BAFD 19S1 (Word Doc.) Economics For Business

BAFD 19S1 Economics for Business NOTES
INTRODUCTION TO MANAGERIAL ECONOMICS
Structure
CHAPTER I
Unit Objectives
1.1Introduction
1.2Definition
1.3.1 Economics
1.3.2 Managerial economics
1.3.3 Macroeconomics & Micro economics
1.3.4 Deference between Micro economics and Macro economics
1.4 Nature of Managerial Economics
1.5 Scope of Managerial Economics
1.5.,1 Demand Analysis and Forecasting
1.5.2. Cost and Production Analysis
1.5.3. Pricing Decisions, Policies and Practices
1.5.4. Profit Management:
1.5.5. Capital Management
1.6 Characteristics of Managerial Economics
1.7 Importance of Managerial Economics
1.8 Significance of Managerial Economics
1.9 Role of Managerial Economics in Decision Making
1.9.1 Steps in Decision Making
1.10 Definitions
1.10.1 Wealth Definition
1.10.2 Welfare Definition
1.10.3 Scarcity Definition
1.10.4 Growth Definition
1.10.5 Modern Definition
1.11 Production Possibility Curve
1.11.1 Key Features of PPC
1.11.2 Reminders of PPC
1.12 Economics with other Sciences and its Significance
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1.12.1. Managerial Economics and Traditional Economics
NOTES 1.12.2. Managerial Economics and Accounting
1.12.3. Managerial Economics and Operational Research
1.12.4. Managerial Economics and Marketing
1.12.5. Managerial Economics and Production Management
1.12.6. Managerial Economics and Personnel Management
Key words
1.14 Questions
1.14.1 Short Questions
1.14.2 Long Questions
1.15 Text Books
1.1 UNIT O B J E C T I V ES
After studying this unit you will be able to
 Explain the meaning of economics and managerial economics
 Understand the nature and scope of managerial economics
 Understand the various definitions related to wealth, Scarcity and

Growth
 Stating the role of production possibility curve
 Knowing the relationship of Economics with other discipline
1.2 INTRODUCTION
Economics is the study of this allocation of resources, the choices that

are made by economic agents. An economy is a system which attempts to
solve this basic economic problem. There are different types of economies;
household economy, local economy, national economy and international
economy but all economies face the same problem. The major economic
problems are
(i) what to produce?

(ii) How to produce?
(iii) When to produce and
(iv) For whom to produce?
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A good grasp of economics is vital for managerial decision making,
NOTES
for designing and understanding public policy, and to appreciate how an
economy functions.
Managerial economics applies economic theory and methods to

business and administrative decision making. Managerial economics
prescribes rules for improving managerial decisions. Managerial economics
also helps managers recognize how economic forces affect organizations and
describes the economic consequences of managerial behaviour. It links
economic concepts with quantitative methods to develop vital tools for
managerial decision making.

NOTES
1.3 DEFINITION
Economics is growing very rapidly as the years pass. As new ideas are
being discovered and the old theories are being revised, therefore, it is not
possible to give a definition of economics which has a general acceptance.
For the sake of convenience, the set of definitions given by various

economists are generally classified under four heads:
 Economics as a science of wealth.
 Economics as a science of material welfare.
 Economics as a science of scarcity and choice.
 Economics as a science of growth and efficiency.
(i) Economics as a Science of Wealth or Definition of Economics by Adam

Smith:
There is no one definition of Economics which has a general

acceptance. The formal roots of the scientific framework of economics can be
traced back to classical economists. Continue reading.
(ii) Economics as a Science of Material Welfare or Definition of Economics

by Alfred Marshall:
The neo-classical school led by Dr. Alfred Marshall gave economics a

respectable place among social sciences. He was the first economist who lifted
economics from the bad repute it had fallen. Continue reading.
(iii) Economics as a Science of Scarcity and Choice or Definition of

Economics by Robbins:
Marshall’s definition of economics remained an article of faith with all

economists from 1830 to 1932. However, with the publication
of Robbins book 'Nature and Significance of Economic Science' 1932, there
developed a fresh controversy in regard to the definition of
economics. Continue reading.

(iv) Economics as a Science of Growth and Efficiency or Definition of
NOTES
Economics by Modern Economists:
After considering the various definitions of Economics, we can easily

conclude that none of them is satisfactory. If we exclude man and his welfare
from the study of Economics, there will be no use of studying it.
1.3.1 Economics is the science of making decisions in the presence of scarce

resources. Resources are simply anything used to produce a good or service
to achieve a goal. Economic decisions involve the allocation of scarce
resources so as to best meet the managerial goal. The nature of managerial
decision varies depending on the goals of the manager.
1.3.2 Managerial economics is the study of how scarce resources are directed
most efficiently to achieve managerial goals. It is a valuable tool for analyzing
business situations to take better decisions.
Economics can be divided into two broad categories:
1.3.3 MICRO ECONOMICS AND MACROECONOMICS
Macroeconomics is the study of the economic system as a whole. It is related

to issues such as determination of national income, savings, investment,
employment at aggregate levels, tax collection, government expenditure,
foreign trade, money supply etc.,
Microeconomics focuses on the behavior of the individuals, firms and their

interaction in markets. Managerial economics is an application of the
principles of micro and macroeconomics in managerial decision making.
1.3.4 Deference between Micro economics and Macro economics
Microeconomics is the study of economics at an individual, group or

company level. Macroeconomics, on the other hand, is the study of a
national economy as a whole.
Microeconomics focuses on issues that affect individuals and

companies. This could mean studying the supply and demand for a specific
product, the production that an individual or business is capable of, or the
effects of regulations on a business.
Macroeconomics focuses on issues that affect the economy as a

whole. Some of the most common focuses of macroeconomics include

unemployment rates, the gross domestic product of an economy, and the
NOTES effects of exports and imports.
While both fields of economics often use the same principles and
formulas to solve problems, microeconomics is the study of economics at a
far smaller scale, while macroeconomics is the study of large-scale economic
issues.
1.4 NATURE OF MANAGERIAL ECONOMICS
1. Managerial economics is concerned with the analysis of finding optimal

solutions to decision making problems of businesses/ firms (micro
economic in nature).
2. Managerial economics is a practical subject therefore it is pragmatic.
3. Managerial economics describes, what is the observed economic
phenomenon (positive economics) and prescribes what ought to be
(normative economics)
4. Managerial economics is based on strong economic concepts (conceptual
in nature)
5. Managerial economics analyses the problems of the firms in the
perspective of the economy as a whole (macro in nature)
6. It helps to find optimal solution to the business problems (problem
solving)
1.5 SCOPE OF MANAGERIAL ECONOMICS
1.5.1. Demand Analysis and Forecasting:
Demand analysis facilitates the identification of the various factors affecting

the demand for a firm’s product. This, in turn helps the firm in manipulating
the demand for its output.
Demand forecasts are the starting point for a firm’s planning and decision-
making. This deals with the basic tools of demand analysis i.e.; Demand
Determinants, Demand Distinctions and Demand Forecasting etc.
1.5.2. Cost and Production Analysis:
A firm’s profitability depends much on its costs of production. A wise

manager would prepare cost estimates of a range of output, identify the

factors causing variations in costs and choose the cost-minimizing output
NOTES
level, taking also into consideration the degree of uncertainty in production
and cost calculations. The main topics discussed under cost and production
analysis are: Cost concepts, cost-output relationships, Economies and
Diseconomies of scale and cost control.
1.5.3. Pricing Decisions, Policies and Practices:
Since a firm’s income and profit depend mainly on the price decision, the
pricing policies and all such decisions are to be taken after careful analysis of
the nature of the market in which the firm operates. The important topics
covered in this field of study are: Market Structure Analysis, Pricing Practices
and Price Forecasting.
1.5.4. Profit Management:
Economists tell us that profits are the reward for uncertainty bearing and risk
taking. A successful business manager is one who can form more or less
correct estimates of costs and revenues at different levels of output. The more
successful a manager is in reducing uncertainty, the higher are the profits
earned by him. It is therefore, profit-planning and profit measurement that
constitutes the most challenging area of business economics.
1.5.5. Capital Management:
Investments are made in the plant and machinery and buildings which are
very high. Therefore, capital management requires top-level decisions. It
means capital management i.e., planning and control of capital expenditure.
It deals with Cost of capital, Rate of Return and Selection of projects.
1.6 CHARACTERISTICS OF MANAGERIAL ECONOMICS
(i) It studies the problems and principles of an individual business firm

or an individual industry. It aids the management in forecasting and
evaluating the trends of the market.
(ii) It is concerned with varied corrective measures that a management

undertakes under various circumstances. It deals with goal
determination, goal development and achievement of these goals.
Future planning, policy making, decision making and optimal

utilization of available resources, come under the banner of
NOTES managerial economics.
(iii) Managerial economics is pragmatic. In pure microeconomic theory,

analysis is performed, based on certain exceptions, which are far
from reality. However, in managerial economics, managerial issues
are resolved daily and difficult issues of economic theory are kept at
bay.
(iv) Managerial economics employs economic concepts and principles,

which are known as the theory of Firm or 'Economics of the Firm'.
Thus, its scope is narrower than that of pure economic theory.
(v) Managerial economics incorporates certain aspects of macroeconomic

theory. These are essential to comprehending the circumstances and
environments that envelop the working conditions of an individual
firm or an industry. Knowledge of macroeconomic issues such as
business cycles, taxation policies, industrial policy of the
government, price and distribution policies, wage policies and
antimonopoly policies and so on, is integral to the successful
functioning of a business enterprise.
(vi) Managerial economics aims at supporting the management in taking

corrective decisions and charting plans and policies for future.
(vii) Science is a system of rules and principles engendered for attaining

given ends. Scientific methods have been credited as the optimal path
to achieving one's goals. Managerial economics has been is also
called a scientific art because it helps the management in the best and
efficient utilization of scarce economic resources. It considers
production costs, demand, price, profit, risk etc. It assists the
management in singling out the most feasible alternative. Managerial
economics facilitates good and result oriented decisions under
conditions of uncertainty.
(viii) Managerial economics is a normative and applied discipline. It

suggests the application of economic principles with regard to policy
formulation, decision-making and future planning. It not only

describes the goals of an organization but also prescribes the means
NOTES
of achieving these goals.
1.7 IMPORTANCE OF MANAGERIAL ECONOMICS
(i) Accommodating traditional theoretical concepts to the actual business

behavior and conditions:
Managerial economics amalgamates tools, techniques, models and theories of

traditional economics with actual business practices and with the
environment in which a firm has to operate. According to Edwin Mansfield,
“Managerial Economics attempts to bridge the gap between purely analytical
problems that intrigue many economic theories and the problems of policies
that management must face”.
(ii) Estimating economic relationships:
Managerial economics estimates economic relationships between different

business factors such as income, elasticity of demand, cost volume, profit
analysis etc.
(iii) Predicting relevant economic quantities:
Managerial economics assists the management in predicting various

economic quantities such as cost, profit, demand,
capital, production, price etc. As a business manager has to function in an

environment of uncertainty, it is imperative to anticipate the future working
environment in terms of the said quantities.
(iv) Understanding significant external forces:
The management has to identify all the important factors that influence a
firm. These factors can broadly be divided into two categories. Managerial
economics plays an important role by assisting management in
understanding these factors.
(a) External factors:
A firm cannot exercise any control over these factors. The plans, policies and
programs of the firm should be formulated in the light of these factors.
Significant external factors impinging on the decision making process of a
firm are economic system of the country, business cycles, fluctuations in

national income and national production, industrial policy of the
NOTES government, trade and fiscal policy of the government, taxation policy,
licensing policy, trends in foreign trade of the country, general industrial
relation in the country and so on.
(b) Internal factors:
These factors fall under the control of a firm. These factors are associated with
business operation. Knowledge of these factors aids the management in
making sound business decisions.
(v) Basis of business policies:
Managerial economics is the founding principle of business policies.

Business policies are prepared based on studies and findings of
managerial economics, which cautions the management against potential
upheavals in national as well as international economy. Thus, managerial
economics is helpful to the management in its decision-making process.
1.8. SIGNIFICANCE OF MANAGERIAL ECONOMICS
• It helps in decision making
• Decision making means a balance between simplification of analysis

to be manageable and complication of factors in hand
• It helps the manager to become an more competent builder
• It helps in providing most of the concepts that are needed for the
analysis of business problems , the concepts such as elasticity of
demand ,fixed, variable cost, SR and LR costs, opportunity costs, NPV
etc.,
• It helps in making decisions in the following:
What should be the product mix?

Which is the production technique?
What is the input mix at least cost?
What should be the level of output and price?
How to take investment decisions?
How much should the firm advertise?

1.9ROLE OF MANAGERIAL ECONOMICS IN DECISION
NOTES
MAKING
To establish appropriate decision rules, managers must

understand the economic environment in which they operate. for
example, a grocery retailer may offer consumers a highly price-
sensitive product, such as milk, at an extremely low markup over cost
—say, 1 percent to 2 percent—while offering less price-sensitive
products, such as nonprescription drugs, at markups of as high as 40
percent over cost.
Managerial economics describes the logic of this pricing practice

with respect to the goal of profit maximization. Similarly, managerial
economics reveals that auto import quotas reduce the availability of
substitutes for domestically produced cars, raise auto prices, and create
the possibility of monopoly profits for domestic manufacturers. it does
not explain whether imposing quotas is good public policy; that is a
decision involving broader political considerations.
Managerial economics only describes the predictable economic

consequences of such actions. Managerial economics offers a
comprehensive application of economic theory and methodology to
management decision making. it is as relevant to the management of
government agencies, cooperatives, schools, hospitals, museums, and
similar not-for-profit institutions as it is to the management of profit-
oriented businesses.
1.9.1 STEPS IN MANAGERIAL DECISION MAKING
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NOTES
How managerial economics does helps in decision making?
Following are the steps helps to managers while taking decisions.
1. Establish objectives.
2. Define the problem.
3. Identify factors that affect the problem.
4. Specify alternative solutions.
5. collect data and other information's.
6. Evaluate and screen alternatives.
7. Implement best alternative and monitor result.

NOTES
1.10DEFINITIONS
Evolution in the Definitions of Economics
• A. Wealth Definition (1776) Adam Smith
• B. Welfare Definition (1890) Alfred Marshall
• C. Scarcity Definition (1932) Lionel Robbins
• D. Growth Definition (1948) P.A. Samuelson
• E. Modern Definition (2011) A.C. Dhas
1.10.1 Wealth
Adam Smith, who is regarded as Father of Economics, defined economics as

“a science which enquires into the nature and cause of wealth of nations”.
Sources of Wealth
He also suggested that the active labors can earn high amount of wages only
through the division of labor in production and distribution of goods and
services.He concludes that apart from wages, there is nothing else which can
be regarded as sources of wealth of a nation.
Features of Wealth Definition
• Characteristics: It takes into account only material goods Exaggerated the

emphasis on wealth It inquires the caused behind creation of wealth
• Criticisms: It considered economics as a dismal or selfish science. It defined

wealth in a very narrow and restricted sense. It considered only material and
tangible goods. It gave emphasis only to wealth and reduced man to
secondary place.
1.10.2Welfare Definition
According to A. Marshall “Economics is 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 material
requisites of wellbeing”.

NOTES
Features of Welfare Definition
• Characteristics: It is primarily the study of mankind. It is on one side a

study of wealth; and on other side the study of man. It takes into account
ordinary business of life – It is not concerned with social, religious and
political aspects of man’s life. It emphasises on material welfare i.e., human
welfare which is related to wealth. It limits the scope to activities amenable to
measurement in terms of money
• Criticisms: It considers economics as a social science rather than a human

science. It restricts the scope of economics to the study of persons living in
organized communities only. Welfare in itself has a wide meaning which is
not made clear in definition.
1.10.3 Scarcity Definition
According to Lionel Robbins: “Economics is the science which studies human

behavior as a relationship between ends and scarce means which have
alternate uses.”
Features of Scarcity Definition
• Characteristics: Economics is a positive science. New concepts: Unlimited

ends, scarce means, and alternate uses of means. It emphases on Choice – A
study of human behavior It tried to bring the economic problem which forms
the foundation of economics as a social science. It takes into account all
human activities.
• Criticisms: It does not focus on many important economic issues of cyclical

instability, unemployment, income determination and economic growth and
development. It did not take into account the possibility of increase in
resources over time. It has treated economics as a science of scarcity only.
1.10.4 Growth Definition
According to Prof. Paul A Samuelson “Economics is the study of how men

and society choose with or without the use of money, to employ the scarce
productive resources which have alternative uses, to produce various
commodities over time and distribute them for consumption now and in

future among various people and groups of society. It analyses the costs and
NOTES
benefits of improving pattern of resource allocation”.
Features of Growth Definition
• Characteristics: It is not merely concerned with the allocation of resources

but also with the expansion of resources. It analyzed how the expansion and
growth of resources to be used to cope with increasing human wants. It is a
more dynamic approach. It considers the problem of resource allocation as a
universal problem. It focused on both production and consumption activities.
It is comprehensive in nature as it is both growth-oriented as well as future-
oriented. It incorporated the features of all the earlier definitions
• Criticisms: It assumes that economics is relevant for scarcity situations and

it ignored surplus resource conditions.
1.10.5 Modern Definition
According to Prof.A.C.Dhas, “Economics is the study of choice making by

individuals, institutions, societies, nations and globe under conditions of
scarcity and surplus towards maximizing benefits and satisfying their
unlimited needs at present and future”.
In short, the subject Economics is defined as the “Study of choices by all in

maximizing production and consumption benefits with the given resources of
scarce and surplus,
Features of Modern Definition
Characteristics:
• It takes into account all the earlier definitions – wealth, welfare, scarcity
and growth.
• It covers both micro and macro aspects of economics.
• It considers both production and consumption activities.
• It emphasizes Choice Making dimension as crucial in economics.
• It aims at obtaining maximum benefits with given resources
• It is suitable in conditions of both scarcity and surplus.
• It takes in to account the present and future –Time dimension – Growth
dimension.

• It is relevant in the context of globalisation and sustainable
NOTES development.
1.11 PRODUCTION POSSIBILITY CURVE
Aproduction possibility curve measures the maximum output of two goods

using a fixed amount of input. The input is any combination of the
four factors of production. They are land and
other natural resources,labor,capital goods, and entrepreneurship.
We can use the PPC to illustrate:
 Scarcity
 Efficiency
 Opportunity costs
 Gains from trade
1.11.1. Key features of the PPC
 Two axes: each axis represents a good that a country produces, such
as capital goods and consumer goods.

 One curve: A curve showing all possible combinations that
NOTES
can be produced given the current stock of capital, labor, natural resources,
and technology. A straight line represents constant opportunity costs, and a
bowed out line represents increasing opportunity costs.
1.11.2. HELPFUL REMINDERS FOR THE PPC
 Use arrows to indicate the direction of any change.
 Unless the prompt states otherwise, use a concave (“bowed out”) PPC
to indicate increasing opportunity costs.

NOTES
1.12 RELATIONSHIP WITH OTHER SCIENCES & ITS

SIGNIFICANCE
1.12.1. Managerial Economics and Traditional Economics:
Managerial Economics has been described as economics applied to decision-

making. It may be viewed as a special branch of economics bridging the gulf
between pure economic theory and managerial practice. The relation between
Managerial Economics and Economics is as close as is Engineering to Physics
and Medicines to Biology. Traditional Economics has two main divisions:
microeconomics and macroeconomics. Microeconomics; also known as price
theory, is the main source of concepts and analytical tools for managerial
economics.
1.12.2.Managerial Economics and Accounting:
Managerial economics and accounting are closely interrelated. Accounting

can be defined as the recording of financial operations of a business firm. A
business manager needs a lot of accounting information data for logical
analysis in decision-making and policy formulation at the level of firm.

NOTES
1.12.3. Managerial Economics and Operational Research:
Operational Research is closely related to managerial economics. Operational

research is the application of mathematical techniques to solving business
problems. It provides all the data required for business decisions and forward
planning. Techniques such as linear programming, game theory, etc. are due
to the works of operational research, linear programming is extensively used
in decision-making.
1.12.4. Managerial Economics and Marketing:
Managerial Economics helps marketing in two ways. First, as a basic

discipline, providing tools and concepts of analysis and second, as an
integrating area, providing its judgment on the optimum sales volume under
the given cost function of a firm, market structure, and the objective function
to be optimized. How much to sell under given circumstances is answered by
an economist and how to sell the desired amount of output is the domain of
the marketing manager. Sometimes, selling more than what is desired may
harm the interest of the firm. It has, however, the sanction neither of
Economics nor of marketing principles as both stresses on the protection of
long run interests of the firm
1.12.5. Managerial Economics and Production Management:
Production is defined as the creation of utility by transforming input into

output. It usually refers to manufacturing activity and the term operations are
used to denote a wider meaning, encompassing all economic activity which
creates economic utility.
1.12.6. Managerial Economics and Personnel Management:
A human resource manager has to concern himself with two types of

problems: (i) an effective utilization of human resources in terms of costs and
productivity and (ii) improvement in the terms and conditions of
employment as an adjunct to employee satisfaction. Manpower planning, at
the micro level, is another important function of an HRD manager wherein a
firm ensures that it has the right number and the right kind of people, at the

right places, at the right time, doing work for which they are economically
NOTES most useful.
1.13 KEYWORDS
Economics Managerial Economics Microeconomics
Macro Economics Wealth Scarcity Growth Production
Possibility Curve Opportunity Cost
1.14.QUESTIONS
1. Define Economics
2. Define Managerial Economics
3. What is Micro Economics?
4. What is Macro Economics?
5. Define Wealth
6. Define Welfare
7. Define Scarcity
8. Define Growth
9. Write the significance of Managerial Economics

NOTES
1. Difference between Micro Economics & Macro Economics

2. Explain the Nature of Managerial Economics
3. Explain the Scope of Managerial Economics
4. Explain Production Possibility Curve
5. Elaborate on Managerial Economics with other Discipline
1.15TEXT BOOKS
1. Varshney and Maheswari, -Managerial Economics

2. D.N Dwivedi, Joel Dean, Managerial Economics.
3. Gupta G.S., Managerial Economics.
4. Peterson, Managerial Economics.
5. Stokes C.J, Economics for Managers.

NOTES
Chapter - 2
DEMAND ANALYSIS
Structure
2.1 Unit objectives

2.2 Introduction
2.3 Demand
2.4 Determinants of Demand
2.4.1 Price of the good
2.4.2 Price of related goods
2.4.3 Consumer’s Income
2.4.4 Taste, preference, fashions and habit
2.4.5 Population
2.4.6 Money Circulation
2.4.7 Value of money
2.4.8 Weather Condition
2.4.9 Advertisement and Salesmanship
2.4.10 Consumer’s future price expectation
2.4.11 Government policy (taxation
2.4.12 Credit facilities
2.4.13 Multiplicity of uses of goods
2.5 Demand schedule
2.6 Demand Curve
2.7 Demand Function
2.8 Law of Demand
2.9 Assumption of Law of Demand
2.10 Elasticity of Demand
2.11 Types of Elasticity of Demand

2.11.1 Price Elasticity
NOTES
1. Relatively Elastic Demand
2. Perfectly Elastic Demand
3. Relatively Inelastic Demand
4. Perfectly Inelastic Demand
5. Unit Elasticity of Demand
2.11.2 Income Elasticity
1. Zero Income Elasticity
2. Negative Income Elasticity
3. Unitary Income Elasticity
4. Income Elasticity is Greater than
5. Income Elasticity is Less than 1
2.11.3 Cross Elasticity
2.12 Demand Forecasting
2.13 Demand Forecasting Methods
2.13.1 Survey Method
i. Experts’ Opinion Poll
ii. Delphi Method
iii. Market Experiment Method
2.13.2 Statistical Methods
i. Trend Projection Method
ii. Barometric Method
iii. Econometric Methods
2.14 Key words
2.15 Questions
2.16 TEXT BOOKS

 Explain the meaning of Demand
NOTES
 Understand the determinants of Demand, Demand Function
 Understanding Law of demand
 Knowing the types of elasticity of demand
 Knowing the various forecasting methods
2.2 INTRODUCTION
The concepts of demand and supply are useful for explaining what is
happening in the market place. Every market transaction involves an
exchange and many exchanges are undertaken in a single day. The circular
flow of economic activity explains clearly that every day there are a number
of exchanges taking place among the four major sectors such as Household,
Firm, Government, Foreign Sector.
2.3 DEMAND
“Demand means effective desire or want for a commodity which is backed up

by the ability (purchasing power) and willingness to pay for it”.
Demand = Desire + Ability to pay + Willingness to spend
• Demand is a relative concept – not absolute
• It is related to price , time and place.
• “The demand for a commodity refers to the amount of it which will be

bought per unit of time at a particular price ( in a particular market)”.
2.4 DETERMINANTS OF DEMAND
2.4.1 Price of the good:
The price of a commodity is an important determinant of demand. Price and

demand are inversely related. Higher the price less is the demand and vice
versa.

NOTES
2.4.2 Price of related goods:
The price of related goods like substitutes and complementary goods also
affect the demand. In the case of substitutes, rise in price of one commodity
lead to increase in demand for its substitute. In the case of complementary
goods, fall in the price of one commodity lead to rise in demand for both the
goods.
2.4.3 Consumer’s Income:
This is directly related to demand. A change in the income of the consumer

significantly influences his demand for most commodities. If the disposable
income increases, demand will be more.
2.4.4 Taste, preference, fashions and habits:
These are very effective factors affecting demand for a commodity. When
there is a change in taste, habits or preferences of the consumer, his demand
will change. Fashions and customs in society determine many of our
demands.
2.4.5 Population:
If the size of the population is more, demand for goods will be more . The
market demand for a commodity substantially changes when there is change
in the total population.
2.4.6 Money Circulation:
More the money in circulation, higher the demand and vice versa.
2.4.7 Value of money:
The value of money determines the demand for a commodity in the market.
When there is a rise or fall in the value of money there may be changes in the
relative prices of different goods and their demand.
2.4.8 Weather Condition:
Weather is also an important factor that determines the demand for certain
goods.

NOTES
2.4.9 Advertisement and Salesmanship:
If the advertisement is very attractive for a commodity, demand will be more.

Similarly if the salesmanship and publicity is effective then the demand for
the commodity will be more.
2.4.10 Consumer’s future price expectation:
If the consumers expect that there will be a rise in prices in future, he may
buy more at the present price and so his demand increases.
2.4.11 Government policy (taxation):
High taxes will increase the price and reduce demand, while low taxes will
reduce the price and extend the demand.
2.4.12 Credit facilities:
Depending on the availability of credit facilities the demand for commodities

will change. More the facilities higher the demand.
2.4.13 Multiplicity of uses of goods:
If the commodity has multiple uses then the demand will be more than if
the commodity is used for a single purpose.
2.5 DEMAND SCHEDULE:
It is a statement in the form of a table that shows the different

quantities in demand at different prices. There are two types of Demand
Schedules:
 Individual Demand Schedule

 Market Demand Schedule
Individual Demand Schedule
It is a demanding schedule that depicts the demand of an individual

customer for a commodity in relation to its price. Let us study it with the help
of an example.

NOTES
Price per unit of commodity X Quantity demanded of commodity
(Px) X (Dx)
100 50
200 40
300 30
400 20
500 10
The above schedule depicts the individual demand schedule. We can see that
when the price of the commodity is ₹100, its demand is 50 units. Similarly,
when its price is ₹500, its demand decreases to 10 units.
Thus, we can conclude that as the price falls the demand increases and as the
price raises the demand decreases. Hence, there exists an inverse relationship
between the price and quantity demanded.
Market Demand Schedule
It is a summation of the individual demand schedules and depicts the

demand of different customers for a commodity in relation to its price. Let us
study it with the help of an example.

NOTES Quantity
Price per Quantity
demanded Market Demand
unit of demanded by
by
commodity consumer A QA + QB
consumer B
X (QA)
(QB)
100 50 70 120
200 40 60 100
300 30 50 80
400 20 40 60
500 10 30 40
The above schedule shows the market demand for commodity X. When the
price of the commodity is ₹100, customer A demands 50 units while the
customer B demands 70 units.
Thus, the market demand is 120 units. Similarly, when its price is ₹500,
Customer A demands 20 units while customer B demands 30 units.
Thus, its market demand decreases to 40 units. Thus, we can conclude that
whether it is the individual demand or the market demand, the law of
demand governs both of them.
2.6 DEMAND CURVE:
The quantity of a commodity demanded depends on the price of that

commodity and potentially on many other factors, such as the prices of other
commodities, the incomes and preferences of consumers, and seasonal effects.
In basic economic analysis, all factors except the price of the commodity are
often held constant; the analysis then involves examining the relationship
between various price levels and the maximum quantity that would

potentially be purchased by consumers at each of those prices. The price-
NOTES
quantity combinations may be plotted on a curve, known as a demand curve,
with price represented on the vertical axis and quantity represented on the
horizontal axis. A demand curve is almost always downward-sloping,
reflecting the willingness of consumers to purchase more of the commodity at
lower price levels. Any change in non-price factors would cause a shift in the
demand curve, whereas changes in the price of the commodity can be traced
along a fixed demand curve.
A curve indicating the total quantity of a product that all consumers

are willing and able to purchase at the prevailing price level, holding the
prices of related goods, income and other variables as constant.
2.7 DEMAND FUNCTION
Demand function is a function that describe how much of a commodity will

be purchased at the prevailing prices of that commodity and related
commodities, alternative income levels, and alternative values of other
variables affecting demand.
Types of Demand Function

Based on whether the demand function is in relation to an individual
NOTES consumer or to all consumers in the market, the demand function cab be
categorized as
 Individual Demand Function

 Market Demand Function
Individual Demand Function
Individual demand function refers to the functional relationship between

demand made by an individual consumer and the factors affecting the
individual demand. It shows how demand made by an individual in the
market is related to its determinants.
Mathematically, individual demand function can be expressed as,
Dx= f (Px, Pr, Y, T, F)
Where,
Dx= Demand for commodity x;
Px= Price of the given commodity x;
Pr= Price of related goods;
Y= Income of the individual consumer;
T= Tastes and preferences;
F= Expectation of change in price in the future.
Market Demand Function
Market demand function refers to the functional relationship between market

demand and the factors affecting market demand. Market demand is affected
by all the factors that affect an individual demand. In addition to this, it is
also affected by size and composition of population, season and weather
conditions, and distribution of income.
Mathematically, market demand function can be expressed as,
Dx= f (Px, Pr, Y, T, F, Po, S, D)
Where,
Dx= Demand for commodity x;

Px= Price of the given commodity x;
NOTES
Pr= Price of related goods;
Y= Income of the individual consumer;
T= Tastes and preferences;
F= Expectation of change in price in the future;
Po= Size and composition of population;
S= Season and weather;
D= Distribution of income.
2.8 LAW OF DEMAND:
The quantity of a commodity demanded in a given time period increases as

its price falls, ceteris paribus. (I.e. other things remaining constant)
2.9 ASSUMPTIONS OF LAW OF DEMAND
i. Assumes that the consumer’s income remains same. If the income of

an individual increases, the demand for products by him/her also
increases, which is against the law of demand. Therefore, the income
of consumer should not change.
ii. Assumes that the preferences of consumer remain same.
iii. Considers that the fashion does not show any changes, because if
fashion changes, then people would not purchase the products that
are out of fashion.
iv. Assumes that there would be no change in the age structure, size, and
sex ratio of population. This is because if population size increases,
then the number of buyers increases, which, in turn, affect the
demand for a product directly.
v. Restricts the innovation and new varieties of products in the market,
which can affect the demand for the existing product.
vi. Restricts changes in the distribution of income.
vii. Avoids any type of change fiscal policies of the government of a
nation, which reduces the effect of taxation on the demand of product.
2.10 ELASTICITY OF DEMAND

Elasticity of Demand is a technical term used by economists to describe the
NOTES degree of responsiveness of the demand for a commodity due to a fall in its
price. A fall in price leads to an increase in quantity demanded and vice
versa.
2.11 TYPES OF ELASTICITY OF DEMAND
Ֆ Price Elasticity
Ֆ Income Elasticity and
Ֆ Cross Elasticity
2.11.1 Price Elasticity
The response of the consumers to a change in the price of a commodity is

measured by the price elasticity of the commodity demand. The
responsiveness of changes in quantity demanded due to changes in price is
referred to as price elasticity of demand. The price elasticity of demand is
measured by dividing the percentage change in quantity demanded by the
percentage change in price.
Price Elasticity = Proportionate change in the Quantity Demanded /
Proportionate change in price
Percentage change in quantity demanded
ΔQ / Q
= ---------
ΔP / P
ΔQ = change in quantity demanded
ΔP = change in price
P = price
Q = quantity demanded
The following are the possible combination of changes in Price and Quantity
demanded. The slope of each combination is depicted in the following
graphs.

1. Relatively Elastic Demand (e >1) a small percentage change in price
NOTES
leading to a larger change in Quantity demanded.
2. Perfectly Elastic Demand (e = ∞) a small change in price will change

the quantity demanded by an infinite amount.
3. Relatively Inelastic Demand (e < 1) a change in price leads to a

smaller percentage change in quantity demanded.

NOTES
4. Perfectly Inelastic Demand (e = 0) the quantity demanded does not

change regardless of the percentage change in price.
5. Unit Elasticity of Demand (e =1) the percentage change in quantity

demanded is the same as the percentage change in price that caused it.

NOTES
2.11.2 Income Elasticity
Income elasticity of demand measures the responsiveness of quantity

demanded to a change in income. It is measured by dividing the percentage
change in quantity demanded by the percentage change in income.
Types of income elasticity
1.Zero Income Elasticity: The increase in income of the individual does not
make any difference in the demand for that commodity. ( Ei = 0)

2.Negative Income Elasticity: The increase in the income of consumers leads
NOTES to less purchase of those goods. ( Ei< 0).
3.Unitary Income Elasticity: The change in income leads to the same

percentage of change in the demand for the good. ( Ei = 1).

NOTES
4.Income Elasticity is Greater than 1: The change in income increases the
demand for that commodity more than the change in the income. ( Ei> 1).
5. Income Elasticity is Less than 1: The change in income increases the

demand for the commodity but at a lesser percentage than the change in the
Income. ( Ei< 1).

NOTES
2.11.3 Cross Elasticity
The quantity demanded of a particular commodity varies according to the

price of other commodities. Cross elasticity measures the responsiveness of
the quantity demanded of a commodity due to changes in the price of
another commodity. For example the demand for tea increases when the price
of coffee goes up. Here the cross elasticity of demand for tea is high. If two
goods are substitutes then they will have a positive cross elasticity of
demand. In other words if two goods are complementary to each other then
negative income elasticity may arise.
The responsiveness of the quantity of one commodity demanded to a change

in the price of another good is calculated with the following formula.
% change in demand for commodity X

= ------------------------------------------------
% change in price of commodity Y
If two commodities are unrelated goods, the increase in the price of one good
does not result in any change in the demand for the other goods. For example
the price fall in Tata salt does not make any change in the demand for Tata
Nano.

NOTES
2.12 DEMAND FORECASTING
All organizations operate in an atmosphere of uncertainty but decisions must

be made today that affect the future of the organization. There are various
ways of making forecasts that rely on logical methods of manipulating the
data that have been generated by historical events. A forecast is a prediction
or estimation of a future situation, under given conditions. Demand forecast
will help the manager to take the following decisions effectively.
2.13 Demand Forecasting Methods
2.13.1 Survey Method:
Survey method is one of the most common and direct methods of forecasting
demand in the short term. This method encompasses the future purchase
plans of consumers and their intentions. In this method, an organization
conducts surveys with consumers to determine the demand for their existing
products and services and anticipate the future demand accordingly.
i. Experts’ Opinion Poll:
Refers to a method in which experts are requested to provide their opinion

about the product. Generally, in an organization, sales representatives act as
experts who can assess the demand for the product in different areas, regions,
or cities.
Sales representatives are in close touch with consumers; therefore, they are
well aware of the consumers’ future purchase plans, their reactions to market
change, and their perceptions for other competing products. They provide an
approximate estimate of the demand for the organization’s products. This
method is quite simple and less expensive.
ii. Delphi Method:
Refers to a group decision-making technique of forecasting demand. In this

method, questions are individually asked from a group of experts to obtain
their opinions on demand for products in future. These questions are
repeatedly asked until a consensus is obtained.

NOTES
iii. Market Experiment Method:
Involves collecting necessary information regarding the current and future

demand for a product. This method carries out the studies and experiments
on consumer behavior under actual market conditions. In this method, some
areas of markets are selected with similar features, such as population,
income levels, cultural background, and tastes of consumers.
2.13.2 Statistical Methods:
Statistical methods are complex set of methods of demand forecasting. These

methods are used to forecast demand in the long term. In this method,
demand is forecasted on the basis of historical data and cross-sectional data.
i. Trend Projection Method:
Trend projection or least square method is the classical method of business

forecasting. In this method, a large amount of reliable data is required for
forecasting demand. In addition, this method assumes that the factors, such
as sales and demand, responsible for past trends would remain the same in
future.
ii. Barometric Method:
In barometric method, demand is predicted on the basis of past events or key

variables occurring in the present. This method is also used to predict various
economic indicators, such as saving, investment, and income. This method
was introduced by Harvard Economic Service in 1920 and further revised by
National Bureau of Economic Research (NBER) in 1930s.
This technique helps in determining the general trend of business activities.

For example, suppose government allots land to the XYZ society for
constructing buildings. This indicates that there would be high demand for
cement, bricks, and steel.
iii. Econometric Methods:
Econometric methods combine statistical tools with economic theories for

forecasting. The forecasts made by this method are very reliable than any
other method. An econometric model consists of two types of methods
namely, regression model and simultaneous equations model.

NOTES
-------------------------------------------------------------------------------------------------------
2.14 KEYWORDS
Demand Demand function Demand schedule Demand Curve
Law of Demand Elasticity Determinants Forecasting

----------------------------------------------------------------------------------------
2.15 QUESTIONS
2.15.1 Short questions
1. Define Demand
2. Write demand function
3. Write demand schedule
4. What are the assumptions of Law of Demand
5. Define elasticity of demand
6. What is cross elasticity of demand
1. Explain the determinants of demand
2. Explain the types of price elasticity of demand
3. Explain the types of income elasticity of demand
4. Explain various demand forecasting methods
2.16 TEXT BOOKS

Chapter - 3
NOTES
PRODUCTION & COST CONCEPTS
Structure
CHAPTER III
3.1 Unit objectives
3.2 Introduction
3.3 Production Function
3.4 Law of variable Proportions
3.4.1 Assumptions of Law of variable proportions
(i) Constant Technology
(ii) Factor Proportions are Variable
(iii) Homogeneous Factor Units
(iv) Short-Run
3.5 Returns to scale
3.5.1 Increasing Returns to Scale
3.5.2 Constant Returns to Scale
3.5.3 Diminishing Returns to Scale
3.6 Iso‐Product Curves
Properties of Iso-Product Curves
Iso-Product Curves Slope Downward from Left to Right
Isoquants are Convex to the Origin
Two Iso-Product Curves Never Cut Each Other
Higher Iso-Product Curves Represent Higher Level of Output
Isoquants Need Not be Parallel to Each Other
No Isoquant can Touch Either Axis
Each Isoquant is Oval-Shaped
3.7 Meaning of Cost
3.8 Cost Concepts
3.9 Cost Determinants
3.10 Types of Costs
3.11 Cost – output relationship in short run

3.12 Cost – output relationship in long run
NOTES
3.13 Break Even
3.13.1 Features
3.13.2 Significance
3.14 Key words
3.15 Questions
3.15.2 Long Question
3.16 TEXT BOOK
 Explain the meaning of Production Function
 Understand the concept of variable proportion
 Understand the various return to scale, iso quant curves
 Stating the role of cost output relationship in short run and long run
 Knowing the break even point
3.2 INTRODUCTION
Production refers to the continuous process of converting raw materials or

semi-finished goods to finished goods. Moreover, these finished goods
contain MRPs that help in selling the products to the end users. End users
may either be individual consumers or other firms who need the finished
goods for their business activities. In addition, production is the result of
cooperation between the different factors of production. Thus, the efforts of
these factors are often in the same direction in order to achieve the goal.
3.3 PRODUCTION FUNCTION
Production is the result of co-operation of four factors of production viz.,

land, labour, capital and organization.

This is evident from the fact that no single commodity can be produced
NOTES without the help of any one of these four factors of production.
3.4 LAW OF VARIABLE PROPORTIONS
Law of Variable Proportions occupies an important place in economic theory.

This law is also known as Law of Proportionality. Keeping other factors fixed,
the law explains the production function with one factor variable. In the short
run when output of a commodity is sought to be increased, the law of
variable proportions comes into operation.
3.4.1 Assumptions of Law of variable proportions
(i) Constant Technology:
The state of technology is assumed to be given and constant. If there is an

improvement in technology the production function will move upward.
(ii) Factor Proportions are Variable:
The law assumes that factor proportions are variable. If factors of production
are to be combined in a fixed proportion, the law has no validity.
(iii) Homogeneous Factor Units:
The units of variable factor are homogeneous. Each unit is identical in quality
and amount with every other unit.
(iv) Short-Run:
The law operates in the short-run when it is not possible to vary all factor
inputs.
3.5 RETURNS TO SCALE
On the basis of these possibilities, law of returns can be classified into

three categories:
i. Increasing returns to scale
ii. Constant returns to scale
iii. Diminishing returns to scale

3.5.1. Increasing Returns to Scale:
NOTES
If the proportional change in the output of an organization is greater than the
proportional change in inputs, the production is said to reflect increasing
returns to scale. For example, to produce a particular product, if the quantity
of inputs is doubled and the increase in output is more than double, it is said
to be an increasing returns to scale. When there is an increase in the scale of
production, the average cost per unit produced is lower. This is because at
this stage an organization enjoys high economies of scale.
Figure-13
A movement from a to b indicates that the amount of input is doubled. Now,

the combination of inputs has reached to 2K+2L from 1K+1L. However, the
output has Increased from 10 to 25 (150% increase), which is more than
double. Similarly, when input changes from 2K-H2L to 3K + 3L, then output
changes from 25 to 50(100% increase), which is greater than change in input.
This shows increasing returns to scale. There a number of factors responsible
for increasing returns to scale.
Some of the factors are as follows:

i. Technical and managerial indivisibility:
NOTES
Implies that there are certain inputs, such as machines and human resource,
used for the production process are available in a fixed amount. These inputs
cannot be divided to suit different level of production. For example, an
organization cannot use the half of the turbine for small scale of production.
Similarly, the organization cannot use half of a manager to achieve small scale
of production. Due to this technical and managerial indivisibility, an
organization needs to employ the minimum quantity of machines and
managers even in case the level of production is much less than their capacity
of producing output. Therefore, when there is increase in inputs, there is
exponential increase in the level of output.
ii. Specialization:
Implies that high degree of specialization of man and machinery helps in

increasing the scale of production. The use of specialized labor and
machinery helps in increasing the productivity of labor and capital per unit.
This results in increasing returns to scale.
iii. Concept of Dimensions:
Refers to the relation of increasing returns to scale to the concept of

dimensions. According to the concept of dimensions, if the length and
breadth of a room increases, then its area gets more than doubled.
3.5.2 Constant Returns to Scale:
The production is said to generate constant returns to scale when the

proportionate change in input is equal to the proportionate change in output.
For example, when inputs are doubled, so output should also be doubled,
then it is a case of constant returns to scale.

NOTES
When there is a movement from a to b, it indicates that input is doubled.

Now, when the combination of inputs has reached to 2K+2L from IK+IL, then
the output has increased from 10 to 20. Similarly, when input changes from
2Kt2L to 3K + 3L, then output changes from 20 to 30, which is equal to the
change in input. This shows constant returns to scale. In constant returns to
scale, inputs are divisible and production function is homogeneous.
3.5.3 Diminishing Returns to Scale:
Diminishing returns to scale refers to a situation when the proportionate

change in output is less than the proportionate change in input. For example,
when capital and labor is doubled but the output generated is less than
doubled, the returns to scale would be termed as diminishing returns to scale.

NOTES
when the combination of labor and capital moves from point a to point b, it
indicates that input is doubled. At point a, the combination of input is 1k+1L
and at point b, the combination becomes 2K+2L. However, the output has
increased from 10 to 18, which is less than change in the amount of input.
Similarly, when input changes from 2K+2L to 3K + 3L, then output changes
from 18 to 24, which is less than change in input. This shows the diminishing
returns to scale.
Diminishing returns to scale is due to diseconomies of scale, which arises

because of the managerial inefficiency. Generally, managerial inefficiency
takes place in large-scale organizations. Another cause of diminishing returns
to scale is limited natural resources. For example, a coal mining organization
can increase the number of mining plants, but cannot increase output due to
limited coal reserves.
3.6 ISO‐PRODUCT CURVE
“The Iso-product curves show the different combinations of two resources

with which a firm can produce equal amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce
a given output.” Samuelson

NOTES
3.6.1 Properties of Iso-Product Curves:
1. Iso-Product Curves Slope Downward from Left to Right:
They slope downward because MTRS of labour for capital diminishes. When
we increase labour, we have to decrease capital to produce a given level of
output.

NOTES
The downward sloping iso-product curve can be explained with the help of
the following figure:
when the amount of labour is increased from OL to OL 1, the amount of

capital has to be decreased from OK to OK1, The iso-product curve (IQ) is
falling as shown in the figure.
The possibilities of horizontal, vertical, upward sloping curves can be

ruled out with the help of the following figure:

i. The figure (A) shows that the amounts of both the factors of
NOTES
production are increased- labour from L to Li and capital from K
to K1. When the amounts of both factors increase, the output
must increase. Hence the IQ curve cannot slope upward from
left to right.
ii. The figure (B) shows that the amount of labour is kept constant
while the amount of capital is increased. The amount of capital is
increased from K to K1. Then the output must increase. So IQ
curve cannot be a vertical straight line.
iii. The figure (C) shows a horizontal curve. If it is horizontal the

quantity of labour increases, although the quantity of capital
remains constant. When the amount of capital is increased, the
level of output must increase. Thus, an IQ curve cannot be a
horizontal line.
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to

understand this fact, we have to understand the concept of diminishing
marginal rate of technical substitution (MRTS), because convexity of an
isoquant implies that the MRTS diminishes along the isoquant. The marginal
rate of technical substitution between L and K is defined as the quantity of K
which can be given up in exchange for an additional unit of L. It can also be
defined as the slope of an isoquant.
It can be expressed as:
MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.
Equation (1) states that for an increase in the use of labour, fewer units of
capital will be used. In other words, a declining MRTS refers to the falling
marginal product of labour in relation to capital. To put it differently, as more
units of labour are used, and as certain units of capital are given up, the
marginal productivity of labour in relation to capital will decline.

NOTES
This fact can be explained in Fig. 5. As we move from point A to B, from B to

C and from C to D along an isoquant, the marginal rate of technical
substitution (MRTS) of capital for labour diminishes. Everytimelabour units
are increasing by an equal amount (AL) but the corresponding decrease in the
units of capital (AK) decreases.
Thus it may be observed that due to falling MRTS, the isoquant is always
convex to the origin.
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves
cannot cut each other. In Fig. 6, two Iso-product curves intersect each other.
Both curves IQ1 and IQ2 represent two levels of output. But they intersect
each other at point A. Then combination A = B and combination A= C.
Therefore B must be equal to C. This is absurd. B and C lie on two different
iso-product curves. Therefore two curves which represent two levels of
output cannot intersect each other.

NOTES
4. Higher Iso-Product Curves Represent Higher Level of Output:
A higher iso-product curve represents a higher level of output as shown in

the figure given below:
In the figure, units of labour have been taken on OX axis while on OY, units
of capital. IQ1 represents an output level of 100 units whereas IQ2 represents
200 units of output.

5. Isoquants Need Not be Parallel to Each Other:
NOTES
It so happens because the rate of substitution in different isoquant schedules
need not be necessarily equal. Usually they are found different and, therefore,
isoquants may not be parallel as shown in Fig. 8. We may note that the
isoquants Iq1 and Iq2 are parallel but the isoquants Iq3 and Iq4 are not parallel
to each other.
6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being

produced with the help of labour alone without using capital at all. These
logical absurdities for OL units of labour alone are unable to produce
anything. Similarly, OC units of capital alone cannot produce anything
without the use of labour. Therefore as seen in figure 9, IQ and IQ 1 cannot be
isoquants.

NOTES
7. Each Isoquant is Oval-Shaped.
It means that at some point it begins to recede from each axis. This shape is a
consequence of the fact that if a producer uses more of capital or more of
labour or more of both than is necessary, the total product will eventually
decline. The firm will produce only in those segments of the isoquants which
are convex to the origin and lie between the ridge lines. This is the economic
region of production. In Figure 10, oval shaped isoquants are shown.

Curves OA and OB are the ridge lines and in between them only feasible
NOTES units of capital and labour can be employed to produce 100, 200, 300 and 400
units of the product. For example, OT units of labour and ST units of the
capital can produce 100 units of the product, but the same output can be
obtained by using the same quantity of labour T and less quantity of capital
VT.
Thus only an unwise entrepreneur will produce in the dotted region of the
iso-quant 100. The dotted segments of an isoquant are the waste- bearing
segments. They form the uneconomic regions of production. In the up dotted
portion, more capital and in the lower dotted portion more labour than
necessary is employed. Hence GH, JK, LM, and NP segments of the elliptical
curves are the isoquants.
3.7 MEANING OF COST
A cost is the value of money that has been used up to produce something.
The expenses faced by the business in the process of supplying goods and
services to consumer
3.8 COST CONCEPTS
The term ‘cost’ is most widely used as the ‘money cost’ of production which
relates to the money expenditure of a firm on:
• Wages and salaries paid to the labour.
• Payment incurred on machinery and equipment.
• Payment for materials, power, light, fuel, transportation etc.
• Payments for rent and insurance
• Payments to Government by way of taxes
3.9 COST DETERMINANTS
1. Level of output: The cost of production varies according to the

quantum of output. If the size of production is large then the cost of
production will also be more.
2. Price of input factors: A rise in the cost of input factors will increase
the total cost of production.

3. Productivities of factors of production: When the productivity of the
NOTES
input factors is high then the cost of production will fall.
4. Size of plant: The cost of production will be low in large plants due to
mass production with mechanization.
5. Output stability: The overall cost of production is low when the
output is stable over a period of time.
6. Lot size: Larger the size of production per batch then the cost of
production will come down because the organizations enjoy
economies of scale.
7. Laws of returns: The cost of production will increase if the law of
diminishing returns appliesin the firm.
8. Levels of capacity utilization: Higher the capacity utilization, lower
the cost of production
9. Time period: In the long run cost of production will be stable.
10. Technology: When the organization follows advanced technology in
their process then the cost of production will be low.
11. Experience: over a period of time the experience in production
process will help the firm to reduce cost of production.
12. Process of range of products: Higher the range of products produced,
Lower the cost of production.
13. Supply chain and logistics: Better the logistics and supply chain,
Lower the cost of production.
14. Government incentives: If the government provides incentives on
input factors then the cost of production will be low.
3.9 YPES OF COSTS
Opportunity cost and actual cost
- Cost incurred for loosing next best alternative

- An actual amount paid or incurred, as opposed to estimated cost or
standard cost.
• Direct and indirect cost
-Direct costs are those cost that have directly accountable to specific cost
object such as a process or product Ex: wages paid ,salary paid labor,
material…etc

-Indirect cost: Indirect cost are those costs which are not directly accountable
NOTES to specific cost object or not directly related to production Ex: insurance,
maintenance ,telecom, ….etc
• Explicit and implicit cost
-Explicit cost refers to the money expended to buy or hire resources from
outside the organization for the process of production
-Implicit cost refers to the cost of use of the self-owned resources of

organization that are used in production
• Historical and replacement cost
-Historical cost refers to the original (actual) cost incurred at the time the asset
was acquired
-The replacement cost is the price that an entity would pay to replace an
existing assets at current market price that may not be market value of that
asset
• Fixed cost and variable cost
-Fixed cost is the cost that remains unchanged irrespective of the output level
or sales revenue such as interest, rent, salaries etc
-Variable cost are those costs that vary depending on a company’s production
volume; they raise as production increases and fall as production decreases
• Real and prime cost
-Real cost of a production refers to the physical quantities of various factors

used in producing commodity Ex: Real cost of a table composes of a
carpenter’s labor to cubic feet of a wood ,a dozen of nails, half a bottle of
varnish…..etc
-Prime cost is The direct cost of commodity in terms of the materials and
labor involved in its production excluding fixed cost By calculating prime
cost the firm can decide how much should be their selling price to earn profit
• Total, average, and marginal cost

-Total cost : it is the cost refers to the total expenses incurred in reaching a
NOTES
particular level of output TC = TVC + TFC
-Average cost is the total cost divided by total units of output Thus, AC =
TC/Q, Where Q is the quantity produced
-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 MCn = TCn – TCn-1 i.e
the marginal cost of the unit of output is the total cost of producing n units
minus the total cost of producing n-1 (i.e …one less in the total) units of
output
3.11 COST – OUTPUT RELATIONSHIP IN SHORT RUN
In the short-run a change in output is possible only by making changes in the

variable inputs like raw materials, labour etc. Inputs like land and buildings,
plant and machinery etc. are fixed in the short-run. It means that short-run is
a period not sufficient enough to expand the quantity of fixed inputs. Thus
Total Cost (TC) in the short-run is composed of two elements – Total Fixed
Cost (TFC) and Total Variable Cost (TVC).
TFC remains the same throughout the period and is not influenced by the
level of activity. The firm will continue to incur these costs even if the firm is
temporarily shut down. Even though TFC remains the same fixed cost per
unit varies with changes in the level of output.
On the other hand TVC increases with increase in the level of activity, and
decreases with decrease in the level of activity. If the firm is shut down, there
are no variable costs. Even though TVC is variable, variable cost per unit is
constant.
So in the short-run an increase in TC implies an increase in TVC only.
Thus:
TC = TFC + TVC
TFC = TC – TVC
TVC = TC – TFC
TC = TFC when the output is zero.
The graph below shows Short-run cost output relationship.

NOTES
In the graph X-axis measures output and Y-axis measures cost. TFC is a
straight line parallel to X-axis, because TFC does not change with increase in
output.
TVC curve is upward rising from the origin because TVC is zero when there
is no production and increases as production increases. The shape of TVC
curve depends upon the productivity of the variable factors. The TVC curve
above assumes the Law of Variable Proportions, which operates in the short-
run.
TC curve is also upward rising not from the origin but from the TFC line. This
is because even if there is no production the TC is equal to TFC.
It should be noted that the vertical distance between the TVC curve and TC
curve is constant throughout because the distance represents the amount of
fixed cost which remains constant. Hence TC curve has the same pattern of
behaviour as TVC curve.
Short-run Average Cost and Marginal Cost
The concept of cost becomes more meaningful when they are expressed in
terms of per unit cost. Cost per unit can be computed with reference to fixed
cost, variable cost, total cost and marginal cost. The following diagram
reveals the relationship that exists among these concepts:

NOTES
Average Fixed Cost (AFC): Average fixed cost is obtained by dividing the
TFC by the number of units produced. Thus:
AFC = TFC/Q where, ‘Q’ refers quantity of production.
Since TFC is constant for any level of activity, fixed cost per unit goes on
diminishing as output goes on increasing. The AFC curve is downward
sloping towards the right throughout its length, with a steep fall at the
beginning.
Average Variable Cost (AVC): Average Variable Cost is obtained by dividing

the TVC by the number of units produced. Therefore:
AVC = TVC / Q
Due to the operation of the Law of Variable Proportions
AVC curve slopes downwards till it reaches a certain level of output and then
begins to rise upwards.
Average Total Cost (ATC): Average Total Cost or simply Average Cost is
obtained by dividing the TC by the number of units produced. Thus:
ATC = TC / Q

The ATC curve is very much influenced by the AFC and AVC curves. In the
NOTES beginning both AFC curve and AVC curve decline and therefore ATC curve
also declines. The AFC curve continues the trend throughout, though at a
diminishing rate. AVC curve continues the trend till it reaches a certain level
and thereafter it starts rising slowly. Since this rise initially is at a rate lower
than the rate of decline in the AFC curve, the ATC curve continues to decline
for some more time and reaches the lowest point, which obviously is further
than the lowest point of the AVC curve. Thereafter the ATC curve starts
rising because the rate of rise in the AVC curve is greater than the rate of
decline in the AFC curve.
Marginal Cost (MC): Marginal Cost is the increase in TC as a result of an

increase in output by one unit. In other words it is the cost of producing an
additional unit of output.
MC is based on the Law of Variable Proportions. A downward trend in MC

curve shows decreasing marginal cost (i.e. increasing marginal productivity)
of the variable input. Similarly an upward trend in MC curve shows
increasing marginal cost (i.e. decreasing marginal productivity). MC curve
intersects both AVC and ATC curves at their lowest points.
The relationship between AVC, AFC, ATC and MC can be summed up as

follows.
1. If both AFC and AVC fall ATC will also fall because ATC = AFC + AVC
2. When AFC falls and AVC rises (a) ATC will fall where the drop in AFC
is more than the rise in AVC (b) ATC remains constant if the drop in
AFC = the rise in AVC, and (c) ATC will rise where the drop in AFC is
less than the rise in AVC.
3. ATC will fall when MC is less than ATC and ATC will rise when MC is
more than ATC. The lowest ATC is equal to MC.
3.12 COST – OUTPUT RELATIONSHIP IN LONG RUN
Long run is a period, during which all inputs are variable including
the one, which are fixes in the short-run. In the long run a firm can change its

output according to its demand. Over a long period, the size of the plant can
NOTES
be changed, unwanted buildings can be sold staff can be increased or
reduced. The long run enables the firms to expand and scale of their
operation by bringing or purchasing larger quantities of all the inputs. Thus
in the long run all factors become variable.
The long-run cost-output relations therefore imply the relationship

between the total cost and the total output. In the long-run cost-output
relationship is influenced by the law of returns to scale.
In the long run a firm has a number of alternatives in regards to the

scale of operations. For each scale of production or plant size, the firm has an
appropriate short-run average cost curves. The short-run average cost (SAC)
curve applies to only one plant whereas the long-run average cost (LAC)
curve takes in to consideration many plants.
The long-run cost-output relationship is shown graphically with the

help of “LCA’ curve.
To draw on ‘LAC’ curve we have to start with a number of ‘SAC’

curves. In the above figure it is assumed that technologically there are only
three sizes of plants – small, medium and large, ‘SAC’, for the small size,
‘SAC2’ for the medium size plant and ‘SAC3’ for the large size plant. If the
firm wants to produce ‘OP’ units of output, it will choose the smallest plant.
For an output beyond ‘OQ’ the firm wills optimum for medium size plant. It
does not mean that the OQ production is not possible with small plant.

Rather it implies that cost of production will be more with small plant
NOTES compared to the medium plant.
For an output ‘OR’ the firm will choose the largest plant as the cost of
production will be more with medium plant. Thus the firm has a series of
‘SAC’ curves. The ‘LCA’ curve drawn will be tangential to the entire family of
‘SAC’ curves i.e. the ‘LAC’ curve touches each ‘SAC’ curve at one point, and
thus it is known as envelope curve. It is also known as planning curve as it
serves as guide to the entrepreneur in his planning to expand the production
in future. With the help of ‘LAC’ the firm determines the size of plant which
yields the lowest average cost of producing a given volume of output it
anticipates.
3.13 BREAK EVEN
Break-even analysis is of vital importance in determining the practical

application of cost functions. It is a function of three factors, i.e. sales volume,
cost and profit. It aims at classifying the dynamic relationship existing
between total cost and sale volume of a company.
Hence it is also known as “cost-volume-profit analysis”. It helps to know the

operating condition that exists when a company ‘breaks-even’, that is when
sales reach a point equal to all expenses incurred in attaining that level of
sales. The break-even point may be defined as that level of sales in which
total revenues equal total costs and net income is equal to zero. This is also
known as no-profit no-loss point. This concept has been proved highly useful
to the company executives in profit forecasting and planning and also in
examining the effect of alternative business management decisions.

NOTES
3.13.1 Features
(i) Safety Margin:
The break-even chart helps the management to know at a glance the profits
generated at the various levels of sales. The safety margin refers to the extent
to which the firm can afford a decline before it starts incurring losses. The
formula to determine the sales safety margin is:
Safety Margin= (Sales – BEP)/ Sales x 100
(ii) Target Profit:
The break-even analysis can be utilised for the purpose of calculating the
volume of sales necessary to achieve a target profit.
When a firm has some target profit, this analysis will help in finding out
the extent of increase in sales by using the following formula:
Target Sales Volume = Fixed Cost + Target Profit / Contribution Margin per
unit
(iii) Change in Price:
The management is often faced with a problem of whether to reduce prices or

not. Before taking a decision on this question, the management will have to
consider a profit. A reduction in price leads to a reduction in the contribution
margin.

This means that the volume of sales will have to be increased even to
NOTES maintain the previous level of profit. The higher the reduction in the
contribution margin, the higher is the increase in sales needed to ensure the
previous profit.
The formula for determining the new volume of sales to maintain the same
profit, given a reduction in price, will be as follows:
New Sales Volume = Total Fixed Cost = Total Profit/ New Selling price –
Average Variable Cost
(iv) Change in Costs:
When costs undergo change, the selling price and the quantity produced and
sold also undergo changes.
Changes in cost can be in two ways:
(i) Change in variable cost, and
(ii) Change in fixed cost.
(v) Decision on Choice of Technique of Production:
A firm has to decide about the most economical production process both at
the planning and expansion stages. There are many techniques available to
produce a product. These techniques will differ in terms of capacity and costs.
The breakeven analysis is the most simple and helpful in the case of decision
on a choice of technique of production.
(vi) Make or Buy Decision:
Firms often have the option of making certain components or for purchasing
them from outside the concern. Break-even analysis can enable the firm to
decide whether to make or buy.
(vii) Plant Expansion Decisions:
The break-even analysis may be adopted to reveal the effect of an actual or

proposed change in operation condition. This may be illustrated by showing
the impact of a proposed plant on expansion on costs, volume and profits.
Through the break-even analysis, it would be possible to examine the various
implications of this proposal.
(viii) Plant Shut Down Decisions:

In the shut down decisions, a distinction should be made between out of
NOTES
pocket and sunk costs. Out of pocket costs include all the variable costs plus
the fixe cost which do not vary with output. Sunk fixed costs are the
expenditures previously made but from which benefits still remain to be
obtained e.g. depreciation.
(ix) Advertising and Promotion Mix Decisions:
The main objective of advertisement is to stimulate or increase sales to all

customers-former, present and future. If there is keen to undertake vigorous
campaign of advertisement. The management has to examine those
marketing activities that stimulate consumer purchasing and dealer
effectiveness.
(x) Decision Regarding Addition or Deletion of Product Line:
If a product has outlive utility in the market immediately, the production

must be abandoned by the management and examined what would be its
consequent effect on revenue and cost. Alternatively, the management may
like to add a product to its existing product line because it expects the
product as a potential profit spinner. The break-even analysis helps in such a
decision.
3.13.2 Significance
Determines the Number of Units to be Sold
The calculation of break-even analysis is done so that the owner knows the
number of units to be sold in order to break-even i.e. no profit and no loss.
The selling price of each product, the variable cost of each product, and the
total fixed costs are required to determine the break-even analysis.
Helps in Budgeting and Setting Targets
Since you know at which point you can break-even, you accordingly can set
budgets. Also, break-even analysis can be used in setting realistic targets for
the business. This is possible because you know at which point a business is
able to achieve profits and hence, you can use this break-even point to set
benchmarks or targets for your firm. If you are not well-versed in analyzing
your finances, then hire a financial controller who will help you make a
budget and set realistic targets for your firm.

Determine the Margin of Safety
NOTES
The margin of safety can be calculated by subtracting the current level of
sales less the break-even point and then dividing it by the selling price per
unit. In the event of a recession or an economic downturn, sales tend to
decline. So, with the help of the break-even analysis, you can determine the
minimum level of sales required to ensure you make profits. By knowing the
margin of safety for a particular product or service, managers can make better
business decisions.
Cost Control and Monitoring
Since managers know that the fixed and the variable costs affect the
profitability of the business, they can see the effect of the changes to costs
with the help of break-even analysis. It helps them to determine the extent of
changes in costs affects the profitability and the break-even point.
Helps Devise a Pricing Strategy
Any change in selling price can affect the break-even point. For instance, if
the selling price is increased, the number of units to be sold to break-even will
be reduced. Likewise, if the selling price is reduced, a firm needs to sell more
to break-even. Thus, with the help of break-even analysis, managers can
decide whether they need to modify the selling price and devise a pricing
strategy for the same.
3.14 KEYWORDS
Production function IsoProduct Curve CostConceptBreak Even

NOTES
3.15 QUESTIONS
1. Define Production Function

2. State the Law of variable Proportions
3. What are Iso‐Product Curves
4. Define Cost Concepts
5. Define Break Even
1. Explain Returns to scale

2. Explain the features of Iso‐Product Curves
3. Explain the types of Costs
4. Explain Determinants of Cost
5. Explain Cost – output relationship in short and long run
6. Explain thefeatures and significance of Break Even
3.16 TEXT BOOKS

NOTES
Chapter - 4
MARKET STRUCTURE & PRICING
Structure
CHAPTER IV
4.1 Unit objectives
4.2 Introduction
4.3 Market Structure : Meaning
4.4 Determinants of Market Structure
4.5 Forms of Market Structure
4.6 Nature of Markets
4.7 Pricing under different Market Conditions and degrees of price
discrimination
4.7.1 Perfect Competition
Characteristics of Perfect Competition
4.7.2 Monopoly
Characteristics of Monopoly
4.7.3 Monopolistic
Characteristics of monopolistic competition
4.7.4 Oligopoly
Characteristics of Oligopoly
4.7.5 Features of overall Market Structure
4.8 Cost Plus Pricing
4.9 Transfer Pricing
4.9.1 Basic approaches to transfer pricing
4.9.2 Method of transfer pricing
4.9.3 Objectives of Transfer Pricing
4.9.4 Fundamental Principles for Transfer Price
4.10 Key words

4.11 Questions
NOTES
4.12 Text Books
 Explain different Market
 Understand the nature and scope of managerial economics
 Understand the various definitions related to wealth, Scarcity and

Growth
 Stating the role of production possibility curve
 Knowing the relationship of Economics with other discipline
4.2 INTRODUCTION
A market consists of all the consumers and producing firms of a particular
good or service. We remember that firms are usually trying to maximise
their profit and the consumers are always trying to maximise their
satisfaction. The firms will decide on what level of output to produce and at
what price to sell their product for. The way in which a firm behaves in
making these two decisions depends on the type of market in which the firm
is operating and the conditions it faces.
4.3 MARKET STRUCTURE
Market structure refers to the nature and degree of competition in the

market for goods and services. The structures of market both for goods
market and service (factor) market are determined by the nature of
competition prevailing in a particular market.
Thus, the market structure can be defined as, the number of firms
producing the identical goods and services in the market and whose structure
is determined on the basis of the competition prevailing in that market.

The term “ market” refers to a place where sellers and buyers meet
NOTES and facilitate the selling and buying of goods and services. But in economics,
it is much wider than just a place, It is a gamut of all the buyers and sellers,
who are spread out to perform the marketing activities.
4.4 THE MAJOR DETERMINANTS OF THE MARKET

STRUCTURE
1. The number of sellers operating in the market.
2. The number of buyers in the market.
3. The nature of goods and services offered by the firms.
4. The concentration ratio of the company, which shows the largest

market shares held by the companies.
5. The entry and exit barriers in a particular market.
6. The economies of scale, i.e. how cost efficient a firm is in producing

the goods and services at a low cost. Also the sunk cost, the cost that
has already been spent on the business operations.
7. The degree of vertical integration, i.e. the combining of different

stages of production and distribution, managed by a single firm.
8. The level of product and service differentiation, i.e. how the

company’s offerings differ from the other company’s offerings.
9. The customer turnover, i.e. the number of customers willing to change

their choice with respect to the goods and services at the time of
adverse market conditions.
4.5 FORMS OF MARKET STRUCTURE
1. Perfect Competition
2. Monopoly
3. Monopolistic Competition
4. Oligopoly

NOTES
4.6 NATURE OF MARKETS
The forces of supply and demand meet and react in a market. Prices are
established and buyers and sellers give signals and incentives to each other.
Markets can involve face-to-face dealings between buyers and sellers, or may
be postal or even electronic.
4.7 PRICING UNDER DIFFERENT MARKET CONDITIONS AND

DEGREES OF PRICE DISCRIMINATION
4.7.1. Perfect Competition
A perfectly competitive market is one in which the number of buyers and

sellers is very large, all engaged in buying and selling a homogeneous
product without any artificial restrictions and possessing perfect knowledge
of market at a time. In the words of A. Koutsoyiannis, “Perfect competition is
a market structure characterised by a complete absence of rivalry among the
individual firms.” According to R.G. Lipsey, “Perfect competition is a market
structure in which all firms in an industry are price- takers and in which there
is freedom of entry into, and exit from, industry.”

NOTES
Characteristics of Perfect Competition:
The following are the conditions for the existence of perfect competition:
(1) Large Number of Buyers and Sellers:
The first condition is that the number of buyers and sellers must be so large
that none of them individually is in a position to influence the price and
output of the industry as a whole. The demand of individual buyer relative to
the total demand is so small that he cannot influence the price of the product
by his individual action.
Similarly, the supply of an individual seller is so small a fraction of the total

output that he cannot influence the price of the product by his action alone. In
other words, the individual seller is unable to influence the price of the
product by increasing or decreasing its supply.
Rather, he adjusts his supply to the price of the product. He is “output

adjuster”. Thus no buyer or seller can alter the price by his individual action.
He has to accept the price for the product as fixed for the whole industry. He
is a “price taker”.
(2) Freedom of Entry or Exit of Firms:
The next condition is that the firms should be free to enter or leave the
industry. It implies that whenever the industry is earning excess profits,
attracted by these profits some new firms enter the industry. In case of loss
being sustained by the industry, some firms leave it.
(3) Homogeneous Product:
Each firm produces and sells a homogeneous product so that no buyer has
any preference for the product of any individual seller over others. This is
only possible if units of the same product produced by different sellers are
perfect substitutes. In other words, the cross elasticity of the products of
sellers is infinite.
No seller has an independent price policy. Commodities like salt, wheat,

cotton and coal are homogeneous in nature. He cannot raise the price of his

product. If he does so, his customers would leave him and buy the product
NOTES
from other sellers at the ruling lower price.
The above two conditions between themselves make the average revenue
curve of the individual seller or firm perfectly elastic, horizontal to the X-axis.
It means that a firm can sell more or less at the ruling market price but cannot
influence the price as the product is homogeneous and the number of sellers
very large.
(4) Absence of Artificial Restrictions:
The next condition is that there is complete openness in buying and selling of
goods. Sellers are free to sell their goods to any buyers and the buyers are free
to buy from any sellers. In other words, there is no discrimination on the part
of buyers or sellers.
Moreover, prices are liable to change freely in response to demand-supply

conditions. There are no efforts on the part of the producers, the government
and other agencies to control the supply, demand or price of the products.
The movement of prices is unfettered.
(5) Profit Maximisation Goal:
Every firm has only one goal of maximizing its profits.
(6) Perfect Mobility of Goods and Factors:
Another requirement of perfect competition is the perfect mobility of goods

and factors between industries. Goods are free to move to those places where
they can fetch the highest price. Factors can also move from a low-paid to a
high-paid industry.
(7) Perfect Knowledge of Market Conditions:
This condition implies a close contact between buyers and sellers. Buyers and
sellers possess complete knowledge about the prices at which goods are being
bought and sold, and of the prices at which others are prepared to buy and
sell. They have also perfect knowledge of the place where the transactions are
being carried on. Such perfect knowledge of market conditions forces the
sellers to sell their product at the prevailing market price and the buyers to
buy at that price.
(8) Absence of Transport Costs:

Another condition is that there are no transport costs in carrying of product
NOTES from one place to another. This condition is essential for the existence of
perfect competition which requires that a commodity must have the same
price everywhere at any time. If transport costs are added to the price of the
product, even a homogeneous commodity will have different prices
depending upon transport costs from the place of supply.
(9) Absence of Selling Costs:
Under perfect competition, the costs of advertising, sales-promotion, etc. do

not arise because all firms produce a homogeneous product.
As shown in Figure, when price is OP, the quantity demanded is OQ. On the
other hand, when price increases to OP1, the quantity demanded reduces to
OQ1. Therefore, under perfect competition, the demand curves (DD’) slopes
downward.
4.7.2 Monopoly
Monopoly is a market situation in which there is only one seller of a product

with barriers to entry of others. The product has no close substitutes. The
cross elasticity of demand with every other product is very low. This means
that no other firms produce a similar product. According to D. Salvatore,
“Monopoly is the form of market organization in which there is a single firm
selling a commodity for which there are no close substitutes.” Thus the

monopoly firm is itself an industry and the monopolist faces the industry
NOTES
demand curve.
The demand curve for his product is, therefore, relatively stable and slopes
downward to the right, given the tastes, and incomes of his customers. It
means that more of the product can be sold at a lower price than at a higher
price. He is a price-maker who can set the price to his maximum advantage.
However, it does not mean that he can set both price and output. He can do
either of the two things. His price is determined by his demand curve, once
he selects his output level. Or, once he sets the price for his product, his
output is determined by what consumers will take at that price. In any
situation, the ultimate aim of the monopolist is to have maximum profits.
Characteristics of Monopoly:
The main features of monopoly are as follows:
1. Under monopoly, there is one producer or seller of a particular product

and there is no difference between a firm and an industry. Under
monopoly a firm itself is an industry.
2. A monopoly may be individual proprietorship or partnership or joint
stock company or a cooperative society or a government company.
3. A monopolist has full control on the supply of a product. Hence, the
elasticity of demand for a monopolist’s product is zero.
4. There is no close substitute of a monopolist’s product in the market.
Hence, under monopoly, the cross elasticity of demand for a monopoly
product with some other good is very low.
5. There are restrictions on the entry of other firms in the area of monopoly
product.
6. A monopolist can influence the price of a product. He is a price-maker,
not a price-taker.
7. Pure monopoly is not found in the real world.
8. Monopolist cannot determine both the price and quantity of a product
simultaneously.
9. Monopolist’s demand curve slopes downwards to the right. That is why,
a monopolist can increase his sales only by decreasing the price of his
product and thereby maximize his profit. The marginal revenue curve of a

monopolist is below the average revenue curve and it falls faster than the
NOTES average revenue curve. This is because a monopolist has to cut down the
price of his product to sell an additional unit.
As we know, there is no difference between organization and industry under

monopoly. Accordingly, the demand curve of the organization constitutes the
demand curve of the entire industry. The demand curve of the monopolist is
Average Revenue (AR), which slopes downward.
it can be seen that more quantity (OQ2) can only be sold at lower price (OP2).
Under monopoly, the slope of AR curve is downward, which implies that if
the high prices are set by the monopolist, the demand will fall. In addition, in
monopoly, AR curve and Marginal Revenue (MR) curve are different from
each other. However, both of them slope downward.
The negative AR and MR curve depicts the following facts:
i. When MR is greater than AR, the AR rises
ii. When MR is equal to AR, then AR remains constant
iii. When MR is lesser than AR, then AR falls
Here, AR is the price of a product, As we know, AR falls under monopoly;

thus, MR is less than AR.

NOTES
In figure, MR curve is shown below the AR curve because AR falls.
4.7.3 Monopolistic Competition
Monopolistic competition refers to a market situation where there are many

firms selling a differentiated product. “There is competition which is keen,
though not perfect, among many firms making very similar products.” No
firm can have any perceptible influence on the price-output policies of the
other sellers nor can it be influenced much by their actions. Thus
monopolistic competition refers to competition among a large number of
sellers producing close but not perfect substitutes for each other.
It’s Features:
The following are the main features of monopolistic competition:
(1) Large Number of Sellers:
In monopolistic competition the number of sellers is large. They are “many

and small enough” but none controls a major portion of the total output. No
seller by changing its price-output policy can have any perceptible effect on
the sales of others and in turn be influenced by them. Thus there is no
recognised interdependence of the price-output policies of the sellers and
each seller pursues an independent course of action.
(2) Product Differentiation:

One of the most important features of the monopolistic competition is
NOTES differentiation. Product differentiation implies that products are different in
some ways from each other. They are heterogeneous rather than
homogeneous so that each firm has an absolute monopoly in the production
and sale of a differentiated product. There is, however, slight difference
between one product and other in the same category.
Products are close substitutes with a high cross-elasticity and not perfect
substitutes. Product “differentiation may be based upon certain
characteristics of the products itself, such as exclusive patented features;
trade-marks; trade names; peculiarities of package or container, if any; or
singularity in quality, design, colour, or style. It may also exist with respect to
the conditions surrounding its sales.”
(3) Freedom of Entry and Exit of Firms:
Another feature of monopolistic competition is the freedom of entry and exit

of firms. As firms are of small size and are capable of producing close
substitutes, they can leave or enter the industry or group in the long run.
(4) Nature of Demand Curve:
Under monopolistic competition no single firm controls more than a small

portion of the total output of a product. No doubt there is an element of
differentiation nevertheless the products are close substitutes. As a result, a
reduction in its price will increase the sales of the firm but it will have little
effect on the price-output conditions of other firms, each will lose only a few
of its customers.
Likewise, an increase in its price will reduce its demand substantially but
each of its rivals will attract only a few of its customers. Therefore, the
demand curve (average revenue curve) of a firm under monopolistic
competition slopes downward to the right. It is elastic but not perfectly elastic
within a relevant range of prices of which he can sell any amount.
(5) Independent Behaviour:
In monopolistic competition, every firm has independent policy. Since the

number of sellers is large, none controls a major portion of the total output.
No seller by changing its price-output policy can have any perceptible effect
on the sales of others and in turn be influenced by them.

(6) Product Groups:
NOTES
There is no any ‘industry’ under monopolistic competition but a ‘group’ of
firms producing similar products. Each firm produces a distinct product and
is itself an industry. Chamberlin lumps together firms producing very closely
related products and calls them product groups, such as cars, cigarettes, etc.
(7) Selling Costs:
Under monopolistic competition where the product is differentiated, selling

costs are essential to push up the sales. Besides, advertisement, it includes
expenses on salesman, allowances to sellers for window displays, free service,
free sampling, premium coupons and gifts, etc.
(8) Non-price Competition:
Under monopolistic competition, a firm increases sales and profits of his

product without a cut in the price. The monopolistic competitor can change
his product either by varying its quality, packing, etc. or by changing
promotional programmes.
In a monopolistic competition, since the product is differentiated between firms,

each firm does not have a perfectly elastic demand for its products. In such a
market, all firms determine the price of their own products. Therefore, it faces a
downward sloping demand curve. Overall, we can say that the elasticity of
demand increases as the differentiation between products decreases.

NOTES
Conditions for the Equilibrium of an individual firm
The conditions for price-output determination and equilibrium of an individual

firm are as follows:
1. MC = MR
2. The MC curve cuts the MR curve from below.
In Fig, we can see that the MC curve cuts the MR curve at point E. At this point,
 Equilibrium price = OP and
 Equilibrium output = OQ
Now, since the per unit cost is BQ, we have
 Per unit super-normal profit (price-cost) = AB or PC.
 Total super-normal profit = APCB
The following figure depicts a firm earning losses in the short-run.

NOTES
we can see that the per unit cost is higher than the price of the firm. Therefore,
 AQ > OP (or BQ)
 Loss per unit = AQ – BQ = AB
 Total losses = ACPB
Long-run equilibrium
If firms in a monopolistic competition earn super-normal profits in the short-

run, then new firms will have an incentive to enter the industry. As these firms
enter, the profits per firm decrease as the total demand gets shared between a
larger number of firms. This continues till all firms earn only normal profits.
Therefore, in the long-run, firms, in such a market, earn only normal profits.

As we can see in Fig above, the average revenue (AR) curve touches the
NOTES average cost (ATC) curve at point X. This corresponds to quantity Q 1 and price
P1. Now, at equilibrium (MC = MR), all super-normal profits are zero since the
average revenue = average costs. Therefore, all firms earn zero super-normal
profits or earn only normal profits. It is important to note that in the long-run, a
firm is in an equilibrium position having excess capacity. In simple words, it
produces a lower quantity than its full capacity. From Fig. 3 above, we can see
that the firm can increase its output from Q1 to Q2 and reduce average costs.
However, it does not do so because it reduces the average revenue more than
the average costs. Hence, we can conclude that in a monopolistic competition,
firms do not operate optimally. There always exists an excess capacity of
production with each firm.
In case of losses in the short-run, the firms making a loss will exit from the
market. This continues until the remaining firms make normal profits only.
4.7.4 Oligopoly
Oligopoly is a market situation in which there are a few firms selling

homogeneous or differentiated products. It is difficult to pinpoint the number
of firms in ‘competition among the few.’ With only a few firms in the market,
the action of one firm is likely to affect the others. An oligopoly industry
produces either a homogeneous product or heterogeneous products.
The former is called pure or perfect oligopoly and the latter is called
imperfect or differentiated oligopoly. Pure oligopoly is found primarily
among producers of such industrial products as aluminum, cement, copper,
steel, zinc, etc. Imperfect oligopoly is found among producers of such
consumer goods as automobiles, cigarettes, soaps and detergents, TVs, rubber
tyres, refrigerators, typewriters, etc.
Characteristics of Oligopoly:
In addition to fewness of sellers, most oligopolistic industries have several

common characteristics which are explained below:
(1) Interdependence:

There is recognized interdependence among the sellers in the oligopolistic
NOTES
market. Each oligopolistic firm knows that changes in its price, advertising,
product characteristics, etc. may lead to counter-moves by rivals. When the
sellers are a few, each produces a considerable fraction of the total output of
the industry and can have a noticeable effect on market conditions.
He can reduce or increase the price for the whole oligopolistic market by
selling more quantity or less and affect the profits of the other sellers. It
implies that each seller is aware of the price-moves of the other sellers and
their impact on his profit and of the influence of his price-move on the actions
of rivals.
Thus there is complete interdependence among the sellers with regard to

their price-output policies. Each seller has direct and ascertainable influences
upon every other seller in the industry. Thus, every move by one seller leads
to counter-moves by the others.
(2) Advertisement:
The main reason for this mutual interdependence in decision making is that
one producer’s fortunes are dependent on the policies and fortunes of the
other producers in the industry. It is for this reason that oligopolistic firms
spend much on advertisement and customer services.
As pointed out by Prof. Baumol, “Under oligopoly advertising can become a

life-and-death matter.” For example, if all oligopolists continue to spend a lot
on advertising their products and one seller does not match up with them he
will find his customers gradually going in for his rival’s product. If, on the
other hand, one oligopolistic advertises his product, others have to follow
him to keep up their sales.
(3) Competition:
This leads to another feature of the oligopolistic market, the presence of com-
petition. Since under oligopoly, there are a few sellers, a move by one seller
immediately affects the rivals. So each seller is always on the alert and keeps
a close watch over the moves of its rivals in order to have a counter-move.
This is true competition.

(4) Barriers to Entry of Firms:
NOTES
As there is keen competition in an oligopolistic industry, there are no barriers
to entry into or exit from it. However, in the long run, there are some types of
barriers to entry which tend to restraint new firms from entering the industry.
They may be:
(a) Economies of scale enjoyed by a few large firms; (b) control over essential
and specialized inputs; (c) high capital requirements due to plant costs,
advertising costs, etc. (d) exclusive patents and licenses; and (e) the existence
of unused capacity which makes the industry unattractive. When entry is
restricted or blocked by such natural and artificial barriers, the oligopolistic
industry can earn long-run super normal profits.
(5) Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the size of

firms. Finns differ considerably in size. Some may be small, others very large.
Such a situation is asymmetrical. This is very common in the American
economy. A symmetrical situation with firms of a uniform size is rare.
(6) Demand Curve:
It is not easy to trace the demand curve for the product of an oligopolistic.
Since under oligopoly the exact behavior pattern of a producer cannot be
ascertained with certainty, his demand curve cannot be drawn accurately,
and with definiteness. How does an individual seller s demand curve look
like in oligopoly is most uncertain because a seller’s price or output moves
lead to unpredictable reactions on price-output policies of his rivals, which
may have further repercussions on his price and output.
The chain of action reaction as a result of an initial change in price or output,

is all a guess-work. Thus a complex system of crossed conjectures emerges as
a result of the interdependence among the rival oligopolists which is the main
cause of the indeterminateness of the demand curve.
If the oligopolistic seller does not have a definite demand curve for his
product, then how does he affect his sales. Presumably, his sales depend
upon his current price and those of his rivals. However, a number of
conjectural demand curves can be imagined.

For example, in differentiated oligopoly where each seller fixes a separate
NOTES
price for his product, a reduction in price by one seller may lead to an
equivalent, more, less or no price reduction by rival sellers. In each case, a
demand curve can be drawn by the seller within the range of competitive and
monopoly demand curves.
Leaving aside retaliatory price movements, the individual seller’s demand

curve under oligopoly for both price cuts and increases is neither more elastic
than under perfect or monopolistic competition nor less elastic than under
monopoly. It may still be indefinite and indeterminate.
This situation is shown in Figure 1 where KD 1 is the elastic demand curve

and MD is the less elastic demand curve. The oligopolies’ demand curve is
the dotted kinked KPD. The reason is quite simple. If a seller reduces the
price of his product, his rivals also lower the prices of their products so that
he is not able to increase his sales.
So the demand curve for the individual seller’s product will be less elastic just
below the present price P (where KD 1and MD curves are shown to intersect).
On the other hand, when he raises the price of his product, the other sellers
will not follow him in order to earn larger profits at the old price. So this
individual seller will experience a sharp fall in the demand for his product.
Thus his demand curve above the price P in the segment KP will be highly
elastic. Thus the imagined demand curve of an oligopolistic has a comer or

kink at the current price P. Such a demand curve is much more elastic for
NOTES price increases than for price decreases.
(7) No Unique Pattern of Pricing Behaviour:
The rivalry arising from interdependence among the oligopolists leads to two
conflicting motives. Each wants to remain independent and to get the
maximum possible profit. Towards this end, they act and react on the price-
output movements of one another in a continuous element of uncertainty.
On the other hand, again motivated by profit maximisation each seller wishes
to cooperate with his rivals to reduce or eliminate the element of uncertainty.
All rivals enter into a tacit or formal agreement with regard to price-output
changes. It leads to a sort of monopoly within oligopoly.
They may even recognise one seller as a leader at whose initiative all the
other sellers raise or lower the price. In this case, the individual seller’s
demand curve is a part of the industry demand curve, having the elasticity of
the latter. Given these conflicting attitudes, it is not possible to predict any
unique pattern of pricing behaviour in oligopoly markets
4.7.5 Features of overall Market Structure

NOTES
4.8 COST PLUS PRICING
Cost plus pricing is a pricing method that attempts to ensure that costs are
covered while providing a minimum acceptable rate of profit for the
entrepreneur. It is calculated by adding a fixed mark-up to average (or
unit) costs of production. Cost-plus pricing is common in markets where a
few firms dominate (an oligopolisticmarket) and share similar production
costs. In this case, cost-plus pricing provides a convenient rule for firms and
reduces the risks associated with price competition.
Another advantage of cost-plus pricing is its desirability from the standpoint

of public relations. This pricing technique provides an obvious rationale for
price increases when cost increases occur.

NOTES
Cost-plus pricing typically involves two steps. First, the firm determines the
per unit cost or average total cost of producing the good. Because average
total cost varies as the quantity of output produced changes, the firm’s
determination of per unit cost requires the specification of an output level.
After the firm establishes the per unit cost, the firm adds a mark-up to the per
unit cost. The mark-up is typically in the form of a percentage, and it
represents costs that can’t be easily allocated to a specific product produced
by the firm plus a return on the firm’s investment.
The following equation illustrates how to determine price with cost-plus

pricing:
Where P is the good’s price, ATC is the average total cost or cost per unit, and
the mark-up is the percentage added to average total cost.
One criticism of cost-plus pricing is that it focuses on average rather than

marginal costs. Because profit maximization requires marginal cost equals
marginal revenue, cost-plus pricing may not result in profit maximization.
Another criticism of cost-plus pricing is that it ignores demand conditions. By

ignoring demand, the firm can establish a cost-plus price that’s above the
market’s equilibrium price, resulting in a surplus. As a consequence, the firm
doesn’t sell all the units it produces.
It’s logical to wonder whether cost-plus pricing ever maximizes profit. In

order for profit-maximization to occur, cost-plus pricing must result in the
firm producing the output level where marginal revenue equals marginal
cost.
In the short-run, the difference between marginal cost and average total cost
may be sizeable. However, studies have shown that long-run average total
cost is typically constant for many firms. Constant long-run average total cost
implies constant marginal cost; therefore, marginal cost equals average total
cost in this situation. The use of average total cost in the place of marginal
cost for pricing results in minimal differences, or

NOTES
Still, because this simple approach ignores demand, it’s unlikely to result in
maximum profit.
4.9 TRANSFER PRICING
Transfer prices are those charged for intra company movement of goods and
services. Firms need to make transfer-pricing decisions when goods are
transferred from the headquarters to the subsidiaries in other countries. This
transfer prices are important because goods transferred from country to
country must have a value for cross-border taxation purposes.
4.9.1 There are three basic approaches to transfer pricing:
 Transfer at cost. The transfer price is set at the level of the production
cost and the international division is credited with the entire profit that
the firm makes. This means that the production centre is evaluated on
efficiency parameters rather than profitability.
 Transfer at arm´s length. Here the international division is charged the

same as any buyer outside the firm. Problems occur if the overseas
division is allowed to buy elsewhere when the price is uncompetitive or
the product quality is inferior, and further problems arise if there are no
external buyers, making it difficult to establish a relevant price.
Nevertheless, this approach has now been accepted worldwide as the
preferred (not required) standard by which transfer prices should be set.
 Transfer at cost plus. This is the usual compromise, where profits are
split between the headquarters and the subsidiaries. The formula used for
assessing the transfer price can vary, but usually it is this method that has
the greatest chance of minimizing time spent on transfer-price
disagreements, optimizing corporate profits and motivating the
headquarters and subsidiaries.

NOTES
4.9.2 The method by which transfer prices are set is determined by
management and can be any of the following five broad systems:
1. Market-based transfer prices – when an external market exists for the

item being transferred between the company’s divisions, the transfer
price is set equal to the market price.
2. Marginal cost transfer prices – the goods or services are transferred at

the marginal cost of producing the item. Many a times, marginal cost
is approximated by the short-run variable cost.
3. Full cost transfer prices – the selling division transfers the asset at a
price equal to the full production cost of the product or service. To
achieve full cost, many companies usually add a mark-up percentage
to the variable cost of the good or product to ensure covering fixed
costs committed to production.
4. Cost-plus a mark-up transfer prices – the products or services are

transferred at a price equal to cost plus a profit mark-up so that the
supplying division will be able to show a profit on such transfers.
5. Negotiated transfer prices – managers of the supplying and receiving

department will negotiate the inter-divisional transfer price between
them, having regard of the market price and costs of the product or
service.
4.9.3 Objectives of Transfer Pricing
1. Goal congruence: The prices should be set so that the divisional

management desire to maximize divisional earnings is consistent with the
objectives of the company as a whole. The transfer prices should not
encourage sub-optimal decision-making. The system should be so designed
that decisions that improve business unit profits will also improve company
profits.
2. Performance appraisal: The prices should enable reliable assessments to be

made of divisional performance. The prices form part of information, which
should:

 Guide decision making
NOTES
 Appraise managerial performance
 Evaluate the contribution made by the division to overall company
profits.
 Assess the worth of the division as an economic unit.
The transfer prices should be designed such that they help in measuring the
economic performance
3. Divisional autonomy: The prices should seek to maintain the maximum

divisional autonomy so that the benefits of decentralization (motivation,
better decision-making, initiatives, etc.) are maintained. The profits of one
division should not be dependent on the actions of other divisions.
4. Simple and easy: The system should be simple to understand and easy to
administer.
5. The transfer price should provide each segment with the relevant
information required to determine the optimum trade-off between company
costs and revenues.
4.9.4 Fundamental Principles for Transfer Price
The fundamental principle is that he transfer price should be similar to the

price that would be charged if the product were sold to outside customers or
purchase from outside vendors. When profit centers of accompany by from
and sell to one another, two decisions must be made periodically for each
product that is being produced by one business unit and sold to another:
1. Should the company produce the product inside the company or

purchase it form and outside vendor? This is the sourcing decision.
2. If produced inside, at what price should the product be transferred

between profit centers? This is the transfer price decision.
3. Transfer price systems can range from the very simple to the extremely
complex, depending on the nature of the business.

NOTES
4.10 KEYWORDS
-------------------------------------------------------------------------------------------
Market Structure Monopoly Oligopoly Monopolistic Perfect

CompetitionCost plus Pricing Transfer Pricing
4.11QUESTIONS
1. Define Market Structure
2. What is Cost plus Pricing?
3. What is Transfer Pricing?
4. What is oligopoly competition?
1. Explain the Nature of Markets
2. Pricing under Perfect competitions and degrees of price

discrimination
3. Pricing under Monopoly and degrees of price discrimination
4. Pricing under Monopolistic competition and degrees of price

discrimination
4.12 TEXT BOOKS


NOTES
Chapter - 5
BUSINESS CYCLE
Structure
5.1 Unit objectives

5.2 Introduction
5.3 Business Cycle
5.4 Factors that affect Business Cycle
5.5 Causes and Effect of Inflation and Recession
5.5.1 Main causes of inflation
1. Demand Pull Inflation
2. Cost Push Inflation
5.6 Causes
National Income
National Income concept
National Income measurement
5.7.1 The Product Method
5.7.2. The Income Method
5.7.3. Expenditure Method
5.8 Circular Flow of Income
5.9 Key words
5.10 Questions
5.11. Short Questions
5.12 Text Books

NOTES
 Explain the Stages Of Business Cycle
 Understand the Demand Pull & Cost Push Inflation
 Understand the definition of National Income
 Knowing the National Income Concept
 Knowing how to measure the National Income
 Understanding the circular flow of income
5.2 INTRODUCTION
The term “business cycle” (or economic cycle or boom-bust cycle) refers to
economy-wide fluctuations in production, trade, and general economic
activity. From a conceptual perspective, the business cycle is the upward and
downward movements of levels of GDP (gross domestic product) and refers
to the period of expansions and contractions in the level of economic
activities (business fluctuations) around a long-term growth trend. National
Income (Y) is a total level of activity of given economy in a particular period.
In other words national income measures the total level of output of an
economy in a given period of time.”Y” is commonly used as the abbreviation
for national income
5.3 BUSINESS CYCLE
The business cycle describes the rise and fall in production output of goods
and services in an economy. Business cycles are generally measured using the
rise and fall in real gross domestic product (GDP) or GDP adjusted for
inflation.
5.3.1 Stages of a Business Cycle
All business cycles are characterized by several different stages:
Expansion:
This is the first stage. When expansion occurs, there is an increase in

employment, incomes, production, and sales. People generally pay their

debts on time. The economy has a steady flow in the money supply and
NOTES
investment is booming.
Peak:
The second stage is a peak when the economy hits a snag, having reached the
maximum level of growth. Prices hit their highest level, and economic
indicators stop growing. Many people start to restructure as the economy's
growth starts to reverse.
Recession:
These are periods of contraction. During a recession, unemployment rises,

production slows down, sales start to drop because of a decline in demand,
and incomes become stagnant or decline.
Depression:
Economic growth continues to drop while unemployment rises and

production plummets. Consumers and businesses find it hard to secure
credit, trade is reduced, and bankruptcies start to increase. Consumer
confidence and investment levels also drop.
Trough:
This period marks the end of the depression, leading an economy into the
next step: recovery.
Recovery:
In this stage, the economy starts to turn around. Low prices spur an increase
in demand, employment and production start to rise, and lenders start to
open up their credit coffers. This stage marks the end of one business cycle.

NOTES
5.4 FACTORS THAT AFFECT THE BUSINESS CYCLE
1. Natural Factors
The trade cycle may change due to natural factors, for example during the
periods of heavy or unexpected rainfall; agricultural productivity may be
affected. It results in a shortage of raw material, and therefore industrial
production is also affected. This shortage can affect the whole economy,
particularly those that rely on agriculture as their main component of the
Gross Domestic Product (GDP).
2. Wars
During a war, economic growth can slow down because of uncertainty in the
market and loss of business confidence and consumer confidence. This
reduces spending and investment in the economy.
3. Political Factors
In developing countries, often there is political instability. The new

government formulates new policies and abandons the policies of previous
governments. This kind of political climate creates uncertainty in the
economy and causes business confidence and investment to fall.

4. The Supply of Money
NOTES
Unplanned changes in the supply of money can cause business fluctuation in
an economy. An increase in the supply of money leads to the expansion
in aggregate demand. But an excessive increase in credit and money can also
set off inflation in the economy. On the other hand decrease in the supply of
money initiates a recession in the economy.
5. Future Expectation
Expectations about future business are also a major factor in the business
cycle. When businesses are optimistic about future expectations, it triggers an
expansion in business activities whereas pessimism about profits in the future
results in the contraction of business activities.
6. Population Explosion
An abnormal increase in population can be a major factor in the

business cycle. When the population increases at a higher rate than an
increase in national output, it can become difficult to provide employment.
However, an increase in the population also pushes the country’s Production
Possibility Curve.
7. International Factors
Most countries of the world are economically interdependent. Any economic

fluctuation in big economies like the USA or Japan affect the other economies,
like how the housing market crash in the USA resulted in a global recession.

NOTES
5.5 CAUSES AND EFFEC OF INFLATION AND RECESSION
Inflation means there is a sustained increase in the price level. The main
causes of inflation are either excess aggregate demand (economic growth too
fast) or cost push factors (supply-side factors).

NOTES
5.5.1 Main causes of inflation
1. Demand-pull inflation – aggregate demand growing faster than aggregate

supply (growth too rapid)
2. Cost-push inflation – higher oil prices feeding through into higher costs
3. Devaluation – increasing cost of imported goods, also boost to domestic
demand
4. Rising wages – higher wages increase firms costs and increase consumers’
disposable income to spend more.
5. Expectations of inflation – causes workers to demand wage increases and
firms to push up prices.

1. Demand-pull inflation
NOTES
Demand-pull inflation is a period of inflation which arises from rapid growth

in aggregate demand.
If aggregate demand (AD) rises faster than productive capacity (LRAS), then
firms will respond by putting up prices, creating inflation.
 Inflation – a sustained increase in the price level.
 Demand-pull inflation – inflation caused by AD increasing faster than

AS.
Demand-pull inflation means:
 Excess demand and ‘too much money chasing too few goods.’
 The economy is at full employment/full capacity.
 The economy will be growing at a rate faster than the long-run trend
rate.
 A falling unemployment rate.

How demand-pull inflation occurs
NOTES
If aggregate demand is rising at 4%, but productive capacity is only rising at
2.5%; firms will see demand outstripping supply. Therefore, they respond by
increasing prices.
Also, as firms produce more, they employ more workers, creating a rise in
employment and fall in unemployment. This increased demand for workers
puts upward pressure on wages, leading to wage-push inflation. Higher
wages increase disposable income of workers leading to a rise in consumer
spending.
Causes of demand-pull inflation
 Lower interest rates. A cut in interest rates causes a rise in consumer

spending and higher investment. This boost to demand causes a rise in
AD and inflationary pressures.
 The rise in house prices. Rising house prices create a positive wealth
effect and boost consumer spending. This leads to a rise in economic
growth.
 Rising real wages. For example, union’s bargaining for higher wage
rates.
 Devaluation. Devaluation in the exchange rate increases domestic

demand (exports cheaper, imports more expensive). Devaluation will also
cause cost-push inflation (imports more expensive)
If the economy is at or close to full employment, then an increase in AD leads

to an increase in the price level. As firms reach full capacity, they respond by
putting up prices leading to inflation. Also, near full employment with labour
shortages, workers can get higher wages which increase their spending
power.

NOTES
AD can increase due to an increase in any of its components C+I+G+X-M
We tend to get demand-pull inflation if economic growth is above the long-

run trend rate of growth. The long-run trend rate of economic growth is the
average sustainable rate of growth and is determined by the growth in
productivity.
Demand pull inflation and Phillips Curve
Demand pull inflation can also be shown on a Phillips Curve. A rise in

demand causes a fall in unemployment (from 6% to 3%) but an increase in
inflation from inflation of 2% to 5%.

2. Cost-push inflation
NOTES
Cost-push inflation occurs when we experience rising prices due to higher
costs of production and higher costs of raw materials. Cost-push inflation is
determined by supply-side factors (cost-push inflation is different to demand-
pull inflation which occurs due to aggregate demand growing faster than
aggregate supply)
Cost-push inflation can lead to lower economic growth and often causes a fall
in living standards, though it often proves to be temporary.
If there is an increase in the costs of firms, then businesses will pass this on to
consumers. There will be a shift to the left in the AS
Cost-push inflation can be caused by many factors
1. Rising wages
If trades unions can present a united front then they can bargain for higher
wages. Rising wages are a key cause of cost push inflation because wages are
the most significant cost for many firms. (Higher wages may also contribute
to rising demand)

NOTES
2. Import prices
One-third of all goods are imported in the UK. If there is devaluation, then
import prices will become more expensive leading to an increase in inflation.
A devaluation / depreciation means the Pound is worth less. Therefore we
have to pay more to buy the same imported goods.
3. Raw material prices
The best example is the price of oil. If the oil price increases by 20% then this
will have a significant impact on most goods in the economy and this will
lead to cost-push inflation. E.g., in 1974 there was a spike in the price of oil
causing a period of high inflation around the world?
4. Profit push inflation
It happens when firms push up prices to get higher rates of inflation. This is
more likely to occur during strong economic growth.
5. Declining productivity

If firms become less productive and allow costs to rise, this invariably leads to
NOTES
higher prices.
6. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to
higher prices, and therefore CPI will increase. However, these tax rises are
likely to be one-off increases. There is even a measure of inflation (CPI-CT)
which ignores the effect of temporary tax rises/decreases.
Policies to Reduce Cost-Push Inflation
 Policies to reduce cost push inflation are essentially the same as

policies to reduce demand-pull inflation.
 The government could pursue deflationary fiscal policy (higher taxes,

lower spending) or monetary authorities could increase interest rates.
This would increase the cost of borrowing and reduce consumer
spending and investment.
 The problem with using higher interest rates is that although it will
reduce inflation it could lead to a big fall in GDP.
 There is no point in rigidly sticking to an inflation target if the

inflation is caused by temporary factors.
 The long-term solution to cost-push inflation could be better supply-

side policies which help to increase productivity and shift the AS
curve to the right. But, these policies would take a long time to have
an effect.
5.6 NATIONAL INCOME
National income is an uncertain term which is used interchangeably with

national dividend, national output and national expenditure. National
income means the total value of goods and services produced annually in a
country. In other words, the total amount of income accruing to a country
from economic activities in a year’s time is known as national income. It
includes payments made to all resources in the form of wages, interest, rent
and profits.
5.7 CONCEPT OF NATIONAL INCOME

There are various concepts of National Income, such as GDP, GNP, NNP, NI,
NOTES PI, DI, and PCI which explain the facts of economic activities.
1. GDP at market price: Is money value of all goods and services produced
within the domestic domain with the available resources during a year.
GDP = (P*Q) Where,
GDP = gross domestic product
P = Price of goods and services
Q= Quantity of goods and services
GDP is made up of 4 Components
 consumption
 investment
 government expenditure
 net foreign exports of a country
GDP = C+I+G+(X-M)
Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import
 Gross National Product (GNP): Is market value of final goods and

services produced in a year by the residents of the country within the
domestic territory as well as abroad. GNP is the value of goods and
services that the country's citizens produce regardless of their
location.
GNP=GDP+NFIA or,
GNP=C+I+G+(X-M) +NFIA
Where,
C=Consumption
I=Investment

NOTES
NFIA= Net factor income from abroad.
 Net National Product (NNP) at MP: Is market value of net output

of final goods and services produced by an economy during a year
and net factor income from abroad.
NNP=GNP-Depreciation
or, NNP=C+I+G+(X-M) +NFIA- IT-Depreciation
Where,
C=Consumption
I=Investment
NFIA= Net factor income from abroad.
IT= Indirect Taxes
 National Income (NI): Is also known as National Income at factor cost

which means total income earned by resources for their contribution
of land, labor, capital and organizational ability. Hence, the sum of
the income received by factors of production in the form of rent,
wages, interest and profit is called National Income.
Symbolically,
NI=NNP +Subsidies-Interest Taxes

or, GNP-Depreciation +Subsidies-Indirect Taxes
or, NI=C+G+I+(X-M) +NFIA-Depreciation-Indirect Taxes +Subsidies
 Personal Income (PI): Is the total money income received by

individuals and households of a country from all possible sources
before direct taxes. Therefore, personal income can be expressed as
follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-
Social Security Contribution +Transfer Payments.
 Disposable Income (DI): It is the income left with the individuals

after the payment of direct taxes from personal income. It is the actual

income left for disposal or that can be spent for consumption by
NOTES individuals.
Thus, it can be expressed as:
DI=PI-Direct Taxes
 Per Capita Income (PCI): Is calculated by dividing the

national income of the country by the total population of a country.
Thus, PCI=Total National Income/Total National Population
5.8 MEASUREMENT OF NATIONAL INCOME
Gross Domestic Product (GDP):
• GDP is the total value of goods and services produced within the
country during a year. This is calculated at market prices and is
known as GDP at market prices.
There are three different ways to measure GDP:
• Product Method,
• Income Method and
• Expenditure Method.
These three methods of calculating GDP yield the same result because
National Product = National Income = National Expenditure.
5.8.1The Product Method:
• In this method, the value of all goods and services produced in

different industries during the year is added up. This is also known as
the value added method to GDP or GDP at factor cost by industry of
origin.
• The following items are included in India in this: agriculture and

allied services; mining; manufacturing, construction, electricity, gas
and water supply; transport, communication and trade; banking and
insurance, real estates and ownership of dwellings and business
services; and public administration and defense and other services (or
government services).

• In other words, it is the sum of gross value added.
NOTES
5.8.2. The Income Method:
• The people of a country who produce GDP during a year receive

incomes from their work.
• Thus GDP by income method is the sum of all factor incomes: Wages
and Salaries (compensation of employees) + Rent + Interest + Profit.
5.8.3. Expenditure Method:
• This method focuses on goods and services produced within the

country during one year
GDP by expenditure method includes:
(1) Consumer expenditure on services and durable and non-durable

goods (C),
(2) Investment in fixed capital such as residential and non-residential

building, machinery, and inventories (I),
(3) Government expenditure on final goods and services (G),
(4) Export of goods and services produced by the people of country (X),
(5) Less imports (M). That part of consumption, investment and

government expenditure which is spent on imports is subtracted from
GDP. Similarly, any imported component, such as raw materials,
which is used in the manufacture of export goods, is also excluded.
Thus GDP by expenditure method at market prices = C+ I + G + (X – M),

where (X-M) is net export which can be positive or negative

NOTES
5.9 CIRCULAR FLOW OF INCOME
Thecircular flow of incomeorcircular flowis amodelof theeconomyin which

the major exchanges are represented as flows ofmoney,goodsandservices, etc.
between economic agents. The flows of money and goods exchanged in a
closed circuit correspond in value, but run in the opposite direction. The
circular flow analysis is the basis of national accounts and hence
of macroeconomics.
The circular flow diagram illustrates the interdependence of the “flows,” or

activities, that occur in the economy, such as the production of goods and
services (or the “output” of the economy) and the income generated from that
production. The circular flow also illustrates the equality between the income
earned from production and the value of goods and services produced. Of
course, the total economy is much more complicated than the illustration
above. An economy involves interactions between not only individuals and
businesses, but also Federal, state, and local governments and residents of the

rest of the world. Also not shown in this simple illustration of the economy
NOTES
are other aspects of economic activity such as investment in capital (produced
—or fixed—assets such as structures, equipment, research and development,
and software), flows of financial capital (such as stocks, bonds, and bank
deposits), and the contributions of these flows to the accumulation of fixed
assets.
-------------------------------------------------------------------------------------------------------
5.10 KEYWORDS
Business Cycle National Income Inflation Recession
Circular Flow of Income GDP Demand Pull Cost Push
5.11 QUESTIONS
1. What is meant by Business Cycle

2. Define National Income
3. Define Inflation
4. What is meant by Recession
1. Explain the various stages of Business Cycle

2. Explain the Causes and Effect of Inflation and Recession
3. Explain the concept of National Income
4. Explain the measurement of National Income
5. Elaborate Circular Flow of Income
5.12 TEXT BOOKS

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BAFD 19S1 Economics for Business NOTES

INTRODUCTION TO MANAGERIAL ECONOMICS

1| SRMIST DDE B.Com Self Learning Material

After studying this unit you will be able to

 Explain the meaning of economics and managerial economics

 Understand the nature and scope of managerial economics

 Understand the various definitions related to wealth, Scarcity and

 Stating the role of production possibility curve

 Knowing the relationship of Economics with other discipline

Economics is the study of this allocation of resources, the choices that

(i) what to produce?

SRMIST DDE B.Com Self Learning Material

Managerial economics applies economic theory and methods to

3| SRMIST DDE B.Com Self Learning Material

For the sake of convenience, the set of definitions given by various

 Economics as a science of wealth.

 Economics as a science of material welfare.

 Economics as a science of scarcity and choice.

 Economics as a science of growth and efficiency.

(i) Economics as a Science of Wealth or Definition of Economics by Adam

There is no one definition of Economics which has a general

(ii) Economics as a Science of Material Welfare or Definition of Economics

The neo-classical school led by Dr. Alfred Marshall gave economics a

(iii) Economics as a Science of Scarcity and Choice or Definition of

Marshall’s definition of economics remained an article of faith with all

SRMIST DDE B.Com Self Learning Material

After considering the various definitions of Economics, we can easily

1.3.1 Economics is the science of making decisions in the presence of scarce

Economics can be divided into two broad categories:

1.3.3 MICRO ECONOMICS AND MACROECONOMICS

Macroeconomics is the study of the economic system as a whole. It is related

Microeconomics focuses on the behavior of the individuals, firms and their

1.3.4 Deference between Micro economics and Macro economics

Microeconomics is the study of economics at an individual, group or

Microeconomics focuses on issues that affect individuals and

Macroeconomics focuses on issues that affect the economy as a

5| SRMIST DDE B.Com Self Learning Material

1.4 NATURE OF MANAGERIAL ECONOMICS

1. Managerial economics is concerned with the analysis of finding optimal

1.5 SCOPE OF MANAGERIAL ECONOMICS

1.5.1. Demand Analysis and Forecasting:

Demand analysis facilitates the identification of the various factors affecting

1.5.2. Cost and Production Analysis:

A firm’s profitability depends much on its costs of production. A wise

SRMIST DDE B.Com Self Learning Material

1.5.3. Pricing Decisions, Policies and Practices:

1.5.4. Profit Management:

1.5.5. Capital Management:

1.6 CHARACTERISTICS OF MANAGERIAL ECONOMICS

(i) It studies the problems and principles of an individual business firm

(ii) It is concerned with varied corrective measures that a management

7| SRMIST DDE B.Com Self Learning Material

(iii) Managerial economics is pragmatic. In pure microeconomic theory,

(iv) Managerial economics employs economic concepts and principles,

(v) Managerial economics incorporates certain aspects of macroeconomic

(vi) Managerial economics aims at supporting the management in taking

(vii) Science is a system of rules and principles engendered for attaining

(viii) Managerial economics is a normative and applied discipline. It

SRMIST DDE B.Com Self Learning Material

1.7 IMPORTANCE OF MANAGERIAL ECONOMICS

(i) Accommodating traditional theoretical concepts to the actual business

Managerial economics amalgamates tools, techniques, models and theories of

(ii) Estimating economic relationships: