Managerial Economics

Module-1: Theory of Demand and Supply
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Learning Objective:
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In this module, you will be able to
●● Explain that the interaction of supply and demand determining price and quantity
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●● Define market equilibrium
●● Compare a market in equilibrium with a market in disequilibrium
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●● Describe what happens to price when there is a surplus or shortage in the market
●● Demonstrate how changes in the determinants of supply and demand affect the
equilibrium price and quantity of a good or service
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●● Explain that a market reacts to changes in supply and demand by moving to a new
equilibrium
●● Use graphs to illustrate shifts in supply and demand and changes in equilibrium
price and quantity
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Learning Outcome: er
In this module, we have discussed about
●● Relation between demand and supply as represented by functions to demand and

supply as represented by diagrams
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●● Demand and supply analysis to work out the effects of restrictions on market
prices
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●● Demand and supply analysis to work out changes in equilibrium price and quantity
in a market
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●● Various elasticities of demand to forecast changes in revenues, prices, and/or

units sold
●● Relationship between elasticity and marginal and total revenue
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●● How to use elasticities to estimate linear demand and supply functions
“Economics as a study of mankind in the ordinary business of life.”

Alfred Marshall-
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1.1.1 Nature of Economics Analysis

Economics is the science dealing with the production, exchange and consumption
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of various commodities in economic systems. It shows how scarce resources can be

used to increase wealth as well as human welfare. The prime focus of economics is
on the scarcity of resources and choices among their alternative uses. The resources
or inputs available to produce goods are limited or scarce, and this scarcity induces
people to make choices among the alternatives. The economic knowledge of
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economics is used to compare the alternatives for choosing the best among them. For
example, a farmer can grow sugarcane, banana, paddy or cotton etc. in his farm, but he
needs to choose a crop depending upon the availability of irrigation water.
Amity Directorate of Distance & Online Education
2 Managerial Economics
Two major factors are responsible for the emergence of economic problems. They
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are:
●● The existence of unlimited human wants and
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●● The scarcity of available resources.
The numerous human wants are to be satisfied through the scarce resources
available in nature. Economics deals with how the numerous human wants are to be
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satisfied with limited resources. Thus, the science of economics centers on want - effort
- satisfaction. Economics not only cover the decision making behavior of individuals but
also the macro variables of economies like national income, public finance, international
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trade and so on.
●● Adam smith (1723 - 1790), in his book An Inquiry into Nature and Causes of
Wealth of Nations. (1776) defined economics as the science of wealth. He
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explained how a nation wealth is created. He considered that the individual in the
society wants to promote only his own gain and in this, he is led by an invisible
hand to promote the interests of the society though he has no real intention to
promote the society’s interests.
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Criticism: Smith defined economics only in terms of wealth and not in terms of
human welfare. Ruskin and Carlyle condemned economics as a .dismal science,
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as it taught selfishness which was against ethics. However, now, wealth is
considered only to be a mean to end, the end being the human welfare. Hence,
wealth definition was rejected and the emphasis was shifted from wealth to
welfare.
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●● Alfred Marshall (1842 - 1924) wrote a book, Principles of Economics. (1890) in
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which he defined economics as a study of mankind in the ordinary business of

life. It examines that part of individual and social action which is most closely
connected with the attainment and with the use of the material requisites of well-
being. The important features of Marshall’s definition are as follows:
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a) According to Marshall, economics is a study of mankind in the ordinary business

of life, i.e., economic aspect of human life.
b) Economics studies both individual and social actions aimed at promoting
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economic welfare of people.

c) Marshall makes a distinction between two types of things, the material things
and immaterial things. Material things are those that can be seen, felt and
touched, ex: book, rice etc. Immaterial things are those that cannot be seen,
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felt and touched, ex: skill in the operation of a thrasher, a tractor etc., cultivation
of hybrid cotton variety and so on. In his definition, Marshall considered only the
material things that are capable of promoting welfare of people.
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Criticism:
a) Marshall considered only material things. But immaterial things, such as the
services of a doctor, a teacher and so on, also promote welfare of the people.
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b) Marshall makes a distinction between

(i) Those things that are capable of promoting welfare of people and

Managerial Economics 3
(ii) Those things which are not capable of promoting welfare of people. But
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anything, ex: liquor, that is not capable of promoting welfare but commands
a price, comes under the purview of economics.
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c) Marshall’s definition is based on the concept of welfare. But there is no clear-
cut definition of welfare. The meaning of welfare varies from person to person,
country to country and one period to another. However, generally, welfare
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means happiness or comfortable living conditions of an individual or group of
people. The welfare of an individual or nation is dependent not only on the stock
of wealth possessed but also on political, social and cultural activities of the
nation.
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1.1.2 Scope of Economics Analysis
Scope means province or field of study. In discussing the scope of economics, we
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have to indicate whether it is a science or an art and a positive science or a normative
science. It also covers the subject matter of economics.
i) Economics - A Science and an Art
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a) Economics is a science: Science is a systematized body of information that
tracks the cause-effect relation. A further characteristic of science is that its
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processes should be measurable. By applying these characteristics, we find
that economics is a branch of science that systematically gathers, classifies
and analyzes the various facts that are important to it. Economics investigates
how generalizations can be deduced with respect to human economic motives.
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Individual motivations and business enterprises can easily be measured in
money terms. Thus, economics is a science.
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b) Economics is also an art: An art is a system of rules designed to achieve a

given end. A science teaches us knowledge; an art shows us how to do it. Using
this description we find that economics provides us with practical guidance in
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solving economic problems. Science and art are mutually complementary and
economics is both a science and an art.
ii) Positive and Normative Economics

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Economics is both positive and normative science.
a) Positive science: It only describes what it is and normative science prescribes

what it ought to be. Positive science does not indicate what is good or what
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is bad to the society. It will simply provide results of economic analysis of a

problem.
b) Normative science: It makes distinction between good and bad. It prescribes
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what should be done to promote human welfare. A positive statement is based

on the facts. A normative statement involves ethical values. For example, 12%
of the labour force in India was unemployed last year. This rate of unemployment
is too high; it is normative statement comparing the fact of 12% unemployment
with a standard of what is unreasonable. It also suggests how it can be rectified.
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Therefore, economics is a positive as well as normative science.

iii) Methodology of Economics

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Economics as a science adopts two methods for the discovery of its laws and
principles, the (a) deductive method and (b) inductive method.
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a) Deductive method – In this method it is descended from the general to
particular, i.e., a start is made from certain principles that are self-evident or
based on strict observations. Then, it is carried down as a process of pure
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reasoning to the consequences that they implicitly contain. For instance,
traders earn profit in their businesses is a general statement which is accepted
even without verifying it with the traders. The deductive method is useful in
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analyzing the complex economic phenomenon where the cause and effect are
inextricably mixed up. However, the deductive method is useful only if certain
assumptions are valid.
b) Inductive method - This method mounts up from particular to general. I.e. it
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begins with the observation of particular facts and then proceeds with the help
of reasoning found on experience so as to formulate laws and particulars on
the basis of observed facts. E.g. Data on consumption of poor, middle and
high income groups of people are collected, classified, analyzed and important
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conclusions are drawn out from the results.
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1.1.3 Relevance of Managerial Economics in Decision Making
Business firms are a mixture of personnel, financial and physical resources that
aid in managerial decision making. It is possible to divide communities into two major
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categories − output and consumption. Companies are economic bodies that are on the
production side while customers are on the distribution side.
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Company efficiency is measured as part of an economic model. A firm’s business

model is called the company theory. Business decisions include other important
decisions such as whether a company should conduct a research and development
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plan, whether a company should launch a new product, and so on. Managerial
economics helps the decision-making process in the following ways:
1. Managerial economics presents various aspects of traditional economics, relevant

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for business decision-making in real life. It derives the ideas, principles and
techniques of analysis from economic theory, which have a impact on the decision-
making process. Those are adopted or changed to allow the manager to take better
decisions when appropriate. Therefore, the goal of constructing a suitable package
from conventional economics was achieved by managerial economy.
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2. Managerial economics also incorporates important ideas from other disciplines

such as psychology, sociology, etc.; if they are found relevant for decision-making.
In addition, managerial economics takes advantage of other academic disciplines
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which have a bearing on a manager’s business decisions in view of the various

explicit and implicit constraints within which resource allocation is to be optimised.
3. Managerial economics helps in formulating variety of business decisions in a
complicated environment like what commodities should be produced? What inputs
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and production techniques should be used? How much output should be produced
and at what prices it should be sold? What are the best sizes and locations of new
plants? Etc.
4. Managerial economics transforms a boss into a more professional model maker.

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Therefore, he can capture the important relationship that characterizes a situation
while leaving out the peripheral relationships and cluttering details.
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5. At the firm level, where for various functional areas, exist, such as finance, marketing,
HR, production, etc. Managerial economics serves as an integrating agent by
coordinating the different areas and brings together the decisions of each department.
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This also makes corporate decision-making not in watertight compartments but in an
integrated context, the essence of which lies in the fact that functional divisions or
experts frequently enjoy tremendous flexibility and accomplish competing goals.
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6. Managerial economics takes a cognizance of the interaction between the firm and
society and accomplishes the key role of business as an agent in the attainment of
social and economic welfare. It has come to be recognized that business has other
social responsibilities besides its responsibilities to shareholders. Management
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economics focuses emphasis on such social commitments as constraints that
are subject to business decisions. It acts as an instrument for the development of
society’s economic wellbeing through socially motivated business decisions.
1.1.4 Demand Analysis
Meaning of Demand
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Demand is the amount of specific economic goods or services a consumer or
group of consumers will want to buy at a given price at a given time. Therefore, demand
means the desire supported by an adequate purchasing power to pay for the product
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when requested and the willingness to spend the money to satisfy that desire.
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Demand = Desire to buy + Ability to pay + Willingness to pay.
Definitions of Demand
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According to Melvin and Boyes, “Demand is a relationship between two variables,

price and quantity demanded, with all other factors that could affect demand being held
constant”.
According to Prof. Bober, “Demand means the various quantities of a given

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commodity or service which consumers would buy in one market in given period of time
at various prices or at various income or at various prices of related goods”.
According to Ferguson, “Demand refers to the quantities of commodity that the

consumers are able to buy at each possible price during a given period of time, other
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things being equal”.
According to B. R. Schiller defines, “Demand is the ability and willingness to buy

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specific quantity of a good at alternative prices in a given time period”.
1.1.5 Individual Demand vs. Market Demand

Individual demand is individual or business demand. This reflects the quantity of a
product that a single customer can purchase at a given point in time at a specific price
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point. Although the term is rather ambiguous, individual demand may be interpreted
from one person’s point of view, a single family or a single household.

Market demand offers the total quantity that customers are seeking. In other words,
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it represents the sum of any single demand. Market demand is an significant economic
marker as it represents a marketplace ‘s competition, a consumer’s willingness
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to purchase those goods and a company’s ability to exploit itself in a competitive
environment.
There is a difference between the concepts of individual demand and market
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demand. Below are the differences:
In individual demand, all the individuals face the same prices, which means
they are price-accepting. Individual demand is dependent on the income of every
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consumer. All consumers face the same prices, but each person’s income is different.
The individual demand for a good is the alternative and maximum quantities that each
individual wants to acquire at different prices and times.
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Instead, the market demand or the aggregate demand for a good is the sum of the
demands of all the consumers. Total market revenue equals the average unit price of
the product multiplied by the average quantity of the product purchased by each buyer
multiplied by the number of buyers.
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Market demand can be defined as the number of goods and services required
by a group of people in a given market, which is influenced by interests, needs, and
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trends. Thus, this demand will depend a lot on the region where it manifests itself since
firms and industries will determine what type of marketing strategies are best suited to
consumers in a region.
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Market demand is one of the main factors used by companies to set the prices of
their products. Price and demand are closely related: the lower the price, the greater
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the demand and vice versa.
1.1.6 Demand by Market Segmentation

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Demand Segmentation process is the method of separating a large collection

of data into different small sets of data that have more or less similar or related
characteristics based on multiple dimensions or dimensional combinations.
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Market segmentation is the process of dividing the overall market into relatively
distinct homogeneous sub-groups of customers with specific needs or features that lead
them to respond to a particular marketing campaign in similar ways. A market segment
is a part of a larger market where individuals, groups, or organisations share one or
more characteristics that cause them to have relatively similar product needs.
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Segmentation is often necessary in both consumer and industrial markets. In each

case, the marketer must decide on one or more useful segmentation variables, that
is, dimensions that divide the total market into fairly homogenous groups, each with
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different needs and preferences. The different ways in which the customers can be
approached by organizations include:
a. Mass Marketing - In mass marketing seller engages in mass production, mass

distribution, and mass promotion of one product for all buyers. For Example, Pepsi
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sold only one kind of flavor in a 6.5 ounce bottle in the olden time. It leads to lowest
costs that result in lower prices or higher margins.

b. Segment Marketing - A market segment consists of a large identifiable group within

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a market with similar wants, purchasing power, geographical location, or buying
behavior. For Example, Pepsi’s market could be divided into segments consisting of
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diet Pepsi drinkers and regular Pepsi drinkers. It enables the product or service and
also its price to be more adapted for the target audience. It facilitates the choice of
distribution and even communications channels.
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c. Niche Marketing - A niche is a more narrowly defined smaller group whose needs
are not currently being well served. This involves segmenting a segment into two or
more sub segments, each of which has its own specialization of product or service
being offered. It has fewer competitors. It enables the adoption of premium pricing
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clue to its specialization in product or the service offered.
d. Micromarketing - Micro marketing is the practice of tailoring products and marketing
programs to suit the tastes of specific individuals and locations. Micromarketing
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includes local marketing and individual marketing.
●● Local Marketing - Involves tailoring brands and promotions to the needs and
wants of local customer groups—cities, neighborhoods, and even specific
stores. Example, ICICI bank provides different mixes of banking services in its
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branches depending on neighborhood demographics.
●● Individual Marketing - Tailoring the products and marketing programs to
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the needs and preferences of individual customers also labeled “one to one
marketing”, “markets of one marketing” and “customized marketing”. Example,
the tailor custom made the clothes or the cabinet maker made furniture to
order. Mass customization is “the process through which firms interact one-to-
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one with masses of customers to create customer-unique value by designing
products and services tailor made to individual needs. Examples, Dell
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computers delivers computers to individual customers loaded with customer

specified hardware and software
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1.1.7 Determinants of Demand

The several determinants of demand for different goods and services are as follows
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a. Determinants of Individual Demand

●● Price: Price is a basic factor and a consumer generally decides to buy a
commodity with consideration of price. More quantity is demanded at low
prices and less is purchased at high prices. Hence, demand is a function of
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price and the relationship is expressed as D = f (P). In this equation, demand

is the dependent variable and price is an independent variable.
●● Income: A buyer’s income determines their purchasing capacity. Income is an
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important determinant of demand, as with the increase in income a person

can buy more goods. Consumers having a greater income usually demand
more goods than poor customers. The demand for luxurious and expensive
goods is also related to income.
●● Tastes, habits and preferences: Demand for various goods depends on the
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person’s tastes, habits and preferences. Demand for several products like
chocolates, ice- cream, beverages etc. depend on individual’s tastes. Demand
for tea, cigarettes, tobacco, etc. is a matter of habits. The preferences of
consumers also changes from time to time. For example consumers prefer
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diesel car rather than petrol car because of price factor of fuel.
●● Complementary and Substitutes: Complementary goods are the ones that
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are required to satisfy the other demand and are consumed together. For
example, Bike and Petrol. If the demand for bikes increases, the demand for
petrol will also increase. On the other hand substitutes are the goods, which
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can be used as an alternative to some other goods. For example: Tea and
Coffee. If the price of coffee rises, the demand for tea increases.
●● People with different tastes and habits have distinct preferences for
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goods: A strict vegetarian will have no demand for meat at any price, whereas
a non-vegetarian who has liking for chicken may demand it even at a high
price. Similar is the case with demand for cigarettes by nonsmokers and
smokers.
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●● Consumer’s expectation: A consumer’s expectation about the future
changes in the prices of a given commodity may also affect its demand. When
consumers expect its prices to fall in future, they will buy less at present.
Similarly, if they expect the price to rise in future, they will buy more at present.
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●● Advertisement effect: In modern times, the preferences of a consumer can
be altered by advertisement and sales propaganda, to only a certain extent.
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In fact, demand for many products such as toothpaste, soap, washing powder,
processed foods, etc., is partially caused by the advertisement effect in a
modern man’s life.
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b. Determinants of Market Demand
●● Scale of preferences: The market demand for a product is majorly influenced
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by the scale of preferences of the buyers. For example, when a large section
of population shifts its preferences from vegetarian foods to non- vegetarian
foods, then the demand for the former will tend to decrease and for the latter
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will increase.
●● Community income and wealth distribution: If there is an equal distribution
of income and wealth, then the market demand for various products of
common consumption tends to be greater than in the case of unequal
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distribution.
●● Product price: At a low market price, the market demand for the product
tends to be high and vice versa. It is dependent on the general standards
of living and spending habits of the people. When people in general adopt a
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high standard of living and are ready to spend more, the demand for many
comforts and luxury items will tend to be higher than otherwise.
●● Number of buyers in the market and the growth of population: The size of
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market demand for a product depends on the number of buyers in the market.
A large number of buyers will usually constitute a large demand. In general,
the growth of population over a period of time tends to imply a rising demand
for essential goods and services.
●● Age structure and sex ratio of the population: Age structure of population
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determines the market demand for products in a relative sense. If the

population of a country comprises more of children, then the demand for toys,

school bags etc., i.e. goods and services required by children will be much
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higher.
●● Level of taxation and tax structure: A progressively high tax rate will
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generally mean a low demand for goods in general and vice versa. But, a
highly taxed commodity will have a lower demand.
●● Inventions and innovations: Introduction of new goods or substitutes as a
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result of inventions and innovations in a dynamic modern economy adversely
affect the demand for the existing products, which as a result of innovations
become obsolete.
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●● Fashions: The change in fashion also affects the market demand for many
products. For example, demand for commodities like jeans, skirts etc., and is
based on current fashions.
●● Climatic conditions: Demand for certain products is determined by the
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weather conditions. For example, in summers, there is a greater demand for
fans, coolers, cold drinks etc. Similarly, demand for umbrellas and rain coats
are seasonal.
●● Culture: Demand for certain goods is determined by social customs, festivals,
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etc. For example, during Diwali festival, there is a higher demand for sweets
and crackers, and during Christmas, cakes and trees are more in demand.
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1.1.8 Elasticity of Demand
In neoclassical economic theory elasticity is an important concept. It is useful in
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understanding the incidence of indirect taxation, marginal concepts as they relate to
the firm theory and wealth distribution and various types of goods. In any discussion of
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welfare distribution, elasticity is also crucial, in particular consumer surplus, producer

surplus or government
Meaning of Elasticity of Demand

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According to Marshall, “The elasticity or responsiveness of demand in a market is

great or small accordingly as the demand changes (rises or falls) much or little for a
given change (rise or fall) in price.”
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Elasticity of demand is the responsiveness of demand for a commodity to changes

in its determinants.
Elasticity of Demand = Percentage change in quantity demanded of commodity /

Percentage change in its price
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Degrees of Price Elasticity of Demand

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The variation in demand is not uniform with a change in price. In case of some
products, a small change in price leads to a relatively larger change in quantity
demanded.
1. Perfectly Elastic Demand

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In this case, a very small change in price leads to infinite change in demand. The
demand curve is a horizontal curve and is parallel to OX axis, the numerical co-efficient
of perfectly elastic demand.
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2. Perfectly Inelastic Demand
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In this case, whatever may be the change in price quantity demanded will remain
perfectly constant. The demand curve is a vertical straight line and is parallel to OY
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axis. The numerical co-efficient of perfectly inelastic demand is O (zero). It may be
presented through a diagram as follows:
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3. Relatively Elastic Demand

In this case a slight change in price leads to more than proportionate change in
quantity demanded. This can be represented by a gradually sloping demand curve. The
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numerical co-efficient of relatively elastic demand is > 1. This can be diagrammatically

reprsented as follows:
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4. Relatively Inelastic Demand
In this case, a large change in price leads to less proportionate change in demand.
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This can be represented by a steeply sloping demand curve. The numerical co-efficient
of relatively inelastic demand is <1. er
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5. Unitary Elastic Demand

In this case, any change in price brings about equal proportionate change in the
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quantity demanded. The numerical co-efficient of unitary elastic demand is always 1

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1.1.9 Concept of Elasticity of Demand- Income, Cross, Price and
Advertizing Elasticity
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Income Elasticity of Demand
The income elasticity is defined as the ratio percentage or a proportional change
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in the quantity demanded to the percentage or proportional change in the income.
Income elasticity is closely related to the population income distribution and the fraction
of a product’s sales which is attributable to buyers having different income brackets.
Specifically, when a buyer in a certain income bracket experiences an increase in
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income their purchase of a product changes to match that of individuals in their new
income bracket.
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Y e D Percentage change in quantity demanded Percentage change in income

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Cross Elasticity of Demand

In arriving at the price elasticity of demand, the change in demand due to a change
in the price of the same commodity is taken into account. In cross elasticity of demand,
the change in the price of commodity Y and its effects on the demand for commodity X
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are considered. The concept of cross elasticity is important in the case of commodities
which are substitutes and complementary. Tea and coffee are substitutes for each other,
whereas pen and ink, car and petrol are complementary goods.
The cross elasticity demand refers to the degree of responsiveness of demand for
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a commodity to a given change in the price of some related commodity”.
X e D = Percentage change in quantity demanded of commodity A Percentage

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

A negative cross elasticity denotes two complement products while a positive cross
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elasticity denotes two replacement products. Such two main relationships run counter to
one’s instincts, but the reason behind them is very simple: assume that products A and
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B are complements, which means an increase in demand for A is due to an increase in
the quantity demanded for B. Therefore, if the price of product B decreases, then the
demand curve for product A will shift to the right, increasing A’s demand, resulting in a
negative value for the cross elasticity of demand. The exact opposite reasoning holds
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for substitutes.
Price Elasticity of Demand
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The extent of response of demand for a commodity to a given change in price,
other demand determinants remaining constant, is termed as the price elasticity of
demand.
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“The price elasticity of demand can be defined as the ratio of the relative change in
demand and price variables”.
It is generally defined as the responsiveness or the sensitiveness of demand to

a given change in the price of a commodity. PED is a measure of responsiveness of
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the quantity of a good or service demanded to changes in its price. The formula for the
coefficient of price elasticity of demand for a good is:
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P e D Percentage change in quantity demanded of commodity / Percentage
change in its price
The above formula usually yields a negative value, due to the inverse nature of
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the relationship between price and quantity demanded, as described by the “law of
demand”. For the sake of convenience negative sign is ignored.
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Advertising Elasticity
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Advertisment demand elasticity (AED) is a measure of the response of a consumer

to increase or decrease the penetration of adverts. The elasticity of ads is a indicator
of the success of a marketing campaign in producing new sales. This is calculated
by dividing the percentage change in the amount required by the percentage change
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in advertising spending. A positive elasticity of advertising means that an increase in

advertising contributes to an increase in demand for the advertised product or service.
(Q1 − Q0 ) ÷ (Q1 + Q0 )
ηA =
( A1 − A0 ) ÷ ( A1 + A0 )
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The symbol ηA represents the advertising elasticity of demand. In the formula,

the symbol Q0 represents the initial demand or quantity purchased that exists when
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spending on advertising equals A0. The symbol Q1 represents the new demand that
exists when advertising expenditures change to A1
1.1.10 Theorems on Price Elasticity

Elasticity of demand is the responsiveness of demand for a commodity to changes
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in its determinants.

Effects of the price elasticity of demand on revenue and tax

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●● If demand is inelastic then a price increase will lead to an increase in revenue
●● If demand is elastic then a price increase will lead to an decrease in revenue
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●● If demand is price inelastic, then a higher tax will lead to higher price for
consumers. The tax incidence will mainly be borne by consumers.
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●● If demand is price elastic, then a higher tax will not lead to a substantial price
increase for consumers. The tax incidence will mainly be borne by producers.

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If demand is relatively inelastic, the burden will be mainly on the consumer
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If demand is relatively elastic, the burden will be mainly on the producer
1.1.11 Use of demand elasticity in Business-Decision Making

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Elasticity of demand is the sensitivity of the quantity demanded of a commodity in

response to the change in factors related to that commodity. It may be of different types,
depending upon the factors responsible for causing a change in demand. Among them,
price elasticity of demand is the most common and is also most relevant to business.
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Price elasticity of demand can be a useful tool for businessmen to make crucial
decisions like deciding the price of goods and services. It plays vital role in other
business procedures too. These uses include -

●● Determination of price - The primary objective of any firm is to earn profits or

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increase revenue. Therefore, increasing the price of products to maximize profit is
the primary concerns of producers. However, during the course of increasing price,
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the producers must not forget that demand and price share inverse relationship.
They need to be aware that demand falls with a price rise and thus, they must
increase the price of their commodity to a level where their desired or optimal profit
is still achievable.
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●● Monopoly price determination - The situation where a single group or
organization controls almost all of market for a particular commodity is known as
monopoly. The monopolistic market lacks competition, thus the commodities are
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often charged high prices in such a market. A monopolist while fixing the price of
the market has to determine whether the nature of product is elastic or inelastic. If
the product is inelastic (less or no effect on demand with change in price), then the
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producer can earn profit by setting a high price. However, if the product is elastic
(highly affected by even slightest change in price), then the producer must set low
or at least a reasonable price so that the consumers are attracted to buy.
●● Price determination of joint products - Joint products are products which are
produced at a single time by a single production process. Examples of joint-products
s
are sheep and wool, cotton and cotton seeds, wheat and hay, etc. We cannot
separate the costs of wheat and hay production, since wheat production will also
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automatically produce the hay. Since they are two separate goods, however, they
cannot be sold at the same market price. The price elasticity of demand plays an
important role for the determination of the prices of these joint products.
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●● Wage determination - Labour is one of the major factors of production, and wage
is the fixed regular payment made to the labour in return of their input. Degree of
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elasticity of commodity has potential to affect the wage to be paid to the labour.
If a commodity is of inelastic nature, then the labour can force the employer to
increase their wages through extreme ways like a strike. As a result, the business
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will have to consider the demands of labour in order to meet the demand of
consumers for the inelastic goods. However, if the commodity is of elastic nature,
labor unions and other associations cannot force the employers to raise wage as
the producers can alter the demand of their products.
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●● International trade – In the case of an inelastic commodity, the change in price

cannot bring a drastic change in the demand of the product. However, even a
slight change in price can cause a huge effect on demand of elastic commodity.
Higher price can be charged for inelastic goods and the lowest possible price must
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be set for elastic goods. Therefore, a country may fix higher prices for goods of
inelastic nature. However, if the country wants to export its products, the nature of
the commodity in the importing country should also be considered.
)A
●● Importance to finance minister - Price elasticity of demand can also be used in

the taxation policy to gain high tax revenue from the citizens. This can be achieved
if the government raises the tax revenue in commodities which are price inelastic.
For example: Government can increase the tax amount in goods like cigarettes
and alcohol. Given how these are the commodities people choose to purchase
(c
regardless of the price tag, the tax revenue will significantly rise.

1.1.10 Theorems on the Price Elasticity of Demand

Notes
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Fundamental Theorem or Demand Theorem:
in
Given these assumptions, Samuelson states his “Fundamental Theorem of
Consumption Theory,” also known as demand theorem, thus:
“Any good (simple or composite) that is known always to increase in demand when
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money income alone rises must definitely shrink in demand when its price alone rises.”
It means that when income elasticity of demand is positive, price elasticity of demand is
negative. This can be shown both in the case of a rise and a fall in the price of a good.
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Rise in Price:
First, we take a rise in the price of, say, good X. To prove this Fundamental
Theorem, let us divide it into two stages. Firstly, take a consumer who spends his entire
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income on two goods X and Y. LM is his original price-income line where the consumer
is observed to have chosen the combination represented by R in Figure 2.
The triangle OLM is the consumer’s area of choice for the differ¬ent combinations
of X and Y available to him, as given by his price- income line LM.
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By choosing only the combination R, the consumer is revealed to have preferred

this combination to all others in or on the triangle OLM. Suppose the price of X raises
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the price of Y remaining constant so that the new price-income line is LS. Now he
chooses a new combination, say, point A which shows that the consumer will buy less
of X than before as the price of X has risen.
)A
In order to compensate the consumer for the loss in his real income as a result
of rise in the price of X, let us give him LP amount of money in terms of good К As
a result, PQ becomes his new price-income line which is parallel to the LS line and
passes through point R. Prof. Samuelson calls it Over Compensation Effect.
(c
Now the triangle OPQ becomes his area of choice. Since R was revealed preferred
to any other point on the original price-income line LM, all points lying below R on the
RQ segment of PQ line will be inconsistent with consumer behaviour.
This is because he cannot have more of X when its price has risen. The consumer
Notes
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will, therefore, reject all combinations below R and choose either combination R or any
other combination, say, В in the shaded area LRP on the segment PR of the price-
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income line PQ. If he chooses the combination R, he will buy the same quantities of
X and Y which he was buying before the rise in the price of X, On the other hand, if he
chooses the combination B, he will buy less of X and more of Y than before.
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In the second stage, if the packet of extra money LP given to the consumer is
taken back, he will be to the left of R at point A on the price-income line LS where he
will buy less of X, if the income elasticity of demand for X is positive. Since with the rise
in the price of X, its demand has fallen (when the consumer is at point A), it is proved
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when income elasticity is positive, price elasticity is negative.
Fall in Price:
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The demand theorem can also be proved when the price of good A–falls. It can
be defined thus: “Any good (simple or composite) that is known always to decrease
demand when money income alone falls must definitely expand in demand when its
price alone falls.” This is explained in Figure 3.
s
LM is the original price-income line on which the consumer reveals his preference
at point R. With the fall in the price of X, the price of У remaining constant, his new
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price-income line is LS. The consumer reveals his preference on this line at, say,
combination A which shows that he buys more of X than before.
The movement from point R to A is the price effect as a result of fall in the price of
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X which has led to increase in its demand.
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)A
Suppose the increase in the real income of the consumer as a result of fall in the
price of X is taken away from him in the form of LP quantity of Y. Now PQ becomes his
new price-income line which is parallel to LS and passes through R.
(c
The new triangle OPQ becomes his area of choice. Since the consumer was
revealing his preference at point R on the line LM, all points lying above R on the

segment RP of line PQ will be inconsistent with his choice. This is because on the RP
Notes
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segment he will have less of good X when its price has fallen. But this is not possible.
The consumer will, therefore, reject all combinations above R. He will either choose
in
combination R or any other combination, say, В on the segment RQ of the line PQ in
the shaded area MRQ. If he chooses the combination R, he will buy the same quantities
of X and Y which he was buying before the fall in the price of X.
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And if he chooses the combination B, he will buy more of X and less of Y than
before. The movement from R to В is the substitution effect of a fall in the price of X.
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If the money taken from the consumer in the form of LP is returned to him, he will be
at the old combination A on the price-income line LS where he will buy more of X with the
fall in its price. The movement from В to A is the income effect. So the demand theorem
is again proved that positive income elasticity means negative price elasticity of demand.
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In the case of indifference curve analysis, the consumer moves from one
combina¬tion to another on the same indifference curve and his real income remains
constant. But in the revealed preference theory, indifference curves are not assumed
and the substitution effect is a movement along the price-income line arising from
s
changing relative prices.
1.2.1 Supply vs Quantity Supplied

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Supply of a commodity is often confused with the ‘stock’ of that commodity
available with the producers. Stock of a commodity, equals the total quantity produced
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during a period less the quantity which is already sold out. But many a times producers
do not offer their entire stocks for sale on the market, some industrial products are
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kept back in godown and are offered for sale on the market when they can get better
prices. In other words, the amount offered for sale may be lower than the commodity
stocks. The term ‘supply’ shows a relationship between quantity and price. By supply it
is meant, the various quantities of a commodity which producers will offer for sale at a
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particular time at various corresponding prices.
●● Meanwhile, the term for a single point in the supply curve is “quantity
supplied” “Quantity supplied” is an example of the quantity or volume willing
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to be supplied for a specified market price. “Quantity supplied” is typically how

many in number depending on the price and quantity provided for a specific
time span or condition.
●● Both the “supply” and the “quantity supplied” into a graph. “Supply” with all
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possible prices and quantities and their intersections can be graphed as the
full supply curve. In the supply curve “Amount supplied” can be seen. This is
one particular point or intersection between a given price and quantity.
)A
●● The supply curve moves towards the right as the output rises. When this
occurs, then both the quantity sum and the potential market price will rise. A
lot of factors influence the production. If the supply disappears the shift is as
an indicator to the left.
Thus –
(c
●● The counterpart of “supply” is “demand” whereas the corresponding term for

“quantity supplied” is “quantity demand.”

●● A change or shift in the supply curve affects all the components while changes
Notes
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in the quantity supplied have a minimal effect.
●● A quantity supplied (with its corresponding price) is a component of a supply
in
curve. A number or collection of the quantity supplied can construct a supply
curve.
A change in the supply is characterized as a “shift,” while a change in the quantity
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supplied is marked by an upward line or movement from the previous quantity supplied
with its matching price to another quantity supplied and its corresponding price
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1.2.2 Supply Function
Supply function refers to the mathematical function that relates price and quantity
supplied for goods or services. The supply function tells how many units of a good that
producers are willing to produce and sell at a given price. It shows the quantities of
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goods and services a producer would provide at various prices.
In a supply function, the determinants of supply can be summarized as under: Sx

= f (Px, Pf, Py…, Pz, O, T, t, s) where, Sx = the supply of commodity X.
s
Px = the price of X.
Pf = the set prices of the factor inputs employed for producing X.

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O = factors outside the economic sphere.
T = technology used, t = tax and s = subsidy.

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1.2.3 Determinants of Supply
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1. Number of sellers – Greater the number of sellers, greater will be the quantity of a
product or service supplied in a market and vice versa. Therefore increase in number
of sellers will increase supply and move the supply curve rightwards while decrease
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in number of sellers will decrease the supply and move the supply curve leftwards.
2. Resource Prices – An increase in resource prices increases the production costs,
thereby shrinking the profits and vice versa. Since profit is a major incentive for
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producers to supply goods, an increase in profits increases the supply and a

decrease in profits reduces the supply. Thus, supply is indirectly proportional to
resource prices. Increase in resource prices reduces the supply and the supply
curve is shifted leftwards whereas decrease in resource prices increases the supply
and the supply curve is shifted towards right.
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3. Technology - Improvements in technology makes products and services generated

more efficiently. That reduces the cost of production and increases the profits. As
a result of this, supply is increased and supply curve moved to the right. Given
)A
that technology usually seldom deteriorates, it is therefore needless to claim that

technology deterioration reduces supply.
4. Tax and Subsidies - Taxes reduce profits, hence tax rise reduces supply while tax
declines increase supply. Subsidies reduce the cost of production to suppliers and
(c
thus increase profits. Increase in subsidies thus raises supply and decreases in
subsidies reduce supply.

5. Expectation of Suppliers - Changes in suppliers’ expectations about a product

Notes
e
or service’s future price could affect their current supply. Unlike other determinants
however, it is difficult to generalize the effect of supplier expectations on supply. For
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example, if farmers suspect a crop ‘s future price will rise, they will withhold their
agricultural produce to benefit from higher prices, thereby reducing the supply.
1.2.4 Supply Schedule and Supply Curve
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If demand is held constant, an increase in supply leads to a decreased price, while
a decrease in supply leads to an increased price. This relationship can be illustrated in
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the form of a table called supply schedule and the data from the table may be given a
diagrammatic representation in the form of a curve.
A Supply Schedule
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Price (P) Quantity (Q)
2 5
4 8
s
3 9
5 15
7
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20

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The Law of Supply

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Supply law reflects the general tendency of a seller to offer their stock of a
commodity for sale in relation to the varying prices. It describes the supply behaviour
of sellers under given conditions. It has been observed that sellers are generally able to
offer more with an increase in costs.
(c
“Other things remaining unchanged, the supply of a commodity expands with a rise
in its price, and contracts with a fall in its price”.

The law of supply can be approached from two different contexts. First being that it
Notes
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represents the sum total of production plus the carryover stocks. The other context for
supply describes the behaviour of producers. The market or total supply represents the
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quantities that the producers are willing to sell for any given time period over a range
of prices. You may be able to manufacture a given product at the individual level, as
long as the selling price is equal to or greater than the cost of producing that product.
Total supply is the sum of the individual product quantities which each farmer brings to
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the market. Market supply is represented by an upward sloping curve with price on the
vertical axis and quantity on the horizontal axis.
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An increase in price in most instances will result in farmers wanting to increase
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the quantity of a given product they will bring to the market; therefore the relationship
between the price and supply is positive. Market supply will be affected by other
variables in addition to the price. Factors that have been identified as important in
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determining supply behaviour include; the number of firms producing the product,
technology, the price of inputs, the price of other commodities which could be produced,
and the weather.
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With higher prices the producers of goods and services will receive greater
profits. Greater profits will result in the means to expand production increasing the
supply. This increased supply will ultimately satisfy the existing demand such that any
additional production must be met with new demand in order for the price increases to
be sustained. The firms which handle your grain or livestock products are not free to
m
set prices as they choose. They can raise prices only if consumers are willing and able
to pay more. Lower prices are the market’s signal to farmers that they have produced
too much of something or that it is something consumers do not want. To be a good
)A
marketer, you need to accept the “discipline of the marketplace”. A good marketer
learns to produce for the market.
a. Assumptions Underlying the Law of Supply

The law of supply is conditional, since we have stated it under the assumption:
(c
●● No change in Cost of production: It is assumed that the price of the product

changes, but there is no change in the cost of production. If the cost of
production increases along with the rise in the price of product, the sellers will
Notes
e
not find it worthwhile to produce more and supply more.
●● No change in method of Production: The technique of production is
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assumed to be unchanged. This is essential for the cost to remain unchanged.
With the improvement in technique, if cost of production is reduced, the seller
would supply more even at falling prices.
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●● Fixed scale of production: During a given period of time, it is assumed
that the scale of production is held constant. If there is a change in scale of
production, the level of supply will change, irrespective of the changes in the
price of the product.
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●● Government policies are unchanged: Government policies like taxation
policy, trade policy, etc., are assumed to be constant. For instance, an
increase in or totally fresh levy of excise duties would imply an increase in the
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cost or in case there is fixation of quotas for the raw materials or imported
components for a product, then such a situation will not permit the expansion
of supply with a rise in prices.
●● Unchanged transport costs: It is assumed that the transport facilities and
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transport costs are unchanged. Otherwise, a reduction in transport cost
implies lowering of cost of production, so that more would be supplied even at
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a lower price.
●● No speculation: The law also assumes that the sellers do not speculate
about the future changes in the price of the product. If, however, sellers
expect prices to rise further in future, they may not expand supply with the
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present price rise.
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●● The prices of substitutes are held constant: The law assumes that there
are no changes in the prices of other products. If the price of some other
product rises faster than that of the given product in consideration, producers
might transfer their resources to the other product which is more profit yielding
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due to rising prices. Under this situation, more of the product in consideration
may not be supplied, despite the rising prices.
b. Extension and Contraction in Supply

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The law of supply refers to the change in supply due to a change in price. If, with a
rise in price, the supply rises, it is called extension of supply. If, with a fall in price, the
supply declines, it is called contraction of supply. The change in the quantity of supply
in accordance with the price change is thus called either “extension” or “contraction” of
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supply and refers to the same supply curve.
c. Increase and Decrease in Supply

)A
These two terms are introduced to explain the changes in supply without any
change in price. Sometimes, there might be more supply forthcoming in the market
without a change in price, in which case it is called increase in supply. If there is less
supply forthcoming in the market without a change in price, then it is called decrease in
supply. The change in supply due to causes or determinants other than price is called
(c
“decrease” or “increase” in supply and can be shown on a different supply Curve.

1.2.5 Price Elasticity of Supply

Notes
e
Price elasticity of supply measures the relationship between change in quantity
supplied and a change in price. If supply is elastic, producers can increase output
in
without a rise in cost or a time delay. If supply is inelastic, firms find it hard to change
production in a given time period.
The formula for price elasticity of supply is:
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Percentage change in quantity supplied divided by the percentage change in price
When PES > 1, then supply is price elastic
O
When PES < 1, then supply is price inelastic
When PES = 0, supply is perfectly inelastic
When PES = infinity, supply is perfectly elastic following a change in demand
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1.2.6 Use of Supply Elasticities in Business-Decision Making.
The supply law demonstrates the course of change — if price goes up, supply must
go up. But how much supply will rise in response to price increases from the supply law
s
cannot be known. To calculate such change we need the principle of supply elasticity
that tests the magnitude of the supplied quantities in response to a price change.
It can be calculated as -
er
ES = % change in quantity supplied/% change in price
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Symbolically,
ES = ∆Q/Q ÷ ∆P/P = ∆Q/∆P × P/Q

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Since price and quantity supplied, in usual cases, move in the same direction, the
coefficient of ES is positive.
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Types of Elasticity of Supply:

For all the commodities, the value of Es cannot be uniform. For some commodities,
the value may be greater than or less than one.
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1. Elastic Supply (ES>1)

Supply is said to be elastic when a given percentage change in price leads to a
larger change in quantity supplied. Under this situation, the numerical value of Es will
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be greater than one but less than infinity. SS1 curve of Fig. exhibits elastic supply. Here
quantity supplied changes by a larger magnitude than does price.
)A
(c

Notes
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2. Inelastic Supply (ES< 1)
Supply is said to be inelastic when a given percentage change in price causes a
smaller change in quantity supplied. Here the numerical value of elasticity of supply is
s
greater than zero but less than one. Fig. depicts inelastic supply curve where quantity
supplied changes by a smaller percentage than does price.
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3. Unit Elasticity of Supply (ES = 1)

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If price and quantity supplied change by the same magnitude, then we have unit
elasticity of supply. Any straight line supply Curve passing through the origin, such as the
one shown in Fig., has an elasticity of supply equal to 1. This can be verified in this way.
)A
(c

Notes
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in
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4. Perfectly Elastic Supply (ES = ∞)
The numerical value of elasticity of supply, in exceptional cases, may reach up to
infinity. The supply curve PS1 drawn in Fig. has an elasticity of supply equal to infinity.
s
Here the supply curve has been drawn parallel to the horizontal axis. The economic
inter¬pretation of this supply curve is that an unlimited quantity will be offered for sale at
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the price OS. If price slightly drops down below OS, nothing will be supplied.
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5. Perfectly Inelastic Supply (ES = 0)

Another degree is the completely or perfectly inelastic supply or zero elasticity. The
)A
S1 curve drawn in Fig. illustrates the case of zero elasticity. This curve describes that
whatever the price of the commodity, it may even be zero, quantity supplied remains
unchanged at OQ. This sort of supply curve is conceived when we consider the supply
curve of land from the viewpoint of a country, or the world as a whole.
(c

Notes
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in
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1.2.7 Market Equilibrium
Price is determined in a free market by the interaction of supply and demand. We
can underline three dynamic laws of supply and demand.
s
1. When the quantity demanded is greater than the quantity supplied, prices tend to
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rise, whereas when the quantity supplied is greater than quantity demanded, prices
tend to fall.
2. In a market, larger the difference between quantity supplied and quantity demanded,
v
greater is the pressure on prices to rise (if there is excess demand) or fall (if there is
excess supply).
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3. When the quantity supplied equals the quantity demanded, prices have no tendency
to change.
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Shift in demand and supply curves and market equilibrium

Since both the supply and demand curves can shift in either of the two directions,
we have to consider four cases of changes in demand and supply. These cases are
so important and universal in nature that they are often called ‘laws of supply and
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demand’. These laws are derived for free markets that we are considering. Such
markets have the following features:
●● The demand curve is downward sloping,

●● The supply curve is upward sloping.
m
●● The buyers and sellers are price-takers.

●● The buyers and sellers are maximizes.
)A
●● The laws of demand and supply are applicable only when these conditions
hold. If anyone these conditions are not applicable the laws may not hold.
1. Shifts in demand
In the figure, the original demand curve is D and the supply curve is S. Here p0 is
(c
the original equilibrium price and q0 is the equilibrium quantity.

Notes
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in
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a. A Rise in Demand
s
Considering a change in the demand conditions such as the rise in the income
of buyers. If the income of the buyers raise then the market demand curve for apples
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will shift to right to D’. This implies that consumers will now be willing to buy a larger
quantity at every price. Thus at the original price P0 they will now be eager to buy
q2 units. So, the excess demand develops in the market. This excess demand q2-
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q0 creates market forces which cause the equilibrium price to rise. The process
will continue until a new equilibrium is reached as at point F where the new demand
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curve intersects the old supply curve. The net result is a rise in market price to p1. The
quantity sold also increase from q0 to q1 in this new equilibrium situation.
Thus, first it is considered, the rightward shift of the demand curve (i.e., a rise in the
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demand for a commodity) causes an increase in the equilibrium price and quantity (as
is shown by the arrows in Fig).
b. A Fall in Demand
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Demand may fall due to changes in the conditions of demand. If, for example, there
is a fall in the price of a substitute for the commodity under consideration, consumers
may want to buy smaller quantities at every price.
m
In the figure suppose D’ is the original demand curve and the original price and
quantity are p1 and q1, respectively. Suppose a fall in demand leads to a leftward shift
of the demand curve. The new demand curve is D. So an excess supply q1– q3 (=FG)
develops in the market. As a result of the operation of the market forces price falls.
)A
The new equilibrium price is p0. The new equilibrium quantity is q0. So we reach the
second conclusion a leftward shift of the demand curve (i.e., a fall in the demand for a
commodity) causes a decrease in the equilibrium price and quantity
2. Shifts in Supply
(c
In the figure the effect of a shift in the supply curve will be considered. Here S and
D are original supply and demand curves. The two curves meet at point E. So p0 and

q0 are the original equilibrium price and quantity. We may now examine the effect of a
Notes
e
change in the conditions of supply.
Such a change increases the quantities that producers are prepared to offer for
in
sale at each price. For example, there was a rightward shift of the supply curve due to
increase in the productivity of factors of production, caused by technological advance.
The Green Revolution which has occurred in India is an example of such a change.
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Techno-logical progress has the effect of reducing the cost of production. As a result a
larger quantity (qt instead of q0) is offered for sale at a lower price (p1 instead of p0).
This happened in the computer industry in the late 90’s.
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a. An increase in supply
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An increase in supply implies that a larger quantity is offered for sale at the
same price (q2, instead of q0 at p0) or the same quantity at a lower price (as point G
indicates). In other words, an excess of supply of q0 q2 (=EH) develops at the original
price p0. It sets in motion market forces which cause the price to fall.
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Since there is not much demand for their product, producers find it difficult to sell
the entire output at the original price. They start charging lower price. Consumers know
about it and start paying a lower price. Consequently price starts falling and it ultimately
reaches the value p1. At this new price the equilibrium quantity is q1. Thus we reach the
m
third conclusion a rightward shift of the supply curve (i.e., an increase in the supply of a
commodity) causes a fall in the equilibrium price and an increase in equilibrium quantity.
)A
b. A Decrease in Supply
Finally, we may examine the effect of a rise in the price of a factor, such as wages
in a unionized industry. As a result, total cost will rise and the sellers will be willing to
offer a smaller quantity for sale at each price. In this case, the original supply curve is
S’. Equilibrium price and quantity are p1 and q1. Now the supply curve shifts to left. The
(c
new supply curve is S.

At the original equilibrium price p1, the quantity offered for sale is zero but the
Notes
e
quantity demanded is still q1. So the entire quantity demanded is excess demand. This
excess demand sets in motion market forces which tend to raise price. The process
in
continues until and unless the new equilibrium price p0 is reached.
At this price the quantity supplied and demanded are equated at q0. Thus we reach
the fourth and final conclusion a leftward shift in the supply curve (i.e., a decrease in
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the supply of a commodity) leads to an increase in the equilibrium price and a fall in
equilibrium quantity.
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1.3.1 Needs of Demand Forecasting
Demand forecasting is based on the statistical data about past behavior and
empirical relationships of the demand determinants. Demand forecasting is not a
speculative exercise into the unknown. It is essentially a reasonable judgment of future
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probabilities of the market events based on scientific background. Demand forecasting
is an estimate of the future demand. It cannot be hundred per cent precise. But, it gives
a reliable approximation regarding the possible outcome, with a reasonable accuracy. It
is based on the mathematical laws of probability.
s
Meaning of Demand Forecasting er
Demand forecasting refers to the expectation about the future course of the market
demand for a product. It involves techniques including both informal methods, such as
educated guesses, and quantitative methods, the use of historical sales data or current
v
data from test markets.
“Demand forecasting means expectation about the future course of the market
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demand for a product”.
Levels of Demand Forecasting

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Demand forecasting may be undertaken at the following levels:
1. Micro level: It refers to the demand forecasting by the individual business firm
for estimating the demand for its product.
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2. Industry level: It refers to the demand estimate for the product of the industry
as a whole. It is undertaken by an Industrial or Trade Association. It relates to
the market demand as a whole.
3. Macro level: It refers to the aggregate demand for the industrial output by the
m
nation as a whole. It is based on the national income or aggregate expenditure

of the country. Country’s consumption function provides an estimate for the
demand forecasting at macro level.
)A
Importance of Demand Forecasting

Importance of demand forecasting can be summarized as follows:
i) Important for production planning: Demand forecasting is a prerequisite

(c
for the production planning of a business firm. Expansion of output of the firm
should be based on the estimates of likely demand, otherwise there may be
overproduction and consequent losses may have to be faced.

ii) Sales forecasting: Sales forecasting is based on the demand forecasting.

Notes
e
Promotional efforts of the firm should be based on sales forecasting.
iii) Control of business: Demand forecasting is important for controlling the
in
business on a sound footing, it is essential to have a well-conceived budgeting
of costs and profits that is based on the forecast of annual demand/sales and
prices.
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iv) Inventory control: A satisfactory control of business inventories, raw materials,
intermediate goods, semi-finished product, finished product, spare.
v) Growth and long-term investment programmes: Demand forecasting
O
is necessary for determining the growth rate of the firm and its long-term
investment programmes and planning.
vi) Stability: Stability in production and employment over a period of time can be made
ity
effective by the management in the light of the suitable forecasting about market
demand and other business variables and smoothening of the business operations
through counter-cyclical and seasonally adjusted business programmes.
Features of Demand Forecasting
s
The main features of demand forecasting are the following:
er
i) It is in terms of specific quantities.
ii) It is undertaken in an uncertain atmosphere.
iii) A forecast is made for a specific period of time which would be sufficient to take
v
a decision and put it into action.
ni
iv) It is based on historical information and the past data.

v) It tells us only the approximate demand for a product in the future.
vi) It is based on certain assumptions.
U
vii) It cannot be 100% precise as it deals with future expected demand.
Characteristics of Demand Forecasting

ity
Eight major characteristics can be identified with forecasting methods to identify

key characteristics of good demand forecasting methods:
i) Time horizon: The length of time over which a decision is being made has a
bearing on the appropriate technique to use depending on the time i.e. short
m
and long demand forecasting can be measured.

ii) Level of details: The level of detail needed should match the focus of decision
making unit in the forecast.
)A
iii) Stability: Forecasting in situations that are relatively stable over time requires
less attention than those that are in constant flux.
iv) Pattern of data: As different forecasting methods vary in their ability to identify
different patterns it is useful to make the pattern in the data fit with the method
(c
that suits it the most.

v) Type of methods: Other assumptions are also made in each forecasting

Notes
e
method that must fit the situation under consideration
vi) Cost: Several costs are associated with adapting forecasting procedure
in
within an organization like managerial development, storage, operation and
opportunity in terms of other techniques that might have been applied.
vii) Accuracy: It is measured by the degree of deviation between past forecast and
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current actual performance or present forecast and future performance.
viii) Ease of application: Models must be chosen within the abilities of the user to
understand them and within the time allowed for using them
O
Essentials of Demand Forecasting
The essentials of demand forecasting method can be summarized as follows:
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1. Simplicity: A simpler method is always more comprehensive than a complicated
one.
2. Economy: It should involve lesser costs as far as possible. Its costs must be
compared against the benefits of forecasts.
s
3. Quickness: It should yield quick results. A time consuming method may delay
the decision making process.
er
4. Accuracy: Forecast should be accurate as far as possible. Its accuracy must
be judged by examining the past forecasts in the light of the present situation.
v
5. Plausibility: It implies management’s understanding of the method used for
forecasting. It is essential for a correct interpretation of the results.
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6. Flexibility: Not only is the forecast to be maintained up to date, there should be

possibility of changes to be incorporated in the relationships entailed in forecast
procedure from time to time.
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Types of Demand Forecasting (on the basis of Time)
1. Short-term Demand Forecasting

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Short-term forecasting relates to a period not exceeding a year. Professor E.J.

Douglas prefers to use the term demand estimation for short-term demand forecasting.
To him demand estimation refers to the determination of the volume of current demand
for a firm’s product, for a short period say over a month or a year.
m
Short-term forecasts relate to the day-to-day particulars which are concerned with
tactical decisions under the given resource constraints; as in the short run, the available
resources, scale of operations etc., are fixed or unalterable, by and large. In short-term
)A
forecasting, a firm is primarily concerned with the optimum utilization of its existing
production capacity.
Usefulness of Short-term forecasting

1. Evolving a sales policy: A short-term demand forecasting is useful in evolving a
(c
suitable sales policy in view of the seasonal variation of demand and so as to avoid
the problem of short supply or overproduction of the firm’s products in the market.

2. Determining price policy: Short-term sales forecasting will help the firm in
Notes
e
determination of a suitable price policy to clear off the stocks during offseason,
and to take advantage in the peak season.
in
3. Evolving a purchase policy: In view of the short-term forecasting of material
prices, a firm can evolve a rational purchase policy for buying raw materials and
control its inventory stocks with a greater economy.
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4. Fixation of sales targets: Demand and sales forecasting in the short-term
helps the business firm in setting sales targets and for establishing controls
over the business. It is no use fixing high sales targets, when sales forecasting
O
reveals a decline in a quarter.
5. Determining short-term financial planning: A firm’s short-term financial policy
and planning can be suitably determined on the basis of short-term demand
forecasting. A firm’s need for cash depends on its production and sales. Without
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sales forecasting a rational financial planning is not possible.
2. Medium-Term Demand Forecasting

Medium-Term demand forecasting refers to the forecasts prepared for intermediate
s
period between long term and short term during which the firm’s scale of operations or
the production capacity may continue. Medium-Term demand forecasting is followed by
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a firm which is subjected to the medium term variation of the business cycle. Business
organization such as cotton industries, garments manufacturers and parts and tools
ma nufacturers often practices the medium term demand forecasting. Medium-term
forecasts are normally forthe periods of one to three years.
v
3. Long-Term Demand Forecasting
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Long-term forecasting refers to the forecasts prepared for long period during which
the firm’s scale of operations or the production capacity may be expanded or reduced.
U
Long-term forecasts are normally for the periods exceeding a year, usually
3-5 years or even a decade or more. Functionally, the long periods which permit
alternations in the scale of production differ from industry to industry and firm to firm.
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Usefulness of Long-term forecasting

1. Importance for Business planning: Long-term forecasting is of great
assistance to long term business planning. Long-term demand potential will
provide the required guidelines for planning of a new business unit or for the
m
expansion of the existing one. Capital budgeting by a firm is based on the long-
term demand forecasting.
2. Manpower planning: It is essential to determine long-term sales forecast for
)A
an appropriate manpower planning by the firm in view of its long-term growth

and progress of the business.
3. Long-term financial planning: Finance is the kingpin of the modern business.
In view of the long-term demand and sales forecasting and the production
(c
planning, it becomes easier for the firm to determine its long-term financial
planning and programmes for raising the funds from the capital market.

Sources of Data Collection for Demand Forecasting

Notes
e
The marker research may be based on two types of sources of data collection, viz.:
primary sources and secondary sources, providing primary data and secondary data,
in
respectively.
Secondary Sources of Data
nl
Secondary data or information’s are those which are obtained from someone else’s
records. These data are already in existence in the recorded or published forms.
Secondary data are like finished products since they have been processed
O
statistically in some form or the other. In a market research for the demand analysis,
a beginning may be made with the collection of secondary data, which would provide
clues for further inquiry. There are sufficient secondary sources for collecting the
required information for market and demand analysis.
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The main sources of secondary data are:
(i) Official publications of the Central, State and Local governments, such as Plan
documents, Census of India, Statistical Abstracts of the Indian Union, Annual Survey
s
of Industries, Annual Bulletin of Statistics of Exports and Imports, Monthly Studies
of Production of Selected Industries, Economic Survey, National Sample Survey
er
Reports, etc.
(ii) Trade and technical or economic journals and publications like the Economic and
Political Weekly, Indian Economic Journal, Stock Exchange Directory, Basic Statistics
v
and other information supplied by the Centre for Monitoring Indian Economy, etc.
(iii) Official publications like the Reserve Bank of India, e.g., Annual Report on Currency
ni
and Finance, Monthly Bulletin of Reserve Bank of India, etc. and of international
bodies like the IMF, UNO, World Bank, etc.
(iv) Market reports and trade bulletins published by stock exchange, trade associations,
U
large business houses, chambers of commerce, etc.

(v) Publications brought out by research institutions, universities, associations, etc.
(vi) Unpublished data such as firm’s account books showing data about sales, profits,
ity
etc.
(vii) Secondary data should not be taken at their face value and are never to be used
blindly.
m
1.3.2 Techniques of Demand Forecasting

The methods of demand forecasting can be broadly classified into two categories
such as
)A
i) Survey method and

ii) Statistical method.
A. Survey Method of Demand Forecasting

(c
The Survey method is the method of gathering data by asking questions to people
who are thought to have desired information. A formal list of questionnaire is prepared.

Generally a non-disguised approach is used. The respondents are asked questions on

Notes
e
their demographic interest opinion.
Advantages of Survey Method
in
i) Surveys are relatively inexpensive especially if they are self-administered
surveys.
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ii) Surveys are useful in describing the characteristics of a large population. No
other method of observation can provide this general capability.
iii) They can be administered from remote locations using mail, email or the
O
telephone.
iv) Consequently, very large samples are feasible, making the results statistically
significant even when analyzing multiple variables.
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v) There is flexibility at the creation phase in deciding how the questions will be
administered: as face-to-face interviews, by telephone, as group administered
written or oral survey, or by electronic means.
vi) Standardized questions make measurement more precise by enforcing uniform
s
definitions upon the participants.
vii) Standardization ensures that similar data can be collected from groups then
interpreted comparatively
er
1. Disadvantages of Survey Method
v
A methodology relying on standardization forces the researcher to develop
questions general enough to be minimally appropriate for all respondents possibly
ni
missing what is most appropriate to many respondents.
i) Surveys are inflexible in that they require the initial study design (the tool and
administration of the tool) to remain unchanged throughout the data collection.
U
ii) The researcher must ensure that a large number of the selected sample will
reply.
iii) It may be hard for participants to recall information or to tell the truth about a
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controversial question.
iv) As opposed to direct observation, survey research can seldom deal with
“context.”
v) Unwillingness of respondents to provide information
m
vi) The interviewer may assure that the information will be kept secret or apply the
technique of offering some presents.
)A
2. Consumers Survey Method

Consumers Survey is undertaken by questioning consumer’s about what they
are planning or intending to buy. A questionnaire may be prepared and mailed to
the consumers. Or it may be sent through enumerators. In the questionnaire, the
(c
respondents may be asked for their reactions to hypothetical changes in demand

determinants such as price, income, prices of substitutes, advertising etc.

Survey methods constitute another important forecasting tool, especially for short-
Notes
e
term projections. The most direct method of estimating demand in the short- run is to
conduct the survey of buyers’ intentions. The consumers are directly approached and
in
are asked to give their opinions about the particular product. The questionnaire must be
carefully prepared bearing in mind the qualities of a good questionnaire.
3. Market controlled experiment method
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Under this method the main determinants of demand of a product like price,
quality, advertising and packaging, are identified. Here the market divisions must
be homogeneous with regard to income, population, caste, religion, sex, age, tastes,
O
preference.
Merits:
ity
- It is a carefully carried out exercise which helps researcher to come out with a
demand function indicating quantities.
- This method can be used to check the results of demand forecasting obtained
from other methods.
s
Demerits:
- These methods are expensive and time consuming.

er
- These methods are risky as they might send wrong signals to the consumers,
dealers and competitors.
- It is difficult to satisfy the conditions of homogeneity.
v
4. Delphi Method
ni
In Delphi Method, an attempt is made to arrive at a consensus of opinion. The

participants are supplied with responses to previous questions from others in the group
by a leader. The leader provides each expert with opportunity to react to the information
U
given by others, including reasons advanced, without disclosing the source.
Delphi method facilitates anonymity of the respondent’s identity. This enables

respondents to be frank and forthright in giving their views. It facilitates posing the
ity
problem to the experts at one time and has their response nearly as good as pooling
the panelists together.
5. Consumer Clinics Method

m
An artificial market situation is created and “consumer clinics” selected. Consumers

are asked to spend time in an artificial departmental store and different prices are
set for different buyer groups. The responses to the price changes are observed and
)A
necessary decisions taken.
B. Statistical Methods of Demand Forecasting

Statistical methods of demand forecasting include the Time Series Analysis,
Moving Averages, Exponential Smoothing, Index Numbers, Regression Analysis as well
(c
as Econometric Models and Input-Output Analysis. These methods use various types

of statistical equations and mathematical models to estimate long term demand for a
Notes
e
product.
Types of Statistical Methods
in
1. Trend Projection Method
Trend projection method is a classical method of business forecasting. This
nl
method is essentially concerned with the study of movement of variable through
time. The use of this method requires a long and reliable time series data. The trend
projection method is used under the assumption that the factors responsible for the past
O
trends in variables to be projected (e.g. sales and demand) will continue to play their
part in future in the same manner and to the same extend as they did in the past in
determining the magnitude and direction of the variable.
ity
Advantages of Trend Projection
Advantages of trend projection method are as follows:
i) Trend projection method is reliable to estimate the future course of action.
s
ii) This method is popular in business forecasting.
iii) It is very simple method.
er
iv) The marketing manager can understand the future demand in market.
Disadvantages of Trend Projection

v
Disadvantages of trend projection method are as follows:
ni
i) Trend projection method is quite expensive.

ii) This method is not useful for short term forecasting.
U
iii) Trend projection method does not disclose the information which can be used
for formulating various business policies.
2. Economic Indicators
ity
An economic indicator is a statistic about the economy. Economic indicators

allow analysis of economic performance and predictions of future performance. One
application of economic indicators is the study of business cycles
Economic indicators include various indices, earnings reports, and economic

m
summaries. Examples: unemployment rate, quits rate, housing starts, Consumer Price
Index, Consumer Leverage Ratio, industrial production, bankruptcies, Gross Domestic
Product, broadband internet penetration, retail sales, stock market prices, money
)A
supply changes.
Types of Economic Indicators

Economic indicators can be classified into three categories according to their
usual timing in relation to the business cycle: leading indicators, lagging indicators, and
(c
coincident indicators.

i) Leading indicators
Notes
e
Leading indicators are indicators that usually change before the economy as a
whole changes. They are therefore useful as short-term predictors of the economy.
in
Stock market returns are a leading indicator: the stock market usually begins to decline
before the economy as a whole declines and usually begins to improve before the
general economy begins to recover from a slump. Other leading indicators include the
nl
index of consumer expectations, building permits, and the money supply.
ii) Lagging indicators
O
Lagging indicators are indicators that usually change after the economy as a whole
does. Typically the lag is a few quarters of a year. The unemployment rate is a lagging
indicator: employment tends to increase two or three quarters after an upturn in the
general economy.
ity
iii) Coincident indicators
Coincident indicators change at approximately the same time as the whole
economy, thereby providing information about the current state of the economy. There
s
are many coincident economic indicators, such as Gross Domestic Product, industrial
production, personal income and retail sales. A coincident index may be used to
er
identify, after the fact, the dates of peaks and troughs in the business cycle.
3. Other Statistical Methods

v
i) Exponential Smoothing
In this technique more recent data are given more weight age. This is based on
ni
the argument that the more recent the observations, the more its impact on future and
therefore is given relatively more weight than the earlier observations.
U
ii) Index Numbers

The Index Numbers offer a device to measure changes in a group of related
variables over a period of time. In case of index numbers a Base Year which is given
ity
the value of 100 and then express all subsequent changes as a movement of this
number. The most commonly used is the Laspeyres’ Price Index.
iii) Correlation and Regression

m
Correlation refers to the interdependence or co-relationship of variables. It reflects

the closeness of the linear relationship between x and Y.
Regression is a way of describing how one variable, the outcome, is numerically

)A
related to predictor variables. The dependent variable is also referred to as Y,

dependent or response and is plotted on the vertical axis (ordinate) of a graph.
These involve the use of econometric methods to determine the nature and degree of
association between/among a set of variables. Econometrics, you may recall, is the use
of economic theory, statistical analysis and mathematical functions to determine the
(c
relationship between a dependent variable and one or more independent variables (like
price, income, advertisement etc.). The relationship may be expressed in the form of a

demand function. Such relationships, based on past data can be used for forecasting.
Notes
e
The analysis can be carried with varying degrees of complexity.
in
iv) Simultaneous Equations Method
Simultaneous Equations Method is a very sophisticated method of forecasting. It
is also known as the ‘complete system approach’ or ‘econometric model building’. This
nl
method is normally used in macro-level forecasting for the economy as a whole; in this
course, our focus is limited to micro elements only.
The method is indeed very complicated. However, in the days of computer,
O
when package programmes are available, this method can be used easily to derive
meaningful forecasts. The principle advantage in this method is that the forecaster
needs to estimate the future values of only the exogenous variables unlike the
regression method where he has to predict the future values of all, endogenous and
ity
exogenous variables affecting the variable under forecast. The values of exogenous
variables are easier to predict than those of the endogenous variables. However, such
econometric models have limitations, similar to that of regression method.
Key Takeaways:
s
●● Economics: It is the science dealing with the production, exchange and
er
consumption of various commodities in economic systems.
●● Macroeconomics: Study of the entire economy.
●● Microeconomics: Study of firms and markets, individual units.
v
●● General equilibrium: Market situation where demand and supply requirements of
all decision makers have been satisfied without creating surpluses or shortages.
ni
●● Partial equilibrium: Analysis that treats one particular sector of the economy as
operating in isolation from the other sectors of the economy.
U
●● Demand: The quantity of the commodity which an individual is willing to purchase

per unit of price at a particular time.
●● Derived demand: Goods whose demand is tied with the demand for some other
ity
goods
●● Direct demand: Goods whose demand is not tied with the demand for some other
goods
●● Demand function: A comprehensive formulation which specifies the factors that
m
influence the demand for the product

●● Inferior goods: a good that decreases in demand when consumer income rises
●● Supply: Willingness and ability to produce a specific quantity of output available to
)A
consumers at a particular price over a given period of time.

●● Law of supply: More of a good will be supplied the higher its price and vice-versa
●● Supply function: It refers to the mathematical function that relates price and
quantity supplied for goods or services.
(c
●● Demand forecasting: It refers to the expectation about the future course of the
market demand for a product.

Check your progress

Notes
e
1. The ratio percentage or a proportional change in the quantity demanded to the
percentage or proportional change in the income
in
a) Income Elasticity
b) Advertising Elasticity
nl
c) Cross Elasticity
d) Price elasticity
2. The change in the price of commodity Y and its effects on the demand for
O
commodity X are considered
b) Advertising Elasticity
ity
c) Cross Elasticity
d) Price elasticity
3. The price elasticity of demand measures
s
a) The slope of a budget curve.
er
b) How often the price of a good changes.
c) The responsiveness of the quantity demanded to changes in price.
d) How sensitive the quantity demanded is to changes in demand
v
4. If price elasticity is between 0 and 1, demand is -
ni
a) Inelastic
b) Elastic
c) Unitary elastic
U
d) Perfectly elastic
5. The elasticity of demand can range between
ity
a) Negative one and one.

b) Zero and infinity.
c) Zero and one.
m
d) Negative infinity
Questions & Exercises

1. What do you understand by demand? Differentiate between Individual demand vs.
)A
market demand
2. What is demand by market segmentation?
3. What is elasticity of demand? Explain Use of demand elasticity in Business-Decision
Making
(c
4. Explain theorems on price elasticity

5. Explain demand forecasting

Notes
e
Check your progress
in
1. a) Income Elasticity
2. c) Cross Elasticity
3. c) The responsiveness of the quantity demanded to changes in price.
nl
4. a) Inelastic
5. b) Zero and infinity.
O
Further Readings
1. William Boyes and Michael Melvin, Textbook of economics, Biztantra,11th
Edition, 2015.
ity
2. N. Gregory Mankiw, Principles of Economics, 7th edition, Cengage, New Delhi,
3. Richard Lipsey and Alec Charystal, Economics, 12th edition, Oxford, University
Press, New Delhi, 2015.
s
4. Karl E. Case and Ray C. fair, Principles of Economics, 14th edition, Pearson
Bibliography
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1. Managerial Economics- Theory and Applications, Dr. D.M Mithani, Himalaya
Publications.
v
2. Managerial Economics, D.N Dwivedi, 6th ed., Vikas Publication.
3. Indian Economy, K P M Sundharam and Dutt, 64th Edition, S Chand publication.
ni
4. Business Environment Text and Cases by Justin Paul, 3rd Edition, McGraw- Hill
Companies.
U
5. Managerial Economics- Principles and worldwide applications, Dominick

6. Managerial Economics, Yogesh Maheshwari, PHI, 2/e, 2011
7. 10. Paul A. Samuelson, William D. Nordhaus, Sudip Chaudhuri and Anindya Sen,
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Economics, 19thedition, Tata McGraw Hill, New Delhi, 201

m
)A
(c

Module-2: Theory of Production and Cost

Notes
e
Learning Objective:
in
●● Describe and explain the concept of economic profits and sunk costs.
nl
●● Describe and explain the concept of diminishing marginal product.
●● Describe and explain the difference between the short run and the long run.
O
●● Describe and explain the short-run costs of the firm and how they vary with the
output levels that are produced.
●● Describe and explain how the firm uses the long-run average cost curve in its
planning.
ity
Learning Outcome:
In this module, we have discussed about
s
●● Concept of the short-run production function, describing the relationship between
the quantity of inputs and the quantity of output;
er
●● Context of the production function, average and marginal products as well as the
law of diminishing marginal returns;
●● Relationships among the short-run costs: total, average and marginal;
v
●● Process of cost minimization;
ni
●● Economies and diseconomies of scale, as well as returns to scale;

●● Distinction between accounting and economic profits;
●● Establishing the profit-maximizing rule, using marginal analysis.
U
“Economics as the science of wealth.”

Adam smith-
ity
2.1.1 Short run vs. Long run

The short run is defined as a period of time where at least one factor of production is
m
assumed to be in fixed supply i.e. it cannot be changed. It is generally assumes that the
quantity of capital inputs such as plant and machinery is fixed and that the production can
be altered by suppliers through changing the demand for variable inputs such as labour,
components, raw materials and energy inputs. Often the amount of land available for
)A
production is also fixed.
In the short run, the law of diminishing returns explains that as more units of a
variable input (i.e. labour or raw materials) are added to the fixed amounts of land and
capital, the change in total output initially will rise and then fall. Diminishing returns to
(c
labour occurs when marginal product of labour starts to fall. This means that total output
will still be rising – but increasing at a decreasing rate as more workers are employed.

What happens to marginal product is linked directly to the productivity of each extra
Notes
e
worker employed. At low levels of labour input, the fixed factors of production - land
and capital, tend to be under-utilized which means that each additional worker will have
in
plenty of capital to use and, as a result, marginal product may rise. Beyond a certain point
however, the fixed factors of production become scarcer and new workers will not have
as much capital to work with so that the capital input becomes diluted among a larger
workforce. As a result, the marginal productivity of each worker tends to fall this is known
nl
as the principle of diminishing returns
Factors of production
O
Factors of production mean inputs and finished goods mean output. Input decides
the quantity of output i.e., output depends upon input. Input is the starting point and output
is the end point of production process and such input-output relationship is called as
“Production Function”. All factors of production like land, labour, capital and entrepreneur
ity
are required altogether at a time to produce a commodity. In economics, production
means creation or an addition of utility
s
v er
ni
U
ity
m
1. Land
)A
Land is not created by mankind but is a gift of nature. Thus, it is referred to as natural
factor of production. It is also called as original or primary factor of production. Normally,
land means surface of earth. From the above picture it is clear that land includes earth’s
surface and resources above and below the surface of the earth. It includes following
natural resources:
(c
●● On the surface (e.g. soil, agricultural land, etc.)

●● Below the surface (e.g. mineral resources, rocks, ground water, etc.)

●● Above the surface (e.g. climate, rain, space monitoring, etc.)

Notes
e
Characteristics of Land
in
●● Land is a free gift of nature: Land is a free gift of nature to mankind and is not a
man-made factor but a naturally occurring factor.
●● Land is a primary factor of production: Though all factors are required
nl
for production, land puts foundation for production process. Starting point of
production process is an acquisition of land. So, it is a primary factor.
●● Land has perfectly inelastic supply: From society’s point of view, supply of
O
land is perfectly inelastic i.e. fixed in quantity. Neither it can be increased nor
decreased. Simply, you cannot change size of the earth. But from individual point
of view, its supply is relatively elastic.
●● Land has grad ability: Land varies from region to region on the basis of fertility.
ity
Some land is more fertile and some are not at all. So, fertility wise, grading of
land is possible. So, in this way, land has grad ability.
●● Land is a passive factor: Land itself doesn’t produce anything; hence it is a
passive factor. It needs the help of labour, capital firm etc.
s
●● Land may have diminishing returns: In this context, return means the
er
quantity of crops. By using fertility of land and with the help of capital and labour
continuously, returns get diminished because of reduction in fertility.
●● Land has a derived demand: Demand for agricultural goods is a direct demand
and for producing such goods, land is indirectly demanded. So, as a factor, land
v
has a derived demand from consumer’s point of view.
ni
●● Land has no social cost: Land is a gift of nature to society. It is already in

existence. Land is no created by society by putting any efforts and paying any
price. So, for society, supply price of land is zero. But, because for the purchase of
U
land or for its improvement, individual has to pay certain price, so its supply price
for individual is not zero.
2. Labour
ity
Labour is an ability to work. Labour is a broad concept because it includes both

physical and mental labour. Labour is a primary or human factor of production. It indicates
human resource. Labourer is a person who owns labour. So labourer means worker. It is
a person engaged in some work.
m
Characteristics of Labour
●● Labour is inseparable from labourer: Labour cannot be separated from
)A
labourer. Worker sells their service and doesn’t sell themselves.

●● Labour is a perishable factor: Labour cannot be stored. Once the labour is lost,
it cannot be made up. Unemployed workers cannot store their labour for future
employment.
●● Cost of producing a labour cannot be determined: It is easy to calculate
(c
production cost of a commodity produced in an industry. But cost of producing a

labour is a vague concept because it includes expenses incurred by parents on

education of their children and other expenses incurred on them right from their
Notes
e
birth date. It is impossible to estimate all such casts accurately.
●● Labour is an active factor of production: Other factors like land, capital are
in
passive, but labour is an active factor of production. Being a human being, this
factor has its own feelings, likes and dislikes, thinking power, etc. We can achieve
better quality and level of production, if land and capital are employed properly in
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close association with Labour. So without labour, we cannot imagine the smooth
conduct of production.
●● Labour is a heterogeneous factor: No two persons possess the same quality of
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labour. Skills and efficiency differs from person to person. So, some workers are
more efficient than others in the same job.
●● Labour has imperfect mobility: Labour doesn’t move easily from one occupation
to another because of several factors like family and cultural background, limited
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educational and technical skills, lifestyle, housing and transport problems, language
barrier, adaptability to new environments, etc.
●● Labour supply is inelastic in general: Supply of labour depends upon many
factors like size of population, age and sex composition, desire to work, quality of
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education, attitude towards work, etc. Thus, supply cannot be changed easily
according to changes in demand.
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●● Labour is a human capital: Society makes investment in labour in the forms of
education, health, training, etc. This improves efficiency of labour. So, it is a human
capital.
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3. Capital
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Capital is the financial assets or the financial value of assets, such as cash. The word
Capital is related with the following three terms namely, wealth, money and income.
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Relation with Wealth

Capital is that part of wealth which is used for production. So, wealth is a broad
concept and capital is a narrowed concept.
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If a commodity is having features like scarcity, utility, externality and transferability, it

becomes wealth. A motor car has all above features, so it is a wealth. When wealth is
used in production process, it becomes capital. If that car is used for taxi (cab) business,
it becomes capital. Therefore, any commodity as a wealth becomes the capital if it is used
for production. Thus, all capital is wealth but all wealth is not capital.
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Relation with Money

)A
Generally, capital means investment of money in business. But in economics money

becomes capital only when it is used to purchase real capital goods like plant, machinery,
etc. When money is used to purchase capital goods, it becomes money capital. But
money in the hands of consumers to buy consumer goods or money hoarded doesn’t
constitute capital. Money by itself is not a factor of production, but when it acquires stock
(c
of real capital goods, it becomes a factor of production. For production we need real
capital and money capital but money capital acquires real capital.

Relation with Income

Notes
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Capital generates income. So, capital is a source and income is a result. Example:
refrigerator is a capital for an ice-cream parlour owner. But, profits which he gets out of his
in
business are his income. So, Capital is a FUND concept and Income is a FLOW concept.
Characteristics of Capital
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The characteristics of capital are:
●● Man-made Factor: Capital is not a gift of nature. So it is not a primary or natural

factor, it is made by man in capital goods industry. It is secondary as well as an
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artificial factor of production.
●● Productive Factor: Capital helps in increasing level of productivity and speed of
production.
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●● Elastic Supply: Supply of capital depends upon capital formation process.
Capital formation depends upon savings and investment. By accelerating capital
formation, capital supply can be increased. But it is a long term process
●● Durable: Capital is not perishable like labour. It has a long life subject to periodical
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depreciation.
●● Easy Mobility: Movement of capital from one place to another is easily possible.
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4. Entrepreneur
The term ‘Entrepreneur’ has been derived from a French word ‘Entreprendre’ that
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means to undertake certain business related activities. The factors of production namely
the land, labour and capital are scattered at different places and all these need to be
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assembled together. This task is performed by a firm. It is an ‘Organization Function’.

Organization function is the work of bringing the required factors together and making
them work harmoniously.
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Entrepreneur has to bear risks and uncertainties. For facing uncertainties he may get
profit or may incur loss. This is the ‘Risk Bearing Function’ and entrepreneur is the risk
bearer.
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Qualities of an Entrepreneur
i) Ability to organize: He should be able to organize various factors effectively. He
has to understand all the aspects of the business.
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ii) Professional approach: He should be objective and professional in approach.

iii) Risk bearer: He should be risk taker. He should be ready to bear risk and
uncertainties.
)A
iv) Innovative: Organiser should be innovative. He should adopt modern techniques of

production. He should not be reluctant to changes.
v) Decision Making: One has to take right decision at a right time by showing his
promptness. Quick decisions are expected but hasty decisions shouldn’t be taken.
(c
Delay in decisions may increase cost of project and reduce the profits.
vi) Negotiation skills: Businessman regularly comes into contact with various persons
like consumers, workers, government officials, etc. so he should communicate tactfully.
2.1.3 Production Function/ Production Analysis

Notes
e
A production function is a function that specifies the output of a firm, an industry, or
an entire economy for all combinations of inputs. In other words, it shows the functional
in
relationship between the inputs used and the output produced. Mathematically, the
production function can be shown as:
Q = f (X1 , X2 .......XK where Q = Output, X1 .............. XK = Inputs used.
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‘A production function defines the relationship between inputs and the maximum
amount that can be produced within a given period of time with a given level of
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technology’. A production function can be stated in the form of a table, schedule or
mathematical equation. But before doing that, two special features of a production
function are given below:
1. Labour and capital are both unavoidable inputs to produce any quantity of a
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good, and
2. Labour and capital are substitutes to each other in production.
2.14 Production Function-- neo-classical
s
Neoclassical growth theory is an economic theory that explains how a steady
er
rate of economic growth benefits from a combination of three driving forces — labour,
capital , and technology. This growth theory suggests that capital accumulation within
an economy, and how people use that capital, is essential to economic development.
Further, the relationship between an economy’s capital and labour influences its
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production.
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The Neo Classical production function is written as follows: Y = F (K,AL)
2.1.5 Production Function-- Cobb- Douglas

U
A production function defines the relationship between inputs and the maximum
amount that can be produced within a given period of time with a given level of
technology’. A production function can be stated in the form of a table, schedule or
mathematical equation. But before doing that, two special features of a production
ity
function are given below:
1. Labour and capital are both unavoidable inputs to produce any quantity of a
good, and
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2. Labour and capital are substitutes to each other in the production.

The important parameters of production functions and measure of series for total
factor productivity from the Cobb-Douglas function specification on three data sets which
)A
are data panel for all countries, income-separated panel data (low , medium and high)
and geographic area panel data. The Cobb-Douglas production function is written as
follows:
Y = A Kα Lβ , 0 < α < 1 and 0 < β < 1

(c
where Y equals real GDP, K equals the total physical capital stock, L equals the
number of workers (labour force), and A equals an index of total factor productivity. We
allow for the possibility of non constant returns to scale by not restricting to equal one.

2.1.6 Production Function-- Leontief

Notes
e
Another form is the fixed proportion production function also called the Leontief
function. It is represented by
in
Q = minimum [ K/a, L/b], where where a and b are constants and ‘minimum’ means
that Q equals the smaller of the two ratios.
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2.1.7 Isocost
A rational firm would combine the various factors of production its production function
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in such a way that with the minimum input and maximum output is obtained at the
minimum cost. Such a combination is referred to as the least cost combination.
Iso-cost Line
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An Iso-cost line indicates all possible combinations of two inputs which can be
purchased with a given amount of investment fund ie. the outlay. Each combination of
inputs has same total cost which includes the cost of two inputs. (X1 and X2) combined.
Example: Total cost = Px1. x1 + Px2. x2
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2.1.8 Isocost - Feature and Example

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Features of isocost are -

1. As total outlay increases, the Iso-cost line moves higher and higher away from the
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origin.
2. The Iso-cost lines are always straight.
3. The slope of an Iso-cost line represents the price ratio.
Example: If C = 900 units, w = 10 units and r = 10 units, the firm could either hire 10
(c
L or rent 10 K or any combination of L and K shown on isocost line AB in figure. For each
unit of capital the firm gives up, it can hire one additional unit of labour. Thus the slope of
the isocost line is - 1. By subtracting wL from both sides of the equation above and then
dividing by r, we get the general equation of the isocost line in the following more useful
Notes
e
form:
K = C/r – wL/r
in
where C/r is the vertical intercept of the isocost line and -w/r is its slope. Thus for
C=100 units and w=r=10 units, the vertical intercept is c/r = 100/10=10K, and the slope
is -w/r = -10/10 = -1. A different total cost by the firm would define a different but parallel
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isocost line, while different relative input prices would define an isocost line with a different
slope.
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2.1.9 Isoquant - Smooth Curvature and Right Angle
Isoquants are the geometric representation of the production function. The
same level of output can be produced by various combinations of the factor inputs. By
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Imagining a continuous variation in the possible combination of labour and capital, a
curve can be drawn by plotting all the alternative combinations for a given level of output.
This curve which is the locus of all possible combination is called the ‘isoquant’
If the two inputs are perfect substitutes, with a given level of production Q3, input X
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can be replaced by input Y at an unchanging rate. The perfect substitute inputs do not
experience decreasing marginal rates of return when they are substituted for each other
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in the production function. If the two inputs are perfect complements, the isoquant map
takes the form with a level of production Q3, input X and input Y can only be combined
efficiently in the certain ratio occurring at the kink in the isoquant. The firm will combine
the two inputs in the required ratio to maximize profit
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ni
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)A
Isoquants are typically combined with isocost lines in order to solve a cost-
minimization problem for given level of output. In the typical case shown in the top figure,
with smoothly curved isoquants, a firm with fixed unit costs of the inputs will have isocost
curves that are linear and downward sloped; any point of tangency between an isoquant
and an isocost curve represents the cost-minimizing input combination for producing the
(c
output level associated with that isoquant. A line joining tangency points of isoquants and
iso-costs is called the expansion path.

2.1.10 Isoquant - Feature and Example

Notes
e
The main properties of the isoquants are similar to those of indifference curves.
These properties are now discussed in brief:
in
1. An Isoquant Slopes Downward from Left to Right
This implies that the Isoquant is a negatively sloped curve. This is because when
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quantify of factor K (capital) is increased, the quantity of L (labor) must be reduced so as
to keep the same level of output.
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s ity
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The above figure depicts that an isoquant IP is negatively sloped curve. This curve
shows that as the amount of factor K is increased from one unit to 2 units, the units of
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factor L are decreased from 20 to 15 only so that output of 100 units remains constant.
2. An Isoquant that lays above and to the Right of another Represents a Higher
Output Level
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It means a higher isoquant represents higher level of output

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m
)A
(c

The above figure represents this property. It shows that greater output can be
Notes
e
secured by increasing the quantity combinations of both the factors X and Y. The
producer increases the output from 100 units to 200 units by increasing the quantity
in
combination of both the X and Y. The combination of OC of capital and OL of labor yield
100 units of production. The production can be increased to 200 units by increasing the
capital from OC to OC1 and labor from OL to OL1.
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3. Isoquants Cannot Cut Each Other
The two isoquants cannot intersect each other.
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s ity
v er
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If two isoquant are drawn to intersect each other as is shown in this figure, then it is a
negation of the property that higher Isoquant represents higher level of output to a lower
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Isoquant. The intersection at point E shows that the same factor combination can produce
100 units as well as 200 units. But this is quite absurd. How can the same level of factor
combination produce two different levels of output, when the technique of production
remains unchanged. Hence two isoquants cannot intersect each other.
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4. Isoquants are Convex to the Origin

This property implies that the marginal significance of one factor in terms of another
factor diminishes along an ISO product curve. In other words, the isoquants are convex to
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the origin due to diminishing marginal rate of substitution.
In this figure MRSKL diminishes from 5:1 to 4:1 and further to 3:1. This shows that
as more and more units of capital (K) are employed to produce 100 units of the product,
)A
lesser and lesser units of labor (L) are used. Hence diminishing marginal rate of technical
substitution is the reason for the convexity of an isoquant
(c

Notes
e
in
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5. Each Isoquant is Oval Shaped
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The ISO product curve is elliptical. This means that the firm produces only those
segments of the ISO-product curves which are convex to the origin and lie between the
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ridge lines. This is the economic region of production.
2.1.11 Optimal Combinations of Inputs: The Least – Cost

Combinations of Input
v
All output variables can be varied on the long-term. At any given amount of
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production, the benefit maximization firm must select the least cost combination of factors
to generate. The least cost combination or the optimum factor combination refers to the
combination of factors that allow a firm to generate a certain amount of output at the
lowest possible cost.
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There are two methods of explaining the optimum combination of factor:
(i) The marginal product approach.

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(ii) The isoquant / isocost approach.
1. Marginal product approach.

In the long run , a firm can vary the quantities of factors it uses to produce goods.
m
It can choose which manufacturing technique to use, which factory design to create,
which kind of machinery to purchase. Obviously the benefit maximization would want to
use the mix of combination factors that is least expensive to it. The business’s income is
)A
maximized if the last rupee spent on each factor brings equivalent revenue. If a business
uses specific input factors or the least mixture of costs, or the optimal balance of factors is
reached if:
Mppa/ pa = Mppb/ pb = Mppc/ pc = Mppn/ pn

(c
In the above equation a, b, c, n are different factors of production. Mpp is the

marginal physical product. A firm compares the Mpp / P ratios with that of another. A firm

will reduce its cost by using more of those factors with a high Mpp / P ratios and less of
Notes
e
those with a low Mpp / P ratio until they all become equal.
2. The Isoquant / Isocost Approach:
in
With the support of iso-product curves and isocosts, the least cost combination of-
factor or producer ‘s equilibrium is now clarified. The optimum combination of factors
nl
or the least cost combination refers to the combination of factors that allow a firm to
generate a certain quantity of output at the lowest cost possible.
Assumptions of Optimum Factor Combination:
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The main assumptions on which this analysis is based areas under:
(a) There are two factors X and Y in the combinations.
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(b) All the units of factor X are homogeneous and so is the case with units of factor Y.
(c) The prices of factors X and Y are given and constants.
(d) The total money outlay is also given.
(e) In the factor market, it is the perfect completion which prevails. Under the
s
conditions assumed above, the producer is in equilibrium, when the following
two conditions are fulfilled.
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(1) The isoquant must be convert to the origin.
(2) The slope of the Isoquant must be equal to the slope of isocost line.
v
ni
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ity
m
In the diagram, the isocost line CD is tangent to the iso-product curve 400 units at
point Q. The firm employs OC units of factor Y and OD units of factor X to produce 400
)A
units of output. This is the optimum output which the firm can get from the cost outlay of
Q. In this figure any point below Q on the price line AB is desirable as it shows lower cost,
but it is not attainable for producing 400 units of output. As regards points RS above Q on
isocost lines GH, EF, they show higher cost.
(c
These are beyond the reach of the producer with CD outlay. Hence point Q is the
least cost point. It is the point which is the least cost factor combination for producing

400 units of output with OC units of factor Y and OD units of factor X. Point Q is the
Notes
e
equilibrium of the producer.
At this point, the slope of the isoquants equal to the slope of the isocost line. The
in
MRT of the two inputs equals their price ratio. Thus we find that at point Q, the two
conditions of producer’s, equilibrium in the choice of factor combinations, are satisfied.
(1) The isoquant is convex the origin.
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(2) At point Q, the slope of the isoquant ΔY / ΔX is equal to the slope of the
isocost in Px / Py. The producer gets the optimum output at least cost factor
combination
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2.1.12 Returns to Scale and Returns to a Factor
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Returns to Scale
If all the inputs are changed at the same time, generally only in the long run, and
are increased proportionately, then the concept of returns to scale has to be used to
understand the output behaviour. The output behaviour is studied when all factors of
production are changed in the same direction and proportion. In the long run, output can
s
be increased by increasing the ‘scale of operations’.
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Increasing the ‘scale of operations’ means an increase in all the factors at the
same time and by the same proportion. For example, in a factory, in the long run, the
scale of operations may be increased by doubling the inputs of labour and capital. The
laws governing the scale of operation are called the laws of returns of scale. The laws
v
of returns to scale always refer to the long run because only in the long run are all the
factors of production variable. In other words, only in the long run is it possible to change
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all the factors of production. Thus the laws of returns to scale refer to that time in the
future when changes in output are brought about by increasing all inputs at the same time
and in same proportion. Returns to scale are classified as follows:
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1. Increasing Returns to Scale (IRS): If output increases more than proportionate

to the increase in all inputs.
2. Constant Returns to Scale (CRS): If all inputs are increased by some proportion,
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output will also increase by the same proportion.

3. Decreasing Returns to Scale (DRS): If increase in output is less than
proportionate to the increase in all inputs
m
Returns to Factor
If all the inputs of a firm are fixed and only the amount of labour differs, then any
decrease or increase in output is achieved with the help of changes in the amount of
)A
labour used. When the firm changes the amount of labour services only, it changes the
proportion between the fixed input and the variable input. As the firm keeps on changing
this proportion by changing the amount of labour, it experiences the law of variable
proportion or diminishing marginal returns.
(c
This law states that, As more and more of the factor input is employed, all other input
quantities remaining constant, a point will finally be reached where additional quantities of
varying input will produce diminishing marginal contributions to total product.

2.1.13 Expansion Path of a Firm

Notes
e
An expansion path also known as a scale line is a curve in a graph with two input
quantities, usually physical capital and labor, plotted on axes. As the production scale
in
expands, the path connects optimum combinations of inputs. A producer finding the
cheapest way to produce a given number of units of a product chooses the point on the
expansion path which is also on the isoquant associated with that output level.
nl
Economists Alfred Stonier and Douglas Hague defined “expansion path” as “that line
which reflects the least–cost method of producing different levels of output, when factor
prices remain constant.
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The points on an expansion path occur where the isocost curves of the firm, each
showing fixed total cost of input, and its isoquants, each showing a different amount of
output, are tangent; each tangency point defines the conditional factor requirements of
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the firm. As the production level of a product increases, the firm moves from one of these
points of tangency to the next; the curve follows the tangency points is known as the
expansion path.
2.1.14 Laws of Returns to Scale Through Production Function
s
The law of returns to scale is concerned with the scale of production. The scale of
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production of a firm is determined by the amount of factors units. In the long run all factors
are variable. The firm therefore can expand its production by using more of all inputs.
When there is increase in the quantity of all factors in the long period, keeping the factor
proportion constant, there is increase in the scale of production.
v
The concept of returns to scale explains the behaviour of output when changes
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are made in the scale of production. Thus, the relationship between quantities of output
and the scale of production in the long run when all inputs are increased in the same
proportion is called law of returns to scale. In case all inputs are increased in the same
proportion and the scale of production is expanded, the effect on output may take three
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forms or stages, such as increasing, constant and diminishing returns to scale.
The law of returns to scale examines the relationship between output and the scale
of inputs in the long-run when all the inputs are increased in the same proportion.
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This law of returns to scale is based on the following assumptions;
i) All factors are variable but the enterprise is always fixed.

ii) There are no changes in technology.
m
iii) Perfect competition prevails in the market.

iv) Returns are measured in physical terms.
)A
Phases of the Law of Returns to Scale

Dr. Marshall states the law thus “An increase in the capital and labour applied in the
cultivation of land causes in general a less than proportionate increase in the amount
of the produce raised, unless it happens to coincide with an improvement in the art of
(c
agriculture.

Stage-1: Law of increasing returns: As the proportion of one factor in a

Notes
e
combination other factors is increased up to a point, the marginal product will increase
or the total product will increase with increasing roofs. Here the rate of increase us
in
represented by Marginal Product (MP). MP is defined as change in total product resulting
from unit change in input. In agriculture, the initial state of production shows increasing
rate. But in non-agricultural sector (industry) generally this law operates.
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Stage-2: Law of constant returns: The law of constant returns is said to be
operated when retunes (MP) remains the same as the business is expanded. The
constant return however is observed for a short period.
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Stage-3: Law of decreasing returns: The law of decreasing returns is the, opposite
to the law of increasing returns. Here MP is declining continuously. The total product is
increasing but with decreasing rate, and eventually it 1so declines and the MP becomes
negative. This law is generally operates in agriculture.
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2.1.15 Laws of Returns to Scale Through Production Function -
Example
The returns to scale can be shown diagrammatically on an expansion path “by the
s
distance between successive ‘multiple-level-of-output” isoquants, that is, isoquants that
show levels of output which are multiples of some base level of output, e.g., 100, 200,
300, etc.”
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Increasing Returns to Scale:
v
Figure shows the case of increasing returns to scale where to get equal increases in
output, lesser proportionate increases in both factors, labour and capital, are required.
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According to the figure –
●● 100 units of output require 3C + 3L

(c
Such that along the expansion path OR, OA > AB > BC. In this case, the production
function is homogeneous of degree greater than one. The increasing returns to scale are

attributed to the existence of machine, management, labour, finance, etc. indivisibilities.

Notes
e
Many equipment products or other tasks are of a limited size and can’t be separated into
smaller units. As a business unit grows, returns to scale increase as they leverage the
in
indivisible variables to their maximum potential.
Increasing returns to scale are often the product of specialisation and labor division.
There is wide scope for specialization and division of labour as the company’s scale
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expands. Job can be split into small activities, and staff can be allocated to smaller
processes. Specialized equipment can be designed for this.
Decreasing Returns to Scale
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Figure shows the case of decreasing returns where to get equal increases in output,
larger proportionate increases in both labour and capital are required
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So that along the expansion path OR, OG < GH < HK.
In this case the production function is less than one degree homogeneous. Because
of the following reasons, returns to scale will start to diminish. Indivisible variables may
become less competitive and inefficient. Business may become unfavourable and cause
m
supervisory and teamwork problems.
Competition is perfect, bidding intensively increases wages, rent and interest. Raw
material costs also go up. Difficulties in transport and marketing arise. All of these factors
)A
tend to increase costs, and the company’s expansion leads to decreasing re-turns to
scale, so that doubling the scale would not lead to doubling the output.
Constant Returns to Scale

(c
Figure shows the case of constant returns to scale. Where the distance between the
isoquants 100, 200 and 300 along the expansion path OR is the same, i.e., OD = DE =

EF. It means that if units of both factors, labour and capital, are doubled, the output is
Notes
e
doubled. To treble the output, units of both factors are trebled.
in
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O
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●● 100 units of output require

●● 1 (2C + 2L) = 2C + 2L
s
●● 200 units of output require
●● (2C + 2L) = 4C + 4L
●●
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300 units of output require
●● (2C + 2L) = 6C + 6L
v
Returns to scale are constant when global econo-mies enjoyed by a business
are neutralized by global disease economies to increase production in the same ratio.
ni
Another explanation is for emerging economies and emerging disease economies to

balance out.
Constant returns to scale also result when production factors at given prices are
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perfectly divisible, replaceable, homogeneous and their supplies are perfectly elastic.
For this reason, the production function is homogeneous of degree one in the case of
constant returns to scale.
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2.2.1 Cost Function/ Cost Analysis

Cost functions are the derived functions. They are derived from the production
function, which describes the availability of efficient methods of production at any one
m
time. Economic theory distinguishes between short-run costs and long-run costs.
Short-run costs are the costs over a period during which some factors of production
(usually capital equipment and management) are fixed. The long-run costs are the costs
)A
over a period long enough to permit the change of all factors of production. In the long
run all factors become variable. Both in the short run and in the long run, total cost is a
multivariable function, that is, a total cost is determined by many factors.
Symbolically we may write the long run cost function as

(c
C = f (X, T, Pf) And the short – run cost function as C = f (X, T, Pf, K)

Where C = total costs X = output T = technology Pf = prices of factors K = fixed

Notes
e
factor(s)
in
2.2.2 Costs Relevant for Management Decision Making
Cost is the all monetary expenses incurred by the manufacturer to produce a goods
or services. In a business where selling and distribution expenses are quite nominal
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the cost of an article may be calculated without considering the selling and distribution
overheads.
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Real Cost
Real cost refers to the overall actual expense involved in creating a good or service
for sale to consumers. The real cost of production for a business typically includes the
value of all tangible resources such as raw materials and labor that are used in the
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production process.
The term “real cost of production” refers to the physical quantities of various factors
used in producing a commodity. For example, real cost of a table is composed of a
carpenter’s labour, two cubic feet of wood, a dozen of nails, half a bottle of varnish paint,
s
depreciation of carpenter’s tools etc., which go into the making of the table. Real cost,
thus, signifies the aggregate of real productive resources absorbed in the production of
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a commodity or service. The real cost of production of a commodity refers to the exertion
of labour, sacrifice involved in the abstinence from present consumption by the savers to
supply capital, and social effects of pollution, congestion, and environmental distortions.
v
Opportunity Cost
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Opportunity cost is the cost of any activity measured in terms of the value of the next
best alternative forgone. It is the sacrifice related to the second best choice available to
someone or group, who has picked among several mutually exclusive choices.
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The concept of opportunity cost is based on the scarcity and versatility

characteristics of productive resources. It is the most fundamental concept in economics.
It is a known economic fact that our wants are unlimited, while our resources are
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scarce but capable of alternative uses. So the problem of choice is involved. We have
to choose the use of a given resource for a particular purpose out of its alternative
applicability. When we choose the resource in one use to have one commodity for
satisfying a particular want, it is obvious that its other use as some other commodity
that can be produced by it cannot be available simultaneously. This means, the second
m
alternative use of the resources is to be sacrificed to have the resource employed in one
particular way, i.e., to get a particular commodity because the same resource cannot be
employed in two ways at the same time.
)A
Apparently, the employment of factors in producing a commodity always involves

the loss of opportunity of production of some other commodity. The sacrifice or loss of
alternative use of a given resource is termed as “opportunity cost.” Thus, the opportunity
cost is measured in terms of the forgone benefits from the next best alternative use of
(c
a given resource. In other words, the opportunity cost of producing a certain commodity
is the value of the other commodity that the resources used in its production could have
produced instead.

Importance of Opportunity Cost

Notes
e
The concept of opportunity cost has a great economic significance:
a) Determines the relative prices of goods: The concept of opportunity cost is useful in
in
explaining the determination of relative prices of different goods. For instance, if the
same group of factors can produce either one car or six scooters, then the price of one
car will tend to be at least six times more than that of one scooter.
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b) Determines the normal remuneration to a factor: The opportunity cost sets the value
of a productive factor for its best alternative use. It implies that if a productive factor
is to be retained in its next best alternative use, it must be compensated for or paid
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at least what it can earn from its next best alternative use. For instance, if a college
Professor can get an alternative employment in a bank as an officer at a salary of
Rs. 20,000 per month, the college has to pay at least Rs. 20,000 salary to retain him
in the college.
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c) Supports for decision making and efficient resource allocation: The concept of
opportunity cost is essential in rational decision making by the producer. This can
be explained with the help of an example. Suppose, a producer in the automobile
industry has to decide as to whether he should produce motor cars or scooters
s
out of his given resources. He can arrive at a rational decision by measuring the
opportunity costs of producing cars and scooters and making a comparison with the
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prevailing market prices of these goods. The concept of opportunity cost serves as a
useful economic tool in analyzing optimum resource allocation and rational decision
making.
v
Incremental Cost
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Incremental cost refers to the cost which is associated with one additional unit
of production. Incremental cost is also called as marginal cost. Incremental cost is
the overall change that a business experiences by producing one additional unit of
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goods. It refers to the difference between the total cost of the present unit and also the
previous unit.
Explicit Cost/Money Cost/Paid out Cost

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Cost of production measured in terms of money is called the money cost. Money
cost is the monetary expenditure on inputs of various kinds’ raw materials, labour etc.,
required for the output. It is the money spent on purchasing the different units of factors
of production needed for producing a commodity. Money cost is, obviously the payment
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made for the factors in terms of money. Money cost is the outlay cost, i.e., actual financial
expenditure of the firm.
The following items of a firm’s expenditure are explicit money costs:

)A
i) Costs of raw materials.

ii) Wages and salaries.
iii) Power charges.
(c
iv) Rent of business or factory premises

v) Interest payments of capital invested.

vi) Insurance premiums.

Notes
e
vii) Taxes like property tax, duties, license fees etc.
viii) Miscellaneous business expenses like marketing and advertising expenses,
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transport cost etc.
Implicit Costs/Self-owned Cost
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Implicit cost that is represented by lost opportunity in the use of a business’s own
resources, excluding cash. The implicit cost for a firm can be thought of as the opportunity
cost related to undertaking a certain project or decision, such as the loss of interest
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income on funds, or depreciation of machinery used for a capital project.
Implicit costs are the opportunity costs of the use of factors which a firm does not
buy or hire but already owns. Implicit costs are not directly incurred by the firm through
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market transactions, but nevertheless are to be reckoned in the measurement of total
money costs of production. These are to be imputed or estimated on the bases of the
opportunity costs, i.e., from what the factors owned by the firm itself could earn in their
next best alternative employment.
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Implicit money costs are imputed payment which is not directly or actually paid out by
the firm as no contractual disbursement is fixed for them. Such implicit money costs arise
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when the firm or entrepreneur supplies certain factors owned by himself. For instance,
the entrepreneur may have his own land in production, for which no rent is to be paid
in the actual sense. But this, however, is to be reckoned as a cost, assuming that if the
entrepreneur had rented this land to somebody, he would have definitely earned some
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rent. Hence, such rent is to be imputed and regarded as implicit money cost.
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Implicit costs are as follows:
●● Wages of labour rendered by the entrepreneur himself.

●● Interest on capital supplied by him.
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●● Rent of land and premises belonging to the entrepreneur himself and used in
the production.
●● Normal returns of entrepreneur, compensation needed for the management
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and organizational activity
Fixed Costs
Fixed costs are the amount spent by the firm on fixed inputs in the short run. Fixed
costs are those costs which remain constant, irrespective of the level of output. These
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costs remain unchanged even if the output of the firm is nil. Fixed costs, therefore, are
known as “supplementary costs” or “overhead costs.”
)A
Fixed costs are those costs that are incurred as a result of the use of fixed factor
inputs. They remain fixed at any level of output in the short run. Fixed costs, in the short
run, remain fixed because the firm does not change its size and amount of fixed factors
employed. Fixed costs usually include:
●● Payments of rent for building.

(c
●● Interest paid on capital.

●● Insurance premiums.
●● Depreciation and maintenance allowances.

Notes
e
●● Administrative expenses salaries of managerial and office staff etc.
●● Property and business taxes, license fees etc.
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Fixed costs may be classified into two categories:
i) Recurrent fixed costs are those which give rise to cash output as certain
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explicit payments like rent, interest on capital, general insurance premiums,
salaries of permanent irreducible staff etc. are to be made at a regular time-
interval by the firm.
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ii) The allocable fixed costs refer to implicit money costs like depreciation
charges which involve no direct cash outlays but are to be reckoned on the
basis of time rather than usage.
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Variable Costs
Variable costs are those costs that are incurred on variable factors. These costs vary
directly with the level of output. In other words, variable costs are those costs which rise
when output expands and fall when output contracts. When output is nil, they are reduced
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to zero.
Variable costs are those costs that are incurred by the firm as a result of the use of
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variable factor inputs. They are dependent upon the level of output. Variable costs are
frequently referred to as direct costs or prime costs. Briefly, variable costs or prime costs
represent all those costs which can be altered in the short run as the output alters. These
v
are regarded as “avoidable contractual costs”
The variable costs include:

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i) Prices of raw materials,

ii) Wages of labour,
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iii) Charges of fuel and power

iv) Excise duties, sales tax,
v) Transport expenditure etc
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m
)A
(c

The TVC curve starts from the origin representing the TVC will be zero if the output is
Notes
e
zero.
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2.2.3 Theory of Cost
Cost refers to the amount payable or relinquished to obtain some resource or
service. Costs can be described as a monetary value of the effort, materials, energy ,
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time and utilities expended, risks incurred and opportunities missed in the manufacture of
products or services.
Theory of Cost explores the cost concepts, costs in the long and short run and
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economies of scale. Cost theory differentiates between the short- and the long-term.
The short run is the duration over which all factors) are fixed; in the short run capital
equipment and entrepreneurship are generally treated as fixed.
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2.2.4 Long Run Cost and Short Run Cost
Long Run is a period of time in which all factors of production and costs are variable.
It is the time where the producer gets enough time to make all kinds of changes,
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adjustments and readjustments in the business and production process.
Characteristics of Long Run Costs

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1. The long run period is long enough to enable a firm to vary all of its factor inputs.
2. In the long run, a firm is not tied to a particular plant capacity. It can move from
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one plant capacity to another whenever it is obliged to do so in the light of
changes in product demand.
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3. The firm can expand its plant in order to meet the long term increase in demand
or reduce plant capacity if there is a demand fall.
4. In the long run, there are only the variable costs or direct costs as total cost.
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There is no dichotomy of total cost as in the long run there would not be any
fixed cost.
5. In the long run, to study the unit cost of a firm, long run average cost curve and
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the long run marginal cost curve are considered.
Nature and Behaviour of Long Run cost curves

Long run average cost curve is derived through short run average cost curves. Short
run cost curves are also called as plant curves. In the short run the firm can be operating
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on any short run average cost curves given the size of the plant. Given the size of the
plant, the firm will be increasing or decreasing its output by changing the amount of the
variable inputs. But in the long run, the firm chooses with which size of plants or on which
)A
short average cost curve it should operate to produce a given level of output so that total
cost is minimum. This may be depicted in the form of a diagram.
(c

Notes
e
in
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As shown in the diagram, to produce up to amount of output OB, the firm will
operate on the SAC1 though it can operate on SAC2 selecting SAC1 would results in
lower cost thanSAC2. For example, if the level of output OA is produced with SAC1,
it will cost AL per unit and same quantity is produced on SAC2 it will cost AH which is
s
more than AL. Similarly, if the firm plans to produce OC quantity, it will select SAC2 plant,
instead of SAC1, where cost is CK which is lesser than CJ. Hence in the long run the
er
firm has a choice in the employment of plant and it will employ that plant which yields
minimum possible unit cost for producing a given output.
Short Run
v
Short run is a period of time over which output can be changed by adjusting the
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quantities of resources such as labour, raw material, fuel but the size or scale of the firm
remains fixed. Short run is a period of time over which at least one factor must remain
fixed. For most of the firms the fixed resource or factors which cannot be increased to
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meet the rising demand of the good is capital i.e., plant and machinery. In other word,
short run is a period during which output can be changed by changing only variable
factors keeping variable factor remaining same
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2.2.5 Types of Cost

In economic analysis, the following types of costs are considered in studying costs
data of a firm:
λ Total Cost (TC)

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λ Total Fixed Cost (TFC)
λ Total Variable Cost (TVC)

)A
λ Average Fixed Cost (AFC)
λ Average Variable Cost (AVC)
λ Average Total Cost (ATC). and

(c
λ Marginal Cost (MC)

Total Cost (TC)

Notes
e
Total cost is the aggregate of expenditures incurred by the firm in producing a given
level of output. Total cost is measured in relation to the production function by multiplying
in
factors of prices with their quantities. If the production functions is: Q = f (a, b, c….n),
then total cost is TC = f (Q) which means total cost varies with output. For measuring
the total cost of a given level of output, thus, we have to aggregate the product of factors
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quantities multiplied by their respective prices. Conceptually, total cost includes all kinds
of money costs, explicit as well as implicit. Thus, normal profit is included in total cost.
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s ity
Normal profit is an implicit cost. It is a normal reward made to the entrepreneur for his
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organizational services. It is just a minimum payment essential to retain the entrepreneur
in a given line of production. If this normal return is not realized by the entrepreneur in
the long run, he will stop his present business and will shift his resources to some other
industry. A firm himself being the paymaster, cannot pay himself, thus the normal profit
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Is treated as implicit costs and adds to the total cost. In the short run, total costs may be
bifurcated into total fixed cost and total variable cost. Thus, total cost may be viewed as
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the sum of total fixed cost and total variable cost at each level of output.
Symbolically, TC = TFC + TVC.

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Total Fixed Cost (TFC)

Total fixed cost corresponds to fixed inputs in the short run production function. It is
obtained by summing up the product of quantities of the fixed factors multiplied by their
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respective unit prices. TFC remains the same at all levels of output in the short run.
Total Variable Cost (TVC)

Corresponding to variable inputs in the short-run production is the total variable cost.
m
It is obtained by summing up the product of quantities of input multiplied by their prices.

Again, TVC = F (Q) which means, total variable cost is an increasing function of output.
Suppose, if a shop proprietor starts with the production of chairs and he employs a
)A
carpenter on a wage of Rs. 200 per chair. He buys wood worth Rs. 2,000 rexine sheets
worth Rs. 1,500, spends Rs. 400 for other requirements to produce 3 chairs.
Then this total variable cost for producing 3 chairs is measured as Rs. 2,000 (wood
price) + Rs 1500 (rexine cost) + Rs. 400 (allied cost) + Rs. 600 (labour charges)
(c
= Rs. 4,500.

Average Fixed Cost (AFC)

Notes
e
Average fixed cost is total fixed cost divided by total units of output. AFC = TFC / Q
Where, Q stands for the number of units of the product. Thus, average fixed costs are the
in
fixed cost per unit of output.
For example: If TFC = 200 and Q = 10 then AFC = 20. Diagrammatically it may be
represented as follows
nl
O
s ity
Average Variable Cost (AVC)
Average variable cost is total variable cost divided by total units of output. AVC =
er
TVC / Q where, AVC means average variable cost. Thus, average variable cost is
variable cost per unit of output.
v
ni
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Hence, AC = AFC + AVC i.e., if we add together AFC and AVC we get Average Cost.
Hence Average cost can be represented in two ways:
m
)A
(c

Notes
e
AC = AFC + AVC or AC = TC/Q
Hence, AFC = TFC/Q or AC - AVC and similarly AVC = TVC/Q or AC - AFC.
in
Average Total Cost (ATC)
Average Total Cost or average cost is total cost divided by total units of output.
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Thus: ATC or AC = TC / Q
In the short run, since TC = TFC + TVC ATC = TC / Q = TFC + TVC / Q = (TFC / Q) +
(TVC / Q)
O
Since = TFC / Q = AFC and TVC /Q = AVC,
Therefore ATC = AFC + AVC.
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Marginal Cost (MC)
The marginal cost is also per unit cost of production. It is the addition made to the
total cost by producing one more unit of output. Symbolically, MCn = TCn –TCn – 1, that
is, the marginal cost of the nth unit of output is the total cost of producing n units minus
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the total cost of producing n – 1 (i.e. one less in the total) units of output.
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The marginal cost curve also assumes U-shape indicating that in the beginning, the
marginal cost declines as output expands thereafter it remains constant for a while and
then starts rising upward. Marginal cost is the rate of change in total costs when output is
increased by one unit. In a geometrical sense, marginal cost at any output is the slope of
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the total cost curve at the corresponding point.
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m
Apparently, the slope of the MC curve also reflects the law of diminishing returns.
In the short run, the marginal cost is dependent of fixed cost and is directly related to
)A
variable cost. Hence, the MC curve can also be derived from the TVC curve. In fact, the
TC and TVC curves have an identical slope at each level of output, because TC curve is
derived just by shifting TVC curve at TFC level. Thus, MC can be derived from the TVC
curve and AVC curve is also derived from the TVC curve.
(c
However, MC will not be the same as AVC. As a matter of fact, AVC curve and
MC curve are the reflection and the consequence of the law of non-proportional output
operating in the short run.

Thus, the AVC curve is exactly the reverse of AP, whereas MC curve is exactly the
Notes
e
reverse of MP curve. The marginal cost curve, the graphical relation between marginal
cost and output, is U-shaped. Marginal cost is relatively high at small quantities of
in
output, then as production increases, it declines, reaches a minimum value, then rises
once again. This U shape is directly attributable to increasing, then decreasing marginal
returns. As marginal produce increases for relatively small output quantities, marginal
cost declines. Then as marginal product decreases with the law of diminishing marginal
nl
returns for relatively large output quantities, marginal cost increases
2.2.6 Internal and External Economies and Dis-economies of Scale
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Economies of Scale
The economies of scale are the advantages arising from different scales or sizes
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of production. The economies can be classified into external economies and internal
economies.
External Economies Scale
s
External Economies are available to all firms in the region. In the external economies
the cost per unit depends on the size of the firm. E.g. Discovery of a new technology
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which can be purchased by all machine owners. These arise by expanding the size of an
industry. A technology can be implemented which may be advantageous to all firms in the
industry.
v
Internal Economies Scale:
Internal economies are the economies available to a particular firm and it gives the
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firm advantage over other firms in the industry. This arises by expanding the size of a
particular firm.
Here the cost per unit depends on the size of the firm. From the view point of
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management, internal economies are important and they can be affected by managerial
decisions whether to change its size or not. The following are the reasons for internal
economies:
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1. Labour Economies: If the division of labour is practised when the firm is

expanding its scale of operation then the firm can reduce the labour cost per
unit. A larger size firm may prefer to perform many activities manually. Labour
economies are more advantageous where a firm’s product is complex.
m
2. Technical Economies: They are very popular in countries like Japan and
Germany. High tech machines or an innovative technology can be used when
the size of the production is large scale. A small business cannot afford to invest
)A
in a costly technology. Hence the advantage of an innovative technology can be

benefitted only by a large sized firm
3. Managerial Economies: When the size of the firm increases a large number
of the managerial talent are drawn towards the business. More specialized staff
join the business and they take part in sharing their knowledge and ideas in the
(c
process of decision making.

4. Market Economies: Huge Firms have high volume of procurement and thereby
Notes
e
get a better purchase price. The price depends on the volume of purchase.
5. Economies of Vertical Integration: A firm may decide to have a vertical
in
integration. The integration helps them to have control over the activities.
Vertical integration may permit purchase for the firm from its own unit which
manufactures raw material. Vertical integration permits cost control as most of
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the cost becomes controllable cost of the enterprise.
6. Financial Economies: A large firm has sound financial economies. The fund
requirement is high and they are available at cheaper rates.
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7. Diversification: When there are many products the loss in one can be balanced
by the profit in the other.
8. Few firms enjoy the International Economies of scale: They are economies
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related to product development, purchase, production, demand fulfillment and
order fulfillment.
Diseconomies of Scale
An economic concept referring to a situation in which economies of scale no longer
s
function for a firm. Rather than experiencing continued decreasing costs per increase in
output, firms see an increase in marginal cost when output is increased. Diseconomies of
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scale are advantages that arise due to the expansion of production scale and lead to the
rise in the cost of production.
Some of the forces which cause a diseconomy of scale are listed below: Internal
v
Diseconomies:
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Like everything else, economies of scale have a limit too. This limit is reached when
the advantages of division of labor and managerial staff have been fully exploited; excess
capacity of plant, warehouses, transport and communication systems, etc is fully used;
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and economies in advertisement cost tapers off.
1. Managerial Inefficiency: Diseconomies arise first at the management level.

Managerial inefficiencies arise for the expansion of scale itself. With fast
expansion of production scale, personal contacts and communications between
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owners and managers, Managers and labor get rapidly reduced.

2. Labour Inefficiency: Another source of diseconomy is the overcrowding
of labor leading to a loss of control over labor productivity. Also, increase in
number of workers leads to increase in labor union activities which simply mean
m
the loss of output per unit of time and hence rise in the cost of production.
3. Duplication of effort: A firm with only one employee cannot have any
duplication of effort between employees. A firm with two employees could have
)A
duplication of efforts, but this is improbable, as the two are likely to know what
each other is working on at all times. When firms grow to thousands of workers,
it is inevitable that someone, or even a team, will take on a project that is already
being handled by another person or team.
(c
4. Office politics: “Office politics” is management behaviour which a manager

knows is counter to the best interest of the business, but is in his personal best
interest. For example, a manager might intentionally promote an incompetent

worker knowing that the worker will never be able to compete for the manager’s
Notes
e
job. This type of behavior only makes sense in a business with multiple levels of
management. The more levels there are, the more opportunity for this behaviour.
in
5. Top-heavy companies: The more employees a firm has, the larger percentage
of the workforce will be “management” (this refers to management of people, as
opposed to management of other resources). A business with a single worker
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doesn’t need any managers. A firm with five employees might employ one as a
manager and the other four as workers. If that manager does nothing other than
manage the workers under him, then the productivity of the firm will be reduced
by 20%. A firm with 20 employees might have 15 workers, 4 supervisors, and 1
O
manager. If neither the manager nor supervisors do anything but manage the
people under them, then we now have reduced productivity by 5/20 or 25%.
Thus, the larger the firm, the lower the percentage of “line workers”.
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6. Ringelmann effect: The Ringelmann effect is the tendency for individual
members of a production group to become increasingly less productive as the
size of group increases.
7. Cannibalization: A small firm only competes with other firms, but larger firms
s
frequently find their own products are competing with each other.
8. Slow response time: In a reverse example, the smaller firm will know
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immediately if people begin to request other products, and be able to respond
the next day. A large business would need to do research, create an assembly
line, determine which distribution chains to use, plan an advertising campaign,
v
etc., before any change could be made. By this time smaller competitors may
well have grabbed that market niche.
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9. Inertia (unwillingness to change): It can be defined as since we have always

done it that way, so there’s no need to ever change” attitude. Generally, an old
successful business is likely to have this attitude than a new, struggling one.
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While “change for change’s sake” is counter-productive, refusal to consider

change, even when indicated, is toxic to a business, as changes in the industry
and market conditions will inevitably demand changes in the firm, in order to
remain successful.
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10. Inelasticity of supply: A business which is heavily dependent on its resource

supply will have trouble increasing production. For instance a timber business
cannot increase production above the sustainable harvest rate of its land. Similarly
service companies are limited by available labor, STEM (Science, Technology,
m
Engineering, and Mathematics professions) being the most cited example
The curve in the economies

)A
The LAC curve is the mirror image of the returns to the scale in the long run. It is
apparent that since returns to the scale are based on the internal economies and the
diseconomies of scale, the long run average cost curve traces these economies of scale.
Economies of scale explain the falling segment of the LAC curve. This shows that the
decline average cost of output in the long run is due to economies of large scale enjoyed
by the firm. Increasing LAC is attributed to the diseconomies of scale after a certain
(c

point of further expansion. In short economies and diseconomies of large scale play
Notes
e
a significant role in determining the shape of the LAC curve. Again the structure of an
industry is also affected by the cost consideration which is conditioned by the economies
and diseconomies of scale.
in
Of the many determinants of the number and size of firms in an industry, the, cost
consideration and relevant economies and diseconomies are a significant determining
factor. Increasing average costs in the long run, attributed to the growing diseconomies
nl
of scale, set a limit to the further expansion of the firm. Economies and diseconomies of
scale reflect upon the behavior of LAC curve.
Analytically speaking the downward slope of the LAC curve may be attributed to the
O
internal economies of scale. Similarly, the upward slope of the LAC curve is caused by
the internal diseconomies of scale. And the horizontal slope of the LAC curve may be
explained in terms of the balance between internal economies and diseconomies.
s ity
v er
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In short, the internal economies and diseconomies have their significance in

determining the shape of the LAC curve of a firm. However, the shift in the LAC curve
may be attributed to the external economies and diseconomies. External economies
reflect in reducing the overall cost function of the firm. Thus, a downward shift in the
m
LAC may be caused by external economies as shown in following Figure. In above

figure, ABCD is the LAC curve. Its AB portion – the downward slope – is subject to the
internal economies. Its BC portion – the horizontal slope – is due to the balance between
economies and diseconomies. Its CD portion – the upward slope – is subject to internal
)A
diseconomies.
In following figure, the original LAC1 curve shifts downward as LAC2 on account of
external economies.
(c

Notes
e
in
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Similarly, an upward shift in the LAC curve may be attributed to the external
diseconomies, as shown in following figure.
s
v er
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In above figure, the original LAC1 curve shifts up as LAC2 owning to the external
diseconomies
2.2.7 Cost and Output Relation

m
The cost analysis relates to the cost-output ratio, i.e. the economists are concerned
with assessing the costs incurred in hiring the inputs and how well they can be rearranged
)A
in order to maximize the company’s efficiency (output). The relation between cost and its
determinants is technically described as the cost function.
C= f (S, O, P, T ….)
Where;
(c
●● C= Cost (Unit or total cost)

●● S= Size of plant/scale of production

●● O= Output level
Notes
e
●● P= Prices of inputs
●● T= Technology
in
2.2.8 An Analysis of the Objectives of a Business Firm: Profit
Maximization Model
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Economists have been using the model of profit maximization for a long time.
The ‘theory of firm’ has been developed on the basis of the assumption that rational
firms pursue the objective of profit maximization, subject to the technical and market
O
constraints. The basic propositions of the theory of firm may be summed up as:
(a) Firm is a unit that transforms valued inputs into outputs of a higher value, given
the state of technology.
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(b) The firm strives towards the achievement of objective ie. profit maximization.
(c) The market conditions (like competition, monopoly, etc.) for a firm to operate
are given.
(d) While choosing between alternatives, the firm prefers the alternative which
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helps it to consistently achieve profit maximization.
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(e) The primary concern of the theory of firm is to analyze changes in the price
and quantity of inputs and outputs. Taking these as central points, the theory of
firm has been carried to varying degrees of elaboration and refinement. Before
taking it up in detail, let us note the basic assumptions on which this theory
v
rests.
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Assumptions of the Model:

1. The firm has a single goal , viz., to maximize profit( Motivational assumption)
2. The firm acts rationally to pursue its goal. Rationality implies perfect knowledge of all
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relevant variables at the time of decision-making.

3. The firm is a single ownership one, i.e; run by its owner, called the entrepreneur
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The Model
The term ‘profit maximization’ is usually taken to mean the generation of largest
absolute amount of profits over the time period being analyzed. This then leads us to
defining the term ‘time period’. Economists have suggested two broad time period: the
m
short-run and long-run; consequently, there is short-run and long-run profit maximization.
The short run is defined as a period where adjustments to changed conditions are
only partial, e.g.; if defined for the product for a firm increases, in the short run it can
)A
meet the increased demand through changes in man-hours and intensive use of existing
machinery, but it cannot increase its production capacity. On the other hand, long-run is a
period where adjustment to changed circumstances is complete. For example, the above
mentioned firm can meet the increased demand in the long-run by making changes in its
production capacity or by setting up an additional plant, besides changes in manhours
(c
and intensive use of its existing machinery.

2.2.9 Baumoul’s Sales Maximization Model

Notes
e
Baumol pointed out that the oligopolistic firms aim is to maximize their sales revenue
not profit maximization. According to him, the reasons behind this are as follows:
in
λ Financial institutions judge the health of a firm largely in terms of the rate of growth
of its sales revenue.
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λ Salaries of top management are correlated more closely to the firm’s sales than
with its profits.
λ Growing sales help in keeping a healthy personnel policy, thus keeping employees
O
happy by giving them higher salaries and better terms.
λ Managers prefer the steady performance with satisfactory profits than spectacular
profit-maximization projects. This is so because if the managers declare their aim as
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spectacular profit maximization but, for obvious reasons, cannot give the spectacular
profit year after year, they shall be penalized for the non-achievement of the goal.
λ Large and growing sales by maintaining or increasing the market share of the firm
increases the competitive power of the firm.
s
Assumptions er
The firms while pursuing the goal of sales maximization cannot completely ignore
the shareholders. The goal of the firm is, thus, the maximization of sales revenue
subject to a minimum profit constraint. The profit constraint is determined by the
expectation of the shareholders and to enable it to raise new capital at a future date.
v
The assumptions are follows.
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1. Goal of the firm is sales maximization subject to minimum profit constraint.

2. There is a single period time horizon of the firm.
3. Advertisement is a major instrument of the firm as non-price competition is the
U
typical form of competition in oligopolistic markets.

4. Production costs are independent of advertisement.
5. Advertisement will always result in creating favourable conditions for the product.
ity
6. Price of the product is assumed as constant.

According to Baumol, it is only after the profit constraint has been satisfied that profits
became subordinate to sales in the firm’s hierarchy of goals. In the following figure, the
profit constraint is shown by a line π. Sales maximiser will keep on selling till the MR
m
remains positive.
The sales maximiser’s level of output would be OQ1 where MR (dTR / dQ) equal
)A
to zero. If the minimum profit constraint (π0 ) is above the level of profits where MR=0
(at point K1 ), the sales revenue maximiser is ‘constraint’ to stop at OQ3 output where
minimum profit constraint π0 is met. On the other hand, if minimum profit constraint is π
(which is less than the profits where MR=0) then the sales revenue maximiser will face no
‘profit constraint’ and would, therefore, produce OQ1 output. Thus, if the minimum profit
(c
constraint is less than the maximum profit, the sales maximiser will produce a greater
output than the profit maximiser.

Notes
e
in
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O
s ity
2.2.10 Marris’s Model Of ‘Managerial Enterprise
er
Marris sought to improve upon the concept of Baumol. He offered a variation of the
Baumol model which emphasized the maximization of growth subject to the position of
the management’s security. Marris’ theory is that executive decisions are constrained by
v
the need for management to defend itself in the event of a loss from dismissal or takeover
raids. Like Williamson, he also suggested that managers have a utility function in which
ni
salary, status, power, prestige and security are important variables. Owners of the firm
are more concerned about profits, market share, output etc. In other words, goals of the
managers and shareholders differ from each other.
U
The utility function of managers (Um) and that of the owners (Uo) may, therefore,
be defined as: Um = f (salaries, power, status, job security) And, Uo = f (profits, market
share, output, capital, public esteem).
ity
The executives aim to optimize the firm’s and shareholders’ growth rate in order to
increase their dividends and share prices. To create a correlation between such a growth
rate and the company’s share prices, Marris establishes a sustainable growth model in
which the manager selects a steady rate of growth at which the company’s revenue,
m
revenues, assets, etc. rise.
If a higher growth rate is chosen, then it is required to spend more on advertisement

and R & D in order to create more demand and new products. Therefore, the manager
)A
will retain a higher proportion of total profits for the expansion of the firm. Consequently,
profits to be distributed to shareholders in the form of dividends will be reduced and
the share prices will fall. The threat of take-over of the firm will loom large among the
managers.
(c
Assumptions
The Marris model is based on the following assumptions:

1. It assumes a given price structure

Notes
e
2. Production costs are given.
3. There is no oligopolistic interdependence.
in
4. Factor prices are constant.
5. Finns are assumed to grow through diversification.
nl
6. All major variables such as profits, sales and costs are assumed to increase at
the same rate.
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Criticisms
Marris’s growth-maximisation model has been severely criticised for its over-
simplified assump-tions by Koutsoyiannis and Hawkins.
ity
●● Marris assumes a given price structure for the firms and does not explain how
prices of products are determined in the market.
●● Another defect of this model is that it ignores the problem of oligopolistic
interdependenceof firms in non-collusive market.
s
●● This model also does not analyse interdependence created by non-price
competition.
●●
er
The model assumes that firms can grow continuously by creating new
products. This is unre-alistic because no firm can sell anything to the
consumers. After all, consumers have their preferences for certain brands
v
which also change when new products enter the market.
●● Marris lumps together the advertising and R&D expenses in his model. This
ni
is a serious shortcoming of the model because the effectiveness of these two

variables is not the same in any given period.
●● Marris assumes that firms have their own R&D department on which they
U
spend much for creating new products. But, in reality, most firms do not have
such departments. For product diversification, they imitate the inventions of
other firms and in case of patented inventions they pay royalties for using
them.
ity
●● The assumption that all major variables such as profits, sales and costs
increase at the same rate is highly unrealistic. It is also doubtful that a firm
would continue to grow at a constant rate, as assumed by Marris. The firm
might grow faster now and slowly later on.
m
●● It is difficult to arrive at the growth rate which maximises the market value of
the firm’s shares and the rate at which the take-over is likely to take place.
)A
2.2.11 Williamson’s Model Of ‘Managerial Discretion

Williamson has developed managerial-utility-maximisation theory as against profit
maximisation. Williamson claims that executives have discretion in following strategies
that maximize their own usefulness rather than seeking to maximize income that
maximize owner-shareholders’ usefulness.
(c
Shareholders and executives of major companies are two distinct categories. The
shareholders want the full return on their investment and, therefore, income maximisation.
The executives, on the other hand, take into account their utility functions other than
Notes
e
benefit maximisation. Thus managers are not only interested in their own emoluments
but also in the size of their employees and their expenditure on them. Profits serves as
in
a limitation to this managerial behavior, given that the stock market and shareholders
demand the payment of a minimum income given the form of dividends, otherwise
managers’ job security is in danger.
nl
The model is stated as –
Maximize – U = ƒ(S, ID) subject to – Π > Π0 + T
O
Since there are no emoluments, discretionary investment absorbs all the
discretionary profit. Thus we may write the managerial utility function as
U = ƒ[S, (Π – Π0 – T)]
ity
For simplicity we may assume that there is no lump-sum tax so that T = t Π. Thus the
managerial utility function becomes
U =ƒ [S, (1 – t) Π – Π0] where (1 — r)Π — Π0 = ΠD is the discretionary profit.
s
Key Takeaways:
●● Production: Transformation of inputs into output
●●
er
Inputs: Resources used in the production of goods and services.
●● Isoquants: These are a geometric representation of the production function.
v
●● Kinked isoquant: This assumes limited substitutability of capital and labour.
●● Marginal rate of substitution: It is defined as the number of units of input that a
ni
producer is willing to sacrifice for an additional unit.

●● Law of variable proportions: refers to how the marginal production of a factor of
production starts to progressively decrease as the factor is increased.
U
●● Law of returns to scale: it explains the changes in production that occur when all
resources are proportionately changed in the long run
●● Production function: A function that states the maximum amount of an output
ity
that can be produced with a certain combination of inputs, within a given period of
time and with a given level of technology.
●● Long-run: The time period when all inputs become variable.
●● Short-run: The time period during which at least one input is fixed.
m
●● Variable inputs: Inputs that can be varied easily and on very short notice
●● Actual costs: Actual expenditure incurred for acquiring or producing a good or
)A
service.
●● Direct costs: Costs which can be directly attributed to the production of a unit of a
given product.
●● Explicit costs: Expenses which are actually paid by the firm
(c
●● Fixed factors: Factors such as capital equipment, building, top management

personnel which cannot be readily varied with the change in output.

●● Implicit costs: Theoretical costs which go unrecognized by the accounting

Notes
e
system.
●● Indirect costs: Costs which cannot be separated and clearly attributed to individual
in
units of production.
●● Opportunity costs: The return from the second best use of the firm’s resources
which the firm forgoes in order to avail itself of the return from the best use of the
nl
resources.
●● Variable costs: Costs which are incurred on the employment of variable factors of
production whose amount can be altered in the short-run.
O
●● Variable factors: Factors such as labour, raw materials, chemicals which can be
readily varied with the change in output.
ity
Check your progress
1. Function specifying output of a firm, an industry, or an entire economy for all
combinations of inputs.
a) Income function
s
b) Cost function er
c) Production function
d) Sales function
2. ______________________ indicates all possible combinations of two inputs which
v
can be purchased with a given amount of investment fund
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b) Isoquant
c) Iso cost line
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d) Price elasticity
3. _____________________ cost is the overall actual expense involved in creating a
good or service for sale to consumers
ity
a) Fixed cost
b) Labour cost
c) Real cost
m
d) Material cost
4. The cost of any activity measured in terms of the value of the next best alternative
forgone is
)A
a) Fixed cost
b) Opportunity cost
c) Real cost
(c
d) Material cost

5. Which line is also known as scale line ?

Notes
e
a) Expansion path
b) Isoquant line
in
c) Isocost line
d) Price line
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1. Differentiate between Individual Short run vs. Long run
O
2. What are the various factors of production?
3. What are isocosts and isocost line?
4. Explain Returns to scale and returns to a factor
ity
5. Describe various types of costs relevant to decision making.
Check your progress

1. c) Production function
s
2. c) Iso cost line er
3. c) Real cost
4. b) Opportunity cost
5. a) Expansion path
v
Further Readings
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Edition, 2015.
U

ity
Bibliography
Publications.
m

)A
Companies.
6. Paul A. Samuelson, William D. Nordhaus, Sudip Chaudhuri and Anindya Sen,
(c

Module-3: Market Structure: Prices and Output

Notes
e
Decisions
in
Learning Objective:
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●● Explain market structures, including perfect competition, monopolistic competition,
oligopoly, and pure monopoly and know the market structure under which a firm
operates
O
●● Understand relationships between price, marginal revenue and cost, economic
profit, and elasticity of demand for each of these market structures
●● Explain a firm’s supply function for each market structure
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●● Explain and calculate the profit maximizing price and output for firms under each
market structure
●● Explain pricing strategy in each market structure
s
●● Understand the effects of demand changes, firm exit and entry, and other factors
on long-run equilibrium for each market structure
er
●● Explain how concentration measures are used in identifying market structures, and
their limitations
Learning Outcome:
v
In this module, we have discussed about:
ni
●● The model of perfect competition and move on to what many consider the
antithesis of perfect competition, the monopoly model.
●● Imperfect competition and two models that fall under it: monopolistic competition
U
and oligopoly.
●● Game theory, the prisoner’s dilemma model and the Nash equilibrium.
●● Pricing strategy in each market structure
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“The more nearly perfect a market is the stronger is the tendency for the
same price to be paid for the same thing at the same time in all parts of the
market”.
m
Prof. Marshall
3.1.1 Perfect and Imperfect Competition

)A
Perfect competition is a market structure characterized by a complete absence of

rivalry among the individual firms. Thus perfect competition in economic theory has a
meaning diametrically opposite to the everyday use of this term. In practice businessmen
use the word competition as synonymous to rivalry. In theory perfect competition implies
(c
no rivalry among firms.

Assumptions of Perfect competition

Notes
e
(1) All firms maximize profits
(2) There is free entry and exit to the market,
in
(3) All firms sell completely identical (i.e. homogenous) goods,
(4) There are no consumer preferences. By looking at those assumptions it
nl
becomes quite obvious, that we will hardly ever find perfect competition in
reality. This is an important aspect, because it is the only market structure that
can result in a socially optimal level of output.
O
3.1.2 Perfect Competition - How price is Decided, What are the
Features and Examples
Perfect competition describes markets such that no participants are large enough
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to have the market power to set the price of a homogeneous product. Because the
conditions for perfect competition are strict, there are few if any perfectly competitive
markets. Still, buyers and sellers in some auction-type markets say for commodities or
some financial assets may approximate the concept. Perfect competition serves as a
s
benchmark against which to measure real-life and imperfectly competitive markets.
A perfectly competitive market

er
A perfectly competitive market is a hypothetical market where competition is at its
greatest possible level. Neo-classical economists argued that perfect competition would
v
produce the best possible outcomes for consumers, and society.
Definition of Perfectly Competitive Market

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According to Prof. Marshall, “The more nearly perfect a market is the stronger is the
tendency for the same price to be paid for the same thing at the same time in all parts of
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the market”.
According to Prof. Benham, “A market is said to be perfect when all the potential
sellers and buyers are promptly aware of the price at which transactions take place and
all of the offers made by other sellers and buyers and when any buyer can purchase from
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any seller and vice-versa”.
Characteristics of Perfectly Competitive Market

Perfectly competitive markets exhibit the following characteristics:
m
i) Infinite buyers and sellers: Infinite consumers with the willingness and ability
to buy the product at a certain price, and infinite producers with the willingness
and ability to supply the product at a certain price.
)A
ii) Zero entry and exit barriers: It is relatively easy for a business to enter or exit
in a perfectly competitive market.
iii) Perfect factor mobility: In the long run factors of production are perfectly
mobile allowing free long term adjustments to changing market conditions.
(c
iv) Perfect information: Prices and quality of products are assumed to be known
to all consumers and producers.

v) Zero transaction costs: Buyers and sellers incur no costs in making an

Notes
e
exchange (perfect mobility).
vi) Profit maximization: Firms aim to sell where marginal costs meet marginal
in
revenue, where they generate the most profit.
vii) Homogeneous products: The characteristics of any given market good or
service do not vary across suppliers.
nl
viii) Non-increasing returns to scale: Non-increasing returns to scale ensure that
there are sufficient firms in the industry.
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Price and Output Determination
Quantity demanded and quantity supplied varies with price, and the equilibrium price
is determined at the point where quantity demanded and quantity supplied is equal. If the
ity
equality between quantity demanded and quantity supplied doesn’t hold for some price,
buyer’s and seller’s desire are inconsistent. In case of either quantity demanded by the
buyers is more than that offered by the sellers or the quantity supplied by the sellers is
greater than the quantity demanded by the buyers the price will change so as to bring
about equality between quantity demanded and quantity supplied.
s
Short run equilibrium
er
In the short run, individual firm under perfect competition may either earn
supernormal profit or normal profit or can incur losses. This depends on the short run cost
curves. These three possibilities are shown by the three short run equilibrium of a firm.
v
Supernormal profit
ni
In the short run a perfectly competitive firm can earn supernormal profits which
means revenue more than cost. The average cost (AC) and marginal cost (MC) curves
are the usual short run cost curves. As the firm maximizes profits at the point where MR =
U
MC and also where MC cuts MR from below, the point of equilibrium of the firm in figure is
at point E, output at this price is OQ* and equilibrium price is P*. The total revenue earned
by the firm is given by the rectangular area OP* EQ*. to produce this output, the total cost
incurred by the firm is given by the rectangular area OABQ*. Therefore, profit earned by
ity
the firm is given by the rectangular region AP*EB. This is the supernormal profit earned by
the firm in the short run, because the market price is greater than the average cost
m
)A
(c

Normal profit
Notes
e
In the short run, it is not possible to earn supernormal profit by all the firms, some of
them may also earn normal profits, which means revenue is equal to cost. Like pervious
in
case, the equilibrium of the firm is shown as E in the figure, the output that maximizes is
OQ*. The total revenue earn by the firm is the rectangular area OP* EQ*, which is also
the total cost of producing the equilibrium output OQ*. Therefore, in this case, the firm
nl
makes normal profit which means no profits. This is possible because the average cost
curve is tangent to the average revenue line.
O
s ity
v er
Loss or Subnormal profit
ni
Here also the equilibrium point E determines the equilibrium level of output OQ* and
price OP*. The total revenue is given by rectangular area OP* EQ* and total cost is the
rectangular OABQ*, which is more than the total revenue by the amount is equivalent to
U
the rectangular area P*ABE. This extra amount of cost incurred by the firm is called loss
or profit, which occurs in the short run because the average cost is more than the market
price.
ity
m
)A
(c

Long Run Equilibrium

Notes
e
In the long run perfectly competitive firms earn only normal profits. This is due to the
unrestricted entry into and exit of firms from the industry in the long run. Let us explain
in
this with two extreme possibilities: first, when existing firms enjoy supernormal profits in
the short run, and next, when the existing firms incur losses in the short run. If some of
the existing firms earn supernormal profit, this attracts new firms to the industry to share
nl
the profits. With the entry of new firms, the supply of goods increases in the market.
Assuming no change in the demand side, this extra supply of the good lowers the price
of the good. This process of adjustment continues till the price becomes equal to the long
run average cost. Due to this, supernormal profit of the existing firms is squeezed until all
O
the firms in the industry earn normal profit.
Alternatively, if the firms are making losses in the short run, then they may not be
able to sustain for long time and as a result they will exit from the industry. After this exit,
ity
the supply of the product in the industry reduces and as a result the equilibrium price
in the industry rises. This process of adjustment continues up to the point where the
marginal firms no longer earn losses. Thus perfectly competitive firms earn only normal
profit in the long run where P= MC=MR=LAC = AR.
s
v er
ni
U
ity
3.1.3 Monopoly - How Price is Decided, what are the Features and
Examples
Monopoly is a market in which a single seller sells a product or service which has
m
no substitute. Economists distinguished between pure monopoly and monopoly. Pure

monopoly is that market situation in which there is absolutely no substitute of the product,
and the entire market is under control of a single firm. A monopoly exist if there is no
)A
close substitute to the product and also when there is a single producer and seller of the
product, like Indian Railways, but it has a very remote substitute in the market, like Buss
services, Flights etc.
Definition of Monopoly
(c
According to Prof. Thomas, “Broadly, the term Monopoly is used to cover any
effective price control, whether of supply or demand of services or goods; narrowly it is

used to mean a combination of manufacturers or merchants to control the supply price of

Notes
e
commodities or services”.
According to Prof. Chamberlain, “Monopoly refers to the control over supply”.
in
According to Prof. Robert Triffin, “Monopoly is a market situation in which the firm is
independent of price changes in the product of each and every other firm”.
nl
Characteristics of Monopoly
The characteristics of Monopoly are as follows:
O
1. Single Seller
Under monopoly, there is a single producer of a particular commodity or service in
the market accruing to a rather large number of buyers. The mono manufacturer may be
ity
an individual, a group of partners or a joint stock business or state, being the only source
of supply for the goods or services with no close substitute. In this market structure, the
firm is the industry and, thus, the market is referred to as ‘pure monopoly’, but, it is more
of a theoretical concept. At times, close substitutes are produced by few manufactures
holding a substantial market share and this imperfect form of extreme market is termed as
s
monopolistic competition. er
2. Restricted Entry
Free entry of new organizations in this market arrangement is prohibited, that
is, other sellers cannot enter the market of monopoly. Few of the primary barriers,
v
constricting the entry of new sellers are:
ni
●● Government license or franchise

●● Resource ownership
●● Patents and copyrights
U
●● High start-up cost

●● Decreasing average total cost
●● Homogeneous Product
ity
A monopoly firm manufactures a commodity that has no close substitute and is a

homogeneous product. With the absence of availability of a substitute, the buyer is bound
to purchase what is available at the tagged price. For instance: there is no substitute for
railways as the ‘bulk carrier’. Thus, to be the sole seller, in the monopolistic setup, a
m
unique product must be produced.
3. Full Control over Price

)A
In a monopoly market, restricted entry constricts competition and the monopolist

exhibits full control over the market conditions. The absence of competition spares the
monopolizing business from price pressure and grants him the opportunity to charge
the product as per his advantage, targeting profit maximizing via predetermined quantity
choice. Thus, a monopolist is a ‘price maker’ and not a ‘price taker’, wherein he decides
(c
the price and the buyers has to accept it. Nevertheless, to evade the entry from new
market participants, the business needs to regulate the set product or service price within
the paradigms of the Monopoly Theorem.
4. Price Discrimination
Notes
e
Price discrimination can be defined as the ‘practice by a seller of charging different
prices from different buyers for the same good or service’. A monopolist has the leverage
in
to carry out price discrimination as he is the market and acts as per his suitability.
5. Increased Scope for Mergers
nl
The scope for vertical and/or horizontal mergers is increase in lieu of control
exhibited by a single entity under a monopoly. The mergers efficiently absorb competition
and maintain the supply chain management.
O
6. Price Elasticity
With regards to the demand of the product or service offered by the monopolizing
business or individual, the price elasticity to absolute value ratio is dictated by price
ity
increase and market demand. It is not uncommon to see surplus and/or a loss
categorized as ‘deadweight’ within a monopoly. The latter refers to gain that evades both,
the consumer and the monopolist.
s
7. Lack of Innovation
On account of solitary market domination, monopolies exhibit an inclination towards
er
losing efficiency over a period of time. The new designing and marketing dexterity also
takes a back seat.
8. Lack of Competition
v
When the market is designed to serve a monopoly, the lack of business competition
ni
or the absence of viable goods and products shrinks the scope for ‘perfect competition’.
Being the sole merchant of an eccentric good with no close imitation, a monopoly has
no opposition. The demand for turnout induced by a monopoly is the market demand,
adhering extensive market control. The incompetence resulting from market dominance
U
also makes monopoly a key type of market failure.
Price-Output Determination under Monopoly

ity
A monopolist firm will be in equilibrium where MR = MC and MC is rising. Like

perfectly competitive firms, monopolist firm also may earn supernormal profit or normal
profit or subnormal profit (loss) in the short run.
m
)A
(c

In the above diagram, a monopolist firm is in equilibrium at point E where MR equal

Notes
e
to MC and MC is rising. In equilibrium, the firm sells OQ amount of output at price OP,
so the total revenue is equal to the area OPCQ. The total cost is the area OABQ and
in
the total profit (supernormal) is the difference of total revenue and total cost, i.e. the area
APCB.
Normal Profit
nl
In the diagram given below, a monopolist firm is in equilibrium at point E where MR
equal to MC and Mc is rising. In equilibrium, the firm sells OQ amount of output at price OP,
so the total revenue is equal to the area OPCQ, which is also the total cost of the firm and
O
the total profit (normal) is the difference of total revenue and total cost, i.e. here nil or zero.
s ity
v er
Subnormal Profit or Loss
ni
U
ity
m
)A
In the above diagram, a monopolist firm is in equilibrium at point E where MR equal

to MC and MC is rising. In equilibrium, the firm sells OQ amount of output at price OP, so
the total revenue is equal to the area OPCQ. The total cost is the area OABQ which is
greater than the total revenue, so the total loss (subnormal) is the difference of total cost
and total revenue, i.e. the area PABC.
(c

3.1.4 Ist Degree Price Discrimination- How Price is Decided, What

Notes
e
are the Features and Examples
Price discrimination can be defined as the ‘practice by a seller of charging different
in
prices from different buyers for the same good or service’. A monopolist has the leverage
to carry out price discrimination as he is the market and acts as per his suitability.
There are many forms of price discrimination, but mainly three types or degrees of
nl
discrimination and they are First-degree, Second-degree and Third-degree discrimination.
The first degree price discrimination involves charging the maximum price possible
for each unit of output. Thus the consumer who attaches the greatest value to the product
O
is identified and charged a price of P1 . Similarly, the consumers are willing to pay P2 for
second unit and P3 for third unit. Here, the MR curve coincides with the demand curve
and the profit maximizing output is where MC and the demand curve intersect, i.e., at
point B.
s ity
v er
ni
3.1.5 IInd Degree Price Discrimination- How Price is Decided, What

U

Second-degree price discrimination involves pricing based on the quantities of output
purchased by individual consumers. In the following diagram, the first Q1 units sold at P1
ity
price and the next (Q2 -Q1 ) units sold at P2 price etc.
m
)A
(c

3.1.6 IIIrd Degree price Discrimination- How Price is Decided, what

Notes
e
Third-degree price discrimination is the most common form of price discrimination.
in
It involves separating consumers or markets in terms of their price elasticity of
demand. This segmentation can be based on several factors. Often third degree price
discrimination occurs in the markets that are geographically separated. Let us consider
nl
an example. It is often seen that books of US publication are sold in other countries at a
lower price compared to US evidently; buyers in other countries have greater elasticity
of demand than do US buyers. At the same time, cost of collecting and shipping books
make it unprofitable for other firms to buy in foreign countries and resell in the United
O
States.
3.1.7 Monopolistic Competition - How Price is Decided, what are the
ity
Features and Examples?
Monopolistic competition is the market structure similar to perfect competition, where
the vigorous price competition among a large number of firms and individuals is present.
The major difference between these two market structures is that at least some degree of
s
product differentiation is present in monopolistically competitive markets. As a result, firms
have at least some discretion in setting prices. However, the presence of many close
er
substitutes limits the price-setting ability of individual firms, and drives profits down to a
normal rate of return in the long-run. As in the case of perfect competition, above normal
profits are only possible in the short-run before rivals are able to take effective counter
measures.
v
Examples of monopolistically competitive market structures include a broad range
ni
of industries producing clothing, consumer financial services, professional services,

restaurants, and so on. The conditions which prevail in a monopolistic competitive market
can be summarized as follows:
U
1. There are relatively large numbers of firms, each satisfying a small, but not
microscopic, share of the market demand for similar, but not identical, products.
2. The product of each firm is not a perfect substitute for the products of product
ity
group represents several closely related, but not identical, products that serve
the same general purpose for consumers. The sellers in each product group
can be considered competing firms within the industry.
3. The firms in the market do not consider the reactions of their rivals when
choosing their product prices or annual sales targets.
m
4. Relative freedom of entry and exit of firms exist in monopolistically competitive

markets.
)A
5. Neither the opportunity nor the incentive exists for the firms in the market to
cooperate in ways that decrease competition.
Features of Monopolistic Competition

Following are the features of a monopolistic competitive market:
(c
i) Large number of firm: Monopolistic competition is characterized by large

number of firms producing close substitutes but not identical product. Each

firm must control a small yet significant portion of the market share such that
Notes
e
by substantially extending or restricting its own sales, it is not able to affect
the sales of any other individual seller. This condition is the same as in perfect
market.
in
ii) There is product differentiation: No seller has full control over the market
supply. Each seller produces very close substitute products. The product is
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neither identical nor markedly different. Since every seller produces slightly
differentiated product, each seller has minor control over the price. Unlike
perfect market conditions, the firm is a price – maker to some extent. That is, a
firm can change the price slightly, though not much. The control over price will
O
depend on the degree of product differentiation.
iii) Absence of Inter-dependence: Existence of a large number of firms insures
the condition too large and too small. Thus, the individual firm’s supply is small
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constituent of total supply. Therefore, individual firm has limited control over price
level. Similarly, each firm can decide, its price or output policies independently
through price discrimination, any action by one firm may not invite reaction from
rival firms.
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iv) Selling cost: Competitive advertisement is an essential feature of monopolistic
competition. Selling cost becomes an integral part of the marketing of firms when
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product is differentiated. It is necessary to tell the buyers about the superiority
of the product and induce the customer to buy the products. However, the
presence of many close substitutes limits the price-setting ability of individual
firms, and drives profits down to a normal rate of return in the long-run. As in
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the case of perfect competition, above-normal profits are only possible in the
short-run before rivals are able to take effective counter measures. Examples
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of monopolistically competitive market structures include a broad range of

industries producing clothing, consumer financial services, professional
services, restaurants, and so on.
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v) Free entry and exit: Under monopolistic competition, new firm firms can exit.
There are no restrictions on entry or exit of the small size of firms. Existence of
supernormal profit attracts entry loss, business firms to quit the market.
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Price and Output Determination in short Run

In a monopolistic competition, every firm has a certain degree of monopoly power i.e.
every firm can take initiative to set a price. Here, the products are similar but not identical,
therefore there can never be a unique price but the prices will be in a group reflecting
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the consumers’ tastes and preferences for differentiated products. In this case the price
of the product of the firm is determined by its cost function, demand, its objective and
certain government regulations, if there are any. As the price of a particular product of a
)A
firm reduces, it attracts customers from its rival groups. Say for example, if ‘Samsung’ TV
reduces its price by a substantial amount or offers discount, then the customers from the
rival group who have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung’ TV sets. As
discussed earlier, the demand curve is highly elastic but not perfectly elastic and slopes
downwards. The market has many firms selling similar products, therefore the firm’s
(c
output is quite small as compared to the total quantity sold in the market and so its price
and output decisions go unnoticed. Therefore, every firm acts independently and for a

given demand curve, marginal revenue curve and cost curves, the firm maximizes profit
Notes
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or minimizes loss when marginal revenue is equal to marginal cost. Producing an output
of Q selling at price P maximizes the profits of the firm.
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In the short run, a firm may or may not earn profits. The equilibrium point for the
firm is at price P and quantity Q and is denoted by point A. Here, the economic profit is
given as area PAQR. The difference between this and the monopoly case is that here the
barriers to entry are low or weak and therefore new firms will be attracted to enter. Fresh
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entry will continue to enter as long as there are profits. As soon as the super normal profit
is competed away by new firms, equilibrium will be attained in the market and no new
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firms will be attracted in the market. This is the situation corresponding to the long run and
is discussed in the next section.
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Price and Output Determination in long Run

The difference between monopolistic competition and perfect competition is that in
monopolistic competition the point of tangency is downward sloping and does not occur
at minimum of the average cost curve and this is because the demand curve is downward
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sloping.
Under monopolistic competition in the long run we see that LRAC is the long run
average cost curve and LRMC the long run average marginal curve. Let us take a
hypothetical example of a firm in a typical monopolistic situation where it is making
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substantial amount of economic profits.
It is assumed that the other firms in the market are also making profits. This situation
)A
would then attract new firms in the market. The new firms may not sell the same products
but will sell similar products. As a result, there will be an increase in the number of close
substitutes available in the market and hence the demand curve would shift downwards
since each existing firm would lose market share. The entry of new firms would continue
as long as there are economic profits. The demand curve will continue to shift downwards
(c
till it becomes tangent to LRAC at a given price P1 and output at Q1 as shown in the
figure. At this point of equilibrium, an increase or decrease in price would lead to losses.
In this case the entry of new firms would stop, as there will not be any economic profits.

Notes
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Due to free entry, many firms can enter the market and there may be a condition
where the demand falls below LRAC and ultimately suffers losses resulting in the exit of
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the firms. Therefore under the monopolistic competition free entry and exit must lead to a
situation where demand becomes tangent to LRAC, the price becomes equal to average
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cost and no economic profit is earned. It can thus be said that in the long run the profits
peter out completely. One of the interesting features of the monopolistically competitive
market is the variety available due to product differentiation. Although firms in the long
run do not produce at the minimum point of their average cost curve, and thus there is
v
excess capacity available with each firm, economists have rationalized this by attributing
the higher price to the variety available. Further, consumers are willing to pay the higher
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price for the increased variety available in the market.
3.1.8 Oligopoly - How Price is Decided, What are the Features and
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Examples
Oligopoly is a market structure, in which a few sellers dominate the sales of a
product and the entry of new sellers is difficult or impossible. The product can be
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either differentiated or standardized. Automobiles, cigarettes, beer and chewing gum

are examples of differentiated products, whose market structures are oligopolistic.
Oligopolistic markets are characterized by high market concentration.
Definition of Oligopoly
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According to Mrs. John Robinson, “Oligopoly is market situation in between

monopoly and perfect competition in which the number of sellers is more than one but is
not so large that the market price is not influenced by any one of them”.
)A
According to Prof. George J. Stigler, “Oligopoly is a market situation in which a

firm determines its marketing policies on the basis of expected behaviour of close
competitors”.
According to Prof. Stoneur and Hague, “Oligopoly is different from monopoly

(c
on one hand in which there is a single seller, on the other hand, it differs from perfect
competition and monopolistic competition also in which there is a large number of

sellers. In other words, while describing the concept of oligopoly, we include the concept
Notes
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of a small group of firms.
Characteristics of Oligopoly
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●● Interdependence: The firms under oligopoly are interdependent in making
decision. They are interdependent because the number of competition is few
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and any change in price & product etc. by a firm will have a direct influence
on the fortune of its rivals, which in turn retaliate by changing their price and
output. Thus under oligopoly a firm not only considers the market demand for
its product but also the reactions of other firms in the industry. No firm can
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fail to take into account the reaction of other firms to its price and output
policies. There is, therefore, a good deal of interdependences of the firm
under oligopoly.
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●● Importance of advertising and selling costs: The firms under oligopolistic
market employ aggressive and defensive weapons to gain a greater share
in the market and to maximise sale. In view of this firms have to incur
a great deal on advertisement and other measures of sale promotion.
Thus advertising and selling cost play a great role in the oligopolistic
s
market structure. Under perfect competition and monopoly expenditure on
advertisement and other measures is unnecessary. But such expenditure is
the life-blood of an oligopolistic firm.
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●● Group behaviour: Another important feature of oligopoly is the analysis -of
group behaviour. In case of perfect competition, monopoly and monopolistic
v
competition, the business firms are assumed to behave in such a way as to
maximize their profits. The profit-maximizing behaviour on his part may not be
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valid. The firms under oligopoly are interdependent as they are in a group.
●● Indeterminateness of demand curve: This characteristic is the direct
result of the interdependence characteristic of an oligopolistic firm. Mutual
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interdependence creates uncertainty for all the firms. No firm can predict the
consequence of its price-output policy. Under oligopoly a firm cannot assume
that its rivals will keep their price unchanged if he makes charge in its own
price. The demand curve as is well known, relates to the various quantities
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of the product that could be sold it different levels of prices when the quantity
to be sold is itself unknown and uncertain the demand curve can’t be definite
and determinate.
●● Elements of monopoly: There exist some elements of monopoly under
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oligopolistic situation. Under oligopoly with product differentiation each firm

controls a large part of the market by producing differentiated product. In such
a case it acts in its sphere as a monopolist in lining price and output.
)A
●● Price rigidity: Under oligopoly there is the existence price rigidity. Prices lend
to be rigid and sticky. If any firm makes a price-cut it is immediately retaliated
by the rival firms by the same practice of price-cut. There occurs a price-war in
the oligopolistic condition. Hence under oligopoly no firm resorts to price- cut
without making price-output decision with other rival firms. The net result will
(c
be price -finite or price-rigidity in the oligopolistic condition.

Causes of Oligopoly
Notes
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1. Economies of scale: The firms in the industry, with heavy investment, using
improved technology and reaping economies of scale in production, sales,
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promotion, etc., will compete and stay in the market.
2. Barrier to entry: In many industries, the new firms cannot enter the industry
as the big firms have ownership of patents or control of essential raw material
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used in the production of an output. The heavy expenditure on advertising by
the oligopolistic industries may also be a financial barrier for the new firms to
enter the industry.
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3. Merger: If the few firms in the industry smell the danger of entry of new firms,
they then immediately merge and formulate a joint policy in the pricing and
production of the products. The joint action of the few big firms discourages the
entry of new firms into the industry.
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4. Mutual interdependence: As the number of firms is small in an oligopolistic
industry, therefore, they keep a strict watch of the price charged by rival firms in
the industry. The firm generally avoids price ware and tries to create conditions
of mutual interdependence.
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3.1.9 Models of Oligopolistic Market: Price Rigidity-- The Kinky
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Demand Curve Model Interdependence-- The Cournot Model
Kinky Demand Curve

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The kinky demand curve model tries to explain that in non-collusive oligopolistic
industries there are not frequent changes in the market prices of the products. The
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demand curve is drawn on the assumption that the kink in the curve is always at the ruling
price. The reason is that a firm in the market supplies a significant share of the product
and has a powerful influence in the prevailing price of the commodity. Under oligopoly, a
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firm has two choices:
(a) The first choice is that the firm increases the price of the product. Each firm in
the industry is fully aware of the fact that if it increases the price of the product,
it will lose most of its customers to its rival. In such a case, the upper part of
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demand curve is more elastic than the part of the curve lying below the kink.
(b) The second option for the firm is to decrease the price. In case the firm
lowers the price, its total sales will increase, but it cannot push up its sales
very much because the rival firms also follow suit with a price cut. If the rival
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firms make larger price cut than the one which initiated it, the firm which first
started the price cut will suffer a lot and may finish up with decreased sales.
The oligopolists, therefore avoid cutting price, and try to sell their products at
)A
the prevailing market price. These firms, however, compete with one another on
the basis of quality, product design, after-sales services, advertising, discounts,
gifts, warrantees, special offers etc.
(c

Notes
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In the above diagram, we shall notice that there is a discontinuity in the marginal
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revenue curve just below the point corresponding to the kink. During this discontinuity the
marginal cost curve is drawn.
3.1.10 Game Theory and Importance of Game Theory in Market
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Structure
Game theory is a method of studying strategic decision making. It is the study of
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mathematical models of conflict and cooperation between intelligent rational decision-
makers. An alternative term suggested “as a more descriptive name for the discipline” is
interactive decision theory. Game theory is mainly used in economics, political science,
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and psychology, as well as logic and biology. The subject first addressed zero-sum
games, such that one person’s gains exactly equal net losses of the other participants.
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Game theory applies to a wide range of class relations, and has developed into an
umbrella term for the logical side of science, to include both human and non-humans, like
computers. Classic uses include a sense of balance in numerous games, where each
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person has found or developed a tactic that cannot successfully better his results, given
the other approach.
Significance of Game Theory

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Competition is a major factor in modern life, in all these competitions persons have
conflicting interest and everybody tries to maximize his gains and minimize loss. The
significance is:
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1. It is a type of decision theory which is based on choice of action.

2. The choice of action it determined after considering the possible alternatives
available to the opponents.
)A
3. It involves the players, i.e., decision makers who have different goals or
objectives. The game theory determines the rules of rational behavior of
these players in which the outcomes are dependent on the actions of the
interdependent players.
(c
4. In a game there are number of possible outcomes, with different values to the
decision makers. They might have some control or but do not have complete
control over others.

5. Game theory is a scientific approach to rational decision making.

Notes
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Features of Game Theory
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A competitive situation is called a game if it has the following features:
1. Finite Number of Competitors.
2. Finite Number of Action.
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3. Knowledge of Alternatives.
4. Choice.
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5. Outcome or Gain.
6. Choice of Opponent.
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Limitations of Game Theory
1. Infinite number of strategy: In practice a player may have infinite number of strategies
courses of action.
2. Knowledge about strategy: Knowledge about opponent strategy may not be available
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to players, this leads to wrong conclusions.
3. Zero outcome: In practice gain of one person may not be equal to the loss of another
person i.e., opponent.
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4. Risk and uncertainty: Game theory does not consider the concept of probability and
ignores the presence of risk and uncertainty.
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5. Finite number of competitors: In real practice it is not possible.
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6. Certainty of Payoff: Payoff may not be known in advance because of various

decisions situations and large number of variables.
7. Rules of the game: Rules of the game may not be followed hence behavior of the
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player cannot be predicted.
3.1.11 Price Leadership Models

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Under price leadership, one firm assumes the role of a price leader and fixes the
price of the product for the entire industry. The other firms in the industry simply follow
the price leader and accept the price fixed by him and adjust their output to this price.
The price leader is generally a very large or dominant firm or a firm with the lowest cost of
production. It often happens that price leadership is established as a result of price war in
m
which one firm emerges as the winner.
There are various models concerning price-output determination underprice

leadership on the basis of certain assumptions regarding the behaviour of the price leader
)A
and his followers. In the following case, there are few assumptions for determining price-
output level underprices leadership:
●● There are only two firms A and B and firm A has a lower cost of production
than the firm B.
(c
●● The product is homogenous or identical so that the customers are indifferent

as between the firms.

●● Both A and B have equal share in the market, i.e., they are facing the same
Notes
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demand curve which will be the half of the total demand curve.
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In the above diagram, MCa is the marginal cost curve of firm A and MCb is the
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marginal cost curve of firm B. Since we have assumed that the firm A has a lower cost of
production than the firm B, therefore, the MCa is drawn below MCb.
Taking the firm A first, firm A will be maximizing its profit by selling OM level of output
v
at price MP, because at output OM the firm A will be in equilibrium as its marginal cost is
equal to marginal revenue at point E. Whereas the firm B will be in equilibrium at point F,
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selling ON level of output at price NK, which is higher than the price MP. Two firms have
to charge the same price in order to survive in the industry. Therefore, the firm B has to
accept and follow the price set by firm A. This shows that firm A is the price leader and
firm B is the follower.
U
Since the demand curve faced by both firms is the same, therefore, the firm B will
produce OM level of output instead of ON. Since the marginal cost of firm B is greater
than the marginal cost of firm A, therefore, the profit earned by firm B will be lesser than
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the profit earned by firm A.
3.1.12 Cartels and Collusion

An important characteristic of oligopoly is collusion in which rival firms enter into an
m
agreement in mutual interest on various accounts such as price, market share, etc. Firms
either openly declare their decision of collusion, or may collude tacitly. Basic oligopoly
characteristics like interdependence of firms, constant consciousness of rival’s action, fear
)A
of price war, etc., create a good opportunity for collusion. You must be wondering as to
why firms would collude after all. Give it a thought; it does make sense the companies
come together in order to get better control over market. When a number of producers
(or sellers) enter into such an agreement formally, it is called explicit collusion; on the
other hand, collusion which is not overt is known as tacit collusion. The most commonly
(c
found form of explicit collusion is known as cartels. The aim of such collusion is to reduce
competition and increase profits of individual members. However governments do not
encourage collusions because it creates monopoly like situation and make various laws to
identity and break up cartels. This has led to the development of tacit collusion, in which
Notes
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firms do not document agreements to collude.
A cartel is defined as a group of firms that gets together to make output and price
in
decisions. The conditions that give rise to an oligopolistic market are also conducive to
the formation of a cartel; in particular, cartels tend to arise in markets where there are few
firms and each firm has a significant share of the market. In the U.S., cartels are illegal;
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however, internationally, there are no restrictions on cartel formation. The organization
of petroleum-exporting countries (OPEC) is perhaps the best-known example of an
international cartel; OPEC members meet regularly to decide how much oil each member
of the cartel will be allowed to produce.
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Oligopolistic firms join a cartel to increase their market power, and members work
together to determine jointly the level of output that each member will produce and/
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or the price that each member will charge. By working together, the cartel members
are able to behave like a monopolist. For example, if each firm in an oligopoly sells an
undifferentiated product like oil, the demand curve that each firm faces will be horizontal
ity
at the market price. If, however, the oil-producing firms form a cartel like OPEC to
determine their output and price, they will jointly face a downward-sloping market demand
curve, just like a monopolist.
In fact, the cartel’s profit-maximizing decision is the same as that of a monopolist,

m
as Figure reveals. The cartel members choose their combined output at the level where
their combined marginal revenue equals their combined marginal cost. The cartel price
is determined by market demand curve at the level of output chosen by the cartel. The
cartel’s profits are equal to the area of the rectangular box labeled abcd in Figure. Note
)A
that a cartel, like a monopolist, will choose to produce less output and charge a higher
price than would be found in a perfectly competitive market.
Once established, cartels are difficult to maintain. The problem is that cartel
members will be tempted to cheat on their agreement to limit production. By producing
(c
more output than it has agreed to produce, a cartel member can increase its share of the
cartel’s profits. Hence, there is a built-in incentive for each cartel member to cheat. Of

course, if all members cheated, the cartel would cease to earn monopoly profits and there
Notes
e
would no longer be any incentive for firms to remain in the cartel. The cheating problem
has plagued the OPEC cartel as well as other cartels and perhaps explains why so few
in
cartels exist.
Key Takeaways
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●● Profit: Difference between total revenue and total cost Market period: A very short
period in which the supply is fixed, that is no adjustment can take place in supply
conditions.
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●● Differentiation: Result of efforts to make a product or brand stand out as a
provider of unique value to customers in comparison with its rivals.
●● Equilibrium: Condition when the firm has no tendency either to increase or to
contract its output.
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●● Actual demand: The actual changes in demand arising from simultaneous
reduction in price.
●● Advertising: any paid form of non-personal presentation of a product, idea, or
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organization
●● Homogeneous products: The product of an industry in which the outputs of
different firms are indistinguishable.
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●● Minimum price: Price at which the sellers refuse to supply the goods at all and
store it with themselves.
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●● Perfect competition: A market structure characterized by a complete absence of
rivalry among the individual firms.
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●● Perfect mobility: The absence of any barriers to movement of factors of

production
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●● Imperfect competition: A market structure wherein individual firms exercise

control over the price to a smaller or larger degree depending upon the degree of
imperfection present in a case.
●● Market period: A very short period in which the supply is fixed, that is no
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adjustment can take place in supply conditions.

●● Monopoly: Existence of a single producer or seller which is producing or selling a
product which has no close substitutes.
m
Check your progress

1. Single Seller is a feature of -
)A
a) Monopoly
b) Oligopoly
c) Monopolistic competition
d) Perfect Competition
(c
2. Kinked demand curve is a feature of

a) Monopoly

b) Oligopoly
Notes
e
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3. Market structure in which a few sellers dominate the sales of a product and the
entry of new sellers is difficult or impossible.
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a) Monopoly
b) Oligopoly
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4. Under ____ one firm assumes the role of a price leader and fixes the price of the
product for the entire industry.
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a) Price discrimination
b) Price Leadership
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d) Perfect Competition er
5. Collusion is a characteristic of
a) Monopoly
b) Oligopoly
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1. Differentiate between Perfect and Imperfect competition

2. Monopoly - How price is decided, what are the features and examples
3. Explain the Price-Output Determination under Monopoly
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4. What are the various degrees of price discrimination?

5. What is a game theory? Explain the significance of game theory.
Check your progress

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1. a) Monopoly
2. b) Oligopoly
)A
3. b) Oligopoly
4. b) Price Leadership
5. b) Oligopoly
(c
Further Readings
Edition, 2015.

Notes
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Bibliography
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Publications.
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Companies.
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(c

Module-4: Macroeconomics Analysis

Notes
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Learning Objective:
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●● Understand the Economic Policy and Analysis: Macro Economic Variables and
nl
Functional Relationships
●● Differentiate different approaches to National Income Measurement - Three
approaches; Models of Circular Flow of Money- Incorporating Savings,
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Investment, Foreign Trade and Government Sector
●● Analyse models of Income Determination with emphasis on Keynesian Model;
Concept of Investment Multiplier
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●● Understand different factors Influencing Consumption Function- Objective,
Subjective And Structural; Demand and Supply of Money: Transaction,
Precautionary and Speculative Demand for Money
●● Know about Liquidity Preference Function; Components of Money Supply
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Learning Outcome:
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●● Economic policies and analysis of various macroeconomic variables

v
●● Use the Income-Expenditure model to explain periods of recession and expansion;
find the GDP Gap (negative or positive)
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●● Use the Expenditure Output model to explain periods of recession and expansion
●● Compare and contrast the circumstances under which it makes sense to apply the
Keynesian model of income determination
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●● Components of money supply and liquidity preference function
“Macroeconomics concerns with such variables as the aggregate volume

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of the output of an economy, with the extent to which its resources are
employed, with the size of national income and with the general price level”.
Ackley Gardner-
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4.1.1 Economic Policy and Analysis: Macro Economic Variables and

Functional Relationships
Macroeconomics is the field of economics that studies the behaviour of an
)A
economy as a whole and not just on specific businesses, but entire industries and
economies. This looks at economy-wide phenomena, such as Gross National Product
(GNP) and how it is affected by changes in unemployment, national income, rate of
growth and price levels. For example, macroeconomics will look at how an increase
or decrease in net exports will affect a nation’s capital account or how GDP would be
(c
affected by unemployment rate.

Macroeconomic policy operates within a framework of goals and constraints. The

Notes
e
most important goals of economic policy are;
i. Full employment – full utilization of human and non-human resources
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ii. High living standards
iii. Price Stability
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iv. Reduction of economic inequality and removal of poverty
v. Rapid economic growth
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vi. External balance vs overall balance in economic relations with the rest of the
world.
4.2.2 Approaches to National Income Measurement - Three approaches
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1. Output or Production Method
This method is also called the value-added method. This method approaches
national income from the output side. Under this method, the economy is divided into
s
different sectors such as agriculture, fishing, mining, construction, manufacturing, trade
and commerce, transport, communication and other services. Then, the gross product
er
is found out by adding up the net values of all the production that has taken place in
these sectors during a given year.
In order to arrive at the net value of production of a given industry, intermediate

goods purchase by the producers of this industry is deducted from the gross value of
v
production of that industry. The aggregate or net values of production of all the industry
and sectors of the economy plus the net factor income from abroad will give us the
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GNP. If we deduct depreciation from the GNP we get NNP at market price.
NNP at market price – indirect taxes + subsidies will give us NNP at factor cost or
U
National Income.
The output method can be used where there exists a census of production for
the year. The advantage of this method is that it reveals the contributions and relative
importance and of the different sectors of the economy.
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2. Income Method
The income method approaches the national income from the distribution side.
According to this method, national income is obtained by summing up of the incomes of
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all individuals in the country. Thus, national income is calculated by adding up the rent
of land, wages and salaries of employees, interest on capital, profits of entrepreneurs
and income of self- employed people. This method of estimating national income has
)A
the great advantage of indicating the distribution of national income among different
income groups such as landlords, capitalists, workers, etc.
3. Expenditure Method
This method arrives at national income by adding up all the expenditure made on
(c
goods and services during a year. Thus, the national income is found by adding up the
following types of expenditure by households, private business enterprises and the
government:
●● Expenditure on consumer goods and services by individuals and households

Notes
e
denoted by C. This is called personal consumption expenditure denoted by C.
●● Expenditure by private business enterprises on capital goods and on making
in
additions to inventories or stocks in a year. This is called gross domestic
private investment denoted by I.
●● Government’s expenditure on goods and services i.e. government purchases
nl
denoted by G.
●● Expenditure made by foreigners on goods and services of the national
economy over and above what this economy spends on the output of the
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foreign countries i.e. exports – imports denoted by (X – M). Thus, GDP = C + I
+ G + (X – M).
4.2.3 Models of Circular Flow of Money- Incorporating Savings,
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Investment, Foreign Trade and Government Sector
1. The circular flow of income in a simple economy where all income is

consumed.
s
The operation of forces in an economy can be expressed in the form of a circular
flow of incomes and spending between households and firms. A household is a group
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of people (consumers) earning incomes and spending them on goods and services
produced by the firms. Money passes from households to firms in return for goods and
services produced by firms and money passes from firms to households in return for
factor services provided by households. The simple notion that the money value of the
v
income of household must equal to the money value of output of firms and the money
value of household expenditures to purchase this output provides the basis for national
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income accounting. In this simple economy we assume that the household spends
all income. This spending on consumer goods (termed consumption (C) is the only
component of aggregate demand (AD) in this simple economy.
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ity
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)A
This economy is in equilibrium because: Y = AD Y = C If Y is greater than C, Y will

fall; if Y is less than C, Y will rise
2. The circular flow of income in a closed economy

(c
A closed economy exists when there is no international trade. We shall also

assume that in this particular closed economy there is no government spending
or taxation. Here, households have two alternative uses of the income – they can
Notes
e
consume it or they can save it. Savings are (S). AD aggregate demand consists of
consumption (C) and savings (S). Savings are lost to Y and will reduce the level of Y.
in
However, some (if not all) of S will be used to finance investment (I). I is the creation of
real capital goods such as machinery and factories, and add to Y. If S = I, then Y is in
equilibrium.
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O
s ity
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In this economy Y = AD Therefore, Y = C + I In equilibrium S = I However, if S is
greater than I, AD and Y will fall. If I is greater than S, AD and Y will rise
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3. The circular flow of income in an open economy:
An open economy is one in which international trade exists. Assume also that there
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is government spending and taxation. Thus, households need not consume all of their
income. Some may be saved (S), spent on imports (M), or taxed (T). So the savings (S)
and imports (M) and taxes imposed (T) are known as “withdrawals” (W) or “Leakages”
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from the actual flow. An increase in withdrawals (W) will reduce the level of output and
income (Y). However, Y will be added to investment (I), government spending (G) and
money spent by foreigners on exports (X). These are known as “injections” (J). In an
open economy the size of Y is determined by the size of AD, which is determined by
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C + I + G + X.
m
)A
(c

Over a period of time there are withdrawals (W) from the income flow. If individuals
Notes
e
save, then the income is taken out of the circular flow. If an economy’s income is
Rs. 1000 and it saves Rs.200, then only Rs. 800 is passed on as expenditure. Other
in
withdrawals are taxes and imports. The later represents a loss of income from the
domestic economy to some overseas economy. Alongside withdrawals there are also
injections (J) into the flow of income. These are in the form of investment, government
spending and exports, savings withdrawn and used to finance investment, either
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directly through the purchase of capital goods or indirectly via financial institutions such
as Banks. Thus, the original withdrawal or savings ends up as an injection elsewhere in
the system. Taxes end up as government spending on goods and services. Exports and
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financed from spending made by other countries. This spending enters into the circular
flow as an injection of income. In this economy, Y = AD Therefore, Y = C + I + G + X
Y = C + J, Where, J equals injections i.e. I, G and X. For equilibrium we require all
withdrawals to equal all injections i.e. W = J. If injections are greater than withdrawals
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then the level of national income (i.e. total incomes) will rise and vice versa.
4.1.4 Models of Income Determination with Emphasis on Keynesian

Model
s
Modern macroeconomics can be said to have begun with Keynes and the
publication of his book The General Theory of Employment, Interest and Money in
er
1936. Keynes expanded on the concept of liquidity preferences and built a general
theory of how the economy worked. Keynes’s theory was brought together both
monetary and real economic factors for the first time, explained unemployment, and
v
suggested policy achieving economic stability.
Keynes contended that economic output is positively correlated with money

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velocity. He explained the relationship via changing liquidity preferences: people

increase their money holdings during times of economic difficulty by reducing their
spending, which further slows the economy. This paradox of thrift claimed that individual
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attempts to survive a downturn only worsen it. When the demand for money increases,
money velocity slows. A slowdown in economic activities means markets might not
clear, leaving excess goods to waste and capacity to idle. Turning the quantity theory
on its head, Keynes argued that market changes shift quantities rather than prices.
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Keynes replaced the assumption of stable velocity with one of a fixed price-level. If
spending falls and prices do not, the surplus of goods reduces the need for workers and
increases unemployment.
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Keynes’s Successors
Keynes’s successors debated the exact formulations, mechanisms, and
consequences of the Keynesian model. One group emerged representing the
)A
“orthodox” interpretation of Keynes; they combined classical microeconomics with

Keynesian thought to produce the “neoclassical synthesis” that dominated economics
from the 1940s until the early 1970s. Two camps of Keynesians were critical of this
synthesis interpretation of Keynes. One group focused on the disequilibrium aspects of
(c

Keynes’s work, while the other took a fundamentalist stance on Keynes and began the
Notes
e
heterodox post-Keynesian tradition.
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Neoclassical synthesis
The generation of economists that followed Keynes, the neo-Keynesians, created
the “neoclassical synthesis” by combining Keynes’s macroeconomics with neoclassical
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microeconomics. Neo-Keynesians dealt with two microeconomic issues: first, providing
foundations for aspects of Keynesian theory such as consumption and investment,
and, second, combining Keynesian macroeconomics with general equilibrium theory.
(In general equilibrium theory, individual markets interact with one another and an
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equilibrium price exists if there is perfect competition, no externalities, and perfect
information.) Paul Samuelson’s Foundations of Economic Analysis (1947) provided
much of the microeconomic basis for the synthesis. Samuelson’s work set the pattern
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for the methodology used by neo-Keynesians: economic theories expressed in formal,
mathematical models. While Keynes’s theories prevailed in this period, his successors
largely abandoned his informal methodology in favor of Samuelson’s.
By the mid-1950s, the vast majority of economists had ceased debating
s
Keynesianism and accepted the synthesis view; however, room for disagreement
remained. The synthesis attributed problems with market clearing to sticky prices that
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failed to adjust to changes in supply and demand. Another group of Keynesians focused
on disequilibrium economics and tried to reconcile the concept of equilibrium with the
absence of market clearing.
v
4.1.5 Concept of Investment Multiplier
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The multiplier tells what the increase in the level of equilibrium income, would be
for the unit of decrease in autonomous spending.
U
ity
m
)A
In the figure, AD1 is the initial aggregate demand function with autonomous
spending equal to 1. After an increase in autonomous spending by Δ
The new autonomous spending is 2 ( 1 + Δ ) and the corresponding aggregate

(c
demand function AD2 it is Y2. The multiplier is given by the ratio of increase in
equilibrium income to increase in autonomous spending.

Denoting the value of the multiplier by α

Notes
e
Y2 - Y1
α=
-
in
2 1
1
Substituting Y1=
1-b
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2
Y2=
1-b
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We have
1 2
= 1-b 1-b
ity
2
- 1
( 2
- 1)
α=
(1-b ) ( 2
- 1
)
s
( -
α=
(1-b ) (
2
2
1)
- 1
)
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1
=
v
1-b
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(1-b) is the marginal propensity to save. The larger the marginal propensity to
consume, the lower is the marginal propensity to save and thus larger is the value
of the multiplier. Since MPS is less than one, the multiplier, in the model, is greater
than one. However, it may be noticed that when we extend our model, there may be
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circumstances in which the multiplier is less than one.
4.1.6 Factors Influencing Consumption Function- Objective,

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Subjective And Structural.

The relationship between aggregate consumption expenditures and aggregate
income of household sector is known as the consumption function, that is C = a + bY
Where C = Consumption spending a = Consumption spending at zero income b =

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the proportion of the increased income spent on consumption Y = Income
Factors affecting the Consumption Function

)A
The amounts of consumption depend solely upon the level of disposable income.
Many other factors help determine how any given level of disposable income will be
(c

divided between consumption and saving. Moreover, changes in these other factors can
Notes
e
shift the consumption function up or down. This can lead to more less consumption at
each level of income.
in
Some of the more important of these factors are listed below.
a. The Stock of Wealth: Wealth has been regarded as the most important
determinant of consumption. All things being equal, it may be predicted that a
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wealthier community would consume a greater share of its income than a group
with the same income but less wealth. The greater a person’s wealth, the lower
the desire to add to future wealth, by reducing the consumption expenditure.
O
Therefore consumption would be higher income. Windfall capital gains losses
also have an impact on aggregate consumption.
b. expectations: The consumption of a person is also influenced by expectations
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regarding the future movements in both income and prices. For example, when
future levels of income are expected to be higher than the present levels, the
consumer community is likely to consume more out of its current disposable
income.
c. Taxation Policy: Taxation measures of the government may influence the
s
average propensity to consume (APC), i.e., C/YD and bring about shifts in the
consumption function. An increase in direct taxes will reduce the disposable
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income at all levels of income and the reverse may occur when taxes are
reduced. Similarly, a tax structure based on progressive taxation leads to
increase in the level of consumption expenditure.
v
d. Distribution of Total Household Income by Size of Household Income: For
example, the total saving out of a given level of total household income is likely
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to be higher if a greater part of the total income accrues to high income classes,
rather than to low income groups.
e. Age Composition of the Population: Both elderly and young families have
U
higher propensities to consume than families in their middle years. A shift in age
composition could shift consumption and saving functions.
Consumption Expenditure
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Consumption expenditure is a very important part of aggregate demand, generally

the largest component of aggregate demand. Of the many variables influencing
consumption expenditure, income is the most important. The relationship between
consumption and income is described by consumption function. We assume that
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consumption demand increases linearly with increase in level of income: C = a+ bY;

a>0, 0<b
)A
(c

Notes
e
in
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O
The intercept ‘a’ on the consumption axis gives the consumption when the level
of income is Zero. The slope of the consumption function is equal to ‘b’. It indicates
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the marginal propensity to consume (MPC). The marginal propensity to consume is the
increase in consumption per unit increase in income. In a two sector economy, income
is either spent or saved; there are no other uses to which it can be put. It follows that
any theory that explains consumption is equivalently explaining the behavior of saving.
s
Let us derive the savings function from the consumption function. Income can be spent
or saved. Thus, Y= C + S. Thisgives us S = Y – C
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Making use of consumption function, we get S = Y – C = Y – a – bY = -a + (1 – b)
Y From the above savings function, it can be seen that when consumption increases
linearly with income, so do savings. (1 – b) gives the marginal propensity to save
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(MPS), which gives the increase in savings per unit increase in income. The sum of
MPC and MPS has to be equal to one. For instance, if MPC = 0.8, than MPS = 0.2.
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4.1.7 Demand and Supply of Money: Transaction, Precautionary and

Speculative Demand for Money
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Demand means holding. People hold money to carry out transactions, like buying,
selling, borrowing, lending, etc. The main factors that influence how much money
people will hold (demand) are: rate of interest, GDP and price level. The money is held
as cash and as deposits in chequable accounts.
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People hold money because money is useful for buying things; and because they
want to take advantage of fluctuating prices of bonds. The two main motives for holding
money are: the transaction motive and the speculative motive.
m
The Transactions Motive People hold money to buy things. This is transaction
motive. How much money do people hold with this motive? It depends upon two
factors: the rate of interest and the cost involved in buying and selling of bonds. The
relevance of these factors is explained below and is subject to some assumptions. The
)A
assumptions are:
(a) Money has only two uses: to hold or to buy bounds.

(b) There is non–synchronization of money and spending. It means that there is a
mismatch between the timing of money inflow and the timing of money outflow.
(c
It is because income arrives once a month while the spending occurs at a

uniform rate throughout the month.

(c) The entire income received at the beginning of the month is spent during the
Notes
e
month.
Precautionary Motive - Transaction demand arises due to unevenness between
in
receipts and expenditures. Similarly, precautionary demand arises due to uncertainty of
future receipts and expenditures. The precautionary demand enables persons to meet
unanticipated increases in expenditures or unanticipated delays in receipts. This type
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of demand for money may be expected to vary with the level of income. People need
more money and are better able to set aside more money for this purpose at higher
income levels. Precautionary demand may also be expected to vary inversely with
interest rate. For example, at a high rate of interest, one may be tempted to assume
O
the greater risk of a smaller precautionary balance in exchange for the high interest
rate that can be earned by converting part of this balance into interest bearing assets.
Although precautionary demand may be formally distinguished from transactions
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demand, the total amount of money held to meet both demands is viewed primarily as a
function of the level of income.
The Speculative Motive Speculative demand for money is for taking advantage of
fluctuating prices of bonds. The market price of a bond depends on
s
(i) Bond ROI and
(ii) Current market ROI.
er
Higher the current ROI, lower the market price of bond. There is inverse relation
between market ROI and market price of bond. Given inverse relation between ROI and
market price of bond, how is speculative Md related to it? The “speculation” is about
v
whether ROI is going to fall, or going to rise in future. The expectation is that if the ROI
is higher than normal, the chances are that ROI will fall in future. ROI higher than normal
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means lower price of bond. So, buy bonds when ROI is high. Buying bonds means less
holding (demand) of money. Therefore, higher the R/I lower the speculative Md
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4.1.8 Liquidity Preference Function

The principle of liquidity preference is a concept that indicates that an investor
will seek a higher interest rate or premium on securities with long-term maturities that
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bear greater risk because investors prefer cash or other highly volatile assets, all other
factors being equal.
According to the theory by Keynes, The demand for liquidity retains trading
strength; the more liquid assets are easier to cash in on full value. Cash is generally
m
recognized as the most liquid commodity. According to the liquidity preference principle,
short-term securities interest rates are lower as investors do not risk liquidity for wider
time periods than medium- or longer-term securities.
)A
First, the transaction motive states that the individuals have a liquidity desire
to ensure that there is adequate cash on hand for basic day-to-day needs. In other
words, there is a strong demand from creditors for liquidity to meet their short-term
commitments, like buying food, paying rent. Higher living costs suggest a higher
demand for cash / liquidity in order to meet certain everyday needs.
(c

Second, the precautionary motive relates to the preference of a person for

Notes
e
additional liquidity in case an unforeseen issue or expense occurs that needs significant
cash outlay. Such incidents have unexpected expenses such as house or car repairs.
in
Third, there could also be speculative reasons for the stakeholders. When interest
rates are small, there is high demand for cash and they would choose to keep assets before
interest rates increase. The speculative motive applies to the reticence of an investor to tie
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up investment capital for fear of missing out on a better chance in the future.
4.1.9 Components of Money Supply
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Growth in the availability of money is an important factor not just for increasing the
cycle of economic growth but also for maintaining global price stability. Money supply
must be managed to grow, if the secure development target is to be achieved.
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The two main components of Money Supply are (1) Currency and (2) Bank
Deposits.
Currency
s
a. Coins - Nowadays the government releases the coins in every country, while private
institutions used to release the coins in the old era as well. Government used to
er
restrict the coins of private institutions in matters of coin weight and metal purity used
in coins to save people from the fraud. There were two types of coins below the gold
and silver values Full-bodied Standard Coins and Token Coins.
b. Currency Notes - Currency notes are an important part of providing income.
v
Currency notes are issued either by a country’s Central Bank or by the Treasury
itself. Indian government releases the One Rupee note and all other notes are
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released by Reserve Bank of India. The notice can be released (issue) in many
forms, such as composition, proportional, minimum fund, variable, constant, etc. The
unchangeable form for the release of the notes is currently in use in all Countries.
U
Notes are promissory notes and In exchange for it, the monetary authority promises
to issue coins or other notes. Now, the releasing of notes does not rely on the gold
or silver stock. The monetary authority keeps in mind the needs of the economy and
meets the note criteria.
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Bank Deposits
The people in all the countries deposit their money in banks. Bank deposits are of
two types— (i) Fixed Deposits and (ii) Demand or Current Deposits
m
a. Fixed Deposit- Fixed deposits are of a definite period of time. Those deposits cannot
be withdrawn by the cheque. Yet the depositor will never withdraw the sum of demand-
deposits. While cash in the form of a demand deposit is as liquid as currency. It is
)A
very secure and easy to make payment from the current or demand deposit account
by cheque. Payment by cheque is convenient because the cheques can withdraw
any amount of cash. It may be dangerous to use the high value notes. Banks have
the proof of cheque payments because these are stated in bank accounts. Whether
there will be a payment-related question then the inquiries will solve it.
(c

b. Demand Deposit - A demand deposit is a bank or other financial institution account

Notes
e
that allows the depositor to withdraw his or her funds from the account without
warning in less than seven days’ notice. Currently demand deposits are starting to be
in
included in the money supply of every country approximately as goods and services
can now be purchased by demand deposits. But it is not payment by cheque is
compulsory by the statute. Anybody can deny that they accept the cheque. Paying in
cash is therefore a legal obligation
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Key Takeaways
●● Macro Economics: The branch of economics that studies the overall working of a
O
national economy.
●● Business Cycle: Recurring fluctuations in economic activity consisting of
recession, recovery, growth and decline.
ity
●● Fiscal Policy: Economic term that defines the set of principles and decisions of a
government in setting the level of public expenditure and how that expenditure is
funded.
●● Gross Domestic Product: It is a measure of a country’s overall economic output.
s
●● Gross National Product: It is the value of all final goods and services produced
by domestically owned factors of production within a given period Inflation: A
general and progressive increase in prices.
er
●● National Income: Aggregate of money value of the annual flow of final goods and
services in the economy during a given period.
v
●● Monetary Policy: Government or central bank process of managing money
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supply to achieve specific goals-such as constraining inflation, maintaining an

exchange rate, achieving full employment or economic growth.
●● Disposable income: It is the total income that actually remains with individuals to
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dispose off as they wish.

●● Gross National Income: The total value produced within a country, together with
its income received from other countries less similar payments made to other
countries.
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●● Value added: Difference between the value of output produced by a firm and
the total expenditure incurred by it on the materials and intermediate products
purchased from other business firms.
m
Check your progress

1. Which method is also known as value-added method?
)A
a) Output Method
b) Income Method
c) Cost Method
d) Expenditure Method
(c

2. The equation C = a + bY is for -

Notes
e
a) Output Method
b) Income Method
in
c) Consumption function
d) Investment Multiplier
nl
3. A major component of money supply is
a) Cheques
O
b) Coins
c) Loans
d) Stocks
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4. ______________ deposits are of a definite period of time.
a) Demand deposit
b) Current deposit
s
c) Fixed deposit
d) Cost deposit
er
5. The notice for demand deposit of ___ days
a) 5
v
b) 7
c) 10
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d) 21

U
1. Explain the approaches to National Income Measurement - Three approaches

2. Describe the models of Circular Flow of Money.
ity
3. Explain the concept of investment multiplier

4. Describe the components of money supply
5. What is the liquidity Preference Function
m
Check your progress

1. a) Output Method
2. c) Consumption function
)A
3. b) Coins
4. c) Fixed deposit
5. b) 7 days
(c

Further Readings
Notes
e
Edition, 2015.
in
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Bibliography
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Publications.
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Companies.
s
er
v
ni
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ity
m
)A
(c

Module-5: Business Environment

Notes
e
Learning Objective:
in
●● Understand about different exogenous variables and factors influencing business
nl
environment
●● Calculate and analyse different approaches in calculating national income
●● Understand the meaning of and relation between monetary and fiscal policy and
O
their implications as well.
Learning Outcome:
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●● Business Environment: An Exogenous Variable, Factors Influencing the Business

Environment
●● National Income Analysis: National Income Aggregates
s
●● Business Cycles: An Analysis of the Fluctuations in the Level of Economic Activity;
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Phases of Business Cycles
●● Inflation and Deflation: Demand - Pull and Cost -Push Inflation.
●● Monetary Policy: Objectives of Monetary Policy; Functions of Central Bank; Credit
v
Policy and Its Implications on the Corporate Sector
●● Fiscal Policy: meaning ,objectives and impact on economy; Money Market; Capital
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Market and Foreign Exchange Market
“Business Environment is the aggregate of all conditions, events and

U
influences that surround and affect it”

Keith Davis-
5.1.1 Business Environment: An Exogenous Variable.

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The process of business transformation does not occur within a vacuum.

Companies operate in a specific context, and they are influenced by this environment
and can influence it. Marketing Environment is made up of factors and forces outside
m
the organization that affect the ability of the management to build and maintain
relationships with targeted customers.
5.1.2 Factors Influencing the Business Environment

)A
1. Demographic Environment - The demographic environment refers to the size,

distribution, and growth rate of groups of people with different characteristics.
The demographic characteristics of interest to marketers relate in some way to
purchasing behaviour, because people from different countries, cultures, age groups,
(c
or household arrangement often exhibit different purchasing behaviours. Marketers

track changing age and family structures, geographic population shifts, educational
Notes
e
characteristics, and population diversity.
●● Population Size and Growth - Population size and growth rates provide
in
one indication of potential market opportunities. The world population is
now close to 7 billion, and almost 100 million people are added each year.
Thus, the world population is expected to grow by 1 billion during the decade
nl
of the 2020s. Approximately 95% of the growth will occur in Asian, African
and Latin American developing countries. Population size and growth rates
across countries are tremendously disparate. Today, China has the largest
population, led by India, and the US a distant sixth. The rapid growth of the
O
Indian population is predicted to become by the year 2100 the most populous
country in the world. The marketers, however, cannot rely solely on population
growth in developing countries for general market size increase. The largest
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growth opportunities are in the developing world, measured by population
size. Still, lower rates of income in developing countries may limit the actual
size of the market for many items.
●● Demographic Characteristics and Trends - Statistics of the global
population and country population are important but most advertisers target
s
subgroups of these large populations. Therefore patterns in population
subgroups are usually the most valuable to marketers. In many countries an
er
significant phenomenon is urban population growth. In general, the largest
cities and the highest city growth rates are in developing countries such as
Brazil, Mexico, and India. However, growth in urban population is evident
v
in many developed countries. Another interesting trend is the aging of the
population, especially evident in Japan, Italy, Britain, and the US. However,
ni
the relatively young populations exist in the developing countries, such as

Nigeria, Mexico, China and Brazil. These trends have important implications
for marketers; older consumers have different needs and purchasing habits
than younger consumers.
U
2. Economic Environment - Market requires both the buying power as well as people.
The economic environment consists of factors that affect consumer purchasing
power and their spending patterns. It includes factors and trends related to the
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income levels and the production of goods and services. While the demographic and
cultural trends generally affect the size and needs of various markets, the economic
trends affect the purchasing power of these markets. It is not enough for a population
to be large or fast growing, to offer good market opportunities; the economy must
provide sufficient purchasing power for consumers to satisfy their wants and needs.
m
Economic trends in different parts of the world can affect marketing activities in
other parts of the world. Market opportunities are the function of both economic size
and growth. The Gross Domestic Product (GDP) represents the total size of a country’s
)A
economy measured in the amount of goods and services produced. Changes in GDP
indicate trends in economic activity. Another important economic factor is the level of
economic activity per person. Per capita data integrate population and economic data
to provide an assessment of the purchasing power of individual consumers in a country.
(c
Many developing countries have large populations relative to their economic

strength; i.e., individual consumers do not have much purchasing power. However,

subgroups within these countries may have substantial purchasing power, or economic
Notes
e
growth may offer substantial opportunities in the future.
3. Natural Environment - Natural environment involves natural resources that are
in
required as inputs by marketers or that are affected by marketing activities. The
factors include:
●● Shortages of Raw Materials - Air and water may seem to be infinite
nl
resources. However, water shortage is already a problem in most of the
industrial nations Renewable resources such as forests and food must also be
used wisely. The rapid usage of non-renewable resources such as Oil, coal,
O
various minerals also pose a serious problem.
●● Increased Pollution – The increased pollution is one of the primary sources
of environment depletion. Industries almost damage the quality of the natural
environment. Disposal of Chemicals and nuclear wastes, the dangerous
ity
mercury levels in the ocean, the quantity of chemical pollutants in the soil and
food supply, littering the environment with non-bio degradable wastes such
as plastics, bottles and other packaged materials are very big examples of
Increased pollution.
s
●● Increased Government Intervention - The governments of different
countries vary in their concern and efforts to promote a clean environment.
er
Some rich countries like Germany are very strict on environmental quality
where some poor nations do little about pollution, largely because they lack
the needed funds or political will.
v
●● Creates New Markets and Opportunities - New technology creates
new markets and opportunities, thereby replacing the older technologies.
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Marketers should watch the technological environment closely. Companies

that do not keep up will soon find their products outdated. And they will miss
new product and market opportunities.
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●● Develop practical and affordable products - Many companies are adding

marketing people to R&D teams to try to obtain a stronger marketing
orientation. Scientists are speculating on fantasy products such as flying cars,
3 D televisions, and living in space colonies. The challenge in each case is not
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only technical but also commercial- to make practical, affordable, versions of

these products.
●● Product safety - As products and technology become more complex,
customers’ needs to know that they are safe. The government agencies must
m
investigate and ban potentially unsafe products. Safety regulations result in

higher research costs and longer time between conceptualization and product
introduction.
)A
3. Political and Legal Environment - Political environment includes the laws,

government agencies, and pressure groups that influence or limit various
organizations and individuals in a given society. The Political/Legal environment
encompasses factors and trends related to governmental activities and specific
laws and regulations affecting the marketing practice. It is closely tied to the social
(c
and economic environments, ie. the pressure from the social environment, such as
ecological or health concerns, or the economic environment, such as slow economic

growth or high unemployment, typically motivate legislation intended to improve

Notes
e
the particular situation. Regulatory agencies implement legislation by developing and
enforcing regulations. Therefore, it is important for marketers to understand specific
in
political processes, laws, and regulations, as well as important trends in each of
these areas. The areas of concern are:
a. Increasing legislation.
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b. Changing government agency enforcement.
c. Increased emphasis on ethics and socially responsible behaviour.
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4. Cultural Environment - The cultural environment is made up of institutions and other
forces that affect a society’s basic values, perceptions, preference, and behaviours.
People grow up in a particular society that shapes their basic beliefs and values.
Core beliefs and values are passed on from parents to children and are reinforced
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by schools, churches, business, and governments. Secondary beliefs and values are
more open to change. Thus, marketers may be able to change secondary beliefs, but
not core beliefs. Society’s major cultural views are expressed in people’s views of:
a. Themselves
s
b. Others
c. Organizations er
d. Society
e. Nature
f. The universe
Cultural factors, including the values, ideas, attitudes, beliefs, and activities of
v
specific population subgroups, greatly affect consumers’ purchasing behaviour. Thus,
marketers must understand important cultural characteristics and trends in different
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markets.
5.1.3 National Income Analysis: National Income Aggregates

U
National income is the total net value of all goods and services produced within
a nation over a specified period of time, representing the sum of wages, profits, rents,
interest and pension payments to residents of the nation. It is the total amount of
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income earned by the citizens of a nation. All incomes are based on production. In this
sense, national income reflects the level of aggregate output.
a. Gross Domestic Product (GDP)

m
Gross Domestic Product (GDP) is the total market value of all final goods and
services currently produced within the domestic territory of a country in a year. The
essential elements to note for GDP are -
)A
●● First, it measures the market value of annual output of goods and services
currently produced. This implies that GDP is a monetary measure.
●● Secondly, for calculating GDP accurately, all goods and services produced in
any given year must be counted only once so as to avoid double counting. So,
GDP should include the value of only final goods and services and ignores the
(c
transactions involving intermediate goods.

●● Thirdly, GDP includes only currently produced goods and services in a year.
Notes
e
Market transactions involving goods produced in the previous periods such
as old houses, old cars, factories built earlier are not included in GDP of the
in
current year.
●● Lastly, GDP refers to the value of goods and services produced within the
domestic territory of a country by nationals or non-nationals. Gross domestic
nl
product is the money value of all final goods and services produced within the
domestic territory of a country during a year.
Algebraic expression under product method is,
O
GDP = (P x Q)
Where GDP = Gross Domestic Product P = Price of goods and service, Q =

Quantity of goods and service denotes the summation of all values.
ity
According to expenditure approach, GDP is the sum of consumption, investment,
government expenditure, net foreign exports of a country during a year.
Algebraic expression under expenditure approach is,
s
GDP = C + I + G + (X – M)
Where,
er
C = Consumption, I = Investment
G = Government expenditure (X - M) = Export minus import
v
The components used to calculate GDP include:
ni
Consumption:
●● Durable goods (items expected to last more than three years)
●● Nondurable goods (food and clothing)
U
●● Services
Government Expenditures:
ity
●● Defense
●● Roads
●● Schools Investment Spending:
●● Nonresidential (spending on plants and equipment), Residential (single-family
m
and multi-family homes).

●● Business inventories
)A
Net Exports:
●● Exports are added to GDP
●● Imports are deducted from GDP
b. Gross National Product (GNP)

(c
Gross National Product is the total market value of all final goods and services
produced annually in a country plus net factor income from abroad. Thus, GNP is the

total measure of the flow of goods and services at market value resulting from current
Notes
e
production during a year in a country including net factor income from abroad. The GNP
can be expressed as the following equation:
in
GNP = GDP + NFIA (Net Factor Income from Abroad)
or, GNP = C + I + G + (X – M) + NFIA
nl
Hence,
GNP includes the following:
●● Consumer goods and services.
O
●● Gross private domestic investment in capital goods.
●● Government expenditure.
●● Net exports (exports-imports).
ity
●● Net factor income from abroad.
c. Net National Product (NNP)

Net National Product (NNP) at Market Price
s
NNP is the market value of all final goods and services after providing for
er
depreciation. That is, when charges for depreciation are deducted from the GNP we get
NNP at market price. Therefore’
NNP = GNP – Depreciation

v
Depreciation is the consumption of fixed capital or fall in the value of fixed capital
due to wear and tear.
ni
Net National Product (NNP) at Factor Cost (National Income)
NNP at factor cost or National Income is the sum of wages, rent, interest and
U
profits paid to factors for their contribution to the production of goods and services in a
year. It may be noted that:
NNP at Factor Cost = NNP at Market Price – Indirect Taxes + Subsidies.

ity
d. Personal Income (PI)

Personal income refers to an individual’s total earnings from wages, investment
enterprises, and other ventures. It is the sum of all the incomes actually received by all
m
the individuals or household during a given period. Personal income is that income
which is actually received by the individuals or households in a country during the year
from all sources. Personal Income is the total money income received by individuals
and households of a country from all possible sources before direct taxes. Therefore,
)A
personal income can be expressed as follows:
PI = NI – Corporate Income Taxes – Undistributed Corporate Profits – Social

Security Contribution + Transfer Payments
(c
e. Disposable Income (DI)

The income left after the payment of direct taxes from personal income is called

Disposable Income. Disposable income means actual income which can be spent on
Notes
e
consumption by individuals and families. Thus, it can be expressed as:
DI = PI – Direct Taxes
in
From consumption approach,
DI = Consumption Expenditure + Savings
nl
5.1.4 Business Cycles: An Analysis of the Fluctuations in the Level
of Economic Activity
O
The business cycle, also known as the economic cycle or trade cycle, is the
movement of gross domestic product ( GDP) downward and upward along its long-term
growth rate. The length of a business cycle is the time span involving a single series
boom and contraction. Usually these fluctuations include variations over time between
ity
periods of relatively fast economic growth (expansions or booms) and periods of relative
stagnation or downturn (contractions or recessions). Business cycles are typically
calculated by taking actual gross domestic product growth levels into consideration.
Business cycle is the upward or downward movement of economic activity
s
occurring around the pattern of growth. The Peak is considered the peak of a loop. A
very high peak is called a ‘boom’ which represents a big jump in output. If the economy
er
starts to fall from the high, company activity is down.
If that downturn continues for more than two consecutive quarters of the year, it
becomes a recession. A major recession is called depression. The latter is in fact much
v
longer and more serious than a recession. The Trough is considered the edge of a
recession or depression. When an economy comes out of the trough, it is an upturn. If
ni
an upturn lasts two consecutive quarters of the year, then it is called an expansion.
5.1.5 Phases of Business Cycles

U
ity
m
)A
(c

5.1.6 Inflation and Deflation: Demand - Pull and Cost -Push Inflation.
Notes
e
Inflation is defined as a persistent increase in the average price level in the
economy, usually measured through the calculation of a consumer price index (CPI).
in
The word “persistent” is of great importance in your understanding of the concept.
A single increase in prices is not called inflation. When inflation occurs, there is a
sustained increase in the price level. It is also important not to confuse inflation with an
nl
increase in the price of a particular good or service.
Inflation is the rise in price levels in an economy over a given time period. This
means that a given amount of currency will buy a lower number of goods as time
O
passes as it loses its value. For this reason controlling inflation is one of the main
economic objectives of a government. There are many ways to control inflation;
however most of them work by either increasing aggregate supply or decreasing
aggregate demand. Both actions result in the equilibrium moving down. The measures
ity
that are required to control the inflation depend on what is thought to be causing it. A
government’s monetary policy can decrease aggregate demand by increasing interest
rates. This will discourage borrowing and increase savings, both of which constrict
consumption, thereby decreasing aggregate demand.
s
1.The Demand-Pull Inflation er
The theory of demand-pull inflation relates to what may be called the traditional theory
of inflation. The essence of this theory is that inflation is caused by an excess of demand
(spending) relative to the available supply of goods and services at existing prices.
v
●● According to classical, the key factor is the money supply because in
accordance with the quantity theory of money only an increase in the money
ni
supply is capable of raising the general price level.

●● Economists like Friedman, Hawtrey, Golden Weiser, who regard inflation as a
purely monetary phenomenon, strongly support this theory of inflation caused
U
by excess money supply. The excess demand in the economy develops owing
to large-scale investment expenditure either in the public or in the private
sector, thereby exceeding the total output.
In modern income theory, however, demand-pull is interpreted to mean an excess
ity
of aggregate money demand relative to the economy’s full employment output level.
The theory assumes that prices for goods and services as well as for economic
resources are responsive to supply and demand forces, and will, thus, moves readily
upward under the pressure of a high level of aggregate demand
m
As a result of this excess demand, prices will rise and excess demand inflation
or demand-pull inflation comes to exist. Thus, we find that according to this theory of
demand- pull inflation, prices rise in response to an excess of aggregate demand over
)A
existing supply of goods and services caused by an increase in the quantity of money
resulting in a fall of interest rates increasing investment expenditures and prices. But
demand-pull inflation may also be caused without an increase in money supply when
MEC or MPC goes up causing an increase in expenditures and hence prices. Since
inflation is due to excess demand, it is considered controllable by the demand reducing
(c
monetary and fiscal policies.

Notes
e
in
nl
O
ity
Inflation is a dynamic disequilibrium process. It implies a steady increase in the
price level over time. Thus excess demand inflation implies that the IS and/or the LM
s
schedules continue to shift upward over time so that excess demand for goods and
services is perpetuated and general equilibrium is never established.
er
Consider the diagram, which analyses the working of excess demand inflation
irrespective of the fact whether excess demand is caused by increased money supply
or by expenditures on C and I.
v
Let us suppose that the full-employment level of output remains fixed at Y0.
ni
General equilibrium is established at Y0 and i0 with price level p0. An increase in the
price level may now come about as a result of an increase in aggregate demand,
which shifts the IS0 schedule to IS1; the resulting excess demand of Y1 – Y0 leads to
a bidding up prices so that the real value of the money supply shrinks and the LMp0
U
schedule shifts to LMp1, where general equilibrium is again established at the higher
interest rate i1 and higher price level p1.
ity
m
)A
(c
Excess Demand Inflation

2. Cost-Push Inflation
Notes
e
The theory of cost-push maintains that prices instead of being pulled-up by
excess demand are also pushed-up as a result of a rise in the cost of production.
in
Under cost-push inflation prices rise on account of a rise in the cost of raw materials,
especially wages. The theory holds that the basic explanation for inflation is the fact
that some producers, group of workers or both, succeed in raising the prices for either
nl
their product or services above the levels that would prevail under more competitive
conditions.
In other words, inflationary pressures originate with supply rather than demand and
O
spread throughout the economy. Inflation of the cost-push type originates in industries
which are relatively concentrated and in which sellers can exercise considerable
discretion in the formulation of both prices and wages. Cost-push inflation may not be
possible in an economy characterized by pure competition.
ity
Since this inflation is due to the forces of cost and supply, it is not subject to easy
treatment because fiscal and monetary measures may cure cost inflation only at the
expense of increasing unemployment and slower growth. That is why many cost-push
inflation experts advocate mitigation rather than elimination of inflation. The Figure
s
Figure shows that according to pure supply (cost-push) inflation theorists in societies
of oligopolies, unions and other pressure groups the aggregate supply curve moves
er
upwards from S0 to .S1to S2 whatever may happen to aggregate demand. A usual
characteristic of such markets is that the money wage rate is inflexible downward, the
result of which is an aggregate supply curve of the kind shown by S0S. With the initial
SoS and D0 curves in the Figure, we can turn to the process by which increases in the
v
money wage rate push up the price level. We assume that there is an increase in the
money wage rate that results entirely from the exploitation of the market strength of
ni
labour unions and in no part from increased productivity of labour or increased demand
for labour. Increase in wage rate has pushed S0S curve to S1S illustrates the pure cost-
push inflation phenomenon.
U
ity
m
)A
(c

The price level at which each possible level of output will be supplied increases
Notes
e
proportionally with the increase in the money wage rate. With aggregate demand
of D0, the result of the higher money wage rate and the resultant upward shift in SS
in
function from S0S to S1S is a rise in the price level from P0 to P1 and a fall in the
output level from Y0 to Y1 (which results in unemployment).Thus, the rise in price level
is accompanied by the appearance of unemployment. Further increase in money wage
will bring further upward shifts in the SS curves (e.g., S2S).
nl
Each increase in money wage rate leads to a higher price level, lower output and
higher unemployment. If left to increases, such increases in the money wage rate
cannot continue indefinitely as the worsening unemployment that follows each such
O
increase may be expected to restrain the Unions’ demands for ever higher money wage
rates.
Thus, this group of economists says that the process of inflation is caused not by
ity
an excess of demand but by increase in cost, particularly when factors of production try
to increase their share of the total product by raising their awards or factor costs called
cost-push inflation.
It is caused by the monopoly elements either in the labour market when there is
s
wage-push or in the commodities market when there is profit-push but mostly it is due
to wage-push which increases the cost of production and hence prices. It has been
er
observed recently that in many countries labour unions have become very powerful so
that they are able to get wage increases almost every year greatly in excess of the
overall average increase in output per man-hour.
v
In some industries or in case of certain goods, prices are determined less
by demand and supply and more by administrative action, for example, when
ni
management in some industries raise prices in an attempt to increase profits, it results

in administrative inflation. This has happened in steel, cement, coal, oil industries
in the world and in India where there has been 30 to 50 per cent increase in prices
U
despite high unemployment of both men and machines. However, both monetarists and
Keynesians reject the idea of administrative type cost-push inflation in fact monetarists
reject all versions of cost-push inflation. Are there no limits to the extent to which this
merry cost-push chase of wages after prices and prices after wages can be carried?
ity
Consider the adjacent Figure.

m
)A
(c
Cost Push Inflation

In this Figure general equilibrium prevails at Y0, i0 and p0. A price increase
Notes
e
instigated autonomously by monopolistic business groups or as a result of wage
pressure raises the price level to p1 and thus shifts the LMp0 schedule to LMp1. But
in
at the new equilibrium between the IS and LM functions the level of output is below
the full-employment level and, thus, there will be un-cleared markets and pressure on
wages and price to return to their former level.
nl
It looks, then, as if a general wage-price increase will create a situation in which
all the higher priced output will not be bought, and this means that cost-push infla-tion
is not likely to be self-sustaining as is sometimes believed. The rise in wages and costs
leading to rise in prices (wage-price spiral) will come to an end. Though the theory of
O
cost-push inflation does tell us that in order to reduce unemployment a slowly rising
price level is better than slowly sagging price level.
ity
5.1.7 Impact of Inflation on Employment, Price Level and Other
Macro Economic Variables
Inflation has its impact on the industry normally through the impact it exercises
on such Macro Economic variables like interest rate prevailing in the economy, growth
s
rate experienced, investment and credit off take, et al. besides of course the impact on
availability and dearness of factors of production er
Inflation and Profitability
Uncertainty about the costs and rates of return caused by very rapidly rising prices
v
can well lead to reductions in capital expenditure programs and this is one of the
reasons why inflation and recession are found together. There could also be squeezes
ni
around fixed investment in pre-empt stock building with whatever liquid resources are
available. Other reasons for the combination of inflation and recession are associated
with the lags in reactions to government policies. The prices often continue to rise even
after monetary and fiscal action has been taken to reduce demand levels. Therefore,
U
the short-term impact of efforts to curb inflation could well be decreases in production
and jobs as their current momentum propels prices forward for a while.
ity
Inflation and Labour Productivity

One of the big inflationary implications is that it is associated by labor unrest. The
private corporate sector is concerned about the effect of strikes on their profit record
and their ability to raise capital in the future , particularly the capital-intensive ones.
The fact that business taxes are based on a benefit principle that does not require
m
replacement costs of fixed assets or inventories might not be very relevant when
the tax rates are at very low levels; and likewise with personal income tax rates for
incorporated companies or nominal capital gains taxation on any form of business. But
)A
when business firms have to face tax rates at high levels and inflation is proceeding
apace, the situation is entirely different.
Inflation and Marketing

(c
Inflation affects all the aspects of corporate activity but marketing that operates as
the interface between supplier and customer, is under the most pressure. The Indian
corporate sector faces deterioration of the existing relationship between buyers and

sellers due to inflation, and thus generates confusion regarding current and future
Notes
e
trading practices. Inflation also affects salaries and wages, shipping costs, packaging,
printing and correspondence charges. Thus inflation for the companies would result in:
in
1. An increased sensitivity on the part of the consumers to the price.
2. A heightened resistance to flattery statements of marketing.
nl
3. A tendency to substitute for the quality product, where although of a lower
quality, are regarded as adequate.
4. An increased resistance to product’s non-essential features.
O
5. A reduced rate of growth in the real demand for commodities.
6. A shift in expenditure away from non-essential commodities.
7. Inflation and the investment Decisions.
ity
Inflation, Interest Rates and Savings
High levels of real value are creating greater savings. Smaller savings mean higher
investment in the productive sector and therefore higher real interest rate, higher is the
s
investment opportunity cost. Inflation causes nominal interest rates to increase, leading to
a transfer of funds to financial investments taking away a large chunk from the productive
er
market. Higher interest rates triggered by high and increasing inflation also lead to the
erosion of market sentiments leading to flight of funds from the financial markets.
5.1.8 An Analysis of Policies to Control Inflation

v
In view of the serious repercussions of inflation on the economy, various measures
ni
are taken to control inflation:
1. Monetary Measures
U
Monetary measures aim at reducing money incomes.
(a) Credit Control: Monetary policy is one of the central monetary interventions.
The country’s central bank adopts a variety of methods for regulating the volume
ity
and quality of credit. To this end, it raises bank rates, sells securities in the open
market, raises the reserve ratio and adopts a number of selective credit control
measures, such as increasing margin requirements and regulating consumer
credit. However, monetary policy may not be effective in controlling inflation,
if inflation is due to cost-push factors. Monetary policy can only be helpful in
m
controlling inflation due to demand-pull factors.

(b) Demonetization of Currency: One of the monetary measures to control
inflation is to demonetize currency of higher denominations. Such measures
)A
are usually adopted when there is abundance of black money in the country.
(c) Issue of New Currency: The most drastic monetary factor in place of the old
currency is the question of new currency. Under this scheme, a certain amount
of old currency notes are exchanged for a new one. The value of bank deposits
(c
is always correspondingly fixed. Such a measure is adopted when the issue of

notes is excessive and there is hyperinflation in the country. This measure is

Notes
e
very effective.
2. Fiscal Measures
in
Monetary policy alone is incapable of controlling inflation. It should, therefore,
be supplemented by the fiscal measures. Fiscal measures are highly effective for
controlling government expenditure, personal consumption expenditure and the public
nl
and private investment. The principal fiscal measures are the following:
a. Reduction in Unnecessary Expenditure: To curb inflation, the Government
O
should reduce excessive expenditure on non-development activities. It will also
put a check on private spending which depends on demand for goods and
services from the government. Yet cutting government spending is no easy
job. Although economic steps are always welcome, it is hard to differentiate
ity
between important and non-essential expenses. Therefore, this measure
should be supplemented by taxation.
b. Increase in Taxes: The rates of personal, corporate and commodity taxes
should be increased to minimize personal consumption spending and even
s
new taxes should be imposed, but tax rates should not be as high as to deter
savings, investment and production. Further, to bring more revenue into the tax-
er
net, the government should penalize the tax evaders by imposing heavy fines.
Such measures are bound to be effective in controlling inflation. To increase the
supply of goods within the country, the government should reduce import duties
and increase export duties.
v
c. Increase in Savings: Increasing savings will tend to reduce disposable
ni
income with the people and also the personal consumption expenditure. Yet
people aren’t in a position to save much willingly due to the increasing cost of
living. Therefore Keynes favored mandatory savings or what he called ‘deferred
payment’ where after a few years the saver gets his money back. To this end ,
U
the government should float public loans with high interest rates, start saving
schemes with prize money, or lottery for a long term. It should also introduce
a compulsory provident fund, pension schemes, etc. compulsorily. All such
measures to increase savings are likely to be effective in controlling inflation.
ity
d. Surplus Budgets: An important measure is to adopt the anti-inflationary

budgetary policy. For this purpose, the government should give up deficit
financing and instead have surplus budgets. It means collecting more in
revenues and spending less.
m
e. Public Debt: At the same time, it should stop repayment of public debt and
postpone it to some future date till inflationary pressures are controlled within
the economy. Instead, the government should borrow more to reduce money
)A
supply with the public. Like the monetary measures, fiscal measures alone
cannot help in controlling inflation. They should be supplemented by monetary,
non-monetary and non-fiscal measures.
(c

Other Measures
Notes
e
The other types of measures are those which aim at increasing aggregate supply
and reducing aggregate demand directly.
in
(a) To Increase Production
The following measures should be adopted to increase production:
nl
(i) One of the foremost measures to control inflation is to increase the production
of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable
oils, etc.
O
(ii) If there is need, raw materials for such products may be imported on preferential
basis to increase the production of essential commodities.
(iii) Efforts should also be made to increase productivity. For this purpose, industrial
ity
peace should be maintained through agreements with trade unions, binding
them not to resort to strikes for some time. The policy of rationalization of
industries should be adopted as a long-term measure. Rationalization increases
productivity and production of industries through the use of brain, brawn and
bullion.
s
(v) All possible help in the form of latest technology, raw materials, financial help,
er
subsidies, etc. should be provided to different consumer goods sectors to
increase production.
Rational Wage Policy

v
Another important measure is to adopt a rational wage and income policy. Under
hyperinflation, there is a wage-price spiral. To control this, the government should
ni
freeze wages, incomes, profits, dividends, bonus, etc. But such a drastic measure can
only be adopted for a short period and by antagonizing both workers and industrialists.
Therefore, the best course is to link increase in wages to increase in productivity. This
U
will have a dual effect. It will control wage and at the same time increase productivity
and hence production of goods in the economy.
5.1.9 Deflation
ity
A general price increase across the entire economy is above the full employment
level as called inflation. When prices decrease, there is deflation. Economists measure
these changes in prices with price indexes. Inflation can occur when an economy
becomes overheated and grows too quickly. Similarly, a declining economy can lead to
m
deflation. Deflation can lower economic output.
5.1.10 Monetary Policy: Objectives of Monetary Policy

)A
The monetary policy of any country refers to the regulatory policy, whereby the
monetary authority maintains its control over the supply of money for the realization
of general economic objectives, such as stability of employment and prices, economic
growth and balance of payments. This involves manipulation of the supply of money,
(c
the level and structure of interest rate and other conditions affecting the availability of
credit. In the context of developing countries like India, monetary policy acquires a still

wider role and it has to be designed to meet the particular requirements of the economy.
Notes
e
Objectives and Relevance of Monetary Policy
in
The objectives of monetary policy include short run stabilization goal and long term
economic growth and development goal. The following are the specific objectives of
monetary policy:
nl
1. High level of output or the national income
2. High Employment
3. High rate of economic growth.
O
4. Price stability or the optimal rate of inflation (inflation rate is the nominal anchor
for monetary policy)
5. Low inequality in the distribution of income and the equity objective of wealth
ity
6. External stability or healthy balance of payment position (stability of external
value of domestic currency). Monetary policy operates through changes in the
stock of money.
Money stock changes will influences the level of aggregate demand and so the
s
level of output or income. Two characteristics of monetary policy are noteworthy. One
is that it is an aggregative policy. Any allocational or sectoral problems are beyond its
er
domain and these are the concerns of credit policy. Second is that it operates on the
demand side and not on the supply side of the goods market (credit policy can affect
even the supply side of goods market)
v
5.1.11 Functions of Central Bank
ni
A central bank’s primary role is to serve as governor of the credit system to ensure
price stability. It controls the amount of credit and currency, pumps in more money when
market is dry of cash, and pumps out money when credit is excessive. The functions of
U
central bank include –
1. Issue of Currency – Central Bank has the sole monopoly for issuing the currency
to secure control over volume of credit and currency. The notes circulate throughout
ity
a country as legal tender money and it is required to keep a reserve in the form of
foreign securities or gold as per statutory rules against the notes issued by it.
2. Banker to Government - Central bank acts to government as a banker — both
central government and state government. It carries out all government banking
m
activities. The Government keeps its cash balances with the central bank in the
current account. Similarly, central bank receives receipts and makes payments on
the government’s behalf.
)A
3. Controller of Money and Credit Supply - Central bank controls the supply of credit
and money through its monetary policy consisting of two pieces-currency and credit.
Central bank has the privilege of issuing bills (with the exception of one-rupee bills,
one-rupee coins, and government issued small coins) and can therefore regulate
the amount of currency. The main objective of credit control function of central bank
(c
is price stability along with full employment (level of output). It controls credit and
money supply by adopting quantitative and qualitative measures.

4. Banker’s bank and Supervisor - One country typically has hundreds of banks. Some
Notes
e
agency should be in charge of regulating and supervising their proper functioning.
The central bank discharges that duty. The Central bank is thus –
in
(i) It is the custodian of their cash reserves.
(ii) Central bank is lender of last resort. Whenever banks are short of funds, they
can take loans from the central bank and get their trade bills discounted. The
nl
central bank is a source of great strength to the banking system.
(iii) It acts as a bank of central clearance, settlements and also the transfers. Its
moral persuasion is usually very effective so far as commercial banks are
O
concerned.
5.1.12 Credit Policy and Its Implications on the Corporate Sector
ity
A credit policy specifies the conditions on which the balance will be repaid by the
customers buying on account. Suppliers typically expand their credit accounts to daily
purchasers to facilitate repeat sales. A strict credit policy means imposing tight limits
on how long a buyer can pay a debt. The credit policy of a firm provides the framework
to determine whether or not to extend the credit to a customer and how much credit to
s
extend. The credit policy decision has two dimensions
er
(1) Credit standards and
(2) Credit analysis.
v
Implications on the Corporate Sector
a. Sliding Sales - A primary reason companies are extending credit is to encourage
ni
more frequent and larger purchases. When borrowers can acquire inventory without
an upfront cash payment, they will be given more flexibility to meet their own
customers ‘ demands. Typically excessively strict definitions fly in the face of the idea
U
of a credit system. Expecting customers to pay back within a week in an industry

with an average payment period of 30 days means the credit service won’t get much
coverage. If you abruptly move from mild or loose policies to a tight payment window,
you also risk destroying relationships with current customers.
ity
b. Short Term Cash flow - A tight strategy is not poor, because it provides the opportunity
for improved cash flow in the short term. The sooner the cash is in hand, the sooner
it will be possible to pay the creditors and buy further inventories. Regulation should
preferably be presented as equal rather than too tight or too loose. A fair strategy that
m
meets industry expectations usually results in the best balance of continuing activity,
cash flow and low number of collection accounts.
c. Leniency - When the credit policy is too sluggish, the business will be exposed
)A
to a high risk of clients refusing to pay on time or at all. This in turn could create
significant cash flow problems for the enterprise.
5.1.13 Fiscal Policy: Meaning, Objectives and Impact on Economy

(c
Fiscal policy is a budgetary policy. It is the policy of the government in respect

of its annual taxation programme, public expenditure and public debt programmes. A

budget is an annual financial statement of the government which includes estimated

Notes
e
expenditure planned for the coming year and estimated revenues to be raised through
taxes and other revenue sources such as surplus of public enterprises over the year.
in
Fiscal policy thus, refers to a policy under which the government implements its
expenditure, revenue and other programmes during a year to produce favourable
distributional effect and avoid undesirable effects on national income and employment.
nl
The objectives of fiscal policy are summarily stated below:
●● Mobilization of resources through deployment of relevant fiscal instruments

●● Ensuring a high rate of capital formation
O
●● Reallocation of resources to ensure the achievement of nation’s socio-
economic objectives
●● Balanced regional growth
ity
●● An increase in the employment opportunities
●● Achievement of the equity objective through appropriate use of fiscal
instruments.
s
5.1.14 Money Market
The money market applies to trade in securities in very short-term debts. It
er
includes big-volume transactions between institutions and traders at the wholesale
level. It includes, at the retail level, money market mutual funds purchased by individual
investors, and money market accounts opened by bank clients. Money Market is a
v
money market with short-term maturities of up to 1 year. Banks, Non-Banking Financial
Companies, and Money market acceptance houses. It enables short-term fund sales,
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and preserves sufficient market liquidity.
Money Market Instruments

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1. Treasury Bills (T-Bills)

Treasury bills or T- Bills are issued by the Reserve Bank of India on behalf of
the Central Government for raising money. They have short term maturities with the
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highest being up to one year. Currently, T- Bills are issued with three different maturity
periods, which are, 91 days T-Bills, 182 days T- Bills, 1 year T – Bills. T-Bills are
issued at a face-value discount. At maturity the investor earns the sum of face value.
This difference between the original and the face value is the return the investor has
received. These are the best investment in short-term fixed income, since they are
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backed by the Indian government.
2. Commercial Papers
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Large companies and businesses issue promissory notes to raise capital for
meeting the short term business needs, known as Commercial Papers (CPs). Such
firms have a high credit rating, owing to which commercial papers are unsecured, with
company’s credibility acting as security for the financial instrument. Corporates, primary
(c
dealers (PDs) and All-India Financial Institutions (FIs) can issue CPs. They have
a fixed maturity period ranging from 7 days to 270 days and investors can trade this

instrument in the secondary market. They offer relatively higher returns as compared to
Notes
e
the treasury bills.
3. Certificates of Deposits (CD)
in
CDs are financial assets that are issued by banks and financial institutions and
offer a fixed interest rate on the invested amount. The primary difference between a CD
nl
and a FD is of the value of principal amount that can be invested. The former is issued
for large sums of money (1 lakh or in multiples of 1 lakh thereafter).
Because of the restriction on minimum investment amount, CDs are more feasible
O
for the organizations. The maturity period of Certificates of Deposits ranges from seven
days to 1 year, if issued by banks. Other financial institutions can issue a CD with
maturity ranging from 1-3 years.
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4. Repurchase Agreements
Also known as repos or buybacks, Repurchase Agreements represent the formal
agreement between two parties, where one party sells a security to another, with the
promise of buying it back at a later date from the buyer. It is also called a Sell-Buy
s
transaction.
The seller sells the security at a fixed time and sum which also includes the cost
er
at which the buyer agreed to purchase the security. The buyer paid interest rate for
agreeing to purchase the security is called the Repo rate. Repos come in handy when
the vendor needs short-term funds, they can just sell the securities and get the funds to
v
dispose of them. The buyer gets an opportunity to earn decent returns on the invested
money.
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5. Banker’s Acceptance
A financial instrument created in the name of the bank by a business or person is
U
known as the Acceptance of the Banker. It allows the issuer to pay a fixed amount to
the holder of the instrument on a set date, varying from 30 to 180 days, starting with the
date of issue of the instrument. This is a stable financial instrument, as a commercial
bank promises payment. Banker’s Acceptance is issued at a discounted price, and the
ity
actual price is paid to the holder at maturity. The difference between the two is the profit
made by the investor.
5.1.15 Capital Market and Foreign Exchange Market

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Capital market is a market where buyers and sellers trade in financial instruments
such as shares, stocks and so on. Participants such as individuals and institutions carry
on the purchase or the sale. This market generally trades in the long-term securities.
)A
There are two types of Capital Market –
●● Primary Market
●● Secondary Market
Functions of Capital Market:

(c
●● It acts as a linking between investors and the savers

●● Facilitates the movement of capital so as to be used more profitability and
productively to boost the national income

Notes
e
●● Boosts the overall economic growth
●● Mobilizes the savings to finance long term investments
in
●● Facilitates the trading of securities
●● Minimizes the transaction and information costs
nl
●● Encourages a massive range of ownership of various productive assets
●● Helps in quick valuations of financial instruments
●● Through derivative trading, it also offers insurance against market or price
O
threats
●● Facilitates transaction settlement
●● Improves the effectiveness of capital allocation
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●● Ensures a continuous availability of funds
Foreign Exchange Market

The foreign exchange market (also known as forex, FX or currency market) is a
global marketplace over-the-counter (OTC) that determines the exchange rate for
s
currencies worldwide. Participants can buy, sell, trade and speculate on the currencies.
The Forex (FX) market is a global trading currency marketplace. It’s decentralized –
er
that is, it doesn’t run like stock markets do in one specific location.
Functions of the Foreign Exchange Market

v
The Foreign Exchange Market is the market in which businesses and banks buy
and sell foreign currency or foreign currencies. Every country has its own Currency that
ni
is used to quote goods and services prices. For instance, dollar is used in the United
States of America; pound is used in the United Kingdom, yen in Japan, and euro in the
member states of Europe.
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●● The Foreign Exchange Market’s principal role is to move funds from one
country to another and Currency to another. This is important to shift
purchasing power because foreign trade and capital transfers require parties
residing in countries with different national currencies. Each party wishes
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to trade and deal in their own currency but since the trade can be invoiced
only in a single currency, the parties must mutually agree on a currency
beforehand.
●● Foreign exchange market also has an significant role of mitigating foreign
m
exchange risk. The Foreign Exchange Market performs the hedging role
which covers the foreign exchange transaction risks. Those are the risks of
unforeseen foreign exchange rate changes.
)A
Key takeaways
●● Gross Domestic Product: It is a measure of a country’s overall economic
output.
●● Gross National Product: It is the value of all final goods and services
(c
produced by domestically owned factors of production within a given period

Inflation: A general and progressive increase in prices

●● Disposable income: It is the total income that actually remains with

Notes
e
individuals to dispose off as they wish.
●● Gross National Income: The total value produced within a country, together
in
with its income received from other countries less similar payments made to
other countries.
●● Value added: Difference between the value of output produced by a firm and
nl
the total expenditure incurred by it on the materials and intermediate products
purchased from other business firms.
●● Net National Product: NNP is the market value of all final goods and services
O
after providing for depreciation. That is, when charges for depreciation are
deducted from the GNP we get NNP at market price
●● Personal income: An individual’s total earnings from wages, investment
enterprises, and other ventures. It is the sum of all the incomes actually
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received by all
●● Business Cycle: The business cycle, also known as the economic cycle or
trade cycle, is the movement of gross domestic product ( GDP) downward and
upward along its long-term growth rate
s
●● Treasury bills: Bills issued by the Reserve Bank of India on behalf of the
Central Government for raising money.
●●
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Certificate of Deposits: Financial assets that are issued by banks and
financial institutions and offer a fixed interest rate on the invested amount.
Check your progress

v
1. ____ is made up of institutions and other forces that affect a society’s basic
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values, perceptions, preference, and behaviours

a) Political environment
b) Cultural environment
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c) Economic environment
d) Natural environment
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2. ____ consists of factors that affect consumer purchasing power and their spending
patterns.
a) Political environment
b) Cultural environment
m
c) Economic environment
d) Natural environment
)A
3. The total market value of all final goods and services currently produced within the
domestic territory of a country in a year is
a) GDP
b) GNP
(c

c) NNP
Notes
e
d) National Income
4. The term NNP stands for -
in
a) Net National Product
b) New National Product
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c) Net National Price
d) New National Price
O
5. The income left after the payment of direct taxes from personal income is called
a) Personal Income
b) Product Income
ity
c) Disposable Income
d) National Income
s
1. What is a business environment? Describe the factors influencing business
environment
er
2. Describe various National Income Aggregates
3. What is a business cycle? What are its phases
v
4. Describe Demand - Pull and Cost -Push Inflation.
5. Explain the impact of inflation on employment and price levels
ni
Check your progress

1. b) Cultural environment
U
2. c) Economic environment
3. a) GDP
ity
4. a) Net National Product

5. c) Disposable Income
Further Readings
m

Edition, 2015.
)A
(c

Bibliography
Notes
e
Publications.
in
nl
Companies.
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s ity
v er
ni
U
ity
m
)A
(c

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Module-1: Theory of Demand and Supply

●● Relation between demand and supply as represented by functions to demand and

●● Various elasticities of demand to forecast changes in revenues, prices, and/or

●● How to use elasticities to estimate linear demand and supply functions

“Economics as a study of mankind in the ordinary business of life.”

1.1.1 Nature of Economics Analysis

of various commodities in economic systems. It shows how scarce resources can be

which he defined economics as a study of mankind in the ordinary business of

a) According to Marshall, economics is a study of mankind in the ordinary business

economic welfare of people.

b) Marshall makes a distinction between

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i) Economics - A Science and an Art

b) Economics is also an art: An art is a system of rules designed to achieve a

ii) Positive and Normative Economics

Economics is both positive and normative science.

a) Positive science: It only describes what it is and normative science prescribes

is bad to the society. It will simply provide results of economic analysis of a

what should be done to promote human welfare. A positive statement is based

Therefore, economics is a positive as well as normative science.

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iii) Methodology of Economics

Company efficiency is measured as part of an economic model. A firm’s business

1. Managerial economics presents various aspects of traditional economics, relevant

2. Managerial economics also incorporates important ideas from other disciplines

which have a bearing on a manager’s business decisions in view of the various

4. Managerial economics transforms a boss into a more professional model maker.

1.1.4 Demand Analysis

Demand = Desire to buy + Ability to pay + Willingness to pay.

According to Melvin and Boyes, “Demand is a relationship between two variables,

According to Prof. Bober, “Demand means the various quantities of a given

According to Ferguson, “Demand refers to the quantities of commodity that the

things being equal”.

According to B. R. Schiller defines, “Demand is the ability and willingness to buy

specific quantity of a good at alternative prices in a given time period”.

1.1.5 Individual Demand vs. Market Demand

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There is a difference between the concepts of individual demand and market

the demand and vice versa.

1.1.6 Demand by Market Segmentation

Demand Segmentation process is the method of separating a large collection

Segmentation is often necessary in both consumer and industrial markets. In each

a. Mass Marketing - In mass marketing seller engages in mass production, mass

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b. Segment Marketing - A market segment consists of a large identifiable group within

computers delivers computers to individual customers loaded with customer

1.1.7 Determinants of Demand

a. Determinants of Individual Demand

price and the relationship is expressed as D = f (P). In this equation, demand

important determinant of demand, as with the increase in income a person

determines the market demand for products in a relative sense. If the

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welfare distribution, elasticity is also crucial, in particular consumer surplus, producer

Meaning of Elasticity of Demand

According to Marshall, “The elasticity or responsiveness of demand in a market is

Elasticity of demand is the responsiveness of demand for a commodity to changes

Elasticity of Demand = Percentage change in quantity demanded of commodity /

Degrees of Price Elasticity of Demand

1. Perfectly Elastic Demand

3. Relatively Elastic Demand

numerical co-efficient of relatively elastic demand is > 1. This can be diagrammatically

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5. Unitary Elastic Demand

quantity demanded. The numerical co-efficient of unitary elastic demand is always 1