2. The Market Forces of
Supply and Demand
Supply and demand are the two words
that economists use most often.
Supply and demand are the forces that
make market economies work.
Modern microeconomics is about
supply, demand, and market
equilibrium.
3. Markets
A market is a group of buyers and
sellers of a particular good or service.
The terms supply and demand refer
to the behavior of people . . . as they
interact with one another in markets.
11. Ceteris Paribus
Ceteris paribus is a Latin phrase that
means all variables other than the
ones being studied are assumed to be
constant. Literally, ceteris paribus
means “other things being equal.”
The demand curve slopes downward
because, ceteris paribus, lower prices
imply a greater quantity demanded!
12. Ceteris Paribus
Ceteris Paribus means “other things being
equal”. What other things?
Consumer income.
Consumer preferences.
Fashion.
Population.
Price of related goods.
Government policies.
Weather conditions.
14. Determinants of Demand
Market price : A larger quantity is demanded at
a lower price & vice versa.
Tastes, habits and preferences : Demand depends
upon a persons tastes, habits and preferences.
Demand for ice – creams, bhel – puri etc depends
upon an individual’s tastes. Tea, betal leafs,
tobacco etc is a matter of habits. People with
different tastes & habits have different
preferences. A strict veg. will have no demand for
fish and a person who likes non – veg will
purchase fish even at a high price.
15. Determinants of Demand
Expectations : If a consumer expects
that the prices of a product are going
to rise in future, the demand may
increase and vice – versa.
Consumer income : A rich consumer
demands more goods than a poor
consumer.
16. Determinants of Demand
Prices of related goods ( substitutes and
complementary ) : When a desire or a want can
be satisfied by alternative similar goods, they
are called as substitutes. Eg. Peas and beans,
groundnut oil and mustard oil, tea or coffee,
jowar or bajra etc.
Demand for a commodity depends on the
relative prices of the substitutes. There will be
more demand for a commodity if it’s
substitutes are highly priced.
17. Determinants of Demand
Complementary products : When, in order to
satisfy a given want, two or more goods are
needed in combination, these goods are
referred to as complementary goods. Eg. car
and petrol, pen and ink, shoes and socks, guns
and bullets.
Complementary goods are always in Joint
Demand. Thus, when the price of a
complementary product will fall, the demand
for its complementary product will increase.
18. Change in Quantity Demanded
versus Change in Demand
Change in Quantity Demanded
Movement along the demand curve.
Caused by a change in the price of
the product.
19. Changes in Quantity
Demanded
0
D1
Price of
Cigarettes
Number of Cigarettes
A tax that raises the
price of cigarettes
results in a movement
along the demand
curve.
A
C
20
2.00
Rs.4.
00
12
20. Change in Quantity Demanded
versus Change in Demand
Change in Demand
A shift in the demand curve, either
to the left or right.
Caused by a change in a
determinant other than the price.
28. Market Supply
Market supply refers to the sum
of all individual supplies for all
sellers of a particular good or
service.
29. Change in Quantity Supplied
versus Change in Supply
Change in Quantity Supplied
Movement along the supply curve.
Caused by a change in the market price
of the product.
30. Change in Quantity Supplied
1 5
Price
Quantity of
Ice-Cream
Cones
0
S
1.00
A
C
Rs.3.00 A rise in the price
of ice cream cones
results in a
movement along
the supply curve.
31. Change in Quantity Supplied
versus Change in Supply
Change in Supply
A shift in the supply curve, either to the
left or right.
Caused by a change in a determinant
other than price.
33. Shifts in Curves versus
Movements along Curves
A shift in the supply curve is called a change
in supply.
A movement along a fixed supply curve is
called a change in quantity supplied.
A shift in the demand curve is called a
change in demand.
A movement along a fixed demand curve is
called a change in quantity demanded.
34. Supply and Demand Together
Equilibrium Price
The price that balances supply and
demand. On a graph, it is the price at
which the supply and demand curves
intersect.
Equilibrium Quantity
The quantity that balances supply and
demand. On a graph it is the quantity at
which the supply and demand curves
intersect.
35. Supply and Demand Together
Price Quantity
Rs 0 0
0.50 0
1.00 1
1.50 4
2.00 7
2.50 10
3.00 13
Price Quantity
Rs 0 19
0.50 16
1.00 13
1.50 10
2.00 7
2.50 4
3.00 1
Demand Schedule Supply Schedule
At Rs.2.00, the quantity demanded is
equal to the quantity supplied!
38. Surplus
When the price is above the equilibrium
price, the quantity supplied exceeds the
quantity demanded. There is excess supply
or a surplus. Suppliers will lower the price
to increase sales, thereby moving toward
equilibrium.
40. Shortage
When the price is below the equilibrium
price, the quantity demanded exceeds the
quantity supplied. There is excess demand
or a shortage. Suppliers will raise the price
due to too many buyers chasing too few
goods, thereby moving toward equilibrium.
41. How an Increase in Demand
Affects the Equilibrium
Price of
Ice-Cream
Cone
2.00
0 7 Quantity of
Ice-Cream Cones
Supply
Initial
equilibrium
D1
1. Hot weather increases
the demand for ice cream...
D2
2. ...resulting
in a higher
price...
Rs.2.50
10
3. ...and a higher
quantity sold.
New equilibrium
42. S2
How a Decrease in Supply Affects
the Equilibrium
Price of
Ice-Cream
Cone
2.00
0 1 2 3 4 7 8 9 11 12 Quantity of
Ice-Cream Cones
13
Demand
Initial equilibrium
S1
10
1. Shortage of milk reduces
the supply of ice cream...
New
equilibrium
2. ...resulting
in a higher
price...
Rs.2.50
3. ...and a lower
quantity sold.
43. Elasticity – The concept
The responsiveness of one variable to
changes in another
When price rises what happens to
demand?
Demand falls
BUT!
How much does demand fall?
44. Elasticity – The concept
If price rises by 10% - what happens to
demand?
We know demand will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which
demand will change
45. Elasticity . . .
… is a measure of how much buyers and
sellers respond to changes in market
conditions
… allows us to analyze supply and
demand with greater precision.
46. Price Elasticity of Demand
Price elasticity of demand is the
percentage change in quantity demanded
given a percent change in the price.
It is a measure of how much the quantity
demanded of a good responds to a change
in the price of that good.
47. Determinants of Elasticity
Time period – the longer the time under
consideration the more elastic a good is likely
to be.
Number and closeness of substitutes –
the greater the number of substitutes,
the more elastic the demand.
The proportion of income taken up by the product
– the smaller the proportion the more inelastic
Luxury or Necessity – necessary goods have
inelastic demand vs. luxury goods have elastic
demand. E.g. Salt vs. luxury cars.
48. Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
if the good is a luxury.
the longer the time period.
the larger the number of close
substitutes.
If the consumer is spending large portion
of his income on the product.
49. Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
if the good is a luxury.
the longer the time period.
the larger the number of close
substitutes.
If the consumer is spending large portion
of his income on the product.
50. Computing the Price Elasticity
of Demand
The price elasticity of demand is computed
as the percentage change in the quantity
demanded divided by the percentage
change in price.
Price Elasticity of Demand =
Percentage Change
in Quantity Demanded
Percentage Change
in Price
Price Elasticity of Demand =
Percentage Change
in Quantity Demanded
Percentage Change
in Price
The Percentage Method
51. Computing the Price Elasticity
of Demand
priceinchangePercentage
demandedquatityinchangePercentage
demandofelasticityPrice
Example: If the price of an ice cream increases from
2.00 to 2.20 and the amount you buy falls from 10 to 8
then your elasticity of demand would be calculated as:
2
percent10
percent20
100
002
002202
100
10
810
.
)..(
)(
52. Ranges of Elasticity
Perfectly Inelastic
Quantity demanded does not respond at
all to price changes.
Inelastic Demand
Quantity demanded does not respond
strongly to price changes.
Price elasticity of demand is less than one.
53. Ranges of Elasticity
Unit Elastic
Quantity demanded changes by the same
percentage as the price.
Elastic Demand
Quantity demanded responds strongly to
changes in price.
Price elasticity of demand is greater than one.
Perfectly Elastic
Quantity demanded changes infinitely with any
change in price.
54. A Variety of Demand Curves
Because the price elasticity of
demand measures how much
quantity demanded responds to the
price, it is closely related to the
slope of the demand curve.
55. Perfectly Inelastic Demand
- Elasticity equals 0
Quantity
Price
4
5
Demand
100
2. ...leaves the quantity demanded unchanged.
1. An
increase
in price...
56. Inelastic Demand
- Elasticity is less than 1
Quantity
Price
4
5
1. A 25%
increase
in price...
10090
2. ...leads to a 10% decrease in quantity.
57. Unit Elastic Demand
- Elasticity equals 1
Quantity
Price
4
51. A 25%
increase
in price...
10075
2. ...leads to a 25% decrease in quantity.
58. Elastic Demand
- Elasticity is greater than 1
Quantity
Price
4
5
1. A 25%
increase
in price...
10050
2. ...leads to a 50% decrease in quantity.
59. Perfectly Elastic Demand
- Elasticity equals infinity
Quantity
Price
Demand4
1. At any price
above 4, quantity
demanded is zero.
2. At exactly 4,
consumers will
buy any quantity.
3. At a price below 4,
quantity demanded is infinite.
60. Elasticity
Price
Quantity Demanded
D
The importance of
elasticity is the
information it
provides on the
effect on total
revenue of
changes in price.
5
100
Total revenue is
price x quantity
sold. In this
example, TR = 5 x
100 = 500.
This value is
represented by the
shaded rectangle.
Total Revenue
61. Elasticity
Price
Quantity Demanded
D
If the firm decides
to decrease price
to (say) 3, the
degree of price
elasticity of the
demand curve
would determine
the extent of the
increase in
demand and the
change therefore
in total revenue.
5
100
3
140
Total Revenue
62. Elasticity
Price
Quantity Demanded
10
D
5
5
6
% Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall
Producer decides to lower price to attract sales
Not a good move!
63. Elasticity
Price (£)
Quantity Demanded
D
10
5 20
Producer decides to reduce price to increase sales
7
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
Good Move!
64. Elasticity
If demand is price
elastic:
Increasing price
would reduce TR
(%Δ Qd > % Δ P)
Reducing price
would increase TR
(%Δ Qd > % Δ P)
If demand is price
inelastic:
Increasing price
would increase TR
(%Δ Qd < % Δ P)
Reducing price
would reduce TR
(%Δ Qd < % Δ P)
65. Computing the Price Elasticity
of Demand ( Other methods)
Price elasticity of demand can also be
calculated by a few other methods. These
methods are :
Total Outlay Method
Midpoint Formula
Geometric Method
66. Total Outlay Method
This method, measures the change on
expenditure on commodities due to a change in
price.
If a given change does not cause any change in
the total amount spent on the commodity, the
demand is said to be unitary elastic.
If the total expenditure increases due to fall in
price, the demand is said to be elastic and vice
versa.
67. Demand is Unitary elastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 4 18
4.00 4.5 18
3.00 6 18
As price falls, the quantity demanded increases,
But the total outlay remains constant.
Hence, elasticity of demand is equal to unity.
68. Demand is Elastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 6 27
4 7 28
3 10 30
As price falls, the quantity demanded increases,
And the total outlay also increases.
Hence, demand is elastic. ( Greater than unity)
69. Demand is inelastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 4 18
4 4.25 17
3 5 15
As price falls, the quantity demanded increases,
but the total outlay decreases.
Hence, demand is inelastic. ( Lesser than unity)
70. Midpoint Formula
The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer regardless
of the direction of the change.
)/ 2 ]P)/ [(PP(P
)/ 2 ]Q)/ [(QQ(Q
=D e m a n do fE la s t ic it yP rice
1212
1212
71. Geometric method
Elasticity at a point on a straight line demand curve
can be calculated as follows :
e = Length of the lower segment
--------------------------------------------------
Length of the upper segment
At the midpoint of the demand curve e = 1
At all points above the midpoint e >1
At all points below the midpoint e < 1
72. Geometric Method
At the point M,
the demand curve
is unit elastic. M is
the midpoint of
this linear demand
curve
Above M, demand
is elastic,
Below M, demand
is inelastic
Price
Quantity
M
Elasticity = 1
Elasticity > 1
Elasticity < 1
73. Income elasticity of Demand
Income elasticity of
demand incomeinchangePercentage
demandedquatityinchangePercentage
=
74. Cross Elasticity of Demand
Cross Elasticity:
The responsiveness of demand of one
good to changes in the price of a related
good – either a substitute or a
complement
Price Elasticity of Demand =
in Quantity Demanded
Percentage
Cross Elasticity of Demand =
Percentage Change
in Quantity Demanded of good X
Percentage Change
in Price of good Y
75. Demand Forecasting
A forecast is a prediction or anticipation
of any event which is likely to happen in
future.
Demand forecast is the prediction of the
future demand for a firm’s product.
76. Forecasts are necessary for :
Scheduling of the production process.
Preparations of budgets.
Manpower Planning.
Setting targets of sales executives.
Advertising & promotion decisions.
Decisions about expansion of a firm.
Other decisions like long term investment
plans, warehousing and inventory decisions.
77. Methods of Demand
forecasting
There are two different sets of methods
for demand forecasting :
Interview & survey methods ( for short
term forecasts )
Projection Approach ( for long term
forecasts )
79. Interview and Survey approach
To anticipate the demand for a product,
information needs to be collected about
the expected expenditure patterns of
consumers.
Depending on the various approaches to
collect this information, different sub –
methods are formulated.
We will study them one by one.
80. Interview and Survey approach
Executive Opinion :
In small companies, usually the owner
takes the responsibility of forecasting.
As a result of the experience and
knowledge he is expected to have, he can
predict what would be the course of
activities in future and plan his own
activities accordingly.
81. Interview and Survey approach
Opinion polling method : Information
about the consumer’s expenditure can be
collected either by the market research
department or through the wholesalers
and retailers.
As a result of technological
advancements, it is now possible to collect
this information by the means of internet.
82. Interview and Survey approach
Collective opinion method :
Jury is a group of individuals, usually the top
bosses or sales, production, marketing
managers having experience in different fields.
The advantage of this method is that instead of
basing the forecast on the opinion of one single
individual, a more accurate forecast can be
drawn.
83. Interview and Survey approach
Sample survey method :
The total number of customers of a
company is called as its population.
When this number is more, it is not
possible to collect information for all the
customers. When only a few customers
are contacted, it is called as a Sample
Survey.
84. User’s Expectations
Consumer and industrial companies
often poll their actual or potential
customers.
Some Industrial manufacturers ask
about the quantities of products their
customers may purchase in future and
take this as their forecast.
85. Delphi Method
Administering a series of questionnaires to
panels of experts. This method gathers
information from all experts and the opinion of
all the experts is shared by all other experts.
In case if an expert finds that his own forecast
is unrealistic, after going through the opinion
of other experts, there is a chance for
corrections.
86. Projection Approach
In this method, the past experience is
projected for the future. This can be done
by two methods :
Correlation or regression analysis.
Time series analysis.
87. Past sales can be used to forecast future demand.
Past sales are viewed from the angles of trends,
various cycles of business, seasonality and then a
forecast is drawn after checking the possibility of
the same treads, cycles and seasonality factors.
This method is easy to use, it is based on past
behavior and does not include new company,
competitor or macroeconomic developments.
Classical approach to time series analysis:
91. Trend Projections – Least Squares
Eyeball fitting is simply a plot of the data
with a line drawn through them that the
forecaster feels most accurately fits the
linear trend of the data.
93. Market Structures
Market structure refers to the number and
size of buyers and sellers in the market for a
good or service.
A market can be defined as a group of firms
willing and able to sell a similar product or
service to the same potential buyers.
95. Major features that determine
market structure
Number of sellers
Product differentiation
Entry and exit conditions
96. Features of the four market structures
Type of
market
Number
of firms
Freedom of
entry
Nature of
product
Examples Implications for
demand curve
faced by firm
Perfect
competition
Large
( 30+)
Unrestricted
Homogeneous
(undifferentiated)
Potatoes, Eggs
(approximately)
Horizontal:
firm is a price taker
Monopolistic
competition
Many
( 10 - 30)
Unrestricted Differentiated Builders,
restaurants
Downward sloping,
but relatively
elastic
Oligopoly Few but
Large
( 02–10)
Restricted
Undifferentiated
or differentiated
Cement
cars, electrical
appliances
Downward sloping.
inelastic or elastic
(depends on
reactions of rivals)
Monopoly One Restricted or
completely
blocked
Unique
Indian railways,
Local electricity
co etc
Downward sloping:
more inelastic.
Firm has a fair
control over price
97. Important Concepts before we move forward with
market Structures
Short-run:
Period of time in which quantities of one or
more production factors cannot be changed.
These inputs are called fixed inputs.
Long-run
Amount of time needed to make all production
inputs variable.
The Short Run versus the Long Run
98. Cost Concepts
TOTAL COST – Total Fixed Cost + Total
Variable Cost.
TC = TFC + TVC
AVERAGE COST - tells us how much is
the cost of producing a typical unit.
AC = TC/ Q
MARGINAL COST - is the change in total
cost from an additional unit produced
MC =TC/ Q
100. Revenue Concepts
TOTAL REVENUE - for a firm is the selling
price times the quantity sold.
TR = (P X Q)
AVERAGE REVENUE - tells us how much
revenue a firm receives for the typical unit sold.
AR = TR / Q
MARGINAL REVENUE - revenue is the
change in total revenue from an additional unit
sold.
MR =TR/ Q
101. Profit
Normal Profit : That part of the cost which is
paid to the entrepreneur as a part of his
compensation.
Super-normal Profit : The profit that the
entrepreneur may get over and above the
compensation that he receives from the firm,
for his contribution.
102. What we analyze in all graphs of Market
Structures…
AR, MR
AC, MC
Profit Maximization Point - The point where
MR = MC ( Profit maximum )
and MC is rising.
Q* ( Equilibrium Output )
P* ( Equilibrium Price )
103. Perfect competition
Features –
1. Large number of buyers and sellers
2. Products are perfect substitutes of each other;
homogeneous products
3. Free entry and exit from the market
4. Perfect knowledge of the market to both buyers
and sellers
5. No govt. intervention
6. Transport cost are negligible hence don’t affect
pricing.
104. The Meaning of Competition
As a result of its characteristics, the perfectly
competitive market has the following outcomes:
The actions of any single buyer or seller in
the market have a negligible impact on the
market price.
Each buyer and seller takes the market price
as given.
105. Total, Average, and Marginal Revenue for a Competitive
Firm
Quantity Price TR
P x Q
AR
TR / Q
MR
TR / Q
1 6 6 6 6
2 6 12 6 6
3 6 18 6 6
4 6 24 6 6
5 6 30 6 6
6 6 36 6 6
7 6 42 6 6
107. O
Rs.
(b) Firm
Q (thousands)
O
(a) Industry
P
Q (millions)
S
D
Pe
MC
AR/P
D = AR
= MR
Qe
AC
C
Short-run equilibrium of industry and firm under
perfect competition
E
B
A
108. Qe
P1
D1 = AR1
= MR1
AR1
O O
(a) Industry
P Rs
Q (millions)
S
D
(b) Firm
MC AC
AC
Q (thousands)
Loss under perfect competition
110. Monopoly
A monopoly has only one seller, who
is able to influence the total supply
and price of the goods and services.
Further, there are no close substitutes
for the goods produced by the
monopolist and there are barriers to
entry.
This single seller represents the
entire Industry.
Hence, this firm is called as a Price
Maker.
111. Main factors that lead to monopoly are:
Ownership of strategic raw materials and
exclusive technical know-how
Possession of product/process patent
rights
Acquisition of government license to
procure certain goods
High entry costs
Governments themselves produce some
commodities to avoid consumer
exploitation
112. Revenues for a firm facing a downward-sloping demand curve
Q
(units)
P = AR
(Rs)
TR
(Rs)
MR
(Rs)
1 8 8
6
2 7 14
4
3 6 18
2
4 5 20
0
5 4 20
–2
6 3 18
–4
7 2 14
113. 6.00
4.50
-4
0
4
8
12
16
1 2 3 4 5 6 7
T O T A L P R O F I T
MR
Quantity
Costsandrevenue(Rs)
MC
AC
AR
b
a
Measuring the maximum profit using average curves
Total profit =
Rs1.50 x 3 = Rs4.50
114. Price Discrimination
A Monopoly can discriminate between
different buyers by charging them different
prices because it has control over the price
and customers have no choice.
It is a situation when a firm charges different
prices for the same product when the
difference in price is not based on the
difference in costs.
The cost curves of the firm are same but the
demand and revenue curves are different.
115. First Degree Price Discrimination
This is a situation where a Monopolist charges
a different price for each customer for each unit
separately.
Eg. In a town, if there is only one cardiac
surgeon, he may charge different rates from
different customers, may be based on their
paying capacity, for a bypass surgery.
116. Second Degree Price Discrimination
Here, the monopolist charges different prices
for different batches or blocks of units of the
same product.
E.g. A monopoly electric company can charge
one rate per unit for the first 1000 units and
then decrease the rate per unit for the
subsequent batches of 500 units.
Here, the per unit price remains the same for all
the units in one batch and changes batch-wise.
117. Third degree Price Discrimination
Here, the monopoly firm divides the entire
market into two or more different groups and
charges a different price for each different
group.
Eg. Indian Railways has different charges for
senior citizens, kids below 12 years, cancer
patients, sports teams etc.
Electric companies have different rates for
farmers, commercial users, domestic users etc.
118. Characters of Monopolistic competition
Product Differentiation: A monopolistic market
consists of relatively large number of sellers,
each satisfying a relatively small share of total
market for similar, but not identical goods,
such that each firm has a very little control
over market price.
Example: Pepsodent & Colgate; Lux, Cinthol &
Santoor, etc.
Product differentiation can be done on the
parameters of Product Quality, Services,
Location, Promotion and packaging.
119. Characters of Monopolistic competition
No interdependence: The presence of numerous firms
with differentiated products ensures no mutual
interdependence among them. Rivals’ reactions can
be ignored as their impact on other firms is very small
and there is no reason for these firms to react.
Example: Aiwa & BPL
Relative Freedom: Under monopolistic competition,
firms have relative freedom to enter or exit from the
market.
Industrial Examples: Toilet soaps, toothpastes,
restaurants, retail trade, etc.
120. Selling Costs
Product differentiation is the important feature of
monopolistically competitive markets. Product
differentiation, which arises because of factors like brand
names, quality, services, etc, enables the sellers to sell
the goods at a higher price. But to create product
differentiation, the firm incurs some additional
expenditure in the form of advertising cost, product
development cost, servicing cost, etc.
Thus, average cost of the monopolistically competitive
firms will rise due to incurrence of additional costs -
product development and advertisements, etc. This
shifts the average cost curve up and consequently the
consumer has to pay a higher price for the goods.
Thus, in monopolistically competitive markets the
average unit cost is given by
[Production cost + Selling cost]/Output
121. Demand Curve of Monopolistic
Competition
Unlike the demand curve of a perfectly
competitive firm, which is perfectly elastic,
the demand curve of a firm operating
under conditions of monopolistic
competition is highly, but not perfectly,
elastic due to product differentiation.
However, since a large number of firms
sell closely substitutable products, it is
much more elastic than a pure
monopolist’s demand curve.
122. Demand Curve of Monopolistic
Competition
The important reasons of not having perfectly elastic
demand curve are:
Presence of few firms (when compared to perfect
competition)
Firms produce only close but not perfect substitute
products.
Thus, the degree of elasticity of demand of a
monopolistically competitive firm depends on the
number of rivals and the degree of product
differentiation.
Fewer the number of rivals and the greater the degree
of product differentiation, the lower is the degree of
elasticity.
124. Rs
QO Qs
AR D
MC
AC
MR
Short-run equilibrium of the firm under monopolistic competition
Ps
ACs
125. Long-run equilibrium of the firm under monopolistic competition
ARL DL
MRL
Rs
QO Q1
P1
LRAC
LRMC
126. Characteristics of Oligopoly
Only a few firms supply goods for the entire market;
the goods may be either homogenous or differentiated.
The firms are mutually interdependent and hence their
pricing, output and other business policies are always
dependent on their rivals’ reactions.
A firm’s demand curve in an oligopoly market is
indeterminable, because the output and price are
dependent on the rivals’ reactions.
Entry is very difficult or impossible.
127. Classification of Oligopoly
Based on product differentiation: Based on product
differentiation market can be classified into two types :
Differentiated oligopoly
Pure oligopoly
Differentiated Oligopoly: The firms sell goods that are
similar but not identical. Product differentiation may be
in terms of quality, quantity, services, etc. E.g.
Automobiles, cigarettes, etc.
Pure Oligopoly: The firms sell homogenous or
standardized goods. E.g. Steel, petrol, and aluminum
128. Classification of Oligopoly
Based on Collusion:
Non-collusive Oligopoly: A market is said to be a
non-collusive oligopoly when the members of
the group compete with one another. E.g.
Automobiles
Collusive Oligopoly (Cartels): In collusive
oligopoly, the members come to an
understanding among themselves to promote
their common interests. E.g. OPEC and cement
129. Oligopoly
• Characteristics
Small number of large firms.
Product differentiation may or may not exist
High barriers to entry. Eg. Capital requirements,
government policy, patents, brand names etc.
• Example
• Aviation
• Steel
• Aluminum
• Petrochemicals
130. The Kinked Demand Curve
Rs/Q
Quantity
MR
D
If the producer lowers price, the
competitors will follow and the
demand will be inelastic.
If the producer raises price & the
& competitors don’t, the
demand will be elastic.
131. Cost concepts
The term cost simply means cost of
production.
It is the expenses incurred in the production
of goods.
It is the sum of all money-expenses incurred
by a firm in order to produce a commodity.
Thus it includes all expenses from the time
the raw material are bought till the finished
products reach the wholesaler.
132. A managerial economist must have a proper
understanding of the different cost concept
which are essential for clear business thinking.
The cost concept which are relevant to business
operation and decision can be grouped on the
basis of their propose under two overlapping
categories:
1. Concept used for accounting purpose
2. Concept used in economics analysis of the
business
133. Opportunity Cost
Opportunity costs are those costs of “displaced
alternatives”.
It is the cost sacrificed for the next best
alternative.
They represent only sacrificed alternatives and
hence are not recorded in any financial account.
The economic principle behind cost in the
modern sense is not the pain or strain involved,
nor the money cost involved in producing a thing.
134. Fixed Cost and Variable Cost
Fixed and variable costs are not two distinct
categories; rather they are the two ends of a
continuum.
In the long-run all costs become variable and
hence this distinction prevails mainly for a
short period.
It is valid only for a particular set of
circumstances. However, this distinction is
useful in evaluating the effect of short-run
changes in volume, upon costs and profits.
135. Fixed Costs and Variable Costs
Fixed costs are costs that don’t change with
the level of output.
E.g. Director’s Salary, Building etc.
Variable costs are costs that vary with the
level of output.
E.g. Raw material, electricity used for
machines etc.
136. Incremental Cost vs. Sunk Cost
Incremental cost refers to the additional cost
incurred due to a change in the level or nature of
activity.
A change in the activity connotes addition of a
product, change in distribution channel,
expansion of market, etc.
Incremental cost are also known as differential
costs.
Incremental cost measures the difference
between old and new total costs.
137. Incremental Cost vs. Sunk Cost
Sunk costs are the costs which remain
unaltered even after a change in the level or
nature of business activity.
These are known as specific costs. The best of
the sunk cost is depreciation.
Incremental cost are very useful in business
decision, but sunk costs appear to be
irrelevant to managerial decisions, as they do
not change with the changing business activity.
138. Break Even Analysis
Break-even analysis is a technique widely used
by production management and management
accountants.
It is based on categorizing production costs
between those which are "variable" (costs that
change when the production output changes)
and those that are "fixed" (costs not directly
related to the volume of production).
Total variable and fixed costs are compared with
sales revenue in order to determine the level of
sales volume, sales value or production at
which the business makes neither a profit
nor a loss (the "break-even point").
140. COST-VOLUME-PROFIT (CVP) ANALYSIS
CVP analysis examines the interaction of a firm’s sales
volume, selling price, cost structure, and profitability. It is a
powerful tool in making managerial decisions including
marketing, production, investment, and financing
decisions.
How many units of its products must a firm sell to break
even?
How many units of its products must a firm sell to earn a
certain amount of profit?
Should a firm invest in highly automated machinery and
reduce its labor force?
Should a firm advertise more to improve its sales?
141. Cost-Volume-Profit Model
Net Income (NI) = Total Revenue – Total Cost
Total Revenue = Selling Price Per Unit (P) * Number of
Units Sold (X)
Total Cost = Total Variable Cost + Total Fixed Cost (F)
Total Variable Cost = Variable Cost Per Unit (V) * Number
of Units Sold (X)
NI = P X – V X – F
NI = X (P – V) – F
142. One Product Cost-Volume-Profit Model
Net Income (NI) = Total Revenue – Total Cost
Total Revenue = Selling Price Per Unit (P) * Number of
Units Sold (X)
Total Cost = Total Variable Cost + Total Fixed Cost (F)
Total Variable Cost = Variable Cost Per Unit (V) * Number
of Units Sold (X)
NI = P X – V X – F
NI = X (P – V) – F
This is an Income Statement
Sales Revenue (P X)
- Variable Costs (V X)
Contribution Margin
- Fixed Costs (F)
Net Income (NI)
143. Break Even Units
Breakeven Units =
Fixed Costs
-----------------------------------
Selling Price – Variable Costs
144. CVP Model – Assumptions
Key assumptions of CVP model
Selling price is constant
Costs are linear and can be divided into
variable and fixed elements.
In multi-product companies, sales mix is
constant
In manufacturing companies, inventories do
not change.
145. Risk
Risk implies future uncertainty about
deviation from expected earnings or
expected outcome.
Risk measures the uncertainty that an
investor is willing to take to realize a gain
from an investment.
146. Business Risks Terms
Risk
The possibility of a financial loss.
Risk management
The process of managing a business’s
exposure to risk in order to achieve business
objectives.
Business risk
The possibility of business failure or loss.
147. Types of Risks
Speculative risk
Risking loss to make a profit.
Possibility of seeing a loss, no change, or
actually making profit
Examples include
buying new machinery
constructing new buildings
Pure risk
The possibility of loss to a business without any
possibility of gain
Economic risks
Natural risks
Human risks
148. Economic Risks
Risks that result from changes in overall business
conditions. Examples of economic risks include:
Competition – More businesses that would
compete with your business open in the area.
Changing consumer lifestyles – The lifestyle of
the consumers in your area changes due to new
industry opening or closing, new businesses, etc.
Population changes – Potential customers
moving out due to economic downfall
or moving in due to new economic opportunities
149. Economic Risks
Limited usefulness of products - new
products introduce replace your products or
the needs of customers’ needs change
Inflation – the availability of cash to
customers will reflect in the buying patterns.
Product obsolescence – products you
offer to the public is not longer needed or
out-of-date.
150. Economic Risks
Government regulation – new regulations
can change the status of your products.
Products can be recalled because of safety
measures such as baby products or
medicines.
Recession – Just as with inflation the
availability of cash affect customer
purchases.
151. Ways to Reduce Risk
Purchase property insurance to cover:
the loss of physical property such as cash,
inventory, vehicles, buildings.
real property such as buildings, land, and fixtures.
personal property such as vehicles, clothing,
furniture, jewelry.
Purchase business interruption insurance
to make up for:
lost income if a business is shut down for repairs
or rebuilding.
Allows a business owner to continue to pay rent,
salaries, and other key payments.
152. Ways to Transfer Risk
Purchase casualty insurance to:
Protects a business from lawsuits.
Pays the claim if a person is injured on your business
premises or if a worker causes damage
Types of casualty insurance
Errors-and-omissions insurance: Protects businesses from
lawsuits resulting from mistakes in advertising.
Product liability insurance: Protects manufacturers from
claims for injuries that result from using their products.
Fidelity bonds: Protect companies from employee theft.
Performance bonds: Protect a business if work is not finished
on time or as agreed.
153. Ways to Transfer Risk
Purchase life insurance to:
Pay a business in the event of the insured
person’s death.
Covers owner(s) and key management
employees
154. Business Risk Retention
Businesses is self-insurance against
business loss.
If a business cannot or does not provide for
ways to transfer risk using one of the described
means, the business should set aside money
each month to help cover the costs should a
loss occur.
Planning for the unexpected, can save a
business.
155. Hedging
A hedge is an investment to reduce the risk
of adverse price movements in an asset.
Normally, a hedge consists of taking an
offsetting position in a related security, such
as a futures contract.
Eg. Virgin Atlantic’s strategy of hedging for oil
prices.
Wheat growers and bread manufacturers.
156. Diversification
Diversification is a risk management
technique that mixes a wide variety of
investments within a portfolio.
The rationale behind this technique contends
that a portfolio constructed of different kinds
of investments will, on average, yield higher
returns and pose a lower risk than any
individual investment found within the
portfolio.
157. Decision Tree Analysis
A decision tree is a decision support tool that
uses a tree-like graph or model of decisions
and their possible consequences, including
chance event outcomes, resource costs, and
utility.
It is one way to display an algorithm that only
contains conditional control statements.
158. Using Decision Trees
Can be used as visual aids to structure
and solve sequential decision problems
Especially beneficial when the
complexity of the problem grows
159. Decision Trees
Three types of “nodes”
Decision nodes - represented by squares (□)
Chance nodes - represented by circles (Ο)
Terminal nodes - represented by triangles (optional)
Solving the tree involves pruning all but the best
decisions at decision nodes, and finding expected
values of all possible states of nature at chance
nodes
Create the tree from left to right
Solve the tree from right to left
