore. Since demand is more than supply, it leads to
scarcity.
Example: The demand for a commodity=1000 units at a given point of time.
The supply of same commodity at the same time period=800 units. The presence
of excess demand i.e demand 1000–(minus) supply 800, is 200 units. The
presence of excess demand forces the price to move upwards. The significant
feature of scarcity is rise in price. In recent times the prices of onions and garlic
touched the sky due to short supply i.e scarcity.
2. MARGINAL:
Marginal is defined as a change in the dependent variable as a result of one
additional unit change in the independent variable. Marginal is always analyzed
with reference to one unit change in the denominator. Since resources at the
disposal of managers are scarce, while allocating these resources among
competing uses they have to estimate the marginal contribution of resources i.e
the contribution of additional units of resources to the total output.
For Example:
a firm employed 10 units of rawmaterials along with a given quantity of other
inputs and produced 100 units of output. The same firm employed 11 units of
rawmaterials along with a given quantity of other inputs and produced 105 units
of output. In this example marginal output i.e.the contribution of eleventh unit
of rawmaterial alone is 105 units –(minus) 100 units= 5 units.
Further the independent variable is to be changed by just one unit .The purpose
behind estimation marginal is to equate sacrifice with satisfaction. For example
price paid by a consumer to buy a commodity ‘y’(sacrifice)must be equal to utility
derived by consuming that commodity(satisfaction) i.e P Y = MU Y.
In the same way the wage paid to workers must be equal to marginal
productivity of workers i.e W= MP L
We can understand the concept of marginal with the help of following numerical.
Example:
No of laborers
Employed Total product Marginal product
units (units) units
1 3 3
2 7 4
3 12 5
4 18 6
5 25 7
6 30 5
7 33 3
8 35 2
The generalised principle for the estimation of marginal product is shown below.
MP nth unit of labour =Total product of ‘n’ units of labour(TP n ) - Total product
of ‘n-1’ ( TPn -1 ) units of labour.
3. INCREMENTAL CONCEPT:
The marginal concept though appears very simple but in real world business
situation, it is difficult to apply this concept. The problem is that the independent
variable may be subject to bulk or chunk change rather than one unit change. The
fact is that a business firm generally never increases the factors of production unit
by unit.
For Example: a firm employed 100 laborers along with other inputs and produced
1000 units of output. It increased the employment of workers to 200 and
produced 1800 units of output. In this example the incremental output is 800
units. From incremental output we can find out marginal as shown below;
Incremental output
Marginal output = ------------------------ .
Incremental employment
4. DISCOUNTING PRINCIPLE:
This is also known as discounting. This is borrowed from accountancy. With the
help of this concept, one can find the present value of future income stream.
Consider the case of a seller: A business firm may sell goods on credit, can get
Rs1100 after one year from now. On the other hand it can sell the same
commodity on cash payment at Rs 1000. The firm has to decide whether to sell
on credit or on cash payment. Individuals always will have time preference in
favor of the present.
It is better for the firm to sell at cash and receive Rs 1000 and deposit the same in
a bank at 10% rate of interest and earn Rs 1100 at the end of one year. In this
context the present value of future sum of Rs1100 is Rs1000.
The principle for the estimation present value is:
R1 R2 R3 Rn
PV = ------- + -------- + -------- + - - - - - +
( 1+ r ) ( 1+ r ) 2 (1+r)3 (1+r)n
R 1, R 2 , R 3 and R n are prospective revenue in 1, 2, 3, n years. Where as ‘r’

is the rate of interest i.e discount factor.
In the above example R s= Rs1100 and r =10%.
1100
PV = -------- = Rs 1000.
( 1+ 10%)
5.. Opportunity Cost Principle:
Opportunity cost principle is related and applied to scarce resource. When there
are alternative uses of scarce resource, one should know which best alternative is
and which is not. We should know what gain by best alternative is and what loss
by left alternative is.
Opportunity cost is the value of the forgone alternative — what you gave up
when you got something.
Example 1: If a person is having cash in hand Rs. 100000/-, he may think of two
alternatives to increase cash.
Option 1: Investing in bank. We will get returns amount 10000/-
Option2: Investing in business. We get returns amount 17000/-
Generally we chose the option 2 because we will get more returns than the
option 1. Here the option 1 is the opportunity cost, that what we have not
chosen.
6.RISK AND UNCERTAINTY:
Business firms have to conduct production operations in an uncertain
environment. It is not possible to forecast future movement of economic
variables with accuracy. The future involves changes. There is no guarantee that
the present trend of economic variables will continue in the future. Thus the
decision environment is uncertain. Even then the firms take the decisions with
great degree of optimism. The changes in environment may be known or
unknown.
The definite outcome from a known change is called certainty.
The indefinite outcome from a known change is called risk.
The indefinite outcome from an unknown change is called as uncertainty.
Risk can be measured using statistical techniques and insured where as
uncertainty cannot be measured and insured.
7.. PROFIT:
Profit is the difference between total revenue and expenditure. If revenue
exceeds cost, a firm can enjoy profits.
For example total revenue is Rs 10000 and total cost is Rs 8000. Profit is =
Rs2000. There are different types of profit concepts. They are:
1. Absolute profit or abnormal profit: Volume of profits realized by a firm by

charging price, higher than average cost of production are known as abnormal
profits.
2. Normal profits: Business firms generally make payments to all other factors
of production from its total revenue. After making payments to other factors of
production, if the leftover income is just sufficient to cover the remuneration of
the organizer ( profit ) or entrepreneur, it is called as normal profit.
3. Accounting and economic profit: While estimating profit, accountants subtract

explicit cost items from total revenue. They never consider implicit cost, this is
also known as economic cost i.e. the cost of employing own factors of production
in the business.
Example: A business employed own and purchased factors of production to
produce certain quantity of output. The value of own factors like building (rent
Rs2000), family members (wages Rs5000), capital (interest Rs1000) = Rs8000.
The value purchased factors of production such as rawmaterial ( Rs 2000) hired-in
workers ( salaries and wages Rs 5000 ), power charges ( Rs1000), Interest on
borrowed capital ( Rs 2000 ) = Rs 10000.
Total revenue received by the firm Rs 20000.
Accounting profit = Total revenue – value of purchased factors

Rs 20000 - Rs10000 = Rs 10000.
Economic profit = Accounting profit – value of own factors.
Rs 10000 – Rs 8000 = Rs.2000.
8.. TIME PERSPECTIVE:

Decision making is the task of coordination along the time path i.e past, present
and future. Whenever the management confronts a decision environment they
must analyze their present problem with reference to past data of facts, figures
and observation in order to arrive at a decision, contemplating clearly its future
implications in terms of actions and reactions thereupon. Thus the time
dimension plays a crucial role in decision making. Economists often classify time
element in terms of very short period, shortperiod and long period.
⮚ In the very short run (also known as market period),the

supply of a commodity remains constant i.e. supply is equal to stock.
⮚ As against this, in the short run supply can be changed by altering factor
proportions. By employing increasing quantities of variable factors along with
given fixed factors we can alter the factor proportion.
⮚ In the long run all factors are variable and firms enjoy complete freedom to adjust
its production process according to demand conditions. Managers generally
perceive these time element concepts in a different way.
Managers face many a constraint in the very short period.The nature of time
period is such that, it is not possible to increase supply even employing more
variable factors of production. Contrary to this, in the long run constraints are
minimized.
For a practicing manager, short run implies immediate future, whereas long run
is the distant future. The manager must calculate the opportunity cost of his
decision, if he has to choose between the present and the future. His decision
principle is that he must take care of the short run as well as the long run. He
must evaluate the short run and long run effects of a decision. Any decision taken
by the manager has its impact in the short run and also in the long run. A manager
cannot ignore either the short run or the long run impact of a decision.
Examples:
1.By fixing very high price a manager may realize more revenue today. But he
should be prepared to face declining sales tomorrow.
2. At present the advertisement expenditure may inflate the cost. But tomorrow
it contributes to increase in sales and increase in revenue.
3..With a view to earn more profit or to reduce other than production costs, a
manager has taken a decision to withdraw all welfare payments like, festival
advance, bonus, education loans to employees children, etc. In the short run
manager may improve the cost side of the balance sheet but this decision may
adversely affect the future growth of a business firm.
Thus a manager while arriving at decisions must evaluate the short run and also
the long run impact of his decisions.
9.. BREAK- EVEN:
This is also called as no profit and no loss situation. When the total revenue is
equal to total cost, we can say that the firm has reached the break-even. This
concept is very useful to managers to know the minimum volume of output they
have to produce or minimum volume of sales revenue they have to realize in
order to reach break -even. Managers can identify break- even in two ways.
1. Break- even in physical terms: If a firm is producing a single product , we can

identify break even quantity i.e. minimum quantity required to equate total cost
with total revenue.
TFC
Break even quantity = -----------
P-AVC
TFC is total fixed cost, P is price, AVC is average variable cost.
Example: Total fixed cost = Rs 10000, Price = Rs 25 Average variable cost is
Rs 15
10000
Break even quantity = ---------- = 1000 units.
25-15
Given the price and cost conditions, a firm has to produce at least 1000 units
to reach break even situation.
Proof: Total revenue = quantity x price =1000 x 25 =Rs 25000.
Total fixed cost = Rs 10000
Total variable cost= quantity x AVC

= 1000 x 15
= Rs 15000
Total cost = Total fixed cost + Total variable cost
= Rs10000 + Rs 15000
=Rs 25000.
* Therefore total cost =Total revenue.
2. Break- even sales revenue: If a firm is producing multiple products, we can
identify break even sales revenue i.e minimum sales revenue required to cover
all costs.
TFC
Break even sales revenue = --------------
CMR
SR. – TVC
CMR= -------------
SR
TFC is total fixed cost, CMR is contribution margin ratio, SR is sales revenue,
TVC is total variable cost. Given the values we can identify break- even sales
revenue.
1. TFC=Rs 25000, TVC =Rs 75000, SR = Rs 150000. Estimate break even sales
revenue.
150000-75000
CMR= --------------------------- =0.5
150000
Break even sales revenue= 25000

-------------- =50000.
0.5
UNIT-II
(Demand and Supply)
MODULE-1: LAW OF DEMAND
CONTENTS:
1.0 : Introduction
1.01: Objectives
1.02: Meaning of demand
1.03: Demand function
1.04: Types of demand
1.05: Price demand
1.06: Demand schedule
1.07: Individual demand curve
1.08: Estimation demand
1.09: Reasons for negative slope of demand curve
1.10: Exceptions to the law of demand
1.11: Summary
1.12: Additional references
1.13: Self assessment test
1.0: INTRODUCTION: In economics the use of the word demand is made to

show the relationship between changes in independent variable i.e the price
income etc and consequent change in dependent variable. i.e quantity of a
commodity that would be purchased. The demand for a commodity at different
prices, income levels indicates the behavior of rational human beings involved in
the consumption of a commodity. The demand for a commodity reflects the size
and pattern of demand for the product.
1.01: OBJECTIVES: The objective of this module is to explain the meaning of

demand, the influencing factors of demand, extension and contraction in
demand, increase and decrease in demand. After studying this module, you
should be able to explain:
The meaning of demand

The determinants of demand
The reasons for negative slope of the demand curve
Exceptions to the law of demand
1.02: MEANING OF DEMAND:
Generally speaking, by demand we mean effective demand. Demand becomes

effective, when the desire is backed by willingness and ability to buy a
commodity at a given price. In other words, a person must three things in order
to have demand for a commodity. They are:
Desire to buy
Willingness to pay for the commodity
Ability to pay for the commodity.
A miser or a greedy person may have enough income and desire to buy a
commodity, but he may not be willing to pay for it. In this case, we can say that
there is no demand for the commodity from the point of view of a miser. This
indicates that a mere desire does not imply demand. It must be backed by
willingness and ability. In simple terms, the effective fulfillment of a desire is
known as demand.
1.03: DEMAND FUNCTION:

We know that the demand for a commodity is determined by large number of
factors. We can write all these factors which influence the demand for a
commodity in the form of a function as shown below.
DX = f (PX PSC Y, T, AE, W . . . . . . .)
In the above function
DX = Demand for commodity -X (Dependent variable)

PX = Price of
PSC = Prices of substitutes and complementary goods to X
Y = Income of consumer
T = Tastes and preferences
AE = Advertisement expenditures
W = Weather conditions
1.04: TYPES OF DEMAND:

Basically there are four types of demand. They are
Price demand
Income demand
Cross demand
Promotional demand
1.05: PRICE DEMAND (Law of demand):
In the above demand function we have identified the determinants of demand
and written the demand function as:
DX = f (PX PSC Y, T, AE, W . . . . . . . )
We know that in reality, the changes in all the independent variables influence
the demand for X commodity. For analytical simplicity, while analyzing the
price demand, we assume variables other than its own price remain constant. In
such a case we can write the simplified price demand function as
DX = f ( PX )
This function tells us that, other things remaining constant; there exists an
inverse relationship between price of X and the demand for X. That is as the price
of X falls, the demand for X extends and as the price of X rises; the demand for X
contracts assuming that there is no change in other determinants of demand.
This relationship between price of X and the demand for X is known as the ‘The
Law of Demand’. Now we can understand the inverse relationship between price
of X commodity and the quantity demanded of X commodity with the help of
demand schedule.
1.06: DEMAND SCHEDULE:

The demand schedule is simply a table showing the number of units of a
commodity would be purchased at various prices at any given point of time. The
individual demand schedule reflects the purchase behavior of a consumer at
different prices. A hypothetical demand schedule of a consumer is shown below.
Price of X commodity Demand for X

(Rs) (Units)
1 10
2 9
3 8
4 7
5 6
The demand schedule shown above reveals inverse relationship between price
of X and demand for X i.e as price rises from Re 1 to Rs 5, the quantity demanded
contracted from 10 units to 6 units and vice-versa. By plotting the information
given above in a diagram and joining the corresponding price and quantity
points, we can derive the demand curve.
1.07: INDIVIDUAL DEMAND CURVE:

A demand curve is a graphic representation of demand schedule. While drawing
the demand curve, we measure demand for X horizontal axis and price on
vertical axis. The usual shape of the normal demand curve is as follows.
GRAPH-1
Y
D
Price
0 X
Demand
The basic feature of the price demand curve is, it slopes downward from left to
right. This reveals the fact that quantity demanded is inversely related to price.
1.08: ESTIMATION OF DEMAND:

With the help linear demand we can understand the relationship between price
and quantity demanded. For example: Qd = a –bPx . In this demand function,
Qd is the quantity demanded, ‘a’is the autonomous demand ie the demand at
zero price (intercept), ‘b’ is the induced demand (slope) and Px is the price. The
estimated demand function is Qd = 10 - . 5 Px. Given demand function we can
construct a demand schedule i. we can identify quantity at different prices as
shown below.
Price Quantity
(Rs) (Units)
0 10
1 9.5
2 9.0
3 8.5
4 8.0
5 7.5
6 7.0
Based on this information we can derive demand curve as shown below.
GRAPH-2
D
Qd = 10 - .5Px
Price
0 10
Demand
ACTIVITY-1
1. What is the meaning of demand?

2. Specify a demand function for four wheelers.
3. Given the estimated demand function Qd = 20 - . 5Px, construct demand
schedule and identify show its intercept and slope in terms of graph.
1.09: REASONS FOR NEGATIVE SLOPE OF THE DEMAND CURVE:
1. Law of Diminishing Marginal Utility:
Economists, who believe in cardinal utility concept, say that diminishing

marginal utility for the consumer is the fundamental reason for negatively
sloped demand curve. According to them as the price of the commodity falls,
consumer purchases more of a commodity, so that the marginal utility from the
commodity also falls to equal the reduced price and vice-versa.
2. Income effect:
As the price of a commodity falls, the real income of a consumer increases in

terms of the commodity whose price has fallen. As a result, a part of the increase
in real income is used buy more of a cheaper commodity. This implies that as
price falls the quantity demanded extends and vice –versa.
3. Substitution effect:
According to ordinal utility approach, the substitution effect of change in price is
the basic reason for the application of Law of Demand. When the price of a
commodity falls, it becomes cheaper compared to other commodities which the
consumer is purchasing. As a result, the consumer would like to substitute this
cheaper commodity for other commodity whose price whose price remains
constant.
4. New consumers:
When the price of a commodity is reduced, then a large number of new

consumers who were not consuming the commodity start purchasing it now,
because they can now afford to buy it.
5. Different uses of the commodity:
Commodities have different uses. If their price rises, they are used only for
important purposes. As a result the demand for such commodities contracts. On
the other hand, when the price is reduced, the commodity may be used for
satisfying different needs. As a result its demand extends.
1.10: EXCEPTIONS TO THE LAW OF DEMAND:

The inverse relationship between price and quantity demand i.e simply the law
of demand does not hold good with respect to all types of commodities and
under all conditions. With respect to some commodities, there exists direct
relationship between price and quantity demanded i.e as price rises, the demand
extends and as price falls, demand contracts. Such commodities are to be treated
as exceptions to the law of demand. The exceptions to the law of demand are
discussed below.
1. GIFFEN GOODS:
There are some commodities which are inferior from the consumers view point..
Sir Robert Giffen was mentioned by Marshhall as having discussed such
exceptions. Giffen stated that with a fall in price of bread its quantity demanded
was reduced rather than increased. This is known as Giffen Paradox.
In a country like India take a poor man who has to spend a major portion of his
income on low quality grain and is therefore, able to spend a small part of it on
other goods. If the price of this coarse grain rises, he will be left with still less
money to spend on other goods. As a result he may be forced to spend this part
of his income also on the grain whose price has risen. On the other hand, if the
price of the grain falls, the real income of the poor consumer rises and he can go
for the consumption of better quality goods.
2. ARTICLES OF DISTINCTION:
These goods are also known as prestige goods are status symbol goods or
Veblen goods. According to Veblen, the demand for articles of distinction such as
diamonds and jewellery is more as their price is higher. This is because, a rich
man’s desire for distinction is satisfied better when the articles of distinction are
highly priced and the poor people cannot afford to buy.
3. EXPECTATIONS:
These expectations are basically related to rise and fall in price in future. If
consumers expect a rise in price of a commodity, they rush to purchase more of
the commodity at the current price even though the current price is much higher
than the previous price. If they expect a fall in price, they purchase less of the
commodity at present in the hope of buying it at a lesser price.
In all these exceptional cases the law of demand does not hold good.
ACTIVITY- II
1. What do you mean by exceptions to the law of demand?
2. What is Giffen’s paradox?
3. Give examples for Veblen goods.
1.11: SUMMARY:
Demand means the effective fulfillment of a desire. A mere desire does not
represent the demand for a commodity. In order to have demand, desire to buy a
commodity must be backed up by willingness and ability to buy. In reality a
large number of factors determine the demand for a commodity. We have
analysed the law of demand by assuming other things remaining constant. In
case of price demand there is an inverse relationship between price and quantity
demanded. With regard to exceptional cases the law of demand does not hold
good.
1.12: ADDITIONAL REFERENCES:

1. Stonier and Hague: A Text Book of Economic Theory.
2. K.N.Verma: Micro economic theory.
1.13: SELF ASSESSMENT TEST:

1. Discuss the reasons for inverse relationship between price and quantity.
UNIT-II
(Demand and Supply)
MODULE- 2: INCOME AND CROSS DEMAND.
CONTENTS:
2.0: Objectives
2.01: Meaning
2.02: Income Demand
2.03: Cross Demand
2.04: Promotional Demand
2.05: Extension and contraction in demand
2.06: Increase and decrease in demand
2.07: Summary
2.08: Additional References
2.09: Self assessment test.
2.0: OBJECTIVES:
The objective of this unit is to explain the meaning of income and cross demand.
After reading this unit you should be able to explain the:
Meaning of income, cross and promotional demand

Expansion and contraction of demand
Increase and decrease in demand.
2.01: MEANING:
Income demand shows the relationship between changes in demand as a result
of change in income, given other things. Cross demand shows the relationship
between changes in demand for A product as a result of change in the price of b
product, given other things. Products A and B may be either substitutes or jointly
demanded. Promotional demand shows the relationship between advertisement
expenditures and the sales, given other things.
2.02: INCOME DEMAND:
The general demand is DX = f ( PX PSC Y, T, AE, W . . . . . . . )

PX = Price of
PSC = Prices of substitutes and complementary goods to X
Y = Income of consumer
T = Tastes and preferences
AE = Advertisement expenditures
W = Weather conditions
Assuming other things remaining constant, we can write the income demand
function as Dx = f (y). Here Dx is the demand for x commodity and y is the
income of consumer.
While analyzing the relationship between change in income and demand for a
commodity, we classify goods in to Superior and inferior.
Superior goods: In case of superior goods, there exist direct relationship between
change in income and demand. We can understand this with the help of a
diagram.
GRAPH-1
Y
Income demand Curve
Y2
Y1
Income
Q Q1 Q2
Demand
The diagram above shows that if income is OY1, the demand is OQ1. If income
rises to OY2 demand increased to OQ2 and if income falls to OY, the demand is
reduced to OQ. The income demand curve incase of normal goods has positive
slope. Income demand curve for consumer durables represent Engel’s Law. This
law states as income increases, the proportion of income diverted towards
purchasing durable consumer goods also increases.
Inferior goods:
Demand is inversely related to change in income with respect to inferior goods.
GRAPH-2
Y2
Income
Y1 Income demand Curve

Y
Q Q1 Q2 X
Demand
As shown in above diagram, original level of income is OY1 and corresponding

demand OQ1. If income rises from OY1 to OY2, the demand for inferior good
decreased from OQ1 to OQ. On the other hand if income falls from OY1 to OY,
the demand increased from OQ1 to OQ2. The income demand curve incase of
inferior goods has negative slope.
ESTIMATION OF INCOME DEMAND:

With the help linear demand function we can understand the relationship
between income and demand. For example: In case of superior goods we can
specify income demand function as Qd = a +by. In this demand function, Qd is
the demand, ‘a’is the autonomous demand ie the demand at zero income
(intercept), ‘b’ is the induced demand (slope) and y is the price income. In case of
inferior goods we can use the demand function as Qd = a –by. The estimated
income demand is Qd = 100 +. 5y (superior or normal goods) and Qd = 100- .5y
(inferior goods) . Given the values of income we can construct demand schedule.
Demand we can construct a demand schedule i. we can identify quantity at
different prices as shown below.
ACTIVITY-I
1. List out superior goods.
2. List out inferior goods.
203: CROSS DEMAND:

This shows the relationship between changes in demand for one commodity as a
result of change in the price of another commodity, assuming other things
remaining constant. These two commodities may be either substitutes or
complementary goods. We can write the cross demand function as shown below.
DA = f (PSC)
DA = Demand for commodity - A (Dependent variable)

PSC = Prices of substitutes and complementary goods to A
Substitutes: If two commodities are substitutes, then we can use A commodity

or B commodity for the same purpose. Examples of substitutes are T.Vs, fans,
watches, coolers, bikes, four wheelers from two companies etc. In the case of
substitutes, if the price of B rises, the demand for A increases and if the price of B
falls, the demand for A decreases. Cross demand curve related to substitute
goods slopes upward from left to right as shown below.
GRAPH-3
Cross demand curve for

Substitutes
P2
P1
Price of B
Q Q1 Q2 X
Demand for A
Complementary goods:
These goods also known as jointly demanded products. Examples are petrol and
automobiles, pen and ink, pen and paper etc. Let us assume that A and B are
complementary goods. Then, if price of B rises the demand for A falls and vice-
versa.
GRAPH-4
P2
P1
e of B
P
The above diagram indicates that as the price of B rises from OP1 to OP2, the
demand for A decreases from OQ1 to OQ. On the other hand if the price of B
falls from OP1 to OP,the demand for A increases from OQ1 to OQ. In case of
complementary goods, the cross demand curve slopes downward from left to
right.
ESTIMATION OF CROSS DEMAND:

With the help linear demand function we can understand the relationship
between price of B and demand for A. For example: In case of substitutes we can
specify cross demand function as Qd = a +bPB. In this demand function, Qd is
the demand, ‘a’is the autonomous demand ie the demand at zero price of B
(intercept), ‘b’ is the induced demand (slope) and PB is the price of B. In case of
complementary goods we can use the cross demand function as Qd = a –bPB.
The estimated cross demand is Qd = 10 +. 5PB (substitutes) and Qd = 10- .5PB
(complementary goods) . Given the values of PB we can construct cross demand
schedule.
ACTIVITY-2
1. List out substitute commodities.
2. List out jointly demanded products.
2.04: PROMOTIONAL DEMAND:
This shows the relationship between changes in demand as a result of change in
advertisement expenditures, assuming other things remaining constant. It is a
fact that business firms generally spend huge amount towards promoting sales
of their product. We can write the promotional demand function as shown
below.
DX = f (AE)
AE = Advertisement expenditures.
We can show the relationship between advertisement expenditures and sales

with the help of following graph.
GRAPH-5
Y Sales
Sales
100 X
Advertisement expenditure
The diagram above shows that in the beginning even without advertisement a
business firm can sell certain quantity of commodity. One can observe direct
relationship between advertisement expenditures and sales up to a certain level
of advertisement expenditure. For example up to Rs 100 crores. After that it is
not possible to increase sales through advertisement. As a result, sales curve has
become parallel to horizontal axis.
2.05: Extension and contraction in demand:
This refers to a movement along the demand curve. Change in demand as a
result of change in price, other things remaining constant, either called as
extension or contraction in demand. Extension and contraction is to be shown on
the same demand curve through different points. We can see this with the help
of following diagram
GRAPH-6
D
Contractio
A n
P
2 B Extension
Price
P
1 C
P
Q Q1 Q2
Demand
According to the above diagram, if the price is OP1, the quantity demand is OQ1.
This is indicated by point B on the demand curve. If the price of the commodity
rises from OP1 to OP2 the quantity demanded is reduced to OQ. This
corresponds to point A on the demand curve. This reduction or fall in demand as
a result of rise in price is described as contraction in demand. On the other hand,
if price falls from OP1 to OP the quantity demanded rises to OQ2 which
corresponds to point C on the demand curve. This is called Extension in demand.
Backward movement from B to A on the demand curve, given other things , is
called as contraction in demand and a forward movement from B to C is called as
extension in demand.
2.06: Increase and decrease in demand:

This refers to shift in demand curve. Given the price, if there is change in other
factors which influence the demand, i.e. income, prices of substitutes and
complementary goods, advertisement expenditure etc, the resulting change in
demand is to be shown through a shift in demand curve. We can understand this
with the help of following diagram.
GRAPH-7
Y
D2
D1
D0
A B C
P
Price
D2
D1
D0
Q Q1 Q2
Demand
The above diagram indicates that, initially if the price is OP, the demand is OQ1
corresponding to point B on D1D1 curve. Given the price assume that there is
change in other factors i.e. increase in income. In such a case the consumer may
buy more of the commodity i.e OQ2 at price OP. As a result of this, D1D1 shifts
toD2D2. On the other hand, given the price, if there is fall in income, then the
consumer may buy less i.e.OQ of the commodity. In this case the demand curve
shifts from D1D1 to D0D0. The upward shift in demand curve from D1D1 to
D2D2 is called increase in demand and a downward shift in demand curve from
D1D1 to D0D0 is called decrease in demand.
2.07: Summary:
Change in demand as a result of change in income, assuming other things
remaining constant is known as income demand. Change in demand for one
commodity as a result of change in price of other related product, ceteris paribus,
is known as cross demand. Change in demand as a result of change in
advertisement expenditure is called as promotional demand. Upward or
downward movement along the same demand curve is known as extension and
contraction where as upward or downward shift in demand curve known as
increase in demand and decrease in demand.
2.08: ADDITIONAL REFERENCES:

1. Stonier and Hague: A Text Book of Economic Theory
2. K.N.Verma: Micro Economic Theory
2.09: Self Assessment Test:

1. Discuss income, cross and promotional demand.
2. Spell out the distinction between extension and contraction in demand.
UNIT-II
(Demand and Supply)
MODULE- : PRICE ELASTICITY OF DEMAND
Notes:
CONTENTS:
3.0: Introduction
3.01: Objectives
3.02: Meaning of elasticity
3.03: Price elasticity of demand
3.04: Estimation of price elasticity
3.05: Factors influencing price elasticity
3.06: Summary
3.07: References
3.08: self assessment test
3.0: INTRODUCTION:
In Module –I of Unit-II we have discussed the law of demand. The law of
demand explains the direction of demand i.e the law of demand states that the
price of a commodity and the quantity demanded of that commodity move in
opposite direction. It does not tell us anything about the extent or magnitude of
change in demand as a result of given percentage change in price. In order to
know the quantum of change in dependent variable as a result of given
percentage change in the independent variable, we have to take the help of
elasticity concept.
3.01: OBJECTIVES:
The objective of this module is to explain the meaning and measurement of price
elasticity of demand. After reading this unit you should be able to understand:
Meaning of elasticity
Meaning of price elasticity
Measurement of price elasticity
Estimation of price elasticity
Influencing factors of price elasticity.
3.02: MEANING OF ELASTICITY:

In general elasticity means the degree of responsiveness of the dependent
variable to a given proportionate change in the independent variable. This we
can write as:
Proportionate change in the dependent variable

Elasticity of demand = ---------------------------------------------------------------------
Proportionate change in the independent variable
3.03: PRICE ELASTICITY OF DEMAND:

This indicates the degree of responsiveness of demand for a commodity to a
given proportionate change in the price of that commodity. In other words we
can say that it is the ratio between percentage changes in quantity demanded to
percentage change in price. While estimating price elasticity, we have to take into
account demand as the dependent variable and the price as the independent
variable. We can write the price elasticity principle as shown below.
Proportionate change in quantity demanded

Price Elasticity of demand = ----------------------------------------------------------------
Proportionate change in price
This we can write as

Change in quantity demanded
-------------------------------------------
Original quantity
Price Elasticity of demand = -------------------------------------
Change in price
---------------------------
Original price
NOTE-1
Use notations for

Here/change in Quantity = ∆ Q
Original Quantity =Q
Change in price = ∆P
Original Price = P
Now we can write the price elasticity as =

= × = ×
Here is equal to slope of the demand curve or rate of change i.e. and P/Q
is the ration between price and quantity
Degrees of Price elasticity: Depending on the value of price elasticity, the price
elasticity of demand is divided in to five. Let us discuss them in detail.
1.Perfectly elastic demand: If an insignificant or near zero percentage change in

price causes an infinite or very large percentage change in demand, it is known
as perfectly elastic demand. In this case, the value of elasticity will be equal to
infinity and the demand curve will be parallel to horizontal axis as shown below.
GRAPH-1
Y
Price elasticity = ∞
D
Price
0 X
Demand
2. Perfectly inelastic demand: If the demand is non-responsive to a given
proportionate change in price, it is known as perfectly inelastic demand. In this
case the value of price elasticity is equal to zero and the demand curve will be
parallel to vertical axis as shown below.
GRAPH-2
Y
D
B
P2
Price elasticity =
rice
P1
The above diagram indicates that, even if the price rises from P1 to P2 or falls
from P2 to P1, the quantity demanded remains constant as ‘OQ’.
3. Unitary elasticity:
If the proportionate change in quantity demanded is exactly equal to

proportionate change in price, then it is called as unitary elastic demand. In this
case the value of elasticity is equal to one(1) and the demand curve will be like
rectangular hyperbola as shown in graph.
GRAPH-3
Y
D
Price elasticity = 1 (one)

Price
0
Demand
4. Relatively elastic demand: If the proportionate change in demand is more
than the proportionate change in price, it is known as relatively elastic demand.
In this case the value of elasticity will be greater than one.
5. Relatively inelastic demand:

If the proportionate change in demand is less than the proportionate change in
price, it is known as relatively inelastic demand. In this case the value of
elasticity will be less than one.
ACTIVITY -1
1. Define elasticity of demand.

2. Draw the shape of demand curve in case of unitary elasticity.
MEASUREMENT OF PRICE ELASTICITY:
In order to measure the price elasticity, there are three methods available in
economic literature. They are:
Total Outlay Method
Point Method
Arc Method.
Now we try to understand each one of the above methods.
Total outlay method:

This method is also known as total expenditure method. Under this method the
price elasticity is measured in terms of pattern of expenditure on any
commodity. That is as price falls, the law of demand states that demand rises.
But here the question is, what happens to the expenditure on that commodity.
Will expenditure increase or decrease or remain constant?. Based on this i.e.
expenditure pattern, the price elasticity of demand is explained in terms of
Elastic demand
Unitary elastic demand
Inelastic demand
Elastic demand: As a result of fall in price the demand increases and at the same
time if the expenditure on this commodity increases, it is known as elastic
demand.
Unitary elastic demand; As a result of fall in price the demand increases and at
the same time if the expenditure on this commodity remains constant, it is
known as elastic demand.
Inelastic demand: As a result of fall in price the demand increases and at the
same time if the expenditure on this commodity decreases, it is known as
inelastic demand.
We can understand elastic, unitary elastic and inelastic demand with the help of
following example:
NOTE- 2
Quantity of A Price of A Total Expenditure

(Units) (Rs) (Rs)
1 10 10
2 9 18
3 8 24 Elastic demand
4 7 28
5 6 30
Unitary elastic
6 5 30
7 4 28
8 3 2 in elastic demand
9 2 18
10 1 10
According to the above example, as price falls from Rs.10 to Rs 6,the quantity of
A commodity increased from 1 unit to 5 units and the expenditure on A
commodity increased from Rs 10 to Rs 30. So this is the case of elastic demand.
As price falls from Rs 6 to Rs 5, the quantity of A increased from 5 units to 6
units. But the expenditure on the commodity remains constant. So this is the case
of unitary elasticity.
Finally, as the price falls from Rs 5 to Rs 1 the quantity of A increased but the
expenditure on this commodity decreased from Rs 30 to Rs 10. So this is inelastic
demand.
By plotting the above data in a diagram we can derive the total expenditure total
outlay curve. The shape of the total expenditure curve is shown below.
GRAPH-4
Y
A
e>1
B
E=0
Price
E<1
D
Total expenditure
Point elasticity Method
This method is known as geometric method. This method is used to find out the
value of price elasticity of demand at any point on a straight line demand curve.
Under this method, the principle for estimating price elasticity at any point on
the demand curve is shown below.
Distance of lower segment of the demand curve

Price elasticity at any point = ------------------------------------------------------------
On the demand curve Distance of upper segment of the demand curve.
We can understand the point elasticity with the help of the following diagram.
GRAPH-5
Y
A
B
C
Price
E
Demand
In the above diagram we have drawn a straight line demand curve AE and
identified different points on this curve such as A,B,C,D and E.
CE (lower segment)
Elasticity of demand at point C is = ---- ---------------------- = 1
CA (upper segment)
Because C is a mid -point on the straight line demand curve. So point C dividng
the AE demand curve in to two equal parts as CE and CA.
DE
The price elasticity of demand at point D= ----- = less than one
AD
0 (ZERO)
The price elasticity of demand at point E= ----- = 0(zero)
AE
BE
The price elasticity of demand at point B= ----- = more than one
AB
AE
The price elasticity of demand at point A= ----- = infinite
Zero
The above analysis indicates that each and every point on the straight line
demand curve denotes a different value of elasticity. If you are moving from mid
point (C) towards quantity axis the value of elasticity decreases. Where as if you
move from mid -point towards price axis the value of price elasticity increases.
Arc Method:
This method is used to find out price elasticity on a segment of the demand
curve rather than at a particular point.
GRAPH-6
Y
D
P2 A
P1 B
D
Price
Q2 X
Q1
Demand
In the above diagram AB represents a small segment on the demand curve DD.
By using Arc method it is possible to find out price elasticity on AB segment
rather than either at point A or at point B. The principle for the estimation of
price elasticity under this method is:
NOTE-3
Price elasticity of demand =
Further we can write this as
Example: Let initial price is Rs 10. Quantity demanded is 100 units. Price falls to Rs 8.
Quantity demanded increased to 140 units. Price elasticity of demand is:
Here change in demand = 40 units
Change in Price = Rs 2
Original demand = 100 Units
New demand =140 units
Original =Rs 10
New Price = Rs 8
Substituting these different values in the above principle we can get price elasticity value.
= ×
= ×
= (-) 1.5
We can say that, on AB segment of the demand curve, the value of price elasticity is (-)
1.5. This indicates that 1% fall in price causes 1.5% rise in demand and vice-versa.
3.04: ESTIMATION OF PRICE ELASTICITY:
With the help of estimated demand function we can find out price elasticity
value. For example Qd = 10- .5 PX. If the price is Rs 10 the value of price elasticity
is:
NOTE-4
Price elasticity of demand = ×

Here or = 0.5 as given demand function. Using the demand function Qd=10-
.5Px, we can find out Qd at Rs 10
Qd = 10 - .5 × 10
= 10 -5
=5
By substituting these values in the demand function we can find out the value of price
elasticity.
Price elasticity = (-)0.5 ×
= (-) 1 since the value of price elasticity of demand is 1(one), its nature
is unitary elastic.
ACTIVITY-2
1. What is the principle for price elasticity?

2. What is the value of price elasticity at midpoint of straight line demand
curve?
3.05: FACTORS INFLUENCIMG PRICE ELASTICITY OF DEMAND:
The value of price elasticity of demand is influenced by different factors. They

are:
1. Nature of commodity:
In case of commodities which are considered as necessaries, the price elasticity

tends to be inelastic. For example: Rice, sugar etc. These commodities have got to
be purchased irrespective of their prices. When price rises, consumers cannot
reduce their consumption. In case of luxury commodities, the price elasticity
tends to be elastic.
2. Number of uses:
If a commodity can be put to large number of uses, its demand tends to elastic.
In this case, as a result of fall in price, consumers want to put that commodity
even for not so important purpose. Due to this, the demand will respond
significantly as a result of fall in price.
3. Availability of substitutes:
If a commodity is having large number of substitutes, its price elasticity of
demand tends to be elastic.
4. Postponement of consumption:
If it is possible to postpone the consumption of a commodity under
consideration, the price elasticity of demand tends to be elastic.
5. Range of prices:
At very low price, the elasticity of demand tends to be inelastic.
6. Time element:
Generally in the long-run the elasticity of demand is more responsive i.e elastic,
compared to the short-run.
7. Habits:
If the consumers are habituated to consume a commodity, then the demand for
such commodities tends to inelastic.
ACTIVITY-3
1. List out the factors influencing price elasticity of demand.
3.06: SUMMARY:
In this module we discussed at length the concept of price elasticity, its

estimation and its determinant. Price elasticity is a ratio between proportionate
change in quantity demanded to proportionate change in price. Price elasticity
indicates the responsiveness in demand as a result of given percentage change in
price. With the help of demand function we can estimate price elasticity.
3.07: References:
1. Stonier and Hague ; Text Book of Economic Theory

2. H.L Ahuja: Advanced Economic Theory
3. Dominick Salvatore ; Managerial economics in a Global Economy
1. Define price elasticity of demand and explain its determinants.
2. Discuss different methods of measuring price elasticity of demand.

UNIT-II
(Demand and Supply)
MODULE- 5: CONCEPTS OF DEMAND
CONTENTS
5.0: Objectives
5.01: Short run and Long run demand
5.01: Individual and Market demand
5.02: Segmented market and total market demand
5.03: Company and industry demand
5.04: Direct and derived demand
5.05: Autonomous and induced demand
5.06: Perishable and durable goods demand
5.07: Domestic and industrial demand
5.08: New and replacement demand
5.09: Final and intermediate demand
5.10: Change in quantity demanded and demand.
5.11: Summary
5.12: References
5.13: Self Assessment Test
5.0: OBJECTIVES:
In module -1 and 2 of Unit –II we discussed the types or kinds of demand
for example: Price, income, cross and promotional demand. The objective
of this module is to present different concepts of demand. After reading
this module you should be able understand the meaning of:
Short run and long run demand

Individual and Market demand
Segmented market and total market demand
Company and industry demand
Direct and derived demand
Autonomous and induced demand
Perishable and durable goods demand
Domestic and industrial demand
New and replacement demand
Final and intermediate demand
Change in quantity demanded and demand.
5.01: Short run and Long run Demand:

Short run demand may be taken to mean immediate, existing demand
which is based on given tastes and preferences, available technology and
given economic environment. Long run demand on the other hand refers to
size and pattern of demand, which is likely to prevail in future as a result of
changes in technology, tastes, product improvement and promotional
efforts and such other factors where adjustments take place over a period
of time. Price, income fluctuations are more relevant as determinants of
short run demand, while changes in food habits, urbanization, work culture
etc must be considered for long run demand analysis.
5.02: Individual and Market demand:

Individual demand indicates the purchase pattern of an individual or a
consumer at different prices. The individual demand schedule gives us
information related to purchase pattern of a consumer at different prices.
For example:
Price of X commodity Quantity demanded

(Rs) (Units)
1 10
2 9
3 8
4 7
5 6
The above shown demand schedule indicates quantity demanded of a

commodity by a particular consumer corresponding to different prices.
But the reality is that a market is visited by large number of consumers with
varying degree of income, tastes, age, etc. As a result the business firm
must have an idea about the market demand for the commodity in order to
arrive at optimal decisions regarding the level of out put to be produced.
Because these different consumers react differently to the prevailing
market price of a commodity. By constructing individual demand schedules
and through horizontal summation of individual demand of different
consumers at any given price, we can arrive at market demand for the
product. The market demand schedule represents aggregate purchase
behavior of consumers in the market. We can understand derivation of
market demand schedule as shown below.
Price of X Quantity Quantity Market

demand
Commodity purchased purchased (A+ B)
by A by B
10 10 20 30
9 20 30 50
8 30 40 70
6 40 50 90
5 50 60 110
This example is given by assuming there are two consumers for X

commodity. In fact there are millions of consumers for any product. To
simplify the analysis we have taken into account two consumers. In the
above table the market demand is arrive at by adding together individual
demand at any given price. For example at price Rs 8, the quantity
purchased by consumer A is 30 units while B is 40 units. Therefore the
market demand is 30 + 40 =70 units. In this way we can find out market
demand for the commodity at any given price. Like individual demand
curve the market demand curve also slopes downward from left to right.
GRAPH- 1
Y ‘A’ Y ‘B’ Y
DM (A+B)
D DB
A 10
Price
10
Price
Price
DM
8
8 8
DB
DA
Here DA is the demand curve of Consumer ‘A’
DB is the demand Curve of Consumer ‘B’
DM is the demand Curve of total market i.e A+B
5.03: Segmented market and Total Market Demand:
Segmented market demand indicates the demand for a product in one

segment i.e one part of the market. A business firm may place its
commodity in different geographic locations across the world. For example:
Domestic market and foreign market. Hindustan Machine Tools sell its
commodity i.e watches, in domestic as well as foreign market. The demand
for its product in domestic market and foreign market separately constitute
segmented market demand. On the other hand the demand fro its product
in domestic and foreign market together represents total market demand.
Through horizontal summation of segmented market demand at any given
price, we can arrive at total market demand. Total market consisting of
varying degrees of income, tastes and preferences, traditions, external
environment etc represent aggregate picture of demand for the product of
a firm . This we can understand with the following example.
Price of Demand Demand Total Market

demand
Watches in domestic in foreign (Domestic +
Foreign)
( Rs) Market Market
10000 10 20 30
9000 20 30 50
8000 30 40 70
6000 40 50 90
5000 50 60 110
5.04: Company and Industry Demand:
An industry is the aggregate of firms/companies. We generally come across

the words: software industry, iron and steel industry, cement industry etc.
For example: in software industry Micro Soft, Wipro, Satyam, TCS, and
many other companies are there. The demand for software products of a
particular firm represents company demand. The demand for software
products of all firms together represents industry demand. Each and every
company must have an idea about the movement of industry demand to
know trend o demand fro its product. Through horizontal summation of
company demand, we can derive the industry demand. The derivation
process of industry demand is same as that of the derivation process of
total demand and market demand.
ACTIVITY-1
1. Is there any difference between company and industry?. If ‘yes’
explain it.
2. How do you do you find out total market demand for software
professionals?
5.05: Direct and Derived:

Direct demand refers to demand for goods meant for final consumption. It
is the demand for consumer goods such as food items, readymade
garments, cigarettes etc. On the other hand, derived demand refers to
demand for goods which are needed for further production. It is the
demand for rawmaterials and factors of production like labour. Thus
demand for inputs or factors of production, is a derived demand. The
demand for rawmaterial depends on the demand for output where
rawmaterials are used to produce that output.
5.06: Induced and Autonomous:

When the demand for a product is influenced by the demand for some
other product, it is called as induced demand. For example: the demand
cement, iron and steel is generally influenced by demand housing or
construction. So the demand for these commodities is induced in nature.
The demand for all complementary goods such as tea-sugar, bread-butter,
automobiles and petrol etc is induced demand. Autonomous demand is not
derived or induced. It is independent demand. Though theoretically we can
speak of autonomous demand but in reality the demand for all
commodities is derived/ induced. In the context of demand analysis, for the
estimation of demand, economists use the demand function Qd = a – bPx.
Here ‘a’ is the autonomous component and ‘b’ is the induced component of
demand.
5.07: Perishable goods and Durable goods Demand:

The demand for bread, rawmaterial like cement which can be used only
once, is called perishable demand. The same unit of these goods cannot be
used repeatedly. On the other hand the demand for capital goods such as
machinery, car, consumer goods such as shirt, television, is called durable
goods demand. The owner of these commodities can put these
commodities in use repeatedly.
5.08: Domestic and Industrial Demand:

The internal demand for firms’ product is called domestic demand. The
external demand for firm’s product is called industrial demand. Assume
that Tata Company produced 10 million tonnes of steel in the year 2010.
Out of the total 10 million tones, its internal demand was 2million tonnes.
This is called domestic demand. The demand from other industries in the
economy was 8 million tones. This is called industrial demand.
5.09: New and Replacement Demand;

If the purchase of an item is meant as an addition to stock, it is new
demand. For example: the demand for latest model a television. Constitute
new demand. On the other hand the demand spare parts represent
replacement demand.
5.10: Final and intermediate demand:

Demand for final product such paint represents final demand. Where as
the demand for intermediate products such as chemicals, which are used as
input in the production of paint to improve the quality of paint, is called as
intermediate demand.
5.11: Change in quantity demanded and change in demand:
Change in quantity demanded is always with reference to a movement

along the same demand curve. The change in purchases of a consumer due
to change in price, ceteris paribus, is called as change in quantity
demanded. This is denoted in terms of either extension in demand or
contraction in demand. On the other hand, change in demand is always
with reference to a shift in demand curve. The change in purchases of a
consumer due to change in other than price, for example income, given the
price, is called as change in demand. This is denoted in terms of either
increase in demand or decrease in demand.
1. What do you understand by domestic and industrial demand?

2. Provide examples for replacement demand.
5.12: Summary
In this module an attempt is made to familiarize to you the various
concepts of demand.. The market demand concept helps the management
to identify the nature of total market demand for their product. Further the
management can find out the nature of the product i.e. intermediate or
final,they are producing. The understanding of these concepts helps the
management to arrive at optimal decisions
5.13: References:
1. R.L Varshney and Maheswari : Managerial economics.
2. Mote,V.L; Samuel Paul and G.S.Gupta : Managerial Economics,
concepts
and cases.
3. Koutsoyiannis : Modern Micro Economics

1. Discuss different concepts of demand and comment on their usefulness
to the management in arriving at optimal decisions.
UNIT-II
(Demand and Supply)
MODULE- 6: LAW OF SUPPLY
Notes:
CONTENTS
6.0: Objectives
6.01: Introduction
6.02: Meaning of Supply
6.03: Supply function
6.04: The law of supply
6.05: Extension and contraction in supply
6.06: Increase and decrease in supply
6.07: Summary
6.08: References
6.0: OBJECTIVES:
The objective of this module is to explain the meaning of supply,
determinants of supply and elasticity of supply. After reading this module,
you should be able to understand:
The meaning of supply

The Law of Supply
Extension and Contraction in Supply
Increase and Decrease in Supply
6.01: Introduction:
In economics the word supply is used to show the relationship between
change in independent variable i.e. price and consequent change in the
dependent variable i.e. quantity of a commodity that would be supplied.
The supply of a commodity at different prices, indicates the behavior of a
rational supplier involved in supplying a commodity. The supply of a
commodity reflects the quantity of a product is available to consumer at
any given point of time.
6.02: Meaning of supply:

The quantity of a commodity that would be offered for sale at a given price,
at a given point of time and in a given place is known as ‘supply’ of a
commodity. We can understand the meaning of supply with an example:
Example: A farmer produced 100 bags of paddy. Out of these 100 bags, he
retained 30 bags with him and offered for sale 70 bags at given price.
Quantity offered for sale is the ‘supply of paddy’ and 100 bags are the total
output or production. So whatever the quantity offered for sale is known
as supply.
6.03: Supply function:

The supply of a commodity is influenced by large number of factors. These
are called determinants of supply. When we write determinants of supply
in the form of an equation, it is called supply function, which is shown
below.
Sn = f ( Pn, Pf, T, O, . …..)
In the supply function Sn is the dependent variable and Pn, Pf,T, O, are
independent variables.
6.04: Law of Supply:

In the supply function we have identified Pn, Pf, T, O, . as the determinants
of supply. In reality we know that the changes in all independent variables
influence the supply of a commodity. For analytical simplicity, while
analyzing the supply of a commodity, we assume other things remaining
constant, except price of the commodity under observation. In such a case
we can write the simplified supply function as:
Sn = f ( Pn).
The function tells us that the supply of ‘n’ commodity depends on price of
‘n’ commodity. If that is the case, there exists direct relationship between
price of ‘n’ and supply of ‘n’, other things remaining constant. That is as
price of ‘n’ rises the supply of ‘n’ goes up and as the price of ‘n’ falls; the
supply of ‘n’ goes down. This relationship between price and supply is
known as ‘Law of Supply’.
Individual Supply schedule:

This consists of different quantities of a commodity offered for sale by a
supplier at different prices. The supply schedule is shown below.
Price of ‘n’ (Rs) Supply of ‘n’ ( Units)
10 50
20 60
30 70
40 80
50 90
60 100
The supply schedule shown above reveals the direct relationship between
price of ‘n’ and supply of ‘n’. As price rises from Rs 10 to Rs 20 the supply
increased from Rs 50 to Rs 60 units and as price rises from Rs 20 to Rs 30
and up to Rs60 the supply increased from 60 to 100 units.
Individual Supply curve:
It is the graphic representation of individual supply schedule. While drawing

the supply curve we measure supply on X axis and price on Y axis. The
shape of normal supply curve is shown below.
GRAPH-1
a
Price
Supply
The basic feature of supply curve is that it slopes upward from left to right.
This reveals the fact that, the quantity supplied is directly related to price.
The supply curve shown above indicates the quantity offered for sale by a
single supplier at different prices.
Statistical Supply function:

We can use the linear supply function Qs = a +bPx to estimate change in
supply as a result of given change in price. Assume that the estimated
supply function is Qs = 5 + .5 Px. With the help of this supply function we
can con construct supply schedule as shown below.
Price of ‘X’ (Rs) Supply of ‘X’ (Units)
1 5.5
2 6.0
3 6.5
4 7.0
5 7.5
With the help of above information we derive the supply curve as shown
below.
GRAPH-2
Y
S
Qs = 5 + .5Px
Price
S
Market Supply Schedule:
In the market there may be more than one supplier for a product. The
market supply schedule consists of quantity of a commodity supplied by
different individual suppliers at different prices. By adding the supply of
individual suppliers at a given price, we can get market supply of a
commodity. Assuming there are two suppliers for a product, a hypothetical
market supply schedule is given below.
Price of Supply of A Supply of B Market Supply

(Rs) (Units) (Units) A+B (Units)
1 10 20 30
2 20 30 50
3 30 40 70
4 40 50 90
5 50 60 110
Market Supply Curve:
The market supply curve is the graphic representation market supply

schedule. We can derive the market supply curve through horizontal
summation of individual supply curves.
GRAPH-3
Y SA Y Y
SB
5 5
5
Price
2
2
S
Price
A SM
SB
0 20 50 30 60 X
X
Supply of A Supply of B
In the above diagrams SA, SB are the individual supply curves. SM is the
market supply curve. At price Rs 2, supplier A offered 20 units, B offered 30
units. Therefore, market supply at Rs2 is 20+30 =50 units. In the same way
at price Rs 5, A offered 50 units while B offered 60 units. Therefore the
market supply is 110 units.
ACTIVITY -1
1. Spell out the meaning of supply.
2. Show the difference between individual and market
supply.
3. Given the supply function Qs =10 + .8 Px, estimate
supply at different prices.
Exceptions to the Law of Supply:

Law of supply i.e the existence of direct relationship between price and
supply, given other things, may not hold good, with respect to all types of
commodities or factors of production. With respect to the supply of factors
of production, we may observe an inverse relationship between price and
supply beyond a point of rise in price of factors of production. Such an
inverse relationship is an exception to the law of supply.
1. Incase of labour supply, the law of supply does not hold good at all
prices. Labour supply i.e. in terms of number of hours a worker wants to
work in a single day. Initially increases as the price of labour i.e the wage
rate per hour, increases. But beyond a point, if price of labour increase,
supply of labour is likely to decrease. This is based on the assumption that
workers have fixed money needs. Due to this, when wage increase, workers
can earn adequate amount of income, even by working less number of
hours. As a result of this, labour supply curve, generally, bends backwards
as shown below.
GRAPH-4
Y
S
Backward bending supply curve

W3
W2
Wage per hour
W
1 S
L0 L2
X
L1
Labour Supply (in hours)
According to the above diagram OL1 is the supply of labour corresponding
OW1 wage rate per hour. As the wage rate increased to W2, supply of
labour increased to OL2. Further if the wage rate increased from W2 to W3,
number of hours offered for work by a worker decreased from OL2 to OL0.
This reveals the fact that at higher wage rate i.e. OW3, workers offered less
number of hours for work. This goes against the law of supply and hence an
exception.
2. Expectations regarding future price may also lead to invalidity of the law
of supply. If the suppliers expect that in near future, price is going to fall
below present prices; suppliers may offer large quantities for sale, even
though the present price is less than the previous price. In this case also, we
can see the presence of inverse relationship between price and quantity
supplied.
ACTIVITY-2
1. What do you understand by backward bending supply curve?
6.05: Extension and contraction in supply:

This refers to a movement along the supply curve. Change in supply as a
result of change in price, other things remaining constant, is either called
an extension or contraction in supply. Extension and contraction is to be
shown on the same supply curve through different points.
GRAPH-5
P2
P1 A
C
P0
Price
S
X
0
According to above diagram, at price OP1, suppliers are supplying Q1
quantity corresponding to point A on supply curve SS. As price increases to
P2, suppliers are supplying Q2 quantity corresponding to point B on SS. The
forward movement from A to B on SS supply curve is known as extension in
supply. As the price decreases from P1 to P0, suppliers supply Q0 quantity
corresponding to point C on SS supply curve. The backward movement on
supply curve, from A to C is known as contraction in supply.
6.06: Increase and decrease in supply:

This refers to shift in supply curve either to right or to left of the original
supply curve. Given the price, if there is change in other factors influencing
the supply, the resulting change in supply is to be shown through a shift in
supply curve.
Y
GRAPH-6
S
S1
A B
P1
S
Price
S1
X
0 Q1 Q2
Supply
In the above diagram SS is the initial supply curve. Point A on S indicates
Q1 quantity supplied, corresponding to P1 price. Given the price, if there is
a change in other things i.e fall in cost of production, suppliers may offer
more than q1 quantity. In such a case supply curve shifts to the right of the
original SS curve and becomesS1S1. Point B on S1S1 indicates Q2 quantity
corresponding to P1 price due to change in other factors influencing supply.
Change in supply from Q1 to Q2 at the same price is known as increase in
supply.
GRAPH-7
Y S1
S
P1 B A
S1
S
Price
0 Q0 Q1
Supply
In the above diagram SS is the initial supply curve. Point A on S indicates Q1

quantity supplied, corresponding to P1 price. Given the price, if there is a
change in other things i.e increase in cost of production, suppliers may offer
less than Q1 quantity. In such a case supply curve shifts to the left of the
original SS curve and becomes S1S1. Point B on S1S1 indicates Q0 quantity
corresponding to P1 price due to change in other factors influencing supply.
Change in supply from Q1 to Q0 at the same price is known as increase in
supply.
ACTIVITY-3
1. How do you show extension and contraction in

supply?
2. How do you show increase and decrease in supply?
6.07: Summary
The word ‘supply’ is used to show the directional relationship between

price and quantity of a commodity or factor offered for sale at a given price
and at a given point of time. Other things remaining constant, there exists
direct relationship between price and supply. This direct relationship
between price and supply is known as the ‘law of supply’. Extension and
contraction in supply refers to a movement along the supply curve.
Increase and decrease in supply refers to shift in supply curve.
6.08: Reference:

2. Mote,V.L; Samuel Paul and G.S.Gupta : Managerial Economics,
concepts
and cases.
1. Discuss the law of supply. Explain its exceptions.

UNIT-II
(Demand and Supply)
MODULE-7: ELASTICITY OF SUPPLY AND
DETERMINATION OF EQUILIBRIUM PRICE.
CONTENTS
7.0: Objectives
7.01: Elasticity of Supply
7.02: Degrees of Elasticity of Supply
7.03: Measurement of Elasticity of Supply
7.04: Estimation of Elasticity of Supply
7.05: Determination of Equilibrium Price
7.06: Summary
7.07: References
7.0: OBJECTIVES:
The objective of this module is to explain the meaning of elasticity

of supply and its measurement. After studying this module you
should be able to understand the:
Definition of elasticity of supply

Different degrees of elasticity of supply
Measurement of elasticity of supply
Determination of equilibrium price
7.01: Elasticity of supply:

In general elasticity refers to degree of responsiveness in
dependent variable as a result of given proportionate change in the
dependent variable. We can define elasticity of supply as the ratio
between proportionate change in supply of a commodity to a given
proportionate change in price of that commodity.
NOTE-1
Elasticity of supply =
This we can write as
= X
Here is equal to the slope of supply curve or rate of change in

supply. is the ratio between price and supply.
7.02: Degrees of Elasticity of Supply:
Based on the value of elasticity of supply, it is divided into

different degrees. They are:
1. Perfectly Elastic supply
If the proportionate change in the supply of a commodity is

infinite or so large with reference to an insignificant or zero
percentage change in price, it is known as perfectly elastic supply.
In this case, the value of elasticity will be equal to infinity and the
supply curve will be parallel to horizontal axis as shown below.
GRAPH-1 Y
Ye = ∞ S
Price
X
0 Supply
Perfectly Inelastic Supply:
If the supply is totally non-responsive to a given percentage change

in price, it is known as perfectly inelastic supply. In such a case the
value of elasticity will be equal to zero and the supply curve is
parallel to vertical axis as shown below.
GRAPH-2
S
Y
Ye = 0
Price
Unitary Elastic Supply:
If the proportionate change in the supply of a commodity is equal

to proportionate change in price, it is known as unitary elastic
supply. In this case, the value of elasticity will be equal to one and
the supply curve is a straight line passing through the origin as
shown below.
GRAPH-3
Y S
Ye = 1
S
Price
Supply
Relatively Elastic Supply:

If the proportionate change in the supply of a commodity is more
than the given proportionate change in price, it is known as
relatively elastic supply. In this case, the value of elasticity will be
equal greater than one (1) and the supply curve is as shown below.
GRAPH-4
Y
S
Ye > 1
S
Price
Supply
Relatively Inelastic Supply:
If the proportionate change in the supply of a commodity is less

than the proportionate change in price, it is known as relatively
inelastic supply. In this case, the value of elasticity will be less
than one and the supply curve is as shown below.
GRAPH-5
Y S
Ye<1
ice
ACTIVITY-1
1. Define elasticity of supply.
2. Define unitary elastic supply.
7.03: Measurement of Elasticity of Supply:
Two methods are generally used to measure supply elasticity. They

are;
1. Mathematical Method
2. Graphic Method.
Mathematical Method:
By using this method it is possible to find out the exact value

supply elasticity. We can understand this method with the help
of following example.
At price Rs.5, suppliers offered 100 units for sale and at price
Rs 10 they offered 300 units. Supply elasticity is
NOTE-2
S = 100 units
= 300 – 100
= 200 units
P = Rs 5
= 10 – 5
= Rs 5
= X
By substituting the values in the above principle we can get
the value of supply elasticity.
Elasticity of supply = X =2
Value of elasticity 2 means 1% change in price causes 2% change

in supply. This is a case of relatively elastic supply.
Graphic Method:
By using this method, we can say whether the elasticity is high or

low. Measurement of elasticity, using graphic method is explained
below.
GRAPH- 6
Y S
G R
P
In the above diagram AS is the supply curve. The measurement of
elasticity of supply at point P is shown below.
NOTE- 3
Elasticity of supply at point P = X
= X
Since QS = PT and GH = RT we can write this as
= X
AQP and PTR are similar triangles, have the ratio or proportion of
sides are equal that is to say
= =
Therefore elasticity of supply = X
The value of indicates the elasticity of supply at point ‘P’ on

AS. In the above diagram
AQ < OQ. Therefore < 1. This is a case of relatively inelastic

supply at price OH.
GRAPH- 7
Y
S
R
G
P
H T
Price
X
0 A Q M
Supply
AQ
In the above graph, the elasticity of supply at point ‘P’ = -----.
According to the
OQ
AQ
Diagram AQ is equal to OQ. Therefore ------ i.e the value of
elasticity
OQ
is equal to one(1). This is a case of unitary elastic supply.
GRAPH-8
Y S
R
G
H P T
Price
X
-x
A 0 Q M
Supply
In the above graph, the elasticity of supply at point ‘P’ = AQ/OQ .

According to the
AQ
Diagram AQ is greater than the OQ. Therefore ------ i.e the value
of elasticity
OQ
Is greater than one (1). This is a case of relatively elastic supply.
ACTIVITY-2
1. Show the relatively elastic supply with graphic method.
7.04: Estimation of Elasticity of Supply:
Using the linear supply function Qs = a + bPx, we can find out

elasticity of supply at any given price. For example the estimated
supply function is
Qs=5 +.5 Px. At price Rs 10 find out supply elasticity.
NOTE-4
7.05: Determination of equilibrium price:
Equilibrium price is determined at a point where demand is equal

to supply. This we can understand with the following example.
The given estimated demand function is Qd = 10 - .5 Px, Where as

the given supply function is Qs= 5 + .5Px. When Qd = Qs then we
can identify the equilibrium price. Now we shall equate Qd with
Qs to identify price.
10- .5Px = 5+ .5Px
10 – 5 =. 5Px + .5 Px
5 = Px
So the equilibrium price is Rs 5. Equilibrium price implies the

price that equates demand with supply. Given the demand and
supply functions at price Rs 5, the demand = 7.5 units and the
supply = 7.5 units.
GRAPH- 9 Y S
D
5 E
D
Price
X
0 7.5
Demand & supply
ACTIVITY -3
1. Given the Qd = 20 - .5Px and Qs = 10 + .5Px, find out

equilibrium price. Estimate equilibrium demand and supply.
7.06: Summary:
Elasticity of supply refers to degree of responsiveness in supply as

a result of given proportionate change in price. It is the ratio
between proportionate changes in supply to proportionate change
in price. Mathematical and graphical methods can be used to
estimate elasticity of supply. The equality between demand for and
supply of a commodity determines the equilibrium price.
7.07: References:

2. Mote,V.L; Samuel Paul and G.S.Gupta : Managerial
Economics, concepts and cases.
5. H.L.Ahuja :Advance Economic Theory
1. Define and discuss elasticity of supply.

2. How do you measure supply elasticity using graphic method?
UNIT-II
(Demand and Supply)
MODULE- 8: DEMAND FORECASTING
CONTENTS
8.0: Introduction
8.01: Objectives
8.02: Meaning of demand forecasting
8.03: Need for demand forecasting
8.04: Types of fore casting
8.05: Steps in demand forecasting
8.06: Techniques of demand forecasting
8.07: Summary
8.08: References
8.0: INTRODUCTION:
Most business decisions are made in the face of risk and
uncertainty. One of the crucial aspects in which managerial
economics differs from pure economic theory lies in the treatment
of risk and uncertainty. Traditional economic theory assumes a risk
free world of uncertainty. But the real world business is full of all
sorts of risk and uncertainty. The element of risk associated with
future is indefinite and uncertain. To cope with risk and
uncertainty, the manager needs to fore see the the course of
variables. The likely future course of variables has to be given
form.i,e forecasting. The aim of economic forecasting is to reduce
the risk or uncertainty that the firm faces in its short- term
decision making and planning for its future growth.
8.01: Objectives:
The objective of this module is to explain different methods of
demand forecasting. After reading this module you should be able
to understand the:
Meaning of forecasting
Need for demand forecasting
Types of forecasts
Steps in demand forecasting
Methods of forecasting
8.02: Meaning of demand forecasting:

Dealing with business, a manager is concerned with problems
faced in immediate present, but cannot ignore the future. The
decision that a manager takes in the present implies a course of
action and reaction in the future. If the manager is concerned with
future event, its order, intensity, he is concerned with future
prediction. If he is concerned with future course of variables, for
example: demand, price, profits, he can project the future.
Projection is of two types. They are forward and backward. It is the

forward projection of data variables, which is named forecasting.
8.03: Need for demand forecasting:

Sales constitute the primary source of revenue for the business
firm. Thus sales forecasts are needed for production planning,
inventory planning, profit planning etc. Production requires
support of men, material, machines, money which will have to be
arranged. Thus man power planning, replacement; new investment
planning, working capital management and financial planning etc
depend on sales forecasts. Thus demand forecasting is crucial for
corporate planning. The survival and growth of business firm has
to be planned, and for this sales forecasting is the most crucial
activity. The purpose of forecasting in general is not to provide an
exact future data with perfect precision. The purpose is just to
bring out the range of possibilities concerning the future under a
given set of assumptions.
8.04: Types of forecasts:

1. Economic and non-economic:
The future course of economic variables such as
demand, prices, profits etc is called economic forecast. On
the other hand crime rate forecast, population forecast,
election result forecast etc are called non-economic
forecasts.
2. Micro and macro forecasts:

Micro forecasts are at the level a business form i.e.
future sales of a particular firm. At the economy level five year
plan projections i.e agricultural production, employment etc are
macro forecasts.
3. Active and passive forecasts:

If the firm extrapolates the demand of previous years to
get the likely demand figures for the future, it is an example
of passive forecast. If the firm is interested in conducting the
demand forecasting exercise afresh in the light of changes in
prices, product diversification etc, is an example of active
forecast.
4. Short-run and long-run forecasts:

If the forecasts are conducted, assuming technology,
tastes and preferences constant, they are called short-run
forecasts. On the other hand, if the firm takes in to consideration
changes in population, technology, tastes of consumers etc in
projecting future sales then it is called long-run forecast.
5. Conditional and non -conditional Forecasting:

If a firm conducts forecasts assuming other things
remaining constant except for example price, it is called
conditional forecast. When we relax the assumption and
estimate the future course of sales in the light of changes in all
the independent variables, they are called non-conditional
forecasts.
8.05: Steps in demand forecasting:

1. Nature of forecast:
The business firm should be clear about the use of forecast
data. At the same time it has to state it objective in terms of
time period i.e. short run or long run.
2. Nature of product:
Firm has to identify the nature of product for which it is
attempting demand forecasting exercise. Nature of product
indicates whether the firm is producing final product like
food, or intermediary product like chemical which is to be
used as an input in final product such as paint.
3. Life cycle of the product:

Before conducting demand forecasting study, firm should
take into account the age of the product and its stage in the
product life cycle. If the product is in the initial years of life
cycle, forecast may show an upward trend, if it is in the last
years, forecast may show downward trend etc.
4. Identification of determinants:
Business firm has to identify the determinants such as price,
income, promotional expenditure,etc.
5. Analysis of determinants:
Researcher has to analyse all those determinants as whether
they are cyclical, seasonal or random variables.
6. Choice of technique:
To conduct the analysis of demand forecast, researcher may
use different techniques. But the choice of appropriate
technique depends on the nature of the product. The
accuracy and relevance of forecast data depends on the
choice of technique.
7. Testing of accuracy:
The testing is needed to reduce the margin of error and there
by improve its validity for practical decision making
purpose.
8.06: Techniques of demand forecasting:

Broadly speaking there are two approaches to demand forecasting.
They are (1). Collect information about the likely purchase
behavior of consumer through conducting opinion polls or
interviews. (2). Use past experience as a guide through a set of
statistical techniques. Now we shall try to understand these
techniques.
Survey method:
Consumer survey: Under this method, business firm can collect in
formation from census of population or from sample population.
Through personal interviews it can collect consumers’ preferences
regarding their product. Census method, in general, yield reliable
results compare to sample method. But census method needs more
time and money compared to sample method. Depending up on the
need and resources at the disposal of firm it has to choose between
sample and census method.
Experts’ opinion method:

It consists of an attempt to arrive at a consensus in an uncertain
area by questioning a group of experts repeatedly until the
response appears to converge along a single line or issues causing
disagreement are clearly defined. The participants are provided
with responses to previous questions from others in the group by a
coordinator. This is also known as Delphi method.
Collective opinion method:

This method also called sales force polling. Under this method
salesmen are expected to estimate future sales in their respective
areas. The rationale of this method is that, salesmen being closest
to the consumer are likely to have the most intimate feel of the
market i.e. customers reaction to the products of the firm and their
sales trends. The estimates of individual salesmen are consolidated
to find out the total future sales. Then, these estimates are reviewed
to eliminate the bias of optimism on the part of some salesmen and
pessimism on the part of others. These are further examined in the
light of proposed changes in price, advertisement expenditures,
income, etc.
Time series and trend projection:

A firm which has been in production process for some time
generally accumulates data related to price and corresponding
sales. Such data when arranged in a chronological order yields the
time series. The time series relating to sales represent the past
pattern of effective demand for a particular product. Such data can
be presented either in tabular form or graphical for further analysis.
The most popular method of analysis of time series is to project
the trend of the time series. A trend line can be fitted through a
series by means of statistical techniques such as method of least
squares. The trend line then projected into the future by
extrapolation.
Example: NOTE-1
Use of economic indicators (Barometric) method:

This method is useful to forecast cyclical swings in economic
activity or business cycles. Under this method we have to identify
leading economic indicators. These are time series that tend to
precede or lead changes in general economic activity, like changes
in the mercury in a barometer precede weather conditions, hence it
is called barometric method.
For the use of this method, the following steps have to be taken.
1. See whether a relationship exists between the demand for a
product and certain economic indicators.
2. Establish the relationship through the method of least squares
and derive the regression equation. Assuming the relationship to be
linear, we can write the equation as Y = a + b X
3. Once the regression equation is derived, the value of Y(
dependent variable) can be estimated for any given values of X.
Example:- NOTE -2
Controlled Experiments:
Under this method an effort is put to vary separately certain
determinants of demand which can be manipulated for example:
price, income, advertisement expenditures etc and conduct
experiments assuming other factors remaining constant. Thus, the
effect of demand determinants like price, advertisement etc can be
assed by either varying them over different markets or by varying
them over different time periods in the same market.
Judgmental Approach:
Management may have to use its own judgment when (a) analysis
of time series and trend projection is not feasible because of wide
fluctuations in sales; (b) use of regression method is not possible
because of lack of historical data. Further, even when statistical
methods are used, all such method cannot incorporate the potential
factors affecting the demand for example a major technological
break through in the product design. Statistical forecasts are more
reliable for larger levels of aggregations. As a result there is need
for use wisdom by the management to supplement statistical
techniques.
Smoothing techniques:
These predict future values of a time series on the basis of some
average of its past values only. Smoothing techniques are useful
when the time series exhibit little trend or seasonal variations.
There are two different smoothing techniques. They are:
(a). Moving Averages: In this method the forecasted value of a
given period is equal to the average value of ( year or quarter or
month) time series in a number of previous periods.
(b). Exponential smoothing:
In exponential smoothing method, the forecast for period t+1 is

a weighted average of actual and forecasted values of the time
series in period t.
8.07: Summary:
In this module we discussed the meaning and importance of
demand forecasting and types of forecasts and techniques of
forecasts. There is no unique method demand forecasting.
Business firm has to choose the right technique depending upon
its objectives, nature of the product and life cycle of the product
and the resources at its disposal, urgency of forecasts.
8.08: References:
1. Dominick Salvatore: Managerial Economics in a Global
Economy
2. R.L.Varshney and Maheswari: Managerial Economics
3. William F.Samuelson : Managerial Economics

Stephen G.Marks
8.09:Self Assessment Test:
1. Discuss the importance of demand forecasting.
2. Given the information related to sales with respect time

find out projected sales in the year 2015.
Year Sales
(In lakh units)
2000 100
2001 125
2002 90
2003 140
2004 180
2005 120
2006 80
2007 200
2008 190
2009 220
3. Given the information related to agricultural income and

demand for tractors in different years find out future demand
for tractors at agricultural income Rs.200 crores.
Year Agricultural Income
Sales of Tractors
In Rs. Crores
(in thousands)
2005 50
20
2006 60
25
2007 45
15
2008 80
30
2009 100
60
2010 140
75
UNIT-III
(Production and Cost Analysis)
MODULE-1: COST CONCEPTS
CONTENTS
1.0: Introduction
1.01: Objectives
1.02: Meaning of cost of production
1.03: Money cost
1.04: Explicit and Implicit cost
1.05: Separable and Non-separable cost
1.06: Fixed and Variable cost
1.07: Incremental and Sunk cost
1.08: Replacement and Historical cost
1.09: Relevant and Irrelevant cost
1.10: Private and Social cost
1.11: Summary
1.12: References
1.0: Introduction:
Cost of production plays an important role in decision making,
given other factors. It is the level of cost relative to revenue that
determines the firm’s overall profitability. In order to maximise
profit the firm try to increase its revenue and lower its cost. While
the external factors determine the level of revenue to a great extent,
the cost can be brought down either by producing the optimum
level output using the least cost combination of inputs or
increasing factor productivities. The firm’s output level is
determined by its cost. Cost of production provides the floor or
base for pricing of a product. A firm which produces with low cost
relative to its rival will have competitive advantage in the market.
As a result no firm ignores its cost analysis.
1.01: Objectives:
The objective of this module is to explain different concepts of
cost. After reading this module, you should be able to understand
the meaning of:
Cost of production
Money cost
Explicit and Implicit Cost
Separable and non-separable cost
Fixed and variable cost
Incremental and sunk cost
Replacement and historical cost
Relevant and irrelevant cost
Private and social cost
1.02: Meaning of cost of production:

In general, the value of inputs used in the production process to
produce a given level of output is called as cost of production. For
example: a business firm employed 10 units of labor and 5 units of
capital and 5 quintals of rawmaterial to produce 100 units of
output. Assume that the price of labor per unit is Rs: 10 the price
of capital per unit is Rs: 20 and the price of rawmaterial per unit is
Rs 500 per quintal. Thus the cost of producing 100 units of output
is Labor cost of Rs 100 + capital cost of Rs 100+ rawmaterial cost
Rs 2500 = Rs.2700. This implies that the physical quantities of
inputs have to be converted into money terms to arrive at cost of
production.
1.03: Money cost:

It is the total expenditure incurred by a business firm towards
producing a volume of output. Business firm may use various
factors of production in the production process to produce output.
We can understand the concept of money cost with the help of
following example.
Rawmaterials worth =Rs 2000

Employed workers and their wages = Rs 400
Interest on capital = Rs.100
Fuel charges Rs 50
Rent towards using building =Rs 100
The money cost of producing given level of output is Rs 2650.
1.04: Explicit and Implicit Cost:

The money cost or total cost of producing given output consists of
explicit and implicit cost. The cost or expenditure incurred by a
firm towards purchased or hired-in factors of production is called
explicit cost or out of pocket cost. On the other hand in addition to
hired-in factors of production, a firm may employ own factors of
production such as own labour (family members), own capital,
own building etc. The payment that a business firm is supposed to
make towards using own factors of production according to market
or opportunity cost is called implicit cost. These costs also known
as book cost or economic cost or implicit cost or imputed cost. We
can understand this cost concept with the help of following
example.
Purchased Rawmaterials worth =Rs 2000
Employed workers (other than family members) and their wages =
Rs 300
Employed workers (family members) and their wages = Rs 100
Interest on borrowed capital = Rs.80
Interest on own capital = Rs.20
Fuel charges Rs 50
Rent towards using own building =Rs 100
In the above example explicit cost items are:

Purchased Rawmaterials worth =Rs 2000
Employed workers (other than family members) and their wages =
Rs 300
Interest on borrowed capital = Rs.80
Fuel charges Rs 50
Total explicit cost is = Rs 2430
The implicit cost items are:
Employed workers (family members) and their wages = Rs 100
Interest on own capital = Rs.20
Rent towards using own building =Rs 100
The total implicit cost is Rs 220.
This classification of cost in to explicit and implicit is useful to

estimate accounting and economic profit. In general accountants’
takes in to consideration accounting cost and they ignore economic
costs. But economists’ takes in to consideration explicit and
implicit costs while calculating profit.
Accounting profit = total revenue – explicit cost

Economic profit = total revenue – (explicit + implicit cost) or
Economic profit = Accounting profit – implicit cost.
ACTIVITY-1
1. Define explicit and implicit costs.
2. What is the difference between accounting and economic profit?
1.05: Separable and non-separable cost:

These costs are also known as direct and indirect costs as well as
traceable and non traceable costs. A direct or traceable cost is one
which can be identified easily on the basis a department or product
or size of the product. For example: rawmwterial cost can be
identified based on product or size of the product. Common are
indirect costs are those that are not traceable department –wise. For
example: the salary of CEO of a business firm, salary of a quality
control engineer, fuel charges, stationery expenses cannot be
traceable.
1.06: Fixed and Variable Cost:

Total cost could be divided into two components such as fixed and
variable costs. In the short-run fixed costs remain constant
irrespective of changes in volume of output. They do not vary as a
result of variations in volume of output. A firm has to incur fixed
costs even when output is zero. There is an inverse relationship
between volume of output and per unit fixed cost. The examples of
fixed costs are: cost incurred on plant and machinery, buildings,
salaries to permanent employees, insurance premium etc. Fixed
costs are also known as over head expenses and supplementary
costs.
Variable costs do change as a result of variations in volume of

output. As output increases variable cost also increases and vice
versa. In the initial stages, as output increases, total variable cost
increases at a decreasing rate. Beyond a level if output increases,
total variable cost increases at an increasing rate. The cost incurred
by business firm towards rawmaterial, wages to workers, fuel
charges and other working expenses are called variable costs.
These costs also called as prime costs and direct costs.
ACTIVITY-1
1. Identify the fixed and variable cost items in your class room.
1.07: Incremental and Sunk cost:

Incremental cost is the change in total cost as a result of producing
additionally a bulk quantity of output. For example: A business
firm produced 100 units of a commodity with total cost Rs 1000.
On the other hand to produce 200 units of output the firm incurred
total cost of Rs 1800. Here the incremental cost is Rs 800. This
increase in total cost is due to change in output by 100 units (bulk
change). Sunk cost is one which is not affected by change in the
level of business activity. It will remain the same whatever the
level of output. The most important example of sunk cost is the
amortization of past expenses i.e. depreciation.
For decision making purpose incremental costs are more

important. Business firms’ always look at incremental costs while
allocating additional load of input in the production process.
Whether to add additional load of input in the production process
or not depends on comparison of incremental costs and
incremental revenues. If incremental costs are less than
incremental revenues, then the business firm will take a decision to
add additional load of inputs or else it may withdraw inputs from
the production process.
1.08: Replacement and Historical Cost:

Historical cost is the cost already incurred by the business firm.
Now the firm cannot avoid or escape. For example: The
expenditure incurred by a firm to buy a machine 5 years back.
Since expenditure already incurred it cannot be avoided. On the
other hand, replacement cost is the expenditure that a business firm
has to incur in order to buy a new or advanced machine to replace
the machine purchased 5 years back. Replacement cost implies the
present price of new machine. For decision making purpose,
managers always takes into consideration replacement costs and
they simply ignore historical costs.
1.09: Relevant and irrelevant costs:

The relevant costs for decision making purpose are those costs
which are incurred as a result of decision under consideration. The
relevant costs are also referred to as incremental costs. Costs that
have been incurred already and costs that will be incurred in the
future regardless of the present decision are irrelevant costs as far
as the present decision problem is concerned.
1.10: Private and social costs:

Private costs are those that accrue directly to the individuals of
firms engaged in relevant activity. External costs, on the other
hand, are passed on to persons i.e. society, not involved in the
activity in any direct way. For example a business firm located on
the banks of a river leaving the effluents in to the river. While the
private cost of leaving the effluents in to the river, to the firm is
zero. On the other hand social cost is definitely positive. Because
the effluents pollute the river water and affects adversely the health
of people located in downstream. These people have to spend
money to cure diseases afflicted through the use of polluted water.
These are called social costs that the society has to incur though it
is in no way involved in the production of commodities which
pollute the environment.
ACTIVITY-3
1. Name the industries which cause positive social cost.
1.11: Summary:
In this module an attempt has been made to understand different
cost concepts that we come across while studying managerial
economics. The value of factors of production employed in the
production process to produce a given volume of output is called
cost of production. Cost of production forms the basis for fixation
of price. In modern times business firms generally concentrating
on cost effective methods and adopting cost reduction policies to
face competition in the market. The different cost concepts
discussed in this module, play an important role in decision
making process with respect arriving at decisions related to output,
price fixation, to add additional quantity of factors of production,
replacement of machinery etc.
1.12: References:
1. P.L.Mehta: Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore: Managerial Economics in a global
economy
3. R.L Varshney and Maheswari: Managerial Economics.
4. H.Craig Petersen and Cris Lewis: Managerial Economics
1.13: Self assessment test:

1. Discuss various cost concepts which are helpful to managers’ in
arriving at business decisions.
UNIT-III
MODULE- 2: COST OUTPUT RELATIONSHIP-I
CONTENTS
2.0: Objectives
2.01: Total Cost
2.02: Total Fixed Cost
2.03: Total Variable Cost
2.04: Cost Functions and Cost Estimation
2.05: Cost estimation Methods
2.06: Summary
2.07: References
2.0: OBJECTIVES:
The objective of this module is to discuss the cost output
relationship. After reading this module you should be able to
understand the relationship between output and
Total cost
Total fixed cost
Total variable cost.
2.01: Total cost:

The value of fixed and variable factors of production employed by
the business firm to produce a given level of output is called total
cost. Output is the result of combining together fixed and variable
factors in required proportions. The fixed factors are plant,
machinery, salaries to permanent employees etc. The variable
factors are rawmaterial, fuel, power charges, other working
expenses etc. Therefore, the total cost consists of fixed and
variable costs together. As the volume of output increases the total
cost also increases. In the short run, the shape and position of total
cost curve is influenced by the nature of returns experienced by the
business firm. Where as in the long run the shape and position of
total cost curve is determined by the nature of returns to scale.
2.02: Total Fixed Cost:

The expenditure incurred by a firm towards employing fixed
factors of production is called total fixed cost. In the short run total
fixed will remain constant. The time period (short run) is such that,
it doesn’t allow the managers’ to make adjustment in fixed factors
of production. Regardless of level of output, business firms’ have
to bear these fixed costs in the short run. The basic nature of fixed
costs is that, they do not change as a result of variations in volume
of output. Even at zero level of output, the fixed costs are positive.
2.03: Total Variable Cost:

The expenditure incurred by a business firm towards employing
variable factors of production is called as total variable cost. These
costs vary as a result of variations in volume of output. As output
increases, variable cost also increases and vice versa. In the
beginning, as output increases, total variable cost also increases but
at a decreasing rate. As there is an increase in output further,
variable cost increases at an increasing rate.
We can understand the relationship between output and cost in the

short run with the help of following numerical example:
Output Total Fixed

Cost Total Variable Cost Total Cost
(In ‘000Units) (Rs in
crores) (Rs in crores)
(Rs in crores)
0 100
---
100
1 100
30
130
2 100
45
145
3 100
55
155
4 100
60
160
5 100
62
162
6 100
78
178
7 100
105
205
8 100
160
260
9 100
225
325
10 100
300
400
It is clear from the above example that total fixed cost remains
constant regardless of the volume of output produced by a firm. In
the short run business firm by employing Rs 100 crore worth of
fixed factors, can produce any volume of output i.e from 0 (zero)
units to 10 thousand units. In the short run, the fixed nature of
fixed costs acts as an obstacle on the part of business firm. In the
short run if there is sudden increase in the demand for the product,
business firm cannot make adjustment in fixed factors to meet
increased demand. It has to produce an increased quantity with the
same fixed factors. The time period is not long enough to affect
changes in fixed factors of production.
As the volume of output increases, variable cost also moving in

the same direction. In the beginning, total variable cost is
increasing at a decreasing rate up to the production level of 5000
units. This is due to the increasing returns experienced by the firm
in the production process. Beyond 5000 units, as output increases,
total variable cost is increasing at an increasing rate. This is due to
the diminishing returns experienced by the firm. At zero level of
output, total variable cost is zero. If firm is not producing output i.e
zero output, there is no need for the firm to incur any amount
towards variable cost.
Total cost is the sum of fixed and variable cost at any given level
of output. That is TC = TFC + TVC. Here TC is the total cost, TFC
is the total fixed cost and TVC is the total variable cost. As the
volume of output increases, total cost also moving in the same
direction. In the beginning, total cost is increasing at a decreasing
rate up to the production level of 5000 units. This is due to the
increasing returns experienced by the firm in the production
process. Beyond 5000 units, as output increases, total cost is
increasing at an increasing rate. This is due to the diminishing
returns experienced by the firm. At zero level of output, total cost
is Rs 100 crore. We can understand the cost output relationship
with the help of following diagram.
GRAPH-1
TC
Y TVC
Total cost (TC)

Total Fixed Cost
(TFC)
Total variable TFC
cost(TVC) 100
100
X
0 Quantity
2.04: Cost Functions and cost Estimation:

The important problem of managerial economist is that of
choosing the type of equation or cost function that fits the data
best. There are three types of cost functions a managerial
economist can adopt. They are : (1) Linear (2) quadratic (3) cubic
cost function.
Linear cost function:
Y = a + bX. Here ‘a’ is the fixed cost and ‘b’ is the proportion of
variable cost. ‘X’ is output. bX is the total variable cost. ‘Y’ is the
total cost. The underlying assumption of this function is that, the
firm has fixed costs which must be met irrespective of the quantity
of output produced. In the linear cost function ‘b’ is assumed be
constant and hence total cost is represented by upward sloping
straight line.
Let us assume that the estimated cost function is Y = 5000 + 250
X. Given this function we can estimate cost at different levels of
output as shown below.
Output(X) Total
Cost(Y)
(Units)
(Rs.)
0 5000
1 5250
2 5500
3 5750
4 6000
5 6250
6 6500
GRAPH-2
Y
Tc
Y= a + bx
TC
TFC Y= 5000+250X
5000 TFC
X
0
Quantity
Quadratic Cost Function:
Y = a + b X +c X2 .
This function indicates that as output (X) increases, total variable

in the beginning increases at a decreasing rate. Beyond a level of
output, Cx2 in the function shows that, total variable cost increases
at an increasing rate. Let us assume that estimated total cost
function as Y = 5000 + 250 X + 1X2. This function indicates, that
the fixed costs of the firm Rs 5000 and whose variable costs are
250X + 1X2. The last variable might arise if the firm’s initial cost
of labour and rawmaterial for producing X units is Rs 250X and
the growing demand for the limited supply of inputs bids up their
prices by the amount X2 as output increases. By substituting the
quantity of output in place of ‘X’ in the above estimated cost
function; we can derive the relationship between output and total
cost.
GRAPH-3 TC
Y
Y=a+bX+CX2
Y = 5000 + 250X + 1X2
TC
TFC
TFC
X
0 Quantity
Managers’ can also use quadratic function as Y = a + b X – c X2.

This function indicates that as the quantity of output increases,
even though the demand for factors of production increases, factor
prices decreases due to elastic supply of factors of production. Let
us assume the estimated demand function as Y = 5000 + 250 X –
0. 1 X2. Given the values of quantity, it is possible to find out the
cost output relationship.
GRAPH- 4
TC
TC Y= a+bX – CX
TFC Y= 5000+250X
5000 TFC
X
0
Quantity
Cubic Cost function:

The form of this cost function is Y = a + b X - c X2 + dx3. This
function indicates that as the volume of output increases, it leads to
increase in the productivity of variable factors of production.
Hence total cost increases but at a decreasing rate. Beyond a point
if output increases, it leads to fall in productivity of variable factors
of production. Hence total cost increases at an increasing rate. Let
us assume the estimated cost function as Y= 18 +30X – 10X2 +X3.
Given the level of output, we can find out cost –output relationship
using the cubic cost function.
GRAPH- 5
TC
Y
Increasing
Decreasing Y=a+bX-Cx2+dx3
productivit
productivity Y = 18+30X-10X2+1X3
y
TC
TFC
TFC
18
0
Quantity
ACTIVITY-1
1. Given the cost function Y= 10 +3X – 6X2 +X3 derive the cost
output relation and show the same with the help of graph.
2. Given the cost function Y= 6000 + 200 X + 0.1 X2, Find the
total cost and total variable cost at output level 400 units and 600
units.
2.05: Cost estimation methods:

Four broad approaches exist for the measurement of actual cost
output relationship. They are:
Accounting method:
This method is used by the cost accountants. In this method the
data is classified in to various categories. By plotting the output
levels and corresponding costs on a graph and joining them by a
line the cost functions are estimated. The cost functions thus found
may be linear or non-linear.
Statistical or Econometric method:

This method adopts statistical techniques to find cost output
relationship. The economic data may relate to past records of the
firm i.e. the time series data or different firms in the same business
at a point of time. i.e. cross section data.
Survivorship method:
This method is based on the rationale that over time competition
tends to eliminate firms of inefficient size and that only the firms
with efficient size will survive and these will have lower average
cost. In this method firms in the industry are classified in to size
groups. Growth of firms in each size is examined. The size –group
whose share in the industry grows the most during a specified time
period is considered the most efficient size. For example if the
share of small firms in the industry moved upwards at the cost of
the share of large firms, it implies that the optimum size of a firm
in the present case is the small sized one.
Engineering Method:
In this method, the cost functions are estimated with the help of
physical relationships such as weight of the finished product and
the weight of rawmaterials used. Then these rawmaterials are
converted into money terms to arrive at an estimate of cost.
2.06: Summary:
In this module an attempt has been made to discuss and understand
cost output relationship. The expenditure incurred by a firm on
various inputs to produce a given level of output is called total
cost. Total cost consists of total fixed cost and total variable cost.
In the short-run total fixed cost will remain constant. On the other
hand, total variable cost depends on the nature of returns
experienced by the business firm. In the beginning, as the volume
of output increases, total variable cost increases at a decreasing
rate. Beyond a level of output, total variable cost increases at an
increasing rate. In the short-run the shape of the total cost curve is
influenced by the nature of total variable cost. Economists
generally use mathematical cost functions i.e. linear, quadratic,
cubic, to identify the nature of cost output relationship.
2.07: References:
1. P.L.Mehta : Managerial Economics- Analysis,Problems and
Cases.
2. Dominick Salvatore : Managerial Economics in a global
economy
3. R.L Varshney and Maheswari : Managerial Economics.

1. Discuss the relationship between cost and output in the short run
with the help of total cost function.
2. Explain mathematical cost functions.
UNIT-III
MODULE- 3: COST OUTPUT RELATIONSHIP –II
CONTENTS
3.0: Objectives
3.01: Average fixed cost and output
3.02: Average Variable Cost and Output
3.03: Average cost and output
3.04: Marginal Cost and Output
3.05: Relationship between AC and MC
3.06: Long run Average Cost and Output
3.07: Cost functions and Estimation of TC,AFC,AVC,
AC, MC.
3.08: Cost Forecasting
3.09: Summary
3.10: References
3.11: Self assessment test.
3.0: Objectives:
The objective of this module is to discuss average cost and output

relationship in the short run and long run. After reading this
module you should be able to understand the relationship between:
Average fixed cost and output

Average variable cost and output
Average cost and output in the short run
Long run average cost and output.
3.01: Average Fixed Cost (AFC) and Output (Q):
Business firm can arrive at average fixed cost i.e. fixed cost per
unit, by dividing total fixed cost with the level of output.
TFC
AFC = -----.
Q
If the TFC is Rs 1000 and the level of output is 100 units, then
AFC is Rs.10. The basic feature of AFC is that it decreases
continuously as the volume of output increases. This is due to the
fact that TFC remains constant in the short-run .
Y
GRAPH-1
AFC
AFC
X
Quantity
3.02: Average Variable Cost (AVC) and Output (Q):
We can arrive at average fixed cost by dividing total variable cost

(TVC) with the level of output.
TVC
AVC = -----
-
Q
If the total variable cost of producing 100 units of output is Rs

2000, then the AVC is Rs 20. The basic feature of AVC is that, in
the beginning, it decreases as the level of output increases. But
after certain level of output, it increases due to diminishing returns
experienced by the business firm.
GRAPH-2
AVC
AVC
X
0
Quantity
3.03: Average Cost (AC) and Output (Q):
We can arrive at average cost by adding together AFC and AVC at

any given level of output. For example to produce 100 units of
output, the AFC is Rs 10 and the AVC is Rs 20. So that AC is Rs
30. In the beginning as output increases AC decreases. Beyond a
level of output as output increases AC decreases.
GRAPH-3
AC
AC
0 Quantity
3.04: Marginal Cost (MC):
The change in total cost as a result of an additional one unit

increase in output is called marginal cost. In the short marginal
cost depends on AVC. We can calculate marginal cost as:
MCn =
TCn - TCn -1.
Here MCn is the marginal cost of nth unit of output. TCn is the
total cost of ‘n’ units of output. TCn -1 is the total cost of n-1 units
of output. For example TCn is Rs 100 where as TCn-1 is Rs 87.
MCn is Rs 13. In the beginning, as output increases MC decreases.
After certain level of output, MC increases. Marginal cost i.e. the
cost of producing an additional unit plays an important role in
decision making by business firms.
Y
GRAPH-4
MC
MC
X
Quantity
3.05: Relationship between AC and MC:
As the volume of output increases AC and MC decrease. But the

rate of fall in MC is more than the rate of fall in AC. On the other
hand as AC increases MC also increases. But the rate of increase in
MC is more than the rate of increase in AC. According to
numerical example given in the next page, as output increases from
1 unit to 5units AC decreased from Rs130 to Rs 32.40. On the
other hand MC decreased from Rs.30 to Rs.2. When out increased
from 8 units to 10 units, AC increased from Rs 32.50 to Rs 40.
Where as MC increased from Rs 55 to 75.
GRAPH-5
MC AC
We can understand the relationship between output and AFC,AVC,
AC,MC with the following example.
Output TFC TVC TCs

AFC AVC AC
MC
0 100 --- 100

Infinite nil infinite --
-
1 100 30 130
100.0 30.0 130.0
30
2 100 45 145
50.0 22.5 72.50
15
3 100 55 155
33.3 18.33 51.63
10
4 100 60 160
25.0 15.0 40.00
5
5 100 62 162
20.0 12.40 32.40
2
6 100 78 178
16.66 13.0 29.66
16
7 100 105 205
14.30 15.0 29.30
27
8 100 160 260
12.50 20.0 32.50
55
9 100 225 325
11.10 25.0 36.10
65
10 100 300 400
10.0 30.0 40.0
75
3.06: Long run Average Cost (LAC) and Output (Q):

In the long run a business firm can make perfect adjustment in its
production capacity through introducing changes in fixed factors of
production along with variable factors of production. The shape of
long run average cost curve depends on the nature of economies of
scale experienced by the business firm. The derivation of LAC
curve is shown below.
GRAPH-6
SAC1 SAC
SAC3
R LAC Curve
According to the above graph, SAC1, SAC2, SAC3 are short run
average cost curves, which represent cost of production or the state
of technology in that short period. A firm can produce OQ1 level
of output with Q1M average cost in short period -1. If there is
increase in the demand for the product, with SAC1 technology the
average cost of producing OQ2 is Q2S. If the firm operates in the
long run, it can adopt new technology represented by SAC2. With
SAC2, firm can produce OQ2 output with average cost Q2N. This
is less than Q2S. Firm can expand its output to OQ3 at which the
average cost is Q3T. If the firm produces OQ4, with SAC2
technology, the average cost is Q4R. By going advanced
technology such as SAC3, it can produce OQ4 with OH average
cost. The thick line which touches all the short run average cost
curves is known as long run average cost curve (LAC curve). The
minimum point of LAC curve is touching the minimum point of
SAC2 at point T. This indicates that in the long run a business firm
can produce OQ3 volume of output with the minimum average
cost Q3T. Since OQ3 level of output corresponds to minimum
average cost in the long run, it ( OQ3) is called as optimum output.
A firm which produces output corresponds to minimum average
cost in the long run is called as an ‘optimum firm’ or most efficient
firm. LAC curve also known as planning curve or envelope curve.
3.07: Cost functions and Estimation of AFC, AVC, AC, and

MC:
Linear cost function:
Y = a+ b X. In this function Y is the total cost, ‘a’ is the total fixed

cost and b X is the total variable cost.
a
AFC = ----
X
bX
AVC = ----- = b
X
a bX
AC = --- + -----
X X
NOTE-1
AC = +b
MC = = b
Given the estimated cost function Y = 100 + 20X, at 100 units of
output
Y i.e total cost = Rs 2100, TFC = Rs 100, TVC = Rs 2000
AFC = Rs 1, AVC =20, MC = Rs 20, AC = Rs 21
Quadratic cost function
Y = a + bX + C X2
AC = = + +
= + b + CX
AFC =
AVC = b + CX
MC = = b+2CX
Given the estimated cost function Y = 5000 + 250X + 1 X2, at 100

units of output
Y = Rs 40,000
AFC = Rs 50
AVC = Rs 350
AC = Rs 400
MC = Rs 450
Cubic cost function:
Y = a +bX – C X2 + dX3
AC = = + - +
AFC =
AVC = b – CX + dX2
MC = = b-2cx+3dx2
Given the cost function Y=18+30X-10X2+x3, at 100 units of

output
Y = Rs 903018
AC = Rs 9030.18
AFC = Rs 0.18
AVC = Rs 9030
MC = Rs 31970
Cost Forecasting
Based on the estimated cost functions, we can forecast the TC, AC,
AFC, and MC at different levels of output
Given the linear cost function
Y = 100+20X, it is possible to forecast Y at different levels of
output.
For example
Output(X) (Units) Total Cost

(Rs)
100 2100
200 4100
300 6100
400 8100
500
10100
In the same way using quadratic and cubic cost functions, it is
possible to forecast total cost, AFC, AVC, AC and MC at different
levels of output.
ACTIVITY-1
1. Given the estimated cost function Y = 6000 + 200 X – 0. 2 X2,

estimate the TC, AFC, AVC, MC at the level of output 200 units
and 300 units. Observe, is there any change in average cost
structure as a result of increase in output.
3.09: Summary:
In this module an attempt has been made to discuss the cost output
relationship in terms of AC, AFC,AVC, MC AND LAC. As output
increases, AFC decreases continuously. AFC curve is a rectangular
hyperbola. As output increases, in the beginning AVC decreases.
Beyond a level of output AVC increases. AC also decreases in the
beginning. Later on it takes an upward movement. MC also
decreases in the beginning and later on it increases. AVC, AC, MC
curves are ‘U’ shaped. LAC curve shows the nature of average cost
in the long run. It is possible to have an idea about optimum firm
with the help of LAC curve. Managers’ generally use different cost
functions based on data availability, to estimate cost output
relationship and to forecast the cost of production corresponding to
different level of planned output.
3.10: References:
Cases.
2. Dominick Salvatore : Managerial Economics in a global
economy

1. Discuss the relationship between output and AFC, AVC, AC,
MC in the short run.
UNIT-III
MODULE – 4: PRODUCTION ANALYSIS
CONTENTS
4.0: Introduction
4.01: Objectives
4.02: Meaning of production function
4.03: Short run production analysis
4.04: Long run production analysis
4.05: Choice of optimum input combination
4.06: Summary
4.07: References
4.0: Introduction:
Production analysis relates physical output to physical units of
factors of production. In the production process various inputs are
transformed in to some form of output. In production analysis, we
study the least cost combination of factor inputs, factor
productivities and returns to scale. Managers’, while employing
resources in the production process, concerned with economic
efficiency of production which refers to minimization of cost for a
given output level. The efficiency of production process is
determined by the proportion in which various inputs are used, the
absolute level of each input and productivity of each input.
4.01: Objectives:
The objective of this module is to discuss the input – output
relationship in physical terms. After reading this module you will
be in a position to understand the:
Meaning of production function

Short run production function
Least cost input combination
4.02: Meaning of production Function:

The functional relationship between physical input and output is
called as production function. Production function expresses the
technological or engineering relationship between output of a
product and inputs employed in its production. In other words, the
relationship between the amount of various inputs used in the
production process and the level of output is called production
function. It represents the technology involved in the production
process. With the help of production function, it is possible to find
out number of units of factors of production required to produce a
given volume of output. In the same way it is possible to find out
the quantity of output that a business firm can produce by
employing given quantity of factors of production. Production
function describes only efficient levels of output; that is the output
associated with each combination of inputs is the maximum output
possible, given the existing level of technology. Production
function changes as the technology changes.
In general we can represent the production function for a firm as Q

= f (K, L,). Where Q is the total output, K is the fixed capital; L is
the variable capital including labour. In the production function Q
is the dependent variable and K, L are the independent variables.
From the above relationship, it is easy to infer that for a given
value of Q, alternative combinations of K and L can be used since
labour and capital are substitutes to a limited extent. This implies
that, a minimum amount of K and L is absolutely essential for the
production of a commodity.
4.03: Short run production analysis:

A business firm cannot make perfect adjustment in fixed factors of
production in the short-run. This time period doesn’t allow the
firm to change fixed factors. It has to continue the production with
the given K even in the presence of upward movement in demand.
This is a basic constraint under which the firm has to conduct
production operations. Firm can increase the output, to meet
increased demand, by employing more of variable factors on the
given fixed factor. In beginning, as the quantity of variable factors
increases, the marginal productivity of variable factors also
increases. Therefore the total product increases at an increasing
rate. This is called the stage of increasing returns i.e. stage-1. After
stage-1, if the firm employs additional units of variable factors,
marginal product of variable factors diminishes. As result the total
output increases at a decreasing rate. This is called as the law of
diminishing returns i.e. stage -2. Beyond this stage if the firm
employs variable factors, the marginal product of variable factors
will become negative, due to lack of support from given fixed
factors. Therefore the firm experiences negative returns in the
production process i.e.stage-3. We can understand these three
stages with the help of following example.
Quantity of L Total Product
Average Product Marginal Product
(Units)
(Units) (Units)
1 3
3 3
2 7
3.5 4
3 12
4.0 5
4 16
4.0 4
5 18
3.6 2
6 18
3.0 0
7 14
2.0 -4
GRAPH-1
M
Y
Total Product
Average product
Marginal Product
Stage Stage II
In the above graph, TPL is the total product of labour, APL is the
average product of labour and MPL is the marginal product of
labour curve. At point M, TPL reaches to maximum. When total
product is the maximum at 6 units of employment of variable
factors, the marginal product becomes zero. Corresponding to
point M on TPL, MPL curve is cutting the horizontal axis. Beyond
6 units of employment of variable factors, MPL is negative.
ACTIVITY -1
1. Spell out the meaning of production function.
2. How many stages are there in the short run production analysis?
What are they?
4.04: Long Run Production Analysis
Long run is a time period where perfect adjustment in all the
factors of production is possible. We can understand input –output
relationship in the long run with the help of isoquant (IQ) or
isoproduct curves.
In the long run a business firm can combine together capital and
labour in different proportions to produce the same level of output.
By joining together the corresponding points of combinations of
capital and labour which yield the same level of output to business
firm, we can derive isoquant.
Isoquant schedule:
Labour
Capital
Output
(Units)
(Units)
(Units)
1
6
100
2
4.5
100
3
4.0
100
4
3.7
100
5
3.5
100
According to the above example, a business firm can employ 1 unit

of labour + 6 units of capital or any other combination as shown in
numerical example, to produce 100 units of output. By plotting the
above data on a graph paper and joining together corresponding
points, we can derive isoquant.
GRAPH-2
Y
6 A
Isoquant is convex to the origin. All points on an isoquant
represent the same level of output, though each and every point
related to a specific quantity of capital and labour. As the
employment of labour increases, the business firm is reducing the
employment of capital, to produce same level of output. But the
fact is that, as employment of labour increases every time by one
unit, the business firm would like to reduce capital in smaller
quantities for every successive additional unit increase in labour .
This is called the Diminishing Marginal Rate of Technical
Substitution of labour for capital. This is equal to the slope of
isoquant. The slope of isoquant = MRTSLK.
Though the business firm can employ any combination of inputs to
produce 100 units of output, there exists difference in cost of
employing these combinations. The aim of the business firm is to
employ that combination of inputs which minimizes cost to
produce 100 units of output. To identify least cost combination of
inputs, in addition to isoquant, we have to understand the isocost or
factor price line.
Factor price line:

Each and every point on factor price line indicates the different
quantities of capital and labour a business can employ actually in
the production process, given the prices of capital & labour and the
volume of investment at its disposal. Let us assume that the price
of capital Rs 20, price of labour Rs 20 and the volume of
investment at the disposal of firm is Rs 130. Based on this
information we can construct isocost schedule as shown below.
Quantity of labour
Quantity of capital
(Units)
( Units)
0. 0
6. 50
0. 5
6.00
1. 0
5. 50
1. 5
5 .00
2. 0
4. 50
2. 5
4. 00
3. 0
3. 50
3. 5
3 .00
4. 0
3. 50
-
-
-
-
-
-
6. 5
0. 0
Business firm can employ any one of the combinations shown

above. The cost of employing any combination is Rs 130. By
plotting the above shown information on a graph paper, and
joining together the corresponding points, we can derive the
isocost line.
GRAPH-3
6.5
Iso cost time
Units of Capital
Units of labour
The slope of isocost line represents the relative factor price ratio
i.e. the ratio between price of labour to price of capital (PL /PK). In
other words also we can say that the slope of isocost indicates the
ratio between wage rate to rate of profit (w /r).
4.05: The choice of optimum input combination:

The combination of factor inputs that produces maximum output
with least cost is called optimum input combination or least cost
input combination. A business firm can identify this combination
at a point where MRTSLK = PL / PK. This is possible at a point
where isocost is tangent to isoquant.
GRAPH-4
Y
6.5
R
Units of Capital
4.5
0 2 6.5
Units of labour
In the above graph at point R isocost line is tangent to isoquant.
Therefore the combination of labour and capital that firm would
like to employ to produce 100 units of output (2 units of labour + 4
. 5 units of capital. See the isoquant schedule) is same as the
combination of labour and capital that firm can actually employ
with Rs 130 total investment ( 2 units of labour + 4 . 5 units of
capital. See the isocost schedule). If the firm employs any other
combination of labour and capital to produce 100 units of output,
its cost on labour and capital will be more than Rs 130. Thus the
combination of 2 units of labour + 4. 5 units of capital is the least
cost combination or optimum combination. This is also called as
optimization of production.
ACTIVITY-2
1. Define isoquant.
2. Define isocost.
3. What is least cost input combination?
4.06: Summary:
Production function represents the relationship between physical
input and output. With the help of production function it is
possible to find out the quantity of capital and labour required to
produce a given level of output. Production function is generally
expressed as Q = f ( K,L). In the short run, beyond a level of
output, firm experiences diminishing returns in the production
process due to the given fixed factors of production. In the long
run, firm can make perfect adjustment in all the factors of
production. Therefore, firm can produce optimum output i.e. the
maximum possible output with minimum cost in the long run.
4.07: References:
Cases.
economy

1. What is production function? Discuss the input- output
relationship in the short run.
2. Explain the process of identification of optimum input
combination with the help of isoquant and isocost line.
UNIT-III
MODULE- 5: Returns to Scale and Linear
Programming in Production
CONTENTS
5.0: Objectives
5.01: Meaning of Returns to Scale
5.02: Types of Returns to Scale
5.03: Linear programming and production analysis
5.04: Types of production functions.
5.05: Summary
5.06: References
5.0: Objectives:
The objective of this module is to discuss the concepts of returns to
scale, linear programming in production and types of production
functions used for estimation. After reading this module you
should be able to understand the :
Different types of returns to scale
Linear programming and production analysis
Estimation of production function
5.01: Meaning of Returns to Scale:

The proportionate change in output as a result of given
proportionate change in input is called returns to scale. This is
simply the input elasticity of output. We can define returns to scale
in terms of a ratio between percentage change in output to
percentage change in input as shown below.
Proportionate change in output

Returns to scale= -------------------------------------------
Proportionate change in input
5.02: Types of Returns to scale:

There are three different types of returns to scale. They are (1)
Increasing returns to scale (2) constant returns to scale (3)
decreasing returns to scale. Now we shall discuss these three types
of returns to scale.
Increasing Returns to Scale:

If the proportionate change in output is more than the proportionate
change in input, it is called as increasing returns to scale. If the
firm experiences increasing returns to scale, then one percent
increase in input causes more than one percent increase in output.
In the same way 100 percent increase in input leads to more than
100 percent increase in output. For example: A firm employed 5
units of labour &10 units of capital and produced 100 units of
output. Suppose the same firm doubled the input use i.e it
employed 10 units of labour & 20 units of capital,and could
produce 300 units of output. The increase in input is 100 percent
where as the increase in output is more than hundred percent.
Under these conditions if the firm doubles the employment, output
gets more than doubled.
GRAPH-1
B
Capital
20
A
10
In the above graph OR is the scale line. It indicates that, every
time, the increase in inputs is 100 percent. But increase in out is
more than 100 percent i.e increased from 100 units to 300 units.
On scale line OA = AB.
Constant Returns to Scale:

If the proportionate change in output is equal to the proportionate
change in input, it is called as constant returns to scale. If the firm
experiences constant returns to scale, then one percent increase in
input causes exactly one percent increase in output. In the same
way 100 percent increase in input leads to 100 percent increase in
output. For example: A firm employed 5 units of labour &10 units
of capital and produced 100 units of output. Suppose the same firm
doubled the input use i.e it employed 10 units of labour & 20 units
of capital, and could produce 200 units of output. The increase in
input is 100 percent and also the increase in output is 100 percent.
Under these conditions if the firm doubles the employment, output
also gets doubled.
GRAPH-2
Y
R
Capital
20
IQ2=20
A
10
IQ1=100 un
0 5 10
Labour

also 100 percent i.e increased from 100 units to 200 units. On
scale line OA = AB.
Decreasing Returns to Scale:

If the proportionate change in output is less than the proportionate
change in input, it is called as decreasing returns to scale. If the
firm experiences decreasing returns to scale, then one percent
increase in input causes less than one percent increase in output. In
the same way 100 percent increase in input leads to less than 100
percent increase in output. For example: A firm employed 5 units
of labour &10 units of capital and produced 100 units of output.
Suppose the same firm doubled the input use i.e it employed 10
units of labour & 20 units of capital, and could produce 180 units
of output. The increase in input is 100 percent and where as the
increase in output is less than 100i.e 80 percent. Under these
conditions if the firm doubles the employment, output gets less
than doubled.
GRAPH-3
Y
R
B
Capital
20
IQ2=180 units
A
10
IQ1=100 units
X
5 10
Labour
less than 100 percent i.e increased from 100 units to 180 units. On
scale line OA = AB.
We can understand the concept of returns to scale with the help of

marginal productivities. In case of increasing returns to scale, the
marginal productivity of factors of production increases. In case of
constant returns to scale the marginal productivity of factors of
production remains constant. In case of decreasing returns to scale,
the marginal productivity of factors of production decreases.
GRAPH-4
Y
Marginal productivity of
factors of productions
B C
Returns to scale
curve
A
D
X
Quantity of factors of
production
In the above graph, we measured the quantity of factors of
production on horizontal axis and marginal productivity on vertical
axis. From point A to B on returns to scale line represents
increasing returns to scale. From point B to C represents constant
returns to scale. From point C to D represents decreasing returns to
scale.
ACTIVITY-1
1. Define the concept of returns to scale.
2. Explain the nature of marginal products under different types of
returns to scale.
5.03: Linear programming and production analysis:

Linear programming is a mathematical technique for solving
constrained optimization and minimization problems, when there
are many constraints and the objective function to be optimized, as
well as constraints faced are linear i.e. represented by straight
lines. The usefulness of linear programming arises because firms
and other organizations face many constraints in achieving their
goals of profit maximization or cost minimization or other
objectives. For example: The optimization problem of a business
firm is maximization of output subject to given cost constraint. In
order to maximize output, the firm should produce at the point
where isocost is tangent to its isoquant.
One of the basic assumptions of linear programming is that a

particular commodity can be produced with only a limited number
of input combinations. Each of these input combinations or ratios
is called a production process or activity and can be represented by
a straight line ray from the origin in input space. For example a
particular commodity can be produced with three different
processes, each utilizing a particular combination of labour (L) and
capital(K).These are : process 1 with K/L =2. Process 2with K/L=
1, and process 3 with K/L = ½. Each of these processes is
represented by the ray from the origin with slope equal to the
particular K/L ratio used.
GRAPH- 5
Y
Process 1
(K/L = 2)
12
Process 2
10 (K/L =1)
8
Process 3
(K/L = ½
Capital
2
In the above graph process 1 uses 2 units of capital for each unit of
labour used, process 2 uses 1 unit of capital for each unit of labour
and process 3 uses ½ unit of capital for each unit of labour. By
joining points of equal output on the rays or processes, we define
isoquant for the particular level of output of the commodity. The
process of derivation of isoquants is shown in the following graph.
GRAPH-6
Y
Process 1
Process
6
Process 3
Capital
3
X
3 4 6
Labour
In the above graph, the isoquants are straight line segments and
have kinks. Point A on process 1 shows that 100 units of output
can be produced by using 3 units of labour and 6 units of capital.
Point B on process 2 shows that 100 units of output can be
produced with 4 units of labour and 4 units of capital. Point C on
process 3 shows that 100 units of output can be produced with 6
units of labour and 3 units of capital. By joining, points A,B, C we
get the isoquant for 100 units of output. Further, since we have
constant returns to scale, the isoquant for twice as much output i.e
200 units is determined by using twice as much of each input with
each process. This defines the isoquant for 200Q with kinks at
points D( 6L,12K), E( 8L,8K), and F( 12L,6K).
If the firm faced only one constraint, such as isocost line whose
level is determined by volume of investment and the prices of
factors of production. Assume the isocost line of firm is GH as
shown below.
GRAPH-7
Process 1
12 D Proce
Feasible Region and Optimal Solution
With isocost line GH the feasible region is shaded triangle OJN
and the optimal solution is at point E where the firm uses 8L and
8K and produces 200 units of output.
GRAPH-8
Y
Process 1
16 G
Process 2
D
12
E Process 3
J F
8
6 N
Capital
H
X
6 8 12 16
ACTIVITY-2
1. Identify feasible set of inputs with linear programming

technique.
5.04: Types of production functions:

Several types of mathematical functions are commonly employed
in the measurement of production function. But in applied research
four types have had the widest use. These are:
Linear Function:
A linear production function would take the form Y= a + b X. Here
Y is the total product. X is the input.
Y a bX
Average product = --- = ---- + -----
X X X
a
= ----- + b
X
Power function:
The production function most commonly used in empirical
estimation is the power function of the form:
A power function expresses output Y, as a function of input X in

the form:
Y = aXb.
The exponents are the elasticities of output. Power function as it is

can not be used for estimation. It is to be written in the log linear
form as:
Log Y = log a + b log X. The best example of power function is

the cobb-douglas production function of the form:
Q = A Ka Lb. Where Q is the output, K is the capital and L is the

labour. ‘a’ and ‘b’ are the parameters to be estimated empirically.
This production function is often referred to as cobb –douglas
production function. In this production function the exponents ‘a’
and ‘b’ represents output elasticity of capital and labour
respectively. The sum exponents ‘a’+ ‘b’ = 1. The sum of
exponents represents returns to scale. If ‘a’+ ‘b’ = 1 it represents
constant returns to scale. If ‘a’+ ‘b’ is more than 1, it represents
increasing returns to scale. If ‘a’+ ‘b’ is less than 1, it represents
decreasing returns to scale.
Quadratic production function:

Y= a + b X – c X2. In this function Y is the total output, and X is
the input. a, b, c are the parameters.
The minus sign in the last term denotes diminishing marginal
returns. The equation allows for diminishing marginal product but
not for increasing and decreasing marginal products. The elasticity
of output is not constant at all points along the curve as in power
function but declines with input magnitude.
Cubic production function

Y= a + b X + c X2 - d X3.
It allows for increasing and decreasing marginal productivity. The
elasticity of output varies at each point along the curve. Marginal
productivity decreases at an increasing rate in the later stages.
ACTIVITY-3
1. Bring out the main features of power function.
5.05: Summary:
In this module we discussed at length the types of returns to scale,
linear programming in production and types of production
functions used in the estimation of input output relationship. The
ratio between the proportionate changes in output to proportionate
change input is called returns to scale. Thus it is the degree of
responsiveness in output as a result of given percentage change in
input. Linear programming technique is used to find out solution to
optimization problem. In the production analysis, the optimization
problem is maximization of output with minimum cost. Using
linear programming technique we can find out optimum input
combination to produce given level of maximum output. Business
firms’ and researchers can adopt different types of production
function to estimate input output relationship.
5.06: References:
Cases.
economy

1. Discuss different types of returns to scale.
2. Discuss the importance of linear programming in production
analysis.
3. Spell out different types of production functions used to estimate
input out relationship.
STATE COUNCIL OF EDUCATIONAL RESEARCH &TRAINING
VARUN MARG, DEFENCE COLONY, NEW DELHI
Teaching- Learning Material

(On the basis of weekly syllabus for the Month of July’ 2011)
For
Class XII
PGT (Economics)
Chief Advisor
Ms. Rashmi Krishnan, Director, SCERT
Advisor
Dr. Pratibha Sharma, Joint Director, SCERT
Mohammad Zamir, Principal, DIET Keshav Puram
Co- ordinators
Dr. Seema Srivastava, Sr. Lecturer, DIET, Moti Bagh
Ms. Meenakshi Yadav, Sr. Lecturer, SCERT
Contributors
Dr. Seema Srivastava, Sr. Lecturer, DIET, Moti Bagh
Ms. Meenakshi Yadav, Sr. Lecturer, SCERT
Mr Bharat Thakur, PGT (Economics) RPVV, Surajmal Vihar

Support Material
For
Teachers
In
Economics – Class XII
Co-ordinators Dr. Seema Srivastava
Ms. Meenakshi Yadav
Contributors Dr. Seema Srivastava
Ms. Meenakshi Yadav
Mr.Bharat Thakur
Technical Support Mr.V.K.Sodhi
Ms.Sapna Yadav
Ms.Radha
Ms.Garima
Ms.Ritu
Class – XII
Teaching -Learning Material for PGT (Economics)
Based on “Week- Wise Distribution of Syllabus 2011 -2012”
For the Month of July: Unit-IV
(18.07.2011 – 25.07.2011) 7 days
(25.07.2011-30.07.2011) 6days
Abstract
Present unit deals with the Concept of Market Structure which comprises of different market
conditions under which the firms produce and sell products in the market. The unit also
elaborates upon various Forms of Market Structure such as Perfect Market and * Imperfect
Market (*Monopoly, Monopolistic Competition and Oligopoly). The conditions and
determination of price under various Forms of Market Structure have been discussed. The
content based classroom activity has been suggested at the end. It will help in developing
Critical Thinking & Analytical ability among students which is the demand of this subject.
Questions based on the content to check the progress have been included. Different types of
Questions such as Very Short Answer Type, Short Answer Type, and Long Answer Type
questions (based on Board pattern) are also given under' Additional Questions’. List of URL’s
have been mentioned in the end. You are requested to search those web links for more
interesting details about the unit covered in the present module. This will enable you to develop
more interesting Teaching- Learning Classroom Processes for children.
Learning objectives
After going through the material/ unit you will be able to:
1. Define the term ‘Market Structure’.
2. State the Elements of Market structure.
3. Explain the Determinants of Market Structure.
4. Classify various Forms of Market Structure.
5. Define Perfect and Imperfect forms of market.
6. Explain the features/Characteristics of Perfect, Monopoly, Monopolistic and

Oligopoly forms of market.
7. Draw and Interpret shapes of AR and MR Curves under Various forms of Market
Structure.
8. Compare various forms of Market Structure.
Teaching Points
 Concept of Market Structure
 Elements of Market Structure
 Determinants of Market Structure
 Forms of Market Structure: (Concept& Features)
1) Perfect Competition
2) Monopoly
3) Monopolistic Competition
4) Oligopoly
 Comparison/Summary of Market Structures
Market Structure and Forms of Market

1. Market Structure
Market Structure is also known as the number of firms producing identical products.
Firm sells goods and services under different market conditions which economists call
Market Structures. A Market Structure describes the key traits of a market, including
the number of firms, the similarity of the products they sell, and the ease of entry into
and exit from, the market examinations of the business sector of our economy reveals
firms’ operating in different Market Structure.
Market Structure is best defined as the organizational and other characteristics of a
market. These characteristics affect the nature of competition and pricing.
1.1 Elements of Market Structure
1. Number and size, Distribution of Firms
2. Entry Conditions
3. Extent of Product Differentiation
Types of Market Structure influences how a firm behaves regarding the following:
 Price
 Supply
 Barriers to Entry
 Efficiency
 Competition
1.2 Determinants of Market Structure

 Freedom of Entry and Exit
 Nature of the Product: Homogeneous or Differentiated
 Control over Supply /Output
 Control over Price
 Control to Entry
2. Forms of Market
Main Forms of Markets

|
|________________________________|
Perfect Market Imperfect Market
|
|____________________-
_________|____________________________|
Monopoly Monopolistic Competition
Oligopoly
3. Perfect Competition
Perfect Competition is a theoretical Market Structure that features unlimited contestability
(No barriers to enter) and unlimited number of producers and consumers, and a Perfect
Elastic Demand Curve. Perfect competition is a market structure where an infinitely
large number of buyers and sellers operate freely and sell a homogeneous commodity at a
uniform price.
3.1 Features of Perfect Competition
1. Infinitely Large number of Buyers and Sellers

When there is very large number of buyers no individual buyer can influence the
market price. Similarly when there are a very large number of sellers, each firm or
seller in a perfectly competitive market forms an insignificant part of the market.
Therefore, no single seller has the ability to determine the price at which the
commodity is sold. So who determines the price in such a market? In a perfectly
competitive market, it is the forces of Market Demand and Market Supply that
determines the price of the commodity. Since each firm accepts the price that is
determined by the market, it becomes a Price Taker. As the market determines the
Price, it is the Price Maker.
Example-1
Table- 1
Market Demand and Supply
Price per Unit Demand (Units) Supply (Units)

(Rs.)
10 1000 500
20 900 650
30 800 800
40 700 950
50 600 1100
Diagram showing Market is Price Maker and Firm is Price Taker
In the Table and Diagram above, the forces of demand and supply equalize at a price of
Rs. 30 per unit. This is the Market Determined Price under Perfect Competition. Once the
market determines the price, each firm accepts it.
No firm in its individual capacity can alter the price given to it by the market. If any firm
were to change a price higher than market determined price, buyers would shift to another
firm. No firm would like to charge a price lower than the market determined price, as by
doing so it loses revenue.
2. Homogenous Product
In a perfect competitive market, firms sell homogeneous products. Homogenous
products are those that are identical in all respects i.e. there is no difference in
packaging, quality colors etc. As the output of one firm is exactly the same as the
output of all others in the market, the products of all firms are perfect substitute for
each other.
3. Free Entry in to and Exit from the market

Very easy entry into a market means that a new firm faces no barriers to entry.
Barriers can be financial, technical or government imposed barriers such as
Licenses, Permits and Patents.
The implication of this feature of Perfect Competition is that while in the short run
firms can make either supernormal profits or losses, in the long run all firms in
market earn only normal profits.
4. Perfect Knowledge of Market

Buyers and sellers have complete and perfect knowledge about the product and prices
of other sellers. This feature ensures that the market achieves a uniform price level.
3.2 Shape of the AR and MR curves under Perfect Competition
Since the firm under Perfect Competition is a Price Taker and cannot change the price
it can change for its product, the Average Revenue (which is equal to price) is the
same for all units of output sold. In this case, Marginal Revenue is also constant and
equal to the Average Revenue.
Average Revenue Curve is also a Demand Curve facing a perfectly competitive firm,
which is perfectly elastic. No real world market exactly fits the features of perfect
market structure is a theoretical or ideal model, but some actual markets do
approximate the model fairly closely. Examples of Perfect Competition include firm
products markets, the Stock Market and Foreign Exchange Market, Currency
Market, Bond Market.
4. Monopoly
Pure Monopoly is the form of market organization in which there is a single seller of a
commodity for which there are no close substitutes. Thus, it is at the opposite extreme
from perfect competition monopoly may be the result of: (1) Increasing returns to
scale; (2) Control over the supply of raw materials; (3) Patents; (4) Government
Franchise.
4.1 Features
1. A Single Seller
There is only one producer of a product. It may be due to some natural conditions
prevailing in the market, or may be due to some legal restriction in the form of
patents, copyright, sole dealership, state monopoly, etc. Since, there is only one seller;
any change in supply plans of that seller can have substantial influence over the
market price. That is why a Monopolist is called a Price Maker. (A Monopolist’s
influence on the market price is not total because the price is determined by the
forces of Demand and Supply and the Monopolist controls only the supply).
2. No Close substitute
The commodity sold by the Monopolist has no close substitute available for it.
Therefore, if a consumer does not want the commodity at a particular price, he is
likely to get available closely similar to what he is giving up. For example, there are
chapters you have studied that the availability of substitute goods impact. The
elasticity of demand for a product since the product has no close substitutes; the
demand for a product sold by a monopolist is relatively inelastic.
3. Barriers to the entry of new firms

There are barriers to entry into industry for the new firms. It may be due to following
reasons:
(i) Ownership of strategic raw material or exclusive knowledge of production
(ii) Patent Rights
(iii) Government Licensing
(iv) Natural Monopolies
The implication of barriers to entry is that in the short run, monopolist may earn
supernormal profit or losses. However, in the long run, barriers to entry ensure that a
monopolistic firm earns only super normal profits.
4. Price Discrimination
Price Discrimination exists when the same product is sold at different price to
different buyers. A monopolist practices price discrimination to maximize profits. For
example Electricity Charges in Delhi are different for Domestic users and
Commercial and Industrial users.
5. Abnormal Profits in the Long run
Being the single seller, monopolists enjoy the benefit of higher profits in the long run.
6. Limited Consumer Choice
As they are the single producer of the commodity, in the absence of any close
substitute the choice for consumer is limited.
7. Price in Excess of Marginal Cost
Monopolists fix the price of a commodity (per unit) higher than the cost of producing one
additional unit as they have absolute control over Price Determination.
4.2 Shape of the AR and the MR Curves under Monopoly
The AR Curve faced by the Monopolistic is Downward Sloping as the Monopolist

can increase sales by reducing price. If the AR Curve is declining, it implies that the
MR is also declining at a faster rate.
4.3 Demand Curve facing the Monopolist
Since there is only one seller in the market, the AR Curve of a monopolist in nothing
else but the Market Demand Curve for the product. The demand is relatively inelastic
as there is only a single seller for the commodity and its product does not have close
substitutes.
5. Monopolistic Competition
Monopolistic competition is a situation in which the market, basically, is a
competitive market but has some elements of a monopoly. In this form of
market there are many firms that sell closely differentiated products. The
examples of this form of market are Mobiles, Cosmetics, Detergents,
Toothpastes etc.
5.1 Features
1. Large number of buyers and sellers

In this form of market, while the buyers are as large as it is under perfect competition
or monopoly, the number of sellers is not as large as that under perfect competition.
Therefore, each firm has the ability to alter or influence the price of the product it
sells to some extent.
2. Product Differentiation
Under Monopolistic Competition products are differentiated. This means that the
product is same, brands sold by different firms differ in terms of packaging, size,
color, color features etc. For example-soaps, toothpaste, mobile instruments etc.
The importance of Product Differentiations is to create an image in the minds of the
buyers that the product sold by one seller is different from that sold by another seller.
Products are very similar to each other, but not identical. This allows substitution of
the product of one firm with that of another. Due to a large number of substitutes
being available Demand for a firm’s product is relatively elastic.
3. Selling Costs
As the products are close substitutes of each other, they are needed to be differentiate
for this firms incurs selling cost in making advertisements, sale promotions,
warranties, customer services, packaging, colors are brand creation.
4. Free Entry and Exit of firm

Like perfect competition, free entry and exit of firms is possible under this market
form. Since there are no barriers to entry and exit, firms operating under Monopolistic
Competition, in the long run, earn only normal profits.
5.2 Shape of the AR and MR Curves under Monopoly
Under Monopolistic Competition, like monopoly, both the AR and MR curves are
downward sloping. A downward sloping AR curve implies that in order to sell more
units of the output the price of the commodity needs to be reduced. However, the AR
and MR curves are flatter under monopolistic competition than under Monopoly
because of the large number of close substitutes available for a firm’s output.
(AR and MR Curves under Monopoly)
5.3 Demand Curve under Monopolistic Competition
The AR curve is nothing else but the demand curve faced by a firm. The demand curve is
also downward sloping. This implies that buyers are willing to buy more of a commodity
only if its price is reduced. As the large number of close substitute is available for a firm’s
product, the demand curve faced by a monopolistically competitive firm is relatively elastic.
6. Oligopoly
The term Oligopoly means ‘Few Sellers’. An Oligopoly is an industry composed of

only few firms, or a small number of large firms producing bulk of its output. Since,
the industry comprises only a few firms, or a few large firms, any change in Price and
Output by an individual firm is likely to influence the profits and output of the rival
firms. Major Soft Drink firms, Airlines and Milk firms can be cited as an example
of Oligopoly.
6.1 Features
1. A Few Firms
Oligopoly as an industry is composed of few firms, or a few large firms
controlling bulk of its output.
2. Firms are Mutually Dependent

Each firm in oligopoly market carefully considers how its actions will affect its
rivals and how its rivals are likely to react. This makes the firms mutually
dependent on each other for taking price and output decisions.
3. Barriers to the Entry of Firms

The main cause of a limited number of firms in oligopoly is the barriers to the
entry of firms. One barrier is that a new firm may require huge capital to enter the
industry. Patent rights are another barrier.
4. Non Price Competition

When there are only a few firms, they are normally afraid of competing with each
other by lowering the prices; it may start a Price War and the firm who starts the
price war was may ultimately loose. To avoid price war, the firm uses other ways
of competition like: Customer Care, Advertising, Free Gifts etc. Such a
competition is called non-price competition.
7. Summary of Market Structures
Sr.No. Characteristics Perfect Monopoly Monopolistic Oligopoly

competition
1. Number of Many One Many Few
Firms
2. Types of Homogeneous Unique/ Differentiated Differentiated
Product Single/
Limited
3. Entry condition Very easy Impossible Easy Difficult
4. Pricing Price Taker Price Price Taker Price maker
Maker
5. Innovative Weak Potentially Moderate Very Strong
Behavior strong
6. Examples Agriculture, Public Retail Trade Steel, Oil,
Stock Market, Activities. Milk, Soft
Currency Drinks,
Market, Bond Airlines
market
Classroom Activity
While teaching the Forms of Market i.e., Perfect Competition, Imperfect Competition (Monopoly,
Monopolistic, Oligopoly), focus on the comparison, analysis of market conditions, price distribution and
other conditions, price determination and other characteristics of each form. Later for developing Critical
Thinking based on Analytical Ability, students can be divided in four groups, i.e. Perfect Competition,
Monopoly, Monopolistic, Oligopoly and then ask each group to prepare as much material as possible
including Prize Distribution, Entry Conditions, Cost and Revenue Curve, Short and Long -Term implications
Examples etc. Then, the role of teacher will be that of a Facilitator, when each group presents, discusses
and compares on each criteria under the category they are placed. After the entire unit 4 is taught, you
may follow the following steps in organizing the activity in the class room: Divide the whole class into four
Market Structures i.e. Perfect Competition, Monopoly, Monopolistic, Oligopoly i.e. Team A, B, C and D
respectively
1. Give them time to prepare for their own assigned form. During the classroom time they should sit in
their respective groups and prepare and collect as much information as much possible including
presentations. (Announce the class that there will be Quiz, at the end of all presentations or next
day.)
2. Teacher should prepare the areas/parameter of discussion i.e.
(i) Prize Determination under each form
(ii) Entry Conditions
(iii) Shape and nature of AR/ MR firms under each form
(iv) Short term/long term implication etc.
Likewise based on content, add the parameters on which discussions can take place in the class.
With the help of some good students (or the teacher teaching the same subjects in the school) make
‘Quiz Questions’ like any other quiz. Write questions on hard board, (place in file), make Time
keeper, Score Keeper who will assist you in organizing the ‘quiz ‘effectively. (Make adequate number
of questions for minimum ‘3’ rounds of Quiz)’. Conclude by giving away participation certificate to
all participants, some incentive/reward to winning team. This will create interest in the subject
among the students. It will also develop a healthy, competitive spirit and analytical ability based
on Critical Thinking.
Summary
A Market Structure describes the Key Traits of a market, including the number of
firms, the similarity of the products they sell, and the ease of entry into and exit, from
the market examinations of the business sector of our economy reveals firms’
operating in different market structure. Elements of Market Structure are 1.
Number and size, Distribution of Firms 2. Entry Conditions 3. Extent of Product
Differentiation. Determinants of Market Structure include: Freedom of Entry and Exit,
Nature of the Product, Homogeneous or Differentiated, Control over Supply /Output,
Control over Price, Control to Entry. Different Forms of Market are: Perfect
Competition and* Imperfect Competition (*Monopoly, Monopolistic Competition,
and Oligopoly) Perfect competition is a theoretical Market Structure that features
unlimited contestability, an unlimited number of producers and consumers,
Homogeneous Products ,Free Entry and Exit and perfect knowledge of Market.
Monopoly, where there is only one provider of a product or service. Features of this
form of Market include: No Close Substitute, Barriers to the Entry of new Firms,
Price Discrimination, Abnormal Profits in the long run, Limited Consumer Choice,
Prices in excess of MC .Monopolistic competition, also called competitive market,
where there are a large number of firms, each having a small proportion of the
market share and slightly differentiated products and Firms can easily enter and exit
from the Market. Oligopoly, in which a market is dominated by a small number of
firms that are mutually dependent that together control the majority of the market
share. In this form of market it is difficult for the new Firms to enter. When there are
only a few firms, they are normally afraid of competing with each other by lowering
the prices; it may start a Price War and the firm who starts the price was may
ultimately loose. To avoid price war, the firm uses other ways of competition line
customer care, advertising, free gifts etc. Such a competition is called non-price
competition.
Technical Terms
Market Structure A Market Structure describes the key traits of a market, including
the number of firms, the similarity of the products they sell, and the ease of entry into
and exit from, the market examinations of the business sector of our economy reveals
firms’ operating in different Market Structure.
Perfect Competition Perfect competition is a market structure where an infinitely

large number of buyers and sellers operate freely and sell a homogeneous
commodity at a uniform price.
Monopoly Pure monopoly is the form of market organization in which there is a
single seller of a commodity for which there are no close substitutes.
Monopolistic competition: Monopolistic competition is a situation in which the

market, basically, is a competitive market and there are many firms that sell closely
differentiated products.
Oligopoly An Oligopoly is an industry composed of only few firms, or a small

number of large firms producing bulk of its output.
Check your Progress
1. What is the relevance of large number of sellers under Perfect Competition?
2. The MR Schedule of a Monopoly firm is given below. Derive the TR and AR

schedules
Output (units) 0 1 2 3 4 5 6 7
MR (Rs.) - 14 10 7 5 0 -3 15
3. Discuss various ways in which a Monopoly market structure may arise.
4. Why is the demand curve facing a monopolistic competitive firm likely to be very
elastic?
5. Explain the following:-

(a) “Free Entry and Exit” Feature of Perfect Competition.
(b) “Differentiated products” features of Monopolistic Competition.
6. Compare and contrast the features of Monopoly and Oligopoly.
7. What is Product Differentiation? What is the significance of Product Differentiation

in monopolistic competition?
8. Draw the AR Curve of a firm under (i) Monopoly (ii) Monopolistic Competition and
Perfect Competition. Explain the difference in these curves.
Additional Questions
Very Short Answer Type Questions
1. Under which market form is a firm Price Taker?
2. Draw a Demand Curve under Perfect Competition.
3. Define the term ‘Equilibrium Price’.
4 .When does the situation of Excess Supply arise?

5. What is the Profit Maximization condition for Perfect Competition?
Short Answer Type Questions

1. Why is a Firm under Perfect Competition a Price Taker?
2. Explain three features of Perfect Competition.
3. Explain the determination of Equilibrium Price under Perfect Competition with the help of a
schedule.
4. Show that an increase in demand leads to a fall in the price of the commodity.
5. Diagrammatically represent the impact of a decrease in Supply on Equilibrium Price and of

Quantity, when demand is perfectly elastic.
6. What will be the impact of increase in Excise duty on the Equilibrium Price and Quantity of a
commodity? Use diagram to explain.
7. Explain the features “Large number of firms and Buyers” under Perfect Competition
Long Answer Type Question /Essay Type Questions

1 .How does an increase in price of Steel affect the equilibrium price and quantity of cars? Explain
with the help of diagram
2. With the help of a diagram explain how a rise in the Income levels impact the equilibrium price of
Shirts?
3. There is Simultaneous change in the demand and supply of a commodity and equilibrium price
increases. Explain this with the help of a diagram.
4. Explain the following features of Perfect Competition:
 Large number of Firms and Buyers

 Homogeneous Product
URL’s
Perfect competition
http://www.metacafe.com/watch/3810573/perfect_competition/
Equilibrium in perfect Competition
http://www.youtube.com/watch?v=7lhX78vlHSY
Perfect competition
http://www.schooltube.com/video/375fef99356c4cc7aa38/Business-Model-Perfect-
Competition
Free Market Economy
http://www.youtube.com/watch?v=4YwUnjqsIQM
Four Market Structures Simulation
http://www.youtube.com/watch?v=KGrmnynjHjI
Episode 25- Market Structures
http://www.youtube.com/watch?v=9Hxy-TuX9fs
Lecture 19 - Chap 9 - oligopoly.wmv
http://www.youtube.com/watch?v=6G_awGuSra4
Opportunity Cost
http://www.youtube.com/watch?v=ezOdQUzLVAo
UNIT-IV
(Pricing)
MODULE- 7: PRICING PROBLEMS AND
TECHNIQUES
CONTENTS
7.0: Objectives
7.01: Pricing problems
Multiple product pricing
Pricing in life-cycle of a product
7.02: Pricing techniques
Skimming price policy
Penetration pricing
Marginal cost pricing
Target return pricing
Cost-plus pricing
Loss leader pricing
Basing point pricing
Administered prices
Pricing by public firms
7.03: Discount structure
7.04: Types of discounts
7.05: Summary
7.06: References
7.07: Self Assessment test.
7.0: Objectives:
The objective of this module is to discuss different pricing
strategies adopted by private and public sector firms. After reading
this module, you should be able to understand the:
Multiple product pricing

Pricing in life cycle of a product
Skimming price policy
Penetration price policy
Cost plus pricing
Loss leader pricing
Discount Structure
Administered prices
Pricing policy adopted by public firms.
7.01: Pricing problems:

Pricing is one of the crucial decisions that a management executive
has to arrive at. Managers generally face problems while setting
prices of products produced in a product line. In the same way, it is
not easy to fix the price of a product on the basis of product life-
cycle. Now we shall try to discuss and understand the specific
pricing problems of business firms.
Multiple product pricing:

The price theory is based on the assumption that a firm produces a
single, homogeneous product. In actual practice, production of a
single homogeneous product is an exception. Almost all firms have
more than one product in their line of production. Many firms
produce a commodity in multiple models, sizes, each so much
differentiated from the other that every model or size of the
product may be considered a different product. For example: the
various models of refrigerators, television sets, washing machines,
cell phones etc, produced by same company may be treated as
different products for at least pricing purpose. The various models
are so differentiated that consumers view them as different
products. It is therefore not surprising that each model has different
average revenue (AR) and marginal revenue (MR) and that one
product of the firm competes against the other product. The pricing
under these conditions is known as multi-product pricing or
product line pricing.
The major problem in pricing multiple products is that each
product has a separate demand curve. But since all products are
produced under one establishment by interchangeable production
facilities, they have only one joint and inseparable marginal cost
curve. That is while revenue curves i.e. AR and MR are separate
for each product; cost curves i.e. AC and MC are inseparable.
Therefore the marginal rule of pricing cannot be applied to fix the
price of each product separately. Under these conditions the price
is fixed in such way to equate marginal revenue from each product
is equal to combined marginal cost (CMC). Suppose if a firm
produces three different sizes i.e. A, B, C, of same product in its
product line, based on price elasticity of demand for different size
groups, then it fix the price by following the condition CMC=
MRA=MRB=MRC .
GRAPH-1
Y Y Y
A B C
Revenue,Price
E3 E2 E1
ARA ARB
MRA MR MR
B
0 0 0
Output Output Output
Pricing in life-cycle of a product:
The life-cycle of a product is generally divided in to five stages.

These stages are (1) Introduction (2) Growth (3) Maturity (4)
Saturation (5) Decline. The pricing strategy varies from stage to
stage over the life-cycle of the product.
The pricing policy in respect of a new product depends on whether

or not close substitutes are available. Depending on this, generally
two kinds of pricing strategies are adopted in pricing a new
product. These are (A) Skimming price policy (B) Penetration
price policy.
GRAPH=2
Y
Sales
Saturati Decline
Maturit
Growth on-on
Introd y
uction
7.02: Pricing techniques:
Business firms generally adopt various pricing techniques
depending up on the nature of the product, elasticity of demand,
availability of substitutes, the income level of consumers, the
pressure on its production capacity and the objectives. Now we
shall try to discuss and understand various pricing techniques
adopted by business firms.
Skimming price policy:

This price policy is adopted where close substitutes of a new
product are not available. This pricing strategy is intended to skim
the cream i.e consumer’s surplus off the market by setting a high
initial price and subsequent lowering of price in a series of
reductions especially incase of consumer durables. The initial high
price is generally be accompanied by intensive selling campaign.
GRAPH-3
Price
Price
0
Time
Penetration price policy:

This pricing policy is generally adopted in the case of new
products for which substitutes are available. This policy requires
fixing a lower initial price designed to penetrate the market as
quickly as possible and is intended to maximize the profits in the
long run.. Therefore, the firms pursuing the penetration price
policy set a low price of the product in the initial stage. As there is
rise in demand in due course of time, price is gradually increased.
GRAPH-4
Y
Price
Price
X
0
Time
Marginal cost pricing:

Under this method business firms always fix the price
corresponding to the equality between marginal cost (MC) and
marginal revenue (MR).
Target -return pricing:

Under this method business fix its target rate of return either on
fixed capital or on total capital. Let us say that a business firm
aimed at 10% profit. Now the firm has to specify clearly whether
its aim is to earn 10% on fixed capital or total capital. Based on
this it has to fix the price in such a way to realize expected rate of
return.
Cost-plus pricing:
This is also known as Mark-up pricing or average cost pricing or
full-cost pricing. The cost-plus pricing is the most common method
of pricing used by the manufacturing business firms. The general
practice under this method is to add a fair percentage of profit
margins to the average variable cost (AVC). The formula for fixing
the price under this method is shown below.
P = AVC + GPM
The AVC is assumed known to the firm with certainty. GPM will
cover the average fixed cost (AFC) and yield a normal profit. Thus
GPM =AFC + NPM. Therefore P = AVC+ AFC+ GPM. Here
NPM is the net profit margin. The net profit margin is assumed to
be known to the business firms. It should yield a fair return on
capital and cover all risks peculiar to the product.
Example: A firm produced 100 units of output. Its total fixed cost
is Rs 6000 and Total variable cost is Rs 30,000. Its aim is to earn
20% profit. Profit margin is always fixed on price which is
unknown. Let us assume price is Rs X. In this example AVC = Rs
300 and AFC =Rs 60. Therefore AC = Rs 360. Based on this
information, we can find out the price that a business firm has to
set, to earn 20% profit margin.
X – 360 =. 20 X
X - . 20 X = 360
X (1- . 20) = 360
X (. 80) = 360
360
X = ------ = Rs 450.
. 80
Given the cost conditions, the firm has to set the price as Rs 450 to
realize 20% profit margin.
Loss leader pricing:

A firm producing jointly demanded products can adopt this type of
pricing strategy. A firm producing Xerox machines and toners can
price the Xerox machine average cost if it is confident of selling
large quantity of toners. The firm incurs loss on Xerox machines
but more than makes it up through the sale of toners. This strategy
is appropriate in case of complementary products where one time
purchase of a high value low volume product i.e. Xerox machine,
leads to repeat purchase of low value but high volume product i.e
toner.
For example: The average cost of Xerox machine is Rs 80,000.

The sale price of Xerox machine is Rs 70,000. Business firm is
incurring loss of Rs 10,000 on the sale of each Xerox machine. The
average cost of toner is Rs 400. The sale price of toner is Rs 600.
Business firm is earning profit to the extent of Rs 200, on the sale
of each toner. It is a fact that toner is a repeat purchase item and
hence the business firm can compensate loss from the sale of
Xerox machines through the profits from the sale of toners and
finally smell the net profit.
Basing point pricing:

The business firms operating under collusive oligopoly generally
follow this pricing policy. Under this, the price quoted by each is
the sum of production cost and the transportation cost from the
basing point. Under this system the delivered price may be
computed by using either single basing point or multiple basing
points. Under the single basing point system, all suppliers quote
the delivered prices which are the sum production cost and
transportation cost from the basing point. Thus the delivered prices
quoted by all firms for a given point of delivery are uniform
regardless of the point from which the delivery is made. Under the
multiple points pricing system, two or more producing centers are
selected as basing points. This pricing system has been in use by
the business firms producing steel in America.
GRAPH-5
In the above graph, P1P is the production cost line which is

parallel to horizontal axis. The horizontal cost line indicates that
the cost of production is identical across firms. PT is the
transportation cost from location A. Business firms decided to
consider location A as the basing point. Business firms will set the
price based on their production cost and transportation cost from
basing point. Firm A, to place commodity in its location, will quote
the price as AP. Where as to place commodity in location B, it will
quote the price as BN and in location C it will quote CQ, location
D, it will quote DH and in location E, it will quote ET price. In the
same other business firms quote their price.
Administered prices:
Administered prices are the prices fixed by the government. The
prices of petroleum products, kerosene, coal, aluminium, fertilisers
and the commodities supplied through public distribution system.
The objective of administered prices is to control the prices of
essential commodities and to arrest price escalation and protect the
welfare of consumers.
Pricing by public firms:

The pricing policy of public sector enterprises is generally
governed by social objectives rather profit considerations alone.
Keeping the social responsibility of supplying commodities the
public sector undertakings follow different pricing strategies
pertaining to nature of the commodity and its users. Public sector
undertakings may follow break-even pricing or profit as the basis
or loss as the basis for its pricing policy.
7.03: Discount structure:

Distributors’ discounts are price discounts that systematically
make the net price vary according to buyers’ position in the chain
of distribution. They are so called because these discounts are
given to various distributors in the trade channel namely dealers,
wholesalers and retailers. For the same reason they are also called
trade channel discounts. As these discounts create differential
prices for different customers on the basis of marketing functions
performed by them example: whether they are wholesaler or
retailer. These discounts also called as functional discounts.
Special discounts are also given to persons other than distributors.
7.04: Types of discounts:

Quantity discounts:
These are price reductions related to the quantities purchased.
Quantity discounts may take several forms. Quantity discounts
may be related to the size of the order being measured in terms of
physical units of a particular product. This method is practicable
where the commodities are homogeneous in nature and may be
measured in terms of truck loads. The important objective of
quantity discounts is to reduce the number of small orders and
there by avoid the high cost servicing them.
Cash discounts:
Cash discounts are price reductions based on promptness of
payment. An example is: 10% discount if paid in 10 days, full
invoice price in 20 days. In practice the size of cash discount may
vary widely. Cash discount is a convenient device to over come
bad credit risks. With respect to the sale of certain commodities
credit risk is high. So that business firm offers maximum discount.
Time differentials:
Charging different prices on the basis of time is another kind of
price discount. Here the objective of the seller is to take advantage
of the fact that buyers’ demand elasticity’s vary over time. The
discounts based on time are: (1) clock-time discounts (2) calendar
time discounts.
Clock-time discounts: When different prices are charged for the

same service or commodity at different times within a 24 hour
period, the price differentials are known as clock time differentials.
The common example of these is the differences between the day
and night rate on trunk calls. This is also the case of peak-load
pricing. Business firms generally charge high price when there is
huge demand i.e peak-load, for given services i.e. the line capacity,
to divert some customers to use their services during off-peak
period. Therefore the firms fix low price during off-peak period.
Calendar time discounts:

Under this method the price differences are based on period longer
than 24 hours. For example: seasonal price variations in the case
woolen clothes, hotel accommodation at hill stations and tourist
places.
7.05: Summary:
Pricing policy of a business firm determines its future growth. It is
the most difficult decision that a management executive or CEO of
a business has to arrive at after giving due importance to various
factors. If a business firm adds a product line, it has to face
problems while setting the price. In the same way, it is very
difficult to price of products based on product life-cycle. Different
pricing techniques are generally adopted by business firms taking
into account the nature of the product, elasticity of demand,
availability of substitutes and the objectives. The government
generally fixes the prices of coal, petrol, kerosene, fertilizers. The
prices fixed by government are called as administered prices. The
public sector under takings also fix the prices products supplied by
them keeping in mind the social responsibility. Business firms also
offer quantity and cash discounts and also implement price
variation policy based on peak and off-peak demand.
7.06: References:
2. Dominick Salvatore: Managerial Economics in a Global

Economy
3. H. Craig Petersen : Managerial Economics

And W. Cris Lewis
4. R.L Varshney and K.L. Maheswari : Managerial Economics
5. D.N.Dwivedi : Managerial Economics

1. Discuss the pricing problems of business firms.
2. Discuss different pricing techniques adopted by business firms.
UNIT – V, MODULE - II
SOURCES AND METHODS OF FUNDS
LEARNING OBJECTIVES:
After studying this chapter, you should be able to:
1. state the meaning and importance of business
finance;
2. classify the various sources of business finance; and
3. evaluate merits and limitations of various sources of
finance
CONTENTS:
1.1 REQUIREMENT OF FUNDS
1.2 SHORT TERM CAPITAL SOURCING METHODS
1.3 LONG TERM CAPITAL SOURCING METHODS
1.4 ACTIVITY
1.5 REFERECES
1.1 REQUIREMENT OF FUNDS:

Business is concerned with the production and distribution of goods
and services for the satisfaction of needs of society. For carrying out
various activities, business requires money. Finance, therefore, is
called the life blood of any business. The requirements of funds by
business to carry out its various activities are called business finance.
The initial capital contributed by the entrepreneur is not always
sufficient to take care of all financial requirements of the business.
The financial needs of a business can be categorised as follows:
(a)Fixed capital requirements: In order to start business, funds are

required to purchase fixed assets like land and building, plant
and machinery, and furniture and fixtures. This is known as
fixed capital requirements of the enterprise. The funds required
in fixed assets remain invested in the business for a long period
of time. Different business units need varying amount of fixed
capital depending on various factors such as the nature of
business, etc. A trading concern for example, may require small
amount of fixed capital as compared to a manufacturing
concern. Likewise, the need for fixed capital investment would
be greater for a large enterprise, as compared to that of a small
enterprise.
(b) Working Capital requirements: The financial requirements

of an enterprise do not end with the procurement of fixed assets.
No matter how small or large a business is, it needs funds for its
day-to-day operations. This is known as working capital of an
enterprise, which is used for holding current assets such as stock
of material, bills receivables and for meeting current expenses
like salaries, wages, taxes, and rent.
The amount of working capital required varies from one business

concern to another depending on various factors. A business unit
selling goods on credit, or having a slow sales turnover, for example,
would require more working capital as compared to a concern selling
its goods and services on cash basis or having a speedier turnover.
The requirement for fixed and working capital increases with the
growth and expansion of business. At times additional funds are
required for upgrading the technology employed so that the cost of
production or operations can be reduced. Similarly, larger funds may
be required for building higher inventories for the festive season or to
meet current debts or expand the business or to shift to a new
location. It is, therefore, important to evaluate the different sources
1.2 SHORT TERM CAPITAL SOURCING METHODS:

1.2.1 Trade Credit
Trade credit is the credit extended by one trader to another for the
purchase of goods and services. Trade credit facilitates the purchase
of supplies without immediate payment. Such credit appears in the
records of the buyer of goods as ‘sundry creditors’ or ‘accounts
payable’. Trade credit is commonly used by business organisations as
a source of short-term financing. It is granted to those customers who
have reasonable amount of financial standing and goodwill. The
volume and period of credit extended depends on factors such as
reputation of the purchasing firm, financial position of the seller,
volume of purchases, past record of payment and degree of
competition in the market. Terms of trade credit may vary from one
industry to another and from one person to another. A firm may also
offer different credit terms to different customers.
Merits
The important merits of trade credit are as follows:
(i) Trade credit is a convenient and continuous source of funds;
(ii) Trade credit may be readily available in case the credit
worthiness of the customers is known to the seller;
(iii) Trade credit needs to promote the sales of an organisation;
Limitations
Trade credit as a source of funds has certain limitations, which are
given as follows:
(i) Availability of easy and flexible trade credit facilities may
induce a firm to indulge in overtrading, which may add to the
risks of the firm;
(ii) Only limited amount of funds can be generated through trade
credit;
(iii) It is generally a costly source of funds as compared to most
other sources of raising money.
1.2.2 Factoring:
Factoring is a financial service under which the ‘factor’ renders
various services which includes:
a. Discounting of bills (with or without recourse) and
collection of the client’s debts. Under this, the receivables
on account of sale of goods or services are sold to the
factor at a certain discount. The factor becomes
responsible for all credit control and debt collection from
the buyer and provides protection against any bad debt
losses to the firm. There are two methods of factoring —
recourse and non-recourse. Under recourse factoring, the
client is not protected against the risk of bad debts. On the
other hand, the factor assumes the entire credit risk under
non-recourse factoring i.e., full amount of invoice is paid
to the client in the event of the debt becoming bad.
b. Providing information about credit worthiness of

prospective client’s etc., Factors hold large amounts of
information about the trading histories of the firms. This
can be valuable to those who are using factoring services
and can thereby avoid doing business with customers
having poor payment record. Factors may also offer
relevant consultancy services in the areas of finance,
marketing, etc.
Merits
The merits of factoring as a source of finance are as follows:
(i) Obtaining funds through factoring is cheaper than financing
through other means such as bank credit;
(ii) With cash flow accelerated by factoring, the client is able to
meet his/her liabilities promptly as and when these arise;
(iii) Factoring as a source of funds is flexible and ensures a
definite pattern of cash inflows from credit sales. It provides
security for a debt that a firm might otherwise be unable to
obtain;
Limitations
The limitations of factoring as a source of finance are as
follows:
(i) This source is expensive when the invoices are numerous and
smaller in amount;
(ii) The advance finance provided by the factor firm is generally
available at a higher interest cost than the usual rate of
interest;
(iii) The factor is a third party to the customer who may not feel
comfortable while dealing with it.
1.2.3 Lease Financing:

A lease is a contractual agreement whereby one party i.e., the owner
of an asset grants the other party the right to use the asset in return for
a periodic payment. In other words it is a renting of an asset for some
specified period. The owner of the assets is called the ‘lessor’ while
the party that uses the assets is known as the ‘lessee’. The lessee pays
a fixed periodic amount called lease rental to the lessor for the use of
the asset. The terms and conditions regulating the lease arrangements
are given in the lease contract. At the end of the lease period, the asset
goes back to the lessor. Lease finance provides an important means of
modernisation and diversification to the firm. Such type of financing
is more prevalent in the acquisition of such assets as computers and
electronic equipment which become obsolete quicker because of the
fast changing technological developments. While making the leasing
decision, the cost of leasing an asset must be compared with the cost
of owning the same.
Merits
The important merits of lease financing are as follows:
(i) It enables the lessee to acquire the asset with a lower
investment; Simple documentation makes it easier to finance
assets;
(ii) Lease rentals paid by the lessee are deductible for computing
taxable profits;
(iii) The lease agreement does not affect the debt raising capacity
of an enterprise;
(iv) The risk of obsolescence is borne by the lesser. This allows
greater flexibility to the lessee to replace the asset.
Limitations
The limitations of lease financing are given as below:
(i) A lease arrangement may impose certain restrictions on the
use of assets. For example, it may not allow the lessee to
make any alteration or modification in the asset;
(ii) The normal business operations may be affected in case the
lease is not renewed;
(iii) It may result in higher payout obligation in case the
equipment is not found useful and the lessee opts for
premature termination of the lease agreement; and
1.2.4 Commercial Paper (CP):

Commercial Paper emerged as a source of short term finance in our
country. Commercial paper is an unsecured promissory note issued by
a firm to raise funds or a short period, varying from 90 days to 364
days. It is issued by one firm to other business firms, insurance
companies, pension funds and banks. The amount raised by CP is
generally very large. As the debt is totally unsecured, the firms having
good credit rating can issue the CP. The merits and limitations of a
Commercial Paper are as follows:
Merits
(i) A commercial paper is sold on an unsecured basis and does
not contain any restrictive conditions; As it is a freely
transferable instrument, it has high liquidity;
(ii) It provides more funds compared to other sources. Generally,
the cost of CP to the issuing firm is lower than the cost of
commercial bank loans;
(iii) A commercial paper provides a continuous source of funds.
This is because their maturity can be tailored to suit the
requirements of the issuing firm. Further, maturing
commercial paper can be repaid by selling new commercial
paper;
Limitations
(i) Only financially sound and highly rated firms can raise
money through commercial papers. New and moderately
rated firms are not in a position to raise funds by this method;
(ii) The size of money that can be raised through commercial
paper is limited to the excess liquidity available with the
suppliers of funds at a particular time;
(iii) Commercial paper is an impersonal method of financing. As
such if a firm is not in a position to redeem its paper due to
financial difficulties, extending the maturity of a CP is not
possible.
1.2.5 Commercial Banks:
Commercial banks occupy a vital position as they provide funds for
different purposes as well as for different time periods. Banks extend
loans to firms of all sizes and in many ways, like, cash credits,
overdrafts, term loans, purchase/discounting of bills, and issue of
letter of credit. The rate of interest charged by banks depends on
various factors such as the characteristics of the firm and the level of
interest rates in the economy. The loan is repaid either in lump sum or
in installments.
Bank credit is not a permanent source of funds. Though banks have

started extending loans for longer periods, generally such loans are
used for medium to short periods. The borrower is required to provide
some security or create a charge on the assets of the firm before a loan
is sanctioned by a commercial bank.
Merits
The merits of raising funds from a commercial bank are as follows:
(i) Banks provide timely assistance to business by providing
funds as and when needed by it.
(ii) Secrecy of business can be maintained as the information
supplied to the bank by the borrowers is kept confidential;
(iii) Formalities such as issue of prospectus and underwriting are
not required for raising loans from a bank. This, therefore, is
an easier source of funds;
Limitations
The major limitations of commercial banks as a source of finance are
as follows:
(i) Funds are generally available for short periods and its
extension or renewal is uncertain and difficult;
(ii) Banks make detailed investigation of the company’s affairs,
financial structure etc., and may also ask for security of assets
and personal sureties. This makes the procedure of obtaining
funds slightly difficult;
(iii) In some cases, difficult terms and conditions are imposed by
banks. for the grant of loan. For example, restrictions may be
imposed on the sale of mortgaged goods, thus making normal
business working difficult.
1.3 LONG TERM CAPITAL SOURCING METHODS:

The capital obtained by issue of shares is known as share capital. The
capital of a company is divided into small units called shares. Each
share has its nominal value. For example, a company can issue 1,
00,000 shares of Rs. 10 each for a total value of Rs. 10, 00,000. The
person holding the share is known as shareholder. There are two types
of shares normally issued by a company. These are equity shares and
preference shares. The money raised by issue of equity shares is
called equity share capital, while the money raised by issue of
preference shares is called preference share capital.
1.3.1 Equity Shares:

Equity shares are the most important source of raising long term
capital by a company. Equity shares represent the ownership of a
company and thus the capital raised by issue of such shares is known
as ownership capital or owner’s funds. Equity share capital is a
prerequisite to the creation of a company.
Equity shareholders do not get a fixed dividend but are paid on the
basis of earnings by the company. They are referred to as ‘residual
owners’ since they receive what is left after all other claims on the
company’s income and assets have been settled. They enjoy the
reward as well as bear the risk of ownership. Their liability, however,
is limited to the extent of capital contributed by them in the company.
Further, through their right to vote, these shareholders have a right to
participate in the management of the company.
Merits
The important merits of raising funds through issuing equity shares
are given as below:
(i) Equity shares are suitable for investors who are willing to
assume risk for higher returns;
(ii) Payment of dividend to the equity shareholders is not
compulsory. Therefore, there is no burden on the company in
this respect;
(iii) Equity capital serves as permanent capital as it is to be repaid
only at the time of liquidation of a company. As it stands last
in the list of claims, it provides a cushion for creditors, in the
event of winding up of a company;
Limitations
The major limitations of raising funds through issue of equity shares
are as follows:
(i) Investors who want steady income may not prefer equity
shares as equity shares get fluctuating returns;
(ii) The cost of equity shares is generally more as compared to
the cost of raising funds through other sources;
(iii) Issue of additional equity shares dilutes the voting power, and
earnings of existing equity shareholders;
1.3.2 Retained Earnings:

A company generally does not distribute all its earnings amongst the
shareholders as dividends. A portion of the net earnings may be
retained in the business for use in the future. This is known as
retained earnings. It is a source of internal financing or self-financing
or ‘ploughing back of profits’. The profit available for ploughing back
in an organisation depends on many factors like net profits, dividend
policy and age of the organisation.
Merits
The merits of retained earnings as a source of finance are as follows:
(i) Retained earnings is a permanent source of funds available to
an organisation;
(ii) It does not involve any explicit cost in the form of interest,
dividend or floatation cost; As the funds are generated
internally, there is a greater degree of operational freedom
and flexibility;
(iii) It enhances the capacity of the business to absorb unexpected
losses;
Limitations
Retained earnings as a source of funds has the following limitations:
(i) Excessive ploughing back may cause dissatisfaction amongst
the shareholders as they would get lower dividends;
(ii) It is an uncertain source of funds as the profits of business are
fluctuating;
(iii) The opportunity cost associated with these funds is not
recognized by many firms. This may lead to sub-optimal use
of the funds.
1.3.3 Preference Shares:

The capital raised by issue of preference shares is called preference
share capital. The preference shareholders enjoy a preferential
position over equity shareholders in two ways:
(i) receiving a fixed rate of dividend, out of the net profits of the
company, before any dividend is declared for equity
shareholders; and
(ii) Receiving their capital after the claims of the company’s
creditors have been settled, at the time of liquidation.
In other words, as compared to the equity shareholders, the preference

shareholders have a preferential claim over dividend and repayment
of capital. Preference shares resemble debentures as they bear fixed
rate of return. Also as the dividend is payable only at the discretion of
the directors and only out of profit after tax, to that extent, these
resemble equity shares. Thus, preference shares have some
characteristics of both equity shares and debentures. Preference
shareholders generally do not enjoy any voting rights. A company can
issue different types of preference shares.
Merits
The merits of preference shares are given as follows:
(i) Preference shares provide reasonably steady income in the
form of fixed rate of return and safety of investment;
(ii) Preference shares are useful for those investors who want
fixed rate of return with comparatively low risk;
(iii) Payment of fixed rate of dividend to preference shares may
enable a company to declare higher rates of dividend for the
equity shareholders in good times;
Limitations
The major limitations of preference shares as source of business
finance are as follows:
(i) Preference shares are not suitable for those investors who are
willing to take risk and are interested in higher returns;
(ii) The rate of dividend on preference shares is generally higher
than the rate of interest on debentures;
(iii) The dividend paid is not deductible from profits as expense.
Thus, there is no tax saving as in the case of interest on
loans.
1.3.4 Debentures:
Debentures are an important instrument for raising long term debt
capital. A company can raise funds through issue of debentures,
which bear a fixed rate of interest. The debenture issued by a
company is an acknowledgment that the company has borrowed a
certain amount of money, which it promises to repay at a future date.
Debenture holders are, therefore, termed as creditors of the company.
Debenture holders are paid a fixed stated amount of interest at

specified intervals say six months or one year. Public issue of
debentures requires that the issue be rated by a credit rating agency
like CRISIL (Credit Rating and Information Services of India Ltd.) on
aspects like track record of the company, its profitability, debt
servicing capacity, credit worthiness and the perceived risk of
lending.
Merits
The merits of raising funds through debentures are given as follows:
(i) It is preferred by investors who want fixed income at lesser
risk; Debentures are fixed charge funds and do not participate
in profits of the company;
(ii) The issue of debentures is suitable in the situation when the
sales and earnings are relatively stable;
(iii) Financing through debentures is less costly as compared to
cost of preference or equity capital as the interest payment on
debentures is tax deductible.
Limitations
A debenture as source of funds has certain limitations. These are
given as follows:
(i) As fixed charge instruments, debentures put a permanent
burden on the earnings of a company. There is a greater risk
when earnings of the company fluctuate;
(ii) In case of redeemable debentures, the company has to make
provisions for repayment on the specified date, even during
periods of financial difficulty;
(iii) Each company has certain borrowing capacity. With the issue
of debentures, the capacity of a company to further borrow
funds reduces.
1.3.5 Financial Institutions:

The government has established a number of financial institutions all
over the country to provide finance to business organisations. These
institutions are established by the central as well as state governments.
They provide both owned capital and loan capital for long and
medium term requirements and supplement the traditional financial
agencies like commercial banks. As these institutions aim at
promoting the industrial development of a country, these are also
called ‘development banks’. In addition to providing financial
assistance, these institutions also conduct market surveys and provide
technical assistance and managerial services to people who run the
enterprises. This source of financing is considered suitable when large
funds for longer duration are required for expansion, reorganisation
and modernisation of an enterprise.
Merits
The merits of raising funds through financial institutions are as
follows:
(i) Financial institutions provide long-term finance, which are
not provided by commercial banks;
(ii) Obtaining loan from financial institutions increases the
goodwill of the borrowing company in the capital market.
Consequently, such a company can raise funds easily from
other sources as well;
(iii) As repayment of loan can be made in easy installments, it
does not prove to be much of a burden on the business;
Limitations
The major limitations of raising funds from financial institutions are
as given below:
(i) Financial institutions follow rigid criteria for grant of loans.
Too many formalities make the procedure time consuming
and expensive;
(ii) Certain restrictions such as restriction on dividend payment
are imposed on the powers of the borrowing company by the
financial institutions
1.4 ACTIVITY:
1. Explain trade credit and bank credit as sources of short-term
finance for business enterprises.
2. Discuss the sources from which a large industrial enterprise
can raise capital for financing modernisation and expansion.
3. What advantages does issue of debentures provide over the
issue of equity shares?
4. State the merits and demerits of public deposits and retained
earnings as methods of business finance.
5. What is a commercial paper? What are its advantages and
limitations?
1.5 REFERECES:
(i) Khan& Jain: Financial Management, PHI Publishers, New
Delhi
(ii) PL.Mehta: Managerial Economics, S.Chand Publishers, New
Delhi
(iii) www.bized.co.uk
(iv) NCERT, Business Studies class XII text books, Chapter-8,
CBSE, New Delhi
UNIT – V, MODULE - 3
CAPITAL BUDGETING TECHNIQUES
LEARNING OBJECTIVES:
After studying this chapter, you should be able to:
1. Nature and procedure of capital budgeting;
2. Techniques used for the capital budgeting along with
their merits and demerits.
3. Solve simple capital budgeting problems.
CONTENTS:
3.1 Procedure of Capital Budgeting
3.2 Nature of Capital Budgeting
3.3 Methods of Evaluating Capital Expenditure
Proposals
3.4 Accounting Rate of Return
3.5 Pay-Back Method
3.6 Present Value Method
3.7 Internal Rate of Return Method
3.8 References
3.9 Activity (Capital Budgeting Techniques – Simple
Problems)
3.1 PROCEDURE OF CAPITAL BUDGETING
Capital investment decision of the firm have a pervasive influence on

the entire spectrum of entrepreneurial activities so the careful
consideration should be regarded to all aspects of financial
management. In capital budgeting process, main points to be borne in
mind how much money will be needed of implementing immediate
plans, how much money is available for its completion and how are
the available funds going to be assigned tote various capital projects
under consideration. The financial policy and risk policy of the
management should be clear in mind before proceeding to the capital
budgeting process. The following procedure may be adopted in
preparing capital budget :-
(1) Organisation of Investment Proposal. The first step in

capital budgeting process is the conception of a profit making
idea. The proposals may come from rank and file worker of any
department or from any line officer. The department head
collects all the investment proposals and reviews them in the
light of financial and risk policies of the organisation in order to
send them to the capital expenditure planning committee for
consideration.
(2) Screening the Proposals. In large organisations, a capital
expenditure planning committee is established for the screening
of various proposals received by it from the heads of various
departments and the line officers of the company. The
committee screens the various proposals within the long-range
policy-frame work of the organisation. It is to be ascertained by
the committee whether the proposals are within the selection
criterion of the firm, or they do no lead to department
imbalances or they are profitable.
(3) Evaluation of Projects. The next step in capital budgeting

process is to evaluate the different proposals in term of the cost
of capital, the expected returns from alternative investment
opportunities with evaluation techniques.
(4) Establishing Priorities. After proper screening of the

proposals, uneconomic or unprofitable proposals are dropped.
The profitable projects or in other words accepted projects are
then put in priority. It facilitates their acquisition or construction
according to the sources available and avoids unnecessary and
costly delays and serious cot-overruns. Generally, priority is
fixed in the following order.
a) Current and incomplete projects are given first priority.
b) Safety projects ad projects necessary to carry on the
legislative requirements.
c) Projects of maintaining the present efficiency of the firm.
d) Projects for supplementing the income
e) Projects for the expansion of new product.
(5) Final Approval. Proposals finally recommended by the

committee are sent to the top management along with the
detailed report, both o the capital expenditure and of sources of
funds to meet them. The management affirms its final seal to
proposals taking in view the urgency, profitability of the projects
and the available financial resources. Projects are then sent to
the budget committee for incorporating them in the capital
budget.
(6) Evaluation. Last but not the least important step in the
capital budgeting process is an evaluation of the programme
after it has been fully implemented. Budget proposals and the
net investment in the projects are compared periodically and on
the basis of such evaluation, the budget figures may be reviewer
and presented in a more realistic way.
3.2 NATURE OF CAPITAL BUDGETING
Nature of capital budgeting can be explained in brief as under

(a)Capital expenditure plans involve a huge investment in fixed
assets.
(b) Capital expenditure once approved represents long-term
investment that cannot be reversed or withdrawn without
sustaining a loss.
(c)Preparation of capital budget plans involve forecasting of
several years profits in advance in order to judge the profitability
of projects.
(d) It may be asserted here that decision regarding capital
investment should be taken very carefully so that the future
plans of the company are not affected adversely.
Emphasis on cash flows. From a capital budgeting standpoint, the

timing of cash flows is important, since a rupee received today is
more valuable than a rupee received in the future. Therefore, even
though accounting net income is useful for many things, it is not
ordinarily used in discounted cash flow analysis. Instead of
determining accounting net income, the manager concentrates on
identifying the specific cash flows of the investment project.
When computing the net present value of a project, cash flow—and

not accounting net income—is ordinarily discounted.
Typical cash outflows Typical cash inflows
Initial investment. Incremental revenues.

Increased working Reductions in costs.
capital requirements. Salvage value.
Repairs and Release of working
maintenance costs. capital.
Incremental operating
costs.
3.3 METHODS OF EVALUATING CAPITAL EXPENDITURE

PROPOSALS
There are number of methods in use for evaluating a capital

investment proposal. Different firms may use different methods for
evaluating the project proposals. Which method is appropriate for the
particular purpose of the firm will depend upon the circumstances but
one thing is very clear that management has to select the most
profitable proposal out of the various proposals under consideration
with the management. The most commonly used methods are given
below:
1. Accounting Rate of Return Method
2. Payback Period Method
3. Net Present Value Method
4. Internal Rate of Return Method
3.4 ACCOUNTING RATE OF RETURN
Accounting Rate of Return: Various proposals are ranked in order

to rate of earnings on the investment in the projects concerned. The
project which shows highest rate of return is selected and others are
ruled out.
The Accounting rate of Return is found out by dividing the average

income after taxed by the average investment, i.e., average net value
after depreciation. The accounting rate of return, thus, is an average
rate and can be determined by the following equation.
Accounting Rate of Return (ARR) =
There are two variants of the accounting rate of return (a) Original
Investment Method, and (b) Average Investment Method.
(a) Original Investment Method: Under this method average

annual earnings or profits over the life of the project are divided
by the total outlay of capital project, i.e., the original
investment. Thus ARR under this method is the ratio between
average annual profits and original investment established. We
can express the ARR in the following way.
ARR= Average annual profits over the life of the project ÷

Original Investment
(b) Average Investment Method: Under average investment

method, average annual earnings are divided by the average
amount of investment. Average investment is calculated, by
dividing the original investment by two or by a figure
representing the mid-point between the original outlay and the
salvage of the investment. Generally accounting rate of return
method is represented by the average investment method.
Rate of return. Rate of Return, as the term is used in our foregoing

discussion, may be calculated by taking (a) income before taxes and
depreciation, (b) income before tax and after depreciation. (c) Income
before depreciation an after tax, and (d) income after tax and
depreciation, as the numerator. The use of different concepts of
income or earnings as well as of investment is made. Original
investment or average investment will give different measures of the
accounting rate of return.
Merits of Accounting Rate of Return Method
The following are the merits of the accounting rate of Return method
(a)It is very simple to understand and use.
(b) Rate of return may readily be calculated with the help of
accounting data.
(c)The system gives due weight age to the profitability of the
project if based on average rate of Return. Projects having
higher rate of Return will be accepted and are comparable with
the returns on similar investment derived by other firm.
(d) It takes investments and the total earnings from the project
during its life time.
Demerits of Return Method
The method suffers from the following weaknesses
(1) It uses accounting profits and not the cash-inflows in appraising

the projects.
(2) It ignores the time-value of money which is an important factor
in capital expenditure decisions. Profits occurring in different
periods are valued equally.
(3) It considers only the rate of return and not the length of project
lives.
(4) The method ignores the fact that profits can be reinvested.
(5) The method does not determine the fair rate of return on
investment. It is left at the discretion of the management. So,
use of arbitrary rate of return cause serious distortion in the
selection of capital projects
(6) The method has different variants, each of which produces a
different rate of return for one proposal due to the diverse
version of the concepts of investment and earnings.
3.5 PAY-BACK METHOD
This method is popularly known as pay-off, pay out or replacement

period methods also. It is the most popular and widely recognised
traditional method of evaluating capital projects. It represents the
number of years required to recover the original cash outlay invested in
a project. It is based on the principle that every capital expenditure
pays itself back over a number of years.
It attempts to measure the period of time, it takes for the original cost
of a project to be recovered from the additional earnings of the project.
It means where the total earnings (or net cash inflow) from investment
equals the total outlay, that period is the pay-back period. The standard
recoupment period is fixed the management taking into account
number of considerations. In making a comparison between two or
more projects, the project having the lesser number of pay-back years
within the standard recoupment limit will be accepted. Suppose, if an
investment earns Rs. 5000 cash proceeds in each of the first two years
of its use, the pay-back period will be two years.
If annual net cash-inflows are even or constant, the pay-back period

can be computed dividing cash outlay original investment) by the
annual cash-inflow. It can be denote as:
Original investment
Pay-back period = _____________________
Annual Cash-inflow
If cash inflows are uneven, the calculation of pay-back period takes a

cumulative form. In such case, the pay back period can be found out by
adding up the figure of net cash inflows until the total is equal to the
total outlay (or original investment).
Merits of Pay-back Method
The pay-back method is widely accepted method for .evaluating the

various proposals. The merits of this method are as follows:
(a)It is easy to calculate and simple to understand. It is an

improvement over the criterion of urgency.
(b) It is preferred by executives who like snap answers for the
selection of the proposal.
(c)It is useful where the firm is suffering from cash deficiency. The
management may like to use pay-back method to emphasis those
proposals which produce an early return of liquid funds. In other
words, it stresses the liquidity objective.
(d) Industries which are subject to uncertainty, instability or
rapid technological charges may adopt the pay-back method for a
simple reason that the future uncertainty does not
permit projection of annual cash inflows beyond a limited
period. in this way, it reduces the possibility of loss through
obsolescence.
(e)It is a handy device for evaluating investment proposals, where
precision in estimates of profitability is not important.
Limitations of Pay-back Method
The pay-back approach suffers from the following limitations
(a)It completely ignores the annual cash inflows after the pay-back
period.
(b) The method considers only the period of a pay back. It does
not consider the pattern of cash inflows, i.e., the magnitude and
timing of cash inflows. For example, if two projects involve
equal cash outlay and yield equal cash inflows over equal time
periods, it means both proposals are equally good. But the
proposal with larger cash inflows in earlier years shall be
preferred over the proposal which generated larger cash inflows
in later years.
(c)It overlooks the cost of capital; i.e., interest factor which is a
important consideration in making sound investment decisions.
(d) The method is delicate and rigid. A slight change in
operation cost will affect the cash inflows and as such pay-back
period shall also be affected.
(e)It over-emphasises the importance of liquidity as a goal of capital
expenditure decisions. The profitability of t project is completely
ignored. Undermining the importune of profitability can in no
way be justified.
3.6 PRESENT VALUE METHOD
The method is also known as 'Time adjusted rate of return' or 'Internal

Rate of Return' Method or Discounted cash-flow method. In recent
years, the method has been recognised as the most meaningful
technique for financial decisions regarding future commitments and
projects. The method is based on the assumption that future rupee
value cannot be taken as equivalent to the rupee value in the present.
When we compare the returns or cash inflows with the amount of
investment or cash outflows, both must be stated on a present value
basis if the time value of money is to be given due importance. The
problem of difference in time (when cash outflows and inflows take
place) can be resolved by converting the future amounts to their
present values to make them comparable.
The discounted cash flow rate of return or internal rate of return of n

investment is the rate of interest (discount at which the present value
of cash inflows and the present value of cash outflows become equal).
The present value of future cash inflows can be calculated with help
of following formula:
S
P = _______
(1 + i )n
Here P = Present value of future cash inflows
S = Future value of a sum of money
i = Rate of Return or required earning rate
n = Number of year
For example, assume that you are to receive Rs.200 two years from
now. You know that the future value of this sum is Rs.200, since this
is the amount that you will be receiving after two years. But what is
the sum's present value - what is it worth right now?
In our example, S = Rs.200 (the amount to be received in future), i =

0.05 (the annual rate of interest), and n=2 (the number of years in the
future that the amount is to be received)
P = Rs.200 / (1 + 0.05)n
P = Rs.200 / (1 + 0.05)2
P = Rs.200 / 1.1025
P = Rs.181.40
As shown by the computation above, the present value of a Rs.200
amount to be received two years from now is Rs.181.40 if the interest
rate is 5%. In effect, Rs.181.40 received right now is equivalent to
Rs.200 received two years from now if the rate of return is 5%.
This method can be examined under two heads. (a) Net Present value
method, and (b) Internal rate of return method.
(a) Net Present Value Method. The net present value method also
known as discounted benefit cost ratio. Under this method, a required
rate of return is assumed, and a comparison is made between the
present value of cash inflows at different times and the original
investment in order to determine the prospective profitability.
This method is based on the basic principle if the present value of

cash inflows discounted at a specified rate of return equals of exceeds
the amount of investment proposal should be accepted. This
discounted rate is also known as the 'required earning ratio'. Present
value tables are generally used in order to make the calculations
prompt and to know the present value of the cash inflows at required
earning ration corresponding to different periods. We can, however,
use the following formula to know the present value of Re. 1 to be
received after a specified period at a given rate of discount.
Where CFt = Cash inflow in time ‘t’
k = Rate of Discount / Cost of capital
I = Initial Cash outflow
Example. Let us suppose an investment proposal requires an initial

outlay of Rs. 40000 with an expected cash-inflow of Rs. 1,000 per
year for five years. Should the proposal be accepted if the rate of
discount is (a) 15 % or (b) 6% ?
Year Cash Present Total Present Total

(1) inflows Value of Present Value of Present
(2) Re 1 Value Re 1 @ value
@ 15 % @ 15 % 6% (5) @ 6%
(3) (2) X (3) (2) X (5)
1. 1,000 .870 870 .943 943

2. 1,000 .756 756 .890 890
3. 1,000 .658 658 .840 840
4. 1,000 .572 572 .792 792
5. 1,000 .497 497 .747 747
________ ________
3353 4212
The method is regarded as superior to other methods of investment

appraisal in several ways:-
(1) The method takes into account the entire economic life of
the project investment and income.
(2) It gives due weight age to time factor of financing. Hence
valuable in long term capital decisions. The discounted cash
flow method explicitly and routinely weighs the time value of
money; it is the best method, to use for long-range decisions.'
(3) it produces a measure which is precisely comparably
among projects, regardless of the character and time shape of
their receipts an outlays.
(4) This approach provides for uncertainty and risk by
recognizing the time factor. It measures the profitability of
capital expenditure by reducing the earnings to the present
value.
(5) It is the best method of evaluating project where the cash
flows are uneven. Cash inflows and outflows are directly
considered under this method while they re averaged under
other methods.
As the total present value of Rs. 3353 at a discount rate of 15 % is less
than Rs. 4000 (the initial investment) the proposal cannot be accepted,
if we ignore the other non-quantitative considerations. But the present
value of Rs. 4212 at a discount rate of 6 % exceeds the initial
investment of Rs. 4,000, the proposal can be acceptable.
The above example shows even cash inflows every year. But if cash
inflows are uneven, the procedure to calculate the present values is
somewhat difficult. For example, if we expect cash flows at - Re. 1
one year after, Rs. 3 two years after. Rs. 4 three years after the present
value at 15 % discount that would be:-
PV of Re. 1 to be received at the end of one year – 1 (.870) = .870
PV of Re. 3 to be received at the end of one year – 2 (.756) = 1.512
PV of Re. 4 to be received at the end of one year – 3 (.658) = 1.974
________
Present value of series 4.356
3.7 INTERNAL RATE OF RETURN METHOD

Internal Rate of Return Method. This method is popularly known
as 'time adjusted rate of return method', 'discounted cash flow rate of
return method', 'yield rate method', 'investor's method', or 'Marginal
efficiency of capital' method. In present value method the required
earning rate is selected in advance. But under internal rate of return
method, rate of interest or discount is calculated. Internal rate of
return is the rate of interest or discount at which the present value of
expected cash flows is equal to t total investment outlay.
According to the National Association of Accountants, America

“Time adjusted rate of Return is the maximum rate of interest that
could be paid for the capital employed over the life of an investment
without loss on the project. “ This rate is usually found by trial and
error method. First we select an arbitrary rate of interest and find the
present value of cash flows during the life of investment at that
selected rate. Then we compare present value with the cost of
investment. If the present value if higher or lower than the cost of
investment, we try another rate and repeat the process. If present
value is higher than the cost, we shall try a higher rate of interest or
vice-versa. This procedure continues till the present values and the
cost of investment (total outlay in project) are equal or nearly equal.
The rate at which present value and cot of investment are equal. That
is called internal rate of return.
(PROBLEMS AND SOLUTIONS ARE EXPLAINED IN THE

NEXT MODULE)
3.8 REFERENCES
(i) Khan& Jain: Financial Management, PHI Publishers, New
Delhi
(ii) PL.Mehta: Managerial Economics, S.Chand Publishers, New
Delhi
(iii) IM.Pandey: Financial Management, S.Chand Publishers,
New Delhi
3.9 ACTIVITY (CAPITAL BUDGETING TECHNIQUES –
SIMPLE PROBLEMS)
(Solutions are given in the next module along with explanation)
1. Computer Co Pvt. Ltd is considering purchasing a machine. Two

machine costing Rs 50000/- and earnings after taxes are expected
to be as under. There is no scrap value. A discounted rate of 10%
is to be used.
Year 1 2 3 4 5
Earnings 2,00,000 2,50,000 1,50,000 1,00,000 75,000
‘A’
Earnings 1,00,000 2,00,000 2,00,000 1,00,000 75,000
‘B’
2. Following is a summary of financial data in respect of five

investment proposals.
Net
Initial annual life of
Outlay cash project
inflows
A 60,000 18,000 15
B 88,000 15,000 25
C 2150 1,000 5
D 20,500 3000 10
E 4,25,000 1,50,000 20
Rank these proposals according to (i) Payback period (ii) simple

average rate of return. The cost of capital being 6%.
3. A management wants to judge whether project ‘X’ is worth taking

up or not. The data regard to this project (having) 10 years is given
below
Year 1 2 3 4 5 6 7 8 9 10
Net 700 980 10,80 11,10 940 760 570 400 200 200
benef 0 0 0 0 0 0 0 0 0 0
it
If the initial outlay on the project is Rs 40,000 with a salvage value of

Rs 10,000. Find out the NPV of the project, given the opportunity cost
of investment is 10%.
4. From the following cash flows calculate the NPV using at 10%
discount rate/interest rate. The initial capital outlay is Rs 50000. Is
this project worth take-up?
Year CFAT PV factor

(@10%)
1 10,000 0.909
2 10,450 0.826
3 11,800 0.751
4 12,250 0.683
5 16,750 0.621
5. Determine NPV / pay back from the following data of two

machines A & B
A B
1. Cost of machine Rs 26,125 Rs 26,125
2. Annual Income after the depreciation
& income tax
Year 1 Rs 3375 Rs
11,375
Year 2 Rs 5375 Rs 9375
Year 3 Rs 7375 Rs 7375
Year 4 Rs 9375 Rs 5375
Year 5 Rs 11375 Rs 3375
Estimated life (year) 05 05
6. Consider an initial investment of Rs20,000 on project which yields
an annual cash inflows of Rs 10,000, Rs 8000, and Rs 6,000
respectively during its three years life span what is the interval rate
of relation of project.
Problem for Practice by students
7. A company is considering an investment proposal to install a new

milling control at a cost of Rs 50,000. The facility has a life
expectancy of 5 years and no salvage value. The tax rate is 35%.
Assume the firm uses straight line depreciation and is allowed for
tax purpose. The estimated cash flows before depreciation and tax
(CFBT) from the investment proposal are as follows.
Year CFBT
1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
Compute NPV at 10% percent discount value.

Present Value Table (Annuity)
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%

1 0.99 0.98 0.97 0.96 0.95 0.94 0.93 0.92 0.91 0.90 0.90 0.89 0.88 0.87 0.87 0.86 0.85 0.84
0 0 1 2 2 3 5 6 7 9 1 3 5 7 0 2 5 7
2 0.98 0.96 0.94 0.92 0.90 0.89 0.87 0.85 0.84 0.82 0.81 0.79 0.78 0.76 0.75 0.74 0.73 0.71
0 1 3 5 7 0 3 7 2 6 2 7 3 9 6 3 1 8
3 0.97 0.94 0.91 0.88 0.86 0.84 0.81 0.79 0.77 0.75 0.73 0.71 0.69 0.67 0.65 0.64 0.62 0.60
1 2 5 9 4 0 6 4 2 1 1 2 3 5 8 1 4 9
4 0.96 0.92 0.88 0.85 0.82 0.79 0.76 0.73 0.70 0.68 0.65 0.63 0.61 0.59 0.57 0.55 0.53 0.51
1 4 8 5 3 2 3 5 8 3 9 6 3 2 2 2 4 6
5 0.95 0.90 0.86 0.82 0.78 0.74 0.71 0.68 0.65 0.62 0.59 0.56 0.54 0.51 0.49 0.47 0.45 0.43
1 6 3 2 4 7 3 1 0 1 3 7 3 9 7 6 6 7
6 0.94 0.88 0.83 0.79 0.74 0.70 0.66 0.63 0.59 0.56 0.53 0.50 0.48 0.45 0.43 0.41 0.39 0.37
2 8 7 0 6 5 6 0 6 4 5 7 0 6 2 0 0 0
7 0.93 0.87 0.81 0.76 0.71 0.66 0.62 0.58 0.54 0.51 0.48 0.45 0.42 0.40 0.37 0.35 0.33 0.31
3 1 3 0 1 5 3 3 7 3 2 2 5 0 6 4 3 4
8 0.92 0.85 0.78 0.73 0.67 0.62 0.58 0.54 0.50 0.46 0.43 0.40 0.37 0.35 0.32 0.30 0.28 0.26
3 3 9 1 7 7 2 0 2 7 4 4 6 1 7 5 5 6
9 0.91 0.83 0.76 0.70 0.64 0.59 0.54 0.50 0.46 0.42 0.39 0.36 0.33 0.30 0.28 0.26 0.24 0.22
4 7 6 3 5 2 4 0 0 4 1 1 3 8 4 3 3 5
1 0.90 0.82 0.74 0.67 0.61 0.55 0.50 0.46 0.42 0.38 0.35 0.32 0.29 0.27 0.24 0.22 0.20 0.19
0 5 0 4 6 4 8 8 3 2 6 2 2 5 0 7 7 8 1
1 0.89 0.80 0.72 0.65 0.58 0.52 0.47 0.42 0.38 0.35 0.31 0.28 0.26 0.23 0.21 0.19 0.17 0.16
1 6 4 2 0 5 7 5 9 8 0 7 7 1 7 5 5 8 2
1 0.88 0.78 0.70 0.62 0.55 0.49 0.44 0.39 0.35 0.31 0.28 0.25 0.23 0.20 0.18 0.16 0.15 0.13
2 7 8 1 5 7 7 4 7 6 9 6 7 1 8 7 8 2 7
1 0.87 0.77 0.68 0.60 0.53 0.46 0.41 0.36 0.32 0.29 0.25 0.22 0.20 0.18 0.16 0.14 0.13 0.11
3 9 3 1 1 0 9 5 8 6 0 8 9 4 2 3 5 0 6
1 0.87 0.75 0.66 0.57 0.50 0.44 0.38 0.34 0.29 0.26 0.23 0.20 0.18 0.16 0.14 0.12 0.11 0.09
4 0 8 1 7 5 2 8 0 9 3 2 5 1 0 1 5 1 9
1 0.86 0.74 0.64 0.55 0.48 0.41 0.36 0.31 0.27 0.23 0.20 0.18 0.16 0.14 0.12 0.10 0.09 0.08
5 1 3 2 5 1 7 2 5 5 9 9 3 0 0 3 8 5 4
UNIT – V, MODULE - IV
CAPITAL BUDGETING TECHNIQUES (Solutions)
1. Computer Co Pvt. Ltd is considering purchasing a machine. Two

machine costing Rs 50000/- and earnings after taxes are expected to
be as under. There is no scrap value. A discounted rate of 10% is to
be used.
Year 1 2 3 4 5
Earnings 2,00,000 2,50,000 1,50,000 1,00,000 75,000
‘A’
Earnings 1,00,000 2,00,000 2,00,000 1,00,000 75,000
‘B’
Solution:
Project Year CFAT

Cumulative CFAT
A 1 2, 00,000
2, 00,000 2 years
2 2, 50,000
4, 50,000
3 1, 50,000
6, 00,000 (50,000/1, 50,000)
4 1, 00,000
7, 00,000
5 75,000
7, 75,000
Payback period = Investment/yearly net cash inflator
Payback period for Project ‘A’ = 2 + (1/3) years
Project Year CFAT Cumulative CFAT

B 1 1,00,000 1,00,000
2 2,00,000 3,00,000 3 years
3 2,00,000 5,00,000
4 1,00,000 6,00,000
5 75,000 675,000
Payback period for Project B = 3 years
2. Following is a summary of financial data in respect of five

investment proposals.
Net
Initial annual life of
Outlay cash project
inflows
A 60,000 18,000 15
B 88,000 15,000 25
C 2150 1,000 5
D 20,500 3000 10
E 4,25,000 1,50,000 20
Rank these proposals according to (i) Payback period (ii) simple average
rate of return. The cost of capital being 6%.
Solution:
The payback period (P) = investment / annual net cash inflows
Calculation of payback period of different projects

Project payback period rank
A 60,000 / 18,000=3.30 3
years
B 88,000 / 15,000=5.87 4
years
C 2150/1000=2.15years 1
D 20,500/3000=6.83 years 5
E 4,25,000/1,50,000=2.83 2
years
Simple average rate of return can be calculated by dividing the average

return per year of the project by its initial investment.
Project ARR Rankings
A (18,000 / 60,000) =0.30 3
B (15,000/ 88,000) = 0.17 4
C (1,000 / 2150) = 0.47 1
D (3,000 / 20,000) = 0.146 5

E (150,000 / 4,25,000)=0.35 2
3. A management wants to judge whether project ‘X’ is worth taking up

or not. The data regard to this project (having) 10 years is given
below
Year 1 2 3 4 5 6 7 8 9 10
Net 700 980 10,80 11,10 940 760 570 400 200 200
benefi 0 0 0 0 0 0 0 0 0 0
t
If the initial outlay on the project is Rs 40,000 with a salvage value of Rs

10,000. Find out the NPV of the project, given the opportunity cost of
investment is 10%.
Solution:
Initial capital investment - Rs 40,000
Salvage value - Rs 10,000
Present value of investment - 40,000 - 10,000 (0.3855)
40,000 – 3855 = 36,145
Computation of PV of project X
Year Net Benefit Discount Present
factor Value
1 7000 0.9091 6364
2 9800 0.8264 8182
3 10800 0.7513 8114
4 11,100 0.6830 7582
5 9400 0.6209 5836
6 7600 0.5645 4290
7 5700 0.5132 2926
8 4000 0.4665 1866
9 2000 0.4241 848
10 2000 0.3855 772
Gross value
46,780
Thus the NPV = Gross present value - Present value of investment
= 46780 - 36,145 = Rs 10,635
Hence the project under consideration

4. From the following cash flows calculate the NPV using 10%
discount rate/interest rate. The initial capital outlay is Rs 50000. Is
this project worth take-up?
Year CFAT PV factor (10%)

1 10,000 0.909
2 10,450 0.826
3 11,800 0.751
4 12,250 0.683
5 16,750 0.621
Solution
Calculation of Net Present Value of the project
Year CFAT PV factor Σ PV

(10%)
1 10,000 0.909 9090
2 10,450 0.826 8632
3 11,800 0.751 8862
4 12,250 0.683 8367
5 16,750 0.621 10,401
Total present value 45,352
(Less) initial Out lay 50,000
It is not worth take-up as the Net PV are -4648
negative
5. Determine NPV / pay back from the following data of two machines
A&B
A B
1. Cost of machine Rs 26,125 Rs 26,125

2. Annual Income after the depreciation
& income tax
Year 1 Rs 3375 Rs 11,375
Year 2 Rs 5375 Rs 9375
Year 3 Rs 7375 Rs 7375
Year 4 Rs 9375 Rs 5375
Year 5 Rs 11375 Rs 3375
3. Estimated life(year) 05 05
Solution:
Calculation of present value of CFAT

Machine A Machine B
Yea CFA PV(10 PV CFA PV(10% PV
r T %) T )
1 3375 0.909 3067.87 11,37 0.909 10339.87
5
2 5375 0.826 4439.75 9375 0.826 7743.75
3 7375 0.751 5538.62 7375 0.751 5538.62
4 9375 0.683 6403.12 5375 0.683 3671.12
5 1137 0.621 7063.87 3375 0.621 2095.87
5
2651 29386
0
Cost of machine 2612 26125
5
Net Present values of the 0385 03261
machines
Hence machine B can be consider for investment as the Machine B

(Rs. 3261/-) has more discounted cash compare to machine A (385/-).
6. Consider an initial investment of Rs20, 000 on project which yields

an annual cash inflows of Rs 10,000, Rs 8000, and Rs 6,000
respectively during its three years life span what is the interval rate of
relation of project.
Solution:
IRR can be computed as follows
Trait NPV of investment Remark

discoun s
t rate
10 [(10000X0.9091) + (8000X0.8264)+ IRR is
percent (6000X0.7513)] – 20,000 = 20,210 – 20,000 = 210 greater
than
10%
12 [(10,000X 0.8929) +(8000X0.7972) + IRR is
Percent (6000X0.7118)] – 20,000 = 195774 – 20,000 = - between
422.6 10% and
12%
11 [(10,000X0.9009)+(8000X0.8116)+(6000X0.73120 IRR is
Percent ] – 20,000 = -11 between
10% and
11%
We can then go to find the value of NPV for different values of discount
rates between 10% and 12% (e.g 10.5%, 10.25%, 10.75% and so on)
until we get the NPV value of investment equals to Zero.
If the minimum acceptable Rate of Return is greater than discount rate,

we reject the project.
Problem for Practice by students
7. A company is considering an investment proposal to install a new

milling control at a cost of Rs 50,000. The facility has a life
expectancy of 5 years and no salvage value. The tax rate is 35%.
Assume the firm uses straight line depreciation and is allowed for tax
purpose. The estimated cash flows before depreciation and tax
(CFBT) from the investment proposal are as follows.
Year CFBT
1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
Compute NPV at 10% percent discount value.
Solution:
Calculation of cash flows after taxes & depreciation
Year CFBT (50,000/5) (2 – 3) (0.35) (4 – 5) CFAT

Depreciation PBT Taxes EAT
1 2 3 4
1 10,000 10,000 Nil Nil Nil 10,000
2 10,692 10,000 692 242 450 10,450

3 12,769 10,000 2769 969 1800 11,800
4 13,462 10,000 3462 1212 2250 12,250

5 20,385 10,000 10385 3635 6750 16,750
11,250
61,250

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UNIT- I

Introduction( Nature and scope of managerial economics)

1.02: DEFINITIONS OF ECONOMICS

1.03: MICRO AND MACRO ECONOMICS

1.01: INTRODUCTION (ORIGIN OF ECONOMICS)

In that book in addition to discussing at length the state craft, he discussed

In the later part of 19th century Alfred Marshall of Cambridge School

Marshall stated that “economics is a study of mankind in the ordinary

According to Marshall, economics is on the one side a study of wealth and

“Welfare is for man and not man is for wealth”.

Lionel Robbins disagreed with Marshall’s description of economics as the

He defined economics as “the positive science which studies human

Economics is the study of social behaviour guiding in the allocation of

McNair and Meriam defined managerial economics as “the application of

economic modes of thought to analyse business situations”.

1.03: MICRO AND MACRO ECONOMICS

1.03.1: MICRO ECONOMICS:

This part of economics studies the behavior of individual units such as

Purchase pattern of a consumer at different prices

Supply pattern of a producer at different prices

Profit maximization by a producer

Utility maximization by a consumer

1.03.2: MACRO ECONOMICS

Micro Economics Macro economics

2 It studies individual units like It is branch of economics which deals with

3 It study a problem of It study a problem of all.

2.02: MEANING AND NATURE OF MANAGERIAL ECONOMICS

2.03: ECONOMICS vs MANAGERIAL ECONOMICS

2.04: MEANING OF ECONOMIC THEORY

Managerial economics is based on identifying problems, organizing

Managerial economics is basically related to the decision making by a

firm. For example the decisions pertaining to:

3. How much to produce?

4. What is the break-even level of output?

5. Where to locate the firm?

6. Where to get raw material?

7. Where to procure finances?

8. How many skilled and semi skilled personnel to be employed?

9. What should be the volume of promotional expenditures?

10. What is the kind of marketing strategy to be adopted?

11. What is the price at which commodity is to be placed in the market?

12. How to place the commodity in the market?

13. Is there any need for product differentiation?

14. Whether to expand the firm or not?

15. How to face competition in domestic and world markets?

2.03: ECONOMICS vs MANAGERIAL ECONOMICS

The decisions of business firms are some way or other related to

The study of managerial economics helps the management executives to

EX: A finance manager selects the sources and uses of funds.

* A production manager chooses the optimum product mix, aiming at

* Marketing manager strives to maximize sales revenue through proper

*A personnel manager chooses the right staffing pattern.

2.04: MEANING OF ECONOMIC THEORY:

Economic theory deals with a number of concepts and principles like

1 Managerial economics is basically micro in character. It

2. To provide solutions to business problems it uses concepts

3. Managerial economics is pragmatic in its approach and

4. Managerial economics is normative in character and not

It is also concerned with the discussion of what should be or

5. Managerial economics, though basically micro in character, also

R 1, R 2 , R 3 and R n are prospective revenue in 1, 2, 3, n years. Where as ‘r’

1. Absolute profit or abnormal profit: Volume of profits realized by a firm by

3. Accounting and economic profit: While estimating profit, accountants subtract

Total revenue received by the firm Rs 20000.