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Basic Principles in the Application
of Managerial Economics
Dr. Nischay K. Upamannyu
What is economics ?
 “Oikon-Nomos”
The term economics comes from the Greek work ‘Oikon’-
House and ‘Nomos’- Law or rule. It is meant “Practical
wisdom of household management”.
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“Economics is the study of how people,
individually and collectively, allocate their
limited resources to try to satisfy their unlimited
wants”.
Economics as a subject came into existence through a

very popular book in 1776 , “An Enquiry into the
Nature and Causes of Wealth of Nations”,
written by Prof. Adam Smith.

Few Important Definition of Economics
1. Wealth Oriented View

2. Welfare Oriented View
3. Scarcity Oriented View
4. Growth Oriented View

Wealth Definition
• Adam Smith (1723-1790) - in his book “An Inquiry
into Nature and Causes of Wealth of Nations”
(1776) defined economics as the science of
wealth. He explained how a nation’s wealth is
created.

Welfare Definition
Alfred Marshall (1842 - 1924) wrote a book
“Principles of Economics” (1890) in which he defined
“Political Economy” or 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 the
material requisites of well being”.

Scarcity Definition
• Lionel Robbins published a book “An Essay on the Nature
and Significance of Economic Science” in 1932.
• According to him, “economics is a science which studies

human behaviour as a relationship between ends and
scarce means which have alternative uses”. The major
features of Robbins’ definition are as follows:

Growth Definition
Prof. Paul Samuelson defined economics as
“the study of how men and society choose, with or

without the use of money, to employ scarce
productive resources which could have alternative
uses, to produce various commodities over time,
and distribute them for consumption, now and in the
future among various people and groups of
society”.

ECONOMICS IS A SOCIAL SCIENCE

Branches of Economics
The modern economic science has two major branches

: Micro economic & Macro economics.
 Macroeconomics emerged as a separate branch in 1936 with

the publication of John Maynard Keynes’.

Introduction – Managerial Economics
Managerial economics is the study of economics theories,
logic and tools of economic analysis that are used in the
process of business decision making by managers.

Definition of Managerial Economics
Spencer and Seigelman “Managerial economics is the

integration of economic theory and business practices
for the purpose of facilitating decision making and forward
planning by management”.

Nature of Managerial economics
1. Micro
economics
2. Normative (prescriptive)
science
3. Pragmatic (Practical)
4. Uses Macro economics
5. Uses theory of firm
6. Management oriented
7. Multi disciplinary
8. Art and science

1. Micro economics: Managerial economics is micro in character or in
nature. This is because it studies the problems of an individual business
unit. It does not study the problems of the entire economy of the
world or nation.
2. Normative (prescriptive) science: Managerial economics is a normative
science. It is concerned with what management should do under particular
circumstances. It determines the goals of the enterprise. Then it develops the
ways to achieve these goals. Managerial economics is prescriptive rather than
descriptive. It prescribes solutions to various business problems.
3.Pragmatic (practical) : Managerial economics is pragmatic.
It concentrates on making economic theory more application oriented. It
tries to solve the managerial problems in their day-today functioning.

4.Uses macro economics: Marco economics is also useful to business
economics. Macro-economics provides an intelligent understanding of the
environment in which the business operates. Managerial economics takes the
help of macro-economics to understand the external conditions such as business
cycle, national income, economic policies of Government etc.
5.Uses theory of firm: Managerial economics largely uses the body of
economic concepts and principles towards solving the business problems.
Managerial economics is a special branch of economics to bridge the gap
between economic theory and managerial practice.
6.Management oriented: The main aim of managerial economics is to help
the management in taking correct decisions and preparing plans and policies
for future. Managerial economics analyses the problems and give solutions just
as doctor tries to give relief to the patient.

7.Multi disciplinary: Managerial economics makes use of most modern
tools of mathematics, statistics and operation research. In decision making
and planning principles such accounting, finance, marketing, production
and personnel etc.
8.Art and science.-Managerial economics is both a science and an art. As a
science, it establishes relationship between cause and effect by collecting,
classifying and analyzing the facts on the basis of certain principles. It points
out to the objectives and also shows the way to attain the said
objectives.
9.Fundamental academic subject:- It is an academic subject that
deserve a serious and scientific treatment. As science involve
generalization, law and prediction.

Scope of Managerial Economics
 The scope of Managerial Economics following

Includes
subjects:
a) Theory of demand
- Demand Analysis
- Demand Theory
b) Theory of Production and cost analysis
c) Theory of Exchange or Price Theory
d) Theory of Profit
e) Theory of Capital and Investment
f) Environmental Issues

 Theory of Demand – According to Spencer and Siegelman, “ A business firm is
an economic organization which transforms productivity sources into goods that
are to be sold in a market,”.
- Demand Analysis- Demand Analysis is necessary for demand forecasting which is an

important aspect of predicting future sales is essential before preparing
production schedule and employing productive resources. It also helps to
manager to understand identifying factors that influence the demand for the products of a
firm. Thus, demand analysis and forecasting is essential for business planning.
- Demand Theory –Demand theory is the study of behavior of consumers.

regarding behavior of consumers, it answers question such as why do the consumer buy a
particular commodity? How much they purchase on the demand of commodity? What
are other factors influencing the demand of commodity? Why and when do the consumers
stop to consume a commodity?

 Theory of Production – Production and cost analysis is important for the
smooth functioning of production process and project planning.
Certain amount of goods has to be produced to earn a certain level of profit. To
obtain such production, some costs have to be incurred, here, the problem before
management is to determine the level of production at which average cost of
production may be minimum. It explains how average and marginal costs change
with the change in production.
 Theory of Exchange or Price Theory – Theory of exchange is popularly

known as price Theory. It explains how the price are determined under different
types of market condition? How and to what extent advertisement can be helpful
in increasing sales of a firm in a market. Price theory is helpful in
determining price of the product in the firm. Price policy affects the demand of
products. It includes the determination of prices under different market
conditions, pricing methods, pricing policies, differential pricing,
product line pricing and price forecasting.

 Theory of Profit- Every business and industrial enterprise aims at earning
maximum profit. Profit is the difference between total revenue and total cost.
Because of the following factors profit is always uncertain:
a) Demand of the product;

b) Prices of the factors of production;
c) Nature and degree of competition in the market ;
d) Price behavior under changing conditions.
Hence, profit planning and profit management are necessary for improving profit
earning efficiency of the firm. Profit management requires that the most efficient
techniques should be used for predicting future. The possibility of risks should be
minimized as far as possible.

 Theory of Capital and Investment – Theory of capital and investment
explains the following important issues:
a) Selection of most suitable investment project

b) Most efficient allocation of capital
c) Assessing the efficiency of capital
d) Minimizing the possibility of under capitalization or over capitalization.
Capital is foundation of any business . Like other factors of production it is

also scarce and expensive. It should be allocated in most efficient manner.

Environmental Issues – Certain issues of macro economics also form a part
of managerial economics. These relate to social and political environment in
which a business and industrial firm has to operate. This is governed by the
factors:
a) The type of economic system of the country
b) Business cycles
c) Industrial policy of the country
d) Trade and fiscal policy of the country
e) Taxation policy of the country
f) Price and labor policy
g) General trends in the production, employment, income , prices , saving and
investment etc.
h) General trends in the work of financial institutions in the country
i) General trends in foreign trade of the country
j) Political system of the country
Significance of managerial economics in
decision making
 Views of Spencer Siegelman – Spencer et.al. described the
and
importance of managerial economics in a business and
enterprises as follows: industrial
a) Reconciling Traditional Theoretical to the

concepts
Actual Business Behavior and conditions
b) Estimating Economic Relationship
c) Predicting Relevant Economic Quantities
d) Understand significant external forces
e) Basis of business policies

 Reconciling Traditional Theoretical Concepts to the actual Business
Behavior and Condition – Managerial economics reconciles the tools,
techniques, model and theories of traditional economics with actual business
practices and with the environment in which a firm has to operate.
 Estimating Economic Relationship- Managerial economics estimates

economic relationships between different business factors such as income,
elasticity of demand and cost volume profit analysis etc.
 Predicting Relevant Economic Quantities – Managerial economics helps

the management in predicting various economic quantities such as – cost, profit,
demand, capital, production, prices etc. as a business manager has to work in an
environment of uncertainty, the future should be well predicted in the light of
these quantities.

 Understanding significant 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 – These are the factors over which a firm can not
have any control. The plans, policies and programs of the firm should be
adjusted in the light of these factors. Important external factors affecting
decision making process of a firm are – economic system of the country,
business cycle, fluctuations in national income and national production,
industrial policy of the 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 etc.
b) Internal Factors- These are the factors that are within the control of a firm.
These factors relate to business operation. Knowledge of these factors helps
the management in making sound business decisions.

 Basis of Business Policies – Managerial economics is the foundation of
business policies. Business policies are prepared on the basis of studies
and finding of managerial economics which warns the
management against all the turning points in national as well as
international economy;
 Thus, Managerial economics is helpful to the management in its decision
making process.

Fundamental concept of M.E
 There are five fundamental concepts that help to the management in

business firm to make correct decisions:
1. Incremental concept
2. Time perspective concept
3. Discounting concept
4. Opportunity cost concept
5. Equi –Marginal Concept

Incremental Concept
The main objective of this principle is maximization of profits. Or In

other words to raise the profits in the business
General rule:
 If the production is increased so the , the total cost of the production will be
increased and simultaneously profit also rises. Hence, It is related to the
marginal cost and marginal revenue concept in economic theory.
Incremental revenue is defined as the change in total revenue
resulting from a decision and Incremental cost is defined as the
change in the total cost resulting from a decision.

A firm gets an order that brings additional revenue of Rs 3,000. The cost
of production from this order is:
 Rs. Rs
Labour 800 Labour
Materials 1300 600
Overheads 1000 Materials
Selling and 1000
Administration 700 Overheads 800
Full Cost 3800

IC = IC- IR
IC = 3800 – 3000 Full Cost 2400
IC= Rs. 800 I R = 3000 -2400
I R= Rs. 600
Time Perspective Concept
 A decision by the firm should take into account of both short-run and long-
run period and firm must evaluate the effect on revenues and cost.
1. Short-run refers to a time period in which some factors are fixed while
others are variable.
2. While long-run is a time period in which all factors of production can
become variable.

 Exp- Suppose a firm is not utilizing its full production capacity. It is
manufacturing a product and selling is at Rs. 200 per unit. The cost of
producing the product is Rs. 160 per unit ( Rs. 120 per unit on variable cost and
Rs. 40 on fixed costs). Firm gets an order of supplying of 2000 units at the rate
of Rs. 160 per unit. If this order is evaluated with short run perspective, it
seems to be profitable because it will fetch a net revenue of Rs. 320000,

 if it is evaluated with long run perspective, the following question arise :
a) If this order are accepted repeatedly at the same price, profitability of the firm
will decrease substantially
b) If the regular customers of the firm come to know about the practice of firm
of accepting orders below full cost, they may demand reduction in regular selling
price of the production
c) The decision of accepting an offer at a price that does not cover the cost
of production in full, may adversely affect the image of the firm.

Discounting Concept
 This principle talks about comparison of the money value

between
present and future time.
Eg: suppose -
 1) 100/- is gifted to a particular person today.
 2) 100/- will be given as gift to same particular person after one year.
Implication of this concept - In the business, everybody prefers to do cash

sale only rather than the credit sale and even they are ready to give cash discount
for cash sale. The reason is we will get a rupee today and today’s rupee is more
valuable than the tomorrow’s rupee. But In credit sale we will get rupee
tomorrow or in the future time and nobody give the discount for credit sale.

Opportunity cost concept
 Devenport, an American economist explains the concept of

opportunity cost with reference to an example, suppose a girl has two
fruits – one mango and one apple, if a bad boy is after her to seize the
fruits, then what a girls should do ?
1. should girl run away having hold at least one fruits

2. should girl let that place without fruit.
 This concept help in selecting the best possible alternative from among
various alternatives available to solve a particular problem. This concept
helps in the best allocation of available resources.
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In the words of Left witch, "Opportunity cost of a particular product is the
value of the foregone alternative products that resources used in its
production, could have produced

Equi-Marginal Concept
This principle is also known the principle of maximum

satisfaction. According to this principle, an input should be
allocated in such a way that the value added by the last unit of
input is same in all uses. In this way. this principle provides a base
for maximum exploitation of all the inputs of a firm so as to
maximize the profitability.

 Example- Suppose that there are 400 workers working in a firm and
firm is producing four types of product – Product A, Product B,
Product C and Product D.
 If the product A is related to rainy season, B & C is related to winter
and Product D is related to summer season. Now in the raining season
the demand of the product would also be increased and demand of
summer and winter product’s would not be as much as it should be in
particular season. Hence, when a firm is not being able to use its
resource fully in the Season of summer and winter so untapped
resources should be used fully in the season of raining.
OBJECTIVE OF MODERN BUSINESS FIRM

Definition of a Business Firm
A business firm is defined as an economic unit engaged in
the production and distribution (or sale) of goods and
services with a view to earn maximum profits.

Objective of Firm
There are a number of theories tell us about the objectives of a firm. The
important ones are the following:
 Profit Maximization
a) Innovation Theory
b) Risk Bearing Theory
c) Monopoly Theory
d) Managerial Efficiency Theory
 Baumol’s Theory of Sales Revenue Maximization theory
 Marris’ Hypothesis of maximization of Growth Rate theory

 Behavioral Theory Cyert and March.
 Profit Maximization –
 Profit is defined differently in business and economics. In accounting

Where, it is difference between total receipts and the explicit (accounting) cost of
carrying out the business; explicit cost is the payments made to the hired
factors of production.
 While, the economic profit is defined as implicit cost which should be

subtracted from the Gross margin, which stands for the imputed cost of self
owned factor of production employed in the business. The economic profit is
the residual after both the explicit and implicit cost are deducted from
the total receipts.

 Example- A carpenter makes 100 chairs per month and sells them at Rs.
450 per piece. His expenses on rent of the shop, cost of wood and other
material are worth Rs. 15000 per month .
 He employs two worker whose monthly wage bills stand at Rs. 7200 and pays
electricity bill of about Rs. 1500 per month. He has invested Rs. 150000 in the
form of machine, tools and inventories in the business, of which Rs. 75000 is
form his own fund and the remaining Rs. 75000 is a loan from a bank at the
interest rate of 18% per annum.
 Further assuming imputed cost of his own time, his wife’s time and his own
saving of Rs. 75000 for the month are Rs. 9000, Rs. 3000 and Rs. 750,
respectively. The various calculation would then be:

 Total Receipts =Rs. 450 * 100 = Rs 45000
 Total Explicit costs =Rs. 15000+7200+1500+75000 (1/12)(0.18)

 =Rs. 24825
 Total Implicit Cost = Rs. 9000+ 3000+750

 = Rs. 12750
- Business Accounting Profit = Rs 45000 -24825

 = Rs. 20175
- Economic Profit = Rs. 45000 – 24825 – 12750 = Rs. 7425.
- According to profit maximization theory - objective of business is generation of

the largest amount of profit

 Innovation Theory – Firms make innovation in new products, new production
techniques, new marketing strategies, etc. these innovations are costly and must be
rewarding for them to flow continuously. For this reason, innovating firms are
sometimes awarded patent right for a specific period of time, during which time no
other firm is permitted to copy the product and or technology. Profit are thus
considered partly a reward for innovation.

 Risk Bearing Theory – Firms invest large sums in the production system,
expecting to produce goods and make profit on it. However, the production may
run into difficulties, be delayed and there may not be an adequate market when
production is ready. In consequence, reward for entrepreneurship are highly
uncertain. The firms take these risks and must be adequately
rewarded.

 Monopoly Theory – Some firms are able to enjoy certain monopoly power in
view of being in possession of a huge capital, economics of scale, patent
protection or socio political power. As a result, there is a lack of perfect
competition and such firms are able to reap economic profits.

 Managerial Efficiency Theory – This category argues that economic profits
can arise because of exceptional managerial skills of well managed
firms.
 For example- if firms that operate at an average level of efficiency can avoid
losses, then those which operate at above that level must reap economic profits.
Thus, existence of profit is essential to ensure good performance.

Baumol’s Theory of Sales Revenue
Maximization
 Prof. Baumol, in his book 'Business behavior, Value and Growth‘ propounded a
theory of Sales Maximization. Main aim of a firm is to maximize
sales.
 Baumol hypothesized that managers often attach their personal prestige

to the company's revenue or sales; therefore they would rather attempt
to maximize the firm's total revenue, instead of profits. Moreover, sales
volumes are better indicator of firm's position in the market, and growing sales
strengthen the competitive spirit of the firm.
 Following arguments are given in favor of maximization of sales
goal:
 More Realistic
 More Practical
 More Availability of Loans
 Strong Position in the Market
 More Advantageous to the Managers

Following arguments are given in favor of
maximization of sales goal:
 More Realistic: Goal of maximization of sales is a more realistic goal- In fact,

firms accord more importance to the goal of sales maximization than profit
maximization.
 More Practical: Revenue maximization thesis of Baumol is more practical. It is
so because goal of revenue (Sales) maximization leads to more production which,
in turn, leads to fall in price. As a result, consumers' welfare is promoted.
 More Availability of Loans: At the time of sanctioning loan to a firm, financial
institutions mainly consider its sales. Prospects of loans are bright for such firms as
have large total sales.
 Strong Position in the Market: Maximum sales of a firm symbolize its strong
position in the market. Sales of a firm will be large only in that situation when
consumers like its production, firm has more competitive power and has been
expanding.
 More Advantageous to the Managers: Maximum sales is a reflection of the
competence of the managers It has a favorable effect on their wages.

Marris’ Hypothesis of maximization of
Growth Rate
 Working on the principle of segregation of managers from owners, Marris

proposed that owners (shareholders) aim at profits and market share,
whereas managers aim at better salary, job security and growth.
 These two sets of goals can be achieved by maximizing balanced growth of the
firm (G), which is dependent on the growth rate of demand for the firm's
products (GD) and growth rate of capital supply to the firm (GC).
Hence growth rate of the firm is balanced when the demand for its product and
the capital supply to the firm grow at the same rate.
 Marris further said that firms face two constraints in the objective of
maximization of balanced growth, which are explained below:
 Managerial Constraint
 Financial Constraint

 Managerial constraints: Marris stressed on the importance of the role of
human resource in achieving organizational objectives. According to him,
skills, expertise, efficiency and sincerity of team managers are vital to
the growth of the firm.
 Financial Constraint - Prudence needed in managing financial resources.

Marris suggested that a prudent financial policy is based on at least three
financial ratio;
 1. Debt equity ratio– it is ratio that indicates borrowed capital and
owner capital. The ration should lowest
 2. Liquidity ratio - This is the ratio between current assets and current
liabilities and is an indicator of coverage provided by current assets to current
liabilities.
 3. Retention ratio - This is the ratio between retained profits and total
profits. the retained profits are that portion of net profit which is not
distributed among shareholders. A high retention ratio is good for growth,

Behavioral Theories
 Objective of Behavioral theory of firms that business aim at satisfactory

behavior, rather than maximization of profit and sales. This is the most
important model which is known as Simon’s satisfying model and the model
developed by Cyert and March.
 According to his satisfying Model, the biggest challenge before modern

business is to get the full information and know about uncertainty for
future. Because of this, firms have to incur cost in acquiring information
in the present, the objective of maximizing either profits, or sales, or
growth is not possible until or unless firm utilize its received information in
correct decision making and it is reflected in through its satisfactory behavior.

According To Prof. H.B Hobson
In English dictionary the meaning of utility Is
“Usefulness” & Some people understand utility
is “pleasure”

• Utility can be also defined as an “attribute of
commodity to satisfy needs and wants of the
consumer”
• “It is power of commodity which satisfy

needs and want of the customer”.

Features of
Utility
Utility is Utility
subjectiv is
e Relativ
e
Utility is Utility is
not independent
essentially from
useful morality
Types of utility
Initial Utility
Total Utility
Marginal Utility
Marginal utility can be
• Positive • Utility is • Utility is

Utility Zero negative
• Total utility • Total utility • Total utility
is becomes starts
increasing maximum declining
so long as when when
Marginal marginal marginal
Utility is utility is utility is
positive zero negative

Table- Showing Utility, Total Utility, Marginal utility, Initial
utility, Positive utility, Zero Utility and Negative Utility
QUANTITY TOTAL MARGINAL Description

chocolates UTILITY UTILITY
1 8 8 Initial Utility
2 14 6 Positive Utility
3 18 4
4 20 2
5 20 0 Zero Utility
6 18 -2 Negative Utility

Can Utility be Measured?

Measurement of Utility
⚫ There are two basic approaches are followed :
1.Cardinal approach
2.Ordinal Approach

Criticism on the measurement of
utility
It has been criticized by Prof. Samuelsson as the

value of money keep changing therefore utility
can not be measured definitely in the terms of
money.

Law of diminishing Marginal Utility
“the quantity consumed of a commodity increases, the
utility derived from each successive unit
decrease”.

Assumption of Law of Diminishing marginal
utility
The unit of the

consumer good
must be a
standard,
There must
Consumer taste
be
& preference
continuity in
consumption,
The
mental
condition
Exceptio
n
Curious
and Rare
thing-
Good
Miser
book or
s Poem
Intoxicate
d thing

INDIFFERENCE CURVE

Indifference
curve
⚫ This approach of consumer behavior is based on consumer preferences. It
believes that human satisfaction being a psychological phenomenon, it
cannot be measured in quantitatively (monetary terms). In this approach,
ordinal approach for making preferences is used.

An indifference curve may be defined as the locus of point each
representing a different combination of two substitute
goods, which yield the same utility or same level of
satisfaction to the consumer.
Therefore, consumer become indifferent between any two combination

of two goods when he want do it. An indifference curve is also
called ISO Utility curve and Equal utility curve.

Assumptions Underlying Indifference Curve
Approach
1. The consumer is rational and possesses full information about all the
relevant aspects of economic environment in which he lives.
2. The consumer is capable of ranking all conceivable combinations of goods
according to the satisfaction which they yield. Thus if he is given various
combinations say A, B, C, D, E he can rank them as first preference,
second preference and so on.
3. If a consumer happy to prefer A to B, he can not tell quantitatively
how much he prefers A to B.
4. If the consumer prefers combination A to B, and B to C, then he must
prefer combination A to C. In other words, he has consistent
consumption pattern behavior.

• What are Indifference Curves?
An indifference curve is a curve which represents all those
combinations of goods which give same satisfaction to the
consumer.

Table Indifference
Schedule
Combination Food Clothing MRS
A 1 12
B 2 6 6
C 3 4 2
D 4 3 1

The Marginal Rate of Substitution (MRS)
Marginal Rate of Substitution: Marginal Rate of Substitution

(MRS) is the rate at which the consumer is prepared to
exchange goods X and Y Consider. There are two reasons for
this.
– The want for a particular good is satiable so that when a consumer has its
more quantity, his intensity of want for it decreases.
– Most of the goods are imperfect substitutes of one another. If, they could
substitute one another perfectly. MRS would remain constant.

Combinatio Food Clothing MRS
n
A 1 12
B 2 6 6
C 3 4 2
D 4 3 1

Indifference
Map
• Indifference Map: A set of indifference curves is called
indifference map.
• An indifference map depicts complete picture of consumer's tastes and
preferences. an indifference map of a consumer is shown which consists of
three indifference curves.

• IC4
IC3
IC2
ICI1

Properties of Indifference
curve
• Indifference curve will be downward slopping.
• Indifference curve can not intersect or touch each other.
• Indifference curve must be convex to the origin.
• Upper indifference curve represent a higher level of satisfaction than the

lower ones
• Neither Indifference curve touch on X axis nor on Y axis.

• Indifference curves slope downward to the right:
This property implies that when the amount of one good
in combination is increased, the amount of the other good is
reduced. This is essential if the level of satisfaction is to
remain the same on an indifference curve.
Q2
P
A
R
B k
K U
0
C D Q1
Explanation
• P is the a Point on the indifference curve U. at this point
the consumer consume OC unit of commodity q1 and OA
units of the commodity q2. when the consumer moves
from the point of P to point R, he consume CD unit more
of q1. as the result of this his utility level increases. To
neutralize this increase in utility he decrease consumption
of q2 by the amount AB unit so as to remain on the same
indifference curve

• Indifference curves are always convex to the origin:
• Indifference curve is not only negative sloped, but are also
convex to origin. The convexity of the indifference curves
implies two properties.
1. that the two commodity are substitutes for each other
2. That the marginal rate of substitution b/w the two goods
decreases as a consumer moves along an indifference curve.

• Two indifference curves can not intersect or
touch each other:
Q2
A
C U1
0 B U0
D
M N Q1

Explanation:
• When two indifference curve intersect each other. Suppose
that there are two indifference UO and U1, Where U1
denotes a higher level of utility than the indifference curve
UO. The curve intersect at a point A and C is a point of
vertically above the point B. it can be said that CPB (C is
more preferable than B), This means that an indifference
curve has to lie wholly above or below another
indifference curve so that a higher indifference curve
represent a higher level of utility

Upper indifference curve Represent a Higher
level of satisfaction than the lower ones
• An indifference curve placed above and to the right of

another represent a high level satisfaction than the lower
ones. It represent a higher level of satisfaction. The reason
is that upper indifference curve contains all along its length a
larger quantity of one or both the good than the lower
indifference curve. And a larger quantity of a commodity
is supposed to yield a greater satisfaction than the smaller
quantity of it.

• A higher indifference curve represents a higher level of
satisfaction than the lower indifference curve: This is because
combinations lying on a higher indifference curve contain mere of
either one or both goods and more goods are preferred to less of them.
C
O
M b
M c
O d
D IC2
a
I
T IC1
Y x
Commodity Of X
y
0

DEMAND ANALYSIS

Topics to be covered
1. Law of Demand
2. Exception to the Law of Demand
3. Determinant of Demand
4. Market Demand versus Individual Demand
5. Shifts in the demand Curve

The concept of Demand

In an ordinary sense, the term demand is expressed as desire
or
want for a goods or services .

TERMS
• Demand The quantity of a good that
buyers are willing and able to
buy at all possible prices
during a period of time.

Demand Determinants
1. Price of the commodity
2. Income of the consumer
3. Price of Related Goods
1. Substitutes
2. Complementary Goods
4. Change in Tastes of the consumers
5. Amount of Wealth
6. Increase in Population
7. Government Policy
8. Consumer Expectations Regarding the Future
9. Climate and Weather of Area

Law of Demand
The Law of demand states that as the price of a commodity rises,
the quantity demanded of the commodity falls, and as the price of a
good falls, the quantity demanded of the commodity rises,
Ceteris paribus,

What Does Ceteris Paribus
Mean?
• This is a Latin term that means all other things held
constant or nothing else changes. For example, an
economist might say: “As the price of Pepsi – Cola raises, the
quantity demanded of Pepsi Cola falls, Ceteris Paribus.”

Assumptions of Law of Demand
 In the rule of demand it is said that other things being equal.
1. The income of the costumer remains same
2. Taste and preference should be same
3. There should not be a new discovery into the commodity
4. Income and price of the commodity should remain same
5. The price of commodities should not be expected to increase in near

future or forthcoming time
6. The commodity should not be a prestigious for the customer.

Exception to the Law of Demand
• There are some exceptions to the law of demand. These
are
following:
1. Articles of Distinction or Veblen goods
2. Giffen Goods
3. Consumer’s psychological Bias or Illusion
4. Necessaries of Life
5. Commodities with special Brand and Trade Mark
6. War or Emergency
7. Small part of Total Expenditure

Demand Curve
• The demand curve is a

graphic presentation of a demand
schedule.
• Leftwite “The demand curve represent the

maximum quantities per unit of time
that consumer will take at various
prices”.

Demand Schedule
Demand schedule is a tabular statement showing various
quantities of a commodity being demanded at various
levels of price, during a given period of time.

Types of Demand

Individual Demand Curve
Individual demand curve is a curve that shows

different quantities of a commodity
demanded by an individual consumer.

Market Demand Curve
Market demand curve is a curve that represent the

aggregate demand of all the consumer in the
market at different prices of a particular
commodity. It is a horizontal summation of
individual demand curve.

Shift in Demand Curve
A shift in the demand curve is when a determinant of demand other than
price changes. It occurs when demand for goods and services changes
even though the price didn't.

Shift in demand Curve

Factor That Causes to shift Demand Curve
1. Income of the buyers

2. Consumer Trends
3. Expectation of future Price
4. The Price of Related Goods
5. The Number of Potential buyers

UNIT - 2

 Meaning of supply
 Significance and Method
 Law of Supply
 Determinant of supply
 Market supply versus Individual Supply
 Shifts in the supply Curve
 Elasticity of supply and its use of managerial decision
 Elasticity of Demand
 Price, Income, Cross and Advertising Elasticity
 Point elasticity and Arc elasticity
 Use of Elasticity of demand for managerial decision

SUPPLY ANALYSIS
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Meaning of Supply
Supply means the amount of a product that are

offered for sale at all possible prices during a given
period of time.

Supply Analysis
“The law of supply states that other things being equal, as

the price of a good increases, the quantity supplied of
that good increases”.

Relationship Price and Quantity supplied
The relation between price and quantity supplied holds

higher prices imply greater profit opportunities for producers,
holding other things, such as input prices, constant. At higher
prices, producers will usually devote greater resources to the
production of that good.

Factor affecting of supply
1. Price commodity
2. Cost of production
3. Price of substitutes
4. Technical improvement
5. Natural Factor
6. Means of transportation and communication
7. Expectation of further change in price
8. Taxation policy

⚫ Price of commodity – There is direct relationship between price and
supply. If the price of commodity increase so the manufacturer or
producer will surely increase supply of that Good. It means, there is
positive relationship between price and supply.
⚫ Cost of production – There is an inverse relationship between cost of

production and supply of the commodity. If cost of production would be
increased so the supply would also decrease and if cost of production
would be decreased so the supply of the commodity would also increase.
⚫ Price of substitutes – If the price of substitute commodity increase,
its supply will decreases because the producer and seller will take more
interest in producing and selling the substitute commodity and the
supply will also increase of substitute commodity

Supply schedule
⚫ A supply schedule is a tabular presentation of the law of

supply. A supply schedule is a table showing different
prices of a commodity and the corresponding quantity
that suppliers are willing to offer for sale.
⚫ Supply schedule can be two type

1. Individual supply schedule
2. Market supply schedule

⚫ Individual supply schedule – Individual supply
schedule present different quantities of commodity at
which an individual producer or seller agrees to sale the
quantity of commodity at different price.
PRICE (IN RS.) SUPPLY (SHIRTS IN 2011)

in lakh
100 10
200 35
300 50
400 60
600 75
800 80

⚫ Market Supply Schedule – Market supply schedule
present different quantity of a commodity which all the
producers or sellers would agree to sell the supply of
commodity at different price level.
PRICE OF SUPPLY BY INDIVIDUAL PRODUCER OR
COMMODITY SELLER
A B C D TOTAL
SUPPLY
10 2000 1000 3000 4000 10000
9 1800 900 2700 3600 9000
8 1600 800 2400 3200 8000
7 1400 700 2100 2800 7000
6 1200 600 1800 1800 6000

Law of supply
⚫ Law of supply explain the relationship between the price
and the quantity of supply of commodity.
⚫ If the price of a commodity increases, producer and seller take

more interest in producing and selling the quantity of commodity,
if there is no change in the cost of production than only supply of
quantity of commodity would increase.

Assumption of the Law of supply
1. There should be no changed in the income
of buyer and seller
2. There should be no changed in the habits,
taste and preference of buyer and seller.
3. There should be no changed in the cost
of production
4. There should be no changed in the
production techniques.

Exceptions to the Law of supply
1. Agricultural Product
2. Artistic Goods
3. Goods of Auction

1. Agricultural product – Law of supply would not be
applied in respect of product because their production
can not be increased beyond the certain limit.
2. Artistic Goods – Law of supply would not be applied
on artistic good because their supply can neither be
increased nor decreased only.
3. Goods of Auction – Law of supply would not be
applied in respect of goods of auction. Because the
supply of those goods are always limited. It can neither
be increased nor decreased.

Supply Elasticity
 Law of supply maintain a direct relationship between price and

the quantity of commodity.
“When the price of a commodity increases, its supply will also

increases proportionately and when the price of a commodity
decreases so its supply of commodity will also decreases.”

Price elasticity of supply refers to degree of responsiveness of supply of a
commodity with reference to change in the price of such commodity.

Methods for Measuring Price Elasticity of
Supply:
Price elasticity of supply can be measured by the following methods:

1. Percentage Method
2. Geometric method

Percentage Method:
 The most common method for measuring price elasticity of supply (Es) is
percentage method. This method is also known as ‘Proportionate Method’.
 According to this method, elasticity is measured as the ratio of percentage
change in the quantity supplied to percentage change in the price.
 Price elasticity of supply (Es) = Percentage Change in quantity supplied /
Percentage change in Price

Where:
1.Percentage change in Quantity supplied = Change in Quantity Supplied (∆Q) /
Initial Quantity Supplied (Q) x 100
2. Change in Quantity (∆Q) = New Quantity (Q1) – Initial Quantity (Q)
3. Percentage change in Price = Change in Price (∆P) / Initial Quantity (P)

× 100
4. Change in Price (∆P) = New Price (P1) – Initial Price (P)

Proportionate Method:
The percentage method can also be converted into the proportionate method.
Putting the values of 1, 2, 3 and 4 in the formula of percentage method, we
get:
E s = ∆Q/Q x 100/∆P/P x 100
Es = ∆Q/Q/∆P/P
Elasticity of Supply (Proportionate Method) = ∆Q/∆P x P/Q
Where:
Q = Initial Quantity Supplied
∆Q = Change in Quantity Supplied
 P= Initial Price
 ∆P= Change in Price

 Example: Suppose, at the price of Rs. 10 per unit, a firm supplies 50 units
of a commodity. When the price rises to Rs. 12 per unit, the firm increases
the supply to 70 units

The price elasticity of supply will be calculated as:
Price elasticity of supply (ES) = Percentage Change in quantity supplied/
Percentage change in Price
 Now,
Percentage change in Quantity supplied = Change in Quantity Supplied (∆Q)/
Initial Quantity Supplied (Q) × 100
= (70-50)/50 × 100 = 40%
Percentage change in Price = Change in Price (∆P)/ Initial Price (P) × 100
= (12-10)/10*100 =20%
Es =40%/20%
 Remark – Price elasticity of supply is Positive

Geometric Method
 According to geometric method, elasticity is measured at a given point on the

supply curve. This method is also known as ‘Arc Method’ or ‘Point Method’.

This method is used to measure the elasticity of supply when there is a greater
change in price and quantity supplied. According to this method, the elasticity
of supply is the coefficient of average between two points along a supply
curve.

Measurement of law of supply
⚫ Elasticity can be measured with using the formula:
% change in the quantity of supply

Es =
% change in its price
⚫ Elasticity of supply is a measurement of changes in the quantity

of supply of a commodity as a result of a certain change in its
price.
⚫ It is measured by dividing proportionate change in the quantity of
supply of a commodity by proportionate change in the price of
that commodity.
Types of Elasticity of supply
1. Perfectly elastic supply

2. Relatively Elastic supply
3. Unitary elastic of supply
4. Relative inelastic or Less elastic of supply
5. Perfectly inelastic supply

Perfectly elastic supply
⚫ If there is a significant changes in the supply of commodity without
any change or a little change in its price so it is called perfectly
elastic supply. This is only imaginary concept because in practical
life there is no commodity.
PRICE OF COMMODITY QUANTITY OF SUPPLY

(Rs. Per Kg.)
10 10000
10 15000
10 18000

Highly Elastic supply
⚫ When the proportionate change in the supply of a commodity
is more than proportionate change in its price, it is called
highly elastic supply.
Exp – If the price of commodity increased by 10% and as
results of its supply of this commodity increases by 20%. It is
called highly elastic supply.

(Rs. Per Kg.) (K.G.)
10 10000
11 12000
12 14000
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Unitary Elastic Supply
⚫ When the proportionate change in the quantity of supply of a
commodity due change in its price is equal so this situation is
called as proportionately equal elastic supply.
PRICE OF QUANTITY OF
COMMODITY (Rs SUPPLY (Kgs)
Per Kg.)
10 10000
11 11000
12 12000

Less than elastic supply or inelastic supply
⚫ When the proportionate change in the quantity of supply of a

commodity is less than proportionate change in its price. This
situation is called less elastic of supply or in elastic supply.

(RS PER KG) KG
10 10000
11 10500
12 11000

Perfectly Inelastic supply
⚫ When the supply of commodity would not change due to

change in the price of the commodity so this situation is
known as Perfectly in elastic supply. Although this situation is
also imaginary situation because we do not find of any good
supply which may falls into this category.

(Rs. Per. Kg.) (Kg)
10 10000
11 10000
12 10000

Shifts in the supply curve
 The position of a supply curve will change due to change of one

or more underlying determinants of supply. For example, a
change in costs, such as a change in labour or raw material costs,
will shift the position of the supply curve.
 Ifthe supply curve shifts to the right, this is an increase

in supply;
 Ifthe supply curve moves inwards, there is a decrease
in
supply meaning that less will be supplied at each price

Elasticity of Demand
 Elasticity is a measure of the responsiveness of one variable

to change in other.
 In Brief , “Elasticity is proportionate % change in
responsiveness of one variable due to proportionate %
change in the other variable.

 Demand for a good depends upon its prices, income of the
consumer and price of related goods.
 Elasticity of demand, therefore, indicates how much quantity

demanded of a good will change due to price or income of the
consumer or price of related goods.
 Accordingly, elasticity of demand is of Four types – (1) Price

Elasticity of Demand (2) Income Elasticity of Demand
(3) Cross Elasticity of Demand (4) Advertising
demand elasticity

Price Elasticity
 The price elasticity of demand is the measure of the
responsiveness of quantity demanded of a good to changes
in the goods price, other things being equal. It is equal to the
Ration of the percentage change in the quantity demanded to a
percentage change in the price.


Definition
 “Elasticity of demand may be defined as the percentage change in

the quantity demanded divided by the percentage change in the
price” Dr Marshall
 Price elasticity of demand measures the responsiveness of the

quantity demanded of a good to the change in its price.”
Boulding

Elasticity of Demand :- " Elasticity of demand is
the rate at which the quantity demanded changes with a
change in price.“
FORMULA :
ED = Proportionate change in quantity demanded
Proportionate change price.

in

Degrees of Price Elasticity of Demand
 Price elasticity of demand of all goods, or one good, at different prices, it is

not always the same. It may be more or it may be less.
 In economics, the study of the concept of elasticity of demand is divided into
five degree and they are;
(1) Perfectly Elastic
(2) Perfectly Inelastic
(3) Unitary Elastic
(4) Greater than unitary elastic or elastic
(5) Less than Unitary Elastic or inelastic.

 Perfectly elastic Demand – A perfectly elastic demand is one
in which demand is infinite at the prevailing price, but any rise in
price will cause quantity demanded to fall to zero. In this case, a
very little rise in price causes the demand to fall to zero and a
very little fall in price causes the demand to extend to infinity.

 Perfectly Inelastic Demand - The demand is said to be perfectly
inelastic when a change in price produces no change in the quantity
demanded of a commodity. In such a case quantity demanded remains
constant regardless of change in price. The amount demanded is totally
unresponsive of change in price. The elasticity of demand is said to be
zero.

 Unitary Demand – In Unitary elastic demand
Elastic
proportionate change in the price of a commodity and proportionate
change in its demand are equal.
 Example- If the price of a commodity increases by 10% there should be
fall of 10% in the demand of this commodity. This can be explained
with the help the following demand curve.

 Relatively elastic demand – In relatively elastic demand
proportionate change in the quantity demanded of a product is more
than the proportionate change in its price
 Exp- if the price of a commodity increases by 10% and in response to it,
demand of the commodity decreases by 15% it will be known as
relatively elastic demand.

 Relatively inelastic Demand – In relatively inelastic demand
proportionate change in the demand of a commodity is less than the
proportionate change in its price.
 Example- If the price of a commodity increases by 20% but the demand
decreases in to it only by 10%, it is known as relatively inelastic
demand.

Methods and Techniques of Measuring Price Elasticity of
Demand
In practical applications, it is not sufficient to determine

whether the demand is elastic or inelastic. An organization
needs to estimate the numerical value of change in demand
with respect to change in the given price for making various
business decisions. The numerical value of elasticity of
demand can only be estimated by its measurement.

Point elasticity of demand
 This method was developed by Prof. Alfred Marshall.

According to it, elasticity of demand of a commodity can be
measured at different points on a demand curve. Point elasticity
refers to price elasticity of demand at any point on the demand
curve.

The Arc Method
 when elasticity is measured between two points on the same

demand curve, it is known as arc elasticity. In the words of Prof.
Baumol, “Arc elasticity is a measure of the average
responsiveness to price change exhibited by a demand curve over
some finite stretch of the curve.”

 Demand Schedule :
 Point Price (Rs) Quantity (kg)
P 8 10
M 6 12
 1. If we move from P to M , the elasticity of demand is
 EP =
 EP = If we move in the reverse direction from M to P , Then,

 Thus, The point method of measuring elasticity at two points on a
demand curve gives different elasticity coefficient because two
different base is used in computing the percentage change in each
case.
 To avoid this discrepancy, elasticity for the ARC is calculated by
taking the average of two prices (P1 + P2)1/2 and the average of
two quantities (Q1 +Q2)1/2).

 From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12
 Applying these values, we get,

Income Elasticity

 An important determinate of demand of commodity is the income
of consumers, this relationship is of great importance to the
businessman in forecasting the sale of his products and It
is measured by income elasticity of demand.

Income Elasticity
In the words of Prof. Watson “ Income elasticity of demand

is the rate of change of quantity with respect to the
change in the income. Other determinants remaining
constant”.

According to C.E. Ferguson-“Income elasticity of
demand is the proportionate change in quantity demanded
divided by proportionate change in income”.
According to Watson “Income elasticity of demand means

the ratio of the percentage change in the quantity demanded to
the percentage change in income”.
According to Richard G. Lipsey “The responsiveness of

demand to change in income is termed as income elasticity of
demand”.

demand
 Income elasticity of demand can be divided among

three different degree of elasticity.
1. Zero income elasticity of demand
2. Negative Income elasticity of demand
3. Positive Income elasticity of demand

Zero income elasticity of demand If the quantity of demand
of a commodity does not change with change in the income
of a consumer, if is zero income elasticity of demand.

 Negative Income Elasticity If the demand for a commodity
falls on an increases in the income of consumers and increase on a
fall in their income, it is called negative income elasticity of
demand. It applies to the goods of inferior quality. For example- if
there is an increase in the income of consumer, they will
discontinue the consumption of inferior goods and start to
consumer superior goods.

 Positive income elasticity of demand - If the demand of
commodity increases on an increase in the income of its
consumers and decreases on a fall in the income of its consumer,
It is called positive income elasticity of demand.
Positive income elasticity of demand may be three type
1. Income Unitary elasticity

2. Greater than Income elasticity of demand
3. Less than Income elasticity of demand

 Unitary Income elasticity
 If the change in demand of

commodity
a is equal to the
change in the income of
consumers, it is called
unitary income elasticity of
demand.
 For example- if the income of

consumers of a commodity
increases by 20% and the demand
of that commodity also increases
by 20%, it will be called unitary
income elasticity of demand.
 Greater than unit income
elasticity of demand
 If the change in the demand of a
commodity is more than the
change in the income of its
consumers, it is called greater
than unit income elasticity of
demand.
 For example- the income of
If consumers a
of
commodity increases by
particular
20% and the
demand of that commodity increases
by 30%, it is called greater than unit
income elasticity of demand.

 Less than income elasticity
of demand
 If the change in demand of
a
commodity is less than the the
change in income of its it is
consumers, called less
than unit income elasticity of
demand.
 For example- if the income of the
consumers of a commodity
increases by 20% while the
demand of that commodity
increases only by 10%, it will be
called less than unit income
elasticity of demand.
Cross Elasticity of Demand

Cross Elasticity of Demand
 If the Price and demand of two commodities is related with one

another then it is called related goods. Thus, cross elasticity
of demand is the measurement of change in the demanded
quantity of a particular commodity in response to a change in the
price of some other related commodity. Related commodities may
be of two types
1. Substitute goods
2. Complementary Goods

 The formula for cross price elasticity of demand
Cross Price Elasticity of Demand = % change in the
demand for Good X % / change in the price of Good Y

Cross Elasticity of Demand for Substitute goods
 Substitute goods are those that may be used in place of another

goods with same degree of comfort and ease. For example- tea is
a substitute for coffee, scooter is a substitute for motor cycle etc.
PRICE OF COFFEE DEMAND OF TEA
Rs 5 50 kgs.
Rs 4 40 Kgs.
Rs 3 30 Kgs.

 Y

 5
 PRICE 4
 coffee
 3
 0
 30 40 50 X
 QUANTITY DEMANDED OF
TEA
Types of Cross elasticity of substitute Goods
1. More than unit cross elasticity of demand

2. Unit Cross Elasticity of Demand
3. Less than Unit Cross Elasticity of Demand
4. Zero Cross Elasticity of Demand
5. Infinite Cross Elasticity of Demand

 More than unit cross elasticity of
demand  If the proportionate change in the
demanded quantity of a
commodity is more than
 X
proportionate change in the price of
 Price
its substitute commodity, it is
 P1 called more than unit cross
 P0 elasticity of demand . I
happens when the t
commodities are close substitute twoto
 0 one another
 Q0 Q1
 Quantity Y
 For example – The price of
commodity Y increase by 10% and
in response to it, the demand of
commodity X, a close substitute to
commodity Y
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Here comes
unit cross elastPicage
 Unit Cross Elasticity of Demand
 If
demanded quantity of
commodity
proportionate is equal a
 X proportionate change to the
 P1 price
change of its substitute
in the
commodity, it is called unit cross
 P0
elasticity
in of demand.
 PRICE
 the
For example – If the price of
commodity Y increases by 10% it
 0 is called unit cross elasticity of
 Q1 Q2 Y demand. It can be
 QUANTITY

 Less than unit cross elasticity of  If proportionate change in the price
Demand of a commodity is more while
proportionate change in the demand of
its substitute commodity in response to
 Y
such change is less, it is called less
than unit cross elasticity of demand.

 P1
 P0  For example- If the price of
commodity Y increase by 20% but in
response to it, the demand of
 0
commodity X, a substitute to
 M M1 X commodity Y, increases only by
10%, it is called less than unit cross

 Zero Cross Elasticity of Demand  If change in the price a commodity
does not bring any change in the
demand of its substitute commodity. It
is called zero cross elasticity of
demand.
 For example- the price of commodity Y
increases by 10% but if it does not
bring any change in the quantity
demanded of commodity X, a substitute
of commodity Y , It will be called zero
cross elasticity demand which is only
imaginary. In real life one does not find
any commodity of such nature.

 Infinite Cross Elasticity of  Ifdemand of a substitute
Demand commodity keeps on
without any change
changingor on a very
small change in the price of its
substitute commodity, it is called
infinite cross elasticity of demand
which is an imaginary concept.
 In this diagram price of commodity

Y has been presented on ‘OY’ axis
and the demand of
commodity X (A substitute
commodity of Y) has been
presented on ‘OX’ axis. If
price of commodity the Y does not
change.

Cross Elasticity of Demand for Complementary Goods
Elasticity of demand of complementary goods is negative in
relation to price. If the price of main goods increases,
demand of complementary goods will decreases.

Types of Cross Elasticity of demand for complementary
goods
 More than unit cross elasticity of demand

 Unit cross elasticity of demand
 Less than unit cross elasticity of demand
 Zero cross elasticity of demand
 Infinite cross elasticity of demand

 More than unit cross elasticity of  If proportionate change in the price
demand of a commodity causes more change
in the demand of its complementary
goods, it is called more than unit
cross elasticity of demand.
 Example- If the price of commodity
Y increases by 10% and as a result,
the demand of commodity X , a
complementary to commodity Y,
increases by 20%, it is called more
than unit elastic demand

 Unit Cross Elasticity of Demand  If change in the price of
commodity
a and change in the
demand of its complementary
commodity are equal, it is called unit
 Example – If the price of commodity Y

increases by 10% and as a result, the
demand of commodity X, a
complementary to commodity Y ,
increases by 10%, it will be called unit

 Less than Unit cross Elasticity  If change in the demand of a
of Demand commodity is less than change in
the price of a commodity to
which it is complementary, it is
called less than unit cross
 Exp- if the price of commodity Y

increases by 20 % and as a result,
demand of commodity X, a
complementary to commodity Y
decreases only by 10%, it is called
less than unit cross elasticity of
demand

 Zero cross elasticity of demand  If demand of a complementary
commodity does not change in
response to a change in the
price of its main commodity, it is
called zero cross elasticity of
demand.
 Example- If the price of commodity

Y increases by 20% but as a result
of it, demand of commodity X, a
complementary to commodity Y
does not change at all, it will be
called zero cross elasticity of
demand.

 Infinite Cross Elasticity of  If demand of a complementary
Demand commodity keeps on changing
without any change or on a very
small change in the price of its main
commodity, it is called infinite cross
elasticity of demand
 Exp- If the demand of commodity

X increases by 20% with out any
change in the price of commodity Y
to which this commodity is
complementary, it is called infinite

What is advertising
⚫ Advertising is a form of promotion or communication intended to

Persuade an audience or take some action up on Product, Service and
Idea.
⚫ Any paid for non personal presentation or promotion of good, service

and idea through mass media such as T.V, Radio, Newspaper, internet ,
magazines, etc by an identified sponsor. (American Marketing
association)

Advertising elasticity of demand
⚫ Advertising elasticity of demand is the measure of rate
change in demand due to change in advertising
expenditure.
⚫ The of change in demand of goods due to

amount is known as advertising elasticity of
advertisement
demand.

How to measure Advertising elasticity of Demand
Proportionate change in
Demand for Product
Advertising Elasticity of Demand = -------------------------------------
Proportionate change in
Advertising Expenditure
q a Q is + sales
AED = ----------------- - Where Q= Previous sales a
Q ---------------- is + advt.
expenditure A
A- Initial Advt. Exp.

Sales Volume
20000
18000
16000
14000
12000
10000
100 200 300 400 500 600

 Example 1. If a business increased its advertising
expenditure on product E from £ 1 million per year to £
1.2 million per year, and the demand for product E rises
from 10 million units to 14 million units, then the
advertising elasticity of demand for product E is:
= 40 % / 20%
= +2

 Example 2. If a business reduced its advertising
expenditure on product F from £ 2 million per year to £
1.8 million per year, and the demand for product F rises
from 1 million units to 1.1 million units, then the
advertising elasticity of demand for product F is:
= + 10% / - 10%
= -1

Factor affecting advertising elasticity of demand
1. The stage of the product’s life cycle

2. Reaction of market Rival Firms
3. Cumulative effect of past advertisement
4. Effect on choice of customer
5. Effect on generating demand of specific product and
service
6. Effect on price of the product
7. Quality and Quantity of advertisement

Uses of Elasticity of demand in managerial
decision making
 Practical Application of Price elasticity of demand
 Practical Application of Income elasticity of demand
 Practical Application of Cross Elasticity of demand

 Managerial Implication of Price Elasticity - The concept of price
elasticity of demand is widely used in business decision making on the
following grounds:
1. Monopolist to fix higher price for his products where demand is
inelastic and fix lower price where demand for the product is elastic.
2. The government formulate taxation policies
3. The government may decide as which industries should be declared
“publics utilities’. For example, electricity, drinking water etc.
4. It also helps the government in fixing a suitable foreign exchange rate
for its domestic currency in relation to the currencies of other countries
5. It is of powerful influence on wages. If the demand for labor in a
particular industry is inelastic, trade unions can demand higher wages
but it is elastic
6H.erPcormiecseyoureof loaetsr ticPiatgye 21o2f demand is useful for farm products which
is
inelastic in nature. Here comes your footer Page 212

 Managerial Implication of Income elasticity of Demand-
Knowledge of income elasticity is highly useful to managers or business
executives of firms as they think of taking marketing decision.
 Income elasticity of demand is used by every business firms during
periods of business expansion and contraction (i.e., trade cycle).
 During the period of business expansion, incomes of consumers are
rising. firms should try to sell more products even then luxury products
may also be sold.
 During the period of recession (business contraction), income of the
consumer fall. The firms can sell less because of low purchasing power
in the hand of the consumer. Hence the demand for their product may
decrease more rapidly.

The more specific usefulness of income elasticity of demand
are as follows:
1. It is useful for the business community to forecast demand for their
products, when changes in personal incomes are expected, other thing
remaining the same.
2. It helps the manufacturer to avoid overproduction or underproduction or

both.
3. It is also used to define ‘inferior product’ and normal products. Inferior

product are those with negative income elasticity where normal products
are those with positive income elasticity's.

Practical Implication of Cross elasticity of demand -
Cross elasticity of demand is of great practical application in
business decision making. Large business firms normally produce
several related products.
 Where a firm’s products are related, the pricing of one product

can influence the demand for other product. Knowledge of
cross elasticity is highly helpful to the managerial decision
makers in the assessment of the likely effect of price decision on
the sales of its competitors.
 The concept of cross elasticity of demand is also useful in

measuring the inter dependence of demand for a product and the
prices of its related products.
 Cross elasticity are positive for substitutes and negative for
complements. Product with positive cross elasticity are
considered to be in the same market whereas products
with negative cross elasticity are considered to belong different
markets.
 It is also useful in stabilizing or specifying the boundaries

between industries. Based on cross elasticity. It is easy to
determine which products to be included in a particular. For
example- should the manufacturing or cars and trucks be
considered one particular industry or two. It is clearly answered
by way of specifying the industries which are based on cross
elasticity.

UNIT -3

 Production Function
 Single variable-Law of Variable Proportion
 Two Variable
 Return to Scale
 Cost concept and analysis
 Short run and Long Run Cost Curves Their Managerial Use
 Market Structure
 Perfect Competition
 Features
 Determination of Price and Output Under Perfect Competition
 Monopoly
 Features
 Pricing and output determination under Monopoly competition
 Monopolistic competition
 Features
 Price and Output determination under Monopolistic competition
 Product Differentiation and Price Discrimination
Meaning Production concept

Meaning of Production
In an ordinary sense, production means the creation of
products.
But in economics, production means the creation of
utilities.

 Edwood Buffa, “Production is a process by which goods and services
are created.”
 L. R Klein – “ The production function is a technical or engineering relation

between input and output. As long as the natural laws of technology remain
unchanged”.

Production Function
 Production function is generally referred to as ‘the technological

relationship between the physical inputs and physical output of a
firm.
 According to George J. Strigleer, ‘Production function is the name given to the

relationship between the rates of input of productive services and the rate of
output…..’

 Physical inputs means All the factors of production like land,
labor, capital etc. whereas physical outputs mean the
quantity of finished products or the quantity of
products produced.
 The mathematical form of production function is thus:
 Q = F (L, K, N, R)
 Where, Q = Output , L= Labor input, K = Capital Input,

N=Land input, R= Raw materials,

Features of Production function
1. It indicates a functional relationship between physical

inputs and physical output of a firm.
2. The production function is always in relation to a period of time.
3. The production function can specify either the maximum from a
given set of inputs or the minimum quantity of inputs
required to produce a given level of output.
4. The production function is purely a technical relationship.
5. Output in the production function is the result of joint use of
factors of production
6. The production function includes all the technically efficient
method of production.

Fixed and variable inputs,
A firm uses many kinds of inputs to produce its output. The

quantities of inputs, it uses vary as the quantity of output varies.
The quantity of some inputs used can be adjusted quickly, but
others are not as easy to adjust. Thus, inputs or factors of
production may be classified as follows:
1. Fixed input or factor of production
2. Variable Input or factor of production

 Fixed Inputs of factors of production –
A fixed input or factor of production is defined as one.
The quantity of which can not be changed in the short
run as the level of output changes. Some examples of
fixed inputs are plants, major equipments, buildings,
services of management and supply of skilled labor

 Variable input or factor or production -
A variable input or factor of production is defined as one the
quantity of which may be changed in the short run as
the level of output changes. Some example of variable
inputs are raw materials and labor services.

Types of Production Function
 Short Run Production Function –

1. Law of Variable Proportion
2. ISOQUANT
 Long Run Production – Return to Scale

Law of proportions
 In the short run, producers have to optimize with only one

variable input. It means all the other variable would be fixed in
nature. While, using one variable, at what extent output can be
increased or maximized. This analysis is also known as law of
variable proportions or law of diminishing returns.
 The production function in this case can be represented as:

Q = f (K, L).

• There are three stages of the law of
variable
proportions :
1. Increasing Returns to the variable factor
2. Diminishing Returns to the variable factor
3. Negative Returns to the scale

Assumptions of Law of
• proportions
The law of variable
assumptions :
proportions is based on the following
1. The techniques of production remain constant.

2. It operates only in the short period.
3. The units of variable input employed are identical in character

Law of variable Proportions
Labor Total Marginal Averag Stages
Product Product e
Product
1 20 -------- 20 INCREASING
2 50 30 25 RETURNS
3 90 40 30
4 120 30 30 DIMINISHIN
5 140 20 28 G RETURNS
6 150 10 25
7 150 0 21.5
8 130 -20 16.25 NEGATIV

9 100 -30 11.1 E
RETURNS

Stages of Law of Proportions
• Increasing Returns to the variable factor – This is the very first
stage, in which when additional units of labor are employed, the total
output increases more than proportionally; so marginal product &
average product also increases.
• Diminishing Returns to the variable factor – This is the second

stage, total output increases, but less than proportionate to increase in
labor. Results of marginal product and actual product starts getting in
diminishing returns. At the certain point, marginal product will be zero
or average product will starts diminishing and this stage is very
important because later on manufacture may get loss.
• Negative returns to the variable – this is a technically inefficient

stage of production and rational firms will never operate in this
stage. Here comes your footer Page 236

ISOQUANT
An Isoquant product curve or equal product curve or a
production indifference curve show the various combinations of
two variable inputs resulting the same level of output.
“An Isoquant curve can be defined as the locus of points

representing various combinations of two inputs- capital
and labor –Yielding the same output”.
PRODUCTION SCHEDULE (PRODUCT)
6 346 490 600 592 775 846
C 5 316 448 558 632 705 775
A 4 282 400 490 564 632 692

P 3 245 346 423 490 548 600
I
T 2 200 282 346 400 448 490
A 1 141 200 245 282 316 346
L 0 1 2 3 4 5 6
LABOUR

COMBINATION UNITS OF UNITS OF TOTAL OUTPUT
LABOUR CAPITAL
A 20 1 1000
B 15 2 1000
11 3 1000
C 8 4 1000
6 5 1000
D
E
Properties of Isoquant curve
1. 1. Isoquant curve has downward sloping or
negative slope
2. 2. Isoquant curve convex to the origin
3. 3. Isoquant are not-intersecting or non-tangible
4. 4. Upper Isoquant represent a higher level of
output
5. 5. ISOQUANT curve neither touch to X Axis Nor to Y
Axis.

Isoquant is downward sloping to the right.

A higher isoquant represents larger output.

No isoquants intersect or touch each other

What is isoquant map
⚫ An Isoquant map is a set of Isoquants curve which
represent many Isoquant curves in a Isoquant map.

Marginal rate of technical substitution
⚫ As already stated, an important assumption in the Isoquant diagram is that

the inputs can be substituted for each other.
⚫ If a unit of labor is reduced, the units of capital must be increased in order
to produce the same output. Here, the rate at which one factor is
substituted for the other that is known as Diminishing marginal
rate of technical substitution.

Rate of Technical Substitution
Rate of technical substitution (of labor for

capital)
 RTS (of L for K)
 - (slope of isoquant)
Change in capital

input Change in
labor input
Isoquant Map or Equal Product Map
⚫ An isoquant map consists of a number of isoquants. An isoquant map

gives a set of equal product curves which show different production
levels. Each isoquant in the map indicates different levels of output.
A higher isoquant represents a higher level of output.
⚫ The distance of an isoquant from the origin shows the relative levels
of output. The farther the isoquant from the origin the greater will be
the level of output along it. But it should be noted that the distance
between two equal product curves does not measure the absolute
difference in the volume of output.

MARKET STRUCTURE

What is market ?
 In ordinary language, the term market refers to a

public
place in which goods and services are bought and sold.

Definition of Market
 Ely, "Market means the general field within which
the force determining the price of particular product operate".
 Stonier and Hague explain the term market as "any

organization whereby buyers and sellers of a good are kept in
close touch with each other“.

Define market structure
 The concept of market structure is central point for both economics

and
marketing. Both disciplines are concerned with strategic decision making.
 In decision making analysis, market structure has an important role

through its impact on the decision making environment.
 Market structure refers to all characteristics of a market that influence the

behavior of buyers and sellers when they come together in trade.

Determinants of Market structure
The Key factors in defining a market structure are:
1. Short run and long run objectives of buyers and sellers in
the market.
2. Beliefs of buyers and sellers about the ability to
set prices
3. Degree of product differentiation
4. Technologies employed by agents in the market
5. Amount of information available to agents about
the
good and about each other
6. Extent of entry and exit barriers.

Market has the following basic components
1. There should be buyers of the product-
2. A commodity should be offered for sale in the market –
3. Buyers and sellers should have close contact with each
other.
4. There should be a price for the commodity -

CLASSIFICATION OF MARKET
1. On the basis of area
2. On the basis of time
3. On the basis of nature of transactions
4. On the basis of volume of business
5. On the basis of regulation
6. On the basis of competition

 On the basis of area - Markets may be classified on the basis
of area into local, national and international markets.
1. If the buyers and sellers are located in a particular locality, it

is called as a local market, e.g. fruits, vegetables etc. These
goods are perishable; they cannot be stored for a long time;
they cannot be taken to distant places.
2. When a commodity is demanded and supplied all over the

country, national market is said to exist.
3. When a commodity commands international market or

buyers and sellers all over the world, it is called international
market.

 On the basis of time - Time element has been used by Marshall for
classifying the market. On the basis of time, market has been classified into,
short period & long period.
1. Very short period market refers to the market in which commodities
that are fixed in supply or are perishable are transacted. Since supply is
fixed, only the changes in demand influence the price. The short period
markets are those where supply can be increased but only to a limited
extent.
2. Long period market refers to a market where adequate time is available
for changing the supply by changing the fixed factors of production. The
supply of commodities may be increased by installing a new plant or
machinery and the output can be changed accordingly.

 On the basis of nature of transactions:- Markets are classified
on the basis of nature of transactions into two broad categories
viz., Spot market and future market.
1. When goods are physically transacted on the spot, the market

is called as spot market.
2. In case the transactions involve the agreements of future

exchange of goods, such markets are known as future
markets.

 On the basis of volume of business - Based on the volume of
business, markets are broadly classified into wholesale and
retail markets.
1. In the wholesale markets, goods are transacted in large

quantities. Are known as wholesale market.
2. In the retail market, good are transacted in small quantities

or on the basis of requirement of individual customer are
known as retailer market. Wholesale markets are in fact, a
link between the producer and the retailer while the retailer
is a link between the wholesaler and the consumer.

 On the basis of regulation- On this basis, market is classified
into regulated and unregulated markets.
1. For some goods and services, the government stipulates

certain conditions and regulations for their transactions.
Market of goods and services is called regulated market.
2. On the other hand, goods and services whose transactions

are left to the market forces belong to unregulated market.

 On the basis of competition - Markets are classified
on the basis of nature of competition.
1. Perfect competition
2. Imperfect competition.

PERFECT COMPETITION
 In practice, businessmen use the word competition as
synonymous to rivalry. In theory, perfect competition implies
no rivalry among firms. Perfect competition, therefore, can be
defined as a market structure characterized by a complete
absence of rivalry among the individual firms.

Feature of perfect competition
1. Large number of buyers and sellers
2. Homogeneity of products (Identical in nature)
3. Free entry exit
4. Absence of government regulation
5. Perfect mobility of factors of production
6. Perfect knowledge
7. Absence of transport costs

Equilibrium price
 Industry equilibrium price set where demand curve intersect the
supply curve. At point where demand curve intersect supply
curve in that point industry determine price. An individual firm
has to consider the price and has to sell product. Hence
individual firm would be price taker and do not influence prices

y D
S
p E
0
Q

Why is Marginal revenue would be equal to Average
revenue
Quantities Price (P) TOTAL AVERAG MARGINAL
sold (Units) REVENUE(T E RVENUE
R=P*Q) REVENUE (MR=N1-N)
(AR=TR/Q
10 3 30 3 --
11 3 33 3 3
12 3 36 3 3
13 3 39 3 3
14 3 42 3 3

 INDUSTRY INDIVIDUAL
FIRM
 YD S
P AR=MR
O
 Q

Price determination under perfect competition
 In Perfect competition, price determination are done by an

industry. In the perfect competition an neither individual firm
does any impact on price of the commodity nor any individual
customer does impact on pricing of the product. In fact price are
set by the exchange process of demand and supply and it is
called equilibrium price that price has to be accepted by entire
firm and entire buyer.

Price determination under perfect competition
 Price determination under perfect competition are understood in
the two way that is known as the short period and long period.
 Very Short Period of Time
 In the short period, price determination is having
three condition
1. Super normal profit
2. Normal profit or average profit
3. Loss
In the long period, hence profit is normal because of that
reason very organization would remain in the long period
and enjoy getting normal profit.

Super normal profit

Normal Profit
 In condition of Normal profit, when firms average revenue (AR) would be
equal to average total cost (ATC). In this condition firm earn Normal Profit.

 Y
 MC

 P ATC P=AR=MR
 0
 Q

Loss
 It is condition when firm AR is less than ATC. In this condition a firm has to
put up with the loss.

In long run
 Hence, only those firm sustained its existence which is having

capacity to be survived. In the long run firm earn normal profit.
 In the condition of Normal Profit firm long average
revenue (LAR) is equal to Long average total cost (LATC).

Origination of MONOPOLY
 The term “Monopoly” was derived from Greek Language. If
break down this term into two parts so it will become Monos
and polis. The meaning of Monos in the Greek language is
‘SINGLE’ and ‘SELLER’. If both the term is integrated than
the single term which will come up that is ‘Monopoly’.


Meaning of Monopoly
 Monopoly is that market structure in which a single seller or producer

controls the whole supply of a single commodity which has no substitute.

Types of Monopoly
 There are various types of monopoly which are mentioned below

1. Natural Monopoly
2. Legal Monopoly
3. Public Monopoly
4. Private Monopoly

 Natural Monopoly – If the supply of a commodity is localized in a
single place then the monopoly is known as the natural monopoly.
Example- Bangladesh has monopoly of jute.
 Legal Monopoly – When a firm is given the legal right to produce a
unique
commodity, it is know as a legal monopoly
Example- RBI has monopoly to produce Indian currency.
 Public Monopoly – When a monopoly is created for the interest of
the
public. It is known as public monopoly
Example – public utilities such as electricity, water, railways etc.
Private monopoly – It is owned and operated by the private individual or
organization for the purpose of getting maximum profits.

 Why MR Curve and AR Curve downward slopping
In the monopoly situation, The faces of AR and MR curves a
downward slopping. The reason is monopolist has the option
and power to reduce the price for increasing sale of product
moreover to raise the price for earning desirable profit.


 y
 Price
 0 MR AR =D
 quantity

Feature of Monopoly
1. There is a single producer or seller of the product.
2. There are no close substitutes for the product. If there is a
substitute, then the monopoly power is lost.
3. No freedom to enter as there exists strong barriers to entry.
4. The monopolist may use his monopolistic power in
any
manner to get maximum revenue.
5. Monopolist works as price maker and not works as
price taker.

 How monopoly can get profit:- although we know monopolist
is having a power to control the supply in the market because of
this, he keeps strictly control over supply of the product
because he knows that there is no competitors exist in the
market. If a monopolist want to retain the customer or want to
earns continuously profit so either he will reduce the price or
selling the more unit.

Table of AR, TR & MR
Quantity sold P=AR TR MR
0 10.00 0 0
1 09.50 9.50 9.50
2 09.00 18.00 8.50
3 08.50 25.50 7.50
4 08.00 32.00 6.50
5 07.50 37.50 5.50
6 07.00 42.00 4.50
7 06.50 45.50 3.50
8 06.00 48.00 2.50
9 05.50 49.50 1.50
10 05.00 50.00 0.50

Profit maximising under monopoly
£
AR
MR
O Q
Monopoly (price equibilarium)
 The aim of the monopolist is to maximize profits. Therefore, he
will produce that level of output and charge a price which gives
him the maximum profits. He will be in equilibrium at that
price and output at which his profits are maximum.
 In order words, he will be in equilibrium position at that level of

output at which marginal revenue equals marginal cost. The
monopolist, to be in equilibrium should satisfy two conditions :
1. Marginal cost should be equal to marginal revenue
2. The marginal cost curve should cut marginal revenue curve

Profit maximising under monopoly
£
MC
AC
AR
MR
O Q
Explanation
 AR is the average revenue curve, MR is the marginal revenue
curve, AC is the average cost curve and MC is the marginal cost
curve. Up to OQ level of output marginal revenue is
greater than marginal cost but beyond OQ the marginal revenue
is less than marginal cost. Therefore, the monopolist will be in
equilibrium where MC = MR. Thus a monopolist is in
equilibrium at OQ level of output and at OP price. He earns
abnormal profit equal to PRST.

Price determination under monopoly
Under the monopoly condition. Price is determined in three
condition are mentioned
 Short term:
1. Profit condition
2. Loss condition
3. No profit and No Loss condition
 Long term : Profit condition

Price determination in monopoly (Profit)

 AR is the average revenue curve, MR is the marginal revenue
curve, AC is the average cost curve and MC is the marginal cost
curve. Up to OQ level of output marginal revenue is
greater than marginal cost but beyond OQ the marginal
revenue
than marginal
is less cost. Therefore, the monopolist will be in
equilibrium where MC = MR. Thus a monopolist is in
equilibrium at OQ level of output and at OP price. He
earns
abnormal profit equal to PRST.

Average profit or normal profit
 y AC
 MC
price

 AC
O
 q Quantity

Price determination (case of loss)

Long Period case
 In the long run the firm has the time to adjust his
plant size or to use the existing plant so as to maximize profits.

Price discrimination or discriminating monopoly
 Price discrimination means selling the same product or
slightly differentiated product at different prices to
different buyers.
 Consumer are discriminated on the basis of their income or

purchasing, time of purchase, etc. when consumer are
discriminated on the basis of these factor in regard to price
charged from them, it is called price discrimination.

Definition
Mrs. Robinson defines it as "charging different price for the same

product or same price for differentiated product".

Example of price discrimination
1. Physicians and hospital, Lawyers, consultant, etc., charge

their customer at different rates mostly on the basis of the
latter’s ability to pay
2. Merchandise sellers sell goods to relatives, friends, old
customers, etc., at lower prices than to others and offer off-
season discount to the same set of customer.
3. Railways and airlines charge lower fares from the children
and student and for different class of travelers
4. Cinema house and auditorial charge differential rates for
cinema shows, musical concerts.
5. higher electricity rates for commercial use and lower for
domestic consumption, etc. are some other examples of price
discrimination.
Price Discrimination by Degrees
 The degree of price refers to the extent to which a seller divide the market or
the consumer. The economic literature presents three degree of price
discrimination.
1. First Degree
2. Second Degree
3. Third Degree

Price discrimination degree
First degree or perfect price discrimination is feasible when the

market size of the product is small and the monopolist is in a
position to know the price of each customer or each group of
coustomer is willing to pay, then he sets the price accordingly
and tries to extract the entire consumer surplus.

Explanation
 At price Rs. 10 the buyer will purchase one unit of the good; at
price Rs. 9 the buyer would purchase 2 units of the good; at
price of Rs. 8 he would purchase 3 units of the good; at price
of Rs. 7 he would take 4 units of the good and so on. Under
simple monopoly, if the seller fixes the price at Rs. 7 the
buyer buys 4 units then he would pay Rs. 28 as the price for 4
units. By doing so, he gets a consumer surplus of Rs. 6. This is
so because; the buyer is willing to pay Rs. 10 for the first unit,
Rs. 9 for the second, Rs.8 for the third and Rs. 7 for the fourth.
In all he is willing to pay Rs. 34. He actually pays only Rs. 28.
But under price discrimination of the first degree the
monopolist charges Rs. 34. As a result the buyer has no
consumer’s surplus.

Price discrimination in Second degree
 Where market size is very large, perfect discrimination is
neither feasible nor desirable. In that case a monopolist uses
second degree discrimination or the ‘block pricing method’.
 The monopolist divides the potential buyers into blocks, e.g,

rich, middle class and poor, and sells the commodity in blocks.
The monopolist sell its product first to the rich customer at the
highest possible price. Once this part of the market is supplied,
the firm lowers down the price for middle class buyers. Finally
bottom price is used for the poor class of buyers.

Price discrimination of the second degree
 Market is divided into four groups. DD is the market demand curve. In the
first group X units of output will be sold at a price of OP1. All the buyers in
this group pay OP1 price and the group gets DK1 P1 as consumer’s surplus.
Similarly for other groups, consumers pay OP2, OP3, OP4 and get the
consumer's surplus equal to DK2 P2, DK3 P3 and DK4 P4 respectively.

Price discrimination at third degree
 When monopolist sets different price for maximizing profit at
different markets. Then, it is called price discrimination at third
stages.
in this situation, monopolist has two demand curve for two
respective market and two different prices are offered having
seen the demand line.

 A uniform prices can not be set for all the markets without losing profits. The
monopolists is required to find different price quantity combinations that can
maximize his profit in each market. For this purpose, he divides his total output
between the market segments so that his MC=MR in each market, and fixes
price accordingly.

 For example – suppose that a monopolist has only two markets A and B.
The demand curve (D) and marginal revenue curve (MR).
(A) represent the AR and MR Curves in market A. D and MR
(B) represent the AR curves in market B.
The horizontal summation of Da and Db gives the total demand curves for
two markets.
© The horizontal summation of Mra and MRb gives the aggregated MR.

MONOPOLISTIC COMPETITION
 Perfect competition and monopoly are rarely found in the real
world. Therefore, professor Edward. H. Chamberlin of
Harvard University brought about a synthesis of the theories
and put forth, "Theory of Monopolistic Competition" in
1933.
 Monopolistic competition is more realistic rather than pure

competition or monopoly. It is a blending of perfect
competition and monopoly.

 Monopolistic competition refers to competition among large
number of sellers and They produce close but not perfect
substitutes.
 Monopolistic competition is that sub category of imperfect

competition which is nearest to pure competition. It is a market
structure in which there are many seller of a commodity but the
product of such seller differ from that of the other sellers.

 Examples- In Indian economy, there are various manufacture
of soap which produce different brands such as Hamam, Lux,
Rexona, Pears, Vivel, etc. thus, the manufacture of Lux has a
monopoly of producing it but it has to face competition from the
manufacturers of other brand of soaps.

FEATURES
1. Large number of sellers
2. Product differentiation
3. Free entry and exit of firms
4. Selling cost
5. Nature of demand curve

Nature of revenue (Demand) and cost
 Large number of sellers -In monopolistic competition the
number of sellers is large. No one controls a major portion of
the total output. Hence each firm has a very limited control over
the price of the product. Each firm decides its own price-output
policy without considering the reactions of rival firms.
 Product differentiation- One of the most important features of

monopolistic competition is product differentiation. Product
differentiation implies that products are different in some ways
from each other.
 Product may be differentiated in order to suit the tastes and
preferences of the consumers. The products are differentiated on
the basis of materials used, workmanship, durability, size,
shape, design, color, fragrance, packing etc.

 Products are differentiated in order to promote sales by influencing the
demand for the products. This can be achieved through propaganda and
advertisement. Advertisement brings a psychological reaction in the minds of
the buyers and thus influences the demand. In addition, location of the shop,
its general appearance, counter service, credit and other facilities increase
sales.
 Patent rights and trade marks also promote product differentiation. Kodak
and Coca Cola are the examples of patent rights. Trade marks like Hamam,
Rexona, Lux etc. help the consumers to differentiate one product over
others.

 Free entry and exit of firms -Another feature of monopolistic
competition is the freedom of entry and exit of firms. Firms
under monopolistic competition are small in size and they are
capable of producing close substitutes. Hence they are free to
enter or leave the industry in the long run. Product
differentiation increases entry of new firms in the group because
each firm produces a different product from the others.
 Selling cost - It is an important feature of monopolistic
competition. As there is keen competition among the firms, they
advertise their products in order to attract the customers and
sell more. Thus selling cost has a bearing on price
determination under monopolistic competition.

 Nature of demand curve - Under monopolistic competition, a
single firm can control only a small portion of the total output.
Though there is product differentiation, as products are close
substitutes, a reduction in price leads to increase in sales and
vice-versa. But it will have little effect on the price-output
conditions of other firms. Hence each will loose only few
customers, due to an increase in price. Similarly a reduction in
price will increase sales. Therefore the demand curve of a firm
under monopolistic competition slopes downwards to the right.
It is highly elastic but not perfectly elastic.

Determination of price and output under
monopolistic competition
 under monopolistic competition, different firms produce
different varieties of products, prices will be determined on the
basis of demand and cost conditions. The firms aim at profit
maximization by making adjustments in price and output,
product adjustment and adjustment of selling costs.
 Equilibrium of a firm under monopolistic competition is based
upon the following assumptions:
1. Large number of firm
2. Independence
3. Freedom of entry
4. Product of differentiation

Price determination in monopolistic
competition
 IN THE SHORT TERM PERIOD

1. Abnormal profit condition
2. Normal profit condition
3. No profit no loss condition
 IN THE LONG TERM PERIOD

 Based on these assumptions, each firm fixes such price and output which
maximizes its profit. Product is held constant. The only variable is price. The
equilibrium price and output is determined at a point where the short run
marginal cost equals marginal revenue.

Super Normal Profit
 DD is the demand curve of the firm. It is also the average revenue curve of
the firm. MC is the marginal cost of the firm. The firm will maximize profits
by equating marginal cost with marginal revenue. The firm maximizes its
profit by producing OM level of output and selling it at a price of OP. The
profit earned by the firm is PQRS. Thus in the short run, a firm under
monopolistic competition earns supernormal profits.

Loss in short run
 In the short run, the firm may incur losses also The firm is in equilibrium by
producing an output of OQ. It fixes the price at OP. As price is less than cost,
it incurs losses equal to pabc. Thus a firm in equilibrium under monopolistic
competition may be making supernormal profits or losses depending
upon the position of the demand curve and average cost curve.

Price determination in long period
 The excess profit is competed away. MC = MR at OM level of output. LAR

is tangent to LAC. Price is equal to average cost and there is no extra profit.
Only normal profit is earned.

UNIT -4

 Meaning
 Features
 Quantity competition- A dominant Firm
 Price Competition – Price Rigidity and Kinked Demand Curve
 Price Strategies
 Price Leadership
 Price Determination
 Full Cost Pricing
 Product Line Pricing
 Pricing Skimming
 Penetration Pricing

Oligopoly (Introduction)
Oligopoly is derived
 from the Greek work
“olig” meaning “few” or
“a small number.”
Oligopoly is a market structure featuring a small

number of sellers that together account for a large
fraction of market sales.

 Oligopoly is defined as a market structure in which there are
a few sellers selling homogenous or differentiated products.
Where oligopoly firms sell a homogenous product, it is
called pure oligopoly.
For example- Cement, steel, petrol, cooking gas,

chemicals,
aluminum and sugar are industries

Features or characteristics
1. Small number of large sellers.
2. Interdependence.
3. Price rigidity.
4. Monopoly element
5. Advertising.
6. Group behavior

 Small number of large sellers – The number of seller dealing in a
homogeneous or differentiated product is small and each seller is catering to
a significant part of the market demand.
 Interdependence – Oligopolistic is not independent to take his decision. The
oligopoly firm has to take into consideration the actions and reactions of his
rivals while determining its price and output polices. The cross elasticity of
demand is very high between the product of the oligopolistic because the
products are close substitutes.
 Price Rigidity – Since any change in price by and oligopolistic invites
counter moves from its rivals, the firm in oligopoly normally sticks to its
price. If a firm tries to reduce the price, its rivals will also do so and they will
not allow to take any advantage of price reduction.

 Presence of monopoly element - so long as products are differentiated
the firms enjoy some monopoly power, as each product will have some
loyal customers. Also when firms collude with each other they can work
together to raise the price and earn some monopoly income.
 Advertising - The only way open to the oligopolistic to raise his sales is
either by advertising or improving the quality of the product.
Advertisement expenditure is used as an effective tool to shift the demand
in favor of the product.
 Group behavior The firms under oligopoly recognize

- their importance of mutual cooperation.
Therefore,
interdependence
there isand
a tendency
realize the
among them for collusion. Collusion as
well as competition prevail in the oligopolistic market leading to
uncertainty and indeterminateness
TYPES OF OLIGOPOLY
1. Perfect and imperfect oligopoly (nature of the product)
2. Open or closed oligopoly (nature of entry and exit)
3. Partial and full oligopoly (nature of acts)
4. Collusive and non- collusive oligopoly (nature of tacit
agreement)

 Perfect and imperfect oligopoly- On the basis of the nature of
product, oligopoly may be classified into perfect (pure) and
imperfect (differentiated) oligopoly. If the products are
homogeneous, then oligopoly is called as perfect or pure
oligopoly. If the products are differentiated and are close
substitutes, then it is called as imperfect or differentiated
oligopoly.
 Open or closed oligopoly- On the basis of possibility of entry

of new firms, oligopoly may be classified into open or closed
oligopoly. When new firms are free to enter, it is open
oligopoly. When few firms dominate the market and new firms
do not have a free entry into the industry, it is called closed
oligopoly.

 Partial and full oligopoly- Partial oligopoly refers to a
situation where one firm acts as the leader and others follow
it. On the other hand, full oligopoly exists where no firm is
dominating as the price leader.
 Collusive and non- collusive oligopoly- Instead of competition

with each other, if the firms follow a common price policy, it
is called collusive oligopoly. If the collusion is in the form of
an agreement, it is called open collusion. If it is
understanding between the firms, then it an is a
collusion. On the other hand, if there is no agreement secretor
understanding between oligopoly firms, it is known as non-
collusive oligopoly.

Price and output determination under oligopoly
 The decision in context of price and output determination under

oligopoly are taken based on this fact whether there is any sort
of collusion among rival firms or they are independent.
 (A) Price Leadership in oligopoly

1. The low cost price Leadership model (Market is equal)
2. The Low cost price Leadership Model (Market is not un-equal)
(B) Price rigidity Model
© Cartel or Collusion Model

Low Price Leader ship Model (When Market is Equal)
There are two type of firm A and B in the market and their cost of
production would be different to each other because of diseconomies
scale and economies scale.
A is low cost firm and B is the high cost firm. B firm will have its own
MR line while A firm will have MR which will also be treated as
demand line for Firm A. their total market will be divided equally.

Assumption
1. Each of the two firms has equal share in the market

(demand curve facing each firm will be the same and will
be half of the total market demand curve of product) .
2. There are two firms, A and B. the firm A has a lower cost of
production than B.
3. The product produced by the two firms is homogeneous so
that the consumers have no preference between them.

Low cost price leadership model when market is un-equal
 In the case of the price leadership model with unequal market share, the two
firm will have different demand curves along with their different cost curves.
The low cost firm’s demand curve will be more elastic than that of the high
cost firm.
 The high cost firm would maximize its profit by selling product at a higher
price while the low cost firm would sell more at a lower price and maximize
its profit. It they enter into a common price agreement.
 It would be in the interest of the high cost firm to sell more quantity at a
lower price set by the price leader by earning a little less than the maximum
profit.

The Sweezy model of kinked demand curve
(Price Rigidity)
 This article was publised in 1939, Prof. Sweezy presented the Kinked
demand curve analysis to explain price rigidities often observed in
oligopolistic market.

1. Sweezy assumes that if the oligopolistic firm lower its price, its rival
will react by matching that price cut in order to avoid losing their
customers.
Thus, the firm lowering the price will not be able to increase its demand
much. This portion of its demand curve is relatively inelastic.
 On the other hand, if the oligopolistic firm increases its price, its rivals will
not follow it and change their prices. Thus the quantity demanded of this
firm will fall considerably. This portion of the demand curve is relatively
elastic. In these two situations, the demand curve of the oligopolistic firm has
a kink at the prevailing market price which explain price rigidity.

Assumption
 The kinked demand curve hypothesis of price rigidity is bases

on the following assumption:
1. There are few firms in the oligopolistic industry
2. The product produced by one firm is a close substitute for
the other firms.
3. The product is of the same quality.
4. Each seller attitude depends on the attitude of his rivals
5. There is an established or prevailing market price
for the product at which all the sellers are satisfied.

Given this assumption, the price output relationship in the
oligopolistic market is explained in the figure. Where KPD is
the Kinked Demand curve and OP0 the prevailing price in the
oligopoly market for the OR product of one seller.
Starting from point P corresponding to the current price OP0

any increase in price above it will considerably reduce his sales,
for his rivals are not expected to follow his price increase.
This is so because the KP Portion of the kinked demand curve is

elastic and the corresponding portion KA or the MR curve is
positive. Therefore , any price increase will not only reduce his
total sale but also his total revenue and profit.
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 On the other hand, if the seller reduces the price of the product below OP0
(or P), his rivals will also reduce their prices. Though he will
increase his sales. His profit would be less than before. The
reason is that the PD portion of the kinked demand curve below
P is less elastic and the corresponding part of marginal revenue
curve below R is negative. Thus, in both the price raising and
price reducing situation, the seller will be a loser. He would
stick to the prevailing market price OP0 which remains rigid.

Concept of Pricing
Pricing is one of the most important marketing mix decisions,
price being the only marketing mix variable that generates
revenues. Pricing strategy is of great importance because it
affects both revenue and buyer behavior.

• “Price is the amount of money charge for a product or service of
the sum of the values that consumers exchange for the benefits
of having or using the product or service”.
Price goes by many names such as rent, tuition fees, fare,

rate, interest, toll charges, premium etc.

Objective of pricing to be continued
1. To achieve target return on investment

2. Stabilize Market condition
3. To maintain or improve target share of market
4. Meet to prevent competitors
5. Survival objective
6. Maximize profit
7. Increase sales volume
8. Market penetration
9.Market skimming 10.Product
quality Leadership

Pricing Strategies and tactics
Setting prices to achieve the firm’s objectives requires the

selection of specific pricing strategy or a combination
of strategies. Determining a price strategy involves several
considerations, including selecting a basic approach to
pricing, determining your pricing policy, and identifying
effective pricing tactics.

• Skimming strategy
• Penetration Pricing Strategy
• Differential Pricing strategy
• Geographical pricing strategy
– FOB
– Uniform delivered price
• Product line pricing strategies
– Price bundling
– Premium pricing or Image pricing
– Complementary pricing
• Captive pricing strategy
• Loss Leader strategy
• Two part Pricing

• Skimming strategy- one of the most commonly discussed strategies is
the skimming strategy. This strategy refers to a setting a high price
for a new product to skim maximum revenues layer by layer from
segments willing to pay the high price

• Penetration pricing strategy- the objective of this strategy is to attain
market share or market penetration. Here, Setting a low price for a
new product in order to attract a large number of buyer and a large
market share.

• Differential Pricing Strategy- This strategy involves a firm
differentiating its price across different market segments.
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• Geographic pricing This pricing strategy focuses on two market
segments divided by a transportation cost. To decide how to fix
the price, companies have two choices: Freight on Board, and
Uniform deliver price.
• Exp- Government charge price of petrol and diesel are determined
on the basis of Geographical bases.

• FOB“- It is when the company
decides to price a higher amount
in an adjacent market because it
requires an additional shipping
fee. That's why it is cheaper for
the market where the production
system is settled. This happens when
the competitive price is also higher in
the adjacent market.

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• Uniform
delivered price
In this case, the firm
settles the same price in
both zones. It is possible
to balance the shipping
fees between the two
markets so that
the company is
able to achieve still
objectives. its
markets The
share the
cost.
transportation
• Product line pricing strategy- These are a set of price strategies
which a multi-product firm can usefully adopt. An important
fact to be noted, is that these products have to be related to each
other. In other words, Setting price steps between product line
items.
• For example- the firm may have different types of shampoos-
normal, conditioner, egg, or medicinal. Within each of these, it
may have different brands.

• Price Bundling- This strategy is used by a firm to even out
the demand for its product. The organization offer bundle a
group of product at reduced price. this is a useful strategy for
perishable, time barred products like food, hotel room, or a
seat on a flight, and for products that can not be substituted,
like the package of stereo music system.

• Premium The price is set high to reflect
Pricing-
exclusiveness of the product. Exp-First class in
airline service. Adidas, Reebok etc.
• Image Pricing- The high price indicates to the consumer high

quality and added value. The firm varies its prices over
different brands of the same product line. This strategy is
commonly used in textiles, cosmetics, toilet soaps, and
perfumes.

• Complementary pricing- The main idea behind this strategy is that it
is possible to overcome the loss due to the product's sale by the gain
provided by related products. that the bank may charge to give a
credit card to a customer. It is possible to highlight three different
types of pricing:,
1. Loss Leader strategy-
2. Captive Pricing Strategy-

UNIT 5

Topics to be discussed
 National Income – Concept

1) Measuring the value of Economic Activity through Gross Domestic
Product
2) GDP Deflator
3) Real GDP vs. Nominal GDP
4) Other Measure of Income
 Inflation – Concept
1) Types
2) Causes
3) Measurement
 Business Cycle
 Profit Concept and Major Theories of Profit –
1) Dynamic Surplus Theory,
2) Risk & Uncertainty Bearing Theory,
3) Innovation Theory
Overview on National Income
Measurement of National Income is a part

of the process of estimating the national
income accounting. It is also known as
National Income Accounting.
The level of national income determine the

level of all other macroeconomic
variables
– Aggregate consumption, saving,
investment, employment and also price
level.
Overview of National Income
The Modern concept of national income was developed by Simon

Kuznets of Havard University 1941, and was awarded Nobel prize
for this work. Presently, National income was also known as National
Income accounting and social accounting.
There are following components of National incomes as follows:

1. Aggregate demand and Supply
2. Aggregate consumption expenditure (Private and Publics)
3. Aggregate Saving and Investment,
4. Total export and Import
5. Net Balance of Foreign Transactions etc.

Meaning of National Income
In General sense “National income” refers to the

aggregate money value of all final goods and service
resulting from the economic activities of the people of
a country over a period of one year.
In the other words, the total amount accruing in a

country from economic activities in a year is known
as National income.

The formula for calculating
National income
N.I= C+I+G+ (X-M)
C - here stands for consumption,

I - stand for total investment expenditure,
G - stands for the expenditure is done by the government, X and M stand
for export and import respectively.

Concept of National Income
1. Gross Domestic Product (at Market

Price and Factor cost)
2. Net Domestic Product
3. Gross National Product
4. Net National Product

The Gross Domestic product can be defined as the sum of market
value of the final goods and services produced in a country during
a specified period of time, generally one year.
While estimating the value of GDP in economy, the income earned

by the foreigners in the country are included and the income
earned by the resident abroad are excluded

GDP should be calculated as :
Personal consumption expenditure +
business investment + Government
spending + Export – Imports
• C+I+G+ (X-M)
• GDP at market price
• GDP at factor price

• GDP at market price can be defined as
the total value of goods and services in a
country within a year in which taxes is
added and subsidy is subtracted.
• GDP at factor price can be defined as

total value of goods and services in a
county within subsidy is added and
taxes is subtracted.

Example
• Just assume that in a particular year, GDP(FC) is Rs.
100. In the same year Indirect Taxes are Rs. 20 while the
subsidies are Rs. 25. So, we can arrive at GDP(MP) using
the following equation:
GDP at FC = GDP MP – Indirect taxes + Subsidy

100 = GDP MP – 20 + 25
GDP MP = 100 +20 -25
GDP MP = Rs. 95

Net domestic product (NDP)
• NDP is the value of net output of the
economy during the year. Net output is
obtained through reducing deprecation from
GDP.
Net domestic product = GDP - depreciation.

Gross National Product (GNP)
• GNP is the money value of all the
final goods and services produced by
normal residents as well as non- resident
in the domestic territory within a country
and also includes net factors income
from abroad.
GNP = GDP + Net factor income from

abroad
Net National Product
• NNP(Net National Product) is the amount

which comes after the minus of
depreciation in the gross national
product (GNP). This is known as Net
National Product.

Value Added Method
Value added method is also known the Product Method, Inventory

method, net product method, Industrial Origin method and Commodity
Services Method. It shows the contribution (value added) of each
producing unit in the production process.
Every individual enterprise adds certain value to the products,
which it purchase from some other firm as intermediate goods.
When value added by each and every individual firm is summed up, we
get the value of national income.

Concept of value added
 “Value added refers to the addition of value to the raw material

(intermediate goods) by a firm, by virtue of its productive activities”.
 It is the contribution of an enterprise to the current flow of goods and
services. It is calculated as the difference between value of output and value
of intermediate consumption.

Steps of Value Added Method
 Step – Identify and Classify the production

Units (Primary, Secondary and Tertiary
sectors)
 Step –Sum total of GVAmp of all sectors give
GDPmp
 Calculate Domestic Income (NDPFC) – By
subtracting the amount of depreciation and net
indirect taxes from GDP mp We get domestic
income NDP fc =

 Estimate net factor income from abroad (NFIA) to
arrive at National Income – NFIA is added to
domestic income to arrive National Income

Precautions of Value Added Method
1. Intermediate Goods are not to be included in the national income.

2. Sale and purchase of second hand goods is not included
3. Production of services for self consumption are not included (It must be noted
that paid services, like services of maids, drivers, private tutors, etc should be
included in the national income.
4. Production of Goods for self consumption will be included
5. Imputed value of owners occupied houses should be included
6. Change in stock of goods will be included – net increase in the stock of
inventories will be included in the national income as it is a part of capital
formation.

The Income method
 The income method consists of the remuneration
paid in terms of money to the factors of production
annually in a country. Thus, GDP by income
method is the sum of all factors incomes :
 Income Method = Wages and Salaries + Rents +
Interest + Dividends + Undistributed Corporate Profits
+ Mixed Income + Direct Taxes + Indirect Taxes +
Depreciation + Net Income from abroad.

Income Method
“All the incomes that accrue to the factors of production by way of wages,
profits, rent, interest, etc. are summed up to obtain the national income”.

Components of Factor Income
 The total sum of all the factor incomes earned within the domestic
territory of a country is known as “Domestic Income (NDPFC)’.
System of National Accounts has elaborated the following components
of Income Method:

Steps of Income Method

Problem for measuring National Income
 Exclusion of Real Transactions

 The value of Leisure
 Cost of environmental Damage
 The underground Economy
 Transfer Payment and Capital Gains
 Valuation of Inventories
 Self Consumption
 Lack of Official Records
 Imputed Income
 Valuation of Government Services

Expenditure Method
 “Factor income earned by factor of production is spent in the form of

expenditure on purchase of goods and services Produced by firms”.
 This method measures national income as sum of total expenditure
incurred
by households, business firms, government and foreigners.

Components of final expenditures

GDP Deflator
The GDP deflator measures the change in the annual

domestic production due to changes in price rates in the
economy.
Hence, it measures the change in nominal GDP and real GDP

during a particular year calculated by dividing the nominal GDP
with the real GDP and multiplying the resultant with 100.
It measures price inflation/deflation concerning the specific base year. It is not

based on a fixed basket of goods or services but can be modified yearly
depending on consumption and investment patterns.

Nominal GDP
Nominal GDP (gross domestic product) is the calculation of annual

economic production of the entire country’s population at the
current market price of goods and services generated by four main
sources, which include capital appreciation on land, wages of labor,
interest on capital investment and profits earned by an entrepreneur
that is calculated only on finished goods and services.

Real GDP
Real GDP can be defined as an inflation-adjusted measure which

shall reflect the value of services and goods that are produced in a
given single year by an economy which can be expressed in the prices
of the base year, and that can be referred to as “constant dollar
GDP”, “inflation corrected GDP”.
Below given is the formula to calculate real GDP.

Inflation
 Inflation means generally a considerable

and
persistent rise in the general level of prices.
 All though, there is no universally accepted definition of

inflation. Inflation is term has been changing over time
depending on the perception of the economists.

Definition
 According to coulborn – “Inflation is a situation of too

much money chasing too few goods”
 According to Ackley- “Inflation is a persistent and

appreciable rise in the general level or average or prices”.

Effects of Inflation
 Effects on investor class

 Effects on business class and manufacture
 Effects on Income Distribution
 Effect on labourers and salaried class
 Effect on consumers
 Borrowers and Lenders

Type of Inflation
 Inflation on the basis of rates are classified as :

1. Creeping Inflation
2. Moderate Inflation
3. Galloping Inflation
4. Hyper Inflation

 Moderate Inflation – A single digit rate of annual inflation is
called ‘Moderate inflation’ or ‘Creeping inflation’ (below 3%).
During the period of moderate inflation, prices increases but at
a moderate rate. The moderate rate may vary from country to
country.
 Galloping Inflation – A very high rate of inflation is called
“Galloping inflation”, all though there is no prescribed
definition which defined that how much.
According to – Baumol and Blinder – “Galloping
inflation refers to an inflation that proceeds at an exceptionally
high rate”. They do not specify what rate of inflation is
exceptionally high’.
 Hyper Inflation – Hyper inflation takes place when prices
shoot up at more than three digit rate per annum. During the
period of hyper inflation, paper currency become worthless
Measure to control Inflation

Monetary measure
 Credit Control - it raises the bank rates, sells securities in the open
market, raises the reserve ratio, and adopts a number of selective
credit control measures, such as raising margin requirements and
regulating consumer credit.
 Demonetization of Currency
 Issue of New Currency

Fiscal Measures
 Reduction in Unnecessary Expenditure

 Increase in Taxes
 Increase in Savings
 Surplus Budgets
 Public Debt

Other Measure
 To Increase Production
 Rational Wage Policy
 Price Control

Business Cycle
The business cycle is the periodic irregular up-and-
down movements in economic activity, measured
by fluctuations in real GDP and other
macroeconomic variables.

 The business cycle starts from a trough (lower point) and passes
through a recovery phase followed by a period of expansion (upper
turning point) and prosperity. After the peak point is reached there is a
declining phase of recession followed by a depression. Again the
business cycle continues similarly with ups and downs.

 Recovery Phase - The turning point from depression to
expansion is termed as Recovery or Revival Phase.
 During the period of revival or recovery, there are
expansions and rise in economic activities.
1. When demand starts rising,

2. production increases and
3. this causes an increase in investment.
4. There is a steady rise in income,
output,
employment, prices and profits.
5. The businessmen gain confidence and become
optimistic (Positive).
6. This increases investments.

 Prosperity Phase - When there is an expansion of
output, income, employment, prices and profits, there is
also a rise in the standard of living. This period is termed as
Prosperity phase.
 The features of prosperity are :-
1. High level of output and trade.
2. High level of effective demand.
3. High level of income and employment.
4. Rising interest rates.
5. Inflation.
6. Large expansion of bank credit.
7. Overall business optimism.

 Recession Phase - The turning point from prosperity
to depression is termed as Recession Phase.
 During a recession period, the economic
activities
become slow down.
1. When demand starts falling,
2. the overproduction and future investment plans are
also given up.
3. There is a steady decline in the output,
income, employment, prices and profits.
4. The businessmen loose confidence and
become pessimistic (Negative).
5. It reduces investment. The banks and the people try to
get greater liquidity, so credit also contracts.
 Depression Phase - When there is a continuous
decrease of output, income, employment, prices and profits,
there is a fall in the standard of living and depression sets
in.
 The features of depression are :-
1. Fall in volume of output and trade.
2. Fall in income and rise in unemployment.
3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.

Business Cycle-one cycle through 4
phases
Real GDP
Peak
per year
Peak
Trough
One cycle Time

Profit concept
 Generally profit is defined as the net income of a

businessman. It is calculated by deducting total
expenses from total revenue.
 in economic point of view, profit has different meaning.

profit means return to the entrepreneur for the use
of his entrepreneurial ability.

Definition
 Profit is the payment made for bearing risk uncertainty and

new promotions of undertaking – Schumpeter
 Profit connotes the aggregate remuneration of

the capitalist entrepreneur - J. S Mill

Characteristics of profit
 Profit is the reward for risk bearing

 It is not fix
 It can also be negative
 More fluctuations

Types of profit
 Gross profit –
 Net Profit

 Gross profit means total earning of the entrepreneur. It is
a mix of various components. It is the total return to the
entrepreneur after paying rent to the land , wages to the
labor and interest to the capital from the total receipts of
business. In brief, all payment made to be deducted.
 Net profit –Net profit is the reward to the entrepreneur for

something which only he perform. Therefore, profit is the
reward for assuming final responsibility.

Theories of Profit
 There are various theories of profit propounded by different

intellectual in economics. Though, none of them is
complete in itself but they provide a partial insight into the
process of emergence of profit.
1. The Residual Claimant Theory
2. Wages Theory
3. Clark’s Dynamic Theory
4. Hawley’s Risk Bearing Theory
5. Innovation Theory of Profit
6. Risk Theory of Profit

 The Residual Claimant Theory – According to this theory,
profit is the difference between total receipts and the total
payment to the factors of production.
It is return which he receives on his own efforts which are
employed by him in the service of the firm.
In brief, the difference between the total receipt and total cost may
be regarded as profit. Drawback of this approach – it treats the
role of entrepreneur as passive activity.
 Clark’s Dynamic Theory of Profit – Profit is the results from

dynamic change. In his view, profit arises on account of dynamic
nature of the economy and such is ruled out of existence
in a static economy.

 Wage Theory of Profit – According to his theory, profit is
the reward to the entrepreneur just like the wages to
the worker. A worker earns wages through its efforts.
In the same way, an entrepreneur earns profit through
his effort.
According to Marhall – “Just as labor get return as wages
for labour, so does entrepreneur gets profit in return of his
services”.
Drawback- Profit is not concerned from Population
and invention.
 Hawley’s Risk Bearing Theory – Hawley emphasized that

risk taking is the main function of entrepreneur and for
which he needs the inducement of profit. Profit is the reward
of risk and responsibilities which entrepreneur bear with
respect of business.
 Innovation Theory of Profit – Prof. Joseph A. Schumpter
propounded the theory of innovation. Profit is the reward to
innovators for their innovative ability. Who is innovator.
An innovator is a person with vision, originality and drive. He
introduces new products, new techniques of production, fresh
methods of management and so on.
 Risk Theory of Profit – This theory of profit is associated with

F.B Hawley’s name. He says profit is the reward for risk and
responsibility taken by the entrepreneur.
 Most of the business are speculative and unless the businessman
has opportunity of getting sufficient profit. He will not start the
business. Hence, profit is regarded as a reward for risk taking or
risk bearing. The higher risk, greater should the expected reward.

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Basic Principles in the Application

The term economics comes from the Greek work ‘Oikon’-

House and ‘Nomos’- Law or rule. It is meant “Practical

wisdom of household management”.

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Economics as a subject came into existence through a

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1. Wealth Oriented View

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• According to him, “economics is a science which studies

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“the study of how men and society choose, with or

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The modern economic science has two major branches

 Macroeconomics emerged as a separate branch in 1936 with

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Managerial economics is the study of economics theories,

logic and tools of economic analysis that are used in the

process of business decision making by managers.

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Spencer and Seigelman “Managerial economics is the

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 The scope of Managerial Economics following

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- Demand Analysis- Demand Analysis is necessary for demand forecasting which is an

- Demand Theory –Demand theory is the study of behavior of consumers.

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 Theory of Exchange or Price Theory – Theory of exchange is popularly

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a) Demand of the product;

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a) Selection of most suitable investment project

Capital is foundation of any business . Like other factors of production it is

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a) Reconciling Traditional Theoretical to the

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 Estimating Economic Relationship- Managerial economics estimates

 Predicting Relevant Economic Quantities – Managerial economics helps

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 There are five fundamental concepts that help to the management in

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The main objective of this principle is maximization of profits. Or In

Incremental revenue is defined as the change in total revenue

resulting from a decision and Incremental cost is defined as the

change in the total cost resulting from a decision.

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Full Cost 3800

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