Decision making

Basic function of human beings

Most important function of business management
 OLDEN DAYS
• Easy decisions
• Small organisations
• Completion was not so stiff
• Decisions were based on experience and
imagination
 MODERN WORLD

• Decision making is complex

• Competition
• Large industries
• Heterogeneous workforce
• Diversification
• Globalisation
• Risk and uncertainty
• Inter-industry and international revelry
 Economics

Social science
• Study of the principles which govern the functioning
of economy and its various components
• Science that deals with human wants and their
satisfaction
Unlimited wants.......................
Resources available for conception is limited ?
 Definitions

Wealth definition
Adam Smith
Classical economist
Father of modern economics
In his famous book “An enquiry into the nature and causes
of wealth of nations” published in 1776, Adam Smith defined
economics as a science of wealth. “Economics was regarded
as the science which studied the production and
consumption of wealth.”
 Subject matter of economics is the study of
economics is how wealth is produced and
consumed
Criticisms.....
too......... Materialistic
Criticised as
Gospel of Mammon
By philosophers
Carlyle, Ruskin etc.
 Welfare definition
Prof. Alfred Marshall
The Neo classical economist
Marshall in his famous book
Principles of Economics defined economics as,
“the 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 the use of material requisites of
well being”
 Welfare definition

Subject matter of economics is the study of

economics is human welfare and the ways to
promote well being or welfare
Study of human beings
Study of economic activities
Study of wealth
because wealth is a means to welfare
 Criticisms.....

• Only concerned with material causes

• There exists services which can bring welfare
• Economics has nothing to do with welfare
• eg: sale of liquors
• Welfare cannot be quantitatively measured
• Man has unlimited wants
• The means to satisfy human wants are limited
• Resources are not only limited but have
alternative uses
• Man has to make a choice
 Growth Definition

Prof.Paul A. Samuelson
“Economics is 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 overtime
and distribute them consumption now and in
the future among various people and groups
in society.”
Comprehensive definition
Growth oriented as well as future oriented
Scope for improvements in future
 Micro and Macro Economics
• Micro Economics
means “small”
Branch which studies the economic behaviour of
Individual unit ...........person ,household, firm
How maximise profit
How a family adjusts its expenditure to income
etc.
 SCOPE OF MICRO ECONOMICS

• Theory of demand
• Theory of production and cost
• Theory of economic welfare
• Theory of pricing
• Theory of factor pricing (Theory of distribution)
Includes determination of wages ,rent, interest,
profit etc.
 Macro Economics
Means “large”
Branch which studies the economic behaviour of
not one particular unit but all units taken together.
Branch which studies economic issues at the
aggregate level or at the level of economy as a
whole
National income, Aggregate output,demand,
consumption, suply,Total employment, general
price level etc.
 SCOPE OF MACRO ECONOMICS
• National income
• Employment
• Monetary Theory
• General price level
• Business cycle
• Economic growth
• Macro distribution theory
• International trade
 Managerial economics(Business
Economics)
Definition
“The integration of economic theory with business practice for
the purpose of facilitating decision making and forward
planning by management.”
Spencer and Siegelman
“ Managerial economics is concerned with application of
economic concepts and economic analysis to the problem of
formulating rational managerial decisions.”
Edwin Mansfield
 Characteristics of Managerial Economics

• Micro economics in nature

• Based on theory of firm
• Pragmatic
• Normative rather than positive
• Both conceptual and practical
• Accepts principles of macro economics
• Use economic theories and concepts for
practical problem solving in business.
• Both science and art
• Multi deciplinary approach
• Social science
• Not an exact science
• Helps the business manager in decision
making
 Scope of Managerial Economics
• Demand analysis
• Production function
• Cost analysis
• Pricing policies
• Profit management
• Capital budgeting
• Inventory management
• Linear programming
• Environmental issues
 uses

• Helps in decision making

• Estimates economic relationships
• Predicting economic quantities
• Bases of business policies
• Model building
• Integrating agent
• Helps meeting obligations
 Responsibility of a managerial economist

• Maximisation of profit
• To make acurate forcasts
• Informing economic treands to management
• Collect and analyse data
• To act as an adviser to the firm
• To forcast market treands
 DECISION MAKING
• Meaning and Definition of Decision-Making
• The word ‘decision’ is derived from the Latin
word ‘decido’. It means ‘to cut off’. Thus, to
decide means to come to a conclusion. A
decision is a choice made from available
alternatives. It represents a course of action
about what must or must not be done.
• Decision-making is the process of selecting one
(best) alternative from two or more alternatives to
achieve a specific objective or to solve a specific
problem. In the words of J. W. Duncan, “Decision-
making is the process of choosing a course of action
from two or more alternatives”. According to Bartol
and Martin, “Decision-making is the process
through which managers identify organisational
problems and attempt to resolve them”
• Thus, decision-making is the selection of best
possible alternative from among the various
alternatives available for the solution of a given
problem.
Decision Making Process (Steps in
Decision-Making)
1. Recognise the need for a decision:
Managers continually scan the organisation’s environment for changes
that create problems to solve or opportunities to pursue.

2. Analyse and define the problem or

opportunity:
The problem must be identified correctly. A crystal clear picture of the
problem is important for the solution. Problem is the difference between
actual state of affairs and desired state of affairs. In other words, it is the
gap between where one is and where one wants to be. C.H. Kepner and
B. Tregoe define problem as any deviation from a set of expectations.
 3. Determine objectives
Determination of the objective or goal of the
organisation is the third step in any business
decision making.
eg,profit maximisation, profit maximisation
along with customer satisfaction etc.
 4. List out constraints :
The business operates in an environment. In the
environment, there will be constraints.
Constraints may be from within or outside the
organisation. The decision maker must be
aware of the various constraints beforehand.
He must develop well-thoughtout plans to
encounter such constraints.
 5. Develop alternatives :
A problem can be solved in several ways.
Ideally speaking, the decision maker should
explore all possible alternatives and choose
the best one.
 6. Evaluate alternatives :
Each of these alternatives have their own benefits and limitations. The pros
and cons of each alternative should be analysed by gathering necessary
information.

7. Choose the best alternative :

The best alternative is the one which satisfies all the criteria. In other words,
the best alternative is the one which coincides with the stated objective.
In short, the most optimal alternative is the best alternative. Important
tools are marginal analysis, linear programming, game theory etc.
 6. Implement the chosen
alternative:
The chosen alternative is to be implemented by the managers. This means
that the alternative selected is applied to the specific problem area. This
requires organisational support and co-operation at all levels.

7. Evaluate the result:

Managers regularly monitor the results of decisions to see whether the
chosen alternative works. In short, the impact of the alternative
implemented has to be examined or evaluated.
 Types of Decisions
1.Programmed decisions
Programmed decisions are repetitive in nature. These decisions involve
simple, common and frequently occurring problems. These decisions are
made in accordance with certain policies rules and procedure. Such
decisions are made by lower level officers.
Eg: granting leave to employees, purchase of raw materials, disciplinary
actions against late comers etc.
2.Non-programmed decisions
Non-programmed decisions are of a non-repetitive nature. Such decisions
deal with unusual problems. Such decisions are made by higher level
officers.
Eg: Deciding where to locate a new branch office, whether to wind up a sick
unit or not, whether to introduce a new product or not
3.Strategic decisions
Strategic decisions are made by the top management. The decisions relate
to problems and matters which are very important and critical for the
survival, success and profitability of the organization. These decisions have
long range implications. They define and establish relationship of the
organization with its external environment. These decisions require more
resources, judgement and skill.
Eg: Price reduction
4.Tactical decisions
These are concerned with routine and repetitive matters arising out of
the functioning of an organization. These do not require managerial
judgement and skill. This is because tactical decisions are meant for
implementing strategic decisions. Tactical decisions are generally taken by
lower level managers. These are more specific. These have short term
implications. Tactical decisions are also called operational decisions.
5. Individual decisions:
Every manager has to make decisions. Only by making decisions, he can
solve the problems effectively. Thus, decisions made by individual
managers by using skill and judgement, pre-determined techniques and
rules are known as individual decisions.

6.Group decisions:
Group decisions are made by two or more managers jointly. These
decisions are made on problems involving interest of many functional
departments. For example, the decision of product selection may be
arrived at jointly by production manager, marketing manager, research
and development manager etc.
7.Personal decisions:
Personal decisions are made by a single individual.
Decision to retire early, to resign the post etc. are
examples of personal decisions. Such personal
decisions shall affect the organization indirectly.
8. Organizational decisions:
Organizational decisions are made by managers in
their formal capacity as managers. These decisions
reflect the basic policy of the organization. Decisions
relating to payment of dividend, alteration of share
capital, adoption of new technology and the like are
examples of organizational decisions.
13.Analytical decisions
Complex problem but output is certain
14.Adaptive decisions
Complex problem but output is uncertain
15.Mechanical decisions- Problem is simple-Out is certain
16. Judgemental decisions-Problem is simple-Output is vague
17.Technical Decisions-Concerned with the process through which the inputs
are converted into output
18.Managerial Decisions- concerned with the integration and coordination of
activities in an organisation to achieve the predetermined goals
 Theories of Decision-Making
• Theory is used to arrive at the decision.
• It Bridges the gap between the basis for a
decision and the decision itself.
 Traditional theory

According to this theory, managerial decisions are

taken by intuition. Intuition means taking a decision
without really considering all alternatives. So it is
otherwise known as intuition theory of decision-
making. Here, a manager simply decides upon a
course of action because he feels that the particular
course of action is the best one. The major demerit
of this theory is that rational thinking is ignored.
• Classical theory: This theory implies that
decisions are made rationally after considering
 Classical theory:
This theory implies that decisions are
made rationally after considering the pros
and cons of all the alternatives carefully.
The decision-maker selects the
alternative that will maximize the return to
the organisation.
 Behavioural theory or
Administrative model
This theory implies that a manager makes decisions not only
on the basis of facts and figures but also on the basis of his
intuition, thinking capacity, habit and value system. This
model describes how managers actually make decisions, in
difficult situations such as uncertainty, ambiguity etc.
The behavioural model of decision-making is based on the work of Herbert A.
Simon (Nobel prize winner). He proposed two concepts. One is bounded
rationality. The other is satisfying.

Bounded rationality Concept

Bounded rationality means that people have limits, or boundaries, on how
rational they can be.
Managers do not have the time or ability to process complete information.
Limits
Cognitive, Emotional, Availability of information etc.
Thus complex problems cant be solved in a rational way.
 Satisfying concept

According to this concept managers shold look

for a satisfactory level of return rather than
maximum return. Thus decision maker is a
satisfier , ie. one who seeks satisfactory
solution rather than optimal solution
For example, instead of trying to maximize
profits, the theory of bounded rationality
argues that managers will try to attain a
satisfactory level of profits.
 Fundamental Concepts of Managerial Economics (or Basic
Economic Tools or Theories in Managerial Economics)

1.Principle of opportunity cost

Every scarce good or activity has an opportunity cost.
Opportunity cost of anything is the cost of the next best alternative which is given
up.
It refers to the cost of foregoing or giving up an opportunity.
It is the earnings that would be realised if the available resources were put to
some other use.

Thus opportunity costs are measured by the sacrifices made in the decision.

If there is no sacrifice involved by a decision, there will be no opportunity cost.

Opportunity cost is also called alternative cost or transfer cost.
 2. Principle of incremental cost
and revenue
Two important incremental concepts used in
Managerial Economics are incremental cost
and incremental revenue. Incremental cost is
a change in total cost resulting from a
decision. Incremental revenue means the
change in total revenue resulting from a
decision.
• . A decision is profitable only if
• (i) It increases revenue more than costs
• (ii) It decreases some costs more than it
increases others
• (iii) It increases some revenue more than it
decreases others,
• and (iv) It reduces costs more than revenue
 Principle of time perspective
'Time' plays a decisive role in economic theory,
particularly in 'pricing'. It was Marshall who
introduced the element of time in the value theory.
He conceived four market forms based on time. They
are very short period, short period, long period and
secular period. In managerial economics we are
concerned with short run and effects of decision on
revenue and cost. A decision should be taken only
after studying the short run and long run effects on
cost and revenue.
 4. Principle of discounting :
.A rupee tomorrow is worth less than a rupee today.
.“A bird in hand is better than two in the bush".
There is a difference should be made between cash received at
different times.
Money received today could be invested to earn additional
money.
An amount to be received after a certain period of time could
not be invested until it is received and therefore it is less
valuable than a rupee received today.
A comparison should be made between the present value and
future values (by discounting the future values) of money.
Application of Economic Theories
in Decision-Making
• The primary function of a managerial
economist is to assist management in the
process of decision-making
• Decisions are always made on the basis of
information
• The managerial economist has to use various
types of information in order to make good
decisions
• In managerial economics decisions are taken
by applying economic theories
• Several business problems are solved by
making use of economic theories
• Economic theories are applied for making
different types of decisions
 Types of Decisions that can be taken with the
help of Economic Theories
1. Selection of product
• Principle of incremental cost and revenue
2. Selection of a suitable product mix
• The theory of contribution(Contribution is the
difference between the added revenue and
the incremental cost) is used in product mix
decision
3. Selection of method of production
• Theory of contribution, production function
 4.Product line decisions
• whether to add new products drop old
products
• theory of contribution
5.Determination of price and quantity
• price theory, demand theory, concept of
elasticity, the law of diminishing marginal
utility, the concept of time perspective
 6.Decision on advertising expenditure
• The concept of elasticity, the equi-marginal
principle, theory of contribution
7.Optimum input combination
• the law of variable proportion, production
function
8.Allocation of resources
• opportunity cost concept, equi-marginal principle,
linear programming
 9.Replacement decision
• theory of contribution, opportunity cost
concept
10.Make or buy decision
• theory of contribution, marginal analysis
11. Shut down decision
• Under certain circumstances, the
management may be forced to take decision
whether to operate the business or shut down
• . By shutting down, the firm stops receiving
revenue and stops paying the avoidable cost
• The firm should shut down only if its revenue is less
than its avoidable cost
• production function, the principle of time
perspective
12. Decision on export and import
-decision on export and import
- Theory of comparative cost.
13. Location decision
Theory of cost
Location theory- location should balance both
land and transportation cost
 DEMAND ANALYSIS
• In ordinary language demand means desire
• But mere desire does not constitute demand
in economics
Desire which is backed by willingness and
ability to pay is called demand in economics
According to Prof. Hibdon,
“Demand means the various quantities of goods that
would be purchased per time period at different
prices in a given market”.
A demand which cannot be met due to shortage of
commodity is known as an unsatiable demand.
• According to Prof. Hibdon, “Demand means
the various quantities of goods that would be
purchased per time period at different prices
in a given market”.
Law of Demand
Generally there is an inverse relationship
between the price of a commodity and the
quantity demanded.
In economics, this relationship is known as the
Law of Demand
 Law of Demand
• The law of demand states that at higher price lower
quantity will be demanded and at lower price higher
quantity will be demanded, other things remaining
equal.
• According to Samuelson, "Law of demand states that
people will buy more at lower prices and buy less at
higher prices".
• The relationship described by the law of demand is
an inverse or negative relationship because the
variables move in opposite directions.
 Assumptions of the Law of Demand
• 1. Income of the buyer remains constant.
• 2. Tastes and preferences of the consumers remain the
same.
• 3. Price of related goods (substitutes and complements)
remain the same.
• 4. Consumers do not know about any new substitute
product.
• 5. There is no expectation of change in the price of
commodity in the near future.
• 6. The commodity should not be a prestige commodity.
• 7. The size of population remains constant.
 Demand Schedule

• The law of demand can be explained with the help of

a demand schedule.
• A demand schedule is a list of prices and
corresponding quantities.
• It is the table or chart showing the quantities of a
commodity demanded at different prices at a
particular time in a particular market.
• The law of demand presented in a table is known as
a demand schedule.
 DEMAND CURVE
It is the graphical representation of demand
schedule. It depicts the relation between price
and quantity demanded on a commodity. To
draw the demand curve the quantity
demanded is measured on X axis and price on
Y axis
Why demand curve slops downwards? Reasons
for law of demand

Law of diminishing marginal utility

UTILITY
The term utility refers to the want
satisfying capacity of a commodity or
service. It is highly subjective and
change from consumer to consumer
and measure in terms of utils
Total utility

The total psychological satisfaction a consumer

obtains from consuming a given quantity of a
particular commodity .

Marginal utility

Additional utility from the conception of an

additional unit of a commodity
Law of diminishing marginal utility
• The law states that as the consumer consumes
more and more units of a commodity , the
additional utility obtained from additional
units goes on decreasing.
 Factors Affecting Demand
(Determinants of Demand)

• A. Determinants of Individual Demand

1.Price of commodity :
Price is the basic factor influencing the demand. When prices
change demand also changes. When the price increases, the
demand falls and vice versa.
2. Nature of commodity : Demand depends on whether the
commodity is a necessity or a luxury or a prestige etc.
Demand of necessary goods generally remains constant.
Demands of comforts and luxuries change with the change in
their prices. Demand of prestige goods, generally remains
constant. Demand of durable goods changes with change in
their price. Thus the nature of commodity determines the
demand.
3. Income and wealth of consumers :
Change in income can bring, about a change
in demand. If the income of consumer
increases, the demand for normal goods will
also increase and vice versa. But in the case
of Inferior goods are goods, the demand
increases as income falls and demand
decreases as income rises. Thus in the case of
normal goods, there is a direct or positive
relationship between income and demand. In
the case of inferior goods, there is an inverse
or negative relationship between income and
demand.
4.Tastes and preferences of consumers :
Any change in fashion, taste, and preference of
consumers brings about changes in demand
5.Price of related goods :
The demand for a commodity is affected not only by
its own price but also by the price of related goods.
These related goods fall into two categories:
a, Substitutes
b, Complements.
Substitute goods
Two goods are said to be substitutes of each
other when one can be used in place of other.
Eg: Tea and coffee .
If the price of a substitute commodity
increases, the demand for original commodity
will increase. On the other hand, if the price
of a substitute commodity falls, the demand
for original commodity will decrease and vice
versa.
Complementary goods:
Two goods are said to be complementary of
each other when they are used together.
Eg: Pen and Ink
In the case of complementary goods, if the demand
of original commodity increases (due to fall in price
or change in other factors), the demand of
complementary goods will also increase. Similarly, if
the demand of original commodity decreases (due to
rise in price or change in other factors), the demand
of complementary goods will also decrease. For
example, if the demand for pen decreases, the
demand for ink will also decrease.
• 6. Consumers' expectations :
Consumers' expectation about a further rise
or fall in future price will affect the demand of
a commodity. If consumers expect a rise in
the price of a commodity in the near future,
they may purchase large quantity and thereby
increase demand. Also when people expect
fall in price and postpone their purchase and
result in decrease in demand.
7. Advertisement : Advertisement will
create, maintain and increase the demand of
goods. Effective advertisement campaigns
influence the demand of goods positively.
 B. Determinants of Market Demand
Market demand for a product refers to the
total demand of all the buyers taken together.
The following factors affect the market
demand of a product:
1. Price of product:
The market demand of a product depends on its price.
When the price falls, demand increases and vice versa.
2. Usefulness:
Changes in usefulness cause changes in demand. For
example, the demand for Christmas cards rises in November
and falls in January. The demand for air conditioners rises
each summer and falls afterwards.
 3. Changes in population :
A change in the population of the country may
cause change in the demand for various goods
and services. Increase in population will lead
to an increase in the demand and vice versa.
• The composition of population also affects
demand. Composition of population means
the proportion of young and old and children
and adult , the ratio of men to women ect. A
change in composition of population has an
effect on the nature of demand for different
commodities.
 4. Distribution of income and wealth :
Distribution of income and wealth in the
society also affects the demand of
commodities.
If there is an unequal distribution of income and
wealth in the country, demand of the goods of
comforts and luxuries will be greater.
If there is equal distribution of income and
wealth, demand of necessary goods and
comforts will be greater.
5. Change in the quantity of money in
circulation :
When the money in circulation increases,
people will have more purchasing power.
Hence demand will increase. Conversely, if
money in circulation decreases, people will
have less purchasing power and therefore,
demand for goods and services also
decreases.
6. Change in climate :
Variations in climate may bring about
changes in demand for particular goods. For
example, the demand for woollen clothes will
be heavy during the winter season. The
demand of fans, coolers etc. increases in
summer. The demand of umbrellas and rain
coats increases in rains. During hot summer
days ice cream will have higher demand.
7. Technological progress :
Inventions and discoveries bring new things in
the market. As a result, people will not
demand older things.
For instance, radios replaced gramaphones;
televisions replaced radios; computers
replaced televisions and typewriters etc.
8. Govt. Policy :
Policies of Government affects the demand of
commodities.
For example, if heavy taxes are imposed on
certain goods, the demand for such goods will
decrease.
On the other hand, if govt. announces tax
concessions for certain commodities, their
demand will increase.
 9. Business cycle :
In the period of boom, demand for almost all
commodities increases. In the period of
recession , demand of commodities decreases.
10. Demonstration effect:
Sometimes people get motivated to buy a
product not because it has become cheaper or
their income have increased but because their
neighbour or relatives bought it. This is known
as demonstration effect or contact effect
11. Availability of credit:
If there is availability of cheap credit, the consumers
will try to spend more on consumer durables. As a
result, the demand for such durable goods increases.
12. Social customs and ceremonies:
Social customs and ceremonies are usually
celebrated collectively. These involve extra
expenditure on certain items. Thus demand
increases
Demand Function
There is a functional relationship between the
demand and its various determinants. When
this relationship is expressed algebraically, we
get what is known as demand function. Thus,
the mathematical expression of relationship
between demand for a commodity and
various factors determining its demand is
called demand function
 Demand Function
D = f (P, Y, T, Ps, U)
where,
• D = Quantity demanded
• P = Price of the commodity
• Y = Income of the consumer
• T = Tastes and preference of consumer
• Ps = Price of substitutes and complements
• U = Consumers' expectation and other factors
 A function expresses the relationship between
two or more variables.
It indicates how the variables are dependent on
one another.
Here, the demand is dependent variable (also
called endogenous variable) and price, income
etc. are independent variables (also called
exogenous variables).
 Classification of Demand

1. Price demand
Price demand refers to the various quantities of a
commodity that a consumer would buy at a given
time in the market at various hypothetical prices
2. Income demand
Income demand refers to the various quantities of a
commodity that a consumer would buy at a given
time at various levels of income. Generally, when the
income increases, demand increases and vice versa
3.Cross Demand
When the demand of one commodity is
related with the price of other commodity, it
is called cross demand.
The commodity may be substitute or
complementary.
 Extension and Contraction of
Demand
The change in demand due to change in price
only (when other factors remain constant) is
called extension and contraction of demand.
Increase in demand due to fall in price is called
extension of demand. Decrease in demand
due to rise in price is called contraction of
demand. Extension and contraction of
demand results in movement on the same
demand curve.
 Shift in Demand

Demand depends not only on price but also on

other factors like income, population, taste
and preference of consumers etc.
The change in demand due to change in any of the
factors other than the price is called shift in demand.
Change in any one of the factors (other than price)
shifts the entire demand curve. A change in demand
will shift the demand curve either upwards or
downwards. An upward shift in demand curve is
called increase in demand. Downward shift in
demand curve is called decrease in demand.
Extension and contraction of demand is called
"change in quantity demanded" and shift in
demand is called "change in demand". Thus
there is a difference between "change in
quantity demanded" and "change in demand".
 Types or Kinds of Demand

1. Joint demand
When two or more commodities are jointly
demanded at the same time to satisfy a
particular want, it is called joint or
complimentary demand. Demand for land,
labour, capital and organisation for producing
commodity is also a case of joint demand.
2.Composite demand
The demand for a commodity which can be
put to several uses is a composite demand. In
this case a single product is wanted for a
number of uses.
For example, electricity is used for lighting,
heating, for running the engine, for the fans
etc. Similarly coal is used in industries, for
cooking etc.
Direct and Derived demand
The demand for a commodity which is for direct
consumption, i.e., demand for ultimate object, is
called direct demand, e.g., food, cloth, etc. Direct
demand is also called autonomous demand.
When the commodity is demanded as a result of the
demand for another commodity or service, it is
known as the derived demand or induced demand.
For example, demand for cement is derived from the
demand for building construction, demand for tyres
is derived from the demand for cars or scooters, etc.
Industry demand and Company demand
Company demand refers to the demand for
the products of a particular company or firm.
On the other hand, industry demand
represents the total demand for the products
of a particular industry.
Importance of the Law of Demand

1. Price determination:
With the help of law of demand a monopolist fixes
the price of his product. He is able to decide the
most profitable quantity of output for him.
2. Useful to government
The finance minister takes the help of this law to
know the effects of his tax reforms and policies. Only
those commodities which have relatively inelastic
demand should be taxed.
3. Useful to farmers:
From the law of demand, the farmer knows how far
a good or bad crop will affect his economic
condition.
4. In the field of planning
The demand schedule has great importance in
planning for individual commodities and industries.
In such cases it is necessary to know whether a given
change in the price of the commodity will have the
desired effect on the demand for commodity within
the country or abroad. This is known from a study of
the nature of demand schedule for the commodity.
 ELASTICITY OF DEMAND
The law of demand states that the demand of a commodity
increases on a fall in its price and decreases on an increase in
its price
The law of demand tells the direction of the change.
But It does not tell the rate at which the changes take place.

ELASTICITY.......................
• In physics, elasticity means the expansion and
contraction of an object as force is applied and
released
• It is the capacity to expand and contract
• In economics, the term elasticity means the rate of
change in one variable in response to the change in
another variable.
• According to E. K. Estham,
"Elasticity of demand is a measure of the
responsiveness of quantity demanded to a change in
price".
Elasticity is the rate of change in the quantity
demanded due to a change in price.
 Types of Elasticity
1. Price elasticity
This is the most important and most popular elasticity. It measures the
responsiveness of demand to change in price. It is measured by using the
following formula:
ED = Proportionate change in Quantity
demanded
---------------------------------------------------------------
Proportionate change in Price
Proportionate change in quantity demanded = Change in quantity demanded
--
---------------------------------------
Original quantity demanded
Proportionate change in price = Change in Price
---------------------
Original Price
 Degree of Elasticity of Demand
(Types of Price Elasticity)

1. Perfectly elastic demand:

When a small change in price leads to a great
change in demand, it is known as perfectly
elastic demand. The demand curve will be a
horizontal straight line. This is only an
imaginary demand curve because in real life
there is no commodity having perfectly elastic
demand.
 2. Perfectly inelastic demand
When a demand of a commodity doesn't
change, whatever be the change in price, it is
called perfectly inelastic demand. The
elasticity is zero (e = 0). Here the demand
curve will be vertical. This is also an imaginary
demand curve because in real life there can be
no such commodity with such demand.
 3. Unit elasticity (Unitary
elasticity)
When a given percentage change in price
causes an equally proportionate change in
demand, it is called unit elasticity. Here the
elasticity is one (e = 1). In this case the
demand curve is in the shape of rectangular
hyperbola.
 4. Relatively elastic demand
When change in price results in a more than
proportionate change in quantity demanded,
it is called relatively elastic demand.
Arithmetically it is known as more than unit
elastic demand (e = >1) . In this case the shape
of the demand curve is flat or semi-horizontal.
5. Relatively inelastic demand
When change in price results in less than
proportionate change in quantity demanded,
it is called relatively inelastic demand.
Arithmetically it is known as less than unit
elastic demand (e = < 1). In this case the
shape of demand curve is steep or semi-
vertical.
 FACTORS AFFECTING IE
• Nature of the product....necessaries –inelastic
luxury............ Elastic
Range of substitutes
Having close substitutes –elastic
Extent of use
More/varied use –elastic
Range of prices
High range-low range –less elastic. Middle
range-elastic
• Level of income
• Durability –durable-elastic
• Proportion of income – small-inelastic
• Influence of habit
 Measurement of Elasticity of
Demand
1. Proportional or Percentage Method
Under this method the elasticity of demand is
measured by the ratio between the
proportionate or percentage change in the
quantity demanded and proportionate or
percentage change in price. It is also known
as formula method. It is computed as follows:
ED = Proportionate change in Quantity demanded --
- ---- -----------------------------------------------

Proportionate change in Price

2. Expenditure or Outlay Method
This method was developed by Marshall.
Under this method the elasticity is measured
by estimating the changes in total expenditure
as a result of changes in price and quantity
demanded.
 For commodities having unit elasticity the total
money spent (expenditure) on commodities will be
the same whatever may be the change in price.
For commodities having greater than unit elasticity,
the total expenditure increases with a fall in price (or
decreases with a rise in price).
In case of commodities having less than unit elasticity,
total expenditure decreases with a fall in price (or
increases with a rising price).
• (1) If price changes, but total expenditure
remains constant, unit elasticity exists.
• (2) If price changes, but total expenditure
moves in the opposite direction, demand is
elastic (greater than one)
• (3) If price changes and total revenue moves
in the same direction, demand is inelastic (less
than one).
3. Geometric or Point Method :
This method also was developed by Marshall.
This is used as a measure of the change in
quantity demanded in response to a very
small change in price. Thus, this method helps
in measuring a small change in price at a
certain point. Under this method we can
measure the elasticity of demand at any point
on a straight line demand curve by using the
following formula:
 4. Arc Method
The point method is applicable only when there are
minute (very small ) changes in price and demand.
When the changes in price and demand are large,
elasticity cannot be measured at a point on the
demand curve. In this case arc method is used to
determine elasticity. Arc elasticity measures elasticity
between two points on a demand curve. It is a
measure of the average elasticity. According to
Watson, "Arc elasticity is the elasticity at the midpoint
of an arc of a demand curve.The following formula is
used to measure the elasticity:
 2. Income elasticity
Income elasticity measures the change in demand in
response to change in the consumer's income. To
compute income elasticity, the following formula is
used
EY = Proportionate change in quantity demanded
--------------------------------------------------
Proportionate change in Income
Proportionate change in quantity demanded = Change in quantity demanded
------------------------------------------
Original quantity demanded

Proportionate change in income = Change in Income

--------------------------
Original Income
 Types of Income Elasticity

1. Zero income elasticity :

Here, a change in income will have no effect
on the quantities demanded. For example,
salt, cigarettes etc.
2. Negative income elasticity :
In this case, an increase in income will lead to
a decrease in the quantity demanded. This
happens in the case of inferior goods.
• .
3. Positive income elasticity :
In this case, an increase in income will lead to
an increase in quantity demanded.
For most goods (normal goods) income
elasticity is positive
 Advertising Elasticity
(Promotional Elasticity)
Advertising directly influences demand. It
brings more sales to a firm. Thus, sales change
in response to advertising. To measure this
responsiveness, the concept of advertising
elasticity of demand is used. Advertising
elasticity may be defined as, "the
responsiveness of demand to changes in
advertising or other promotional expenses". It
is computed as follows:
• REVIEW QUESTIONS
• Ea = Proportionate change in sales
• Proportionate change in advertising and
other promotional expenditure
• Proportionate change in sales = Change in
Sales
• Sales
• Proportionate change in advertising = Change
in Advertising Expenditure
• expenditure Advertising
Expenditure
• Generally up to a certain point an increase in
advertisement can bring about more than
• 2. Availability of substitutes: The demand
for goods which have substitutes is normally
elastic. For example, coffee and tea are
substitutes. If the price of tea increases,
people may switch over to coffee. If the price
of coffee rises, people may shift to tea. Thus
substitutes generally have elastic demand. If a
commodity has no substitutes, its demand will
be inelastic. The demand of salt is inelastic
mainly due to this reason
3. Income of Consumers
Rich people are less affected by the change in
price. So, if a commodity is consumed mainly
by rich people, its demand will tend to be
inelastic because they will demand the
commodity at all levels of prices. On the other
hand, if a commodity is consumed mainly by
the poor people, its demand will tend to be
more elastic because they will change the
quantity of consumption according to the
change in price (less at higher prices and more
at lower prices).
 4. Proportion of income spent
If a consumer is spending only a small portion
of his total income on the consumption of a
commodity, the demand for such commodity
will be inelastic. For example, salt, match box,
news paper etc. On the other hand, if a
consumer spends a major part of his income
on a commodity, its demand will be elastic
5. Habit of consumers
If a consumer is habitual of a particular
product or a particular brand of a product, its
demand will be relatively inelastic. For
example, the demand for tobacco has proved
to be relatively inelastic partly because the
smoking habit is very strong and there is no
close substitute for tobacco.
6. Number of uses of the commodity
If a commodity can be put to several uses, its
demand will be elastic. This is because if the
price increases, the consumers will use it for
limited purpose and if its price falls, the
consumers will use it freely for all the
purposes. Examples : electricity, Coal, steel,
aluminium, etc. If a commodity has only few
uses, its demand will be inelastic.
7. Postponement of the use of Commodity
If we can postpone the buying of some
commodities to a future date, such goods will
have elastic demand. For example TV,
refrigerator, car etc. can be postponed for
next session. Therefore, their demand will be
elastic. The commodity the use of which
cannot be postponed will have relatively less
elastic (or inelastic) demand. Examples:
Medicines, foodgrains etc.
8. Demand of complementary goods :
Demand of complementary goods depends
upon the demand of main product. If the
demand of main product is elastic, the
demand of complementary goods also will be
elastic (e.g., car and petrol). If the demand of
main product is inelastic the demand of
complementary goods also will be inelastic
(e.g., pen and ink).
9.Distribution of income and wealth in the
society
If there is unequal distribution of income and
wealth in a society, the demand of
commodities in general will be relatively
inelastic. If the distribution of income and
wealth in a society is equal, the demand of
commodities in general will be elastic.
• 10. Durability of the commodity : If a
commodity is durable and can be used for a
long time, the demand of such commodity will
be elastic. This is because the consumers are
likely to get such commodity repaired in case
of price rise (e.g., radio). If a commodity
cannot be used for a long time, its demand
will be relatively inelastic.
• 11. Range of prices : If the price of a
commodity is too high or too low, its demand
will be comparatively inelastic.
 Factors Affecting Elasticity of Demand (Determinants of
Elasticity)

1.Nature of Commodity : This is the most

important factor which influences elasticity.
Generally the demand for luxuries is more
elastic than the comforts and necessaries.
The consumer will buy necessaries in a fixed
quantity, whatever may be their prices, e.g.,
food grain, salt, medicines etc. But comforts
and luxuries have elastic demand. These will
be purchased more by the people when their
prices fall.
• 2. Availability of substitutes :
The demand for goods which have substitutes
is normally elastic. For example, coffee and
tea are substitutes. If the price of tea
increases, people may switch over to coffee. If
the price of coffee rises, people may shift to
tea. If a commodity has no substitutes, its
demand will be inelastic. The demand of salt
is inelastic mainly due to this reason.
3.Income of Consumers : Rich people are less
affected by the change in price. So, if a
commodity is consumed mainly by rich
3. Income of Consumers
Rich people are less affected by the change in
price. So, if a commodity is consumed mainly
by rich people, its demand will tend to be
inelastic because they will demand the
commodity at all levels of prices. On the
other hand, if a commodity is consumed
mainly by the poor people, its demand will
tend to be more elastic because they will
change the quantity of consumption
according to the change in price.
4. Proportion of income spent
If a consumer is spending only a small
portion of his total income on the
consumption of a commodity, the demand
for such commodity will be inelastic.
For example, salt, match box, news paper etc.
On the other hand, if a consumer spends a
major part of his income on a commodity, its
demand will be elastic.
5. Habit of consumers
If a consumer is habitual of a particular
product or a particular brand of a product, its
demand will be relatively inelastic.
For example, the demand for tobacco has
proved to be relatively inelastic partly because
the smoking habit is very strong and there is
no close substitute for tobacco.
6. Number of uses of the commodity
If a commodity can be put to several uses, its
demand will be elastic. This is because if the
price increases, the consumers will use it for
limited purpose and if its price falls, the
consumers will use it freely for all the
purposes.
Examples : electricity, Coal, steel, aluminium,
etc. If a commodity has only few uses, its
demand will be inelastic
7. Postponement of the use of Commodity
If we can postpone the buying of some
commodities to a future date, such goods will
have elastic demand. For example TV,
refrigerator, car etc. can be postponed for
next session. The commodity the use of
which cannot be postponed will have
relatively less elastic (or inelastic) demand.
Examples: Medicines, food grains etc.
8. Demand of complementary goods :
Demand of complementary goods depends upon
the demand of main product. If the demand of
main product is elastic, the demand of
complementary goods also will be elastic (e.g., car
and petrol). If the demand of main product is
inelastic the demand of complementary goods
also will be inelastic (e.g., pen and ink).
9. Distribution of income and wealth in the
society
If there is unequal distribution of income and
wealth in a society, the demand of
commodities in general will be relatively
inelastic. If the distribution of income and
wealth in a society is equal, the demand of
commodities in general will be elastic.
10.Durability of the commodity :
If a commodity is durable and can be used for
a long time, the demand of such commodity
will be elastic. This is because the consumers
are likely to get such commodity repaired in
case of price rise (e.g., radio). If a commodity
cannot be used for a long time, its demand
will be relatively inelastic.
11.Range of prices :
If the price of a commodity is too high or too
low, its demand will be comparatively
inelastic.
 Practical Importance of the
Concept of Elasticity
1. Helpful in price determination
The price of a commodity is determined by
studying the effect of change in the price on
its demand. A knowledge of elasticity of
demand will help the manufacturer to take a
decision whether to increase or decrease the
price of the product to earn maximum sales
and profit.
2. Importance to a monopolist
To earn maximum profit and sales revenue, a
monopolist has to consider the effect of price
on the demand of his product. For this he
takes the help of the concept of elasticity of
demand and determines the price. He will fix
a higher price only when the demand is
inelastic. If the demand is elastic, he will fix
comparatively a lower price.
• 3. Helpful in price discrimination
Price discrimination simply means charging
different prices from different customers or
different markets. This is possible only if the
elasticity of demand is different among the
groups of consumers or in the market. A
manufacturer can fix a higher price of his
product for the markets or consumers with
inelastic demand. He will fix lower price for
the same product for the markets and
consumers with elastic demand.
• 5. Helpful in the determination of prices of
factors of production :
Rewards (price) of each factor of production
like land, labour, capital etc. is determined on
the basis of elasticity of demand. If a
production factor (e.g., labour) has inelastic
demand, it gets a higher price (wages). On the
other hand, the factor with elastic demand
always gets low price.
.
6. Price determination in case of joint supply:
The price determination of joint products
becomes a little difficult due to joint cost of
production (e.g., wool and mutton). In such
cases the concept of price elasticity of
demand comes to the help of businessmen. If
the demand for wool is inelastic as compared
to the demand for mutton, a high price for
wool is charged
7. Importance in international trade
The concept of elasticity has great importance
in international trade. It helps the govt. in
determining the terms of international trade.
If a country imports goods having elastic
demand and exports goods having inelastic
demand, it will get benefits from the
international trade. Further, the concept of a
elasticity of demand is useful to the
government in fixing an appropriate foreign
exchange rate for its domestic currency in
relation to the foreign currencies.
• 8. Helpful to government
The concept of elasticity helps the government
in formulating taxation policy. Government
can impose higher tax on commodities having
inelastic demand (e.g. petroleum products,
medicines etc.). On the other hand, the govt.
can levy low tax for the commodities having
elastic demand. Take over of public utility
services is also determined by govt. with the
help of the concept of elasticity of demand.
9. Explanation of the paradox of poverty of
farmers
The income of farmers may be lower in a year
of good harvest because of the sudden fall of
price of their produce. But their incomes may
be higher in a year of poor harvest. This is
called paradox of poverty. It is commonly said
that a good harvest brings poverty to the
farmer. The demand for most agricultural
products is inelastic. The concept of elasticity
of demand explains the paradox of poverty.
4. Demand forecasting
This concept is of great significance in demand
forecasting because it explains the change in
demand with change in income in future. So
the demand and supply balance can be made
on the basis of demand forecasting and
shortage and over supply can be avoided.
 Demand Forecasting
Forecasting simply refers to estimating or
anticipating future events. It is an attempt to
foresee the future by examining the past.
Demand forecasting means estimating or
anticipating future demand on the basis of
past data.
According to Evan J. Douglas, “Demand
forecasting is the process of finding values for
demand in future time periods”.
Objectives of Demand Forecasting
A. Short Term Objectives
1. To help in preparing suitable sales and production policies.
2. To help in ensuring a regular supply of raw materials .
3. To reduce the cost of purchase and avoid unnecessary purchase.
4. To ensure best utilisation of machines.
5. To make arrangements for skilled and unskilled workers so that suitable
labour force may be maintained.
6. To help in the determination of a suitable price policy.
7. To determine financial requirements.
8. To determine separate sales targets for all the sales territories.
9. To eliminate the problem of under or over production.
 B. Long term Objectives

1. To plan long term production.

2. To plan plant capacity.
3. To estimate the requirements of workers for long period and
make arrangements.
4. To determine an appropriate dividend policy.
5. To help the proper capital budgeting .
6. To plan long term financial requirements.
7. To forecast the future problems of material supplies and
energy crisis.
 Role and Importance of Demand
Forecasting
1. It enables a firm to produce the required quantities at the right time and
arrange well in advance for the factors of production. This helps to avoid
the possibilities of over production and under production.
2. It helps in formulating an appropriate pricing policy because the price is
determined on the basis of expected demand.
3. It helps in discovering new marketing opportunities.
4. It is the base for marketing planning. Without the knowledge of future
expected demand, it is not possible to prepare correct marketing
programme.
5. It reduces the business risks.
6. It helps in reducing the cost of purchasing and inventory.
• 7. It helps in financial planning to avoid under-capitalisation and
over-capitalisation.
8. It helps management in arranging the required
labour force.
9. It is the foundation for budgeting.
10. It guarantees effective control.
11. It ensures a judicious allocation of resources of
the firm among its various activities.
12. Production planning is possible.
13. It determines the speed at which the company
can grow.
14. At the macro level, demand forecasting is of
great help to government and planning commission
for planning and allocation of the scarce resources of
the economy.
Limitations of Demand Forecasting

• 1. If the forecasters are inefficient and

inexperienced, forecasts prepared by them
may be wrong.
• 2. Demand of a product depends to a large
extent upon the needs, taste, fashion and
style etc. of consumers but all these are ever
changing. Thus it becomes very difficult to
forecast future demand.
3.Demand of a product depends to some extent
upon the psychology of consumers also. But it
is very difficult to study the psychology of
consumers correctly.
4.Successful forecast can be made only after
considering the plans of competitors. It is very
difficult to anticipate the plans of competitors.
5.We should remember that forecasting
produces only estimates. A certain amount of
error is always involved.
 Factors Affecting Demand
Forecasting
1. Prevailing business condition
This includes price level changes, change in national income, per capita
income, consumption pattern, savings and investment habits,
employment etc.
2.Conditions within the industry
While preparing demand forecasts for a particular business enterprise, it
becomes necessary to study the changes in the demand of the whole
industry, number of units within the industry, design and quality of
product, price policy, competition within the industry etc
3. Conditions within the firm
These factors include plant capacity of the firm, quality of the product,
price of the product, advertising and distribution policies, production
policies, financial policies
4. Factors affecting export trade
These factors include import and export
control, terms and conditions of export, exim
policy, export conditions, export finance etc.
5. Market behaviour
Trends in the market
6. Sociological conditionsThese conditions
relate to size of population, density, change
in age groups, size of family, family life cycle,
level of education, family income, social
awareness etc.
7.Psychological conditions
Factors like changes in consumer tastes,
habits, fashions, likes and dislikes, attitudes,
perception, life styles, cultural and religious
bents etc
8. Competitive conditions :
Competitors may enter into market or go out
of market. A demand forecast prepared
without considering the activities of
competitors may not be correct.
Process of Demand Forecasting or
Steps in Demand Forecasting
• 1. Setting the objective
• 2. Determining time period
• 3. Selecting a method of demand
forecasting
• 4. Collecting data
• 5. Estimating results
Methods of Demand Forecasting
(For Established Products)
• (A) Survey methods
• (a) Consumers’ interview
method(Consumers survey):
 Advantages (Merits)

• 1 It is a simple method because it is not

based on past record.
• 2 It suitable for industrial products.
• 3 The results are likely to be more
accurate.
• 4 This method is used for forecasting the
demand of new products and established
products
 Disadvantages (Demerits)

• 1 It is expensive and time consuming.

• 2 Consumers may not give their secrets or
buying plans.
• 3 This method is not suitable for long term
forecasting.
• 4 It is not suitable when the number of
consumers is large.
 (b) Collective opinion method
Under this method the salesmen estimate the
expected sales in their respective territories
on the basis of previous experience. Then
demand is estimated after combining the
individual forecasts (sales estimates) of the
salesmen. This method is also known as sales
force opinion method.
 Advantages (Merits)

• 1 This method is simple.

• 2 It is based on the first hand knowledge
of salesmen.
• 3 This method is particularly useful for
estimating demand of new products.
• 4 It utilises the specialised knowledge of
salesmen who are in close touch with the
prevailing market conditions.
 Disadvantages (Demerits)

• 1 The forecasts may not be reliable if the

salespeople are not trained.
• 2 It is not suitable for long period
estimation.
• 3 It is not flexible.
• 4 Salesmen may give lower estimates that
makes possible easy achievement of sales
quotas fixed for each salesman.
 (c) Experts' opinion method
• : This method was originally developed at
Rand Corporation in 1950 by Olaf Helmer,
Dalkey and Gordon. Under this method,
demand is estimated on the basis of opinions
of experts and distributors other than
salesmen and ordinary consumers. This
method is also known as Delphi method.
Delphi is the ancient Greek temple where
people come and pray for information about
their future.
 Advantages (Merits)

• 1 Forecast can be made quickly and

economically.
• 2 This is a reliable method because it uses
the collective knowledge of experts.
• 3 The firm need not spare its time on
preparing estimates of demand.
• 4 This method is suitable for both new
products and established products.
 Disadvantages (Demerits)

• 1 This method is expensive.

• 2 This method sometimes lacks reliability.
• 3. Experts may commit mistakes.
 (d) Consumer clinics
• : In this method some selected buyers are
given certain amounts of money and asked to
buy the products. Then the prices are changed
and the consumers are asked to make fresh
purchases with the given money. In this way
the consumers’ responses to price changes are
observed. Thus the behaviour of the
consumers is studied. On this basis demand is
estimated. This method is an improvement
over consumers interview method.
• Merits
• 1. It provides an opportunity to study the
behaviour of consumers directly.
• 2. It provides reliable and realistic picture
about future demand.
• 3. It gives useful information to aid in the
decision making process.
•
• Demerits
• 1. It is a time consuming method.
• 2. Selecting the participants is very difficult.
• 3. It is expensive.
• 4. Consumers may take it as a game. They
may not reveal their preferences.
• (e) End use method: This method is based
on the fact that a product generally has
different uses. In the end use method, first a
list of end users (final consumers, individual
industries, exporters etc.) is prepared. Then
the future demand for the product is found
either directly from the end users or indirectly
by estimating their future growth. Then the
demand of all end users of the product is
added to get the total demand for the
• Merits
• 1. It provides sector-wise demand
forecasts.
• 2. It gives accurate predictions.
• 3. It does not require any historical data.
• Demerits
• 1. It is costly and time consuming.
• 2. It requires complex calculations.
• Statistical Methods
• Statistical methods use the past data as a
guide for knowing the level of future demand.
Statistical methods are generally used for long
run forecasting. These methods are used for
established products. Statistical methods
include : (i) Trend projection method, (ii)
Regression and Correlation, (iii) Extrapolation
method, (iv) Simultaneous equation method,
and (v) Barometric method
• (i) Trend projection
• Under the trend projection method demand is
estimated on the basis of analysis of past data.
This method makes use of time series (data
over a period of time). The trend in the time
series can be estimated by using any one of
the following four methods: (a) Least-square
method. (b) Free-hand method. (c) Moving
average method and (d) semi-average
method.
• Merits
• 1. It is very simple.
• 2. It yields good forecasts.
• 3. It is quick and inexpensive.
• 4. It is appropriate for long term forecasts.
• Demerits
• 1. It cannot explain the turning points of a
business cycle.
• 2. It is not appropriate for short term
forecasts.
• 3. It has limited value in actual business
forecasting
• (ii) Regression and Correlation: These
methods combine economic theory and
statistical technique of estimation. Under
these methods the relationship between the
sales (dependent variable)and other variables
(independent variables such as price of related
goods, income, advertisement etc.) is
ascertained. Such relationship established on
the basis of past data may be used to analyse
the future trend. The regression and
• Merits
• 1. It gives accurate result.
• 2. It is prescriptive as well as descriptive.
• 3. It is quite consistent.
• 4. It not only forecasts the directions but
also the magnitude of the change
• Demerits
• 1. It is costly and time consuming.
• 2. It involves complicated calculations.
• 3. It requires too much statistical data.
• Barometric technique : This is an
improvement over the trend projection
method. This method is based on the idea that
future can be predicted from certain
happenings in the present. Here certain
economic and statistical indicators from the
selected time series are used to predict
variables. Personal income, non-agricultural
placements, gross national income, prices of
industrial materials, wholesale commodity
• Merits
• 1. It is simple.
• 2. It can be used even in the absence of
past data.
• 3. It is an accurate method.
• Demerits
• 1. It can be used for short term forecast
only.
• 2. It cannot be used in case of new
products.
• 3. It is not always possible to get an
appropriate economic indicator to predict the
demand trend
• (iv) Extrapolation: Under this statistical
method, the future demand can be
extrapolated by applying Binomial expansion
method. This method is used on the
assumption that the rate of change in demand
in the past has been uniform.
• (v) Simultaneous equation method : This
involves the development of a complete
econometric model which can explain the
behaviour of all the variables which the
company can control. This method is not very
popular.
• Methods of Demand Forecasting for New
Products
• Demand forecasting of new product is more
difficult than forecasting for existing product.
The reason is that the product is not available.
Hence, no historical data are available. Thus it
is very difficult to forecast the demand for
new products. However, Prof. Joel Dean has
suggested the following methods for
forecasting demand of new products:
• 1. Evolutionary approach :
• 2. Substitute approach
• 3. Growth curve approach
• 4. Opinion poll approach
• 5. Sales Experience approach
• 6. Vicarious approach :
 Criteria of a Good Forecasting
Method
• 1. Plausibility: Plausibility simply means
reasonable or believable. The business
executives should have confidence in the
method.
• 2. Simplicity: The method should be simple
and easy.
• 3. Economy: The method should give good
result. At the same time, it should be less
costly.
• 4. Accuracy: The method should be as
 Production Function

Production is the process by which inputs are transformed into

outputs. A function represents a relationship between two
variables. The functional relationship between input and
output is known as production function.
According to Citowiski, “Production of a firm is the function of
factors of production. If it is presented mathematically, it is
called production function”. The production function states
the maximum quantity of output which can be produced from
any selected combination of inputs. In other words, it states
the minimum quantities of input that are necessary to
produce a given quantity of output.
The production function can be expressed in an
equation in which the output is the dependent
variable and inputs are the independent variables.
The equation is as follows:
Q = f (L, K, T.....n)
Where, Q = output
L = labour
K = capital
T = level of technology
n = other inputs employed in
production.
Production function can also be represented by
a table or graph.
There are two types of production function -
Short run production function and long run
production function. In the short run
production function the quantity of only one
input varies while all other inputs remain
constant. In the long run production function
all inputs are variable.
The production function is largely determined
by the level of technology. The production
function varies with the changes in
technology. Whenever technology improves,
a new production function comes into
existence. Therefore, in the modern times the
output depends not only on traditional factors
of production but also on the level of
technology.
Assumptions of Production Function
The production function is based on the
following assumptions.
1.The level of technology remains constant.
2.The firm uses its inputs at maximum level of
efficiency.
3.It relates to a particular unit of time.
4.A change in any of the variable factors
produce a corresponding change in the
output.
5.The inputs are divisible into most viable units.
 Managerial Uses of Production
Function
1. It helps to determine least cost factor combination
The production function is a guide to the entrepreneur to
determine the least cost factor combination. Profit can be
maximized only by minimizing the cost of production. In
order to minimize the cost of production, inputs are to be
substituted. The production function helps in substituting the
inputs.
2. It helps to determine optimum level of output
The production function helps to determine the optimum level of output
from a given quantity of input. In other words, it helps to arrive at the
producer’s equilibrium
3. It enables to plan the production
The production function helps the entrepreneur (or
management) to plan the production.
4. It helps in decision-making
Production function is very useful to the
management to take decisions regarding cost
and output. It also helps in cost control and
cost reduction. In short, production function
helps both in the short run and long run
decision-making process.
Cobb Douglas Production Function

Paul H. Douglas and C.W Cobb of the U.S.A

have studied the production of the American
manufacturing industries and they formulated
a statistical production function. It is
popularly known as Cobb-Douglas Production
Function. Cobb Douglas Production Function
refers to the production function in which one
input can be substituted by other but to a
limited extent. It is stated as follows:
 Q = K La C(1- a)
where, Q = output
L = quantity of labour
C = quantity of capital
K and a = positive constants
In this production function the output (Q) is a function of two
inputs L and C.
According to Cobb-Douglas production function, about 3/4 of
the increase in output is due to labour and the remaining 1/4
is due to capital. On this basis, Cobb-Douglas production
function can be expressed as under :
Q = KL3/4 C1/4 L + C = 3/4 + 1/4 = 1
• An important point in Cobb-Douglas
production function is that it indicates
constant returns to scale. It means that if
each input factor is increased by one percent,
output will exactly increase by one percent. In
other words, there will be no economies or
diseconomies of scale.
• Although the Cobb-Douglas production
function is non-linear, it can be transformed
into a linear function by converting all
variables into logarithms. That is why this
function is known as a log linear function.
 Importance of Cobb-Douglas
Production Function
Cobb- Douglas production function has the
following merits
1.It is the most commonly used production
function in the field of econometrics.
2.It is suitable to all industries.
3.It is useful in international and inter- industry
comparisons.
4.It is more popular in empirical research.
5.It useful in interpreting the macroeconomic
results.
 Limitations of Cobb- Douglas
Production Function
• C-D production function has the following limitations:
• 1. It includes only two factors (inputs). It neglects other
inputs.
• 2. It assumes constant returns to scale. This is not
correct.
• 3. It assumes perfect competition in the factor market.
This is unrealistic.
• 4. There is the problem of measurement of capital which
takes only the quantity of capital available for production.
• 5. It is based on the substitutability of factors. It
neglects complementarily of factors.
 Laws of Production
Production function shows the relationship
between input and output.
The laws of production shows the relationship
between additional input and additional
output.
The laws of production consist of –
(1) Law of Diminishing Returns (to analyse
production in the short period), and
(2) Laws of Returns to Scale (to analyse
production in the long period).
In the short run, output can be increased by
using more of the variable factor (s), while
fixed factors are kept constant. This refers to
the law of variable proportion.
In the long run, output can be increased by
changing all factors of production. This is
because all the factors of production are
variable in the long run. This refers to the
laws of returns to scale.
Law of Diminishing Returns or Law
of Variable Proportion
• The law of variable proportion is the modern
approach to the 'Law of Diminishing Returns
(or The Laws of Returns).
• This law was first explained by Sir. Edward
West (French economist). Adam Smith,
Ricardo and Malthus (Classical economists)
associated this law with agriculture.
• The law of variable proportion shows the
input-output relationship or production
function with one input factor variable while
keeping the other input factors constant.
• The law of variable proportion states that, if
one factor is used more and more (variable),
keeping the other factors constant, the total
output will increase at an increasing rate in
the beginning and then at a diminishing rate
and eventually decreases absolutely.
• According to K. E. Boulding,
"As we increase the quantity of
any one input which is combined
with a fixed quantity of the other
inputs, the marginal physical
productivity of the variable input
must eventually decline".
Total Product or Total Physical Product (TPP)
This is the quantity of output a firm obtains in total
from a given quantity of input.
Average Product or Average Physical Product (APP)
This is the total physical product (TPP) divided by the
quantity of input.
Marginal Product or Marginal Physical Product (MPP)
It is the increase in total output that results from a one
unit increase in the input, keeping all other inputs
constant. In other words, it is the extra output
produced by using an additional unit of input while
other inputs are held constant.
 Stage I
Total product increases at an increasing rate
and this continues till the end of this stage.
Average product also increases and reaches its
highest point at the end of this stage.
Marginal product increases at an increasing
rate. Thus TP, AP and MP - all are increasing.
Hence this stage is known as stage of
increasing return.
 Stage II
Total product continues to increase but at a
diminishing rate until it reaches its maximum
point at the end of this stage. Both AP and MP
diminish, but are positive. At the end of the
second stage, MP becomes zero. MP is zero
when the TP is at the maximum. AP shows a
steady decline throughout this stage. As both
AP and MP decline, this stage is known as
stage of diminishing return.
 Stage III

In this stage the TP declines. AP shows a

steady decline, but never becomes zero. MP
becomes negative. It goes below the X axis.
Hence, the third stage is known as stage of
negative return.
 Assumptions of the Law of
diminishing retuns

1. The Production technology remains unchanged.

If there is an improvement in the technology, due
to inventions, the average and marginal product will
increase instead of decreasing.
2. Only one input factor is variable and other factors are
kept constant.
3. All the units of the variable factor are homogeneous.
If the next additional unit applied is bigger in size,the
output obtained may increase
4. It is possible to change the factor
proportions.
5. Factors of production are scarce.
6. The law operates in the short run.
7. The fixed factor is indivisible
The capacity of fixed factors cannot be
divvied and used for some other production
 Causes for the operation of the
law of diminishing returns
Why does the Law of Variable Proportions
Operate ?
1. Imperfect substitutes
There is a limit to the extent to which one
factor can be substituted for another. In
other words, two factors are not perfect
substitutes. For example, in the construction
of building, capital cannot substitute labour
fully.
2. Scarcity of the factors of production
Output can be increased only by
increasing the variable factors. In the short
run certain input factors like land and capital
are scarce. This leads to diminishing marginal
productivity of the variable factors.
3. Economies and diseconomies of scale
The internal and external economies of large scale
production are available as production is expanded.
Therefore, average cost goes on diminishing. But this
continues only up to a certain stage. When the production is
expanded beyond a level, diseconomies will start entering
into production. Hence the output will come down (or cost
will go up).
 Economies of scale
1.INTERNAL ECONOMIES
1.Technical economies
2.Labour economies
3.Managerial economies
4.Marketing economies
5.Economies in Transport and storage
6.Financial economies
7.Risk bearing economies
8.Welfare economies
 External Economies
1.Development of infrastructure
2. Better power supply
3. Centres for service and repairs
4.Advanced banking facilities
5.Establishment of technical institutions and
training centres
6.Advanced high –tech banking facilities
DISECONOMIES
INTERNAL
Scarcity of some factors of production
Wide management
Technical difficulties
EXTERNAL
Transportation Cost
Accommodation Cost
Labour Cost
Raw material cost
 4. Specialisation
The stage of diminishing returns comes
into operation when the limit to maximum
degree of specialisation reaches. This stage
emerges when the fixed factor becomes more
and more scarce in relation to the variable
factor thereby giving less and less support to
the latter. As a result, the efficiency and
productivity of the variable factors diminish.
 Laws of Returns to Scale
Law of returns to scale is a long run analysis
In the long period, output can be increased by
increasing all the input factors
The law of returns to scale is concerned, not
with the proportions between the factors of
production, but with the scale of production
The term return to scale means the changes in
output as all factors change in the same
proportion
• According to Prof. Roger Miller,
“Returns to scale refer to the relationship
between changes in output and proportionate
changes in all factors of production”.
The law of returns to scale seeks to analyse the
effects of scale on the level of output.
 Assumptions of the Laws of
Returns to Scale

1.All input factors are variable.

2.There are no technological changes.
3.There is perfect competition.
4.The output is measured in quantities.
5. A worker works with given tools and
implements.
 Stages of Returns to Scale

Increasing Returns to Scale

When inputs are increased in a given
proportion and output increases in a greater
proportion, the returns to scale are said to be
increasing.
In other words, proportionate increase in all
factors of production results in a more than
proportionate increase in output, it is a case of
increasing returns to scale.
 Constant Returns to Scale

When inputs are increased in a given proportion and output

increases in the same proportion, constant return to scale is
said to prevail.
In case of constant returns to scale the average output
remains constant. Constant returns to scale operate when the
economies of the large scale production balance with the
diseconomies.
 Decreasing Returns to Scale

If the firm continues to expand beyond the stage of constant

returns, the stage of diminishing returns to scale will start
operate. A proportionate increase in all inputs results in less
than proportionate increase in output, the returns to scale is
said to be decreasing.
Thus, according to the laws of returns to scale, when all
input factors are increased, total output generally increases at
an increasing rate, later at a constant rate and finally at a
diminishing rate. The three stages are not three different laws
of returns to scale, but three aspects of one and the same law.
 Production Function with Two
Variable Inputs
Isoquants
A production function with two variable inputs can be
represented by isoquants The term ‘iso- quant’ has been
derived from the Greek word ‘ iso’ (means equal) and Latin
word ‘quantus’ (means quantity). Thus isoquant means equal
quantity or equal product. Isoquants are the curves which
represent the different combinations of inputs producing a
particular quantity of output. Any point on the isoquant
represents or yields the same level of output. Thus isoquant
shows all possible combinations of the two inputs (say labour
and capital) capable of producing equal or a given level of
output. Isoquants are also known as iso product curves or
equal product curves or production indifferent curves.
 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.
• 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.
• Equal product map is also known as equal product
contours
 Assumptions of Iso-quants

1.There are only two inputs.

2.The two inputs can be substituted for each
other. If quantity of labour is reduced, the
quantity of capital must be increased to
produce the same output.
3.Technology remains constant.
4. The shape of the iso-quant depends upon the
extent of substitutability of the two inputs.
Properties or Features of Isoquant

1. Isoquant is downward sloping to the right. This means that if more of one
factor is used less of the other is needed for producing the same output.
2. A higher isoquant represents larger output.
3. No isoquants intersect or touch each other. If so it will mean that there
will not be a common point on the two curves. This further means that
same amount of labour and capital can produce the two levels of output
which is meaningless.
4. Isoquants need not be parallel to each other. It so happens because the
rate of substitution in different isoquant schedules need not necessarily
be equal.
• 5. Isoquant is convex to the origin. This implies that the slope of the
isoquant diminishes from left to right along the curve. This is because of
the operation of the principle of diminishing marginal rate of technical
substitution.
• 6. No isoquant can touch either axis. If an isoquant touches X axis
then it would mean that without using any labour the firm can produce
output with the help of capital alone. But this is wrong because the firm
can produce nothing with units of capital alone. If an isoquant touches Y
axis, it would mean that without using any capital the firm can produce
output with the help of labour alone. This is impossible. So isoquant as
shown in will never exist.
• 7 Isoquants have negative slope. This is so because when the
quantity of one factor (labour) is increased the quantity of the other factor
(capital) must be reduced, so that total output remains the same. If the
marginal productivity of the factor becomes zero the isoquant will bend
back and it will have positive slope.
 Isocost Curve

In order to select the optimum quantity of two

inputs; the firm has to consider their
quantities and their prices. Factors of
production are available at a price. Therefore,
their prices and amount of money which the
firm wants to spend has to be taken into
consideration. Isocost line represents these
two things.
 An isocost line indicates the different combination of the two
factors which the firm can buy at given prices with a given
amount of money. It shows all the combinations of labour
and capital that the firm can purchase with a given outlay and
at given prices. Thus isocost shows the prices of the two
factors and the total amount of money to spend. To make it
more clear, let us take an example. Suppose a firm decides to
spend Rs.5000 on two factors - capital and labour. If the
weekly wage of a worker is Rs.50, the firm can employ 100
workers. Similarly if one unit of capital costs Rs.20, the firm
buy 250 units of capital. Thus the firm can spend the whole
amount of Rs.5000 either on labour (100 workers) or on
capital (250 units) or partly on labour and partly on capital.
•
The slope of the isocost line is determined by
the firm's outlay and the price of two factors.
If the price of any one of the factors changes,
there would be a corresponding change in the
slope of the isocost line. If the firm wants to
spend more amount there will be a parallel
upward shift in the isocost line. If it wants to
spend less, there will be a parallel downward
shift in the isocost line.
Optimum Input Combination (Least cost combination
or Producer's Equilibrium

The isoquant shows different combinations of two factors

producing the same level of output. However, the producer
will not accept all combinations. He wants to maximise his
profit. Profit can be maximised only by maximising the output
at minimum cost. Therefore, he will select the optimum input
combination which involves the least cost. Optimum input
combination or least cost combination is that combination
which produces maximum output at the minimum cost. In
other words, the optimum or least cost combination is that
combination where the average cost of production is the
minimum. This is the producer's equilibrium.
The principle of least cost combination is based on the
following assumptions:
• 1. Capital and labour are the two factors involved
in production.
• 2. All the units of both the factors are
homogeneous.
• 3. The prices of the input factors are given.
• 4. The total money outlay is also given.
• 5. There is perfect competition in the factor
market.
Selection of the Optimum or Least
Cost Combination
This can be found out by combining the firm's
production function and cost function. The
production function is represented by
isoquant and cost function is represented by
isocost curve.
The optimum or least cost combination
(producer's equilibrium) can be found out
with the help of isoquants and isocost lines. A
firm's equilibrium will be attained at a point
where the isoquant touches the isocost line.
 Business Cycle

• In a modern dynamic economy, many fluctuations occur in business and

other economic activities. The dynamic forces operating in the economy
are responsible for this. These economic fluctuations may be classified
into four (a) secular trend, (b) seasonal fluctuation, (c) cyclical fluctuation,
and (d) random fluctuation. Among all these fluctuations, cyclical
fluctuations have attracted greater attention of the economists.
Cyclical fluctuations create significant disturbances in the functioning
of an economy and their causes are not easily perceived. Theses cyclical
fluctuations are called business cycles. The British economists use the
term 'trade cycle' while the American economists prefer to use the tern
'business cycle'. Some economists like M.W. Lee prefer to use the term
'economic cycle'. John Wage called business cycles by the term
‘commercial cycles’ in 1833.
A business cycle refers to regular fluctuations
in economic activities in the economy as a
whole.
They are wavelike fluctuations in aggregate
economic activity particularly in national
income, employment and output.
A business cycle is a period of up and down
movement in aggregate measures of current
economic output and income.
According to Wesly C Mitchell (a noted
American authority on business cycles),
"business cycles are a species of fluctuations
in the economic activities of organised
communities".
In the words of Prof. Estey, “Cyclical fluctuations
are characterized by alternating waves of
expansion and contraction. They do not have a
fixed rhythm, but they are cyclical in the
phases of contraction and expansion, recur
frequently and in fairly similar pattern.”
 Characteristics of Business Cycles

• 1. A business cycle is a wave-like

movement. I
• 2. Trade cycles are repetitive and rhythmic.
The period of prosperity is followed by
depression and which again is followed by a
period of prosperity. Thus the economy moves
from one extreme to another, almost like a
pendulam.
• 3. A business cycle is an economy wide phenomenon. To start with,
it may set in industrial sector. But once having started, it soon spreads to
other sectors of the economy like agriculture, trade and transport etc.
• 4. Business cycles are self-reinforcing. Once the cyclical movement
starts in any one direction (either prosperity or depression), it tends to
feed on itself.
• 5. The business cycles differ in time. While some last for 2 to 4
years, others last for 8 to 10 years or even more. While the upward swing
in some cycles is longer than the downward swing, the reverse is the case
in some others.
• 6. In business cycles prices and production generally rise or fall
together.
• 7. The business cycles are more marked in capital goods industries
than in consumer goods industries.
• 8. Prof. Samuelson observes that "No two business cycles are quite
the same yet they are recognisable as belonging to the same family".
 Types of Business Cycle

1. Major and Minor Trade Cycles:

Major trade cycles are those the period of which is very large.
Minor trade cycles are the cycles which occur during the period
of a major cycle.
Prof. Hanson determines the period of a major cycle between 8
years and 33 years. Two or three minor cycles occur during
the period of a major cycle. Period of a minor cycle is 40
months.
• 2. Building Cycles: Building cycles are the trade cycles
which are related with construction industry. Period of such
cycles range from 15 to 20 years.
• 3. Long Waves: Period of a long wave is of 50 years. It
was discovered by a Russian economist Kondratief. One or
two major trade cycles occur during the period of a long
wave.
• 4. Short Kitchin Cycle: The period of this cycles is very
short, approximately 4 months duration.
• 5. Longer juglar cycle: This cycle has an average 9.5
years duration.
• 6. Very long Kondratief wave: It takes more than 50
years to run its course.
 Phases or Stages of a Business
Cycle
A business cycle passes through certain well defined phases.
Broadly, there are 2 phases - upward or expansion phase and
the downward or contraction phase. The expansion phase
extends from trough to peak while the contraction phase
covers the length from peak to trough. But in these two main
phases there are four or even five sub-phases. Generally, a
business cycle is divided into 5 well-defined and
interconnected recurring phases as follows:
 1. Depression
Depression is a situation of severely falling prices and lowest
level of economic activities.
The remarkable features of depression are : (a) The price level
is very low, (b) The volume of production and trade is falling,
(c) Unemployment is very high, (d) The firms are incurring
losses, (e) Interest, wages and rent are all falling, (f) Aggregate
expenditure and effective demand go on declining, (g) Bank
credit contracts, (h) There is little or no opportunity to invest,
(i) Stock market is dull and stock prices are falling to a low
level, (j) Construction activity comes to a complete stand still,
(k) The consumer goods industries are least affected, while
capital goods industries come to a complete stand-still.
 2. Revival or Recovery:
Depression cannot last long for ever. It gives
place to revival or recovery. After the lowest
point of depression is reached the economic
situations begin to improve. There is revival of
business and economic activity. Revival of
business activity first appears in the capital
goods industries.
An increase in demand for capital goods leads to
an increase in investment and employment in
these industries. Increase in employment
leads to rise in income. Increase incomes push
up the demand for goods and services. A rise
in their demand leads to a rise in their prices
and profits, further investment, further
production and higher income and savings.
Thus once investment expansion movement
starts, it gathers momentum.
•
 The striking features of revival phase are;
(a) The level of prices, production, employment
and income slowly and steadily rises
(b) The stock market becomes more sensitive
(c) The profit margin slowly rises
(d) Bank loans and demand for credit start
increasing
(e) With the recovery in industrial sector, the
agricultural sector of the economy also
recovers
(f) Increased business and factor income result
in increased expenditure which causes further
increase in income and business activity.
This, in turn, results in further increased
expenditure and so on.
Thus during recovery, the expectations of the
businessmen will improve and optimism
develops in the business community.
Optimism and increased economic activities lead
to prosperity. During this stage the economy is
fully recovered and reaches at an optimum
level. Now there is alround stability of output,
wages, prices, income etc. All the factors of
production are fully employed. Prosperity is
characterized by high capital investment,
expansion of bank credit, high prices, high
wages, high profits and a high rate of
formation of new business enterprises.
• Special features of prosperity phase are : (a)
There is a high level of output and trade; (b)
3. Full Employment or Prosperity
Phase:
Optimism and increased economic activities
lead to prosperity. During this stage the
economy is fully recovered and reaches at an
optimum level. Now there is alround stability
of output, wages, prices, income etc. All the
factors of production are fully employed.
Prosperity is characterized by high capital
investment, expansion of bank credit, high
prices, high wages, high profits and a high rate
of formation of new business enterprises.
Special features of prosperity phase are
(a) There is a high level of output and trade; (b)
There is a high level of effective demand, (c)
There is a high level of employment and
income;
(d) Wages, interest and profits are high
(e) There is a large expansion of bank credit
(f) Business failures are very few
(g) There is heavy investment in durable capital
goods industries. Thus there is a feeling of
optimism in the whole economy and business
confidence is at its highest.
 4. Boom or Overfull Employment
• Boom is the peak point of Busines cycle. Business optimism
stimulate further investment.
• Rise in investment increases pressure on available men and
materials.
• wages and prices rise.
• Number of jobs exceed the number of workers available in the
market.
• This situation is called overfull employment.
• Prices, wages, interest and profit move in the upward
direction. Business people borrow more and invest it.
• This adds fuel to the fire.
• The tempo of boom reaches new heights.
• There is an atmosphere of over optimism all round.
• Important characteristics of recession are:
• (a) There is a downfall in the activities of stock exchanges;
• (b) Failure of some business creates panic among
businessmen,
• (c) No new ventures are taken up,
• (d) Banks curtail credit,
• (e) Business expansion stops,
• (f) Workers are laid off, (g) There is unemployment in the
economy, (h) Income, expenditure, prices, profits, industrial
and trade activities all fall. Thus recession is a period of utter
confusion and chaos. Once the recession starts in the
economy, it gathers momentum till it reaches its final stage of
business cycle i.e depression. Thus, in brief, recession is the
intervening phase between the boom and depression. As
already observed, depression is the period of utmost suffering
for businessmen
5. Recession :
Where boom ends recession starts. The over
optimism of boom gives way to
overpessimism, i.e., recession. Recession is a
turn from boom to depression. It is generally
for short period. Recession is a period of
declining economic activities. The recession is
first reflected in a stock market. During this
period businessmen lose their confidence.
The failure of some business houses
discourages fresh investments. Bank loans
are withdrawn. There is sharp contraction in
bank credit. Due to decline in production,
 Hicks Theory
• Prof. J.R. Hicks has developed a new theory of
business cycle.
• This is also known as the modern theory of
business cycle.
• This theory is based on the principles of
multiplier and accelerator.
According to Hicks, "Main cause of cyclical
fluctuations is the combined result of
multiplier process and accelerator effects".
According to him, investment is of two types –
1. Autonomous investment and
2. Induced investment.
Autonomous investments are the investments
which are not affected by the changes of income or
demand. These investments continue to grow on
their own.
On the other hand, induced investments are the
investments which are affected by the changes of
income, or demand or production etc. The force of
autonomous investment is expressed in multiplier,
while the force of induced investment is expressed
in accelerator.
 PRICING
The firm’s costs determine its supply. Supply
along with demand determines price. Price
determines the firm’s revenue. Both cost and
revenue determines the firm’s profit. Hence, it
is essential to understand the nature of cost
and the nature of revenue.
 Price Theory

Price theory is the keystone of economic

theory. It is the central part of the study of
economics. It is otherwise known as theory of
value. Simply put, price theory tells how the
price of a commodity or service is determined
in different market situations. It includes the
study of various factors determining the price.
 Price Mechanism (Market
Mechanism)
Price mechanism is the instrument of decision-
making in a capitalist, or a free market economy.
Price mechanism refers to the free operation of the
market forces of demand and supply. It is the process
of price determination by the interaction of free
market forces of demand and supply. Demand and
supply of a commodity determine its equilibrium
price. Any change in demand or supply or a
simultaneous change in demand or supply leads to a
change in equilibrium price.
 Components of Price Mechanism

There are three components of price

mechanism.
(a) principle of demand
(b) principle of supply, and
(c) equilibrium price.
The principle of demand states that there is an
inverse relation between price and demand.
The principle of supply states that there is a
direct relation between price and supply. This
means when the price increases supply also
increases and when the price decreases
supply also decreases. Equilibrium price is the
price at which demand and supply of a
commodity are equal.
It is determined at the point of interaction
between demand and supply. In other words,
equilibrium price is determined where
demand and supply are equal. Thus prices are
determined by the free forces of demand and
supply.
 Market

In economics, market is defined as “an

arrangement by which buyers and sellers of a
commodity interact to determine its price and
quantity”. It is a mechanism through which
buyers and sellers communicate in order to
trade goods and services.
 Kinds of Market

According to nature of competition, markets

can be broadly classified into perfect
competitive market, monopoly market and
imperfect competitive market. Imperfect
competitive market is again classified into
monopolistic competitive market, oligopoly
and duopoly.
Meaning of Perfect Competition

Perfect competition means complete freedom

in economic life and absence of rivalry among
firms. Perfect competition is the market
situation in which there are a large number of
buyers and sellers of a homogeneous product
and the price of the product is determined by
the market forces. All sellers accept that price.
According to Bilas , “The perfect competition
is characterized by the presence of many
firms, they all sell identically the same
 Characteristics of Perfect Competition
(Assumptions or Conditions)

• Homogeneous Product
• Free entry and exit
• Perfect knowledge about the market
• Perfect mobility of factors of production
• Absence of transportation cost
• Absence of artificial restriction
• Large number of buyers and sellers
 Normal price, Market price and Reverse price

• Normal price: This is the price in the point

where there is a relatively permanent
equilibrium between demand and supply
• Market price: This is the price in the point
where there is a temporary equilibrium
between demand and supply
• Reverse price: It is that price below which
sellers are not prepared to sell
 Difference between Market Price
and Normal Price
Market Price Normal Price
1. It is a very short period price 1. It is a long period price.
2. It is influenced more by demand factors. 2. It is influenced more by supply
factors and cost of production.
3. All goods have a market price 3. Only reproducible goods alone have
a normal price.
4. A firm with a market price may earn 4. A firm with a normal price can earn
super normal profit or incur losses. only normal profit.
5. Market price is a reality. 5. Normal price is a mirage.
6. There will be a temporary equili- 6. There will be a permanent
equilibrium
brium between demand and supply. between demand and supply.
7. It fluctuates frequently (even daily) 7. It is relatively stable.
 MONOPOLY

Monopoly is a market situation in which there is only

one seller or producer of a product for which there is
no close substitute. He controls the whole supply of a
particular product. He has complete control over the
price also. He is a price maker. He tries to fix the price
that will maximise his profit. He is the firm. He
constitutes the industry also. Hence under monopoly,
there is no distinction between firm and industry. In
other words, the firm and industry are one and the
same.
 Features of Monopoly

1. One seller and a large number of buyers.

2. No close substitutes for the product
3. Fuller control over the supply of the commodity.
4. The monopolist fixes the price for the commodity. He
is the price maker and not price taker.
5. Other sellers or new firms cannot enter into the
market easily.
6. The firm and industry are one and the same.
• Cross elasticity of the demand for the
products of monopolist is zero
• No competing firms
• Monopolist is a price maker
 Kinds of Monopoly

• 1. Natural Monopoly : This is the outcome of natural factors and not due
to any man made efforts. For instance a firm may be owning a well which supplies
mineral water. Similarly, Bengal has the natural monopoly of jute. De Beers
company of South Africa has monopoly of diamonds.
• 2. Legal Monopoly : Some times the law of the country grants exclusive
rights to an individual or to a group of firms. All monopolies protected by the law
of the country are called legal monopolies.

• 3. Social monopolies : These are owned and managed by the government.

Their aim is not to make maximum profit. These are also known as public
monopolies. In India, railways, posts, telegraphs, etc. are public monopolies.
• 4. Voluntary monopolies : These are monopolies created voluntarily by the
person concerned or by the firms concerned. These are in the form of trusts,
cartels, holding companies, syndicates etc. For instance ACC is a voluntary
monopoly created to eliminate competition and to have greater profits by fixing a
high price of the cement.
5. Service monopoly: Monopoly may arise in service also. For
example, there is only one doctor in a locality. He is in the
position of a monopolist.
On the basis of price making, monopoly firms can be classified
into the following two types.
6. Simple monopoly : If the monopoly firm charges the same
price from all its customers, it is called simple monopoly.
7. Discriminating monopoly : If the monopoly firm charges
different prices from different groups of customers, it is called
discriminating monopoly.
 Arguments Against Monopoly
(Case Against Monopoly)
1. Monopoly Promotes inefficiency: Monopoly is often considered to be bad. The major
objection to monopoly is that it causes economic inefficiency. It leads to a lower output and
to higher prices than would exist under perfect competition.
2. Welfare loss in monopoly: In addition to the monopolist producing lower levels of output at
higher prices, the monopolist produces at an output where the price Pm (monopoly price) is
greater than MCm (Marginal cost of monopoly). This means the value of the last unit
produced by the monopolist (Pm) is greater than the cost (MCm). So from society’s point of
view the monopolist is producing too little output.
3. Monopoly results in concentration of economic power: Monopoly leads to concentration of
economic power because the monopolist controls substantial quantities of input and
outputs. Some think that the biggest itself is bad in a democratic society for reasons relating
to equity, justice and quality.
4. Monopoly retards innovation: It is also argued that lack of competition tends to retard
technological advance. The monopolist becomes comfortable, earning his monopolists profits
so he does not work hard for product improvement, advanced technology to promote
efficiency, etc.
5. Unfair practices: Monopolies tend to corrupt the body politic. Because of their strong
financial resources and powerful position they are able to bribe legislators and bring pressure
on them to pass such laws. as are favourable to them. They even bribe the judges to pass the
judgements in their own favour.
 Perfect Competition Monopoly
1. Many sellers 1. Single seller
2. Individual seller has no control over the 2. Complete control over the market supply
market supply
3. Product is homogeneous 3. Product has no close substitute
4. Entry is free and easy 4. Entry is blocked
5. Perfect competition 5. No competition
6. Uniform price 6. Different prices in discriminating monopoly
7. Industry is composed of all the firms 7. Firm itself is the industry.
producing homogeneous product.
8. Average revenue curve is parallel to 8. Average revenue curve slopes downwards
ox-axis from left to right
9. AR and MR are equal to each other 9. MR curve is always below AR curve
10. Seller can sell any quantity of output at 10. Seller can sell additional units only by
the prevailing price reducing the price
11. When the firms earn normal profits, 11. Monopoly firm is the industry which attains
industry attains equilibrium equilibrium either with abnormal profit
or abnormal loss
12. Firm earns abnormal profits only in the 12. Firm enjoys abnormal profits in short-run
short-run and long-run
13. Firm reaches equilibrium only when MC 13. Firm reaches equilibrium with increasing,
curve cuts MR curve from below decreasing or constant marginal cost curves.
14. Firm reaches equilibrium when its 14. Firm reaches equilibrium even with failling
average cost is minimum average cost curve
 PRICE DISCRIMINATION
Price discrimination is the act of selling the same product at
different prices to different buyers during the same period of
time.
In the words of Mrs. John Robinson "the act of selling the
same article, produced under single control at different prices
to different buyers is known as price discrimination".
By discriminating the prices, a monopolist can maximise
his profit. Price discrimination is merely an extension of
monopoly pricing.
 Types of Price Discrimination
1. Personal discrimination : When a monopolist charges different prices from different
customers for the same product or service, it is called personal discrimination. It may be on
the basis of income of customers. For example, doctors and lawyers may charge more fees
from the rich and less from the poor.
2. Local discrimination : The monopolist may charge a low price in one market (place) and a
high price in another market for the same commodity.
'Dumping' is the best example of local discrimination. In the case of dumping, the
monopolist sells his output at a lower price in a foreign market and at a higher price in the
domestic market.
3. Trade discrimination : Here the monopolist charges different prices for different uses.
Electricity board, for example, may charge higher prices for industrial use and a lower price
for domestic use. Such a discrimination is also known as use discrimination.
4. Time discrimination : Here the price of the same commodity differs at different times. For
example, telegraph and telephone rates during night are less than during day times.
5. Age discrimination: If discrimination is on the basis of age, it is called age discrimination. For
example, railways and transport companies charge half the rates for children below 12 years
of age.
6. Size discrimination: On the basis of the volume of transaction, different rates may be
charged. For example, price in the retail market is higher than prices in the wholesale market.
 Degrees of Price Discrimination

According to Prof. Pigou there are three degrees of price discrimination. They are as
follows:
1. Price discrimination of the first degree : When a monopolist charges different
prices from different persons for the same commodity or service, it is known as
price discrimination of the first degree. A doctor for example, charges different
fees from different patients for the same service. This is personal discrimination.
2. Price discrimination of the second degree : Here the monopolist divides the
buyers into different classes. The prices charged for each individual of a particular
class is that minimum price which any member of that class is prepared to pay.
Railways charges the fares in this way.
3. Price discrimination of the third degree : Under this kind of price discrimination,
the monopolist divides his customers into two or more classes or groups of
markets on the basis of elasticity of demand and charges different prices from
different markets. This is the most common type.
 When is Price Discrimination Possible (Factors leading to price
discrimination)

1. Direct services : In case where the sale of direct services are involved by
persons like doctors or lawyers, price discrimination becomes possible.
2. Personal preferences and prejudices : Consumers are ready to pay a
higher price for certain brands. Whenever consumers have preferences
and prejudices for particular brand of a commodity, price discrimination is
possible.
3. No-possibility of transfer between markets : When a commodity or
service cannot be transferred from one market to another, price
discrimination is possible.
4. Legal sanction : Discriminating prices are possible under a legal monopoly
sanctioned by law. For example Indian Railways charges different fares.
Similarly KSEB charges different rates for electricity.
5. Ignorance of buyers : A monopolist may charge different
prices when the customers are ignorant. If they have
knowledge of price discrimination, they will oppose it.
6. Locality : Price discrimination is made possible because of the
locality in which goods are sold.
7. Nature of Commodity : Different prices may be charged
depending upon the nature of the commodity handled. Price
discrimination can be adopted in respect of goods and
services of comforts and luxuries.
8. Irrational feelings of buyers : Some buyers may feel that
high-priced commodity is better than a low-priced
commodity. In this situation, price discrimination is possible.
 Dumping

Dumping is a special case of price discrimination.

Mrs. John Robinson has defined dumping as selling at a lower
price in an export market and at a high price at home.
This situation arises when a firm deals with export market
as well as domestic market. A monopolist enjoys monopoly in
the home market and faces perfect competition in the foreign
market. As a result, the monopolist will charge a higher price
in the home market and a lower price in the foreign market.
This type of price discrimination is called 'price dumping'.
Under price dumping the producer sells goods in the foreign
market at a low price to promote exports by taking advantage
of monopoly power enjoyed in the home market.
 MONOPOLISTIC COMPETITION

Both perfect competition and monopoly are purely

imaginary situations. Perfect competition is a myth
while monopoly is short lived.
In the real world we can see a combination of
monopoly and competition. This situation is
technically known as imperfect competition.
There are three forms of imperfect competition
1.monopolistic competition, 2.Oligopoly and 3.Duopoly.
 Meaning of Monopolistic
Competition
The term monopolistic competition was coined by Prof. E. H.
Chamberlin of America.
Monopolistic competition refers to a market situation in
which competition is imperfect. It is a market structure in
which relatively many firms supply a similar but
differentiated product, with each firm having a limited degree
of control over price.
Prof. A.L. Meyers defined monopolistic competition as “A
situation where there may be many sellers, but with
differentiated products, so that competition is no longer on
price basis”.
 Features of Monopolistic
Competition

1. Large number of producers : Under monopolistic

competition, there are a large number of sellers or firms (25,
40, 50 or 70). But this number is not so large as under perfect
competition.
2. Product differentiation : The products of different firms are
differentiated on the basis of brands. For example, there are a large
number of tooth pastes produced by different producers under different
brand names like Colgate, Promise, Pepsodent, Close up, Cibaca,
Forehance etc. Differentiation is done by using different brand names,
trade marks, packing, colour, design etc. Due to product differentiation
different producers sell their products at different prices. Thus each firm
fixes its own output and its own price.
3. Free entry and exit of firms : New firms are free to enter into
markets and old firms are free to go out of market.
4. Important role of selling costs: Under monopolistic
competition advertisement and selling costs play an
important role. Firms will have to spend large amount on
advertisement and sales promotion to promote sales and
profit.
5. No combination of all firms: Under monopolistic
competition, though there are several firms competing with
one another in selling the differentiated products, these firms
do not come together into a combination in the form of
industry. Chamberlin used the term "Group" to denote the
collection of firms producing unidentical but close substitute
products. For example, all firms producing soap constitute
'soap group' instead of 'soap industry'.
6. More elastic demand: Due to product differentiation, the firm enjoys
some monopoly power and therefore demand curve will be more elastic
and thus downward sloping. But it is less steep as compared to that of
monopoly firm.
7. Non price competition: Under monopolistic competition, the competition
is generally non-price competition. Different producers sell their products
at different prices but they compete with each other on the basis of
quality, colour, packing, design etc.
8. Lack of perfect knowledge of the market: There are innumerable
products each being a close substitute of the other. The result is that the
buyers do not know about all these products, their quantities and prices.
 Wastes of Monopolistic
Competition (Evils)

1. Unused capacity: Under monopolistic competition a firm’s

equilibrium output is less than its optimum output. Thus
there is unused capacity.
2. Waste of advertisement: Under monopolistic competition
huge expenditure is incurred on advertisement. It imposes
burden on consumers.
3. Unemployment: Under monopolistic competition, the
resources are not utilised up to the minimum point of long
run average cost curve. This aggravates the problem of
unemployment.
4. Inefficiency: Under monopolistic competition, there are large
number of inefficient firms. These are not advantageously
placed to produce more and reduce their price. They continue
their business without leaving space for others.
5. Consumers are hypnotised: Product differentiation, like
beauty, is in the eyes of the buyer. By way of different brand
names, colour, package, beautiful displays etc. consumers are
hypnotised to buy even inferior quality goods at higher prices.
 Difference between Monopoly
and Monopolistic Competition

1. Under monopoly there is only one producer or seller of

particular commodity. But under monopolistic competition
there are large number of sellers.
2. Under monopoly, the question of product differentiation does
not arise. Under monopolistic competition, the producers
make product differentiation.
3. Under monopoly, there is no competition, but under
monopolistic competition, there is some degree of
competition.
4. Under monopoly new firms cannot enter into market easily,
while under monopolistic competition, new firms can enter
into the market and existing firms can leave the market.
5. Under monopoly, the demand of the product is less elastic
because there is no close substitute. Under monopolistic
competition, demand of the product is elastic because there
are some close substitutes.
6. Under monopoly, selling costs have no role to play. On the
other hand, under monopolistic competition, selling costs
have an important role.
 Perfect Competition and
Monopolistic Competition
Similarities

1. In both markets each firm acts

independently, without regard to the
responses of its competitors.
2.In both market situations, free entry
guarantees that firms earn normal profit in
long run equilibrium.
 Differences
1. Under perfect competition products are identical. But under monopolistic competition
product are differentiated.
2. Perfect competition is not a real concept. Monopolistic competition is a real concept.
3. Under perfect competition, there are large number of buyers and sellers. But under
Monopolistic competition the number of buyers and sellers is not so large.
4. Under perfect competition, buyers and sellers have perfect knowledge of market conditions.
But under Monopolistic competition the buyers and sellers do not have complete knowledge
about the products.
5. Under perfect competition, selling costs do not play any role. Under Monopolistic
competition , selling costs have an important role.
6. All perfectly competitive firms are price takers. But all firms under Monopolistic competition
are price makers.
7. Under perfect competition demand curve is horizontal. But under Monopolistic competition
the demand curve is a sloping down ward curve.
8. Under perfect competition, AR and MR are straight lines parallel to X axis. Price, demand, AR
and MR all are same. Under Monopolistic competition Price, Demand, and AR are same. But
MR is less than AR.
 OLIGOPOLY

Chamberlin, Paul M. Sweezy and Baumol are among the

modern economists who have developed theories of
oligopoly.
Meaning of Oligopoly
The term 'Oligopoly' is derived from two Greek words, 'oligoi'
which means 'a few' and 'pollein' which means to sell.
Thus oligopoly is a market situation in which there are
only few sellers producing homogeneous or differentiated
products. Fellned calls oligopoly as competition among few
sellers. J.M. Clark terms it as ‘workable competition’.
Samuelson calls it as ‘quasi-monopoly’. It is also called ‘limited
competition’, ‘incomplete competition’ etc.
 Reasons for Oligopoly
(a) Large capital requirements
(b) Economies of scale
(c) Aggressive entrepreneurs
(d) Patent rights
(e) Mergers
(f) Possession of some essential resources.
The automobile industry in India is oligopolistic in
nature as only few firms produce and supply automobiles.
Other examples are cement industry, steel industry etc.
 Features of Oligopoly

1. Few Sellers : Under oligopoly, the number of sellers is very

small.
2. Homogeneous or differentiated product : Under oligopoly,
firms produce either homogeneous products (like cement,
steel, aluminium etc.) or differentiated products (cigarettes,
automobiles etc. )
3. Interdependence of firms : Under oligopoly, all the sellers
depend upon each other. Activities of one seller affect others
also. A firm has to take into consideration the actions and
reactions of other firms while determining its price and level
of output.
4
Price rigidity : Under oligopoly, activities of all firms are interdependent. Due
to this reason, the firms do not like to change the price of their product
frequently. The result is that the market price tends to be rigid or stable.
5. Element of monopoly : In oligopolistic market, there are only few firms.
Hence there may be some monopoly, if there is product differentiation.
6. Excessive expenditure on advertisement : Each firm does not change its
price. Hence, the only way to increase the sale is heavy advertisement and
improvement in the design and quality of the product. In the words of
Baumol, “it is only under oligopoly that advertising comes fully into its
own”. According to him, advertising is a matter of life and death under
oligopoly. Thus, advertisement plays an important role in a firm under
oligopoly.
7. Uncertainty of demand curve : Under oligopoly a firm cannot forecast its
demand or revenue curve. This is because it is very difficult to forecast
whether competitors will change their policies or not. Due to these
reasons, demand or revenue curve of an oligopoly firm is uncertain or
indeterminate.
 Classification of Oligopoly

1. On the Basis of Product Differentiation

(a)Pure or perfect oligopoly : When all firms of an industry

produce and sell identical or homogeneous product, it is
called pure or perfect oligopoly.
(b) Differentiated or imperfect oligopoly : When all the
firms of an industry produce and sell differentiated products
or close substitutes for each other (but not perfect
substitutes), it is called differentiated or imperfect oligopoly.
 2. On the Basis of Entry of Firms
(a) Open oligopoly : In the case of open oligopoly, the firms are free to come
into the market and go out of the market.
(b) Closed oligopoly : This is the market situation where new firms are not
allowed to enter the industry.
3. On the Basis of Price leadership
(a) Partial oligopoly : Partial oligopoly refers to that market
situation where the industry is dominated by one big firm (known as the
leader) and the other firms (known as the followers) of the industry follow
the price policy determined by leader.
(b) Full oligopoly : Full oligopoly refers to that market situation where there
is no leader and no followers. Here price leadership is absent.
4.On the Basis of Agreement
(a) Collusive oligopoly : It is the market
situation where the firms belonging to an
industry follow a common policy of pricing. In
other words, they combine together to avoid
competition among themselves regarding the
price and output of the industry by means of
an agreement.
(b) Non-Collusive oligopoly : Under this
market situation there is no agreement among
the firms regarding the price and output of the
entire market.
 Price Leadership

Constant price war and instability will result in price

leadership. Under price leadership, price will be determined
by a leading firm (dominant firm ) and the other firms will
follow the same price. Thus under price leadership price is
determined by leader firm (large firm) and all other firms of
the industry follow this price. The leader firm is a price maker
and the other firms are price-takers. The firm which acts as
the leader firm is one which is either a low-cost firm,
dominant firm or experienced and respected firm.
 Types of Price Leadership

1. Dominant price leadership

Under this situation, there is one large firm with few small firms.
Large firm is dominant. It may be producing a major share of the total output of
the industry. It dominates the market. All firms follow the dominant firm and
accept the price set by it and adjust output accordingly.
2. Barometric price leadership
Under this type of price leadership, an experienced and reputed firm
(need not be the large ) assumes the role of protecting the interest of all firms. It
fixes the price of the product. This price is suitable for all the firms. Therefore, all
the firms in the industry readily accept this price. Thus, one firm acts as a
‘Barometer’, reflecting the changing market conditions or costs of production that
require a change in price.
3. Aggressive price leadership :
Under this type of price leadership one dominating firm compels all other
firms to follow its price policy. If any of the firms resists, it will be competed out of
the market by the dominant firm.
 Advantages of Price Leadership

1. It eliminates uncertainty.
2. It also eliminates price war.
3. It eliminates competition and develops
co- operation.
4. It gives protection to small firms which
lack knowledge in costing principles.
5. It is a very easy method of pricing.
6. It brings uniformity in pricing.
 Duopoly

Duopoly is a market with only two sellers. Infact, it is a

limiting case of oligopoly. Both producers or sellers produce
and sell almost identical product. However, their pricing
policies and marketing policies may be different. They may
agree to co-operate each other or they may go in for cut-
throat competition. They may fix the same price or they may
fix different prices. This market structure was first studied by
French Economist Augustin Cournot in 1938.
 Characteristics of Duopoly

1. There are only two producers or sellers of a product.

2. Both the producers or sellers produce and sell almost
identical products.
3. Both the producers or sellers may adopt their independent
price policy or they may agree upon a uniform price.
4. Both the producers and sellers may adopt independent
marketing policies or they may agree upon a common policy
in this regard.
5. Both the producers may agree to co-operate with each other
or they may compete with each other.
6. Actions by one firm will have a reaction by the other.
 Monopsony

It is a market situation under which there is a single

buyer of a product or service. Being alone, the buyer
is in a position to influence the price to a
considerable extent. He can restrict the entry of new
producers and sellers also. Thus monopsony is the
opposite of monopoly.
According to Prof. J. K. Mehta, "In Geometric
language, monopsony buyer succeeds in paying
lower price for the product without purchasing it in
bulk quantity ".
 Features of Monopsony
1.There is a single buyer of a product or service
in the market.
2.The buyer has complete control over the
demand of product or service.
3.The buyer is in a position to influence the
price to a great extent.
4.The buyer can restrict the entry of new
producers and sellers in the market.
Other Forms of Market Structures

(a) Dupsony : This is a market with two buyers.

This is the opposite of duopoly.
(b) Oligopsony: This is a market situation in which
there will be a few buyers and many sellers. As the
sellers are more and buyers are few the price of the
product will be comparatively low.
(c) Bilateral monopoly : This is a market situation
in which there is a single seller and a single buyer. In
the whole market a single seller faces a single buyer.
Thank You…
Prageesh C Mathew
(M.Com , M.Ed , MBA , PGDHRM , M.Sc Applied
Psychology)

Asst. Prof. in Commerce

Newman College , Thodupuzha

Ph : Res . 04862-248242
9947710433