102 ECONOMIC ANALYSIS FOR BUSINESS DECISIONS course note

Dr. Bhati Rakesh MBA SEM-I 0
Sinhgad Institute of Business Administration & Computer
Application, Lonavala
NOTES FOR
MASTER OF BUSINESS ADMINISTRATION
(M.B.A)
(FIRST YEAR-Semester-I)
SUBJECT CODE & SUBJECT:
(102)-ECONOMIC ANALYSIS FOR
BUSINESS DECISIONS
BY:
Dr. Bhati Rakesh Kumar

ECONOMIC ANALYSIS FOR BUSINESS DECISIONS
SUBJECT DESCRIPTION: Economics emphasize on the influence on micro and macro economics on
managerial decision making, explaining the supply, demand and cost functions, its relative impact on the
economy and the company correlating to profit and investment analysis.
GOALS: To enable the students to learn the application of the economic principles and policies on managerial
decision making.
OBJECTIVES: On successful completion of the course the students should have:
1. Understood the economic principles and policies on managerial decision making.
2. Learn demand, supply, cost and profit concepts and functions along with its applications.
3. To learn profit policies, planning and problem solving techniques.
SYLLABUS FOR
MASTER OF BUSINESS ADMINISTRATION (M.B.A) (FIRST YEAR)
SUBJECT CODE & SUBJECT: (102) Economic Analysis for Business Decisions
Module/Topic Details with sub and sub-sub Topic
Basic Concepts of Economics: Introduction to Economics , Basic Economic Problem, Circular Flow of
Economic Activity , Adam Smith and Invisible Hand. Nature of the firm - rationale, objective of maximizing
firm value as present value of all future profits, maximizing, satisficing, optimizing, principal agent problem,
Accounting Profit and Economic Profit , Role of profit in Market System
Demand Analysis and Forecasting: Determinants of Market Demand at Firm and Industry level –
Elasticity of Demand - Market Demand Equation – Use of Multiple Regression for estimating demand –
Case study on estimating industry demand (formulating equation and solving with the aid of software
expected)
Demand and Supply: Market Equilibrium – Pricing under perfect competition, monopolistic competition,
Case study on pricing under monopolistic competition , Oligopoly - product differentiation and price
discrimination; price- output decision in multi-plant and multi-product firms.
Cost Concepts: Cost Concept, Opportunity Cost, Marginal, Incremental and Sunk Costs, Cost Volume Profit
Analysis, Breakeven Point, Case Study on marginal costs. Risk Analysis and Decision Making: Concept of
risk, Expected value computation, Risk management through Insurance, diversification, Hedging, Decision
Tree Analysis, Case Study on Decision tree Technique.
Money and Capital Markets in India: Role and Functions of Money Markets, Composition of Money
Market, Money Market Instruments , Reserve Bank of India – Functions , Regulatory Role of RBI w.r.t.
Currency, Credit and Balance of Payment, Open Market Operations. Role and Functions of Capital Markets,
Composition of Capital market, Stock Exchanges in India, Role of SEBI, understanding of stock market
quotations in financial press expected.
Public Finance Infrastructure: Familiarity with important terms/agencies/approaches/practices related to
National Income (such as GDP, PPP, Growth Rate), Foreign Trade (such as GATT, WTO) Union budget
(such as Revenue Account, Capital Account, Revenue Deficit, Fiscal Deficit, Plan and Non-plan expenditure)
is expected. Understanding of Summarized budget for the current financial year is required (knowledge of
detailed budget provisions not required).

CHAPTER-1
Basic Concepts of Economics: Introduction to Economics, Basic Economic Problem, Circular Flow of Economic
Activity, Adam Smith and Invisible Hand. Nature of the firm - rationale, objective of maximizing firm value as present
value of all future profits, maximizing, satisficing, optimizing, principal agent problem, Accounting Profit and
Economic Profit , Role of profit in Market System
Overview of Economics
Let's face it: If there's one fundamental principle guiding life on earth, it's scarcity. There simply aren't
enough beachfront houses, luxury cars, and seats at the theater for everyone who wants one! And on a more serious
note, there's not enough food, clothing, and medical care for everyone who needs it.
The entire discipline of economics—and all economic activity—arises from a scarcity of goods and services
in comparison to human wants and needs. If there is not enough of something for everyone who wants or needs it,
society faces a serious problem: How do we decide who gets that something and who goes without it?
Throughout history there have always been people who obtained what they wanted or needed by force. The
barbarians who sacked Rome practiced this form of “economic activity,” and in modern times it is practiced by
armed robbers. But a society worthy of the name requires an orderly system of producing and distributing the
necessities and luxuries of life. Such a system is essential to a stable society. Economics is the study of systems of
production and distribution—which are called economies—and of their fundamentals, dynamics, and results.
A social science that studies the allocation of limited resources used to produce the goods and services that satisfy
unlimited consumer wants and needs. Economics is one of several social sciences (others are sociology, political
science, and anthropology) which applies the scientific method to human behavior. The distinguishing feature of
economics is a concern with the fundamental problem of scarcity--unlimited wants and needs and limited resources.
Economics is commonly divided into two branches--macroeconomics and microeconomics.
Economics is first and foremost the study of scarcity--the pervasive condition that exists because society has
unlimited wants and needs but limited resources. Virtually everything studied in economics, whether it is market
exchanges, unemployment, efficiency, or business cycles, relates to the scarcity problem.
Two Branches and Many Fields
The study of economics is divided into two main branches--macroeconomics and microeconomics.
Macroeconomics is the study of the aggregate or national economy, dealing with such national issues as
unemployment, inflation, and business cycles. Microeconomics is the study of markets, dealing with such issues as
prices, industry concentration, and labor employment.
Both branches build on a common set of principles (such as scarcity), but also rely on distinct theories.
Reflecting this division, most universities and colleges offer introductory and higher level courses devoted to each
branch.
Economics is further divided into numerous fields that extend macroeconomic and microeconomic principles to
examine specific areas. Some of the more common and popular fields are: public finance, monetary, development,
labor, international, econometrics, mathematical, industrial organization, regional, urban, environmental, and
economic thought. Public finance, for example, studies the spending and taxing functions of government;
international investigates trade among nations; and economic thought investigates the progression of economic
theories.
Most economists gravitate toward one of the two main branches, then specialize in a particular field for much
of their work (research and teaching), while maintaining a moderate degree of familarity with one or two related
fields.
A Social Science
Economics is one of several social sciences that uses the scientific method to study human behavior.
Economics is distinguished from other social sciences, such as political science, anthropology and sociology, in
that it studies human behavior related to the fundamental problem of scarcity.
Comparable to any science, economics uses the scientific method of hypothesis verification to examine and
explain the economic world. This scientific side of economics is commonly termed positive economics. Economics
is also deeply involved with the pursuit of economic goals and public policies, a side commonly termed normative
economics.
Whereas positive economics seeks to identify what is, normative economics is concerned with what should
be. Both are important to economic study and each is intertwined with the other. Normative economic policy
recommendations rely on the scientific principles identified through positive economics. Positive economic
investigations pursue the issues economists believe are most important for improving society.
Economic Systems
The study of economics can also be considered the study of the economy, the system that society uses to
allocate resources. This system involves production, consumption, and exchange decisions made by households,

businesses, and governments. Virtually all economies of the real world are mixed economies, making using of
both markets and governments. Two theoretical economic systems often used as benchmarks to evaluate the
performance of real world economies are pure market economy, which relies exclusively on markets, and pure
command economy, which relies exclusively on governments. Capitalism is a mixed economy that relies more
heavily on markets than government. Socialism and communism are two mixed economies that rely more heavily
on governments than markets.
A Little History
Because scarcity is an inherent characteristic of humanity, curious humans have been concerned with
what is now called economics since the dawn of civilization. Plato, Aristotle, and other philosophers pondered
many of the economic questions that remain important today.
The starting point for the modern study of economics, however, can be traced to the publication of An Inquiry
into the Nature and Causes of the Wealth of Nations by Adam Smith in 1776. The Wealth of Nations, as it is
commonly called, was the first book to compile and systematically analyze the principles of economics. A
primary theme of The Wealth of Nations was the key role of voluntary market exchanges in the efficient
allocation of resources, a notion that Adam Smith termed the invisible hand.
Other scholars extended and formalized this study of economics throughout the 1800s, with notable
contributions coming from Jean Baptiste Say, Thomas Robert Malthus, David Ricardo, John Stuart Mill, and
William Stanley Jevons.
Some of the most important contributions came from Alfred Marshall in the late 1800s. Marshall
developed the notion of elasticity, the difference between short run and long run, and the basic graphical analysis
of markets that forms the foundation of modern microeconomics.
The next major advancement in economic study came from John Maynard Keynes with publication of The
General Theory of Employment, Interest and Money in 1936. Largely an attempt to explain and correct the
problems of the Great Depression of the 1930s, The General Theory, formed the foundation of Keynesian
economics and led to the development of macroeconomics as a separate branch of economic study.
FUNDAMENTAL ECONOMIC PROBLEMS
These questions are of importance because an economic system is often judged by the way in which it
distributes its goods and services. it is also a question of direct concern to each of us because the answer
determines not only the nation's well being but our individual standard of living as well.
It is often said that the central purpose of economic activity is the production of goods and services to satisfy our
changing needs and wants.
The basic economic problem is about scarcity and choice. Every society has to decide:
 What goods and services to produce: Does the economy uses its resources to operate more hospitals or hotels? Do
we make more iPhones and iPads or double-espressos?
 How best to produce goods and services: What is the best use of our scarce resources? Should school playing
fields be sold off to provide more land for affordable housing? Should coal be produced in the India or is it best
imported from other countries?
 Who is to receive goods and services: Who will get expensive hospital treatment - and who not? Should there be a
minimum wage? If so, at what level should it be set?
Scarcity
We are continually uncovering of new wants and needs which producers attempt to supply by employing
factors of production. For a perspective on the achievements of countries in meeting people’s basic needs, the
Human Development Index produced by the United Nations is worth reading. The economist Amartya Sen
(Winner of the 1998 Nobel Prize for Economics) has written extensively on this issue.
Scarcity means we all have to make choices
Because of scarcity, choices have to be made by consumers, businesses and governments. For example,
over six million people travel into London each day and they make choices about when to travel, whether to use
the bus, the tube, to walk or cycle – or whether to work from home. Millions of decisions are being taken, many
of them are habitual – but somehow on most days, people get to work on time and they get home too!
Trade-offs when making choices
Making a choice made normally involves a trade-off – this means that choosing more of one thing can
only be achieved by giving up something else in exchange.
 Housing: Choices about whether to rent or buy a home – there are costs and benefits to renting a property
or in choosing to buy a home with a mortgage. Both decisions involve risk. People have to weigh up the
costs and benefits of the decision.
Working: Do you work full-time or part-time? Is it worth your while studying for a degree? How have these
choices been affected by the introduction of university tuition fees?
Transport and travel: The choice between using Euro-Tunnel, a low-cost ferry or an airline when travelling
to Western Europe.

The cost benefit principle: Every purchase is a trade-off, of course. If you decide to spend Rs. 20,000 on a new
car, you’re saying that’s worth more to you than 20 bicycles or four vacations to Europe or the down
payment on a house. Every choice involves opportunity costs; when you choose one thing, you’re giving up
others. Plus, what you’re giving up isn’t always financial. Or obvious.”
In many of these decisions, people consider the costs and benefits of their actions – economists make use
of the ‘marginal’ idea, for example what are the benefits of consuming a little extra of a product and what are
the costs. Economic theory states that rational decision-makers weigh the marginal benefit one receives from an
option with its marginal cost, including the opportunity cost. This cost benefit principle well applied will get
you a long way in economics!
Consumer welfare and rationality
What makes people happy? Why despite several decades of rising living standards, surveys of happiness
suggest that people are not noticeably happier than previous generations?
Typically we tend to assume that, when making decisions people aim to maximise their welfare. They have a
limited income and they seek to allocate their money in a way that improves their standard of living.
Of course in reality consumers rarely behave in a well informed and rational way. Often decisions by people are
based on imperfect or incomplete information which can lead to a loss of welfare not only for people
themselves but which affect others and our society as a whole.
As consumers we have all made poor choices about which products to buy. Behavioural economics is an exciting
strand of the subject that looks at whether we are rational in our everyday decisions. One of the best people to
read on behavioural economics is Dan Ariely (pictured).
BEHAVIOURAL ECONOMICS:
Behavioural Economics is the name given to the discipline that tries to mix insights from Psychology with
Economics, and looks at economic problems through the eye of a “Human”, rather than an “Econ”. Behavioural
economics uses insights from psychology to explain why people make apparently irrational decisions such as
why people eat too much and do not save enough for retirement.
An Econ is said to be infinitely rational and immensely intelligent, emotionless being who can do cost-benefit
analyses at will, and is never (ever) wrong. The reality is often very different. Most of us are not infinitely
rational, but rather face “bounded rationality”, with people adopting rules of thumb instead of calculating optimal
solutions to every decision
Nudge, a book written by US economists Cass Sunstein and Richard Thaler, in 2008, offered an accessible and
influential guide to applying behavioural economics to policy problems from fighting obesity to getting people to
save for retirement. In the UK, the coalition government is trying to use ideas drawn from behavioural economics
to raise organ donation rates, discourage smoking, improve food hygiene and stimulate charitable giving.
Opportunity Cost: There is a well-known saying in economics that “there is no such thing as a free lunch!”
This means that, even if we are not asked to pay money for something, scarce resources are used up in the
production of it and there is an opportunity cost involved.
Opportunity cost measures the cost of any choice in terms of the next best alternative foregone.
 Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the lost wages
foregone. If you are being paid Rs. 6 per hour to work at the local supermarket, if you take a day off from
work you might lose Rs. 48 of income.
 Government spending priorities: The opportunity cost of the government spending nearly Rs. 10 billion on
investment in National Health Service might be that 10 billion less is available for spending on education or the
transport network.
 Investing today for consumption tomorrow: The opportunity cost of an economy investing resources in
capital goods is the production of consumer goods given up.
 Making use of scarce farming land: The opportunity cost of using farmland to grow wheat for bio-fuel means
that there is less wheat available for food production
CIRCULAR FLOW:
A model of the continuous movement of production, income, and the services of scarce resources that
flow between producers and consumers. In particular, the circular flow is a model of the continuous production
and consumption interaction among the four major sectors of the macroeconomy--household, business,
government, and foreign--using the three macroeconomic markets--product, resource, and financial. The circular
flow model provides a easy way of getting the "big picture" and of seeing how the key parts of the
macroeconomy fit together.
The circular flow model is a fundamental representation of macroeconomic activity among the major players in
the economy--consumers, producers, government, and the rest of the world. Different versions of the model
sequentially combined the four sectors--household, business, government, and foreign--and the three markets--
product, resource, and financial--into increasingly more comprehensive representations of the economy.

The basic model illustrates the interaction between the household and business sectors through the product and
resource markets. However, more realistic circular flow models include saving, investment, and investment
borrowing enabled by the financial markets; taxes and expenditures of the government sector; and imports and
exports of the foreign sector.
The prime conclusion of the circular flow model is that the overall volume of the circular flow is largely
unaffected by the path taken. In particular, household income can be used for consumption, saving, or taxes. The
income diverting away from consumption and to saving or taxes does not disappear, but is used to finance
investment by business sector and purchases by the government sector.
Four Sectors
The circular flow model illustrates the interaction among the four macroeconomic sectors--household, business,
government, and foreign. These four sectors capture four fundamental macroeconomic functions and their
expenditures are combined together to purchase the economy's total production.
 Household sector: This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is
responsible for consumption and undertakes consumption expenditures. It also owns all productive resources.
 Business sector: This includes the institutions (especially proprietorships, partnerships, and corporations) that
undertake the task of combining resources to produce goods and services. This sector does the production. It also
buys capital goods with investment expenditures.
 Government sector: This includes the ruling bodies of the federal, state, and local governments. Regulation is the
prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors
to do what they would not do voluntarily. It buys a portion of domestic product',500,400)">gross domestic
product as government purchases.
 Foreign sector: This includes everyone and everything (households, businesses, and governments) beyond the
boundaries of the domestic economy. It buys exports produced by the domestic economy and produces imports
purchased by the domestic economy, which are commonly combined into net exports (exports minus imports).
Three Markets
The four macroeconomic sectors interact through three macroeconomic markets--product, resource, and
financial. These three markets exchange the goods, services, and resources that are used for economic activity.
 Product Markets: The product markets exchange the production of final goods and services, or what is termed
gross domestic product. The buyers of this production are the four macroeconomic sectors--household, business,
government, and foreign. The seller of this production is primarily the business sector.
 Resource Markets: The services of the four factors of production--labor, capital, land, and entrepreneurship--are
traded through resource markets. Resource markets are used by the business sector to acquire the factor services
needed for production. Payment for these factor services then generate the income received by the household
sector, which owns the resources.
 Financial Markets: The commodity exchanged through financial markets is legal claims. Legal claims represent
ownership of physical assets (capital and other goods). Because the exchange of legal claims involves the counter
flow of income, those seeking to save income buy legal claims and those wanting to borrow income sell legal
claims.
The Physical Flow
The foundation of the circular flow is the physical movement of goods and
services, what is termed the physical flow. This flow is illustrated in the
exhibit to the right for the simplest circular flow model, two sectors
(household and business) and two markets (product and resource). The
physical flow is the movement of goods and services from the business
sector to the household sector and the movement of resource services from
the household sector to the business sector, usually represented as a
counter-clockwise movement.
For example, suppose that Duncan Thurly buys an OmniMotors XL GT
9000 Sports Coupe. This car physically "flows" from the OmniMotors
Dealership in the business sector through the product markets and ends up
in the possession of a member of the household sector, which is Duncan. This is represented by the upper half of
the circular flow exhibit.
In addition, the labor services of Gerald Cheverhold, an OmniMotors employee, physically "flows" from the
household sector, where Gerald resides, through the factor markets, and ends up with OmniMotors in the
business sector, where it is used in the production of an OmniMotors XL GT 9000 Sports Coupe. This is
represented by the lower half of the circular flow exhibit.
The Payment Flow
The physical flow of goods, services, and resources is countered by the payment flow that moves in the opposite
direction. The payment flow is the movement of money payments from the household to the business sector in
The Physical Flow

exchange for final goods and services and from the business to the household sector in exchange for the services
of resources, usually represented as a clockwise movement.
The basic payment flow is illustrated by the revised circular
flow model to the left. The gray inner ring represents the
physical flow. The green outer ring represents the payment flow
moving in the opposite direction.
For example, when Duncan purchases his OmniMotors XL GT
9000 Sports Coupe, the car "flows" from the dealer to him, from
the business sector to the household sector in the upper half of
the diagram. However, moving in the opposite direction is the
payment for this car. The payment "flows" from Duncan to the
dealer, from the household sector to the business sector.
In the lower half of the diagram, the labor services of Gerald
Cheverhold "flows" from the household sector to the business
sector. However, moving in the opposite direction is the payment for this labor. The payment "flows" from
OmniMotors to Gerald, from the business sector to the household sector.
Four Measures
The essence, the core, of the circular flow is the flow of
payments between the household and business sectors through
the product and resource markets. This core flow can be divided
into four parts, each of which is important to the study of
macroeconomics.
 Gross domestic product, or GDP, is the upper right-hand segment
of the flow. This is the revenue received by the business sector
for the production of final goods and services sold to the
household sector.
 Factor payments are the lower right-hand segment of the flow.
These are wage, interest, rent, and profit payments made by the
business sector to hire labor, capital, land, and entrepreneurship resources from the household sector.
 National Income is the lower left-hand segment of the flow. It is the income earned by the household sector for
supplying labor, capital, land, and entrepreneurship resources to the business sector.
 Consumption expenditures are the upper left-hand segment. These are payments made by the household sector
to purchase gross domestic product from the business sector.
Four Models
The circular flow model actually consists of four separate models, each
sequentially adding sectors or markets and thus providing greater
complexity and realism.
 Two Sectors, Two Markets: The simplest circular flow model contains
two sectors (household and business) and two markets (product and
resource). This model highlights the core circular flow of production,
income, and consumption.
 Two Sectors, Three Markets: A second version of the circular flow model
adds the financial markets. This addition illustrates how saving is diverted
from the household sector to the business sector to finance investment
expenditures.
 Three Sectors, Three Markets: A third version of the model
includes the government sector. This model highlights the importance
of taxes, which are also diverted from household sector income and
used to finance government purchases.
 Four Sectors, Three Markets: The most comprehensive circular flow model includes the foreign sector. Adding
the foreign sector highlights the role of trade with the rest of the world, especially exports and imports.
The complete circular flow model, with all four macroeconomic sectors (household, business, government
and foreign) and all three macroeconomic markets (product, resource, and financial), is presented in the
above exhibit.
THE OBJECTIVE OF THE FIRM
In this, we assume that the objective of the firm is to maximize its value to its shareholders. Value is
represented by the market price of the company’s common stock, which, in turn, is a reflection of the firm’s
investment, financing, and dividend decisions.
The Payment Flow
Four Circulating Measures
The Complete Model

Profit Maximization vs. Wealth Maximization
Frequently, maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive
a goal as that of maximizing shareholder wealth. For one thing, total profits are not as important as earnings per
share. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury bills.
Even maximization of earnings per share, however, is not a fully appropriate objective, partly because it does not
specify the timing or duration of expected returns. Is the investment project that will produce Rs.100,000 return 5
years from now more valuable than the project that will produce annual returns of Rs.15,000 in each of the next 5
years? An answer to this question depends upon the time value of money to the firm and to investors at the
margin. Few existing stockholders would think favorably of a project that promised its first return in 100 years.
We must take into account the time pattern of returns in our analysis.
Another shortcoming of the objective of maximizing earnings per share is that it does not consider the risk or
uncertainty of the prospective earnings stream. Some investment projects are far more risky than others. As a
result, the prospective stream of earnings per share would be more uncertain if these projects were undertaken. In
addition, a company will be more or less risky depending upon the amount of debt in relation to equity in its capital
structure. This risk is known as financial risk; and it, too, contributes to the uncertainty of the prospective stream
of earnings per share. Two companies may have the same expected future earnings per share, but if the earnings
stream of one is subject to considerably more uncertainty than the earnings stream of the other, the market price
per share of its stock may be less.
For the reasons above, an objective of maximizing earnings per share may not be the same as maximizing market
price per share. The market price of a firm’s stock represents the focal judgment of all market participants as to
what the value is of the particular firm. It takes into account present and prospective future earnings per share, the
timing, duration, and risk of these earnings, and any other factors that bear upon the market price of stock. The
market price serves as a performance index or report card of the firm’s progress; it indicates how well management
is doing in behalf of its stockholders.
MANAGEMENT VS. STOCKHOLDERS
In certain situations the objectives of management may differ from those of the firms stockholders. In a large
corporation whose stock is widely held, stockholders exert very little control or influence over the operations of the
company. When the control of a company is separate from its ownership, management may not always act in the
best interests of the stockholders [Agency Theory]. [Managers] sometimes are said to be "satisficers" rather than
"maximizers"; they may be content to "play it safe" and seek an acceptable level of growth, being more concerned
with perpetuating their own existence than with maximizing the value of the firm to its shareholders. The most
important goal to a management [team]of this sort may be its own survival. As a result, it may be unwilling to take
reasonable risks for fear of making a mistake, thereby becoming conspicuous to the outside suppliers of capital. In
turn, these suppliers may pose a threat to management’s survival.
It is true that in order to survive over the long run, management may have to behave in a manner that is
reasonably consistent with maximizing shareholder wealth. Nevertheless, the goals of the two parties do not
necessarily have to be the same. Maximization of shareholder wealth, then, is an appropriate guide for how a firm
should act. When management does not act in a manner consistent with this objective, we must recognize this as a
constraint and determine the opportunity cost. This cost is measurable only if we determine what the outcome
would have been had the firm attempted to maximize shareholder wealth.
A Normative Goal: Because the principal of maximization of shareholder wealth provides a rational guide for
running a business and for the efficient allocation of resources in society, we use it as our assumed objective in
considering how financial decisions should be made. The purpose of capital markets is to efficiently allocate
savings in an economy from ultimate savers to ultimate users of funds who invest in real assets. If savings are to be
channeled to the most promising investment opportunities, a rational economic criteria must exist that governs
their flow. By and large, the allocation of savings in an economy occurs on the basis of expected return and risk.
The market value of a firm’s stock embodies both of these factors. It therefore reflects the market’s tradeoff
between risk and return. If decisions are made in keeping with the likely effect upon the market value of its stock, a
firm will attract capital only when its investment opportunities justify the use of that capital in the overall
economy.
Put another way, the equilibration process by which savings are allocated in an economy occurs on the basis of
expected return and risk. Holding risk constant, those economic units (business firms, households, financial
institutions, or governments) willing to pay the highest yield are the ones entitled to the use of funds. If rationality
prevails, the economic units bidding the highest yields will be the ones with the most promising investment
opportunities. As a result, savings will tend to be allocated to the most efficient users. Maximization of

shareholder wealth then embodies the risk-return tradeoff of the market and is the focal point by which funds
should be allocated within and among business firms. Any other objective is likely to result in the suboptimal
allocation of funds and therefore lead to less than optimal level of economic want satisfaction.
This is not to say that management should ignore the question of social responsibility. As related to business
firms, social responsibility concerns such things as protecting the consumer, paying fair wages to employees,
maintaining fair hiring practices, supporting education, and becoming actively involved in environmental issues
like clean air and water. Many people feel that a firm has no choice but to act in socially responsible ways; they
argue that shareholder wealth and, perhaps, the corporations vary existence depends upon its being socially
responsible. However, the criteria for social responsibility are not clearly defined, making formulation of a
consistent objective function difficult.
Moreover, social responsibility creates certain problems for the firm. One is that it falls unevenly on different
corporations. Another is that it sometimes conflicts with the objective of wealth maximization. Certain social
actions, from a long-range point of view, unmistakably are in the best interests of stockholders, and there is little
question that they should be undertaken. Other actions are less clear, and to engage in them may result in a
decline of profits and in shareholder wealth in the long run. From the standpoint of society, this decline may
produce a conflict. What is gained in having a socially desirable goal achieved may be offset in whole or part by
an accompanying less efficient allocation of resources in society. The latter will result in a less than optimal
growth of the economy and a lower total level of economic want satisfaction. In an era of unfilled wants and
scarcity, the allocation process is extremely important.
Many people feel that management should not be called upon to resolve the conflict posed above. Rather,
society, with its broad general perspective, should make the decisions necessary in this area. Only society, acting
through Congress and other representative governmental bodies, can judge the relative tradeoff between the
achievement of a social goal and the sacrifice in the efficiency of apportioning resources that may accompany
realization of the goal. With these decisions made, corporations can engage in wealth maximization and thereby
efficiently allocate resources, subject, of course, to certain governmental constraints. Under such a system,
corporations can be viewed as producing both private and social goods, and the maximization of shareholder
wealth remains a viable corporate objective.
THE PRINCIPLE AGENT PROBLEM
The principal-agent problem occurs when one person (the principal) authorizes another person (the
agent) to act on their behalf. But the agent then undertakes actions that are not necessarily in the best interests of
the principal, but are in the best interests of the agent. In particular, the agent might pursue the satisfaction of
personal utility, which conflicts with the maximization of utility of the principal.
One problem in assuming that businesses set price and output to maximise profits is that decision-taking
where there is a divorce between ownership and control can be difficult to monitor. How do the owners of a
business know that managers making the key day-to-day decisions are operating to maximise shareholder value?
This lack of information is known as the principal-agent problem. In other words, one person, the principal, hires
an agent (e.g. a sales or finance manager) to perform tasks on his behalf but he cannot ensure that the agent
performs them in precisely the way the principal would like. The decisions and the performance of the agent are
impossible and or expensive to monitor and the incentives of the agent may differ from those of the principal.
Examples of the principle-agent problem that have hit the financial headlines include the management of
financial assets on behalf of investors (e.g. Equitable Life) and the management of companies on behalf of
shareholders (e.g. during the turbulent years experienced by Marks and Spencer).
Another example drawn from the public sector might be the efficient and effective running of public services
such as education, health and transport in the India by private firms under regulation by government authorities
There are various strategies available for coping with the principal agent problem.
One is the rapid expansion of employee share-ownership schemes.
Ryan Air one of Europe’s fastest growing low-cost airlines offered its pilots a share-scheme for the first time in
January 2001. The deal entails a 15% rise in basic pay over five years for the more than 220 pilots as well as the
share options and a productivity agreement.
A second option in offsetting the principal agent problem is the introduction of other variants of performance-
related pay or long-term employment contracts for senior management.
PROFIT:
Generally speaking, the difference between revenue received by a firm for production and cost incurred in
the production, or the excess of revenue over cost. Three specific notions of profit exist, each with a different
meaning. Accounting profit is the difference between revenue and accounting cost. Economic profit is the

difference between revenue and total opportunity cost. Normal profit is opportunity cost of entrepreneurship.
Profit is occasionally used synonymously with the term rent, or economic rent.
In general, profit is the revenue remaining after paying expenses. It is the primary motivator for a great deal of
production activity undertaken by business firms. The common catch-phrase is that firms seek to "maximize
profit." This pursuit of profit creates important incentives to achieve an efficient allocation of resources.
Greater profit can be achieved by increasing revenue or by decreasing cost.
 Revenue can be increased by producing products with higher prices. But prices are higher because buyers are
willing to pay more, which presumes they receive greater satisfaction (or utility).
 Cost can be decreased by using resources with lower prices, meaning resources with lower opportunity cost. But
opportunity cost is lower because alternative goods and services produced by the resources are less valuable.
All together, the pursuit of profit motivates firms to allocate resources to the production of goods and services
that are most highly valued by society. Firms allocate resources away from goods that are less valuable and
which generate less profit. These resources are then allocated toward goods that are more value, and which
generate more profit.
Revenue Minus Cost
A generic formula for specifying and calculating profit is:
profit
= revenue - cost
The critical consideration in this formula is what exactly is included as "cost." Accounting profit includes
accounting expenses as "cost." Economic profit includes economic, or opportunity, cost as "cost."
Profit Times Three
Different types of cost underlie three common notions of profit in the study of economics, especially short-run
production of a firm--accounting profit, economic profit, normal profit.
 Accounting Profit: The most common notion of profit in the real world of business activity, is the
difference between revenue and accounting cost. This is the profit listed on a firm's balance sheet, appears
periodically in the financial sector of the newspaper, and is reported to the Internal Revenue Service for tax
purposes. When real world talk turns to profit, it is invariably accounting profit.
Accounting profit is based on accounting cost--the explicit, out-of-pocket, expenses incurred by a firm.
While these explicit payments often compensate resources for their opportunity cost, such is not necessarily
the case. In some cases, an accounting cost is made even though no opportunity cost has occurred. In other
cases, an opportunity cost is incurred without an explicit payment.
 Economic Profit: The notion of profit preferred in economics is the difference between the total revenue
received by a firm and the total opportunity cost of production. Economic profit is what remains after ALL
opportunity cost associated with production, the opportunity cost incurred by ALL factors of production, is
deducted from the revenue generated by the production.
Economic profit is the "conceptually correct" notion of profit used in economics. If profit is revenue minus
cost, then economic profit is THE measure of profit.
 Normal Profit: The last notion of profit is the opportunity cost of using entrepreneurial abilities in the
production of a good, or the profit that could have been received by entrepreneurship in another business
venture. Like the opportunity costs of other resources, normal profit is deducted from revenue when
determining economic profit. It is, however, never included as an accounting cost when accounting profit is
computed.
Economic Profit and Rent
Economic profit is closely related to the term economic rent. In many cases the two terms can be use
synonymously with no loss of meaning. Both are the excess of revenue received over opportunity cost. If a
difference does exist, it is based on who receives the economic profit/rent. Economic profit is generally the term
used when a firm has an excess of revenue over opportunity cost. Economic rent, in contrast, is commonly used
when a specific resource receives revenue (that is, factor payment) over and above opportunity cost.
The idea of economic rent as an excess payment has its basis in rental payments to landowners. The
presumption is that because the land is "fixed" in supply, then the land would be supplied regardless of rental
payment. Whether the rent is high or low, the quantity of land supplied is the same. While this idea is not really
correct--land has alternative uses just like any other resource--the idea that economic rent represents excess
revenue, like economic profit, remains in use.
Adam Smith and His Invisible Hand of Capitalism
Adam Smith, a Scot and a philosopher who lived from 1723 to 1790, is considered the founder of modern
economics. In Smith's time, philosophy was an all-encompassing study of human society in addition to an inquiry
into the nature and meaning of existence. Deep examination of the world of business affairs led Smith to the
conclusion that collectively the individuals in society, each acting in his or her own self-interest, manage to
produce and purchase the goods and services that they as a society require. He called the mechanism by which

this self-regulation occurs “the invisible hand,” in his groundbreaking book, The Wealth of Nations, published in
1776, the year of America's Declaration of Independence.
While Smith couldn't prove the existence of this “hand” (it was, after all, invisible) he presented many instances
of its working in society. Essentially, the butcher, the baker, and the candlestick maker individually go about their
business. Each produces the amount of meat, bread, and candlesticks he judges to be correct. Each buys the
amount of meat, bread, and candlesticks that his household needs. And all of this happens without their consulting
one another or without all the king's men telling them how much to produce. In other words, it's the free market
economy in action.
In making this discovery, Smith founded what is known as classical economics. The key doctrine of classical
economics is that a laissez-faire attitude by government toward the marketplace will allow the “invisible hand” to
guide everyone in their economic endeavors, create the greatest good for the greatest number of people, and
generate economic growth. Smith also delved into the dynamics of the labor market, wealth accumulation, and
productivity growth. His work gave generations of economists plenty to think about and expand upon.
INVISIBLE HAND:
The notion that buyers and sellers, consumers and producers, households and businesses, by pursuing
their own self-interests do what is best for the economy automatically without any government intervention, as
if guided by an invisible hand. The invisible hand is an essential component of the economic analysis of
markets developed by Adam Smith in The Wealth of Nations. It continues to be a cornerstone of more
conservative economic policies that call for limits on government intervention in the economy.
How Does It Work?
The logic of the invisible hand is best illustrated through market competition among buyers and sellers. On
the demand side of a market, "selfish" buyers seek to obtain the most output at the lowest price. On the supply
side of a market, "selfish" sellers seek to obtain the highest price for the least output. Both sides are guided by the
"selfish" goal of getting the most and giving up the least.
Competition among buyers and sellers generates equilibrium and results in equality between the maximum
demand price that buyers are willing to pay and minimum supply price that sellers are willing to accept. When
the demand price and the supply price are equal, the market is efficient. When markets throughout the
economy are efficient, there is an efficient allocation of resources.
The invisible hand of market forces is thus guiding the economy to economic efficiency without the need for
government intervention.
A Few Qualifications
The invisible hand of competition does tend to move markets and the economy toward efficiency, it is very
effective, unless it encounters roadblocks along the way. The primary roadblocks come under the heading of
market failures. They include: (1) goods that are characterized by non rival consumption and/or problems excluding
non payers from consumption, (2) limited competition and market control by either buyers or sellers, (3) external
costs or benefits that are not reflected in demand price or supply price, or (4) limited or imperfect information about
the product or market transaction by either buyer sellers.
In each of these cases, the invisible hand of the market does not achieve efficiency without government
intervention.
A Word About Politics
The invisible hand notion has long been a rallying cry for those who favor little or no government
intervention in the economy. The logic is relatively clear--if the markets and the economy can achieve
efficiency without actions by government, then government actions are not needed to achieve efficiency.
Political conservatives, who champion limited government intervention, tend to embrace the invisible hand
notion a great deal more than political liberals, who promote activity government intervention.

CHAPTER 2
DEMAND DETERMINANTS:
Five ceteris paribus factors that affect demand, but which are assumed constant when a demand curve is
constructed. They are buyers' income, buyers' preferences, other prices, buyers' expectations, and number of
buyers. Changes in the demand determinants cause shifts of the demand curve and disruptions of the market.
Demand determinants are five ceteris paribus factors that are held constant when a demand curve is constructed.
They are held constant to isolate the law of demand relation between demand price and quantity demanded. When
the determinants change they cause a change in the location of the demand curve. In effect, demand determinants
can be said to "determine" the position of the demand curve.
What They Are
The five ceteris paribus demand determinants are buyers' income, buyers' preferences, other prices, buyers'
expectations, and number of buyers.
 Buyers' Income: The amount of income that buyers have available to spend on a good affects the ability to
purchase a good. In general, income has a direct affect on the ability to buy a good, that is, more income
means more buying. However, income can actually affect demand in two ways. For normal goods, more
income means more demand. For inferior goods, however, more income means less demand.
 Buyers' Preferences: The satisfaction buyers obtain from a good, based on buyers' preferences, wants,
needs, likes, and dislikes, affects the willingness to purchase a good. If a good provides greater
satisfaction, then buyers are inclined to purchase more.
 Other Prices: The demand for one good is based on the prices paid for other goods purchased by buyers. A
change in the price of a substitute good (or substitute-in-consumption) induces buyers to alter the mix of
goods purchased. An increase in the price of a substitute motivates buyers to buy more of one good and
less of the substitute good. A change in the price of a complement good (or complement-in-consumption)
induces buyers to demand more or less of both goods. An increase in the price of a complement motivates
buyers to buy less of one good as they buy less of the complement good.
 Buyers' Expectations: The decision to purchase a good today depends on expectations of future prices.
Buyers seek to purchase the good at the lowest possible price. If buyers expect the price to decline in the
future, they are inclined to buy less now. If they expect the price to rise in the future, they are inclined to
buy more now.
 Number of Buyers: The number of buyers willing and able to buy a good affects the overall demand. With
more buyers, there is more demand. With fewer buyers, there is less demand.
How They Work
These five demand determinants cause the demand curve to shift. This can be illustrated using the
negatively-sloped demand curve. This demand curve captures the specific one-to-one, law of demand relation
between demand price and quantity demanded. The demand determinants are assumed to remain constant with the
construction of this demand curve. When they change, the curve shifts.
The demand determinants are assumed constant for two reasons:
 One: To isolate the law of demand relation between demand price and quantity demanded
 Two: To systematically analyze what happens to demand when each determinant changes.
Reason number two provides a powerful analytical tool. By turning demand determinants off and on, allowing
each to change one at a time, a more thorough understanding of the demand side of
the market can be had.
Now, consider how changes in the demand determinants shift the demand curve. A
change in any of the five determinants can cause either an increase in demand or a
decrease in demand.
 Increase in Demand: An increase in demand is a rightward shift of the
demand curve. An increase in demand means that for any price, for every
price, buyers are willing and able to buy more of the good.
 Decrease in Demand: A decrease in demand is a leftward shift of the
demand curve. A decrease in demand means that for any price, for every
price, buyers are willing and able to buy less of the good.
Two Changes
Shifts of the demand curve caused by changes in the demand determinants suggests
two related notions--a change in demand and a change in quantity demanded.
 A Change in Demand: This a change in the overall demand relation, a
change in all price-quantity pairs. It is caused by a change in one of the five
demand determinants and is indicated by a shift of the demand curve.
Demand Determinants

 A Change in Quantity Demanded: This is a change in the specific amount of the good that buyers are
willing and able to purchase. It is caused by a change in the demand price and is indicated by a movement
along the demand curve from one point to another.
WHY DOES THE DEMAND CURVE SLOPE DOWNWARDS
Demand curve slopes downward to the right. The downward slope of the demand curve reads the law of demand
i.e. the quantity of a commodity demanded per unit of time increases as its price falls and vice versa. The reasons
behind the law of demand i.e. inverse relationship between price and quantity demanded are following:
Substitution Effect: When the price of a commodity falls it becomes relatively cheaper if price of all other related
goods, particularly of substitutes, remain constant. In other words, substitute goods become relatively costlier.
Since consumers substitute cheaper goods for costlier ones, demand for the relatively cheaper commodity
increases. The increase in demand on account of this factor is known as substitution effect.
Income Effect: As a result of fall in the price of a commodity, the real income of its consumer increase at least in
terms of this commodity. In other words, his/her purchasing power increases since he is required to pay less for the
same quantity. The increase in real income (or purchasing power) encourages demand for the commodity with
reduced price. The increase in demand on account of increase in real income is known as income effect. It should
however be noted that the income effect is negative in case of inferior goods. In case, price of an inferior good
accounting for a considerable proportion of the total consumption expenditure falls substantially, consumers’ real
income increases: they become relatively richer. Consequently, they substitute the superior good for the inferior
ones, i.e., they reduce the consumption of inferior goods.
Thus, the income effect on the demand for inferior goods becomes negative.
Diminishing Marginal Utility: Diminishing marginal utility as well is to be held responsible for the rise in
demand for a product when its price declines. When an individual purchases a product, he swaps his money
revenue with the product in order to increase his satisfaction. He continues to purchase goods and services as long
as the marginal utility of money (MUm) is lesser than the marginal utility of the commodity (MUC). Given the
price of a commodity, he modifies his purchase so that MUC = MUm. This plan works well under both
Marshallian assumption of constant MUm as well as Hicksian assumption of diminishing MUm. When price falls,
(MUm = Pc) < MUC. Thus, equilibrium state is upset. To get back his equilibrium state, i.e., MUm = PC, = MUC,
he buys more quantities of the commodity. For, when the supply of a commodity rises, its MU falls and once again
MUm = MUC. For this reason, demand for a product rises when its price falls.
PRICE ELASTICITY OF DEMAND:
The relative response of a change in quantity demanded to a change in price. More specifically the price elasticity
of demand is the percentage change in quantity demanded due to a percentage change in price. This notion of
elasticity captures the demand side of the market. A comparable elasticity on the supply side is the price elasticity
of supply. Other notable demand elasticities are income elasticity of demand and cross elasticity of demand.
The price elasticity of demand reflects the law of demand relation between price and quantity. An elastic demand
means that the quantity demanded is relatively responsive to changes in price. An inelastic demand means that the
quantity demanded is not very responsive to changes in price.
Suppose, for example, that the price of Vada pav increases by 10 percent (say Rs2.00 to Rs2.20). The higher price
is bound to cause the quantity demanded to decline. The price elasticity of demand answers the question: How
much? If the quantity demanded decreases by more than 10 percent (say from 100 hot Vada pav to 50 Vada pav ),
then demand is elastic. If the quantity demanded decreases by less than 10 percent (say from 100 hot fudge sundaes
to 99 hot fudge sundaes), then demand is inelastic.
A Summary Formula
The price elasticity of demand is often summarized by this handy formula:
price elasticity
of demand
=
percentage change in quantity demanded
percentage change in price
According to the law of demand, higher demand prices are related to smaller quantities demanded. As such, the
numerator and denominator of this formula always have opposite signs--if one is positive, the other is negative. If
the demand price increases and the percentage change in price is positive, then the quantity demanded decreases
and the percentage change in quantity demanded is negative. When calculated, the price elasticity of demand,
therefore, is always negative.
However, it is often convenient to ignore the negative sign when evaluating the relative response of quantity
demanded to price. For example, quantity demanded is very responsive to price if a 10 percent increase in price
induces a 50 percent decrease in quantity demanded. This generates a large "negative number," which is actually a
small "value." To avoid the possible confusion over a big number being a small value, the negative value of the
price elasticity of demand is generally ignored and focus is placed on the absolute magnitude of the number itself.

A Range of Elasticity
The price elasticity of demand is commonly divided into one of five
elasticity alternatives--perfectly elastic, relatively elastic, unit elastic,
relatively inelastic, and perfectly inelastic--depending on the relative
response of quantity to price. These five alternatives form a continuum of
possibilities.
The chart to the right displays the five alternatives based on the coefficient
of elasticity (E). The negative value obtained when calculating the price
elasticity of demand is ignored.
 Perfectly Elastic: The top of the chart begins with perfectly elastic,
given by E = ∞. Perfectly elastic means an infinitesimally small
change in price results in an infinitely large change in quantity
demanded.
 Relatively Elastic: The second category is relatively elastic, in
which the coefficient of elasticity falls in the range 1 < E < ∞. With relatively elastic demand, relatively
small changes in price cause relatively large changes in quantity. Quantity is very responsive to price. The
percentage change in quantity is greater than the percentage change in price. Here a 10 percent change in
price leads to more than a 10 percent change in quantity demanded (maybe something 20 percent).
 Unit Elastic: The third category is unit elastic, in which the coefficient of elasticity is E = 1. In this case,
any change in price is matched by an equal relative change in quantity. The percentage change in quantity
is equal to the percentage change in price. For example, a 10 percent change in price induces a equal 10
percent change in quantity demanded. Unit elastic is essentially a dividing line or boundary between the
elastic and inelastic ranges.
 Relatively Inelastic: The fourth category is relatively inelastic, in which the coefficient of elasticity falls in
the range 0 < E < 1. With relatively inelastic demand, relatively large changes in price cause relatively
small changes in quantity. Quantity is not very responsive to price. The percentage change in quantity is
less than the percentage change in price. In this case, a 10 percent change in price induces less than a 10
percent change in quantity demanded (perhaps only 5 percent).
 Perfectly Inelastic: The final category presented in this chart is perfectly inelastic, given by E = 0.
Perfectly inelastic means that quantity demanded is unaffected by any change in price. The quantity is
essentially fixed. It does not matter how much price changes, quantity does not budge.
Slope and Elasticity
The price elasticity of demand is related to, but different from, the slope of the demand curve. Consider the
formula for calculating the slope of the demand curve.
slope =
Change in price
Change in quantity demanded
Now consider the formula for calculating the price elasticity of demand.
price elasticity of demand =
percentage change in quantity demanded
percentage change in price
The key differences between these are:
 First, price is in the numerator and quantity is in the denominator for slope. In contrast, quantity is in the
numerator and price is in the denominator for elasticity. At the very least, slope is the inverse of elasticity.
When one is bigger the other is smaller.
 Second, slope is calculated using the measurement units for price and quantity. In contrast, elasticity is
calculated using percentage changes. As such, slope includes the measurement units (such as dollars per
hot fudge sundae), whereas elasticity is just a number with no measurement units. The value of slope
changes if the measurement units change (such as cents versus dollars). Not so for elasticity. Elasticity is
in relative values not absolute measurement units.
Three Determinants
Three factors that affect the numerical value of the price elasticity of demand are the availability of substitutes,
time period of analysis, and proportion of budget. A given good can have a different price elasticity of demand if
these determinants change.
 Availability of Substitutes: The ease with which buyers can find substitutes-in- consumption affects the
price elasticity of demand. The general rule is that goods with a greater availability of substitutes is more
sensitive to price changes. With more substitutes available, buyers can easily respond to price changes.
Consider, for example, Auntie Noodles Frozen Macaroni Dinner, an enjoyable, nutritious, and satisfying
Alternative Coefficient (E)
Perfectly Elastic E = ∞
Relatively Elastic 1 < E < ∞
Unit Elastic E = 1
Relatively Inelastic 0 < E < 1
Perfectly Inelastic E = 0

meal. Unfortunately for the Auntie Noodles company, it is one of thousands of comparable food products
on the market. The number of available substitutes makes the price elasticity of demand extremely elastic.
 Time Period of Analysis: The longer the time period of analysis, the more responsive quantities are to
price changes. Brief periods do not allow buyers the time needed to adjust their consumption decisions to
price changes. Buyers need time to find substitutes-in-consumption. Longer time periods allow buyers the
time needed to find alternatives. For example, the demand for 4M Cable Television is not very elastic.
Given the lack of close substitutes, buyers continue to buy even though prices rise, especially for brief
periods like a few months. However, given enough time (years? decades?) buyers are able to seek out
alternatives such as satellite dishes, and thus change their quantity demanded of cable television, resulting
in a more elastic demand.
 Proportion Of Budget: The price elasticity of demand depends on the proportion of the budget that buyers
devote to a good. The rule is this: The larger the portion, the more responsive quantity demanded is to
price changes. A house, for example, is a BIG budget item for most normal human beings. A relatively
small change, say 1 percent on a Rs100,000 house, can make a BIG difference in the buyer's decision to
buy. As such, relatively small changes in price are likely to induce relatively large changes in quantity
demanded.
Three Other Elasticities
The price elasticity of demand is one of four common elasticities used in the analysis of the market. The other
three are price elasticity of supply, income elasticity of demand, and cross elasticity of demand.
 Price Elasticity of Supply: On the other side of the market is the price elasticity of supply. This is the
relative response of quantity supplied to changes in the price. It is also analogously specified as the
percentage change in quantity supplied to a percentage change in price.
 Income Elasticity of Demand: This is the relative response of demand to changes in income, or the
percentage change in demand due to a percentage change in income. This elasticity quantifies the buyers'
income demand determinant.
 Cross Elasticity of Demand: This is the relative response of demand to changes in the price of another
good, or the percentage change in the demand for one good due to a percentage change in the price of the
other good. This elasticity quantifies the other prices demand determinant.
MEASUREMENT OF PRICE ELASTICITY:
(i) Total Outlay Method
(ii) Proportional Method
(iii) Geometrical Method
(i) Total Outlay Method: This method analyses the relationship between the price of commodity and total
revenue earned by the seller. Under this method, the elasticity of demand can be expressed in three ways, i.e.,
unitary elasticity, greater than unity elasticity, and less than unity elasticity.
a. Unitary Elasticity: Under the total outlay method, the unitary elasticity of demand is represented by the
situation when, even though the price has changed the total amount spent or total revenue (from seller’s point
of view) remains the same. This situation is represented by a ‘rectangular hyperbola’, where the elasticity is
unity throughout the demand curve at different price stages. (e = 1) P ↑ O ↕, P ↓ O ↕
b. Greater-than-unity Elasticity: Under the total outlay method, greater than unity elasticity of demand refers to
the situation when with the fall in price, the total amount spent by the consumer increases, and with the rise in
price, the total amount spent by the consumer decreases. (e > 1) P ↑ O↓, P ↓ O ↑
c. Less-than-unity Elasticity: Under the total outlay method, less than unity elasticity of demand refers to the
situation when the total amount spent or total revenue increases with the rise in price and the decreases with
the fall in price. (e < 1) P ↑ O ↑, P ↓ O↓
Price (Rs.) Quantity Demanded (Kgs) Total Outlay / Revenue (Rs.) Elasticity
10 100 1,000 e < 1
9 110 990 e < 1, e = 1
8.5 115 990 e = 1, e >1
10.2 125 1,275 e > 1
11 130 1,430 e > 1
(ii) Proportional Method: Under this method, elasticity of demand is measured in terms of a ratio of the
percentage change in the quantity demanded to the percentage change in price. It can be mathematically expressed
as follows:

Under this method, the elasticity of demand is always negative, although by convention, it is taken to be
positive. It is negative because the fall in price is followed by a rise in demand. Again, the elasticity is
stated in three forms, i.e., greater than unity elasticity, unitary elasticity and less than unity elasticity of
demand.
(iii) Geometrical Method: Geometrical method of measuring elasticity of demand can measure elasticity of
demand at any point on the demand curve. Elasticity is stated in terms of fraction and in three forms,
i.e., greater than unity, unitary and less than unity elasticity of demand. The middle of the curve
represent unitary elasticity, below to which, elasticity is less than unity, and above to which, elasticity
is greater than unity:
Point and Arc Elasticity:
1. The point elasticity refers to elasticity of demand at any point on a demand curve. Point elasticity
considers small changes in demand and price. The elasticity of demand on a particular point of demand
curve can be mathematically calculated as below:
2. According to Baumol, arc elasticity of demand is a measure of the average responsiveness to price
changes. This could be measured through finite stretch of a demand curve. Therefore, any two points on a
demand curve forms an arc, and between these two points, the arc provides measurement of elasticity of
demand over a certain range of price and quantities. This can be simply plotted into the following
mathematically formula:
IMPORTANCE OF ELASTICITY OF DEMAND
The concept of elasticity of demand is of great importance in practical life. Its main points are given as under:
1. Useful for Business: It enables the business in general and the monopolists in particular to fix the price.
Studying the nature of demand the monopolist fixes higher prices for those goods which have inelastic demand and
lower prices for goods which have elastic demand. In this way, this helps him to maximise his profit.
2. Fixation of Prices: It is very useful to fix the price of jointly supplied goods. In the case of joint products like
paddy and straw, the cost of production of each is not known. The price of each is then fixed by its elastic and
inelastic demand.
3. Helpful to Finance Minister: It helps the Finance Minister to levy tax on goods. After levying taxes more and
more on goods which have inelastic demand, the Government collects more revenue from the people without
causing them inconvenience. Moreover, it is also useful for the planning.
4. Fixation of Wages: It guides the producers to fix wages for labourers. They fix high or low wages according to
the elastic or inelastic demand for the labour.
5. In the Sphere of International Trade: It is of greater significance in the sphere of international trade. It helps
to calculate the terms of trade and the consequent gain from foreign trade. If the demand for home product is
inelastic, the terms of trade will be profitable to the home country.
6. Paradox of Poverty. It explains the paradox of poverty in the midst of plenty. A bumper crop instead of
bringing prosperity may result in disaster, if the demand for it is inelastic. This is specially so, if the products are
perishable and not storable.
7. Significant for Government Economic Policies. The knowledge of elasticity of demand is very important for
the government in such matters as controlling of business cycles, removing inflationary and deflationary gaps in
the economy. Similarly, for price stabilization and the purchase and sale of stocks, information about elasticity of
demand is most useful.

8. Determination of Price of Public Utilities. This concept is significant in the determination of the prices of
public utility services. Economic welfare of the society largely depends upon the cheap availability
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. In these conditions the forecasting is to be done by
taking into consideration the inclination and wishes of the customers to purchase. For this a research is to be
conducted. But there is one problem that it is difficult for a customer to say anything
without seeing and using the product before. Thus it is very difficult to forecast the demand for new products. Any
way Prof. Joel Dean has suggested the following methods for forecasting demand of new products:
1. Evolutionary approach: This method is based on the assumption that the new product is the improvement and
evolution of the old product. The demand is forecasted on the basis of the demand of the old product. For example,
the demand for black and white TV should be taken in to consideration while forecasting the demand for colour
TV sets because the latter is an improvement of the former.
2. Substitute approach: Here the new product is treated as a substitute of an existing product, e.g. polythene bags
for cloth bags. Thus the demand for a new product is analysed as a substitute for some existing goods or service.
3. Growth curve approach: Under this method the growth rate of demand of a new product is estimated on the
basis of the growth rate of demand of an existing product. Suppose Pears soap is in use and a new cosmetic is to be
introduced in the market. In this case the average sale of Pears soap will give an idea as to how the new cosmetic
will be accepted by the consumers.
4. Opinion poll approach: Under this method the demand for a new product is estimated on the basis of
information collected from the direct interviews (survey) with consumers.
5. Sales Experience approach: Under this method, the new product is offered for sale in a sample market, i.e. by
direct mail or through multiple shop or departmental shop. From this the total demand is estimated for the whole
market.
6. Vicarious approach: This method consists of surveying consumers' reactions through the specialised dealers
who are in touch with consumers. The dealers are able to know as to how the customers will accept the new
product. On the basis of their reports demand can be estimated.
The above methods are not mutually exclusive. It is de desirable to use a combination of two or more methods in
order to get better results.
PRICING UNDER VARIOUS MARKETS
Types of Market Structures
Monopoly Oligopoly Monopolistic
Competition
Perfect
Competition
No. of firms One Few Many Almost
infinite
Barriers to entry Significant Significant Few None
Pricing decisions MC = MR Strategic pricing MC = MR MC = MR = P
Output decisions Most output restriction Output restricted Output restricted,
product differentiation
No output
restriction
Interdependence No competitors Interdependent
decisions
Each firm independent Each firm
independent
LR profit Possible Possible None None
P and MC P > MC P > MC P > MC P = MC
PERFECT COMPETITION
Perfect competition in economic theory has a meaning diametrically opposite to the everyday use of the
term. In practice, businessmen use the word competition as synonymous to rivalry. In theory, perfect competition
implies no rivarly among firms. Perfect competition, therefore, can be defined as a market structure characterised
by a complete absence of rivalry among the individual firms.
FEATURES
1. Large number of buyers and sellers: There must be a large number of firms in the industry. Each individual
firm supplies only a small part of the total quantity offered in the market. As a result, no individual firm can
influence the price. Similarly, the buyers are also numerous. Hence, no individual buyer has any influence on the

market price. The price of the product is determined by the collective forces of industry demand and industry
supply. The firm is only a 'price taker'. Each firm has to adjust its output or sale according to the prevailing market
price.
2. Homogeneity of products: In a perfectly competitive industry, the product of any one firm is identical to the
products of all other firms. The technical characteristics of the product as well as the services associated with its
sale and delivery are identical. The demand curve of the individual firm is also its average revenue and its marginal
revenue curve. The assumptions of large numbers of sellers and product homogeneity imply that the individual
firm in pure competition is a price taker. Its demand curve is infinitely elastic indicating that the firm can sell any
amount of output at the prevailing market price.
3. Free entry exit: There is no barrier to entry or exit from the industry. Entry or exit may take time but firms
have freedom of movement in and out of the industry. If the industry earns abnormal profits, new firms will enter
the industry and compete away the excess profits. Similarly, if the firms in the industry are incurring losses some
of them will leave the industry which will reduce the supply of the industry and will thus raise the price and wipe
away the losses.
4. Absence of government regulation: There is no government intervention in the form of tariffs, subsidies,
relationship of production or demand. If these assumptions are fulfilled, it is called pure competition which
requires the fulfillment of some more condition.
5. Perfect mobility of factors of production: The factors of production are free to move from one firm to another
throughout the economy. It is also assumed that workers can move between different jobs. Raw materials and other
factors are not monopolised and labour is not unionised. In short, there is perfect competition in the factor market.
6. Perfect knowledge : It is assumed that all sellers and buyers have complete knowledge of the conditions of the
market. This knowledge refers not only to the prevailing conditions in the current period but in all future periods as
well. Information is free and costless. Under these conditions uncertainty about future developments in the market
is ruled out.
7. Absence of transport costs: In a perfectly competitive market, it is assumed that there are no transport costs.
PRICE DETERMINATION UNDER MONOPOLY
Monopoly is that market form in which a single producer controls the whole supply of a single commodity which
has no close substitute.
From this definition there are two points that must be noted:
(i) Single Producer: There must be only one producer who may be an individual, a partnership firm or a joint
stock company. Thus single firm constitutes the industry. The distinction between firm and industry disappears
under conditions of monopoly.
(ii) No Close Substitute: The commodity produced by the producer must have no closely competing substitutes, if
he is to be called a monopolist. This ensures that there is no rival of the monopolist. Therefore, the cross elasticity
of demand between the product of the monopolist and the product of any other producer must be very low.
PRICE-OUTPUT DETERMINATION UNDER MONOPOLY: A firm under monopoly faces a downward
sloping demand curve or average revenue curve. Further, in monopoly, since average revenue falls as more units of
output are sold, the marginal revenue is less than the average revenue. In other words, under monopoly the MR
curve lies below the AR curve. The Equilibrium level in monopoly is that level of output in which marginal
revenue equals marginal cost. The producer will continue producer as long as marginal revenue exceeds the
marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond this point the
producer will stop producing.
It can be seen from the
diagram that up till OM output, marginal revenue is greater than marginal cost, but beyond OM the marginal
revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium at output OM where marginal
revenue is equal to marginal cost and the profits are the greatest. The corresponding price in the diagram is MP’ or
OP. It can be seen from the diagram at output OM, while MP’ is the average revenue, ML is the average cost,
therefore, P’L is the profit per unit. Now the total profit is equal to P’L (profit per unit) multiply by OM (total
output).
In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop producing. In the
long run, the monopolist can change the size of plant in response to a change in demand. In the long run, he will
make adjustment in the amount of the factors, fixed and variable, so that MR equals not only to short run MC but
also long run MC.

COMPARISON OF PRICE DETERMINATION UNDER PERFECT COMPETITION AND MONOPOLY:
The key points of comparison of price determination under Perfect Competition and Monopoly is as below:
Perfect Competition Monopoly
(i) The demand curve or average revenue curve is perfectly
elastic and is a horizontal straight line.
(i) The demand curve or average revenue curve is
relatively elastic and a downward sloping from
left to right.
(ii) The firm is in equilibrium at the level of output where
MC is equal to MR. Since in perfect competition MR is
equal to AR or price, therefore, when MC is equal to MR, it
is also equal to AR or price at the equlibrium position, i.e.,
MC=MR=AR (Price)
(ii) The firm is in equilibrium at the level of
output where MC is equal to MR.
(iii) In equilibrium position, the price charged by the firm
equals to MC.
(iii) In equilibrium position, the price charged by
the firm is above MC.
(iv) The firm is in long-run equilibrium at the minimum
point of the long-run AC curve.
(iv) The firm is in long-run equilibrium at the
point where AC curve is still declining and has
not reached the minimum point.
(v) The firm is in equilibrium at the level of output at which
MC curve is rising, and is cutting MR curve from below.
(v) The firm is in equilibrium at the level of
output at which MR curve is sloping downwards,
and MC curve is cutting it from below or above.
(See figure 1)
(vi) In the long run, the firm is earning normal profit. There
may be super normal profit in the short run but they will be
swept away in the long run, as new firms entered into the
industry.
(vi) The firm can earn abnormal or supernormal
profit even in the long run, as there is no
competitor in the industry.
(vii) Price can be set lower at greater output in case of
constant-cost and decreasing-cost industries.
(vii) Price is set higher and output smaller by the
monopolist. (See Figure 2)
PRICE DISCRIMINATION IN MONOPOLY:
Price discrimination may be (a) personal, (b) local, or (c) according to trade or use:
(a) Personal: It is personal when different prices are charged for different persons.
(b) Local: It is local when the price varies according to locality.
(c) According to Trade or Use: It is according to trade or use when different prices are charged for different uses
to which the commodity is put, for example, electricity is supplied at cheaper rates for domestic than for
commercial purposes.
Some monopolists used product differentiation for price discrimination by means of special labels, wrappers,
packing, etc. For example, the perfume manufacturers discriminate prices of the same fragrance by packing it with
different labels or brands.

Conditions of Price-Discrimination: There are three main types of situation:
(a) When consumers have certain preferences or prejudices. Certain consumers usually have the irrational
feeling that they are paying higher prices for a good because it is of a better quality, although actually it
may be of the same quality. Sometimes, the price differences may be so small that consumers do not
consider it worthwhile to bother about such differences.
(b) When the nature of the good is such as makes it possible for the monopolist to charge different prices.
This happens particularly when the good in question is a direct service.
(c) When consumers are separated by distance or tariff barriers. A good may be sold in one town for Re. 1
and in another town for Rs. 2. Similarly, the monopolist can charge higher prices in a city with greater
distance or a country levying heavy import duty.
Conditions making Price Discrimination Possible and Profitable: The following conditions are essential to
make price discrimination possible and profitable:
(a) The elasticities of demand in different markets must be different. The market is divided into sub-markets.
The sub-market will be arranged in ascending order of their elasticities, the higher price being charged in the least
elastic market and vice versa.
(b) The costs incurred in dividing the market into sub-markets and keeping them separate should not be so large
as to neutralise the difference in demand elasticities.
(c) There should be complete agreement among the sellers otherwise the competitors will gain by selling in the
dear market.
(d) When goods are sold on special orders because then the purchaser cannot know what is being charged from
others.
Price Determination under Price Discrimination:
(i) First of all, the monopolist divides his total market into sub-markets. In the following diagrams,
the monopolist has divided his total market into two sub-markets, i.e., A and B:
(ii) The monopolist has now to decide at what level of output he should produce. To achieve maximum
profit, hence, he will be in equilibrium at output at which MR=MC, and MC curve cuts the MR curve from below.
In the above diagram (c) it is shown that the equilibrium of the discriminating monopolist is established at output
OM at which MC cuts CMR. The output OM is distributed between two markets in such a way that marginal
revenue in each is equal to ME. Therefore, he will sell output OM1 in Market A, because only at this output
marginal revenue MR’ in Market A is equal to ME (M1E’ = ME). The same condition is applied in Market B
where MR” is equal to ME (M2E” = ME). In the above diagram, it is also shown that in Market B in which
elasticity of demand is greater, the price charged is lower than that in Market B where the elasticity of demand is
less.
Price Determination under Oligopoly
Oligopoly is that market situation in which the number of firms is small but each firm in the industry takes into
consideration the reaction of the rival firms in the formulation of price policy. The number of firms in the industry
may be two or more than two but not more than 20. Oligopoly differs from monopoly and monopolistic
competition in this that in monopoly, there is a single seller; in monopolistic competition, there is quite a larger
number of them; and in oligopoly, there are only a small number of sellers.
CLASSIFICATION OF OLIGOPOLY: The oligopolistic industries are classified in a number of ways:
(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is further classified as below:
(i) Perfect or Pure Duopoly: If the duopolists in an industry are producing identical products it is called
perfect or pure duopoly.
(ii) Imperfect or Impure Duopoly: If the duopolists in an industry are producing differentiated products it is
called imperfect or impure duopoly.
(b) Oligopoly: If there are more than two firms in an industry and each firm takes consideration the reactions of
the rival firms in formulating its own price policy it is called oligopoly. Oligopoly is further classified as below:
(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are producing identical products it is called
perfect or pure oligopoly.

(ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry are producing differentiated products it
is called imperfect or impure oligopoly.
CAUSES OF OLIGOPOLY:
1. Economies of Scale: The firms in the industry, with heavy investment, using improved technology and
reaping economies of scale in production, sales, promotion, etc, will compete and stay in the market.
2. Barrier to Entry: In many industries, the new firms cannot enter the industry as the big firms have ownership
of patents or control of essential raw material used in the production of an output. The heavy expenditure on
advertising by the oligopolistic industries may also be a financial barrier for the new firms to enter the
industry.
3. Merger: If the few firms in the industry smell the danger of entry of new firms, they then immediately merge
and formulate a joint policy in the pricing and production of the products. The joint action of the few big firms
discourages the entry of new firms into the industry.
4. Mutual Interdependence: As the number of firms is small in an oligopolistic industry, therefore, they keep a
strict watch of the price charged by rival firms in the industry. The firm generally avoid price ware and try to
create conditions of mutual interdependence.
CHARACTERISTICS OF OLIGOPOLY:
1. Every seller can exercise an important influence on the price-output policies of his rivals. Every seller is
so influential that his rivals cannot ignore the likely adverse effect on them of a given change in the price-
output policy of any single manufacturer. The rival consciousness or the recognition on the part of the
seller is because of the fact of interdependence.
2. The demand curve under oligopoly is indeterminate because any step taken by his rivals may change the
demand curve. It is more elastic than under simple monopoly and not perfectly elastic as under perfect
competition.
3. It is often noticed that there is stability in price under oligopoly. This is because the oligopolist avoids
experimenting with price changes. He knows that if raises the price, he will lose his customers and if he
lowers it he will invite his rivals to price war.
EFFECTS OF OLIGOPOLY:
1. Small output and high prices: As compared with perfect competition, oligopolist sets the prices at higher
level and output at low level.
2. Restriction on the entry: Like monopoly, there is a restriction on the entry of new firms in an oligopolistic
industry.
3. Prices exceed Average Cost: Under oligopoly, the firms fixed the prices at the level higher than the AC. The
consumers have to pay more than it is necessary to retain the resources in the industry. In other words, the
economy’s productive capacity is not utilised in conformity with the consumers’ preferences.
4. Lower efficiency: Some economists argued that there is a low level of production efficiency in oligopoly.
There is no tendency for the oligopolists to build optimum scales of plant and operate them at the optimum
rates of output. However, the Schumpeterian hypothesis states that there is high tendency of innovation and
technological advancement in oligopolistic industries. As a result, the product cost decreases with production
capacity enhancement. It will offset the loss of consumer surplus from too high prices.
5. Selling Costs: In order to snatch markets from their rivals, the oligopolistic firms may engage in aggressive
and extensive sales promotion effort by means of advertisement and by changing the design and improving the
quality of their products.
6. Wider range of products: As compared with pure monopoly or pure competition, differentiated oligopoly
places at the consumers’ disposal a wider variety of commodities.
7. Welfare Effect: Under oligopoly, vide sums of money are poured into sales promotion to create quality and
design differentiations. Hence, from the point of view of economic welfare, oligopoly fares fairly badly. The
oligopolists push non-price competition beyond socially desirable limits.
PRICE DETERMINATION UNDER OLIGOPOLY: The price and output behaviour of the firms operating in
oligopolistic or duopolistic market condition can be studied under two main heads:
1. Price and Output Determination under Duopoly:
(a) If an industry is composed of two giant firms each selling identical or homogenous products and having half
of the total market, the price and output policy of each is likely to affect the other appreciably, therefore there
is every likelihood of collusion between the two firms. The firms may agree on a price, or divide the total
market, or assign quota, or merge themselves into one unit and form a monopoly or try to differentiate their
products or accept the price fixed by the leader firm, etc.
(b) In case of perfect substitutes the two firms may be engaged in price competition. The firm having lower
costs, better goodwill and clientele will drive the rival firm out of the market and then establish a monopoly.

(c) If the products of the duopolists are differentiated, each firm will have a close watch on the actions of its rival
firms. The firm good quality product with lesser cost will earn abnormal profits. Each firm will fix the price of
the commodity and expand output in accordance with the demand of the commodity in the market.
2. Price and Output Determination under Oligopoly:
(a) If an industry is composed of few firms each selling identical or homogenous products and having powerful
influence on the total market, the price and output policy of each is likely to affect the other appreciably, therefore
they will try to promote collusion.
(b) In case there is product differentiation, an oligopolist can raise or lower his price without any fear of losing
customers or of immediate reactions from his rivals. However, keen rivalry among them may create condition of
monopolistic competition.
There is no single theory which satisfactorily explains the oligopoly behaviour regarding price and output in the
market. There are set of theories like Cournot Duopoly Model, Bertrand Duopoly Model, the Chamberlin Model,
the Kinked Demand Curve Model, the Centralised Cartel Model, Price Leadership Model, etc., which have been
developed on particular set of assumptions about the reaction of other firms to the action of the firm under study.
COLLUSIVE OLIGOPOLY: The degree of imperfect competition in a market is influenced not just by the
number and size of firms but by how they behave. When only a few firms operate in a market, they see what their
rivals are doing and react. ‘Strategic interaction’ is a term that describes how each firm’s business strategy depends
upon its rivals’ business behaviour.
When there are only a small number of firms in a market, they have a choice between ‘cooperative’ and ‘non-
cooperative’ behaviour:
 Firms act non-cooperatively when they act on their own without any explicit or implicit agreement with
other firms. That’s what produces ‘price wars’.
 Firms operate in a cooperative mode when they try to minimise competition between them. When firms in
an oligopoly actively cooperate with each other, they engage in ‘collusion’. Collusion is an oligopolistic
situation in which two or more firms jointly set their prices or outputs, divide the market among them, or
make other business decisions jointly.
A ‘cartel’ is an organisation of independent firms, producing similar products, which work together to raise prices
and restrict output. It is strictly illegal in Pakistan and most countries of the world for companies to collude by
jointly setting prices or dividing markets. Nonetheless, firms are often tempted to engage in ‘tacit collusion’, which
occurs when they refrain from competition without explicit agreements. When firms tacitly collude, they often
quote identical (high) prices, pushing up profits and decreasing the risk of doing business. The rewards of
collusion, when it is successful, can be great. It is more illustrated in the following diagram:
.
The above diagram illustrates the situation of oligopolist A and his demand curve DaDa assuming that the other
firms all follow firm A’s lead in raising and lowering prices. Thus the firm’s demand curve has the same elasticity
as the industry’s DD curve. The optimum price for the collusive oligopolist is shown at point G on DaDa just
above point E. This price is identical to the monopoly price, it is well above marginal cost and earns the colluding
oligopolists a handsome monopoly profit.
PRICE DETERMINATION MODELS OF OLIGOPOLY:
1. Kinky Demand Curve: The kinky demand curve model tries to explain that in non-collusive oligopolistic
industries there are not frequent changes in the market prices of the products. The demand curve is drawn on the
assumption that the kink in the curve is always at the ruling price. The reason is that a firm in the market supplies a
significant share of the product and has a powerful influence in the prevailing price of the commodity. Under
oligopoly, a firm has two choices:
(a) The first choice is that the firm increases the price of the product. Each firm in the industry is fully aware of
the fact that if it increases the price of the product, it will lose most of its customers to its rival. In such a case, the
upper part of demand curve is more elastic than the part of the curve lying below the kink.
(b) The second option for the firm is to decrease the price. In case the firm lowers the price, its total sales will
increase, but it cannot push up its sales very much because the rival firms also follow suit with a price cut. If the
rival firms make larger price cut than the one which initiated it, the firm which first started the price cut will suffer
a lot and may finish up with decreased sales. The oligopolists, therefore avoid cutting price, and try to sell their

products at the prevailing market price. These firms, however, compete with one another on the basis of quality,
product design, after-sales services, advertising, discounts, gifts, warrantees, special offers, etc.
In the above diagram, we shall notice that
there is a discontinuity in the marginal revenue curve just below the point corresponding to the kink.
During this discontinuity the marginal cost curve is drawn. This is because of the fact that the firm is in
equilibrium at output ON where the MC curve is intersecting the MR curve from below. The kinky
demand curve is further explained in the following diagram:
In the above diagram, the demand
curve is made up of two segments DB and BD’. The demand curve is kinked at point B. When the price is
Rs. 10 per unit, a firm sells 120 units of output. If a firm decides to charge Rs. 12 per unit, it loses a large
part of the market and its sales come down to 40 units with a loss of 80 units. In case, the producer lowers
the price to Rs. 4 per unit, its competitors in the industry will match the price cut. Its sales with a big price
cut of Rs. 6 increases the sale by only 40 units. The firm does not gain as its total revenue decreases with
the price cut.
2. Price Leadership Model: Under price leadership, one firm assumes the role of a price leader and fixes the price
of the product for the entire industry. The other firms in the industry simply follow the price leader and accept the
price fixed by him and adjust their output to this price. The price leader is generally a very large or dominant firm
or a firm with the lowest cost of production. It often happens that price leadership is established as a result of price
war in which one firm emerges as the winner.
In oligopolistic market situation, it is very rare that prices are set independently and there is usually some
understanding among the oligopolists operating in the industry. This agreement may be either tacit or explicit.
Types of Price Leadership: There are several types of price leadership. The following are the principal types:
(a) Price leadership of a dominant firm, i.e., the firm which produces the bulk of the product of the industry. It
sets the price and rest of the firms simply accepts this price.
(b) Barometric price leadership, i.e., the price leadership of an old, experienced and the largest firm assumes the
role of a leader, but undertakes also to protect the interest of all firms instead of promoting its own interests as in
the case of price leadership of a dominant firm.
(c) Exploitative or Aggressive price leadership, i.e., one big firm built its supremacy in the market by following
aggressive price leadership. It compels other firms to follow it and accept the price fixed by it. In case the other
firms show any independence, this firm threatens them and coerces them to follow its leadership.
Price Determination under Price Leadership: There are various models concerning price-output determination
under price leadership on the basis of certain assumptions regarding the behaviour of the price leader and his
followers. In the following case, there are few assumptions for determining price-output level under price
leadership:
(a) There are only two firms A and B and firm A has a lower cost of production than the firm B.
(b) The product is homogenous or identical so that the customers are indifferent as between the firms.
(c) Both A and B have equal share in the market, i.e., they are facing the same demand curve which will be the
half of the total demand curve.
In the above diagram, MCa is the marginal cost
curve of firm A and MCb is the marginal cost curve of firm B. Since we have assumed that the firm A has a lower
cost of production than the firm B, therefore, the MCa is drawn below MCb. Now let us take the firm A first, firm

102 ECONOMIC ANALYSIS FOR BUSINESS DECISIONS course note

102 ECONOMIC ANALYSIS FOR BUSINESS DECISIONS course note

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