Download to read offline
![Dr. Bhati Rakesh 3 | P a g e
INTRODUCTION
The discovery of managerial economics as a separate course in management studies has been
attributed to three major factors:
1] The growing complexity of business decision-making processes, because of changing market
conditions and the globalization of business transactions.
2] The increasing use of economic logic, concepts, theories, and tools of economic analysis in business
decision-making processes.
3] Rapid increase in demand for professionally trained managerial manpower.
It should be noted that the recent complexities associated with business decisions has increased the
need for application of economic concepts, theories and tools of economic analysis in business decisions.
The reason has been that making appropriate business decision requires clear understanding of existing
market conditions market fundamentals and the business environment in general. Business decision-
making processes therefore, requires intensive and extensive analysis of the market conditions in the
product, input and financial markets. Economic theories, logic and tools of analysis have been developed for
the analysis and prediction of market behaviours. The application of economic concepts, theories, logic, and
analytical tools in the assessment and prediction of market conditions and business environment has
proved to be a significant help to business decision makers all over the globe.
DEFINITION OF MANAGERIAL ECONOMICS
Managerial economics has been generally defined as the study of economic theories, logic and tools
of economic analysis, used in the process of business decision making. It involves the understanding and use
of economic theories and techniques of economic analysis in analyzing and solving business problems.
Economic principles contribute significantly towards the performance of managerial duties as well as
responsibilities. Managers with some working knowledge of economics can perform their functions more
effectively and efficiently than those without such knowledge. Taking appropriate business decisions
requires a good understanding of the technical and environmental conditions under which business
decisions are taken. Application of economic theories and logic to explain and analyse these technical
conditions and business environment can contribute significantly to the rational decision-making process.
According to McNair and Meriam, "Managerial Economics consists of the use of economic modes of thought
to analyse business situation."
Spencer and Siegelman have defined Managerial Economics as "The integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by management."
SCOPE OF MANAGERIAL ECONOMICS
Managerial economics comprises both micro- and macro-economic theories. Generally, the scope of
managerial economics extends to those economic concepts, theories, and tools of analysis used in analysing
the business environment, and to find solutions to practical business problems. In broad terms, managerial
economics is applied economics. The areas of business issues to which economic theories can be directly
applied are divided into two broad categories:
1. Operational or internal issues; and,
2. Environment or external issues.
Operational problems are of internal nature. These problems include all those problems which
arise within the business organization and fall within the control of management. Some of the basic internal
issues include: choice of business and the nature of product (what to produce); choice of size of the firm
(how much to produce); choice of technology (choosing the factor combination); choice of price (product
pricing); how to promote sales; how to face price competition; how to decide on new investments; how to
manage profit and capital; and, how to manage inventory.
UNIT– 1
UNIT -I Managerial Economics: Concept of Economy, Economics, Microeconomics,
Macroeconomics. Nature and Scope of Managerial Economics, Managerial Economics and
decision-making. Concept of Firm, Market, Objectives of Firm: Profit Maximization Model,
Economist Theory of the Firm, Cyert and March’s Behavior Theory, Marris’ Growth
Maximisation Model, Baumol’s Static and Dynamic Models, Williamson’s Managerial
Discretionary Theory.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-3-320.jpg)
![Dr. Bhati Rakesh 12 | P a g e
3. The application of the law to the indivisible bulky commodity seems to be absurd. Because no one would
normally buy at a time more than one unit of good like television set, refrigerator, scooter, motor car etc.
It would be absurd to talk of increase in the stock of such goods and marginal utility thus derived.
4. The law unrealistically assumes constant marginal utility of money, which is highly unsatisfactory, with
the increase in purchase of goods, for consumption, the marginal utility of money will increase due to the
diminishing stock of purchasing power.
IMPORTANCE OF THE LAW:
The law of diminishing marginal utility has great economic significance, theoretical as well as practical. From
the theoretical point of view the law is important because,
1. The law explains the behaviour and the equilibrium condition of a rational consumer with respect to a
single want and commodity.
2. The law of diminishing marginal utility is the basic law of economics. It provides the foundation for
various laws of consumption. The law of demand is the outcome of the law of diminishing marginal
utility. The law of demand states that larger quantities are purchased at a lower price. The reason is that
as more units of a commodity are purchased its marginal utility to the consumer becomes less and less
and so he gives lesser importance to additional units of a commodity. Therefore, he will buy additional
units of a commodity only at a lower price.
3. The law explains the Paradox of value (The diamond-water paradox): The value-in-use and value-in-
exchange for a commodity are different. Diamonds have great value-in-exchange, as they are scarce in
supply, they have greater marginal utility, and therefore, value is high. On the other hand, water is in
abundant supply and its marginal utility is very low. Therefore, it commands no price even though its
total utility is high. Thus water has great value in use but no value in exchange. Diamonds have great
value in exchange though they are less useful than water. The price of a commodity is thus, related to its
marginal utility.
4. Prof. Marshall has built up his theory of taxation and public expenditure on the basis of the law of
diminishing marginal utility. The principle of progression has been deduced in the theory of taxation by
the application of this law, to money. Further, it is argued that there should be equitable distribution of
wealth because the utility derived by the rich from money is much less than what could accrue to the
poor. If Rs. 100 deducted from the rich man’s income, means only a small sacrifice of comparatively little
utility, while the addition to the amount to the poor man’s income, will increase his satisfaction by more
than what a rich man has lost, therefore, methods should be devised to redistribute the national income
on a more equitable basis.
PRACTICAL SIGNIFICANCE OF THE LAW:
1. To the producer, the law serves as a guide to promote sales by reducing prices. Because, when the price
falls, to attain equilibrium the consumer has to decrease the marginal utility to that extent. To do this he
has to purchase more goods as the marginal utility diminishes only when the stock increases.
2. The law is useful to the finance minister in formulating an appropriate tax policy. He can justify
progressive taxation on higher income on the ground that rich people will feel relatively lesser impact of
the tax burden as the marginal utility of money is lower with the increase in income.
3. Similarly socialists can agitate for a redistribution of wealth to promote welfare on the ground that the
transfer will cause more gain to the poor and less sacrifice to the rich.
EXCEPTIONS TO THE LAW OF DIMINISHING MARGINAL UTILITY:
Under the assumptions of homogeneity, continuity, reasonability, constancy and rationality, the law is deemed
to be universal. In certain cases, however, it has been observed that a consumer tends to attain increasing
marginal utility with an increase in the stock of a commodity consumed or acquired. Such cases are treated as
exception to the law of diminishing marginal utility. These exceptions are:
1] Hobbies: It is often argued that in the case of hobbies like stamp collection, collection of antique goods,
collection of old coins etc, every additional unit gives more pleasure, that is, marginal utility, tends to
increase. No doubt this is true, but, it is not a genuine exception to the law of diminishing utility, because in
such cases, homogeneity condition of the law is violated. Indeed each time a new variety of stamp or coin or
antique is collected by a person but not of the same variety.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-12-320.jpg)
![Dr. Bhati Rakesh 13 | P a g e
2] Alcoholics: The law seems to be inapplicable to alcoholics as intoxicants increases with every successive
dose of liquor. This is true, but the rationality condition of the law is violated. The introspective behaviour
of an alcoholic at that time is irrational or abnormal.
3] Misers: In the case of a miser, it is pointed out that greed increases with every additional acquisition of
money. Hence, the marginal utility of money does not diminish for him with more and more money. But,
when the miser spends his money his utility of the commodity will be diminishing perhaps more rapidly
than in the case of others. Hence, a miser’s behaviour cannot be a significance exception to the law of
diminishing marginal utility.
4] Music and poetry: In the case of music and poetry it’s commonly experienced that a repeat gives a better
satisfaction than the first one. Hence, it is thought that the law of diminishing marginal utility may not be
applicable here. But there is a limit to repeated hearing of the same music and poetry because, it will
become monotonous and yields disutility, so it is not a genuine exception to the law.
5] Reading: Since more reading gives more knowledge a scholar would get more and more satisfaction with
every additional book. But, here we may point out that it is not a real exception to the law as the condition
of homogeneity is violated here. Knowledge and satisfaction increases by reading different books and not
the same book over and over again.
THE LAW OF MAXIMUM SATISFACTION / THE LAW OF EQUI-MARGINAL UTILITY/ THE LAW OF
SUBSTITUTION:
This law is developed by H.H Gossen so it is also called the second law of Gossen. We know human wants are
unlimited but the resources to fulfill the wants are limited. A rational consumer always tries to maximize his
satisfaction by spending his limited money income. Consumer can maximize his satisfaction if he is able to
equalize the marginal utility derived from the consumption of different units of several commodities by
spending his all limited money income so that this law is known as law of maximum satisfaction or law of equi-
marginal utility.
This law is also known as law of substitution because consumer can maximize his/her satisfaction when he/she
substitutes the commodities having high marginal utility instead of commodities having the low marginal
utility. Mathematically it is expressed as:
This law is based on the following ASSUMPTIONS:
1. Consumers should be rational
2. Price of commodity remains constant
3. Income of consumers remains constant
4. Utility can be measured in numbers
5. Marginal utility of money remains constant
EXCEPTIONS/ LIMITATIONS of the law of substitution:
1. Utility can’t be measured in numbers: Utility can’t be measured in terms of numbers. It can only be
expressed in terms of range i.e. high or low.
2. Ignorance of consumers: If the consumer is ignorant about the availability of substitute goods in market
then he can’t substitute the commodity having high M.U instead of low.
3. Frequent change in price: This law assumes that price of commodity remains constant. Generally utility
is judged on the price. If the price changes then there is not application on the law of diminishing M.U. At
that time we can’t measure M.U of different commodity properly.
4. Influence of custom and fashion: In the case of commodity related to custom and fashion this law is not
applicable because while purchasing such commodity they don’t care about equalizing M.U from different
commodity.
5. M.U of money doesn’t remains constant: This law assumes that M.U of money is constant but in reality
M.U of money is changeable on the basis of amount of money with people.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-13-320.jpg)
![Dr. Bhati Rakesh 18 | P a g e
PERFECT SUBSTITUTES AND COMPLEMENTS:
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is
constant.
Two goods are perfect complements when the indifference curves for the goods are shaped as right
angles [L-shape]
THE BUDGET LINE:
The budget line shows all the different combinations of commodities
that a consumer can purchase, given his money income and the prices of
commodities. The budget line can be written as follows:
Px.X + Py.Y = M
Where, Px is the price of commodity X, Py is the price of commodity
Y M : is the consumer’s income
Subtracting Px.X from both sides of the above equation gives
Py.Y = M - Px.X
Divide each side of above equation by Py yields;
X
P
P
P
M
Y
y
x
y
Slope is given by the change in Y due to change in X; -
y
x
P
P
ΔX
ΔY
The slope of the budget line in the ratio of the prices of the two goods ( i.e.
Y
X
P
P
)
CHANGES IN THE BUDGET LINE:
(1) Parallel Shifts: if the consumer’s money income increases or decreases, or if the prices changes for both
goods decrease or increase proportionally, then the budget line will shift out to the right in a parallel
manner, or in to the left in a parallel manner.
(2) Inward Pivots: if the price of one good increases, the budget line will pivot inward with respect to that
good’s axis. In the example below, the price of Good X increases.
(3) Outward Pivots: if the price of one good decreases, the budget line will pivot outward with respect to
that good’s axis. In the example below, the price of Good Y decreases.
CONSUMER’S EQUILIBRIUM - INDIFFERENCE CURVE ANALYSIS:
According to the ordinal approach, a consumer has a given scale of preference for different combinations of two
goods. By just comparing the levels of satisfaction, he can derive maximum satisfaction out of a given money
income.
Consumer’s equilibrium refers to a situation in which a consumer with given income and given prices
purchases such a combination of goods and services as gives him maximum satisfaction and he is not willing to
make any change in it.
ASSUMPTIONS OF CONSUMER’S EQUILIBRIUM:
1. Consumer is rational and so maximises his satisfaction from the purchase of two goods.
2. Consumer’s income is constant.
3. Prices of the goods are constant.
4. Consumer knows the price of all things.
5. Consumer can spend his income in small quantities.
6. Goods are divisible.
7. There is perfect competition in the market.
8. Consumer is fully aware of the indifference map.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-18-320.jpg)
![Dr. Bhati Rakesh 31 | P a g e
(iii) CONSUMER CLINICS:
In this method some selected buyers are given certain amounts of money and asked to buy the products.
Then the prices are changed and the consumers are asked to make fresh purchases with the given money.
In this way the consumers" responses to price changes are observed. Thus the behaviour of the
consumers is studied. On this basis demand is estimated. This method is an improvement over
consumer’s interview method.
Merits:
1] It provides an opportunity to study the behaviour of consumers directly.
2] It provides reliable and realistic picture about future demand.
3] It gives useful information to aid in the decision making process.
Demerits:
1] It is a time consuming method.
2] Selecting the participants is very difficult.
3] It is expensive.
4] Consumers may take it as a game. They may not reveal their preferences.
(iv) END USE METHOD:
This method is based on the fact that a product generally has different uses. In the end use method, first a
list of end users (final consumers, individual industries, exporters etc.) is prepared. Then the future
demand for the product is found either directly from the end users or indirectly by estimating their
future growth. Then the demand of all end users of the product is added to get the total demand for the
product.
(B) STATISTICAL METHODS:
Statistical methods use the past data as a guide for knowing the level of future demand. Statistical
methods are generally used for long run forecasting. These methods are used for established products.
Statistical methods include: (i) Trend projection method, (ii) Regression and Correlation, (iii)
Extrapolation method, (iv) Simultaneous equation method, and (v) Barometric method.
(i) Trend projection method: Future sales are based on the past sales, because future is the grand-
child of the past and child of the present. Under the trend projection method demand is estimated
on the basis of analysis of past data. This method makes use of time series (data over a period of
time). We try to ascertain the trend in the time series. The trend in the time series can be estimated
by using any one of the following four methods: (a) Least-square method, (b) Free-hand method,
(c) Moving average method and (d) semi-average method.
(ii) Regression and Correlation: These methods combine economic theory and statistical technique
of estimation. Under these methods the relationship between the sales (dependent variable) and
other variables (independent variables such as price of related goods, income, advertisement etc.)
is ascertained. Such relationship established on the basis of past data may be used to analyse the
future trend. The regression and correlation analysis is also called the econometric model building.
(iii) Extrapolation: Under this statistical method, the future demand can be extrapolated by applying
Binomial expansion method. This method is used on the assumption that the rate of charge in
demand in the past has been uniform.
(iv) Simultaneous equation method.-This involves the development of a complete econometric model
which can explain the behaviour of all the variables which the company can control. This method is
not very popular.
(v) Barometric technique: This is an improvement over the trend projection method. According to
this technique the events of the present can be used to predict the directions of change m the
future. Here certain economic and statistical indicators from the selected time series are used to
predict variables. Personal income, non-agricultural placements, gross national income, prices of
industrial materials, wholesale commodity prices, industrial production, bank deposits etc. are
some of the most commonly used indicators.
Advantages of Statistical Methods:
1]The method of estimation is scientific
2]Estimation is based on the theoretical relationship between sales (dependent variable) and price,
advertising, income etc. (independent variables)
3]These are less expensive. 4 Results are relatively more reliable.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-31-320.jpg)
![Dr. Bhati Rakesh 32 | P a g e
Disadvantages of Statistical Methods:
1]These methods involve complicated calculations.
2]These do not rely much on personal skill and experience.
3]These methods require considerable technical skill and experience in order to be effective.
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.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-32-320.jpg)
![Dr. Bhati Rakesh 37 | P a g e
than percentage change in price, supply is said to be more than unit elastic.
e)Perfectly elastic Supply (Es =a) When price does not change at all in response to of the change in
quantity supplied of commodity, its supply said to be perfectly elastic.
(ii) Geometric Method of Measuring Price Elasticity of Supply:
According to geometric method, elasticity is measured at a
given point on the supply curve. This method is also known as
‘Arc Method’ or ‘Point Method’.
At point ‘A’ in the figure, the price is OP and the quantity
supplied is OQ. When the price rises to OP1, quantity supplied
also rises to OQ1. The supply curve is extended beyond the Y-
axis, so that it meets the extended X-axis at point ‘L’. Now, at
point A, elasticity of supply is equal to:
ES = ∆Q/∆P × P/Q
Symbols have usual meaning as discussed under ‘percentage
Method’
From the diagram, ∆Q = QQ1; ∆P = OP and Q =OQ
Putting these values in the formula, we get: ES = QQ1/PP1 × OP/OQ
But, QQ1 = AC; PP1 = BC and OP = AQ. Substituting these values in (1), we get
ES = AC/BC × AQ/OQ
Now, ∆BAC and ∆ALQ are similar triangles on account of AAA property. It means that the ratio of their
sides will be equal.
This implies: AC/BC = LQ/AQ
Substituting the value of (3) in (2), we get:
ES = LQ/AQ × AQ/OQ
Or simply, ES = LQ/OQ = Intercept on X-axis/Quantity supplied at that price
ce
t that pri
Quantity a
xis
on the X-a
Intercept
E8
Under this method, we can conceive following three possible situations of Elasticity of Supply.
(i) Es = 1, when a straight line, positively sloped, supply curve starts from the origin ‘O’.
(ii) Es > 1, when a straight line positively sloped, supply curve starts from the Y-axis.
(iii) Es < 1, when a straight line positively sloped, supply curve starts from the X-axis.
FACTORS INFLUENCING ELASTICITY OF SUPPLY:
1] Nature of the commodity: If the commodity is perishable in nature then the elasticity of supply will be
less. Durable goods have high elasticity of supply.
2] Time period: If the operational time period is short then supply is inelastic. When the the production
process period is longer the elasticity of supply will be relatively elastic.
3] Scale of production: Small scale producer’s supply is inelastic in nature compared to the large producers.
4] Size of the firm and number of products: If the firm is a large scale industry and has more variety of
products then it can easily transfer the resources. Therefore supply of such products is highly elastic.
5] Natural factors: Natural calamities can affect the production of agricultural products so they are relatively
inelastic.
6] Nature of production: If the commodities need more workmanship, or for artistic goods the elasticity of
supply will be high.
Apart from the above mentioned factors future expectations of the market, natural resources of the country and
government controls can also play a role in determining supply of a good. In the long run, supply is affected by
cost of production. If costs are rising, some of the existing producers may.
EQUILIBRIUM: DETERMINATION OF PRICE AND QUANTITY
Equilibrium is a situation in which opposing forces balance each other.
A market equilibrium is a situation in which:
quantity demanded equals quantity supplied at a single price called market (equilibrium) price (P*).
Price adjusts when plans do not match.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-37-320.jpg)
![Dr. Bhati Rakesh 41 | P a g e
4. It helps in decision-making :Production function is very useful to the management to take decisions
regarding cost and output. It also helps in cost control and cost reduction. In short, production function helps
both in the short run and long run decision-making process.
COST ANALYSIS:
When commodities and services are produced, various expenses have to be incurred, e.g., purchase of raw
materials, payment to labour, landlord, capitalist, etc. The sum total of the expenses incurred plus the normal
profit expected by the producer is called the cost of production. The various concepts of cost are discussed
below:
1] Nominal Cost and Real Cost: Nominal cost is the money cost of production. The real costs of production
are the pain and sacrifices of labour involved in the process of production.
2] Explicit and Implicit costs: Explicit costs are the accounting costs or contractual cash payments which
the firm makes to other factor owners for purchasing or hiring the various factors. Implicit costs are the
costs of self-owned factors which are employed by the entrepreneur in his own business. These implicit
costs are the opportunity costs of the self-owned and self-employed factors of the entrepreneur, that is, the
money incomes which these self-owned factors would have earned in their next best alternative uses.
3] Accounting Costs and Economic Cost: Accounting costs are the actual or explicit costs which are paid
by the entrepreneurs to the owners of hired factors and services. On the other hand, economic costs not
only include the explicit costs but also the implicit costs of the self-owned factors or resources which are
used by the entrepreneur in his own business.
4] Outlay cost and Opportunity Cost: Outlay costs involve actual expenditure of funds on, say, wages,
materials, rent, interest, etc. The opportunity cost (or transfer earnings) of any good is the expected return
from the next best alternative good that is forgone or sacrificed. For example, if a farmer who is producing
wheat can also produce potatoes with the same factors. Then, the opportunity cost of a quintal of wheat is
the amount of output of potatoes given up.
5] Business Cost and Full Cost: Business costs include all the expenses which are incurred in carrying out a
business. The concept of business cost is similar to the accounting or actual cost. The concept of Full cost
includes two other costs: the opportunity cost and normal profit. Normal profit is a necessary minimum
earning which a firm must get to remain in its present occupation.
6] Private costs and Social Costs: Private costs are the economic costs which are actually incurred or
provided for by an individual or a firm. It includes both explicit and implicit costs. Social cost, on the other
hand, implies the cost which a society bears as a result of production of a commodity. Social cost includes
both private cost and the external cost. External cost includes (a) the cost of free goods or resources for
which the firm is not required to pay for its used, e.g., atmosphere, rivers, lakes etc. (b) the cost in the form
of ‘disutility’ caused by air, water, and noise pollution, etc.
7] Total, Average and Marginal Costs: Total cost refers to the total outlays of money expenditure, both
explicit and implicit on the resources used to produced a given output. Average cost is the cost per unit of
output which is obtained by dividing the total cost (TC) by the total output (Q), i.e., TC/Q = average cost.
Marginal cost is the addition made to the total cost as a result of producing one additional unit of the
product. Marginal cost is defined as change in TC/ change in Q.
8] Fixed Costs and Variable Costs: Fixed costs are the expenditure incurred on the factors such as capital,
equipment, plant, factory building which remain fixed in the short run and cannot be changed. Therefore,
fixed costs are independent of output in the short run i.e., they do not vary with output in the short run.
Even if no output is produced in the short run, these costs will have to be incurred. Variable costs are costs
incurred by the firms on the employment of variable factors such as labour, raw materials, etc., whose
amount can be easily increased or decreased in the short run. Variable costs vary with the level of output in
the short run. If the firm decided not to produce any output, variable costs will not be incurred.
9] Short-run and Long-run Cost: Short-run costs are the costs which vary with the change in output, the
size of the firm remaining the same. Short-run costs are the same as variable costs. On the other hand, long-
run costs are incurred on the fixed assets, like plant, building, machinery, land etc. Long-run cost are the
same as fixed-costs. However, in the long-run even the fixed costs become variable costs as the size of the
firm or scale or production is increased.
ANALYSIS OF SHORT RUN COST OF PRODUCTION:
Definition of Short Run: Short run is a period of time over which at least one factor must remain fixed. For
most of the firms, the fixed resource or factors which cannot be increased to meet the rising demand of the
good is capital i.e., plant and machinery.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-41-320.jpg)
![Dr. Bhati Rakesh 51 | P a g e
Premium Pricing – Price is set above the price charged by the competitors for similar product.
Tender / Sealed bid pricing – A contract or tender for the production of the product is floated in the
market and many parties submit their proposals. The party with the lowest bid or quote gets the tender
and the quoted amount is the price.
(4) OTHER METHODS
Differentiated pricing – Different prices are charged from different customers on the basis of –
1] Customer segments
2] Time
3] Location/Area
4] Product Quantity
5] Product attributes
Affordability / Social welfare – In case of essential commodities, prices are set in such a way that all
sections of people in the society can afford it. Price may also be below the cost of product due to
subsidies provided by the government.
PRICING STRATEGIES
Product line pricing – Prices are set on the basis of well established price points of other products in
the product line.
Optional Pricing – A base price is set for the basic product and prices are set for optional features,
services along with the main product.
Bundle pricing – Sellers offer a bundle or package of different products or services for a lower price
than they would charge if the customer bought all of them separately.
Penetration Pricing – The seller tries to penetrate the market with a low price and increases the price
subsequently with increase in demand.
Skimming Pricing – The seller tries to skim the profit from the market by charging a high price in the
initial stages and lowers the price in the long run.
Value based pricing – Seller sets the prices according to the value perceived by the customer of the
product/service.
Loss leader Pricing – Prices are set very low, sometimes below cost to encourage sales of other
products or a retail outlet.
Captive pricing – A special price is offered to loyal customers.
Psychological pricing – Prices are set according to emotional appeals that influence buying decisions.
E.g. Prestige pricing, Odd/even pricing, Bata pricing, Leader pricing
Promotional pricing – Prices are set below MRP to stimulate purchases and increase awareness. It
includes – Pricing for Special events, Low Interest Financing, Cash rebates, Warranties & Discounts
Discount Pricing – It involves reduction of price from MRP for performing certain activities. It includes
cash discounts, quantity discounts and seasonal discounts.
Discriminatory Pricing – Seller sells a product at two or more prices based on Customer segments,
Location, Time and availability of product, Product or brand image.
Going Rate Pricing – Price is set on the basis of prevailing market rate.
EDLP (Every Day Low Prices) – Retail stores offer low prices to customers every day in comparison
with competitors to promote sales and increase footfall without any special occasion, event or discount.
COST PLUS PRICING: The most widely used method for determining prices involves setting prices
predominantly on the basis of the company’s costs. This method is referred to as ‘cost-plus’ pricing. In its
simplest form it involves a company calculating average costs of production and then allocating a specified
markup, which may be related to rate of return required by the company, to arrive at the selling price. The
major advantage of this method is its simplicity. However, despite its widespread use, it has been criticized.
Before we examine the basis of these criticisms we need to examine further the mechanics of cost-plus pricing,
as well as some of the reasons why this apparently ‘simple’ approach to pricing may be more complex than it
seems at first glance.
MARKUP PRICING is the most commonly employed pricing method. Given the popularity of the
technique, it behooves managers to fully understand the rationale for markup pricing. When this rationale is
understood, markup pricing methods can be seen as the practical means for achieving optimal prices under a](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-51-320.jpg)
![Dr. Bhati Rakesh 53 | P a g e
price as a more strategic tool of marketing. This approach is particularly useful for services marketing where
the service cannot be stored, i.e. is highly perishable, such as cinema seats or hotel bedrooms. Prices can then
be based on making a contribution to fixed costs by charging prices which cover variable, but not total costs.
EasyJet and Ryanair make good use of marginal-cost pricing in their marketing strategies. These
operators cover their variable costs when selling an airline seat rather than let the plane fly with empty seats.
Provided of course that there are enough ‘full price’ paying passengers, this is an effective way of not only
making a contribution to profits, but at the same time making life difficult for costplus competitors.
Another example of marginal cost pricing can be found in the hotel industry. Hoteliers know that if a
hotel room is not sold on a particular evening then the revenue that letting the room would generate for that
evening is lost for ever. This is due to the service product characteristic of ‘perishability’, i.e. a service cannot be
stored and sold again on another occasion.
This makes it imperative that demand and supply of services be balanced and matched. Price is the
primary mechanism for achieving this match. In the case of the hotel reducing the price of unsold rooms, this
allows the marketer to generate some contribution and the room should be let at a discount if the full price
cannot be achieved. Marginal pricing, especially for services, makes sense and is popular.
CYCLICAL PRICING
Cyclical Pricing refers to appropriate pricing strategy at different stages of Business Cycle Every Business
Cycle consists of four phases: Recession, Depression, Recovery and Prosperity. Contraction comprises of the
first two phases and the last two phases constitute expansion.
Business Cycles cause decline in aggregate economic activity, which results in fall in purchasing power of the
consumers. As a result of this, it is argued that strategies are to be revised and appropriate pricing policies need
to be adopted depending on the phase of Business Cycle the economy passes through.
There lies a difference in opinion regarding appropriate pricing policy during various phases of Business Cycle.
Experts are polarized in terms of appropriateness of pricing policy. Here both the suggested policies are
presented:
(1) Rigid Pricing (2) Flexible Pricing
Let us examine justifications of both the options one by one:
1] Rigid Pricing: During contraction and depression of an economy, purchasing power of customers decline.
But so far as necessity items are concerned, customers do not have to find any choice but to purchase these
products irrespective of the condition of the economy. Thus, adjustment of price for different stages of
Business Cycle cannot show better results.
For the expensive durable goods, which are not so necessary, deliberate reduction in price, the advocates of
this pricing strategy believes, will cause postponement of purchase decision by prospective buyers with an
expectation of further decline in price. So, adjustment in price depending on phases of Business cycle in
unlikely to help the firms.
For the capital goods (machines used to manufacture other machines), price reduction during contraction
cannot improve business performance, since business of end product shows lackluster. Thus, if price is
reduced during contraction, it is unlikely that any improvement in business will be experienced. This logic
favours Rigid Pricing, which does not allow any adjustment of price depending on different stages of
business.
2] Flexible Pricing: Flexible Pricing, as a concept, is just opposite to Rigid Pricing. The justification of Flexible
Pricing is easier to understand if we consider the case of agricultural products. Since supply of agricultural
products is inelastic, (i.e., the supply curve is a vertical straight line), leftward shift in the demand curve of
these products reduces equilibrium price. Only a policy to recourse to Flexible Pricing, and by linking it to
the general price index, loss arising out of unsold products will have to be borne by the producers. This
adjustment in price is referred to as “General Price Index Pricing”.
For industrial products, the argument is different. Higher profit of firms can be generated by securing more
customers through reduction in price. That is, reduced per unit profit can more than offset increase in
quantity, provided price elasticity of demand for the product is high. There can be another possibility.
If a new type of car is invented, where a cheaper fuel can be used (say, bio-diesel), then that type of car can
be sold at a high price (assuming that there is a huge price gap between bio-diesel and ordinary diesel)
even during contraction phase of Business Cycle. Since this adjustment of price is totally dependent on
nature of demand, it is referred to as “Product Demand Linked Pricing”.
PENETRATION PRICING](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-53-320.jpg)
![Dr. Bhati Rakesh 54 | P a g e
Penetration pricing is a pricing strategy that is used to quickly gain market shareby setting an initially low price
to entice customers to purchase from the company. Such pricing strategy is generally used by new entrants into
a market. An extreme form of penetration pricing is called predatory pricing.
Rationale Behind Penetration Pricing
It is common for a new entrant to use a penetration pricing strategy to compete effectively in the marketplace.
Price is one of the easiest ways to differentiate new entrants among existing market players. The overarching
goal of the pricing strategy is to:
1. Capture market share
2. Create brand loyalty
3. Switch customers from competitors
4. Generate significant demand and utilize economies of scale
5. Drive competitors out of the market
Situations where penetration pricing works effectively:
1. When there is little product differentiation
2. Demand is price-elastic
3. Where the product is suitable for a mass market (utilizing economies of scale)
Illustration and Example of Penetration Pricing
A current small-sized player in the marketplace that sells laundry detergent at $15. Company A is an
international company with a large amount of excess production capacity and is, therefore, able to produce
laundry detergents at a significantly lower cost. Company A decides to enter the market, employ a penetration
pricing strategy, and sell laundry detergent at a sale price of $6.05. The company’s cost to produce a laundry
detergent is $6.
With a marginal cost of $6 and a sale price of $6.05, Company A is making nominal profits per sale. However,
the company is comfortable with this decision as their overarching goal is to switch customers over, capture as
much market share as possible, and utilize economies of scale with their high production capacity.
Company A believes that its competitor will not be able to sustain itself in the long-term and will eventually exit
the market. When the competitor exits the marketplace, it will become the only seller of laundry detergent and
therefore be able to establish a monopoly over the market.
ADVANTAGES OF PENETRATION PRICING
1] High adoption and diffusion: Penetration pricing allows a product or service to be quickly accepted
and adopted by customers.
2] Marketplace dominance: Competitors are typically caught off guard in a penetration pricing strategy
and are afforded little time to react. The company is able to utilize the opportunity to switch over as
many customers as possible.
3] Economies of scale: The pricing strategy generates high sales quantity that allows a firm to realize
economies of scale and lower marginal cost.
4] Increased goodwill: Customers that are able to find a bargain in a product or service are likely to
return to the firm in the future. In addition, the increased goodwill creates positive word of mouth.
5] High turnover: Penetration pricing results in an increased turnover rate, making vertical supply chain
partners such as retailers and distributors happy.
DISADVANTAGES OF PENETRATION PRICING
Pricing expectation: When a firm uses a penetration pricing strategy, customers often expect permanently low
prices. If prices gradually increase, customers will become dissatisfied and may stop purchasing the product or
service.
1] Low customer loyalty: Penetration pricing typically attracts bargain hunters or those with low
customer loyalty. Said customers are likely to switch to competitors if they find a better deal.
2] Damage brand image: It may affect the brand image and cause customers to perceive the brand as
cheap.
3] Price war among competitors: It results in retaliation from competitors trying to maintain their
market share. Pricing war may decrease profitability for the overall market.
4] Inefficient long-term strategy: It is not a viable long-term pricing strategy. In many cases, firms that
use the strategy face a loss of profits. In this case, the firm may not be able to recover its cost if it uses
penetration pricing over an extended timeframe.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-54-320.jpg)
![Dr. Bhati Rakesh 55 | P a g e
PRICE LEADERSHIP
Price leadership is a situation in which one company, usually the dominant one in its industry, sets
prices which are closely followed by its competitors. This firm is usually the one having the lowest production
costs, and so is in a position to undercut the prices charged by any competitor who attempts to set its prices
lower than the price point of the price leader. Competitors could charge higher prices than the price leader, but
this would likely result in reduced market share, unless competitors could sufficiently differentiate their
products.
Price leadership is not in the best interests of customers when the price leader sets prices higher than
would have resulted under a normal level of competition. However, the reverse is usually the case, where the
price leader uses its production and purchasing volume to continually drive down prices - which must be
matched by any competitors who want to remain in the industry.
For price leadership to exist at a high price point, there needs to be tacit collusion between the main
competitors in the industry. This is not the case when price leadership drives down the price point, since
competitors have little choice but to match the low prices.
The following are conditions under which price leadership can exist:
1] Collusion. Competitors tacitly agree to follow the price leadership of one company.
2] Overwhelming market share. If one company has by far the largest market share in the industry, its
much smaller competitors have no choice other than to follow its lead on prices.
3] Trend knowledge. One company may be unusually good at spotting industry trends, so the other
companies in the industry find it easier to follow its pricing leadership than to spend time and money to
develop the same level of knowledge. This is known asbarometric price leadership.
Advantages of Price Leadership
The following is an advantage of the price leadership method:
1] High profit margin. If a company can set high price points and competitors are willing to follow those
price points, then the company can earn inordinately high profits.
Disadvantages of Price Leadership
The following are disadvantages of using the price leadership method:
1] Defensive effort. There are several reasons why an industry may accept a particular company as its price
leader, several of which involve having to monitor competitors and take reactive steps if they do not
follow the company's price leadership position.
2] Complacency. A company that successfully exercises price leadership may become complacent and not
keep its cost structure sufficiently lean to allow it to still earn a profit if a price war develops.
PRICE SKIMMING
Price skimming, also known as skim pricing, is a pricing strategy in which a firm charges a high initial
price and then gradually lowers the price to attract more price-sensitive customers. The pricing strategy is
usually used by a first mover who faces little to no competition. Price skimming is not a viable long-term pricing
strategy as competitors eventually launch rival products and put pricing pressure on the first company.
Rationale Behind Price Skimming
Price skimming is used to maximize profits when a new product or service is deployed. Therefore, the
pricing strategy is largely effective in a breakthrough product where the firm is the first to enter the
marketplace. In such a strategy, the goal is to generate the maximum profit in the shortest time possible rather
than maximum sales. It allows a firm to quickly recover its sunk costs before increased competition and pricing
pressure.
Consider the diffusion of innovation, a theory that explains the rate at which a product spreads throughout
a social system. Innovators are those who want to be the first to get a new product or service. They are risk
takers and price insensitive. A price skimming strategy tries to get the highest possible profit from innovators
and early adopters. As the demand from the two segments fills up, the price of the product is reduced to target
price-sensitive customers such as early majorities and late majorities.
Illustration and Example of Price Skimming
Company A is a phone manufacturing company that recently developed a new proprietary technology to be
released to the market. Company A follows a price skimming strategy and sets a skim price at P1 to recover its
research and development cost. After satisfying demand at P1, the company sets a follow-on price at P2 to
capture price-desensitive customers and to put pricing pressure on competitors that enter the market.
In the price skimming strategy above, Company A generates revenue = A + B with sales of Q1. With their follow-
on pricing, the company generates additional revenue = C with sales of Q2-Q1.
With the pricing strategy, the company generates total revenue of A + B + C with total sales of Q2.
Advantages of Price Skimming
a) Perceived quality: Price skimming helps build a high-quality image and perception of the product.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-55-320.jpg)
![Dr. Bhati Rakesh 66 | P a g e
local basis, to let customers know their differences. Common methods of advertising for these firms are
through local press and radio, local cinema, posters, leaflets and special promotions.
(8) Monopolistically competitive firms are assumed to be profit maximisers because firms tend to be small with
entrepreneurs actively involved in managing the business.
(9) There are usually a large numbers of independent firms competing in the market.
EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION
In the short run supernormal profits are possible, but in the long run new firms are attracted into the industry,
because of low barriers to entry, good knowledge and an opportunity to differentiate.
MONOPOLISTIC COMPETITION IN THE SHORT RUN
At profit maximisation, MC = MR, and output is Q and price P.
Given that price (AR) is above ATC at Q, supernormal profits are
possible (area PABC).
As new firms enter the market, demand for the existing firm’s
products becomes more elastic and the demand curve shifts to
the left, driving down price. Eventually, all super-normal profits
are eroded away.
MONOPOLISTIC COMPETITION IN THE LONG RUN
Super-normal profits attract in new entrants, which shifts the
demand curve for existing firm to the left. New entrants
continue until only normal profit is available. At this point,
firms have reached their long run equilibrium.
Clearly, the firm benefits most when it is in its short run and
will try to stay in the short run by innovating, and further product differentiation.
Examples of monopolistic competition
Examples of monopolistic competition can be found in every high street.
Monopolistically competitive firms are most common in industries where differentiation is possible, such as:
• The restaurant business
• Hotels and pubs
• General specialist retailing
• Consumer services, such as hairdressing
The survival of small firms
The existence of monopolistic competition partly explains the survival of small firms in modern economies. The
majority of small firms in the real world operate in markets that could be said to be monopolistically
competitive.
THE ADVANTAGES OF MONOPOLISTIC COMPETITION
Monopolistic competition can bring the following advantages:
1] There are no significant barriers to entry; therefore markets are relatively contestable.
2] Differentiation creates diversity, choice and utility. For example, a typical high street in any town will
have a number of different restaurants from which to choose.
3] The market is more efficient than monopoly but less efficient than perfect competition - less allocatively
and less productively efficient. However, they may be dynamically efficient, innovative in terms of new
production processes or new products. For example, retailers often constantly have to develop new
ways to attract and retain local custom.
THE DISADVANTAGES OF MONOPOLISTIC COMPETITION
There are several potential disadvantages associated with monopolistic competition, including:
1] Some differentiation does not create utility but generates unnecessary waste, such as excess packaging.
Advertising may also be considered wasteful, though most is informative rather than persuasive.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-66-320.jpg)
![Dr. Bhati Rakesh 67 | P a g e
2] As the diagram illustrates, assuming profit maximisation, there is allocative inefficiency in both the long
and short run. This is because price is above marginal cost in both cases. In the long run the firm is less
allocatively inefficient, but it is still inefficient.
Inefficiency
The firm is allocatively and productively inefficient in both
the long and short run.
There is a tendency for excess capacity because firms can
never fully exploit their fixed factors because mass
production is difficult. This means they are productively
inefficient in both the long and short run. However, this is
may be outweighed by the advantages of diversity and
choice.
As an economic model of competition, monopolistic
competition is more realistic than perfect competition - many
familiar and commonplace markets have many of the
characteristics of this model.
OLIGOPOLY
The word Oligopoly is derived from two Greek words – ‘Oligi’ meaning ‘few’ and ‘Polein’ meaning ‘to sell’. An
Oligopoly market situation is also called ‘competition among the few’.
CHARACTERISTICS OF OLIGOPOLY
Now that the Oligopoly definition is clear, it’s time to look at the characteristics of Oligopoly:
1] Few firms: Under Oligopoly, there are a few large firms although the exact number of firms is undefined.
Also, there is severe competition since each firm produces a significant portion of the total output.
2] Barriers to Entry : Under Oligopoly, a firm can earn super-normal profits in the long run as there are
barriers to entry like patents, licenses, control over crucial raw materials, etc. These barriers prevent
the entry of new firms into the industry.
3] Non-Price Competition: Firms try to avoid price competition due to the fear of price wars and hence
depend on non-price methods like advertising, after sales services, warranties, etc. This ensures that
firms can influence demand and build brand recognition.
4] Interdependence: Under Oligopoly, since a few firms hold a significant share in the total output of the
industry, each firm is affected by the price and output decisions of rival firms. Therefore, there is a lot of
interdependence among firms in an oligopoly. Hence, a firm takes into account the action and reaction
of its competing firms while determining its price and output levels.
5] Nature of the Product: Under oligopoly, the products of the firms are either homogeneous or
differentiated.
6] Selling Costs: Since firms try to avoid price competition and there is a huge interdependence among
firms, selling costs are highly important for competing against rival firms for a larger market share.
7] No unique pattern of pricing behavior: Under Oligopoly, firms want to act independently and earn
maximum profits on one hand and cooperate with rivals to remove uncertainty on the other hand.
Depending on their motives, situations in real-life can vary making predicting the pattern of pricing
behavior among firms impossible. The firms can compete or collude with other firms which can lead to
different pricing situations.
8] Indeterminateness of the Demand Curve: Unlike other market structures, under Oligopoly, it is not
possible to determine the demand curve of a firm. This is because on one hand, there is a huge
interdependence among rivals. And on the other hand there is uncertainty regarding the reaction of the
rivals. The rivals can react in different ways when a firm changes its price and that makes the demand
curve indeterminate.
THREE IMPORTANT ECONOMIC MODELS OF OLIGOPOLY ARE AS:
(1) Price and output determination under collusive oligopoly.
(2) Price and output determination under non-collusive oligopoly.
(3) Price leadership model.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-67-320.jpg)
![Dr. Bhati Rakesh 70 | P a g e
DUOPOLY MODELS:
There are four main duopoly models which explain the price and quantity determinations in duopoly. These
models are:
1] Cournot and Edgeworth Model: Cournot approach is based, on the assumptions that rivals output
remains the same and one duopolists plans to change in his output. Edgeworth model assumes that
rival's price of the good to remain unchanged as one duopolists plans a change in his price of the good.
2] Stackberg's Approach: It is based on the assumptions that one of the duopolists is a 'Leader' and the
other is the follower.
3] Hotelling Spatial Equilibrium Model: In this model, the products of the duopolists are differentiate in
the eyes of the buyers by virtue of the location of the duopolists.
4] Game Theory Approach: Whenever there are two or a few firms competing in an industry for profit,
each firm can and dose react to the price, quantity, quality and product changes which other firm
undertakes. The duopolists or oligopoly have a reaction function. As firms under duopoly are
independent, they, therefore, employ strategies. The competing firm also make plans to contract and
makes decisions about output and price of the good keeping in view the strategy of its rivals. The plans
made by these firm, are known as game strategies. The game theory model describes the firms,
interaction model. It is the analytical framework in which two or more firms compete for economics
profits that depend on the strategy that the others employ.
All games theory models have at least three common elements:
(a) Players: Players in the game theory are the firms.
(b) Strategies: Strategies are the plans, the possible choices of the firms for production of output, prices of
goods, changes in the quality of the product.
(c) Pay offs (economic profit): These are the profits or losses realized by the firm.
PROFIT POLICY:
In developing nations, the Public Sector Enterprises are required to play a dominant role in economic
development; PSEs follow the profit price policy. Such a policy would make the state utilise its own resources
rather than taxing its citizens. PSEs must be carried on a profit making basis not only in the sense that the
public enterprises must yield an economic price but also get for the community sufficient resources for
financing a part of investment and maintenance outlay of the government.
This involves a profit price policy regard to PSEs. The theory of no profit no loss in PSEs is particularly
inconsistent with a socialist economy and if followed in a mixed economy nations, it will hinder its
development. In support of this view, in USSR, PSEs made a double contribution to development finance;
reinvestment of profits for their own expansion and contribution to the state budget.
ARGUMENTS FOR A PROFIT PRICE POLICY
The following arguments are advanced in favour of a profit price policy.
(1) When the state makes large investments in establishing PSEs, it expects a return in the form of profits in
order to enhance its resources for the development of the economy.
(2) The main aim of every private enterprise is to earn profits. It is therefore essential that PSEs should also
earn profits and should not be dependant on the state for financial help and subsidy.
(3) When PSEs operate side by side with private enterprises and compete with them in such areas as oil,
steel, consumer goods, shipping, airways etc. they must earn profits like private enterprises.
(4) Even in the case of those PSEs where the state has a monopoly, it is not desirable to have a no profit no
loss policy or change a low price to consumers of the product or service. For there is no guarantee that
the users of the product or service will save more on this count. Therefore the best course is to change a
price which gives a minimum of profit to the PSE which will ultimately go to the state for capital
formation.
(5) The running of PSEs on profit price policy will contribute to the general revenues of the state. As
pointed out by Indian Planning commission “When taxation has its limits, public exchequer should
benefit by the surplus of public enterprise. When private sector pays a portion of its profits for general
revenues, there is no grounds and debt servicing and even dispenses with deficit financing.
(6) Further surpluses, accruing from profit making enterprises provide adequate funds for improvement,
modernisation and expansion of the plants in PSEs.
WHAT PROFIT PRICE SHOULD BE FOLLOWED?
Nevertheless, it is difficult to have a particular rate of profit for all the PSEs. Moreover, all PSEs cannot
earn profits simultaneously for the following reasons.
(1) Those PSEs which have not broken even cannot earn profits for the reason that their overhead costs
will be high.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-70-320.jpg)
![Dr. Bhati Rakesh 71 | P a g e
(2) In the case of heavy industries, the gestation period is long. Therefore, it takes them a very long period
to break even and start earning profits. At the most such PSEs pay their way and not run in losses.
(3) in the case of public utilities, public welfare and not profitability is the principle objective. They try to
equate MC with price. They lay stress on output rather on rate of return on investment.
CRITICISM
(1) Certain economists do not favour profit price policy in the case of all PSEs. Some advocate a no profit no
loss policy for public utilities or the marginal cost pricing rule. Others accept the profit price policy with
certain reservations.
(2) In cases, where the product of a PSE is used as an input for production in the private sector, a profit
price policy will adversely affect the development of the private industry.
(3) If the price of products of PSEs is rigged up to provide a surplus, the pertinent question arises why
consumers of those products should be made to pay a special tax through the back door for the benefit
of the state.
(4) In those PSEs where the government has a monopoly or semi monopoly , there is a great temptation on
their part to deliberately create huge surpluses by charging the users of their products very high prices.
(5) Such a profit price policy is therefore harmful to the society for the reason that high prices can lead to a
high cost economy.
BREAK EVEN ANALYSIS.
The break Even analysis (BEA) indicates at what level total costs and total revenue are in equilibrium. It
is an analytical technique that is used to identify the level of output and sales volume at which the firm ‘breaks-
even’ i.e. the revenues are sufficient to cover all costs.
BEA establishes the relationship among fixed and variable costs of production, value of output, sales value and
profit. It is hence, also known as Cost Volume Project (CVP) analysis.
Three approaches are commonly used to solve the BE problems.
They are; the graphical method, the equation method and the contribution margin method.
1] The Graphical Method or Break Even Chart
When the BEA is represented graphically, it is shown as the break even chart. The BEC shows the
relationship of production costs and revenue to the volume of output. This relationship is determined by a BEP
on a graph. The BEP is a specific level of output or volume of sales where total revenue and total costs of a firm
are equal. It is the point of zero profit. This point is also known as no-profit, no loss or profit beginning point.
2] The Equation Method
The same results can be arrived at by the equation method:
Profit = TR – TVC – TFC
Where TR = Price x Quantity
TVC = AVC x Quantity
TFC is a constant
BE point is where profit = 0
And 0 = (Price x Quantity) – (AVC x Quantity) – TFC
Rearranging the above equation:
BE Quantity = TFC
Price – AVC
3] Margin of Safety
This type of BEA can be used to calculate the level of sales which most be attained to avoid less or to
calculate the margin of safety MS. MS is the difference between the firm’s actual level of sales and sales at the
BE point as represented in the diagram.
It is expressed as MS = Actual sales revenue – BE sales. Nevertheless, firms compute the MS in terms of ratio
are:
MS Ratio= MS
Actual Sales
The MS is an indicator of the strength of a firm. If the margin is large, it represents that the firm can make
profit even it has to face difficulties. On the other hand, if the margin is small, a small reduction in sales can lead
to loss. MS is nil at the point BE point for the reason that actual sales volume is equal to the cost.
PROFIT FORECASTING
Profit planning cannot be done without proper profit forecasting. Profit forecasting means projection of
future earnings after considering all the factors affecting the size of business profits, such as firm’s pricing
policies, costing policies, depreciation policy, and so on. A thorough study including a proper estimation of both](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-71-320.jpg)
![Dr. Bhati Rakesh 76 | P a g e
INTRODUCTION: CONSUMPTION FUNCTION
Consumption expenditure is the expenditure made by households on goods and services. The
consumption function shows the consumption expenditure of households at each disposable income. The
Keynesian consumption function can be expressed as
C = a + bYd
where C = consumption, a = autonomous consumption, bYd = induced consumption, b = marginal propensity to
consume out of disposable income and Yd = disposable income.
From the above equation, it can be seen that consumption is comprised of two components:
autonomous consumption and induced consumption.
Autonomous consumption refers to consumption that is independent of disposable income and is
determined by consumer sentiment, the wealth of households, interest rates, expectations of price changes,
the availability of credit and the distribution of income. Autonomous consumption is positive (a > 0).
Induced consumption refers to consumption that is dependent on disposable income. According to
Keynes, consumption will increase with an increase in disposable income (b > 0) but the increase in
consumption will be less than the increase in disposable income (b < 1).
CONSUMPTION FUNCTION: In the diagram, the consumption function (C) is upward sloping as consumption
expenditure increases with disposable income. The slope of the consumption function is (b) which is known as
the marginal propensity to consume out of disposable income (MPCYd). The marginal propensity to consume
out of disposable income is the proportion of an increase in disposable income that is spent on consumption
(ΔC/ΔYd).
DETERMINANTS/FACTORS OF THE CONSUMPTION FUNCTION:
There are a number of determinants/factors both subjective and objective which determine the position of
consumption function. The factors or causes of shifts in consumption function are as fallows:
(1) SUBJECTIVE FACTORS:
Psychological Characteristics of Human Nature: The subjective factors affecting propensity to
consume are internal to the economic system. The subjective factors include characteristics of human
nature, social practices which lead households to refrain or activate to appending out of their income.
For example, religious belief of the people towards spending, their foresight attitude towards life, level
of education, etc. etc., directly affect propensity to consume or determine the slope and position of the
consumptions curve. The subjective factors do not undergo a material change over a short period of
time. These remain constant in the short run.
(2) OBJECTIVE FACTORS:
The objective factors are external to economic system. The undergo rapid changes and bring market in the
consumption function. The main objective factors are as under:
1] Real Income: Real income is the basic factor which determines community’s propensity to consume.
When real income of the community increases, consumption expenditure also increases but by a
smaller amount. The consumption function shifts upward.
2] Distribution of wealth: If there is unequal distribution of wealth in a country, the consumption
function will also be unequal. People with low income group have high propensity to consume and rich
people low propensity to consume. An equal distribution of wealth raises the propensity to consume.
3] Expectation Change in Price: If people expect prices are going to rise in near future, they hasten to
spend large sum out of a given income just after the promulgation of first Martial Law in our country. So
we can say that when prices are expected to be high in future, the propensity to consume increases or
the consumption function shifts upward. When they are expected to be low, the propensity to consume
decreases or the consumption function shifts downward.
4] Changes in Fiscal Policy: Taxes also play an important part in influencing the propensity to consume.
If the nature of taxes is such that they directly affect the poor people and reduce their income, then the
propensity to consume is high and if rich persons are not taxed at a progressive rate and they
accumulate more wealth, then the propensity to consume is low.
5. Consumption Function and Investment Function: Introduction, Consumption Function,
Investment Function, Marginal efficiency of capital and business expectations, Multiplier,
Accelerator. Business Cycle: Introduction, Meaning and Features, Theories of Business Cycles,
Measures to Control Business Cycles, Business Cycles and Business Decisions.
UNIT – 5](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-76-320.jpg)
![Dr. Bhati Rakesh 77 | P a g e
5] Change in the Rate of Interest: A change in the rate of interest exercises influence on the propensity to
consume. When the interest rate is raised, it generally induces people to decrease expenditure and save
more for lending purposes. On the other hand, when the interest rate is reduced, it usually encourages
expenditure as lending then becomes less attractive. So we conclude that an increase in the rate of
interest generally reduces propensity to consume or shifts the consumption function downward and a
fall in the rate of interest usually helps to the increase of propensity to consume or shifts the
consumption function upward.
6] Availability of Goods: Propensity to consume is also affected by the availability of consumption goods.
If the goods are available in abundance, then the propensity to consume increases. If they are scarce
and are priced very high, then the propensity to consume will decline.
7] Credit Facilities: cheap credit facilities are available in the country, the consumption function will
move upward.
8] Higher Living Standard: If the real income of the people increases in the country and people adopt the
use of new produce like television, washing machines, refrigerators, care, etc., etc., the consumption
function is high.
9] Stock of Liquid Assets: If the consumer have greater amounts of liquid assets; there will be more
desire for the households to spend out of disposable income. The consumption function shifts upward
and vice versa.
10] Consumer Indebtedness: In case the consumer are heavily indebted and they pay bigger monthly
installments to replay the dept, then propensity to consume is low or the consumption function shifts
downward and vice versa.
11] Windfall Gains: If there are unexpected gains due to stock market boom in the economy, it tends to
shift the consumption function upward. They are windfall gains. The unexpected losses in the stock
market lead to the downward shifting of the consumption curve.
12] Demographic Factors: The consumption function is also influenced by demographic factors like size of
family, occupations, place of residence etc. Persons living in cities, for instance, spend more than those
living in rural areas.
13] Attitude Towards Saving: If a community is consumption oriented, there will be less saving in the
country. The consumption function shifts upward. In case, people save more and spend less, then the
consumption function will shift downward.
14] (ix) Demonstration Effect: If people are easily influenced by advertisements on radio and television
and seeing pattern of living of the rich neighbors, the level of total consumption will go up.
HOW TO RAISE THE PROPENSITY TO CONSUME?
The propensity to consume can raised by:
1] Transferring wealth from rich to the poor.
2] Increased wages.
3] Provision of cheap end easy credit facilities.
4] Advertisements.
5] Development of means of transport.
6] Urbanization and through advertisement.
INTRODUCTION: INVESTMENT FUNCTION
Investment is an important component of national income. It plays an important role in the
determination of equilibrium level of national income and corresponding level of employment. When the term
investment is used in economics, it refers to the: "Expenditure incurred by individuals an businesses on the
purchase of new plant and machinery, the building of the houses, factories, schools, construction of roads etc. It
is, in other words the acquisition of new physical capital".
INVESTMENT EXPENDITURES:
Investment, in brief, includes the following kinds of expenditures:
1] Stock or Inventories: The inventories expenditures incurred by businesses on the purchase of new
raw material, semi finished gods and on stock of unsold goods (inventories) are counted as investment.
2] Fixed Capital: The expenditure made on new plants and machinery vehicles, houses facilities, etc., are
also included in investment. In the words of J.M. Keynes: "Investment means real investment which
refers to increase in the real capital stock of the economy".](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-77-320.jpg)
![Dr. Bhati Rakesh 78 | P a g e
TYPES OF INVESTMENT:
There are two types of investment (1) Induced investment and (2) Autonomous investment.
1] Induced Investment: Investment in the economy is influenced by the income or output of the economy.
The large the national income, the higher is the investment. Induced investment is the change in investment
which is induced by the change in the national income. The investment function signifies that as the real
national income rises, the level of inducement investment also rises and as the real national falls. The level
of investment also down.
Shift in the Investment Curve: The induced investment is the increasing function of profit. If firm
expect profit, they are induced to invest. The profit expectation of firms depend upon aggregate demand for
goods and services in the economy. The level of aggregate demand itself depends upon the level of national
income. The higher the level of national income, the higher thus is the level of induced investment.
(2) Autonomous Investment: The investment which is not influenced by changes in national income is
autonomous investment. In other words an autonomous investment is independent of the level national
income. As regards the size of autonomous investment, it is influenced by many basic factors such as
increase in population. Manpower, level of technology, the role of interest, the expectations of future
economic growth and the role of capacity utilization etc. In case, there is an introduction of new
technologies, or the rate of interest falls or if the businessmen expect the sales to grow more, the
producer choose to operate to full capacity, the autonomous investment is influenced.
FACTORS AFFECTING INVESTMENT
Main factors influencing investment by firms
1] Interest rates: The marginal efficiency of capital states that for investment to be worthwhile, it needs to
give a higher rate of return than the interest rate. If interest rates are 5%, an investment project needs to
give a rate of return of at least 5% or more. As interest rates rise, fewer investment projects will be
profitable. If interest rates are cut, then more investment projects will be worthwhile.
2] Economic growth: Firms invest to meet future demand. If demand is falling, then firms will cut back on
investment. If economic prospects improve, then firms will increase investment as they expect future
demand to rise. There is strong empirical evidence that investment is cyclical. In a recession, investment
falls, and recover with economic growth. The accelerator theory states that investment depends on the rate
of change of economic growth. In other words, if the rate of economic growth increases from 1.5% a year to
2.5% a year, then this increase in the growth rate will cause an increase in investment spending as the
economy is on an up-turn. The accelerator theory states that investment is dependent on economic cycle
3] Confidence: Investment is riskier than saving. Firms will only invest if they are confident about future
costs, demand and economic prospects. Keynes referred to the ‘animal spirits’ of businessmen as a key
determinant of investment. Keynes noted that confidence that wasn’t always rational. Confidence will be
affected by economic growth and interest rates, but also the general economic and political climate. If there
is uncertainty (e.g. political turmoil) then firms may cut back on investment decisions as they wait to see
how event unfold. Confidence is often driven by economic growth and changes in the rate of economic
growth. It is another factor that makes investment cyclical in nature.
4] Inflation: In the long-term, inflation rates can have an influence on investment. High and variable inflation
tends to create more uncertainty and confusion, with uncertainties over the cost of investment. If inflation
is high and volatile, firms will be uncertain at the final cost of the investment, they may also fear high
inflation could lead to economic uncertainty and future downturn. Countries with a prolonged period of low
and stable inflation have often experienced higher rates of investment.
5] Productivity of capital: Long-term changes in technology can influence the attractiveness of investment.
In the late nineteenth century, new technology such as Bessemer steel and improved steam engines meant
firms had a strong incentive to invest in this new technology because it was much more efficient than
previous technology. If there is a slowdown in the rate of technological progress, firms will cut back
investment as there are lower returns on the investment.
6] Availability of finance: In the credit crunch, many banks were short of liquidity so had to cut back lending.
Banks were very reluctant to lend to firms for investment. Therefore despite record low-interest rates,
firms were unable to borrow for investment – despite firms wishing to do that.
7] Another factor that can influence investment in the long-term is the level of savings. A high level of savings
enables more resources to be used for investment. With high deposits – banks are able to lend more out. If
the level of savings in the economy falls, then it limits the amounts of funds that can be channelled into
investment.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-78-320.jpg)
![Dr. Bhati Rakesh 79 | P a g e
8] Wage costs: If wage costs are rising rapidly, it may create an incentive for a firm to try and boost labour
productivity, through investing in capital stock. In a period of low wage growth, firms may be more inclined
to use more labour intensive production methods.
9] Depreciation: Not all investment is driven by the economic cycle. Some investment is necessary to replace
worn out or outdated equipment. Also, investment may be required for the standard growth of a firm. In a
recession, investment will fall sharply, but not completely – firms may continue with projects already
started, and after a time, they may have to invest on less ambitious projects. Also, even in recessions, some
firms may wish to invest or startup.
10] Public sector investment: The majority of investment is driven by the private sector. But, investment also
includes public sector investment – government spending on infrastructure, schools, hospitals and
transport.
11] Government policies: Some government regulations can make investment more difficult. For example,
strict planning legislation can discourage investment. On the other hand, government subsidies/tax breaks
can encourage investment.
INVESTMENT FUNCTION
Savings are the excess of disposable income over consumption expenditure. The savings function shows
the savings of households at each disposable income.
The Keynesian savings function can be expressed as : S = -a + (1 – b)Yd
Where,
S = savings,
-a = autonomous savings,
(1 – b)Yd = induced savings,
(1 – b) = marginal propensity to save out of disposable income and
Yd = disposable income.
From the above equation, it can be seen that savings are comprised of two components: autonomous savings
and induced savings.
Autonomous savings refer to savings that are independent of disposable income and are determined by
consumer sentiment, the wealth of households, interest rates, expectations of price changes, the
availability of credit and the distribution of income. Autonomous savings are negative (a > 0).
Induced savings refer to savings that are dependent on disposable income. According to Keynes, savings
will increase with an increase in disposable income [(1 – b) > 0] but the increase in savings will be less
than the increase in disposable income [(1 – b) < 1].
In a diagram, the savings function (S) is upward sloping as savings increase with disposable income. The
slope of the savings function is (1 – b) which is known as the marginal propensity to save out of disposable
income (MPSYd). The marginal propensity to save out of disposable income is the proportion of an increase in
disposable income that is saved (ΔS/ΔYd).
As any additional amount of disposable income will either be spent or saved, the sum of the marginal
propensity to consume out of disposable income and the marginal propensity to save out of disposable income
is equal to one (MPCYd + MPSYd = 1). The average propensity to consume out of disposable income (APCYd) is the
proportion of disposable income that is spent
on consumption (C/Yd). The average
propensity to save out of disposable income
(APSYd) is the proportion of disposable
income that is saved (S/Yd). As any amount of
disposable income will either be spent or
saved, the sum of the average propensity to
consume out of disposable income and the
average propensity to save out of disposable
income is equal to one (APCYd + APSYd = 1).
MARGINAL EFFICIENCY OF CAPITAL AND BUSINESS EXPECTATIONS,
Marginal efficiency capital (MEC) is a Keynesian concept. According to J.M. Keynes, nations output
depends on its stock capital. An increase in the stock of capital increases output. The question is how much
increase in investment raises output? Well, this depends on the productivity of new capital i.e. on the marginal
efficiency of capital. Marginal efficiency of capital is the rate return expected to be obtainable on a new capital
asset over its life time.
S = Y – C, where C = a + bY
S = Y – (a + bY)
S = Y – a – bY
S = – a + Y – bY
S = – a + (1 – b) Y
S = – a + s Y
where: b = MPC and s = MPS
Proof:
C = a + bY
S = – a + (1 – b) Y
C + S = 0 + bY + (1 – b) Y
C + S = (b + 1 – b) Y
C + S = Y and
b + s = 1](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-79-320.jpg)
![Dr. Bhati Rakesh 80 | P a g e
The marginal efficiency of capital is the expected annual rate of return on an additional unit of a capital
good. It is also described as the rate of return expected to be received on money if it were invested in a newly
produced asset. According to J.M. Keynes: "The marginal efficiency of capital is the rate of discount which
makes the present value of the prospective yield from the capital asset equal to its supply price. The marginal
efficiency of capital will progressively diminish as investment in the asset increases. The marginal efficiency of
capital (MEC) curve is, therefore negatively sloped".
J.M. Keynes defines marginal efficiency of capital as the: “The rate of discount which makes the present
value of the prospective yield from the capital asset equal to its supply price”.
A businessman while investment in a new capital asset, examines the expected rate of net return
(profit) on it during its lifetime against the supply price of capital asset (cost of capital asset) if the expected
rate of profit is greater than the replacement cost of the asset, the businessman will invest the money in the
project.
Example: For example, if a businessman spends Rs.10,000 on the purchase of a new griding machine.
We assume further that this new capital asset continues to produce goods over a long period of time. The net
return (excluding meeting all expenses except the interest cost) of the griding machine expected to be Rs.1000
per annum. The marginal efficiency of capital will be 10%.
(1000/10000) Χ (100/1) = 10%
Formula:
The following formula is used to know the present value of aeries of expected income throughout the life span
of the capital assets.
Sp = (R1/1+r) + (R2/1+r2) + ............ = (Rn/1+rn)
Here:
Sp = Stands for supply price of the new capital asset.
R1 + R2 - Rn = Stands for returns received on yearly basis.
R = It is the rate of discount applied each the years.
According to J.M. Keynes, the behavior of investment in respect of new investment depends upon the various
stock of capital available in the economy at a particular period of time. As the stock of capital increases in the
economy, the marginal efficiency of capital goes on diminishing. The MEC curve is negatively sloped
Investment (Rs. in billion)Marginal Efficiency of Capital
20 10%
25 9%
40 7%
70 5%
100 2%
RELATIVE ROLE OF MEC AND THE RATE OF INTEREST:
The MEC and the rate of interest are the two important factors which affect the volume of new investment in
a country. An investor while making a new investment, weighs the MEC of new investment against the
prevailing rate of interest. As long as the MEC is higher than the rate of interest, the investment will be made till
the MEC and the rate of interest are equalized.
For example, if the rate of interest 7%, the induced investment will continue to be made till the MEC and the
rate of interest are equalized. At 7% rate of interest, the new investment will be Rs.40 billion. In case, the rate of
interest comes down to 2%, the new investment in capital assets will be Rs.100 billion.
Summing up, if investment is to be increased in the country, either the rate of interest should go down or MEC
should increase.
FACTORS AFFECTING MEC:
The marginal efficiency of capital is influenced by short run as well as long run factors. These factors
are now discussed in brief:
SHORT RUN FACTORS:
1] Demand for the product. It the market for a particular good is expected to grow and its costs are likely
to fall, the rate of return from investment will be high. If entrepreneurs expect a fall in demand of goods
and a rise in cost, the will decline.
2] Liquid assets. If the entrepreneurs are holding large volume of working capital, they can take
advantage of the investment opportunities that come in their way. The MEC will be high and vice versa.
3] Sudden changes in income. The MEC is also influenced by sudden changes in income of the
entrepreneurs. If the business community gets windfall profits, or there are tax concession etc., the MEC](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-80-320.jpg)
![Dr. Bhati Rakesh 81 | P a g e
will be high and hence investment in the country will go up. On the other hand, MEC falls with the
decrease in income.
4] Current rate of investment. Another factor which influences MEC is the current date of investment in
a particular industry. If in a particular industry, much investment has already taken place and the rate
of investment currently going on in that industry is also very large, then the marginal efficiency of
capital will be low.
5] Wave of optimism and pessimism. The marginal efficiency of capital is also affected by waves of
optimism and pessimism in the business circle. If businessmen are optimistic about future, the MEC will
be overestimated. During periods of pessimism the MEC is under estimated.
LONG RUN FACTORS: The long run factors which influence the marginal efficiency capital are as under:
1] Rate of growth of population. Marginal efficiency of capital is also influenced by the rate of growth of
population. If population is growing at a rapid speed, it is usually believed that at the demand of various
classes of goods will increase. So a rapid rise in the growth of population will increase the marginal
efficiency of capital and a slowing down in its rate of growth will discourage investment and thus
reduce marginal efficiency of capital.
2] Technological development. If investment and technological development take place in the industry,
the prospects of increase in the net yield brightens up. For example, the development of automobiles in
the 20th century has greatly stimulated the rubber industry, the steel and oil industry, etc. So we can say
that inventions and technological improvements encourage investment in various projects and increase
marginal efficiency of capital.
3] The quantity of capital goods of relevant types already in existence. If the quantity of any
particular of goods is available in abundance in the market and the consumers can partially or full meet
the demand, then it will not be advantageous to invest money in that particular project. So in such cases,
the marginal efficiency of capital will be low.
4] Rate of taxes. Marginal efficiency of capital is directly influenced by the rate of taxes levied by the
government on various commodities, When taxes are levied, the cost of commodities is increased and
the revenue is lowered.
When profits are reduced, marginal efficiency of capital will naturally be affected. It will be low.
MULTIPLIER
A) GRAPHICAL DEMONSTRATION OF THE MULTIPLIER EFFECT
a) In the graph above, the vertical double-headed arrow represents the size of the initial positive demand
shock. The vertical distance of the shift upward indicates the amount demand initially rises holding
income constant.
b) But output and income rise much more than the size of the initial demand shock. The change in output
is indicated by Y1 – Y0, also show by the horizontal double-headed arrow in the graph above.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-81-320.jpg)
![Dr. Bhati Rakesh 82 | P a g e
c) The fact that Y rises more than the size of the initial demand shock represents the multiplier. That is,
the quantitative effect of a demand shock on equilibrium output is larger than the size of the shock.
d) The existence of a multiplier explains why the effects of an AD shock are larger than the size of the
original AD shock. For example, a $10 billion positive investment shock will have more than a $10
billion effect on equilibrium output.
b) INTUITION BEHIND THE MULTIPLIER
a) Let’s consider the intuition behind the multiplier. Suppose that there is a positive AD shock. This
causes sales, expected sales, and output to rise. Higher output raises employment and income. Higher
income causes higher consumption, which raises AD even more and the cycle continues again. Thus, the
effect on output is larger than the size of the original demand shock. One could say that the multiplier
process “magnifies” the effect of any initial demand shock.
b) Note that the multiplier works in both directions. If the initial shock is negative, it will also be
magnified.
c) ALGEBRAIC ANALYSIS OF THE MULTIPLIER PHENOMENON
Now we will use a simple algebraic version of the Keynesian Cross model to demonstrate the multiplier
model with equations.
Begin with the consumption function:
o C = a + (MPC)(Y-T)
o Think of “T” as the total income people pay in taxes.
o After-tax or “disposable” income equals Y-T
The definition of aggregate demand is: AD = C + I + G + Ex –Im
In equilibrium, output equals aggregate demand, so Y = AD
Hence, Y = C + I + G + Ex – Im or substituting the consumption function for C gives Y = [a + (MPC)(Y-T)]
+ I + G + Ex –Im
Now, solve this equation for Y, the equilibrium level of output by collecting the terms that depend on Y
on the left side o the equation:
o Y – (MPC)Y = a –(MPC)T + I + G +Ex – Im
o Y (1 – MPC) = a –(MPC)T + I + G +Ex – Im
o Y = [ 1 / (1 - MPC) ] [a –(MPC)T + I + G + Ex – Im]
The expression 1/(1 – MPC) is called The Multiplier. The multiplier is a measure of by how much an
initial AD shock is magnified to get the total effect of the shock on equilibrium output.
Since the MPC is always between 0 and 1, the multiplier is always greater than or equal to 1.
Conceptually, this means that the value of the initial shock is multiplied by a number greater than one to
get the total effect of the shock (ie: total effect > initial shock). If, however, the MPC equals 0 (or the tax
rate is 100%), then we get a multiplier of 1.
o You can show from the graph, that if the MPC is zero, the AD curve is horizontal. When AD shifts
up in this special case equilibrium output rises just as much as the size of the initial shock, and
no more. Thus, the graph gives the same answer as the algebra.
o Intuitively, if the MPC is zero we would not expect any “magnification effect” because there is no
feedback through income creation and consumption after the economy adjusts to the initial
demand shock.
o Notice that the multiplier is larger as MPC increases, this is because the bigger is MPC the
greater the initial shock in demand will be magnified as higher incomes induce even more
consumption.
Example: Suppose that investment rises from I0 to I1.
o Initial equilibrium output, Y0 is:
o Y0 = [ 1/(1 – MPC) ] * (a –(MPC)T + I0 + G + Ex – Im)
o Final equilibrium output, Y1 is:
o Y1 = [ 1/(1 – MPC) ] * (a –(MPC)T + I1 + G + Ex – Im)
o Subtract the Y0 equation from Y1 equation to obtain:
o ΔY = Y1 – Y0 = [ 1/(1 – MPC) ] * (I1 – I0) = [1/(1 - MPC)] ΔI
o As we can see, as long as 0 < MPC <1, the multiplier will be greater than 1. Multiply the
multiplier by the size of the initial shock, ΔI, and you will get the size of the total effect of the AD
shock on equilibrium output, ΔY](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-82-320.jpg)
![Dr. Bhati Rakesh 83 | P a g e
d) THE INVESTMENT ACCELERATOR
Investment is highly procyclical, rising when output is high and falling when output is low. Therefore, the
assumption in the basic Keynesian Cross model that investment is exogenous is not very realistic. We can
improve the model by incorporating an investment equation that allows investment to vary with output.
Economists call the positive link between investment and output “the accelerator” The accelerator
measures the additional I generated from an increase in Y.
(1) An equation capturing investment volatility
The basic investment accelerator equation (which looks very similar to the consumption function) is
I = b + (ACC)*Y
b is determined exogenously, and is similar to a in the consumption function. The accelerator, ACC, is
always between 0 and 1 (like the MPC) but it typically is low (possibly about 0.1) because I is a
relatively small percentage of Y.
With a positive ACC in this model, I will rise when Y rises and I will decline when Y falls, just as our
theory predicts and the data demonstrate.
(2) Effect on the multiplier
Using the following equations, we will calculate equilibrium Y
C = a + (MPC) (Y – T)
I = b + (ACC)Y
AD = C + I + G + Ex – Im
Y = AD (which is true in equilibrium: Y = AS = AD)
Y = [a + (MPC) (Y – T)] + [b + (ACC)Y] + G + Ex –Im
Y – (MPC)Y – (ACC)Y = a –(MPC)T + b + G + Ex – Im
Y [1 – MPC – ACC] = a –(MPC)T + b + G + Ex – Im
Equilibrium Y = [ 1 / ( 1 – MPC – ACC )] [a –(MPC)T + b + G + Ex – Im]
This is the equation for equilibrium output, taking into consideration the endogenous effects a change in Y
has on consumption and investment. As we can see algebraically, an increase in the ACC will increase the
value of the multiplier. This should make sense conceptually also. If we have any AD shock (change in the
stock market, change in government spending, etc), we will see an increase in I. This is another way of
saying that I is procyclical: any increase in Y will have an increase in I. In addition, in this model I rises just
like C when income goes up, which makes the multiplier effect larger.
Effect of the accelerator on the KC model graph:
o The accelerator effect raises the slope of the AD curve. When ACC > 0, an increase of Y not only
raises consumption, but it also raises investment.
o As we have seen before, if the AD curve is steeper, the multiplier is larger. Thus, the graph above is
consistent with our algebraic analysis of the accelerator.
ACCELERATOR
John Hicks was an economist early in the 1900s that took the work of Adams and Ricardo and joined
it with the work of many of his contemporaries to answer some remaining questions. Hicks thought
about how the multiplier effect and accelerator effect interact with one another.
The Multiplier Effect and Accelerator Effect
The multiplier effect is the total impact an incremental dollar in income could have
throughout the economy. You might think, ''Well, it's Rs.1.00.'' But think of the flow of money
through the economy. If you earn that extra dollar, you'll probably spend it on something. The
producer of that good will get the money, and it will end up - at least partially - as income for
someone else.
That person will then buy something, providing income for someone else. If, by the time that dollar is
'done' being spent, it has turned into Rs.4 in wages for you and other people down the supply chain,
then the economy has a multiplier of four.
The accelerator effect is a little easier to articulate. It's the expected increase in investment
as the economy grows. This doesn't happen at exactly the same time, but as the economy
grows and people's income increases, this also increases investments - either in savings
accounts or more aggressive investments.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-83-320.jpg)
![Dr. Bhati Rakesh 84 | P a g e
INTRODUCTION: BUSINESS CYCLE
Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering
the growth rate of real gross domestic product. Economies expand and contract - sometimes things are good,
sometimes not so much. The idea of this happening in a cycle is called a business cycle. This concept dates back
to economists from the 1800s like Adam Smith and David Ricardo. They identified the general growth and
decline of goods and services over the course of years. They would see economic growth, with signs such as
individuals accumulating more wealth and goods, saving more money, and unemployment dropping near to the
point of full employment. Then, after some time, things would change, and there would be fewer jobs, meaning
fewer people with extra money to buy things, meaning less output and production, which would lead to an
economic slowdown, or recession. Business cycles are identified as having four distinct phases: peak, trough,
contraction, and expansion. The timing of a cycle is not predictable, but its phases seem to be. Many economists
cite four phases - prosperity, liquidation, depression, and recovery - using the terms originally developed by the
American economist Wesley Mitchell, who devoted his career to studying business cycles.
IMPORTANCE OF BUSINESS CYCLES
Every company must go through their share of ups and downs. And each trading cycle is characterized by its
own unique features. There are four basic phases – expansion, peak, trough/depression, and recovery. A firm
must always identify which phase it is currently in. It must also always be prepared for a sudden change in the
cycles since these cycles are impossible to predict. Let us see the importance of business cycles and their
relevance for firms.
(Source: Economic Discussion)
1] Help Frame Appropriate Policies
A business cycle will affect all the sectors of an economy. Similarly,
it will also affect all sectors of a firm as well. Right from demand to
supply to the cost of production every aspect will depend on the
phase of the business cycle. So the firm must be able to correctly
identify its current phase. This will help them frame appropriate
business and trade policies. For example, if the firm is going
through expansion it will be the correct time for aggressive
investment policies or an expansion in the workforce.
2] Strategic Business Decisions
The business cycle of a firm will also have a huge impact on their
business decisions. Managers and entrepreneurs take strategic
business decisions based on the phases of the trade cycle. A business cannot be stagnant it must constantly
keep updating to stay with the times. So different phases of the cycle demand different actions from the
firm.
So if the economy is going through an expansion the management can make the strategic decision to expand
the business or increase their output levels. But if the firm is in a trough then spending must be reined in
and policies should be formed accordingly. Management may even decide to shut down some product lines
temporarily or even permanently. Such important business decisions will depend on the trade cycle.
3] Greatly Affect Cyclic Businesses
Changes in the economy affect all firms but not uniformly. There are certain businesses that are more
vulnerable to a change in the phase of a trade cycle. Such firms have to keep a very close look at the changes
in the economy at all times. Some examples are the fashion industry, electronics industry, food and
beverage industry, real estate industry etc.
For such firms when the economy is in a boom, they must capitalize. Because a depression in the economy
will affect them the most. So this is one of the main importance of business cycles.
4] Entry and Exit from Market
For the success of a product launch, the phase of the trade cycle for its introduction is a very important
factor. It is much harder for a new product to survive a sluggish economy that is moving towards a
depression. Even the prices, sales policy, promotions of the new product will depend on the phases of the
business cycle.
And on the other hand, if a product has to exit the market, again the conditions must be studied. If the
economy is coming out of a depression and seeing a revival then perhaps the exit can be delayed. This is
another importance of business cycles.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-84-320.jpg)
![Dr. Bhati Rakesh 85 | P a g e
THEORIES OF BUSINESS CYCLES
To seek an explanation of the causes of business cycle, various theories have been put forward from time to
time to throw light on this highly complex phenomenon of the capitalist world. These theories can be classified
broadly into: (a) Non-monetary theories. (b) Monetary theories.
Among the non-monetary theories are-
1] Meteorological or Sunspot Theory;
2] Psychological Theory;
3] Over-production Theory,
4] Over Saving Theory;
5] Innovation Theory; and
6] Cobweb Theorem.
Among the monetary theories of Business cycle the important ones are the following:
1] Howtrey’s Theory;
2] Dr. Hayek’s over-investment Theory;
3] Keynes’ Theory;
4] Prof. Hicks Theory of Business cycle.
A full treatise is required to discuss in fuller details all these theories. A few of the old theories are no longer
accepted now.
1] Climatic Theory Or Sun-Spot Theory: The theory has been presented by Jevons. According to him, the
main cause of economic fluctuations is the changes in climatic conditions. He ‘says that spots appear on the
surface of the sun after regular intervals which affect the emission of heat and conditions of rainfalls.
Production in agriculture sector is adversely effected and incomes of the farmers are reduced. A low income
in agriculture sector causes a decrease in the demand for industrial goods. So depression in agriculture
sector is transferred to industrial and other sectors of the economy. When the spots disappear, rainfalls and
climatic conditions become favorable, output in agriculture sector increases. Incomes of the farmers expand
and they increase demand for industrial products. It means overall prosperity and depression occurs due to
changes in climatic conditions.
2] Psychological theory : Professor Pigou explains trade cycle based upon human psychology. There are
moods of optimism and pessimism which are responsible for the alternating phases of trade cycle. When
business community is optimistic about earning profit, investment increases. Increase in investment
expands the level of national income and employments. At prosperity fear of recession prevails among
business community and they becomes pessimistic about earning profit without any sound reason. This
behavior reduces investment and contracts the level of income and employment.
3] Over investment or Over production theory: According to this theory, business cycles emerge due to
over investment. Over investment is the result of competition. This over investment will result in over
production. Supply exceeds demand. Prices will fall. This will result in loss and this depression spreads
from one industry to another. According to this theory. over investment is responsible for business cycles.
4] Over saving or under Consumption theory: This theory was stated by Malthus, Hobson etc. In a
capitalistic country rich people have large incomes and they invest more. This will increase production. But
in capitalistic society the majority of the people are poor. They cannot make effort to purchase more of
goods. Hence the demand for goods will be less than supply. Then prices will fall. Finally it leads to
depression. According to this theory, under consumption is responsible for business cycles.
5] Monetary theories : According to Hawtrey and Hayek the monetary factors are responsible for business
cycle. According to them changes in money supply are causes for trade cycles. Many business people carry
on businss with bank credit. By taking credit from banks in larger amount they will invest more in the
business. Production, employment and incomes increase, leading to a further demand for bank credit.
Banks multiply credit. Thus, it will lead to expansion of business. But banks cannot go on providing more
and more credit. After a limit they adopt restrictive credit policy. They increase interest rate. They ask the
people to repay loans. As a result, the business people cannot expand the business. This reduces the
production leading to unemployment. Thus, depression sets into economy.
6] Innovation theory: According to Schumpeter, innovations cause business cycles. Introduction of a new
product, new techniques creation of a new market, use of new type of raw-materials etc., are called as
innovations. Organisers introduces these innovations. Innovations increases the demand for capital. Banks
expand credit prices rise. Production, employment and incomes of the people increase. Thus, the
introduction of an innovation leads to a spurt in economic activity and a period of prosperity. But the effect
of an innovation gradually dies and the economic activity takes a downward turn. Again, after sometime
another innovation takes place resulting in an upward movement of economic acitivity.
7] Keynes theory : Keynes’ “General Theory” also provides an explanation of trade cycle, because trade cycle
is nothing more than the fluctuations in income, output and employment.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-85-320.jpg)
![Dr. Bhati Rakesh 86 | P a g e
According to Keynes, “fluctuations in the level of national income and employment are due to changes in the
volume of investment”. Investment is determined by two factors i.e., the rate of interest and expected rate
of profit (MEC). Interest is relatively stable factor and it does not change in the short-run. Therefore it plays
no significant role in cyclical fluctuations. The other factor, MEC (expected r.ite of profit) changes frequently
because it is mostly dependent on expectations of earning profit when business community is expecting to
earn abnormal profit and MEC exceeds the rate of interest, investment expands. An increase investment
leads to many times more increase in income and employment through the positive effect of multiplier. So
expansion phase of trade cycle is due to increase in investment resulting from a rise in MEC.
On the other hand, a fall in MEC will reduce the volume of investment. Reduction in investment will contract
income and employment through the inverse action of multiplier. It means the phase of i recession starts
due to fall in MEC. The intensity of cyclical fluctuations depends upon the value of multiplier. In the end we
may conclude that economic fluctuations are due to MEC.
8] Hicks theory: Keynes theory takes multiplier effect only into account. He neglects acceleration effect. Hicks
taked both multiplier and acceleration effects into account. Modem theory explains trade cycle in terms of
interaction between multiplier and accelerator. According to Hicks, intensity of economic fluctuations is
much more due to combined effect of multiplier and accelerator.An increase in investment leads to many
times more increase in national income through the working of multiplier.
For example, if the value of multiplier is 5, an investment of Rs.100 will raise national income by Rs.500.The
effect of accelerator increases the speed of investment in economy. An increase in.-national income by
Rs.500 will raise aggregate consumption by Rs. 400 if marginal propensity to consume (MPC) is 4/5.
Further investment will be required to meet the additional demand for consumption goods of Rs. 400
Suppose capital goods worth Rs. 10,000 can produce consumption goods worth Rs. 400 regularly. It means
there will be further investment of Rs. 10,000 which will cause further increase in national.
The accelerator like multiplier works in both directions. If the demand for consumer goods deceases, it
leads to a fall in the demand for capital goods, As a result of this, national income will start contracting
rapidly due to combined effect of multiplier and accelerator.Therefore modern theory of trade cycle
explains reasonably the causes of trade cycle in the economy.
IMPORTANT THEORIES
1] OVER-INVESTMENT THEORY:
According to this theory trade cycle occurs because of the over investment in investment industries.
The investment industries are building and construction, iron and steel, engineering etc. During every
boom investment increases. This statement is supported by the fact that during boom, investment goods
industries expand faster than consumption goods industries and during depression investment goods
industries suffer more than consumption goods industries. However, opinion among the writers differs on
the question as to why in the boom phase investment goods industries expand faster than consumption
goods industries.
Hayeis Machlup, Ropke and Ribbons hold banks responsible for it. Banks give credit at unduly low rates
of investment and in this way they encourage investment. Credits being cheap, all sorts of inefficient and
even uneconomical units are set up. The entrepreneurs adopt more and more rounds about methods of
production. Resources are withdrawn from consumer’s goods industries and invested in production goods
industries through the process of forced saving. This brings about the disparity in the growth rates of
consumption goods industries and investment goods industries.
At some points the banks feel that too much credit has been created. They raise the rate of
interest.Borrowing becomes a costly affair and the rate of investment falls this will bring about the
contraction of credit and hence contraction of economic activity leading to depression. But economists like
Cassel consider the process of production rather than the expansion of bank credit to be more important
cause of a trade cycle. According to them a revival in economic activity leading to boom takes place because
of real forces like new inventions. However, here also the assumption of ‘elastic money supply’ remains.
2] UNDER CONSUMPTION THEORY:
The chief exponent of this theory is I.S. Hobson. According to him, trade cycles appear due to mal-
distribution of national income.
This mal-distribution of national income takes place because during boom the entrepreneurs and
businessmen gather income with business activities and banks and become richer. Since they cannot
consume the whole income they save.
There is too much saving during the boom period. Reduction in the level of consumption means a fall in the
demand for consumers’ goods because the amount saved is not spent on consumption.
The supply of consumer’s goods will be far greater than the demand for them. Prices of these goods begin to
fall. The general outlook becomes pessimist. If this downward movement continues depression will set in.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-86-320.jpg)
![Dr. Bhati Rakesh 87 | P a g e
3] KEYNES’ SAVING AND INVESTMENT THEORY:
In this ‘General’ Theory Keynes has given an explanation of business or trade cycle. Keynes never attempted
an elaborate theory of business cycle as such. In fact business cycles show rhythmic fluctuations in the
aggregate income, output and employment which is the main subject matter of Keynes’ ‘General Theory’.
In Dillard’s words, “Keynes’ General Theory is not a theory of business cycle as such. It is much more
and also much less than that, it is more than a theory of business cycle in the sense that it offers a general
explanation for the level of employment quite independently by the cyclical nature of changes in
employment.
It is less than a complete theory of business cycle because it makes no attempt to give a detailed account of
the various phases of the cycle and does not examine closely the empirical data of cyclic fluctuations,
something which any complete study of the business cycle would presumably do.”
According to Keynes’ business cycles appear as a result of the fluctuations in the rate of investment and
the fluctuations in the rate of investment are due to the marginal efficiency of capital (MEC) Keynes’ has
defined marginal efficiency of capital as the relation between the prospective yield of that type of capital
and the cost of producing the units.”
In simple words, we define marginal efficiency of capital as the expected rate of profit on new investment or
capital goods. Thus, the fluctuations in economic activity are due to the marginal efficiency of capital or the
expected rate of interest on new investment.
The rate of interest which is the second determinant of investment is stable in short period and in the
long period it cannot go beyond a maximum and minimum limit. It is, therefore, the marginal efficiency of
capital which is always fluctuating due to complex variables viz.; expected trends of prices, element of risks
in enterprise, the existing stock of capital goods. Therefore, fluctuations in investment are largely due to
fluctuations in the marginal efficiency of capital. When the marginal efficiency of capital rises there will be
burst in investment leading to a boom. The burning point from the boom to contraction is explained by
saying that there is a decline in the prospective yields on capital (i.e. marginal efficiency of capital) due to
growing increase of the capital goods.
A wave of boom will set in and this will cause a further fall in marginal efficiency of capital. The result
will be deciding production and consequent depression. Just as Keynes’ explains the turning point from
boom to contraction, similarly, he explains that a change from depression to recovery is due to the revival
of the marginal efficiency of capital.
Along with the revival of marginal efficiency of capital, there will be the revival of business confidence
which is more important. Because without the revival of business confidence even if the rate of Interest is
reduced, investment will remain the same because in the absence of business confidence marginal
efficiency of capital remains low. As the investment increases income increases more due to the multiplier
effect so the overall business activity starts upwards.
4] HICKS’ THEORY OF TRADE CYCLE:
Prof Hicks explains the phenomenon of trade cycles by combining the principle of multiplier and
acceleration. According to Hicks, investment is of two types. (i) Autonomous investment and (ii) Induced
investment.
Autonomous investment is independent of the variations in income, output and consumption, while
induced investment is determined by the fluctuations in income, output and consumption. The force of
autonomous investment is expressed in multiplier while the force of induced investment is expressed in
acceleration. Thus, according to Hicks, autonomous investment and induced investment cause cyclical
fluctuations in economic activity via multiplier and accelerator respectively.
Let us assume that the initial equilibrium position of the economy is disturbed by a change in autonomous
investment. This will lead to increase in income and output to the extent indicated by the multiplier. Now
this expansion of income and output will affect the induced investment via the accelerator. This gives rise to
further expansion of income (multiplier) and investment (accelerator) of the economy and so on. In this
way during this period of upswing, output increases faster than the equilibrium rate.
Investment also increases faster than the normal rate. The expansion of income and output will
continue till the economy reaches the upper limit or ceiling determined by full employment. After this
ceiling, it starts declining. The rate of expansion in output and income is slowed down to the natural rate.
This leads to decrease in the amount of induced investment. The multiplier and accelerator forces will work
in the reverse order. A fall in investment reduces income at a faster rate and the reduced income again
reduce the level of investment and so on. Now the level of output and income will not only reduce to the
equilibrium level but rather below it. The reason is obvious as the multiplier and the accelerator work just
in the opposite directions. This will go on declining till it reaches the minimum (lower) turning point. Thus,
the cycle is complete the main limitation of this theory lies in the use of acceleration principle which the
modern economists consider as a crude tool. This principle assumes that investment generated by a change
in output is independent of the absolute size of the change.](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-87-320.jpg)
![Dr. Bhati Rakesh 88 | P a g e
CAUSES OF BUSINESS CYCLES
The cyclic pattern of changes that occurs in the economy is caused by many factors in combination. There are
internal factors within the economy that may be causing these changes. And there are also external factors
which may lead to a boom or bust of an economy. Let us take a look at all the causes of business cycles.
INTERNAL CAUSES OF BUSINESS CYCLES
These endogenous factors can cause changes in the phases of the firm and the economy in general. Let us take a
look at the internal causes of business cycles.
1] Changes in Demand: Keynes economists believe that a change in demand causes a change in the
economic activities. When the demand in an economy increases the firms start producing more goods
to meet the demand.
There is more output, more employment, more income, and higher profits. This will lead to a boom in
the economy. But excessive demand may also cause inflation.
On the other hand, if the demand falls, so does the economic activity. This may lead to a bust, which if it
continues for a longer period of time may even lead to depression in the economy.
2] Fluctuations in Investments: Just as fluctuations in demand, fluctuations in investment is one of the
main causes of business cycles. The investments will fluctuate on the basis of a lot of factors such as the
rate of interest in the economy, entrepreneurial interest, profit expectation, etc.
An increase in investment will lead to an increase in economic activities and cause expansion. A
decrease in investment will have the opposite effect and may cause a trough or even depression
3] Macroeconomic Policies: The monetary policies and the economic policies of a nation will also result
in changes in the phases of a business cycle. So if the monetary policies are looking to expand economic
activities by promoting investment, then the economy booms. On the other hand, if there is an increase
in taxes or interest rates we will see a slowdown or a recession in the economy.
4] Supply of Money: There is another belief that says that business cycles are purely monetary
phenomena. So changes in the money supply will bring about the trade cycles. An increase of money in
the market will cause growth and expansion.
But too much money supply may also cause inflation which is adverse. And the decrease in the supply of
money will initiate a recession in the economy.
EXTERNAL CAUSES OF BUSINESS CYCLES
1] Wars: During times of wars and unrest, the economic resources are put to use to make special goods
like weapons, arms, and other such war goods. The focus shifts from consumer products and capital
goods. This will lead to a fall in income, employment, and economic activity. So the economy will face a
downturn during war times.
And later post-war the focus will be on rebuilding. Infrastructure needs to be reconstructed (houses,
roads, bridges, etc). This will help the economy pick up again as progress is being made. Economic
activity will increase as effective demand will increase.
2] Technology Shocks: Some exciting and new technology is always a boost to the economy. New
technology will mean new investment, increased employment, and subsequently higher incomes and
profits. For example, the invention of the modern mobile phone was the reason for a huge boost in the
telecom industry.
3] Natural Factors: Natural disasters like floods, droughts, hurricanes, etc can cause damage to the crops
and huge losses to the agricultural sector. Shortage of food will cause a surge in prices and high
inflation. Capital goods may see a reduction in demand as well.
4] Population Expansion: If the population growth is out of control that might be a problem for the
economy. Basically of the population growth is higher than the economic growth the total savings of an
economy will start dwindling. Then the investments will reduce as well and the economy will face
depression or a slow down.
Stabilization policies are also known as counter cycle policies. These policies try to counter the natural ups and
downs of business cycles. Expansionary stabilization policies are useful to reduce unemployment during
contraction and contractionary policies are used to reduce inflation during expansion.
INSTRUMENTS OF STABILIZATION POLICIES
1] Monetary Policy: Monetary policy is employed by the government as an effective tool to promote
economic stability and achieve certain predetermined objectives. It deals with the total money supply
and its management in an economy. Objectives of monetary policy include exchange rate stability, price
stability, full employment, rapid economic growth, etc.
2] Fiscal Policy: Fiscal policy helps to formulate rational consumption policy and helps to increase
savings. It raises the volume of investments and the standards of living. Fiscal policy creates more jobs,
reduces economic inequalities and controls, inflation and deflation. Fiscal policy as an instrument to](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-88-320.jpg)
![Dr. Bhati Rakesh 89 | P a g e
fight depression and create full employment conditions is much more effective as compared to
monetary policy.
3] Physical Policy: When monetary policy and fiscal policy are inadequate to control prices, government
adapts physical policy. These policies can be introduced swiftly and thus the result is quite rapid.
Theses controls are more discriminatory as compared to monetary policy. They tend to vary effectively
in the intensity of the operation of control from time to time in various sectors.
Business Cycles and Business Decisions](https://image.slidesharecdn.com/economicanalysisforbusiness-210224074512/85/Economic-analysis-for-business-89-320.jpg)
Uploaded byASM's IBMR- Chinchwad
Economic analysis for business
The document presents lecture notes for a Master's level course on Economic Analysis for Business Decisions, detailing course outcomes and coverage of key concepts in managerial economics. It discusses topics such as demand and supply analysis, market equilibrium, pricing strategies, and the role of economic theories in decision-making processes within businesses. The notes emphasize the importance of understanding both micro and macroeconomic aspects as they relate to business challenges and operational strategies.
More Related Content
Similar to Economic analysis for business
Economic analysis for business
- 1. Dr. Bhati Rakesh1 | P a g e LECTURE NOTES FOR MASTER OF BUSINESS ADMINISTRATION (M.B.A) (FIRST YEAR-Semester-I) SUBJECT CODE: (103) SUBJECT: Economic Analysis for Business Decisions BY: dR. Rakesh KUMAR Bhati
- 2. Dr. Bhati Rakesh2 | P a g e Course Outcomes: On successful completion of the course the learner will be able to CO# COGNITIVE ABILITIES COURSE OUTCOMES CO103.1 REMEMBERING DEFINE the key terms in economics. CO103.2 UNDERSTANDING EXPLAIN the reasons for existence of firms and their decision making goals. CO103.3 APPLYING MAKE USE OF the basic concepts of Demand, Supply, Demand Forecasting, Equilibrium and their determinants. CO103.4 ANALYSING ANALYSE cost function and the difference between short-run and long-run cost function and establish the REATIONSHIP between production function and cost function. CO103.5 ANALYSING EXAMINE the effect of non-price factors on products and services of monopolistic and oligopoly firms. CO103.6 EVALUATING DESIGN competition strategies, including costing, pricing, product differentiation, and market environment according to the natures of products, the market structures and Business Cycles. 1. Managerial Economics: Concept of Economy, Economics, Microeconomics, Macroeconomics. Nature and Scope of Managerial Economics, Managerial Economics and decision-making. Concept of Firm, Market, Objectives of Firm: Profit Maximization Model, Economist Theory of the Firm, Cyert and March’s Behavior Theory, Marris’ Growth Maximisation Model, Baumol’s Static and Dynamic Models, Williamson’s Managerial Discretionary Theory. (6+1) 2. Utility & Demand Analysis: Utility – Meaning, Utility analysis, Measurement of utility, Law of diminishing marginal utility, Indifference curve, Consumer’s equilibrium - Budget line and Consumer surplus. Demand - Concept of Demand, Types of Demand, Determinants of Demand, Law of Demand, Elasticity of Demand, Exceptions to Law of Demand. Uses of the concept of elasticity. Forecasting: Introduction, Meaning and Forecasting, Level of Demand Forecasting, Criteria for Good Demand Forecasting, Methods of Demand Forecasting, Survey Methods, Statistical Methods, Qualitative Methods, Demand Forecasting for a New Products. (Demand Forecasting methods - Conceptual treatment only numericals not expected) (8+1) 3. Supply & Market Equilibrium: Introduction, Meaning of Supply and Law of Supply, Exceptions to the Law of Supply, Changes or Shifts in Supply. Elasticity of supply, Factors Determining Elasticity of Supply, Practical Importance, Market Equilibrium and Changes in Market Equilibrium. Production Analysis: Introduction, Meaning of Production and Production Function, Cost of Production. Cost Analysis: Private costs and Social Costs, Accounting Costs and Economic costs, Short run and Long Run costs, Economies of scale, Cost-Output Relationship - Cost Function, Cost-Output Relationships in the Short Run, and Cost-Output Relationships in the Long Run. 4. Revenue Analysis and Pricing Policies: Introduction, Revenue: Meaning and Types, Relationship between Revenues and Price Elasticity of Demand, Pricing Policies, Objectives of Pricing Policies, Cost plus pricing. Marginal cost pricing. Cyclical pricing. Penetration Pricing. Price Leadership, Price Skimming. Transfer pricing. Price Determination under Perfect Competition- Introduction, Market and Market Structure, Perfect Competition, Price-Output Determination under Perfect Competition, Short-run Industry Equilibrium under Perfect Competition, Short-run Firm Equilibrium under Perfect Competition, Long-run Industry Equilibrium under Perfect Competition, Long-run Firm Equilibrium under Perfect Competition. Pricing Under Imperfect Competition- Introduction, Monopoly, Price Discrimination under Monopoly, Bilateral Monopoly, Monopolistic Competition, Oligopoly, Collusive Oligopoly and Price Leadership, Pricing Power, Duopoly, Industry Analysis. Profit Policy: Break Even analysis. Profit Forecasting. Need for Government Intervention in Markets. Price Controls. Support Price. Preventions and Control of Monopolies. System of Dual Price. 5. Consumption Function and Investment Function: Introduction, Consumption Function, Investment Function, Marginal efficiency of capital and business expectations, Multiplier, Accelerator. Business Cycle: Introduction, Meaning and Features, Theories of Business Cycles, Measures to Control Business Cycles, Business Cycles and Business Decisions. Suggested Text Books: 1. Managerial Economics, Peterson, Lewis, Sudhir Jain, Pearson, Prentice Hall 2. Managerial Economics, D. Salvatore, McGraw Hill, New Delhi. 3. Managerial Economics, Pearson and Lewis, Prentice Hall, New Delhi 4. Managerial Economics, G.S. Gupta, T M H, New Delhi. 5. Managerial Economics, Mote, Paul and Gupta, T M H, New Delhi. Suggested Reference Books: 1. Managerial Economics, Homas and Maurice, Tata McGraw Hill 2. Managerial Economics - Analysis, Problems and Cases, P.L. Mehta, Sultan Chand Sons, New Delhi. 3. Managerial Economics, Varshney and Maheshwari, Sultan Chand and Sons, New Delhi. 4. Managerial Economics, D.M.Mithani 5. Managerial Economics, Joel Dean, Prentice Hall, USA. 6. Managerial Economics by H L Ahuja, S Chand & Co. New Delhi. Semester I 103 – Economic Analysis for Business Decisions 3 Credits LTP: 2:1:1 Compulsory Generic Core Course
- 3. Dr. Bhati Rakesh3 | P a g e INTRODUCTION The discovery of managerial economics as a separate course in management studies has been attributed to three major factors: 1] The growing complexity of business decision-making processes, because of changing market conditions and the globalization of business transactions. 2] The increasing use of economic logic, concepts, theories, and tools of economic analysis in business decision-making processes. 3] Rapid increase in demand for professionally trained managerial manpower. It should be noted that the recent complexities associated with business decisions has increased the need for application of economic concepts, theories and tools of economic analysis in business decisions. The reason has been that making appropriate business decision requires clear understanding of existing market conditions market fundamentals and the business environment in general. Business decision- making processes therefore, requires intensive and extensive analysis of the market conditions in the product, input and financial markets. Economic theories, logic and tools of analysis have been developed for the analysis and prediction of market behaviours. The application of economic concepts, theories, logic, and analytical tools in the assessment and prediction of market conditions and business environment has proved to be a significant help to business decision makers all over the globe. DEFINITION OF MANAGERIAL ECONOMICS Managerial economics has been generally defined as the study of economic theories, logic and tools of economic analysis, used in the process of business decision making. It involves the understanding and use of economic theories and techniques of economic analysis in analyzing and solving business problems. Economic principles contribute significantly towards the performance of managerial duties as well as responsibilities. Managers with some working knowledge of economics can perform their functions more effectively and efficiently than those without such knowledge. Taking appropriate business decisions requires a good understanding of the technical and environmental conditions under which business decisions are taken. Application of economic theories and logic to explain and analyse these technical conditions and business environment can contribute significantly to the rational decision-making process. According to McNair and Meriam, "Managerial Economics consists of the use of economic modes of thought to analyse business situation." Spencer and Siegelman have defined Managerial Economics as "The integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management." SCOPE OF MANAGERIAL ECONOMICS Managerial economics comprises both micro- and macro-economic theories. Generally, the scope of managerial economics extends to those economic concepts, theories, and tools of analysis used in analysing the business environment, and to find solutions to practical business problems. In broad terms, managerial economics is applied economics. The areas of business issues to which economic theories can be directly applied are divided into two broad categories: 1. Operational or internal issues; and, 2. Environment or external issues. Operational problems are of internal nature. These problems include all those problems which arise within the business organization and fall within the control of management. Some of the basic internal issues include: choice of business and the nature of product (what to produce); choice of size of the firm (how much to produce); choice of technology (choosing the factor combination); choice of price (product pricing); how to promote sales; how to face price competition; how to decide on new investments; how to manage profit and capital; and, how to manage inventory. UNIT– 1 UNIT -I Managerial Economics: Concept of Economy, Economics, Microeconomics, Macroeconomics. Nature and Scope of Managerial Economics, Managerial Economics and decision-making. Concept of Firm, Market, Objectives of Firm: Profit Maximization Model, Economist Theory of the Firm, Cyert and March’s Behavior Theory, Marris’ Growth Maximisation Model, Baumol’s Static and Dynamic Models, Williamson’s Managerial Discretionary Theory.
- 4. Dr. Bhati Rakesh4 | P a g e The microeconomic theories dealing with most of these internal issues include, among others: The theory of demand, which explains the consumer behaviour in terms of decisions on whether or not to buy a commodity and the quantity to be purchased. Theory of Production and production decisions. The theory of production or theory of the firm explains the relationship between inputs and output. Analysis of Market structure and Pricing theory. Price theory explains how prices are determined under different market conditions. Profit analysis and profit management. Profit making is the most common business objective. However, making a satisfactory profit is not always guaranteed due to business uncertainties. Profit theory guides firms in the measurement and management of profits, in making allowances for the risk premium, in calculating the pure return on capital and pure profit, and for future profit planning. Theory of capital and investment decisions. Capital is the foundation of any business. It efficient allocation and management is one of the most important tasks of the managers, as well as the determinant of the firm’s success level. Some of the important issues related to capital include: choice of investment project; assessing the efficiency of capital; and, the most efficient allocation of capital. Environmental issues are issues related to the general business environment. These are issues related to the overall economic, social, and political atmosphere of the country in which the business is situated. The factors constituting economic environment of a country include: 1. The existing economic system 2. General trends in production, income, employment, prices, savings and investment, and so on. 3. Structure of the financial institutions. 4. Magnitude of and trends in foreign trade. 5. Trends in labour and capital markets. 6. Governments economic policies. 7. Social organizations, such as trade unions, consumers’ cooperatives, and producer unions. 8. The political environment. 9. The degree of openness of the economy. Managerial economics is particularly concerned with those economic factors that form the business climate. In macroeconomic terms, managerial economics focus on business cycles, economic growth, and content and logic of some relevant government activities and policies which form the business environment. ECONOMIC ANALYSIS AND BUSINESS DECISIONS Business decision-making basically involves the selection of best out of alternative opportunities open to the business organization. Decision making processes involve four main phases, including: Phase One: Determining and defining the objective to be achieved. Phase Two: Collection and analysis of information on economic, social, political, and technological environment. Phase Three: Inventing, developing and analyzing possible course of action. Phase Four: Selecting a particular course of action from available alternatives. Note that phases two and three are the most crucial in business decision-making. They put the manager’s analytical ability to test and help in determining the appropriateness and validity of decisions in the modern business environment. Personal intelligence, experience, intuition and business acumen of the manager need to be supplemented with quantitative analysis of business data on market conditions and business environment. It is in fact, in this area of decision-making that economic theories and tools of economic analysis make the greatest contribution in business. If for instance, a business firm plans to launch a new product for which close substitutes are available in the market, one method of deciding whether or not this product should be launched is to obtain the services of a business consultant. The other method would be for the decision-maker or manager to decide. In doing this, the manager would need to investigate and analyze the following thoroughly: a) production related issues; and, (b) sales prospects and problems. With regards to production, the manager will be required to collect and analyze information or data on: (a) available production techniques; (b) cost of production associated with each production technique; (c) supply position of inputs required for the production process; (d) input prices; (e) production costs of the competitive products; and, (f) availability of foreign exchange, if inputs are to be imported.
- 5. Dr. Bhati Rakesh5 | P a g e Regarding the sales prospects and problems, the manager will be required to collect and analyse data on: (a) general market trends; (b) the industrial business trends; (c) major existing and potential competitors, as well as their respective market shares; (d) prices of the competing products; (e) pricing strategies of the prospective competitors; (f) market structure and the degree of competition; and, (g) the supply position of complementary goods. The application of economic theories in solving business problems helps in facilitating decision-making in the following ways: First, it can give clear understanding of the various necessary economic concepts, including demand, supply, cost, price, and the like that are used in business analysis. Second, it can help in ascertaining the relevant variables and specifying the relevant data. For example, in deciding what variables need to be considered in estimating the demand for two different sources of energy, petrol and electricity. Third, it provides consistency to business analysis and helps in arriving at right conclusions. IMPORTANCE OF MANAGERIAL ECONOMICS In a nutshell, three major contributions of economic theory to business economics have been enumerated: 1. Building of analytical models that help to recognize the structure of managerial problems, eliminate the minor details that can obstruct decision making, and help to concentrate on the main problem area. 2. Making available a set of analytical methods for business analyses thereby, enhancing the analytical capabilities of the business analyst. 3. Clarification of the various concepts used in business analysis, enabling the managers avoids conceptual pitfalls. USES OF MANAGERIAL ECONOMICS : Managerial economics accomplishes several objectives. First, it presents those aspects of traditional economics, which are relevant for business decision making it real life. For the purpose, it calls from economic theory the concepts, principles and techniques of analysis which have a bearing on the decision making process. These are, if necessary, adapted or modified with a view to enable the manager take better decisions. Thus, managerial economics accomplishes the objective of building suitable tool kit from traditional economics. Secondly, it also incorporates useful ideas from other disciplines such a psychology, sociology, etc., if they are found relevant for decision making. In fact managerial economics takes the aid of other academic disciplines having a bearing upon the business decisions of a manager in view of the carious explicit and implicit constraints subject to which resource allocation is to be optimized. Thirdly, managerial economics helps in reaching a variety of business decisions. What products and services should be produced? What inputs and production techniques should be used? How much output should be produced and at what prices it should be sold? What are the best sizes and locations of new plants? How should the available capital be allocated? Fourthly, managerial economics makes a manager a more competent model builder. Thus he can capture the essential relationships which characterize a situation while leaving out the cluttering details and peripheral relationships. Fifthly, at the level of the firm, where for various functional areas functional specialists or functional departments exist, e.g., finance, marketing, personal production, etc., managerial economics serves as an integrating agent by coordinating the different areas and bringing to bear on the decisions of each department or specialist the implications pertaining to other functional areas. It thus enables business decision making not in watertight compartments but in an integrated perspective, the significance of which lies in the fact that the functional departments or specialists often enjoy considerable autonomy and achieve conflicting coals. Finally, managerial economics takes cognizance of the interaction between the firm and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare. It has come to be realized that business part from its obligations to shareholders has certain social obligations. Managerial economics focuses attention on these social obligations as constraints subject to which business decisions are to be taken. In so doing, it serves as an instrument in rehiring the economic welfare of the society through socially oriented business decisions.
- 6. Dr. Bhati Rakesh6 | P a g e ECONOMIC OBJECTIVES OF FIRMS The main objectives of firms are given in figure but sometimes there is an overlap of objectives. For example, seeking to increase market share, may lead to lower profits in the short-term, but enable profit maximisation in the long run. PROFIT MAXIMISATION Usually, in economics, we assume firms are concerned with maximising profit. Higher profit means: 1. Higher dividends for shareholders. 2. More profit can be used to finance research and development. 3. Higher profit makes the firm less vulnerable to takeover. 4. Higher profit enables higher salaries for workers ALTERNATIVE AIMS OF FIRMS However, in the real world, firms may pursue other objectives apart from profit maximisation. PROFIT SATISFICING: In many firms, there is a separation of ownership and control. Those who own the company (shareholders) often do not get involved in the day to day running of the company. This is a problem because although the owners may want to maximise profits, the managers have much less incentive to maximise profits because they do not get the same rewards, (share dividends) Therefore managers may create a minimum level of profit to keep the shareholders happy, but then maximise other objectives, such as enjoying work, getting on with other workers. (e.g. not sacking them) This is the problem of separation between owners and managers. This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers share options and performance related pay although in some industries it is difficult to measure performance. The traditional theory does not distinguish between owners and managers’ interests. The recent theories of firm, which are also called managerial and behavioral theories of firm, assume owners and managers to be separate entities in large corporations with different goals and motivation. Some important alternative objectives of business firms, especially of large business corporations are also discussed. BAUMOL’S HYPOTHESIS OF SALES REVENUE MAXIMIZATION According to Baumol, “maximization of sales revenue is an alternative to profit maximization objective“. The reason behind this objective is to clearly distinct ownership and management in large business firms. This distinction helps the managers to set their goals other than profit maximization goal. Under this situation, managers maximize their own utility function. According to Baumol, the most reasonable factor in managers utility functions is maximization of the sales revenue. The factors, which help in explaining these goals by the managers, are following: Salary and other earnings of managers are more closely related to seals revenue than to profits. Banks and financial corporations look at sales revenue while financing the corporation. Trend in sale revenue is a good indicator of the performance of the business firm. It also helps in handling the personnel problems. Increasing sales revenue helps in enhancing the prestige of managers while profits go to the owners. Managers find profit maximization a difficult objective to fulfill consistently over time and at the same level. Profits may fluctuate with changing conditions. Growing sales strengthen competitive spirit of the business firm in the market and vice versa.
- 7. Dr. Bhati Rakesh7 | P a g e So far as empirical validity of sales revenue maximization objective is concerned, realistic evidences are unsatisfying. Most empirical studies are, in fact, based on inadequate data because the necessary data is mostly not available. If total cost function intersects the total revenue (TR) function before it reaches its highest point, Baumol’s theory fails. It is also argued that, in the long run, sales maximization and profit maximization objective can be merged into one. In the long run, sales maximization lends to yield only normal levels of profit, which turns out to be the maximum under competitive conditions. Thus, profit maximization is not inequitable with sales maximization objective. MARRIS’S HYPOTHESIS OF MAXIMIZATION OF FIRM’S GROWTH RATE According to Robin Marris, managers maximize firm’s growth rate subject to managerial and financial constraints. Marris defines firms balanced growth rate (G) as follows: G = Gd = Gc where, Gd = growth rate of demand for firms product. Gc = growth rate of capital supply to the firm. In simple words, a firm’s growth rate is considered to be balanced when demand for its product and supply of capital to the firm increase at the same rate. The two growth rates according to Marris, are translated into two utility functions such as: Manager’s utility function Owner’s utility function The manager’s utility function (Um) and owner’s utility function (Uo) may be specified as follows: Um = f (salary, power, job security, prestige, status) and Uo = f (output, capital, market-share, profit, public esteem). Owner’s utility function (Uo) implies growth of demand for firms’ products and supply of capital. Therefore, maximization of Uo mans maximization of demand for a firm’s products or growth of supply of capital. According to Marris, by maximizing these variables, managers maximize both their utility function and that of the owner’s. The, managers can do so because most of the variables such as salaries status, job security, power, etc., appearing in their own utility function and those appearing in the utility function of the owners such as profit, capital market, share, etc. are positively and strongly correlated with the size of the firm. These variables depend on the maximization of the growth rate of the firms. The managers, therefore, seek to maximize a steady growth rate. Marris’s theory, though more accurate and sophisticated than Baumol’s sales revenue maximization has its own weaknesses. It fails to deal satisfactorily with the market condition of oligopolistic interdependence. Another serious shortcoming is that it ignores price determination, which is the main concern of profit maximization hypothesis. In tbe opinion of many economists, Marris’s model too, does not seriously challenge the profit maximization hypothesis. WILLIAMSON’S HYPOTHESIS OF MAXIMIZATION OF MANAGERIAL UTILITY FUNCTION Like Baumol and Marris, Williamson argues that managers are very careful in pursuing the objectives other than profit maximization The managers seek to maximize their own utility function subject to a minimum level of profit. Managers’ utility function (U) is expressed below: U = f(S, M, ID) where, S = additional expenditure on staff M = Managerial emoluments ID = Discretionary investments According to Williamson’s hypothesis, managers maximize their utility function subject to a satisfactory profit. A minimum profit is necessary to satisfy the shareholders and also to secure the job of managers. The utility functions which managers seek to maximize include both quantifiable variables like salary and slack earnings anti non-quantitative variable such as prestige power, status, job security, professional excellence, etc. The non-quantifiable variables are expressed in order to make them work effectively in terms of expense preference defined as satisfaction derived out of certain types of expenditures. Like other alternative hypotheses, Williamson’s theory too suffers from certain weaknesses. His model fails to deal with the problem of oligopolistic interdependence. Williamson’s theory is said to hold only where rivalry between firms is not strong. In case there is strong rivalry, profit maximization is claimed to be a more appropriate hypothesis. Thus, Williamson’s managerial utility function too does not offer a more satisfactory hypothesis than profit maximization.
- 8. Dr. Bhati Rakesh8 | P a g e CYERT-MARCH HYPOTHESIS OF SATISFYING BEHAVIOR Cyert-March hypothesis is an extension of Simon’s hypothesis of firms’ satisfying behavior Simon had argued that the real business world is full of uncertainties. Accurate and adequate data are not readily available. If data are available, managers have little time and ability to process them. Managers also work under a number of constraints. Under such conditions it is not possible for the firms to act in terms of consistency assumed under profit maximization hypothesis. Nor do the firms seek to maximize sales and growth. Instead they seek to achieve a satisfactory profit or a satisfactory growth and so on. This behavior of business firms is termed as satisfaction behavior. Cyert and March added that, apart from dealing with uncertainty, managers need to satisfy a variety of groups of people such as managerial staff, labor, shareholders, customers, financiers, input suppliers, accountants, lawyers, etc. All these groups have conflicting interests in the business firms. The manager’s responsibility is to satisfy all of them. According to the Cyert-March, “firm’s behavior is satisfying behavior which implies satisfying various interest groups by sacrificing firm’s interest or objectives.” The basic assumption of satisfying behavior is that a firm is an association of different groups related to various activities of the firms such as shareholders, managers, workers, input supplier, customers, bankers, tax authorities, and so on. All these groups have some expectations from the firm, which are needed to be satisfied by the business firms. In order to clear up the conflicting interests and goals, managers form an objective level of the firm by taking into consideration goals such as production, sales and market, inventory and profit. These goals and objective level are set on the basis of the managers past experience and their assessment of the future market conditions. The objective level is also modified and revised on the basis of achievements and changing business environment. But the behavioral theory has been criticized on the following grounds: Though the behavioral theory deals with the activities of the business firms, it does not explain the firm’s behavior under dynamic conditions in the long run. It cannot be used to predict the firm’s activities in the future. This theory does not deal with the equilibrium of the business industry. This theory fails to deal with interdependence of the firms and its impact on firms behavior. ROTHSCHILD’S HYPOTHESIS OF LONG-RUN SURVIVAL AND MARKET SHARE GOALS Rothschild suggested another alternative objective and alternative to profit maximization to a business firm. According to Rothschild, the primary goal of the firm is long-run survival. Some other economists have suggested that attainment and retention of a market share constantly, is an additional objective of the business firms. The managers, therefore, seek to secure their market share and long-run survival. The firms may seek to maximize their profit in the long run though it is not certain. The evidence related to the firms to maximize their profits in the long run, is not certain. Some economists argue that if management is kept separate from the ownership, the possibility of profit maximization is reduced. This means that only those firms with the objective of profit maximization can survive in the long run. A business firm can achieve all other subsidiary goals easily by maximizing its profits. The motive of business firms behind entry-prevention is also to secure a constant share in the market. Securing constant market share also favors the main objective of business firms of profit maximization.
- 9. Dr. Bhati Rakesh9 | P a g e UTILITY: Why do you buy the goods and services you do? It must be because they provide you with satisfaction—you feel better off because you have purchased them. Economists call this satisfaction utility. The term utility refers to the want satisfying power of a commodity or service assumed by a consumer to constitute his demand for that commodity or service. • Utility is synonymous with "Pleasure", "Satisfaction" & a Sense of Fulfillment of Desire. • Utility “WANT SATISFYING POWER" of a Commodity. • Utility is a Psychological Phenomenon. • Utility refers to Abstract Quality whereby an Object serves our Purpose. - Jevons • Utility is the Quality of a Good to Satisfy a Want. - Hibdon • Utility is the Quality in Commodities that makes Individuals want to buy them. Mrs. Robinson FEATURES OF UTILITY: • Utility is Introspective or Subjective: It deals with the Mental Satisfaction of a Man. For Example, Liquor has Utility for a Drunkard but for a Teetotaler, it has no Utility. • Utility is Relative: Utility of a Commodity never remains same. It varies with Time, Place & Person. For Example, Cooler has utility in summer but not during Winter. • Utility is Not Essentially Useful: A Commodity having Utility need not be Useful. E.g., Liquor is not useful, but it Satisfies the Want of an Addict thus have Utility for Him. • Utility is Ethically Neutral: Utility has nothing to do with Ethics. Use of Liquor may not be good from the Moral Point of View, but as these Intoxicants Satisfy wants of the Drunkards, they have utility UTILITY AND SATISFACTION: The term utility is, however, distinct from satisfaction. Utility implies potentiality of satisfaction in a commodity. It serves as a basis to induce the consumer to buy the commodity. But, the real satisfaction is the end result of the consumption of a given commodity. Though utility and satisfaction are psychological, there is a distinctive gap between the two experiences. Utility is anticipation of satisfaction visualized. Satisfaction is the actual realization. Sometimes, satisfaction derived from the consumption of a commodity may be less or more than what is expected in the visualization of utility. For example when a consumer buys a motor car and if it starts giving him trouble his satisfaction so realized from the use of the motor car will be less than what he had estimated about his utility. Nonetheless in economic theory for the sake simplicity and convenience in analysis, economist usually assumes utility and satisfaction as synonymous terms. TOTAL UTILITY AND MARGINAL UTILITY: The concepts of total utility and the marginal utility are the basic concepts used in the cardinal measurement of utility. 1. Total utility (TU): "Total utility is the total satisfaction obtained from all units of a particular commodity consumed over a period of time". The total utility associated with a good is the level of happiness derived from consuming the good. Formula: TUx = ΣMUx 2. Marginal utility (MU): "Marginal utility means an additional or incremental utility. Marginal utility is the change in the total utility that results from unit one unit change in consumption of the commodity within a given period of time". Marginal utility is a measure of the additional utility that is derived when an additional unit of the good is consumed. Marginal utility, thus, can also be described as difference between total utility derived from one level of consumption and total utility derived from another level of consumption. Formula: MU = ΔTU /ΔQ UNIT – 2 Utility & Demand Analysis: Utility – Meaning, Utility analysis, Measurement of utility, Law of diminishing marginal utility, Indifference curve, Consumer’s equilibrium - Budget line and Consumer surplus. Demand - Concept of Demand, Types of Demand, Determinants of Demand, Law of Demand, Elasticity of Demand, Exceptions to Law of Demand. Uses of the concept of elasticity. Forecasting: Introduction, Meaning and Forecasting, Level of Demand Forecasting, Criteria for Good Demand Forecasting, Methods of Demand Forecasting, Survey Methods, Statistical Methods, Qualitative Methods, Demand Forecasting for a New Products. (Demand Forecasting methods - Conceptual treatment only numericals not expected)
- 10. Dr. Bhati Rakesh10 | P a g e MEASUREMENT OF UTILITY: Economists use an abstract measure for the amount of satisfaction you receive from something; it is called a 'util'. A util is an abstraction because it isn't something in the physical world like an inch or rupee. It is something inside your head, it represents one unit of satisfaction or happiness. You might get 25 utils of satisfaction from eating a bowl of ice cream while someone else would only get 5 utils of satisfaction. Utils is the term used by Marshall for expressing the measurement of imaginary units of utility or satisfaction Utility being an introspective phenomenon cannot be directly measured in a precise manner. Economist however adopted an indirect measurement of utility in terms of ’price’ a consumer is willing to pay for a given commodity. When a consumer is willing to pay a high price for a commodity, it means there is high utility estimated by him for that commodity and vice versa. But, this is just a rough indication it suggests no precise and proportionate measurement of utility. From the stand point of theory, however, there are 2 basic approaches to the measurement of utility namely: (1) Cardinal approach 2. Ordinal approach The terms cardinal and ordinal have been taken from mathematics. The numbers 1,2,3,4,5,6, etc are cardinal in the sense that number 6 is twice the size of number 3 and number 4 is twice the size of 2. In the cardinal analysis, the utility contained in commodities are made quantifiable. For example: an orange may yield to a consumer utility of 10 units whereas a mango yields 20 units. From this it is clear that the consumer derives twice as much utility from a mango compared to an orange. The units of measurements are purely imaginary and the cardinal analysis termed the imaginary units of utility of ‘utils’. On the other hand Prof Hicks Allen and their followers among the modern economists have suggested an ordinal measurement of utility. In their view utility cannot be quantified so its numerical expression is unrealistic. The ordinal measurements are 1st, 2nd, 3rd, 4th, 5th, 6th etc. It is not possible from this ranking to know the actual size of related number. The 2nd need not be twice as that of 1st, the size may be of any pattern. For example: 1st, 2nd, 3rd, could be 10, 15, 25, or 10, 20, 45 or 55, 65, 95 etc. According to ordinalists, utility being subjective and a mental concept cannot be measured and to quantify utility is absurd. Ordinal approach contains that the theory of consumer behaviour can be explained or analyzed even without measuring utility as the cardinal approach does. In the all ready stated example the ordinalists say that the consumer prefers a banana to an orange and rank the commodities in the scale of preferences without taking the trouble of measuring the imaginary quantum of utility. This method of ordinal approach is also called’ indifference curve approach’. Dr. Alfred Marshall and his followers advocated the cardinal approach to utility, while, the modern economists like Hicks, Allen, supported the ordinal approach. Hence the cardinal approach has come to be known as, Marshallian utility analysis” and the ordinal approach is called ‘Hicksian’s indifference approach’. THE LAW OF DIMINISHING MARGINAL UTILITY: This law was first of all developed by H.H Gossen in 1854 AD, which is also the first law of Gassen. This law is based on universal human experience. It explains that for more units of commodity; its M.U derived from each additional unit diminishes in comparison to the previous unit. Hence the law of diminishing marginal utility implies that consumption of each successive units of a particular commodity gives less and lesser satisfaction to the consumer if a consumer consumes it in a certain time period. Prof. Boulding defines the law of diminishing marginal utility in the following words,” As a consumer increases the consumption of any one commodity, keeping constant, the consumption of all other commodities, the marginal utility of the variable commodity must eventually decline”. Marshall has defined the law thus: “the additional benefits which a person derives from a given stock of thing diminish with every increase in the stock that he already has”. This law simply states that as the consumer consumes more and more units of a particular commodity, the marginal utility of additional unit goes on diminishing. But the law does not state the rate of decline.
- 11. Dr. Bhati Rakesh11 | P a g e ILLUSTRATION OF THE LAW: To illustrate the tendency of the diminishing marginal utility, a hypothetical utility schedule computed through the introspective method of inquiry in consumers consumption experience is stated as follows: RELATIONSHIP BETWEEN TOTAL UTILITY AND MARGINAL UTILITY: (i) The total utility curves starts at the origin as zero consumption of commodity yield zero utility. (ii) The TU curve reaches at its maximum or at peak when MU is zero. (iii) The MU curve falls through the graph. A special point occurs when the consumer gains no marginal utility from consumption of commodity. After this point, marginal utility becomes negative. (iv) The MU curve can be derived from the total utility curve. It is the slope of the line joining two adjacent quantities on the curve. ASSUMPTIONS OF THE LAW OF DIMINISHING MARGINAL UTILITY: The law of diminishing marginal utility is conditional. Its validity is attributed to the following assumptions or conditions: 1. Homogeneity: The law holds true only if all the successive units taken in the process of consumption are homogeneous in character like quality size, taste, flavors, colour etc. If there is a change in the characteristics of the units of the given commodity, it is quite likely that the marginal utility may tend to increase rather than diminish with the successive addition unit of consumption. 2. Continuity: The consumption process is continuous at a given time, that is, units are taken one after another successively without any interval of time. Indeed, the first cup of tea in the morning, and the second one in the evening will not result in diminishing marginal utility. 3. Reasonability: The units of consumption are in reasonable size, that is, of normal standard unit. For instance, we should think of a glass of milk, a cup of tea etc. and not a spoon of milk or tea. 4. Constancy: The law presumes that, there is no change in income, taste, habit or preference of the consumer. Similarly, the price of the commodity is also assumed to be given. 5. Rationality: The consumer is assumed to be a rational economic man whose behaviour is normal and who is aiming at maximization of satisfaction. Above all, the Marshallian exposition of the law of diminishing marginal utility is based on the cardinal measurement of utility. It is assumed that utility can be numerically expressed by the consumer, that is, he is capable of mentioning the quantum of utility derived from each additional unit consumed or acquired by him. CRITICISMS OF THE LAW: Though the law expresses a universal tendency of consumer’s introspective behaviour, its traditional exposition has been criticized on various counts. 1. The traditional or Marshallian explanation of the law presumes the cardinal measurement of utility. The law assumes that utility can be numerically measured added or subtracted. This is rather not convincing because utility being a subjective or introspective phenomena cannot be measured numerically. It is a feeling experienced by the consumer. We cannot therefore have a objective measure of a subjective feeling. 2. The law is based on unrealistic assumptions or conditions. The condition assumed like homogeneity, continuity, constancy and rationality all together present at a time is very difficult to find in practice. Units of a Commodity Total Utility Marginal Utility 1 20 20 2 37 17 3 51 14 4 62 11 5 68 6 6 68 0 7 64 -4 8 50 -14
- 12. Dr. Bhati Rakesh12 | P a g e 3. The application of the law to the indivisible bulky commodity seems to be absurd. Because no one would normally buy at a time more than one unit of good like television set, refrigerator, scooter, motor car etc. It would be absurd to talk of increase in the stock of such goods and marginal utility thus derived. 4. The law unrealistically assumes constant marginal utility of money, which is highly unsatisfactory, with the increase in purchase of goods, for consumption, the marginal utility of money will increase due to the diminishing stock of purchasing power. IMPORTANCE OF THE LAW: The law of diminishing marginal utility has great economic significance, theoretical as well as practical. From the theoretical point of view the law is important because, 1. The law explains the behaviour and the equilibrium condition of a rational consumer with respect to a single want and commodity. 2. The law of diminishing marginal utility is the basic law of economics. It provides the foundation for various laws of consumption. The law of demand is the outcome of the law of diminishing marginal utility. The law of demand states that larger quantities are purchased at a lower price. The reason is that as more units of a commodity are purchased its marginal utility to the consumer becomes less and less and so he gives lesser importance to additional units of a commodity. Therefore, he will buy additional units of a commodity only at a lower price. 3. The law explains the Paradox of value (The diamond-water paradox): The value-in-use and value-in- exchange for a commodity are different. Diamonds have great value-in-exchange, as they are scarce in supply, they have greater marginal utility, and therefore, value is high. On the other hand, water is in abundant supply and its marginal utility is very low. Therefore, it commands no price even though its total utility is high. Thus water has great value in use but no value in exchange. Diamonds have great value in exchange though they are less useful than water. The price of a commodity is thus, related to its marginal utility. 4. Prof. Marshall has built up his theory of taxation and public expenditure on the basis of the law of diminishing marginal utility. The principle of progression has been deduced in the theory of taxation by the application of this law, to money. Further, it is argued that there should be equitable distribution of wealth because the utility derived by the rich from money is much less than what could accrue to the poor. If Rs. 100 deducted from the rich man’s income, means only a small sacrifice of comparatively little utility, while the addition to the amount to the poor man’s income, will increase his satisfaction by more than what a rich man has lost, therefore, methods should be devised to redistribute the national income on a more equitable basis. PRACTICAL SIGNIFICANCE OF THE LAW: 1. To the producer, the law serves as a guide to promote sales by reducing prices. Because, when the price falls, to attain equilibrium the consumer has to decrease the marginal utility to that extent. To do this he has to purchase more goods as the marginal utility diminishes only when the stock increases. 2. The law is useful to the finance minister in formulating an appropriate tax policy. He can justify progressive taxation on higher income on the ground that rich people will feel relatively lesser impact of the tax burden as the marginal utility of money is lower with the increase in income. 3. Similarly socialists can agitate for a redistribution of wealth to promote welfare on the ground that the transfer will cause more gain to the poor and less sacrifice to the rich. EXCEPTIONS TO THE LAW OF DIMINISHING MARGINAL UTILITY: Under the assumptions of homogeneity, continuity, reasonability, constancy and rationality, the law is deemed to be universal. In certain cases, however, it has been observed that a consumer tends to attain increasing marginal utility with an increase in the stock of a commodity consumed or acquired. Such cases are treated as exception to the law of diminishing marginal utility. These exceptions are: 1] Hobbies: It is often argued that in the case of hobbies like stamp collection, collection of antique goods, collection of old coins etc, every additional unit gives more pleasure, that is, marginal utility, tends to increase. No doubt this is true, but, it is not a genuine exception to the law of diminishing utility, because in such cases, homogeneity condition of the law is violated. Indeed each time a new variety of stamp or coin or antique is collected by a person but not of the same variety.
- 13. Dr. Bhati Rakesh13 | P a g e 2] Alcoholics: The law seems to be inapplicable to alcoholics as intoxicants increases with every successive dose of liquor. This is true, but the rationality condition of the law is violated. The introspective behaviour of an alcoholic at that time is irrational or abnormal. 3] Misers: In the case of a miser, it is pointed out that greed increases with every additional acquisition of money. Hence, the marginal utility of money does not diminish for him with more and more money. But, when the miser spends his money his utility of the commodity will be diminishing perhaps more rapidly than in the case of others. Hence, a miser’s behaviour cannot be a significance exception to the law of diminishing marginal utility. 4] Music and poetry: In the case of music and poetry it’s commonly experienced that a repeat gives a better satisfaction than the first one. Hence, it is thought that the law of diminishing marginal utility may not be applicable here. But there is a limit to repeated hearing of the same music and poetry because, it will become monotonous and yields disutility, so it is not a genuine exception to the law. 5] Reading: Since more reading gives more knowledge a scholar would get more and more satisfaction with every additional book. But, here we may point out that it is not a real exception to the law as the condition of homogeneity is violated here. Knowledge and satisfaction increases by reading different books and not the same book over and over again. THE LAW OF MAXIMUM SATISFACTION / THE LAW OF EQUI-MARGINAL UTILITY/ THE LAW OF SUBSTITUTION: This law is developed by H.H Gossen so it is also called the second law of Gossen. We know human wants are unlimited but the resources to fulfill the wants are limited. A rational consumer always tries to maximize his satisfaction by spending his limited money income. Consumer can maximize his satisfaction if he is able to equalize the marginal utility derived from the consumption of different units of several commodities by spending his all limited money income so that this law is known as law of maximum satisfaction or law of equi- marginal utility. This law is also known as law of substitution because consumer can maximize his/her satisfaction when he/she substitutes the commodities having high marginal utility instead of commodities having the low marginal utility. Mathematically it is expressed as: This law is based on the following ASSUMPTIONS: 1. Consumers should be rational 2. Price of commodity remains constant 3. Income of consumers remains constant 4. Utility can be measured in numbers 5. Marginal utility of money remains constant EXCEPTIONS/ LIMITATIONS of the law of substitution: 1. Utility can’t be measured in numbers: Utility can’t be measured in terms of numbers. It can only be expressed in terms of range i.e. high or low. 2. Ignorance of consumers: If the consumer is ignorant about the availability of substitute goods in market then he can’t substitute the commodity having high M.U instead of low. 3. Frequent change in price: This law assumes that price of commodity remains constant. Generally utility is judged on the price. If the price changes then there is not application on the law of diminishing M.U. At that time we can’t measure M.U of different commodity properly. 4. Influence of custom and fashion: In the case of commodity related to custom and fashion this law is not applicable because while purchasing such commodity they don’t care about equalizing M.U from different commodity. 5. M.U of money doesn’t remains constant: This law assumes that M.U of money is constant but in reality M.U of money is changeable on the basis of amount of money with people.
- 14. Dr. Bhati Rakesh14 | P a g e 6. Individual goods: In the case of individual this law is not applicable because such goods like T.V, motorcycle, fridge, etc are purchased once at a time. As a result there is not the possibility of comparison of M.U of such goods among each other. 7. Shortage of goods: If there is shortage of goods in market there is no any question to equalize the M.U from several commodities. 8. Addiction: This law is not applicable for addict because druggist, drunkard, etc are not ready to sacrifice any single drop of drug or alcohol for other commodity. CONSUMER SURPLUS Dupuit originated the concept of consumer’s surplus. But, it was Marshall who popularized it by presenting it in a most refined way. Marshall viewed that when a consumer buys a commodity, his satisfaction derived from derived from it may be in excess of the dissatisfaction he has experienced in parting with money for paying its price. This excess of satisfaction is called” consumer’s surplus”. A consumer is willing to pay the price for a commodity upto its marginal utility compared with the marginal utility of money which he has to pay. If the marginal utility of a commodity is high which is actual market price is low, the consumer derives extra satisfaction, that is, consumer surplus. Consumer surplus therefore can be measured as the difference between the maximum price the consumer is willing to pay for a commodity and the actual market price charged for it. As Marshall puts it, “the excess of the price which a consumer would be willing to pay rather than go without the things over that which he actually does pay, is the economic measure of this surplus of satisfaction. It may be called consumer’s surplus.” This concept is based on the law of diminishing marginal utility. Prof. Marshall applies the phrase’ consumer’s surplus’ to the difference between the sum which measures total utility and that which measures total exchange value(price paid). For, while the price that he has to pay for each unit is equal to the utility of the marginal unit, the utility of each of the earlier units is more than that of the last. Therefore, he gains more utility than he loses by making the payments. His gain is more than the loss. This is the source of his surplus satisfaction. Thus: Consumer surplus=price prepared – actual price paid Measurement of consumer surplus Unit of marginal market consumer surplus Commodity utility price price prepared-actual X m.u market price 1 35 10 35-10 = 25 2 30 10 30-10 = 20 3 22 10 22-10 = 12 4 10 10 10-10 = 0 Total 4 units Total price/mu 57 Utility = 40 97 Thus, CS = TU – (P x Q) 97 - (10 x 4) 97 – 40 CS = 57 Where, CS: Consumer surplus , TU: Total utility P: Price , Q: Quantity Consumer surplus can be diagrammatically represented: If OP is price, OQ is the units purchased MU of OQ=price OP total money paid=OP x OQ therefore, price paid OPQR Price prepared to pay = total utility OMRQ Therefore, OMRQ – OPRQ = MRP (CONSUMER SURPLUS) ASSUMPTIONS: This concept is based on the following assumptions. (1) Cardinal measurement of utility. (2) Constant marginal utility of money. (3) The commodity in question does not have substitutes.
- 15. Dr. Bhati Rakesh15 | P a g e CRITICISMS: (1) This law is based on certain assumptions and critics argue that these assumptions are unrealistic. a. Utility cannot be measured cardinally; therefore, consumer’s surplus cannot be measured and expressed numerically. b. Marginal utility of money does not remain constant. c. If commodities have substitutes, with the rising prices, he will purchase other goods rather than pay a higher price for the same. The concept has no theoretical validity. (2) It is meaningless to apply the doctrine of consumer’s surplus to necessaries as the utility derived from necessaries as the utility derived from necessaries is infinite. (3) The concept is imaginary and illusory. It does not exist in reality. We create surplus out of our imagination. (4) It is of no practical significance. Prof. Little says,” The doctrine of consumer’s surplus is a useless theoretical toy”. IMPORTANCE OF THE CONCEPT: (1) The concept of consumer’s surplus does emphasize the amenities that we enjoy in a modern society. Much of the consumer’s surplus, we enjoy depends on our surroundings and the opportunities of consumption available to us, example, amenities of life in America as compared to Central Africa. It thus clarifies conjectural importance. The concept enables us to compare the advantages of environment and opportunities or conjectural benefits. The larger the consumer’s surplus, the better off is the people. The concept, thus, serves as an index of economic betterment. (2) It is useful in price policy of a monopoly firm. The monopolist can put a higher price on the goods if consumer’s surplus is high, without causing any reduction in sales. (3) It is of significance to the exchequer in determining indirect taxation. The finance minister can easily levy more taxes where consumer’s surplus is high. (4) By estimating the difference in consumer’s surplus resulting from a change in price, we can know and compare the effects of a given change in the price of any commodity on the different classes of people. It is, therefore, widely adopted in welfare economics. (5) Gains from international trade can be measured in terms of consumer’s surplus obtained in the imported goods. INDIFFERENCE CURVE ANALYSIS: Indifference Curve approach was first propouned by British economist Edgeworth in 1881 in his book “Mathematical Physics.” The concept was further developed in 1906 by Italian economist Pareto, in 1913 by British economist W .E. Johnson, and in 1915 by Russina economist Stutsky. The credit of rendering this analysis as an important tool of theory of Demand goes to Hicks and Allen. In 1934, they presented it in a scientific form in their article titled “A Reconsideration of the Theory of Value.” It was discussed in detail by Hicks in his book, “Value and Capital”. ASSUMPTIONS: Indifference curve approach has the following main assumptions: (1) Rational Consumer: It is assumed that the consumer will behave rationally. It means the consumer would like to get maximum satisfaction out of his total income. (2) Diminishing Marginal rate of Substitution: It means as the stock of a commodity increases with the consumer, he substitutes it for the other commodity at a diminishing rate. (3) Ordinal Utility: A consumer can determine his preferences on the basis of satisfaction derived from different goods or their combinations. Utility can be expressed in terms of ordinal numbers, i.e., first, second etc. (4) Completeness: In a comparison of any two bundles, A = (xA, yA) and B = (xB, yB), an individual should be able to say either (i) “I prefer A to B”; or (ii) “I prefer B to A”; or (iii) “I am indifferent between A and B”, i.e., “I like equally A and B”. This property of preferences is called completeness. Essentially the consumer is not allowed to say “I don’t know” or “I am not sure.” (5) Transitivity: If a person states, “I prefer A to B,” as well as “I prefer B to C,” then he/she also has to prefer A to C. This assumption says that preferences are consistent, so that comparisons between bundles A and C are consistent with comparisons between bundles A and B and between B and C. Transitivity in indifference
- 16. Dr. Bhati Rakesh16 | P a g e means that a person who says, “I am indifferent between A and B,” as well as “I am indifferent between B and C,” also has to be indifferent between A and C. (6) More is preferred to less: A consumer preferences is that “more is better”. . Since “more is better”, if bundle A = (xA, yA) has more of both goods than bundle B = (xB, yB), i.e., if xA > xB and yA > yB, then clearly a consumer will prefer A to B. Similarly if bundle A has less of both goods than bundle B, then a consumer will prefer B to A. However, if bundle A has more of X but less of Y than B, the comparison is not obvious. The consumer may prefer A to B, or prefer B to A, or be indifferent between A and B. INDIFFERENCE CURVE: An indifference curve (IC) is a geometrical presentation of a consumer is scale of preferences. An IC is a locus of all such points which shows different combinations of two commodities which yield equal satisfaction to the consumer. Since the combination represented by each point on the indifference curve yields equal satisfaction, a consumer becomes indifferent about their choice. In other words, he gives equal importance to all the combinations on a given indifference curve. According to Ferguson, “An indifference curve is a combination of goods, each of which yield the same level of total utility to which the consumer is indifferent.” According to Leftwitch, “A single indifference curve shows the different combinations of X and y that yield equal satisfaction to the consumer.” One can create a collection of all the bundles, A, B, C, D, ..., such that a particular consumer is indifferent between any two of them. The line in X-Y space that connects the points in this collection {A, B, C, D, ...} is called an indifference curve, I1 (Figure ). Of course, the same consumer typically has many indifference curves. For example, he has both A-B-C-D and E-F-G-H as indifference curves, and he prefers any bundle on E-F-G-H to any on A-B-C-D. In general, there is an indifference curve through any point in X-Y space. Since “more is better,” an indifference curve cannot have a positive slope. Indifference curves have a negative slope, and in special cases zero slope. An indifference curve defines the substitution between goods X and Y that is acceptable in the mind of the consumer. As we move towards the Southeast along a typical indifference curve the consumer receives more X and less Y, while she declares that she is equally well off. LAW OF DIMINISHING MARGINAL RATE OF SUBSTITUTION: The concept of indifference curve analysis is based on law of diminishing marginal rate of substitution. According to Prof. Bilas, “The marginal rate of substitution of X for Y (MRSxy) is defined as the amount of y which the consumer is just willing to give up to get one more unit of x and maintain the same level of satisfaction.” The marginal rate of substitution is equal to the ratio of the marginal utilities, MRS = Δy/Δx = - MUx/MUy MOVE CHANGE IN UTILITY A to C (MUy)(Δy) C to B (MUx)(Δx) ──────────────────────────── TOTAL, A to B (MUx)(Δx) + (MUy)(Δy) = 0 Total change in utility between A and B is zero because A and B are on the same indifference curve. Rearranging the terms in this we derive the slope of the indifference curve, (MUy)(Δy) = -(MUx)(Δx) MRS = Δy/Δx = - MUx/MUy.
- 17. Dr. Bhati Rakesh17 | P a g e For a convex indifference curve, its slope goes from high on the left to low on the right. This means that, as the consumer has more Y, she is willing to give up less and less in X in exchange for acquiring equal amounts of Y. Her indifference curves exhibit diminishing marginal rate of substitution. i.e. 1 U U X Y MRS PROPERTIES OF INDIFFERENCE CURVES: The important characteristics of indifference curves are as follows: (1) Indifference Curves are Negatively Sloped: As the consumer increases the consumption of X commodity, he has to give up certain units of Y commodity in order to maintain the same level of satisfaction. Therefore indifference curve slopes downward from left to right. This means that an indifference curve is negatively sloped. (2) Indifference Curve Cannot Intersect Each Other: Given the definition of indifference curve and the assumptions behind it, the indifference curves cannot intersect each other. It is because at the point of tangency, the higher curve will give as much as of the two commodities as is given by the lower indifference curve. This is absurd and impossible. (3) Higher Indifference Curve Represents Higher Level: A higher indifference curve that lies above and to the right of another indifference curve represents a higher level of satisfaction and combination on a lower indifference curve yields a lower satisfaction. In other words, we can say that the combination of goods which lies on a higher indifference curve will be preferred by a consumer to the combination which lies on a lower indifference curve. (4) Indifference Curve are Convex to the Origin: This is an important property of indifference curves. They are convex to the origin (bowed inward). This is equivalent to saying that as the consumer substitutes commodity X for commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference curve. Hence it can never be a straight line nor concave to the origin because of MRS xy (5) Indifference Curves do not Touch the Horizontal or Vertical Axis: One of the basic assumptions of indifference curves is that the consumer purchases combinations of different commodities. He is not supposed to purchase only one commodity. In that case indifference curve will touch one axis. This violates the basic assumption of indifference curves. SOME EXCEPTIONAL SHAPES OF INDIFFERENCE CURVES: Indifference curves where Goods X and Y are perfect substitutes. The gray line perpendicular to all curves indicates the curves are mutually parallel. Indifference curves for perfect complements X and Y. The elbows of the curves are collinear.
- 18. Dr. Bhati Rakesh18 | P a g e PERFECT SUBSTITUTES AND COMPLEMENTS: Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. Two goods are perfect complements when the indifference curves for the goods are shaped as right angles [L-shape] THE BUDGET LINE: The budget line shows all the different combinations of commodities that a consumer can purchase, given his money income and the prices of commodities. The budget line can be written as follows: Px.X + Py.Y = M Where, Px is the price of commodity X, Py is the price of commodity Y M : is the consumer’s income Subtracting Px.X from both sides of the above equation gives Py.Y = M - Px.X Divide each side of above equation by Py yields; X P P P M Y y x y Slope is given by the change in Y due to change in X; - y x P P ΔX ΔY The slope of the budget line in the ratio of the prices of the two goods ( i.e. Y X P P ) CHANGES IN THE BUDGET LINE: (1) Parallel Shifts: if the consumer’s money income increases or decreases, or if the prices changes for both goods decrease or increase proportionally, then the budget line will shift out to the right in a parallel manner, or in to the left in a parallel manner. (2) Inward Pivots: if the price of one good increases, the budget line will pivot inward with respect to that good’s axis. In the example below, the price of Good X increases. (3) Outward Pivots: if the price of one good decreases, the budget line will pivot outward with respect to that good’s axis. In the example below, the price of Good Y decreases. CONSUMER’S EQUILIBRIUM - INDIFFERENCE CURVE ANALYSIS: According to the ordinal approach, a consumer has a given scale of preference for different combinations of two goods. By just comparing the levels of satisfaction, he can derive maximum satisfaction out of a given money income. Consumer’s equilibrium refers to a situation in which a consumer with given income and given prices purchases such a combination of goods and services as gives him maximum satisfaction and he is not willing to make any change in it. ASSUMPTIONS OF CONSUMER’S EQUILIBRIUM: 1. Consumer is rational and so maximises his satisfaction from the purchase of two goods. 2. Consumer’s income is constant. 3. Prices of the goods are constant. 4. Consumer knows the price of all things. 5. Consumer can spend his income in small quantities. 6. Goods are divisible. 7. There is perfect competition in the market. 8. Consumer is fully aware of the indifference map.
- 19. Dr. Bhati Rakesh19 | P a g e CONDITIONS OF CONSUMER’S EQUILIBRIUM: There are two main conditions of consumer’s equilibrium; (i) Price line should be tangent to the indifference curve, i.e. MRSxy = Px / Py (ii) Indifference curve should be convex to the point of origin. (iii) Price line should be tangent to indifference curve: CONSUMER EQUILIBRIUM: In order to maximize total utility, TU, the consumer will choose units of the two goods, X and Y, so that MRSX,Y = Y x MU MU = Y x P P (From the ordinal utility analysis) In case of equilibrium: Slope of indifference curve = slope of price line The above expression is equivalent to… X x P MU = Y Y P MU (From the cardinal utility analysis) Note Importantly: Both of the expressions above guarantee that TOTAL utility will be maximized. Given convex and smooth indifference curves, the consumer maximizes utility at a point A, where the slope of the indifference curve (MRS) is equal to the slope of the budget constraint. At the chosen point A we have tangency of the indifference curve and the budget constraint line (Figure), px/py = MRS = MUx/MUy, i.e., MUx/px = MUy/py. This means that the consumer receives equal satisfaction for the last dollar spent in each good. Slope of indifference curve = (Y1-Y0)/(X1-X0) BREAKING UP PRICE EFFECT INTO INCOME AND SUBSTITUTION EFFECT (WITH DIAGRAM) A consumer chooses between good 1 and good 2. Giver her income, m, the prices of the goods, p11 and p2, and her preferences, she chooses that basket of goods that maximizes her utility. In Figure its means that she initially chooses point A. If the price of good 1 falls from p11 to p12, the budget line rotates outwards from BL1 to BL2. When the consumer chooses a new basket, she ends up in point B. Her consumption of good 1 has consequently increased from q11 to q12, which is the total effect. It consists of the income effect (i.e. on the increase in purchasing power) and substitution effect (i.e. on the change in the slope of the budget line). If the relative prices change, the slope of the budget line changes. All budget lines that have the same relative prices as BL2 must also have the same slopes as that budget line. Furthermore, for the consumer to have the same utility as before, she must consume on the same indifference curve as she did before, i.e. on I1. We therefore construct an imaginary budget line, BL*, that has the same slope as BL2 and that, just as BL1, is a tangent to I1. (However, since it has a different slope than BL1, it must touch I1 at different point than that budget line does.) If this had been the real situation, the consumer would have chosen point C. She had then increased her consumption of good 1 from q11 to q1*. At the same time, she would have decreased her consumption of good 2. This substitution from good 1 to good 2 depends on the change in the relative price, but it does not result in any change in the level of utility. This part is the substitution effect. The remaining change, from q1 * to q12, is the part that depends on the increase in the consumer’s purchasing power. As she moves to a higher indifference curve, from I1 to I2, she increases her utility. This part is the income effect.
- 20. Dr. Bhati Rakesh20 | P a g e CRITISM: Robertson, Armstrong, Knight etc. have criticized indifference curve analysis on account of the following. (1) Unrealistic assumption: Indifference curve analysis is based on the assumption that a consumer has complete knowledge regarding the preference of two goods. In reality, he cannot take quick decisions in real life in respect of different combinations. (2) Complex analysis: Indifference curve analysis can explain easily that behaviour of the consumer which is restricted to the combination of only two goods. If the consumer wants combinations of more than two goods, then indifference curve analysis becomes highly complex. (3) Imaginary: Indifference curve analysis is based on imaginary combinations. A consumer does not decide always like a computer as to which of the combinations of two goods he would prefer. (4) Assumption of Convexity: This theory does not explain why an indifference curve is convex to the point of origin. In real life, it is not necessary that all goods should have diminishing marginal rate of substitution. (5) Unrealistic combinations: When we consider different Combinations of two goods, sometimes we come across such funny combinations that have no meaning for the consumer. For instance, there is a combination of 10 shirts + 2 pairs of shoes. If in the subsequent combinations shirts are given up to get more pairs of shoes then we way arrive at a combination representing 2 shirts + 10 pairs of shoes, which is ridiculous. (6) Impractical: Indifference curve analysis is based on the unrealistic assumption that goods are homogenous. ‘This assumption holds good only under perfect competition, which is more 9 theoretical concept. In real life, monopolistic and oligopolistic conditions are found more prevalent. INTRODUCTION: CONCEPT OF DEMAND Demand theory attempts at answering questions regarding the magnitude of demand for a product or service based on its importance to human wants. It also attempts to assess how demand is impacted by changes in prices and income levels and consumers preferences/utility. Based on the perceived utility of goods and services to consumers, companies are able to adjust the supply available and the prices charged. In economics, demand has a specific meaning distinct from its ordinary usage. In common language we treat ‘demand’ and ‘desire’ as synonymously. This is incongruent from its use in economics. In economics, demand refers to effective demand which implies three things: Desire for a commodity Sufficient money to purchase the commodity, rather the ability to pay Willingness to spend money to acquire that commodity For instance, a person may desire to own a car but unless he has the required amount of money with him and the willingness to spend that amount on the purchase of a car, his desire shall not become a demand. The following should also be noted about demand: Demand always alludes to demand at price. The term ‘demand’ has no meaning unless it is related to price. For instance, the statement, 'the weekly demand for potatoes in Pune city is 10,000 kilograms' has no meaning unless we specify the price at which this quantity is demanded. Demand always implies demand per unit of time. Therefore, it is vital to specify the period for which the commodity is demanded. For instance, the statement that demand for potatoes in Pune city at Rs. 8 per kilogram is 10,000 kilograms again has no meaning, unless we state the period for which the quantity is being demanded. A complete statement would therefore be as follows: 'The weekly demand for potatoes in Pune city at Rs. 8 per kilogram is 10,000 kilograms'. It is necessary to specify the period and the price because demand for a commodity will be different at different prices of that commodity and for different periods of time. Demand is an effective desire, i.e., a desire which is backed by willingness and ability to pay for a commodity in order to obtain it. In the words of Prof. Hibdon:"Demand means the various quantities of goods that would be purchased per time period at different prices in a given market".
- 21. Dr. Bhati Rakesh21 | P a g e DETERMINANTS OF DEMAND: There are various factors affecting the demand for a commodity. They are: (1) Price of the good: The price of a commodity is an important determinant of demand. Price and demand are inversely related. Higher the price less is the demand and vice versa. (2) Price of related goods: The price of related goods like substitutes and complementary goods also affect the demand. In the case of substitutes, rise in price of one commodity lead to increase in demand for its substitute. In the case of complementary goods, fall in the price of one commodity lead to rise in demand for both the goods. (3) Consumer’s Income: This is directly related to demand. A change in the income of the consumer significantly influences his demand for most commodities. If the disposable income increases, demand will be more. (4) Taste, preference, fashions and habits: These are very effective factors affecting demand for a commodity. When there is a change in taste, habits or preferences of the consumer, his demand will change. Fashions and customs in society determine many of our demands. (5) Population: If the size of the population is more, demand for goods will be more . The market demand for a commodity substantially changes when there is change in the total population. (6) Money Circulation: More the money in circulation, higher the demand and vice versa. (7) Value of money: The value of money determines the demand for a commodity in the market. When there is a rise or fall in the value of money there may be changes in the relative prices of different goods and their demand. (8) Weather Condition: Weather is also an important factor that determines the demand for certain goods. (9) Advertisement and Salesmanship: If the advertisement is very attractive for a commodity, demand will be more. Similarly if the salesmanship and publicity is effective then the demand for the commodity will be more. (10) Consumer’s future price expectation: If the consumers expect that there will be a rise in prices in future, he may buy more at the present price and so his demand increases. (11) Government policy (taxation): High taxes will increase the price and reduce demand, while low taxes will reduce the price and extend the demand. (12) .Credit facilities: Depending on the availability of credit facilities the demand for commodities will change. More the facilities higher the demand. (13) Multiplicity of uses of goods: if the commodity has multiple uses then the demand will be more than if the commodity is used for a single purpose. DEMAND DISTINCTIONS: TYPES OF DEMAND Demand may be defined as the quantity of goods or services desired by an individual, backed by the ability and willingness to pay. (1) Direct and indirect demand: (or) Producers’ goods and consumers’ goods: demand for goods that are directly used for consumption by the ultimate consumer is known as direct demand (example: Demand for T shirts). On the other hand demand for goods that are used by producers for producing goods and services. (example: Demand for cotton by a textile mill) (2) Derived demand and autonomous demand: when a produce derives its usage from the use of some primary product it is known as derived demand. (example: demand for tyres derived from demand for car) Autonomous demand is the demand for a product that can be independently used.(example: demand for a washing machine) (3) Durable and non durable goods demand: durable goods are those that can be used more than once, over a period of time (example: Microwave oven) Non durable goods can be used only once (example: Band-aid) (4) Firm and industry demand: firm demand is the demand for the product of a particular firm. (example: Dove soap) The demand for the product of a particular industry is industry demand (example: demand for steel in India )
- 22. Dr. Bhati Rakesh22 | P a g e (5) Total market and market segment demand: a particular segment of the markets demand is called as segment demand (example: demand for laptops by engineering students) the sum total of the demand for laptops by various segments in India is the total market demand. (example: demand for laptops in India) (6) Short run and long run demand: Short run demand refers to demand with its immediate reaction to price changes and income fluctuations. Long run demand is that which will ultimately exist as a result of the changes in pricing, promotion or product improvement after market adjustment with sufficient time. (7) Joint demand and Composite demand: when two goods are demanded in conjunction with one another at the same time to satisfy a single want, it is called as joint or complementary demand. (example: demand for petrol and two wheelers) A composite demand is one in which a good is wanted for several different uses. ( example: demand for iron rods for various purposes) (8) Price demand, income demand and cross demand: Demand for commodities by the consumers at alternative prices are called as price demand. Quantity demanded by the consumers at alternative levels of income is income demand. Cross demand refers to the quantity demanded of commodity ‘X’ at a price of a related commodity ‘Y’ which may be a substitute or complementary to X. (a) Price Demand: The ability and willingness to buy specific quantities of a good at the prevailing price in a given time period. (b) Income Demand: The ability and willingness to buy a commodity at the available income in a given period of time. (c) Market Demand: The total quantity of a good or service that people are willing and able to buy at prevailing prices in a given time period. It is the sum of individual demands. (d) Cross Demand: The ability and willingness to buy a commodity or service at the prevailing price of the related commodity i.e. substitutes or complementary products. For example, people buy more of wheat when the price of rice increases. LAW OF DEMAND: The law of Demand is known as the “first law in market”. Law of demand shows the relation between price and quantity demanded of a commodity in the market. Law of Demand states that the quantity demanded of a good or service varies inversely with its price. In other words, when the price goes up, quantity demanded goes down. Likewise, when the price goes down, quantity demanded goes up. In the words of Marshall “the amount demanded increases with a fall in price and diminishes with a rise in price”. According to Samuelson, “Law of Demand states that people will buy more at lower price and buy less at higher prices”. So the relationship described by the law of demand is an inverse or negative relationship because the variables (price and demand) move in opposite direction. It shows the cause and effect relationship between price and quantity demand. The law of demand holds only in the short run. Formula For Law of Demand: Qdx = f (Px) ceteris paribus Ceteris Paribus. In economics, the term is used as a shorthand for indicating the effect of one economic variable on another, holding constant all other variables that may affect the second variable. ASSUMPTIONS OF LAW OF DEMAND: Law of demand is based on certain basic assumptions. They are as follows (1) There is no change in consumers taste and preference (2) Income should remain constant. (3) Prices of other goods should not change. (4) There should be no substitute for the commodity. (5) The commodity should not confer any distinction. (6) The demand for the commodity should be continuous. (7) People should not expect any change in the price of the commodity.
- 23. Dr. Bhati Rakesh23 | P a g e SCHEDULE OF LAW OF DEMAND: The demand schedule of an individual for a commodity is a list or table of the different amounts of the commodity that are purchased the market at different prices per unit of time. An individual demand schedule for a good say shirt is presented in the table below: Individual Demand Schedule for Shirts: Price per shirt (In Rs.) 100 80 60 40 20 10 Quantity demanded per year Qdx 5 7 10 15 20 30 According to this demand schedule, an individual buys 5 shirts at Rs 100 per shirt and 30 shirts at Rs. 10 per shirt in a year. LAW OF DEMAND CURVE/DIAGRAM: The law of demand can also be presented through a demand curve. A demand curve is a locus of points showing various alternative price quantity combinations. Demand curve shows the quantities of a commodity which a consumer would buy at different prices per unit of time, under the assumptions of the law of demand It is a graphical representation of the demand schedule. In the figure, the quantity. demanded of shirts in plotted on horizontal axis OX and "price is measured on vertical axis OY. Each price- quantity combination is plotted as a point on this graph. If we join the price quantity points a, b, c, d, e and f, we get the individual demand curve for shirts. The DD/ demand curve slopes downward from left to right. It has a negative slope showing that the two variables price and quantity work in opposite direction. When the price of a good rises, the quantity demanded decreases and when its price decreases, quantity demanded increases, ceteris paribus. EXCEPTIONAL DEMAND CURVE: The demand curve slopes from left to right upward if despite the increase in price of the commodity, people tend to buy more due to reasons like fear of shortages or it may be an absolutely essential good. The law of demand does not apply in every case and situation. The circumstances when the law of demand becomes ineffective are known as exceptions of the law. Some of these important exceptions are as under. (1) Giffen Goods: Some special varieties of inferior goods are termed as Giffen goods such as bajra, potato etc. Sir Robert Giffen of Ireland first observed that people used to spend more of their income on inferior goods like potato and less of their income on meat. After purchasing potato the staple food, they did not have staple food potato surplus to buy meat. So the rise in price of potato compelled people to buy more potato and thus raised the demand for potato. This is against the law of demand. This is also known as Giffen paradox. (2) Conspicuous Consumption/Veblen Effect: Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status. So-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product. Some buyers have a desire to own
- 24. Dr. Bhati Rakesh24 | P a g e unusual or unique products to show that they are different from others. In this situation even when the price rises the demand for the commodity will be more. (3) Conspicuous Necessities: Certain things become the necessities of modern life. So we have to purchase them despite their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone down in spite of the increase in their price. These things have become the symbol of status. So they are purchased despite their rising price. (4) Ignorance: A consumer’s ignorance is another factor that at times induces him to purchase more of the commodity at a higher price. This is especially true, when the consumer believes that a high-priced and branded commodity is better in quality than a low-priced one. (5) Emergencies: During emergencies like war, famine etc, households behave in an abnormal way. Households accentuate scarcities and induce further price rise by making increased purchases even at higher prices because of the apprehension that they may not be available. . On the other hand during depression, fall in prices is not a sufficient condition for consumers to demand more if they are needed. (6) Future Changes in Prices: Households also act as speculators. When the prices are rising households tend to purchase large quantities of the commodity out of the apprehension that prices may still go up. When prices are expected to fall further, they wait to buy goods in future at still lower prices. So quantity demanded falls when prices are falling. (7) Change in Fashion: A change in fashion and tastes affects the market for a commodity. When a digital camera replaces a normal manual camera, no amount of reduction in the price of the latter is sufficient to clear the stocks. Digital cameras on the other hand, will have more customers even though its price may be going up. The law of demand becomes ineffective. (8) Demonstration Effect: It refers to a tendency of low income groups to imitate the consumption pattern of high income groups. They will buy a commodity to imitate the consumption of their neighbors even if they do not have the purchasing power. (9) Speculative Goods / Outdated Goods / Seasonal Goods: Speculative goods such as shares do not follow the law of demand. Whenever the prices rise, the traders expect the prices to rise further so they buy more. Goods that go out of use due to advancement in the underlying technology are called outdated goods. The demand for such goods does not rise even with fall in prices (10) Seasonal Goods: Goods which are not used during the off-season (seasonal goods) will also be subject to similar demand behaviour. (11) Goods In Short Supply: Goods that are available in limited quantity or whose future availability is uncertain also violate the law of demand. FACTORS BEHIND THE LAW OF DEMAND: The downward slope of the demand curve depicts the law of demand, i.e., the quantity of a commodity demanded per unit of time increases as its price falls, and vice verse. The factors that make the law of demand operate are following. (1) Substitution Effect: When price of a commodity falls, prices of all other related goods (particularly of substitutes) remaining constant, the goods of latter category become relatively costlier. Since utility maximising consumers substitute cheaper goods for costlier ones, demand for the cheaper commodity increases. The increase in demand on account of this factor is known a substitution effect. (2) Income Effect: As a result of fall in the price of a commodity, the real income of the consumer increases. Consequently, his purchasing power increases since he is required to pay less for the same quantity. The increase in real income encourages the consumer to demand more of goods and services. 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. (3) Utility-Maximising Behavior: The utility-maximising behavior of the consumer under the condition of diminishing marginal utility is also responsible for increase in demand for a commodity when its price falls. As mentioned above, when a person buys a commodity, he exchanges his money income for the commodity in order to maximise his satisfaction. He continues to buy goods and services so long as marginal utility of his money (MUm) is less than the marginal utility of the commodity (MUo). Given the price of a commodity, the consumer adjusts his purchases. so that. MUm = Po = MUo (4) When price of the commodity falls, (MUm = Po) < MUo, and equilibrium is disturbed. In order to regain his equilibrium, the consumer will have to reduce the MUo to the level of MUm. This he can do only by
- 25. Dr. Bhati Rakesh25 | P a g e purchasing more of the commodity. Therefore, the consumer purchases the commodity till MUm= Po = MUo. This is another reason why demand for a commodity increases when its price decreases. (a) Law of Diminishing Marginal utility: As the consumer buys more and more of the commodity, the marginal utility of the additional units falls. Therefore the consumer is willing to pay only lower prices for additional units. If the price is higher, he will restrict its consumption (b) Principle of Equi- Marginal Utility: Consumer will arrange his purchases in such a way that the marginal utility is equal in all his purchases. If it is not equal, they will alter their purchases till the marginal utility is equal. (5) Different uses of a commodity: Some commodities have several uses. If the price of the commodity is high, its use will be restricted only for important purpose. For e.g. when the price of tomato is high, it will be used only for cooking purpose. When it is cheaper, it will be used for preparing jam, pickle etc... (6) Psychology of people: Psychologically people buy more of a commodity when its price falls. In other word it can be termed as price effect. (7) Tendency of human beings to satisfy unsatisfied wants. MOVEMENTS ALONG THE DEMAND CURVE VS. SHIFT OF DEMAND CURVE: ELASTICITY OF DEMAND The concept of price-elasticity of demand was first of all introduced in economics by Dr. Marshall. It refers to the degree of responsiveness of quantity demanded to the changes in the determinants of demand. According to Alfred Marshall: "Elasticity of demand may be defined as the percentage change in quantity demanded to the percentage change in price." According to Kenneth Boulding: "Elasticity of demand measures the responsiveness of demand to changes in price." As a formula, this is: ε = Percentage Change in Quantity Demanded / Percentage Change in Price It measures how much buyers respond to a percentage change in the price. Another way to write the formula is: ε = (dq/q) / (dp/p) This can be written as: ε = p .dq / q dp For example: Quantity demanded is 20 units at a price of Rs.500. When there is a fall in price to Rs. 400 it results in a rise in demand to 32 units. Therefore the change in quantity demanded is12 units resulting from the change in price of Rs.100. The Price Elasticity of Demand is = 500 / 20 x 12/100 = 3 Note that the law of demand implies that dq/dp < 0, and so ε will be a negative number. In some contexts, it is common to introduce a minus sign in this formula to make this quantity positive. Slope (dq/dp) and elasticity (ε) are two different concepts. With linear demand curves, elasticity changes along the demand curve, however its slope does not. Elasticity is concerned with responses in one variable to changes in the other variable. The slope of the curve is concerned with values of the respective variables at each position along the curve (i.e., its' shape and direction). The elasticity can be measured between two points on a demand curve (called arc elasticity) or on a point (called point elasticity).
- 26. Dr. Bhati Rakesh26 | P a g e THE DETERMINANTS OF PRICE ELASTICITY OF DEMAND: The exact value of price elasticity for a commodity is determined by a wide variety of factors. The two factors considered by economists are the availability of substitutes and time. The better the substitutes for a product, the higher the price elasticity of demand.. The longer the period of time, the more the price elasticity of demand for that product. The price elasticity of necessary goods will have lower elasticity than luxuries. The elasticity of demand depends on the following factors: (1) Nature of the commodity: The demand for necessities is inelastic because the demand does not change much with a change in price. But the demand for luxuries is elastic in nature. (2) Extent of use: A commodity having a variety of uses has a comparatively elastic demand. (3) Range of substitutes: The commodity which has more number of substitutes has relatively elastic demand. A commodity with fewer substitutes has relatively inelastic demand. (4) Income level: People with high incomes are less affected by price changes than people with low incomes. (5) Proportion of income spent on the commodity: When a small part of income is spent on the commodity, the price change does not affect the demand therefore the demand is inelastic in nature. (6) Urgency of demand / postponement of purchase: The demand for certain commodities are highly inelastic because you cannot postpone its purchase. For example medicines for any sickness should be purchased and consumed immediately. (7) Durability of a commodity: If the commodity is durable then it is used it for a long period. Therefore elasticity of demand is high. Price changes highly influences the demand for durables in the market. (8) Purchase frequency of a product/ recurrence of demand: The demand for frequently purchased goods are highly elastic than rarely purchased goods. (9) Time: In the short run demand will be less elastic but in the long run the demand for commodities are more elastic. DEGREES OF PRICE ELASTICITY: Different commodities have different price elasticity. Some commodities have more elastic demand while others have relative elastic demand. Basically, the price elasticity of demand ranges from zero to infinity. It can be equal to zero, less than one, greater than one and equal to unity.
- 27. Dr. Bhati Rakesh27 | P a g e MEASUREMENT OF ELASTICITY OF DEMAND: 1. Total Expenditure Method / Total Revenue Method / Total Outlay Method: The price elasticity can be measured by noting the changes in total expenditure brought about by changes in price and quantity demanded. (i) If no change in total expenditure as change in price than Ed=1 (ii) If total expenditure and price changes in opposite direction Ed>1 (iii) If total expenditure and price changes in same direction Ed<1 Price elasticity Of Demand Direction of price change Direction of quantity change Direction of total revenue change TR = PQ ED > 1 (elastic demand) P Q TR P Q TR ED < 1 (inelastic demand) P Q TR P Q TR 2. Proportionate or Percentage Method: Under this method elasticity of demand is measured by the ratio of the percentage change in quantity demanded to the percentage in price. Ed = ice Pr change in Percentage Demanded Quantity change in Percentage = Ed = Q P P Q Where, P = initial price Q= initial quantity ∆Q = Change in Quantity ∆P = Change in price 3. Geometric Method/Point Elasticity Method: "The measurement of elasticity at a point of the demand curve is called point elasticity". The point elasticity of demand method is used as a measure of the change in the quantity demanded in response to a very small change in price. The point elasticity of demand is defined as: "The proportionate change in the quantity demanded resulting from a very small proportionate change in price". (i) Measurement of Elasticity on a Linear Demand Curve: The price elasticity of demand can also be measured at any point on the demand curve. If the demand curve is linear (straight line), it has a unitary elasticity at the mid point. The total revenue is maximum at this point. Any point above the midpoint has elasticity greater than 1, (Ed > 1). Here, price reduction leads to an increase in the total revenue (expenditure). Below the midpoint elasticity is less than 1. (Ed < 1). Price reduction leads to reduction in the total revenue of the firm. Graph / Diagram: The elasticity at each point on the demand curve can be traced with the help of point method as: Ed = Lower Segment / Upper Segment (ii) Arc Elasticity of Demand (Non Linear Demand Curve): If the demand curve is non linear, then elasticity at a point can be measured by drawing a tangent at the particular point. The Arc elasticity measures the "average" elasticity between two points on the demand curve. The formula is simply (change in quantity/change in price)*(average price/average quantity). It is defined as: "The average elasticity of a range of points on a demand curve". = in prices Difference ces Sum of pri ntities Sum of qua tes in quanti Difference = 2 1 2 1 2 1 2 1 p p p p q q q q USES OF THE CONCEPT OF ELASTICITY: 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.
- 28. Dr. Bhati Rakesh28 | P a g e (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 DEMAND FORECASTING: Today business enterprises are working under the conditions of uncertainties. Uncertainties can be minimized through planning and forecasting. The success of a business firm depends upon its ability to forecast future events. Future is uncertain. There is great deal of uncertainty with regard to demand. Since the demand is uncertain, production, cost, revenue, profit etc. are also uncertain. Through forecasting it is possible to minimise the uncertainties. Forecasting simply refers to estimating or anticipating future events. It is an attempt to foresee the future by examining the past. Thus demand forecasting means estimating or anticipating future demand on the basis of past data. OBJECTIVES OF DEMAND FORECASTING: A. SHORT TERM OBJECTIVES: (1) To help in preparing suitable sales and production policies. (2) To help in ensuring a regular supply of raw materials. (3) To reduce the cost of purchase and avoid unnecessary purchase. (4) To ensure best utilization of machines. (5) To make arrangements for skilled and unskilled workers so that suitable labour force may be maintained (6) To help in the determination of a suitable price policy. (7) To determine financial requirements. (8) To determine separate sales targets for all the sales territories. (9) To eliminate the problem of under or over production. B. LONG TERM OBJECTIVES: (1) To plan long term production. (2) To plan plant capacity. (3) To estimate the requirements of workers for long period and make arrangements. (4) To determine an appropriate dividend policy. (5) To help the proper capital budgeting. (6) To plan long term financial requirements. (7) To forecast the future problems of material supplies and energy crisis. FACTORS AFFECTING DEMAND FORECASTING: For making a good forecast, it is essential to consider the various factors governing demand forecasting. These factors are summarized as follows. (1) Prevailing business conditions: While preparing demand forecast it becomes necessary to study the general economic conditions very carefully. These include the price level changes, change in national income, percapita income, consumption pattern, savings and investment habits, employment etc. (2) Conditions within the industry: Every business enterprise is only a unit of a particular industry. Sales of that business enterprise are only a part of the total sales of that industry. Therefore, while preparing demand forecasts for a particular business enterprise, it becomes necessary to study the changes in the demand of the whole industry, number of units within the industry, design and quality of product, price policy, competition within the industry etc.
- 29. Dr. Bhati Rakesh29 | P a g e (3) Conditions within the firm: Internal factors of the firm also affect the demand forecast. These factors include plant capacity of the firm, quality of the product, price of the product, advertising and distribution policies, production policies, financial policies etc. (4) Factors affecting export trade: If a firm is engaged in export trade also it should consider the factors affecting the export trade. These factors include import and export control, terms and conditions of export, exim policy, export conditions, export finance etc. (5) Market behaviour: While preparing demand forecast, it is required to consider the market behavior which brings about changes in demand. (6) Sociological conditions: Sociological factors have their own impact on demand forecast of the company. These conditions relate to size of population, density, change in age groups, size of family, family life cycle, level of education, family income, social awareness etc. (7) Psychological conditions: While estimating the demand for the product, it becomes necessary to take into consideration such factors as changes in consumer tastes, habits, fashions, likes and dislikes, attitudes, perception, life styles, cultural and religious bents etc. (8) Competitive conditions: The competitive conditions within the industry may change. Competitors may enter into market or go out of market. A demand forecast prepared without considering the activities of competitors may not be correct. PROCESS OF DEMAND FORECASTING/ STEPS IN DEMAND FORECASTING: Demand forecasting involves the following steps: (1) Determine the purpose for which forecasts are used. (2) Subdivide the demand forecasting programme into small I parts on the basis of product or sales territories or markets. (3) Determine the factors affecting the sale of each product and their relative importance. (4) Select the forecasting methods. (5) Study the activities of competitors. (6) Prepare preliminary sales estimates after, collecting necessary data. (7) Analyse advertisement policies, sales promotion plans, personal sales arrangements etc. and ascertain how far these programmes have been successful in promoting the sales. (8) Evaluate the demand forecasts monthly, quarterly, half yearly or yearly and necessary adjustments should be done. (9) Prepare the final demand forecast on the basis of preliminary forecasts and the results of evaluation. METHODS OF DEMAND FORECASTING (FOR ESTABLISHED PRODUCTS): There are several methods to predict the future demand. All methods can be broadly classified into two. (A) Survey methods, (B) Statistical methods (A) SURVEY METHODS: Under this method surveys are conducted to collect information about the future purchase plans of potential consumers. Survey methods help in obtaining information about the desires, likes and dislikes of consumers through collecting the opinion of experts or by interviewing the consumers. Survey methods are used for short term forecasting. Important survey methods are (a) consumers interview method, (b) collective opinion or sales force opinion methodic) experts opinion method, (d) consumers clinic and (f) end use method. (i) CONSUMERS' INTERVIEW METHOD (CONSUMERS SURVEY): Under this method, consumers are interviewed directly and asked the quantity they would like to buy. After collecting the data, the total demand for the product is calculated. This is done by adding up all individual demands. Under the consumer interview method, either all consumers or selected few are interviewed. When all the consumers are interviewed, the method is known as complete enumeration method. When only a selected group of consumers are interviewed, it is known as sample survey method
- 30. Dr. Bhati Rakesh30 | P a g e Advantages: (1) It is a simple method because it is not based on past record. (2) It suitable for industrial products. (3) The results are likely to be more accurate. (4) This method can be used for forecasting the demand of a new product. Disadvantages: (1) It is expensive and time consuming. (2) Consumers may not give their secrets or buying plans. (3) This method is not suitable for long term forecasting. (4) It is not suitable when the number of consumer is large. (ii) COLLECTIVE OPINION METHOD: Under this method the salesmen estimate the expected sales in their respective territories on the basis of previous experience. Then demand is estimated after combining the individual forecasts (sales estimates) of the salesmen. This method is also known as sales force opinion method. Advantages: This method is simple. (1) It is based on the first hand knowledge of Salesmen. (2) This method is particularly useful for estimating demand of new products. (3) It utilises the specialised knowledge of salesmen who are in close touch with the prevailing market conditions. Disadvantages: (1) The forecasts may not be reliable if the salespeople are not trained. (2) It is not suitable for long period estimation. (3) It is not flexible. (4) Salesmen may give lower estimates that make possible easy achievement of sales quotas fixed for each salesman. (iii) EXPERTS' OPINION METHOD: This method was originally developed at Rand Corporation in 1950 by Olaf Helmer, Dalkey and Gordon. Under this method, demand is estimated on the basis of opinions of experts and distributors other than salesmen and ordinary consumers. This method is also known as Delphi method. Delphi is the ancient Greek temple where people come and prey for information about their future. Advantages: (1) Forecast can be made quickly and economically (2) This is a reliable method because estimates are made on the basis of knowledge and experience of sales experts. (3) The firm need not spare its time on preparing estimates of demand. (4) This method is suitable for new products. Disadvantages: (1) This method is expensive. (2) This method sometimes lacks reliability
- 31. Dr. Bhati Rakesh31 | P a g e (iii) CONSUMER CLINICS: In this method some selected buyers are given certain amounts of money and asked to buy the products. Then the prices are changed and the consumers are asked to make fresh purchases with the given money. In this way the consumers" responses to price changes are observed. Thus the behaviour of the consumers is studied. On this basis demand is estimated. This method is an improvement over consumer’s interview method. Merits: 1] It provides an opportunity to study the behaviour of consumers directly. 2] It provides reliable and realistic picture about future demand. 3] It gives useful information to aid in the decision making process. Demerits: 1] It is a time consuming method. 2] Selecting the participants is very difficult. 3] It is expensive. 4] Consumers may take it as a game. They may not reveal their preferences. (iv) END USE METHOD: This method is based on the fact that a product generally has different uses. In the end use method, first a list of end users (final consumers, individual industries, exporters etc.) is prepared. Then the future demand for the product is found either directly from the end users or indirectly by estimating their future growth. Then the demand of all end users of the product is added to get the total demand for the product. (B) STATISTICAL METHODS: Statistical methods use the past data as a guide for knowing the level of future demand. Statistical methods are generally used for long run forecasting. These methods are used for established products. Statistical methods include: (i) Trend projection method, (ii) Regression and Correlation, (iii) Extrapolation method, (iv) Simultaneous equation method, and (v) Barometric method. (i) Trend projection method: Future sales are based on the past sales, because future is the grand- child of the past and child of the present. Under the trend projection method demand is estimated on the basis of analysis of past data. This method makes use of time series (data over a period of time). We try to ascertain the trend in the time series. The trend in the time series can be estimated by using any one of the following four methods: (a) Least-square method, (b) Free-hand method, (c) Moving average method and (d) semi-average method. (ii) Regression and Correlation: These methods combine economic theory and statistical technique of estimation. Under these methods the relationship between the sales (dependent variable) and other variables (independent variables such as price of related goods, income, advertisement etc.) is ascertained. Such relationship established on the basis of past data may be used to analyse the future trend. The regression and correlation analysis is also called the econometric model building. (iii) Extrapolation: Under this statistical method, the future demand can be extrapolated by applying Binomial expansion method. This method is used on the assumption that the rate of charge in demand in the past has been uniform. (iv) Simultaneous equation method.-This involves the development of a complete econometric model which can explain the behaviour of all the variables which the company can control. This method is not very popular. (v) Barometric technique: This is an improvement over the trend projection method. According to this technique the events of the present can be used to predict the directions of change m the future. Here certain economic and statistical indicators from the selected time series are used to predict variables. Personal income, non-agricultural placements, gross national income, prices of industrial materials, wholesale commodity prices, industrial production, bank deposits etc. are some of the most commonly used indicators. Advantages of Statistical Methods: 1]The method of estimation is scientific 2]Estimation is based on the theoretical relationship between sales (dependent variable) and price, advertising, income etc. (independent variables) 3]These are less expensive. 4 Results are relatively more reliable.
- 32. Dr. Bhati Rakesh32 | P a g e Disadvantages of Statistical Methods: 1]These methods involve complicated calculations. 2]These do not rely much on personal skill and experience. 3]These methods require considerable technical skill and experience in order to be effective. 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.
- 33. Dr. Bhati Rakesh33 | P a g e INTRODUCTION: SUPPLY The supply of a good or service refers to the quantities of a good or a service that producers are willing and able (ready) to produce (sell) at different prices in a given time period, ceteris paribus. Supply is the “Quantity of a commodity, which a seller offers for sale, in the market, at a particular price and at a particular time”. The definition of supply includes the following three things: (i) The quantity of a commodity offered for sale by a seller. (ii) The price of the commodity given in the market at which the seller is willing to sell that quantity of the commodity. (iii) The time period during which the seller is willing to sell that quantity of the commodity. Supply is derived from a producer's desire to maximize profits. Profit is the difference between revenues and costs. Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce. Supply is an expression of seller’s plans or intentions – an offer to sell – not a statement of actual sales. STOCK AND SUPPLY: Supply is different from stock. Stock is the total quantity of goods, which is stored in the warehouse, but it will not be offered for sale. Hence supply is only a part of the stock, which is offered for sale. The concept of supply should be studied from the manufacturer point of view. Supply is a flow concept. It is studied as so much per day, per week, per month, per year, etc. Supply is only restricted to what the firms offer for sale and not with how much they sell. Individual Supply: Supply of a particular commodity by an individual firm at a given price in the market is termed as individual supply. Market Supply: Quantities of a particular commodity offered for sale by all the firms at a given price in the market is known as market supply. Supply Schedule: is a table showing how much of a commodity, firms can sell at different prices. Individual Supply Schedule It is a table showing different quantities of a commodity that an individual firm is ready to sell at different prices. Market Supply Schedule It is a table showing different quantities of a commodity that all the firms in a market are willing to sell at different prices of that commodity at a given time. Supply Curve It is a graphical presentation of supply schedule, showing positive relationship between price and quantity supplied of a commodity. A graphical representation of how much of a commodity a firm sells at different prices. The supply curve is upward sloping from left to right. Therefore the price elasticity of supply will be positive. Factors are responsible for upward slope of the supply curve: (i) A rise in price of the commodity causes rise in profits, as a result firms are induced to supply more quantity of the commodity to increase profit. (ii) A rise in price of the commodity induces the seller to dispose of at least a part of his stock. The reverse happens when there is a fall in price of the commodity. (iii) An increase in the price of the commodity causing higher profit attracts the new firms to enter the market and this adds to the supply of the commodity leading to more quantity supplied at a higher price. Supply & Market Equilibrium: Introduction, Meaning of Supply and Law of Supply, Exceptions to the Law of Supply, Changes or Shifts in Supply. Elasticity of supply, Factors Determining Elasticity of Supply, Practical Importance, Market Equilibrium and Changes in Market Equilibrium. Production Analysis: Introduction, Meaning of Production and Production Function, Cost of Production. Cost Analysis: Private costs and Social Costs, Accounting Costs and Economic costs, Short run and Long Run costs, Economies of scale, Cost-Output Relationship - Cost Function, Cost- Output Relationships in the Short Run, and Cost-Output Relationships in the Long Run. UNIT – 3
- 34. Dr. Bhati Rakesh34 | P a g e Individual Supply Curve: Graphical presentation of the relationship between price and individual supply of a commodity is called individual supply curve Market Supply Curve: It is the graphical representation of market supply schedule. It is a horizontal summation of the individual supply curves. DETERMINANTS OF SUPPLY: 1. The cost of factors of production: Cost depends on the price of factors. Increase in factor cost increases the cost of production, and reduces supply. 2. The state of technology: Use of advanced technology increases productivity of the organization and increases its supply. 3. External factors: External factors like weather influence the supply. If there is a flood, this reduces supply of various agricultural products. 4. Tax and subsidy: Increase in government subsidies results in more production and higher supply. 5. Transport: Better transport facilities will increase the supply. 6. Price: If the prices are high, the sellers are willing to supply more goods to increase their profit. 7. Price of other goods: The price of other goods is more than ‘X’ then the supply of ‘X’ will be increased. SUPPLY FUNCTION: Supply function studies the functional relationship between supply of a commodity and its various determinants. It is expressed in the following equation: Sx = F (Px , Pr, Nf, G, Pf, T, Ex, GP) Where, (i) Own price of a commodity (Px) (ii) Price of related goods (Pr) (iii) Number of firms in the industry (N f) (iv) Goal of the firm (G) (v) Price of factors of production (Pf) (vi) State of technology (T) (vii) Business confidence or expectation (Ex) (viii) Government policy (relating to taxation and subsidies) (Gp) LAW OF SUPPLY: The law of supply states that ceteribus paribus (Latin for 'assuming all else is held constant'), the quantity supplied for a good, rises as the price rises. The law of supply shows a positive (direct) relationship between price and quantity supplied. The quantity of a good supplied in a given time period increases as its price increases, ceteris paribus. The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases. Producers are willing to supply only if they at least cover their marginal cost of production. Because of the law of supply, supply curve has positive slope (is upward sloping.) It states the positive relationship between price and quantity supplied, assuming no changes in other factors. It is a qualitative statement, as it indicates the direction of change in the quantity supplied, but it does not indicate the magnitude of change. It does not establish any proportional relationship between change in price and the resultant change in quantity supplied. Law is one sided as it explains only the effect of change in price on the supply, and not the effect of change in supply on the price. REASONS FOR LAW OF SUPPLY: The main reasons for operation of law of supply are: 1. Profit Motive: The basic aim of producers, while supplying a commodity, is to secure maximum profits. When price of a commodity increases, without any change in costs, it raises their profits. So, producers
- 35. Dr. Bhati Rakesh35 | P a g e increase the supply of the commodity by increasing the production. On the other hand, with fall in prices, supply also decreases as profit margin decreases at low prices. 2. Change in Number of Firms: A rise in price induces the prospective producers to enter into the market to produce the given commodity so as to earn higher profits. Increase in number of firms raises the market supply and vice versa. 3. Change in Stock: When the price of a good increases, the sellers are ready to supply more goods from their stocks. However, at a relatively lower price, the producers do not release big quantities from their stocks. They start increasing their inventories with a view that price may rise in near future. EXCEPTIONS OF THE LAW OF SUPPLY: 1. The supply curve of rare goods (such as the artwork of a dead painter) or non-reproducible goods is a vertical straight line. An unchanged quantity is offered for sale at all possible prices. In this case, the supply curve becomes perfectly inelastic. Land is also completely inelastic in supply. 2. The law of supply breaks down in the case of labour supply curve. Labour supply curve is backward bending due to the operation of income effect and substitution effect of wage rate changes. Below the wage rate OW1, as wage rate rises, supply of labour tends to rise. Here substitution effect is stronger than the income effect. But beyond OW1 wage rate, any rise in it will cause labour to work less and will induce him to take more leisure. Thus, income effect becomes stronger than the substitution effect. As a result, the supply curve of labour becomes backward bending. 3. If firms anticipate that the product prices will fall much in the near future, they will sell more now just to clear their stocks of goods. Such possibility may arise in the short run. 4. The supply curve may be negative sloping in the share market. As the share market is characterized by uncertainty, people anticipate the change in prices of shares. When the price of a share falls, people may expect that its price will fall further. 5. Perishable goods such as fruits, sea produce, and flowers have very short shelf life and they need to be made available in the market before they perish. So for such goods the sellers cannot simply wait for a longer time and supply these in the market even when the prices are not rising. MOVEMENT ALONG A SUPPLY CURVE OR CHANGE IN QUANTITY SUPPLIED: When supply of a commodity changes due to change in it price and other factors are remaining constant. It is called change in quantity supplied. MOVEMENT ALONG A SUPPLY CURVE CHANGE IN QUANTITY SUPPLIED A movement in a supply curve is a change in supply as a result of a change in price Shift in supply curve shows the situation of increase or decrease in supply, even own price of the commodity remains constant due to change in the factors. Extension of Supply: It refers to expansion in quantity supplied in response to increase in own price of the commodity Increase in Supply: When supply of a commodity increases due to factors other than price is known as increase in supply. In this situation, supply curve shifts rightward Causes for the Increase in Supply: (i) Fall in the price of substitute goods. (ii) Fall in the price of factors of production. (iii) Improvements in technology. (iv) Increase in the number of firms in the market. (v) Reduction in factor price. (vi) Decrease in taxation.
- 36. Dr. Bhati Rakesh36 | P a g e Contraction of Supply: It refers to contraction in quantity supplied in response to decrease in own price the commodity Decrease in Supply: When supply of a commodity decreases due to factors other than price is called decrease in supply. In this situation, supply curve shifts leftward. Causes for the Decrease in Supply (i) Rise in the price of substitute goods. (ii) Rise in the price of factors of production. (iii) Outdated technology. (iv) Decrease in the number of firms in the market. (v) Increase in factor price. (vi) Increase in taxation. PRICE ELASTICITY OF SUPPLY: It is the responsiveness of quantity supplied due to change in price of own commodity. It is calculated as the percentage change in quantity supplied caused by a given percentage change in price of the commodity. Price elasticity of supply (Es) = Percentage Change in quantity supplied / Percentage change in Price Where, 1. Percentage change in Quantity supplied = Change in Quantity Supplied (∆Q) / Initial Quantity Supplied (Q) x 100 2. Change in Quantity (∆Q) = New Quantity (Q1) – Initial Quantity (Q) 3. Percentage change in Price = Change in Price (∆P) / Initial Quantity (P) × 100 4. Change in Price (∆P) = New Price (P1) – Initial Price (P) 100 P ΔP 100 Q ΔQ ice Pr Change in Percentage Supplied Quantity Change in Percentage E8 = Q P P Q METHOD OF MEASURING PRICE ELASTICITY OF SUPPLY: (i) Percentage Method of Measuring Price Elasticity of Supply: According to this method, Elasticity of Supply is the ratio between ‘percentage change in quantity suppliedand ‘percentage in price of the commodity a)Perfectly Inelastic Supply (Es = 0) When quantity supplied does not change at all in response to change in price of the commodity, its supply said to be perfectly inelastic b)Less than Unit Elastic (Es < 1) When percentage change in quantity supplied is less than the percentage change in price, supply is said to be less than unit elastic. c)Unit Elastic Supply (Es = 1) Supply of a commodity is said to be unit elastic, when percentage change in quantity supplied equal to percentage change in price. d)More than Unit Elastic Supply (Es > 1) When percentage change in quantity supplied is more
- 37. Dr. Bhati Rakesh37 | P a g e than percentage change in price, supply is said to be more than unit elastic. e)Perfectly elastic Supply (Es =a) When price does not change at all in response to of the change in quantity supplied of commodity, its supply said to be perfectly elastic. (ii) Geometric Method of Measuring Price Elasticity of Supply: According to geometric method, elasticity is measured at a given point on the supply curve. This method is also known as ‘Arc Method’ or ‘Point Method’. At point ‘A’ in the figure, the price is OP and the quantity supplied is OQ. When the price rises to OP1, quantity supplied also rises to OQ1. The supply curve is extended beyond the Y- axis, so that it meets the extended X-axis at point ‘L’. Now, at point A, elasticity of supply is equal to: ES = ∆Q/∆P × P/Q Symbols have usual meaning as discussed under ‘percentage Method’ From the diagram, ∆Q = QQ1; ∆P = OP and Q =OQ Putting these values in the formula, we get: ES = QQ1/PP1 × OP/OQ But, QQ1 = AC; PP1 = BC and OP = AQ. Substituting these values in (1), we get ES = AC/BC × AQ/OQ Now, ∆BAC and ∆ALQ are similar triangles on account of AAA property. It means that the ratio of their sides will be equal. This implies: AC/BC = LQ/AQ Substituting the value of (3) in (2), we get: ES = LQ/AQ × AQ/OQ Or simply, ES = LQ/OQ = Intercept on X-axis/Quantity supplied at that price ce t that pri Quantity a xis on the X-a Intercept E8 Under this method, we can conceive following three possible situations of Elasticity of Supply. (i) Es = 1, when a straight line, positively sloped, supply curve starts from the origin ‘O’. (ii) Es > 1, when a straight line positively sloped, supply curve starts from the Y-axis. (iii) Es < 1, when a straight line positively sloped, supply curve starts from the X-axis. FACTORS INFLUENCING ELASTICITY OF SUPPLY: 1] Nature of the commodity: If the commodity is perishable in nature then the elasticity of supply will be less. Durable goods have high elasticity of supply. 2] Time period: If the operational time period is short then supply is inelastic. When the the production process period is longer the elasticity of supply will be relatively elastic. 3] Scale of production: Small scale producer’s supply is inelastic in nature compared to the large producers. 4] Size of the firm and number of products: If the firm is a large scale industry and has more variety of products then it can easily transfer the resources. Therefore supply of such products is highly elastic. 5] Natural factors: Natural calamities can affect the production of agricultural products so they are relatively inelastic. 6] Nature of production: If the commodities need more workmanship, or for artistic goods the elasticity of supply will be high. Apart from the above mentioned factors future expectations of the market, natural resources of the country and government controls can also play a role in determining supply of a good. In the long run, supply is affected by cost of production. If costs are rising, some of the existing producers may. EQUILIBRIUM: DETERMINATION OF PRICE AND QUANTITY Equilibrium is a situation in which opposing forces balance each other. A market equilibrium is a situation in which: quantity demanded equals quantity supplied at a single price called market (equilibrium) price (P*). Price adjusts when plans do not match.
- 38. Dr. Bhati Rakesh38 | P a g e demand curve intersects supply curve, and the market just clears and there is no tendency to change since the price balances the plans of buyers and sellers. At the market equilibrium, the price accepted by producers for the last unit (marginal cost) is equivalent to the price the last consumer is willing and able to pay (marginal benefit). The equilibrium price (P*) is the price at which the quantity demanded equals the quantity supplied. Price regulates buying and selling plans. Equilibrium quantity (Q*) is the amount bought and sold at the equilibrium price P*. The interaction between buyers and sellers through price adjustment, which results in equilibrium quantity, determine the answer to “what to produce.” "How we produce" is determined by profit seeking behavior and using resources efficiently (using the least-cost methods of production). The answer to "for whom" question includes only those people willing and able to pay market price (P*). Market equilibrium does not make everyone fully satisfied but it is efficient. (optimal but not perfect) We will analyze the equilibrium using tables, diagrams and mathematical equations through the following example. Tabular Illustration of Equilibrium, Surplus, and Shortage: Price (Rs) Quantity Demand Quantity Supply (Qs – Qd) Price Adjustments 1 10 6 -4 Shortage At prices below the equilibrium price, a shortage arises, which forces the price up. 2 9 7 -2 Shortage 3 8 8 0 (D = S) Market Equilibrium At the equilibrium price, buying plans selling plans agree and the price doesn’t change. 4 7 9 2 Surplus At prices above the equilibrium price, a surplus arises, which forces the price down. 5 6 10 4 Surplus The equilibrium (eq.) price is determined at the intersection of the demand (for a good) and the supply (of that good), which is at A, where eq. price is P* and eq. quantity is Q*. At this quantity Q*, the quantity demanded is exactly equal to the quantity supplied, i.e., Qd= Qs, and so there is no excess demand or excess supply. This is the eq. price in the market. This is also called the "market clearing" price. At price P1 the quantity supplied is P1C while the quantity demanded is P1B. Thus we have an excess supply (surplus) of BC. At price P2 the quantity supplied is P2D while the quantity demanded is P2E. Thus we have an excess demand (shortage) of DE Thus we can conclude that if prices are below the market equilibrium prices, (as in P2 here) we will have a shortage. Reversely if prices are above the market equilibrium prices, (as in P1 here) we will have a surplus.
- 39. Dr. Bhati Rakesh39 | P a g e INTRODUCTION: PRODUCTION ANALYSIS Production theory generally deals with quantitative relationships, that is, technical and technological relationships between inputs, especially labour and capital, and between inputs and outputs. An input is a good or service that goes into the production process. As economists refer to it, an input is simply anything which a firm buys for use in its production process. An output, on the other hand, is any good or service that comes out of a production process. Economists classified inputs as (i) labour; (ii) capital; (iii) land; (iv) raw materials; and, (v) time. These variables are measured per unit of time and hence referred to as flow variables. In recent times, entrepreneurship has been added as part of the production inputs, though this can be measured by the managerial expertise and the ability to make things happen. Inputs are classified as either fixed or variable inputs. Fixed and variable inputs are defined in both economic sense and technical sense. In economic sense, a fixed input is one whose supply is inelastic in the short run. In technical sense, a fixed input is one that remains fixed (or constant) for certain level of output. A variable input is one whose supply in the short run is elastic, example, labour, raw materials, and the like. Users of such inputs can employ a larger quantity in the short run. Technically, a variable input is one that changes with changes in output. In the long run, all inputs are variable. Production refers to the manufacturing of goods and services with the use of various resources such as labor, plant and machinery, land, raw materials etc. For example: when a firm produces cars or when a bank produces financial services, the activity is called production. Hence, production includes making of goods as well as services, using various inputs or resources, which people can buy and utilize. Production means transforming inputs (Labour, Machines, Raw materials etc.) into an output. “Production is the process by which the resources (input) are transformed into a different and more useful commodity. Various inputs are combined in different quantities to produce various levels of output.” CREATION OF UTILITY: (i) Time Utility: Utility of a commodity changes from time to time. For example’ an umbrella has immense utility in rainy season, but has no utility or relative less utility during winter time. (ii) Form Utility: Utility of a commodity changes with the change in shape, size and formation.
- 40. Dr. Bhati Rakesh40 | P a g e (iii) Place Utility: It is added to a commodity by transporting it from the place where it is plenty to the place where it is scarce. For example, utility of coal increases when it is transported from coal mines to open market. Traders and merchants create place utility. (iv) Possession Utility: When the change in possession of a commodity increases utility, then it is known as possession utility. (v) Advertisement Utility: Utility of a commodity also increases through continuous advertisement of that commodity. PRODUCTION FUNCTION Production function is a tool of analysis used in explaining the input-output relationship. It describes the technical relationship between inputs and output in physical terms. In its general form, it holds that production of a given commodity depends on certain specific inputs. In its specific form, it presents the quantitative relationships between inputs and outputs. A production function may take the form of a schedule, a graph line or a curve, an algebraic equation or a mathematical model. The production function represents the technology of a firm. An empirical production function is generally so complex to include a wide range of inputs: land, labour, capital, raw materials, time, and technology. These variables form the independent variables in a firm’s actual production function. A firm’s long-run production function is of the form: Q = f(Ld, L, K, M, T, t) where Ld = land and building; L = labour; K = capital; M = materials; T = technology; and, t = time. For sake of convenience, economists have reduced the number of variables used in a production function to only two: capital (K) and labour (L). Therefore, in the analysis of input-output relations, the production function is expressed as: Q = f(K, L) represents the algebraic or mathematical form of the production function. It is this form of production function which is most commonly used in production analysis. As implied by the production function, increasing production, Q, will require K and L, and whether the firm can increase both K and L or only L will depend on the time period it takes into account for increasing production, that is, whether the firm is thinking in terms of the short run or in terms of the long run. Economists believe that the supply of capital (K) is inelastic in the short run and elastic in the long run. Thus, in the short run firms can increase production only by increasing labour, since the supply of capital is fixed in the short run. In the long run, the firm can employ more of both capital and labour, as the supply of capital becomes elastic over time. In effect, there exists two types of production functions: The short-run production function; and, The long-run production function THE SHORT- AND LONG-RUN PRODUCTION FUNCTIONS The short-run production function, often referred to as the single variable production function, can be written as: Q = f(L) In the long-run, both capital (K) and labour (L) is included in the production function, so that the long-run production function can be written as: Q = f(K, L) A production function is based on the following assumptions: (i) perfect divisibility of both inputs and output; (ii) there are only two factors of production – capital (K) and lacour (L); (iii) limited substitution of one factor for the other; (iv) a given technology; and, (v) inelastic supply of fixed factors in the short-run. Any changes in the above assumptions would require modifications in the production function. The two most important forms of production functions used in economic literature in analysing input-output relationships are the Cobb-Douglas production function and the Constant Elasticity of Substitution (CES) production function. MANAGERIAL USE OF PRODUCTION FUNCTION: The production function is of great help to a manager or business economist. The managerial uses of production function are outlined as below: 1. It helps to determine least cost factor combination: The production function is a guide to the entrepreneur to determine the least cost factor combination. Profit can be maximized only by minimizing the cost of production. In order to minimize the cost of production, inputs are to be substituted. The production function helps in substituting the inputs. 2. It helps to determine optimum level of output: The production function helps to determine the optimum level of output from a given quantity of input. In other words, it helps to arrive at the producer's equilibrium. 3. It enables to plan the production: The production function helps the entrepreneur (or management) to plan the production.
- 41. Dr. Bhati Rakesh41 | P a g e 4. It helps in decision-making :Production function is very useful to the management to take decisions regarding cost and output. It also helps in cost control and cost reduction. In short, production function helps both in the short run and long run decision-making process. COST ANALYSIS: When commodities and services are produced, various expenses have to be incurred, e.g., purchase of raw materials, payment to labour, landlord, capitalist, etc. The sum total of the expenses incurred plus the normal profit expected by the producer is called the cost of production. The various concepts of cost are discussed below: 1] Nominal Cost and Real Cost: Nominal cost is the money cost of production. The real costs of production are the pain and sacrifices of labour involved in the process of production. 2] Explicit and Implicit costs: Explicit costs are the accounting costs or contractual cash payments which the firm makes to other factor owners for purchasing or hiring the various factors. Implicit costs are the costs of self-owned factors which are employed by the entrepreneur in his own business. These implicit costs are the opportunity costs of the self-owned and self-employed factors of the entrepreneur, that is, the money incomes which these self-owned factors would have earned in their next best alternative uses. 3] Accounting Costs and Economic Cost: Accounting costs are the actual or explicit costs which are paid by the entrepreneurs to the owners of hired factors and services. On the other hand, economic costs not only include the explicit costs but also the implicit costs of the self-owned factors or resources which are used by the entrepreneur in his own business. 4] Outlay cost and Opportunity Cost: Outlay costs involve actual expenditure of funds on, say, wages, materials, rent, interest, etc. The opportunity cost (or transfer earnings) of any good is the expected return from the next best alternative good that is forgone or sacrificed. For example, if a farmer who is producing wheat can also produce potatoes with the same factors. Then, the opportunity cost of a quintal of wheat is the amount of output of potatoes given up. 5] Business Cost and Full Cost: Business costs include all the expenses which are incurred in carrying out a business. The concept of business cost is similar to the accounting or actual cost. The concept of Full cost includes two other costs: the opportunity cost and normal profit. Normal profit is a necessary minimum earning which a firm must get to remain in its present occupation. 6] Private costs and Social Costs: Private costs are the economic costs which are actually incurred or provided for by an individual or a firm. It includes both explicit and implicit costs. Social cost, on the other hand, implies the cost which a society bears as a result of production of a commodity. Social cost includes both private cost and the external cost. External cost includes (a) the cost of free goods or resources for which the firm is not required to pay for its used, e.g., atmosphere, rivers, lakes etc. (b) the cost in the form of ‘disutility’ caused by air, water, and noise pollution, etc. 7] Total, Average and Marginal Costs: Total cost refers to the total outlays of money expenditure, both explicit and implicit on the resources used to produced a given output. Average cost is the cost per unit of output which is obtained by dividing the total cost (TC) by the total output (Q), i.e., TC/Q = average cost. Marginal cost is the addition made to the total cost as a result of producing one additional unit of the product. Marginal cost is defined as change in TC/ change in Q. 8] Fixed Costs and Variable Costs: Fixed costs are the expenditure incurred on the factors such as capital, equipment, plant, factory building which remain fixed in the short run and cannot be changed. Therefore, fixed costs are independent of output in the short run i.e., they do not vary with output in the short run. Even if no output is produced in the short run, these costs will have to be incurred. Variable costs are costs incurred by the firms on the employment of variable factors such as labour, raw materials, etc., whose amount can be easily increased or decreased in the short run. Variable costs vary with the level of output in the short run. If the firm decided not to produce any output, variable costs will not be incurred. 9] Short-run and Long-run Cost: Short-run costs are the costs which vary with the change in output, the size of the firm remaining the same. Short-run costs are the same as variable costs. On the other hand, long- run costs are incurred on the fixed assets, like plant, building, machinery, land etc. Long-run cost are the same as fixed-costs. However, in the long-run even the fixed costs become variable costs as the size of the firm or scale or production is increased. ANALYSIS OF SHORT RUN COST OF PRODUCTION: Definition of Short Run: Short run is a period of time over which at least one factor must remain fixed. For most of the firms, the fixed resource or factors which cannot be increased to meet the rising demand of the good is capital i.e., plant and machinery.
- 42. Dr. Bhati Rakesh42 | P a g e Short run, then, is a period of time over which output can be changed by adjusting the quantities of resources such as labor, raw material, fuel but the size or scale of the firm remains fixed. Definition of Long Run: In the long run there is no fixed resource. All the factors of production are variable. The length of the long run differs from industry to industry depending upon the nature of production. For example, a balloon making firm can change the size of firm more quickly than a car manufacturing firm. Firm’s Short Run Cost Curves: The short run is an epoch in which the firm cannot change its plant, equipment and the scale of organisation. To meet the amplified demand, it can raise output by hiring more labour and raw materials or asking the existing labour force to work overtime. The scale of organisation being fixed, the short run total costs TC are divided into total fixed costs (TFC) and total variable costs (TVC), TC = TFC + TVC. (1) Total Costs: These are those expenses incurred by a firm in producing a given quantity or a commodity. They include payments for rent, interest, wages, taxes and expenses on raw materials, electricity, water, advertising etc. (2) Total Fixed Cost: These costs of production that do not change with output. They are independent of the level of output. For example, the firm's resources which remain fixed in the short run are building, machinery and even staff employed on contract for work over a particular period. (3) Total Variable Costs: These costs of production that change directly with productivity. They rise when output increases and fall when output declines. For example, wages paid to the labor engaged in production, prices of raw material which a firm. incurs on the production of output are variable costs. A firm can reduce its variable cost by lowering output but it cannot decrease its fixed cost. These expenses remain fixed in the short run. In the long run there are no fixed resources. All resources are variable. Therefore, a firm has no fixed cost in the long run. All long run costs are variable costs. (4) Short-run average costs: In the short run analysis of the firm average costs are more important than total costs. The units of productivity that a firm produces do not cost the same amount to the firm. (5) Short run average variable Costs: These are equal total variable costs at each level of output divided by the number of units produced. SAVC = TVC / Q. (6) Short Run Average Total Costs: These are the average costs of producing any given output. They are arrived at by dividing the total costs at each level of output by the number of units produced. The shape of these curves is U shaped. SAC or SAVC = TC / Q = (TFC / Q) + TVC / Q = AFC + AVC (7) Short run Marginal Cost: A fundamental concept for the determination of the exact level of output of a firm is the marginal cost. Marginal Cost is the addition to total cost by producing an additional unit of output. SHORT RUN COSTS OF A FIRM IS NOW EXPLAINED WITH THE HELP OF A SCHEDULE : The short run cost data of the firm shows that total fixed cost TFC (column 2) remains constant at100/- regardless of the level of output. The column 3 indicates variable cost which is associated with the level of output. Total variable cost is zero when production is zero. Total variable cost increases with the increase in output. The variable does not increase by the same amount for each increase in output. Initially the variable cost increases by a smaller amount up to 3rd unit of output and after which it increases by larger amounts. Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for each level of output. The rise in total cost is more sharp after the 4th level of output. The concepts of costs, i.e., (1) total fixed cost (2) total variable cost and (3) total cost can be illustrated graphically.
- 43. Dr. Bhati Rakesh43 | P a g e ANALYTICAL IMPORTANCE OF FIXED AND VARIABLE COSTS: In the time of distinction between fixed cost and variable cost is a matter of degree, it all depends upon the contracts of a firm and the period of time under consideration. For example, if a firm makes contract with the labor for a certain period, then the firm has to bear the cost of the labor irrespective of the total produce. Under such conditions, the wages paid to the labor will be classified as fixed cost and not variable cost, as discussed under the heading of variable cost. Secondly, when the period of time is short, the distinction between fixed cost and variable cost can be made rigid but not in a longer period of time all fixed costs change into variable cost in the long run. FIRMS LONG RUN COST CURVES: In the long run, there are no fixed factors of production and hence no fixed costs. The firm can change its size or scale of plant and employ more or less inputs. Thus in the long run all factors are variable and hence all costs are variable. The long run average total cost or LAC curve of the firm shows the minimum average cost of producing various levels of output from all possible short run average cost curves SAC. Thus the LAC curves are derived from the SAC curves. The LAC curve can be viewed as a series of alternative short run situations into any one of which the firm can move. Each SAC curve represents a plant of a particular size which is suitable for a particular range of output. The firm will therefore make use of various plants up to that level where the short run average costs fall producing various outputs from all the plants used together. Let these three plants represented by their short run average cost curves SAC1, SAC2 and SAC3 which is represented in the diagram 2. Each curve represents the scale of the firm. SAC1 depicts a lower scale while the movement from SAC2 to SAC3 shows the firm to be of a larger size. Given this scale of firm it will produce up to the least cost per unit of output. For producing ON output, the firm can use SAC1 or SAC2 plant. The firm will however use the scale of plant represented by SAC1, since the average cost of production ON output is NB which is less than NA, the cost of producing this output on SAC2 plant. If the firm is to produce OL output it can produce at either of the two plants.
- 44. Dr. Bhati Rakesh44 | P a g e But it would be advantageous for the firm to use the plant SAC2 for the OL level of output. But it would be more possible for the firm to produce the larger output OM at the lowest average cost ME from this plant. However for output OH, the firm would use the SAC3 plant where the average cost HG is lower than HF of the SAC2 plant. Thus in the long run in order to produce any level of output the firm will use the plant which has the minimum unit cost. If the firm expands its scale by the three stages represented by SAC1, SAC2, and SAC3 curves, the thick wav like portions of these curves from the long run average cost curve. The dotted portions of these SAC curves are of no consideration during the long run because the firm would change the scale of plant rather than operate on them. CONCLUSION: In either case, the LAC falls or rises more slowly than the SAC curve because in the long run all costs become variable and few are fixed. The plant and equipment can be worked fully and more efficiently so that both the average variable costs are lower in the long run than in the short run. That is why the LAC curve is flatter than the SAC curve. Likewise, the LMC curve is flatter than SMC curve because all costs are variable and there are few fixed costs. In the short run, the market cost is related to both the fixed and variable costs. As a result the SMC curve falls and rises more swiftly than the LMC curve. It first calls and is below the LAC curve. Then it rises and cuts the LAC curve at its lowest point E and is above the latter throughout its length as given in the diagram 3. FEATURES OF LONG RUN AC CURVES: (1) Tangent curve: Different SAC curves represent different operational capacities of different plants in the short run. LAC curve is locus of all these points of tangency. The SAC curve can never cut a LAC curve though they are tangential to each other. This implies that for any given level of output, no SAC curve can ever be below the LAC curve. Hence, SAC cannot be lower than the LAC in the long run. Thus, LAC curve is tangential to various SAC curves. (2) Envelope curve: It is known as Envelope curve because it envelopes a group of SAC curves appropriate to different levels of output. (3) Flatter U-shaped or dish-shaped curve: The LAC curve is also U shaped or dish shaped cost curve. But It is less pronounced and much flatter in nature. LAC gradually falls and rises due to economies and diseconomies of scale. (4) Planning curve: The LAC cure is described as the Planning Curve of the firm because it represents the least cost of producing each possible level of output. This helps in producing optimum level of output at the minimum LAC. This is possible when the entrepreneur is selecting the optimum scale plant. Optimum scale plant is that size where the minimum point of SAC is tangent to the minimum point of LAC. (5) Minimum point of LAC curve should be always lower than the minimum point of SAC curve: This is because LAC can never be higher than SAC or SAC can never be lower than LAC. The LAC curve will touch the optimum plant SAC curve at its minimum point. (6) A rational entrepreneur would select the optimum scale plant. Optimum scale plant is that size at which SAC is tangent to LAC, such that both the curves have the minimum point of tangency. In the diagram, OM2 is regarded as the optimum scale of output, as it has the least per unit cost. At OM2 output LAC = SAC. (7) LAC curve will be tangent to SAC curves lying to the left of the optimum scale or right side of the optimum scale. But at these points of tangency, neither LAC is minimum nor will SAC be minimum. SAC curves are either rising or falling indicating a higher cost ECONOMIES OF SCALE: INTERNAL ECONOMIES OF SCALE: Internal economies of scale are those which arise from the growth of the firm independently of what is happening to other firms. The broad divisions of internal economies of scale are (1) Technical Economies (2) Marketing Economies (3) Financial Economies (4)Risk Bearing Economies.
- 45. Dr. Bhati Rakesh45 | P a g e INTERNAL ECONOMIES: This happens when better use is made in factors of production within the firm and by increasing output the factors in the internal economies are as follows. (1) LABOUR ECONOMIES: Enlarged scale of production allows division of labour and specialization with the result of an improvement in the skills. The division of labour which apart from increasing the skills of labour force, results in (i) Time Saving which is lost in shifting the worker from one job to another (ii) Promotion of New Inventions and (iii) Automation of Production Process. (2) TECHNICAL ECONOMIES: (a) Economies of superior technique: If firm is big it can use high technology (automated machinery) and it can produce high quality goods and cost can be also reduced. (b) Economies of increased dimensions: This is purely mechanical advantage A big ship is more economical then small ship for transportation Double Decker is more economical than single Decker for traveling. (c) Economies of linked process: Arranging production process in a correct sequence/order can lead to make Production continuous. Complete production process should be at one place only. (d) Economies of Power: Uses of Large Machines are more economical than using small machines. (e) Economies of continuation: Production process should be continuous so that the usage of raw material and other input can be utilized in properly and in efficient manner. Wastage can be reduced. (3) MANAGERIAL ECONOMIES: As a firm grows, there is greater potential for managers to specialise in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles. (4) MARKETING ECONOMIES: If a firm purchase high volume of raw material from the suppliers it cost less, than purchasing small volumes. Employing purchasing expert in the firm to purchase required raw material for the production prevents wastage of excess raw material and it also reduces cost. (5) FINANCIAL ECONOMIES: Many small businesses find it hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates. (6) RISK MINIMIZING ECONOMIES: Producing different types of products by one company has good scope in market rather than producing single variety. Eg: ITC company produces different types of soaps. EXTERNAL ECONOMIES: In the words of Cairn cross, "External economies are those which are shared in by a number of firms or industries when the scale of production in any industry or group of industries increases. They are not monopolised by a single firm when it grows in size, but are conferred on it when some other firms grow larger.' External economies of scale occur when a firm benefits from lower unit costs as a result of the whole industry growing in size. The main types are: (1) Economies of localization: All firms should be localized to have economies. Different production department should be located at one place. This gives advantage in transportation and in timely labour utilization in production. (2) Economies of information and technical market intelligence: Industry enjoys research advantage, when Management can get whatever the information they want with in short time when firms allocated at one place. (3) Economies of vertical integration: Some industries rather than producing spare parts by themselves, they are purchasing from outside companies. This happens when company feels that buying of parts is cheaper than they produce by themselves. (4) (Make or Buy decision) E.g.: TATA Company purchased gear box for cars from kinetic Company, Mahindra cars purchasing engine from Renault Company. (5) Economies of Bi products: The firm using one raw material for manufacturing different other products can give more returns (profits) to the firm. E.g. Amul India, Company producing different food products from milk.
- 46. Dr. Bhati Rakesh46 | P a g e
- 47. Dr. Bhati Rakesh47 | P a g e REVENUE ANALYSIS AND PRICING POLICIES: Introduction, Revenue: Meaning and Types, Every firm or producer aims at maximisation of its profits. The maximisation of profit is only possible when the cost of production of a commodity is at its minimum level and the price is at its maximum level. Thus, the volume of profit is the difference between the total revenue and total cost of an individual firm or producer. In economics, revenue is studied in terms of Total Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR). a) Total Revenue: A firm sells 100 units of a particular commodity for Rs. 10 each. If you were to calculate the amount realized by the firm, the answer is simple – Rs. 1,000 (100 x 10). This is the total revenue for the firm. Hence, the total revenue refers to the amount of money realized by a firm on the sale of a commodity. Total revenue is expressed as follows: TR = P x Q … where TR – Total Revenue, P – Price, and Q – Quantity of the commodity sold. b) Average Revenue: Average revenue is simply the revenue earned per unit of the output. In simpler words, it is the price of one unit of the output. Average revenue is expressed as follows: AR=TR/Q … where AR – Average Revenue, TR – Total Revenue, and Q – Quantity of the commodity sold. By using the formula for total revenue, we get AR=P×QQ Or AR = P c) Marginal Revenue: Marginal revenue (MR) is the change in total revenue resulting from the sale of an additional unit of a commodity. For example, consider a firm selling 100 units of a commodity and realizing a total revenue of Rs. 1,000. Further, it realizes a total revenue of Rs. 1,200 after selling 101 units of the same commodity. Therefore, the marginal revenue is Rs. 200. Marginal revenue is also defined as the rate of change of total revenue resulting from the sale of an additional unit of a commodity. Therefore, MR=ΔTRΔQ … where MR – Marginal revenue, TR – Total revenue, Q – Quantity of the commodity sold, and Δ – the rate of change. Further, for one unit change in output, we have MRn = TRn – TRn-1 Where, TRn – the total revenue when the sales are at the rate of ‘n’ units per period. TRn-1 – the total revenue when the sales are at the rate of (n-1) units per period. RELATIONSHIP BETWEEN REVENUES AND PRICE ELASTICITY OF DEMAND There are simple, direct relations between price elasticity, marginal revenue, and total revenue. It is worth examining such relations in detail, given their importance for pricing policy. It is important to note that the marginal revenue, average revenue and price elasticity of demand are related to one another through the following formula: MR=AR×e–1e … where ‘e’ is the price elasticity of demand. Further, If e = 1, then MR=AR×1–11=0 If e > 1, then MR is positive. If e < 1, then MR is negative. All linear demand curves, except perfectly elastic or perfectly inelastic ones, are subject to varying elasticities at different points on the curve. In other words, any linear demand curve is price elastic at some Revenue Analysis and Pricing Policies: Introduction, Revenue: Meaning and Types, Relationship between Revenues and Price Elasticity of Demand, Pricing Policies, Objectives of Pricing Policies, Cost plus pricing. Marginal cost pricing. Cyclical pricing. Penetration Pricing. Price Leadership, Price Skimming. Transfer pricing. Price Determination under Perfect Competition- Introduction, Market and Market Structure, Perfect Competition, Price-Output Determination under Perfect Competition, Short-run Industry Equilibrium under Perfect Competition, Short-run Firm Equilibrium under Perfect Competition, Long-run Industry Equilibrium under Perfect Competition, Long-run Firm Equilibrium under Perfect Competition. Pricing Under Imperfect Competition- Introduction, Monopoly, Price Discrimination under Monopoly, Bilateral Monopoly, Monopolistic Competition, Oligopoly, Collusive Oligopoly and Price Leadership, Pricing Power, Duopoly, Industry Analysis. Profit Policy: Break Even analysis. Profit Forecasting. Need for Government Intervention in Markets. Price Controls. Support Price. Preventions and Control of Monopolies. System of Dual Price. UNIT – 4
- 48. Dr. Bhati Rakesh48 | P a g e output levels but inelastic at others. The slope of a linear demand curve, ΔP/ΔQ, is constant; thus, its reciprocal, 1/(ΔP/ΔQ) = ΔQ/ΔP, is also constant. However, the ratio P/Q varies from 0 at the point where the demand curve intersects the horizontal axis and price = 0, to +∞at the vertical price axis intercept where quantity = 0. Because the price elasticity formula for a linear curve involves multiplying a negative constant by a ratio that varies between 0 and +∞, the price elasticity of a linear curve must range from 0 to –∞. Figure illustrates this relation. As the demand curve approaches the vertical axis, the ratio P/Q approaches infinity and _P approaches minus infinity. As the demand curve approaches the horizontal axis, the ratio P/Q approaches 0, causing _P also to approach 0. At the midpoint of the demand curve (ΔQ/ΔP) _ (P/Q) = –1; this is the point of unitary elasticity. PRICE ELASTICITY AND PRICE CHANGES The relation between price elasticity and total revenue can be further clarified by examining Figure and Table. Figure reproduces the demand curve shown in Figure along with the associated marginal revenue curve. The demand curve shown in Figure is of the general linear form where a is the intercept and b is the slope coefficient. It follows that total revenue (TR) can be expressed as P x Q. By definition, marginal revenue (MR) is the change in revenue following a one-unit expansion in output, ΔTR/ΔQ, The relation between the demand (average revenue) and marginal revenue curves becomes clear when one compares Equations. Each equation has the same intercept a. This means that both curves begin at the same point along the vertical price axis. However, the marginal revenue curve has twice the negative slope of the demand curve. This means that the marginal revenue curve intersects the horizontal axis at 1/2QX, given that the demand curve intersects at QX. Figure shows that marginal revenue is positive in the range where demand is price elastic, zero where _P = –1, and negative in the inelastic range. Thus, there is an obvious relation between price elasticity and both average and marginal revenue. As shown in Figure), price elasticity is also closely related to total revenue. Total revenue increases with price reductions in the elastic range (where MR> 0) because the increase in quantity demanded at the new lower price more than offsets the lower revenue per unit received at that reduced price. Total revenue peaks at the point of unitary elasticity (where MR= 0), because the increase in quantity associated with the price reduction exactly offsets the lower revenue received per unit. Finally, total revenue declines when price is reduced in the inelastic range (where MR < 0). Here the quantity demanded continues to increase with reductions in price, but the relative increase in quantity is less than the percentage decrease in price, and thus is not large enough to offset the reduction in revenue per unit sold. PRICE ELASTICITY AND OPTIMAL PRICING POLICY Firms use price discounts, specials, coupons, and rebate programs to measure the price sensitivity of demand for their products. Armed with such knowledge, and detailed unit cost information, firms have all the tools necessary for setting optimal prices. As a practical matter, firms devote enormous resources to obtain current and detailed information concerning the price elasticity of demand for their products. Price elasticity estimates represent vital information because these data, along with relevant unit cost information, are essential inputs for setting a pricing policy that is consistent with value maximization. This stems from the fact that there is a relatively simple mathematical relation between marginal revenue, price, and the point price elasticity of demand. Given any point price elasticity estimate, relevant marginal revenues can be determined easily. When this marginal revenue information is combined with pertinent marginal cost data, the basis for an optimal pricing policy is created. PRICING POLICIES Pricing means the process of selecting the pricing objectives, determining the possible range of prices, developing price strategies, setting the final price, and implementing and controlling pricing decision. The determination of price is very important and crucial decision. It affects all parties involved in the production, distribution, and consumption of goods. Price affects the volume of production and the amount of profit. It is a source of income to distributors. According to M.J. Jones and S.W. Jetty, “Pricing begins with an understanding of the corporate mission, target markets, and the marketing objectives; then pricing objectives are developed; next management estimates as to extent of flexibility in establishing prices by studying costs and profits internally and demand and competition externally; prices are, then set between these two extreme ends by deciding price strategies in the light of objectives so set; specific methods are used to set prices; final aspects in implementation and control that includes effective monitoring to get feedback on consumer response and competitive reaction.” According to W.J.Stanon, “Pricing is the functions of determining the products value in monetary terms.”
- 49. Dr. Bhati Rakesh49 | P a g e OBJECTIVES OF PRICING POLICIES, The pricing objectives reflect overall goal of the organization. It describes the what an organization wants to achieve through pricing. All the pricing policies and strategies are determined by the parameter of pricing objectives. So, pricing objective provides the guideline-setting the pricing policies and strategies. Moreover, the pricing objectives determine the overall objectives of the organization. The pricing objectives are as follows: 1. Profit Oriented Objectives Profit oriented objectives focus on profit. This objective can be profit maximization and achieve target return. To maximize profit: One of the objectives of pricing is to maximize the profit. It is very important to maximize the profit to run the organization.Some company set price to their products or services with a view of maximizing profit. It is very important to focus on profit maximization. Achieving target return: Another objective of pricing is to achieve target return.Some company may determine the price of their goods or services to achieve a certain return on investment or on sales. This is the desired profit. It is necessary to have target return in the pricing process. Achieving target return on sales: It is necessary to achieve target return on sales in pricing.Mostly resellers manage their pricing to achieve a target return on sales. For example, 10% of sales. If there is not more competition this objectives can be used. Achieving target return on investment: Pricing should focus on achieving target return on investment too.Manufacturing company manages pricing in order to achieve specified return on investment in manifesting, research and development, establishment and commercialization. For example, 5% on investment. 2. Sales Oriented Objectives Sales oriented pricing objectives focus on sales volume rather than on profit. The profit can be to gain sales volume and market share. Sales volume increase: One of the pricing objectives may be determined in terms of increasing sales volumes over the certain period of time. For example, 10% increase annually. This does not mean that profit should be avoided. Organization believes that higher sales volume will lead to lower unit costs and higher long run profit. It is necessary to focus in the increment in sales volume of the company. Maintain market share: Pricing should have the basic objectives in maintaining market share.Market share is really a meaningful measure of the success of a firm's marketing strategy. A market share price objective can be either to maintain the market share, to increase it or sometimes to decrease it. The company uses the price as an input to enjoy a target market share. This market share is normally expressed as a percentage of the total industry sales.
- 50. Dr. Bhati Rakesh50 | P a g e 3. Status Oriented Objectives Status oriented pricing focus on maintaining the current position. This objective can be described as “Don’t Rock the Boat” objective. The large companies in order to minimize the risk of loss and maintain their status adopt this objective. Organization does not take any initiative in the price change. These objectives are as follows: Stabilization of price: Pricing should have the objectives in stabilizing the price of a product.Some organization may set their pricing objective in order to maintain or stabilize price and prevent from market uncertainty. These objectives are adopted for minimizing the risk of loss. Small organizations in market adopt these objectives. These objectives build up their status and goodwill. Meet competition: The objective of pricing is to meet the competition in the market. Now there is big competition in the market.In highly competitive market some organization may set the meet competition. Under this objective organization set the prevailing market price. It is important to meet the competition in the market. Without it, market cannot achieve its objectives. IMPORTANCE OF PRICING The importance of pricing has been increasing substantially in the recent years. The role of the price is crucial not only in the national economy but also in the marketing sector, especially to the marketing organization or executives. Pricing is important to the economy, to the organization and to the customers. Some of the importance’s of the pricing in the business can be : (1) It is an effective tool for product differentiation & sales volume It helps to deal with market competition, inter-firm rivalry, inflation in the economy etc. (2) It acts as a tool to measure and compare products easily and qualitatively. (3) It governs the type and quality of customers. It affects – (4) The marketing programme (5) Alteration of resources (6) Consumer’s perception of product (7) It regulates – a. Promotional activities b. Extent of advertising c. New product development d. Improvement of product in terms of Quality, Sales volume / Revenue (1) COST BASED – BASED ON COST OF PRODUCTION Mark-up / Cost plus pricing – Selling price includes total cost plus mark-up /margin that the firm desires. Mark up Price = Unit cost (VC + FC)/(1 – desired return on sale) Full cost or Absorption cost pricing – Selling Price includes full cost of production and sales plus a mark-up required (desired) by the firm. It makes use of standard costing techniques. The cost includes – Fixed Cost + Variable Cost + Selling and administrative cost + Advertisement cost Break even or Target return pricing – Firm determines the breakeven point i.e. the volume of sales required to reach a no profit, no loss situation then sets prices in order to achieve a certain level of return on investment. T.R.P = Unit Cost + (Desired return X Invested Capital)/Unit Sales (2) MARKET / CUSTOMER / DEMAND BASED What the traffic can bear – The seller sets the maximum price that the buyers are willing to pay under given circumstances. Skimming Pricing – The seller sets a relatively high price when the product is introduced and then lowers the price over time. Penetration Pricing – The product is introduced at low prices initially and the price is increased subsequently with increase in demand and market share. (3) COMPETITION BASED Going rate or parity pricing – Price is determined on the basis of price of competitor’s product price is set similar to the price of competitor’s product. Discount Pricing – Price of the product is set below the price of competitor’s product.
- 51. Dr. Bhati Rakesh51 | P a g e Premium Pricing – Price is set above the price charged by the competitors for similar product. Tender / Sealed bid pricing – A contract or tender for the production of the product is floated in the market and many parties submit their proposals. The party with the lowest bid or quote gets the tender and the quoted amount is the price. (4) OTHER METHODS Differentiated pricing – Different prices are charged from different customers on the basis of – 1] Customer segments 2] Time 3] Location/Area 4] Product Quantity 5] Product attributes Affordability / Social welfare – In case of essential commodities, prices are set in such a way that all sections of people in the society can afford it. Price may also be below the cost of product due to subsidies provided by the government. PRICING STRATEGIES Product line pricing – Prices are set on the basis of well established price points of other products in the product line. Optional Pricing – A base price is set for the basic product and prices are set for optional features, services along with the main product. Bundle pricing – Sellers offer a bundle or package of different products or services for a lower price than they would charge if the customer bought all of them separately. Penetration Pricing – The seller tries to penetrate the market with a low price and increases the price subsequently with increase in demand. Skimming Pricing – The seller tries to skim the profit from the market by charging a high price in the initial stages and lowers the price in the long run. Value based pricing – Seller sets the prices according to the value perceived by the customer of the product/service. Loss leader Pricing – Prices are set very low, sometimes below cost to encourage sales of other products or a retail outlet. Captive pricing – A special price is offered to loyal customers. Psychological pricing – Prices are set according to emotional appeals that influence buying decisions. E.g. Prestige pricing, Odd/even pricing, Bata pricing, Leader pricing Promotional pricing – Prices are set below MRP to stimulate purchases and increase awareness. It includes – Pricing for Special events, Low Interest Financing, Cash rebates, Warranties & Discounts Discount Pricing – It involves reduction of price from MRP for performing certain activities. It includes cash discounts, quantity discounts and seasonal discounts. Discriminatory Pricing – Seller sells a product at two or more prices based on Customer segments, Location, Time and availability of product, Product or brand image. Going Rate Pricing – Price is set on the basis of prevailing market rate. EDLP (Every Day Low Prices) – Retail stores offer low prices to customers every day in comparison with competitors to promote sales and increase footfall without any special occasion, event or discount. COST PLUS PRICING: The most widely used method for determining prices involves setting prices predominantly on the basis of the company’s costs. This method is referred to as ‘cost-plus’ pricing. In its simplest form it involves a company calculating average costs of production and then allocating a specified markup, which may be related to rate of return required by the company, to arrive at the selling price. The major advantage of this method is its simplicity. However, despite its widespread use, it has been criticized. Before we examine the basis of these criticisms we need to examine further the mechanics of cost-plus pricing, as well as some of the reasons why this apparently ‘simple’ approach to pricing may be more complex than it seems at first glance. MARKUP PRICING is the most commonly employed pricing method. Given the popularity of the technique, it behooves managers to fully understand the rationale for markup pricing. When this rationale is understood, markup pricing methods can be seen as the practical means for achieving optimal prices under a
- 52. Dr. Bhati Rakesh52 | P a g e wide variety of demand and cost conditions. Profit margins, or markups, are sometimes calculated as a percentage of price instead of cost. Profit margin is the numerator of the markup-on-price formula, as in the markup-on-cost formula. However, unit cost has been replaced by price in the denominator. The markup-on- cost and markup-on-price formulas are simply alternative means for expressing the relative size of profit margins. To convert from one markup formula to the other, just use the following expressions: Markup on Cost = Markup on Price/1 – Markup on Price Markup on Price = Markup on Cost/1 + Markup on Cost Therefore, the 30 percent markup on cost is equivalent to a 23 percent markup on price: Markup on Price = 0.3 /1 + 0.3 = 0.23 or 23% Markup pricing is sometimes criticized as a naive pricing method based solely on cost considerations— and the wrong costs at that. Some who employ the technique may ignore demand conditions, emphasize fully allocated accounting costs rather than marginal costs, and arrive at suboptimal price decisions. However, a categorical rejection of such a popular and successful pricing practice is clearly wrong. Although inappropriate use of markup pricing formulas will lead to suboptimal managerial decisions, successful firms typically employ the method in a way that is consistent with profit maximization. Markup pricing can be viewed as an efficient rule of- thumb approach to setting optimal prices. ROLE OF COST IN MARKUP PRICING : Although a variety of cost concepts are employed in markup pricing, most firms use a standard, or fully allocated, cost concept. Fully allocated costs are determined by first estimating direct costs per unit, then allocating the firm’s expected indirect expenses, or overhead, assuming a standard or normal output level. Price is then based on standard costs per unit, irrespective of short-term variations in actual unit costs. During peak periods, when facilities are fully utilized, expansion is required to increase production. Under such conditions, an increase in production requires an increase in all plant, equipment, labor, materials, and other expenditures. However, if a firm has excess capacity, as during off-peak periods, only those costs that actually rise with production—the incremental costs per unit—should form a basis for setting prices. Successful firms that employ markup pricing use fully allocated costs under normal conditions but offer price discounts or accept lower margins during off-peak periods when excess capacity is available. In some instances, output produced during off-peak periods is much cheaper than output produced during peak periods. “Early bird” or afternoon matinee discounts at movie theaters provide an interesting example. Except for cleaning expenses, which vary according to the number of customers, most movie theater expenses are fixed. As a result, the revenue generated by adding customers during off-peak periods can significantly increase the theater’s profit contribution. ROLE OF DEMAND IN MARKUP PRICING: Successful companies differentiate markups according to variations in product demand elasticities. Foreign and domestic automobile companies regularly offer rebates or special equipment packages for slow-selling models. Similarly, airlines promote different pricing schedules for business and vacation travelers. The airline and automobile industries are only two examples of sectors in which vigorous competition requires a careful reflection of demand and supply factors in pricing practice. MARKUPS CHARGED ON A VARIETY OF GROCERY ITEMS: by Post and Kellogg’s competing with a variety of local store brands. Cheerios and Wheaties, both offered only by General Mills, Inc., enjoy a markup on cost of 15 percent to 20 percent. Thus, availability of substitutes directly affects the markups on various cereals. It is interesting to note that among the wide variety of items sold in a typical grocery store, the highest margins are charged on spices. Apparently, consumer demand for nutmeg, cloves, thyme, bay leaves, and other spices is quite insensitive to price. The manager interviewed said that in more than 20 years in the grocery business, he could not recall a single store coupon or special offered on spices. This retail grocery store pricing example provides valuable insight into how markup pricing rules can be used in setting an efficient pricing policy. It is clear that the price elasticity concept plays a key role in the firm’s pricing decisions. To examine those decisions further, it is necessary to develop a method for determining optimal markups in practical pricing policy. MARGINAL COST PRICING: Marginal or direct cost pricing is where prices are based not on full costs that include fixed costs, but direct or marginal costs. Fixed costs are not charged to production as they are treated as a period charge and written off to the profit and loss account. In this way, the problems associated with having to cover costs, and the methods of having to allocate fixed costs, are avoided. This makes use of the notion of ‘contribution’ discussed earlier. Needless to say, in the long run all costs, including fixed costs, must be covered, but marginal cost pricing does at least allow a company to take advantage of market opportunities and to use
- 53. Dr. Bhati Rakesh53 | P a g e price as a more strategic tool of marketing. This approach is particularly useful for services marketing where the service cannot be stored, i.e. is highly perishable, such as cinema seats or hotel bedrooms. Prices can then be based on making a contribution to fixed costs by charging prices which cover variable, but not total costs. EasyJet and Ryanair make good use of marginal-cost pricing in their marketing strategies. These operators cover their variable costs when selling an airline seat rather than let the plane fly with empty seats. Provided of course that there are enough ‘full price’ paying passengers, this is an effective way of not only making a contribution to profits, but at the same time making life difficult for costplus competitors. Another example of marginal cost pricing can be found in the hotel industry. Hoteliers know that if a hotel room is not sold on a particular evening then the revenue that letting the room would generate for that evening is lost for ever. This is due to the service product characteristic of ‘perishability’, i.e. a service cannot be stored and sold again on another occasion. This makes it imperative that demand and supply of services be balanced and matched. Price is the primary mechanism for achieving this match. In the case of the hotel reducing the price of unsold rooms, this allows the marketer to generate some contribution and the room should be let at a discount if the full price cannot be achieved. Marginal pricing, especially for services, makes sense and is popular. CYCLICAL PRICING Cyclical Pricing refers to appropriate pricing strategy at different stages of Business Cycle Every Business Cycle consists of four phases: Recession, Depression, Recovery and Prosperity. Contraction comprises of the first two phases and the last two phases constitute expansion. Business Cycles cause decline in aggregate economic activity, which results in fall in purchasing power of the consumers. As a result of this, it is argued that strategies are to be revised and appropriate pricing policies need to be adopted depending on the phase of Business Cycle the economy passes through. There lies a difference in opinion regarding appropriate pricing policy during various phases of Business Cycle. Experts are polarized in terms of appropriateness of pricing policy. Here both the suggested policies are presented: (1) Rigid Pricing (2) Flexible Pricing Let us examine justifications of both the options one by one: 1] Rigid Pricing: During contraction and depression of an economy, purchasing power of customers decline. But so far as necessity items are concerned, customers do not have to find any choice but to purchase these products irrespective of the condition of the economy. Thus, adjustment of price for different stages of Business Cycle cannot show better results. For the expensive durable goods, which are not so necessary, deliberate reduction in price, the advocates of this pricing strategy believes, will cause postponement of purchase decision by prospective buyers with an expectation of further decline in price. So, adjustment in price depending on phases of Business cycle in unlikely to help the firms. For the capital goods (machines used to manufacture other machines), price reduction during contraction cannot improve business performance, since business of end product shows lackluster. Thus, if price is reduced during contraction, it is unlikely that any improvement in business will be experienced. This logic favours Rigid Pricing, which does not allow any adjustment of price depending on different stages of business. 2] Flexible Pricing: Flexible Pricing, as a concept, is just opposite to Rigid Pricing. The justification of Flexible Pricing is easier to understand if we consider the case of agricultural products. Since supply of agricultural products is inelastic, (i.e., the supply curve is a vertical straight line), leftward shift in the demand curve of these products reduces equilibrium price. Only a policy to recourse to Flexible Pricing, and by linking it to the general price index, loss arising out of unsold products will have to be borne by the producers. This adjustment in price is referred to as “General Price Index Pricing”. For industrial products, the argument is different. Higher profit of firms can be generated by securing more customers through reduction in price. That is, reduced per unit profit can more than offset increase in quantity, provided price elasticity of demand for the product is high. There can be another possibility. If a new type of car is invented, where a cheaper fuel can be used (say, bio-diesel), then that type of car can be sold at a high price (assuming that there is a huge price gap between bio-diesel and ordinary diesel) even during contraction phase of Business Cycle. Since this adjustment of price is totally dependent on nature of demand, it is referred to as “Product Demand Linked Pricing”. PENETRATION PRICING
- 54. Dr. Bhati Rakesh54 | P a g e Penetration pricing is a pricing strategy that is used to quickly gain market shareby setting an initially low price to entice customers to purchase from the company. Such pricing strategy is generally used by new entrants into a market. An extreme form of penetration pricing is called predatory pricing. Rationale Behind Penetration Pricing It is common for a new entrant to use a penetration pricing strategy to compete effectively in the marketplace. Price is one of the easiest ways to differentiate new entrants among existing market players. The overarching goal of the pricing strategy is to: 1. Capture market share 2. Create brand loyalty 3. Switch customers from competitors 4. Generate significant demand and utilize economies of scale 5. Drive competitors out of the market Situations where penetration pricing works effectively: 1. When there is little product differentiation 2. Demand is price-elastic 3. Where the product is suitable for a mass market (utilizing economies of scale) Illustration and Example of Penetration Pricing A current small-sized player in the marketplace that sells laundry detergent at $15. Company A is an international company with a large amount of excess production capacity and is, therefore, able to produce laundry detergents at a significantly lower cost. Company A decides to enter the market, employ a penetration pricing strategy, and sell laundry detergent at a sale price of $6.05. The company’s cost to produce a laundry detergent is $6. With a marginal cost of $6 and a sale price of $6.05, Company A is making nominal profits per sale. However, the company is comfortable with this decision as their overarching goal is to switch customers over, capture as much market share as possible, and utilize economies of scale with their high production capacity. Company A believes that its competitor will not be able to sustain itself in the long-term and will eventually exit the market. When the competitor exits the marketplace, it will become the only seller of laundry detergent and therefore be able to establish a monopoly over the market. ADVANTAGES OF PENETRATION PRICING 1] High adoption and diffusion: Penetration pricing allows a product or service to be quickly accepted and adopted by customers. 2] Marketplace dominance: Competitors are typically caught off guard in a penetration pricing strategy and are afforded little time to react. The company is able to utilize the opportunity to switch over as many customers as possible. 3] Economies of scale: The pricing strategy generates high sales quantity that allows a firm to realize economies of scale and lower marginal cost. 4] Increased goodwill: Customers that are able to find a bargain in a product or service are likely to return to the firm in the future. In addition, the increased goodwill creates positive word of mouth. 5] High turnover: Penetration pricing results in an increased turnover rate, making vertical supply chain partners such as retailers and distributors happy. DISADVANTAGES OF PENETRATION PRICING Pricing expectation: When a firm uses a penetration pricing strategy, customers often expect permanently low prices. If prices gradually increase, customers will become dissatisfied and may stop purchasing the product or service. 1] Low customer loyalty: Penetration pricing typically attracts bargain hunters or those with low customer loyalty. Said customers are likely to switch to competitors if they find a better deal. 2] Damage brand image: It may affect the brand image and cause customers to perceive the brand as cheap. 3] Price war among competitors: It results in retaliation from competitors trying to maintain their market share. Pricing war may decrease profitability for the overall market. 4] Inefficient long-term strategy: It is not a viable long-term pricing strategy. In many cases, firms that use the strategy face a loss of profits. In this case, the firm may not be able to recover its cost if it uses penetration pricing over an extended timeframe.
- 55. Dr. Bhati Rakesh55 | P a g e PRICE LEADERSHIP Price leadership is a situation in which one company, usually the dominant one in its industry, sets prices which are closely followed by its competitors. This firm is usually the one having the lowest production costs, and so is in a position to undercut the prices charged by any competitor who attempts to set its prices lower than the price point of the price leader. Competitors could charge higher prices than the price leader, but this would likely result in reduced market share, unless competitors could sufficiently differentiate their products. Price leadership is not in the best interests of customers when the price leader sets prices higher than would have resulted under a normal level of competition. However, the reverse is usually the case, where the price leader uses its production and purchasing volume to continually drive down prices - which must be matched by any competitors who want to remain in the industry. For price leadership to exist at a high price point, there needs to be tacit collusion between the main competitors in the industry. This is not the case when price leadership drives down the price point, since competitors have little choice but to match the low prices. The following are conditions under which price leadership can exist: 1] Collusion. Competitors tacitly agree to follow the price leadership of one company. 2] Overwhelming market share. If one company has by far the largest market share in the industry, its much smaller competitors have no choice other than to follow its lead on prices. 3] Trend knowledge. One company may be unusually good at spotting industry trends, so the other companies in the industry find it easier to follow its pricing leadership than to spend time and money to develop the same level of knowledge. This is known asbarometric price leadership. Advantages of Price Leadership The following is an advantage of the price leadership method: 1] High profit margin. If a company can set high price points and competitors are willing to follow those price points, then the company can earn inordinately high profits. Disadvantages of Price Leadership The following are disadvantages of using the price leadership method: 1] Defensive effort. There are several reasons why an industry may accept a particular company as its price leader, several of which involve having to monitor competitors and take reactive steps if they do not follow the company's price leadership position. 2] Complacency. A company that successfully exercises price leadership may become complacent and not keep its cost structure sufficiently lean to allow it to still earn a profit if a price war develops. PRICE SKIMMING Price skimming, also known as skim pricing, is a pricing strategy in which a firm charges a high initial price and then gradually lowers the price to attract more price-sensitive customers. The pricing strategy is usually used by a first mover who faces little to no competition. Price skimming is not a viable long-term pricing strategy as competitors eventually launch rival products and put pricing pressure on the first company. Rationale Behind Price Skimming Price skimming is used to maximize profits when a new product or service is deployed. Therefore, the pricing strategy is largely effective in a breakthrough product where the firm is the first to enter the marketplace. In such a strategy, the goal is to generate the maximum profit in the shortest time possible rather than maximum sales. It allows a firm to quickly recover its sunk costs before increased competition and pricing pressure. Consider the diffusion of innovation, a theory that explains the rate at which a product spreads throughout a social system. Innovators are those who want to be the first to get a new product or service. They are risk takers and price insensitive. A price skimming strategy tries to get the highest possible profit from innovators and early adopters. As the demand from the two segments fills up, the price of the product is reduced to target price-sensitive customers such as early majorities and late majorities. Illustration and Example of Price Skimming Company A is a phone manufacturing company that recently developed a new proprietary technology to be released to the market. Company A follows a price skimming strategy and sets a skim price at P1 to recover its research and development cost. After satisfying demand at P1, the company sets a follow-on price at P2 to capture price-desensitive customers and to put pricing pressure on competitors that enter the market. In the price skimming strategy above, Company A generates revenue = A + B with sales of Q1. With their follow- on pricing, the company generates additional revenue = C with sales of Q2-Q1. With the pricing strategy, the company generates total revenue of A + B + C with total sales of Q2. Advantages of Price Skimming a) Perceived quality: Price skimming helps build a high-quality image and perception of the product.
- 56. Dr. Bhati Rakesh56 | P a g e b) Cost recuperation: It helps a firm quickly recover its costs of development. c) High profitability: It generates a high profit margin for the company. d) Vertical supply chain benefits: It helps distributors earn a higher percentage. The markup on a Rs.500 product is far more substantial than on a Rs.5 item. Disadvantages of Price Skimming a) Deterrence: If the firm is unable to justify its high price, consumers may not be willing to purchase the product. b) Limitation of sales volume: A firm may not be able to utilize economies of scale if a skim price generates too little sales. c) Inefficient long-term strategy: Price skimming is not a viable long-term pricing strategy as competitors will eventually enter the market with rival products and pricing pressure. d) Consumer loyalty: If a product that costs Rs.1,000 at launch has a follow-on price of Rs.200 in a couple of months, innovators and early adopters may feel ripped off. Therefore, if the firm has a history of price skimming, consumers may wait a couple of months before purchasing the product. TRANSFER PRICING Expanding markets brought about by improvements in communication and transportation, as well as falling trade barriers, have led to the development of large, multidivision firms that cut across national boundaries. Avexing challenge for many large corporations surrounds the need to set an appropriate price for the transfer of goods and services among divisions. The transfer pricing problem results from the difficulty of establishing profitable relationships among divisions of a single company when each separate business unit stands in verticalrelation to the other. A vertical relation is one where the output of one division or company is the input to another. Vertical integration occurs when a single company controls various links in the production chain from basic inputs to final output. Media powerhouse AOL-Time Warner, Inc., is vertically integrated because it owns AOL, an Internet service provider (ISP) and cable TV systems, plus a number of programming properties in filmed entertainment (e.g., Warner Bros.) and television production (e.g., HBO, CNN), commonly referred to as content providers. Vertically integrated companies in this field own and operate the distribution network and the programming that is sold over that network. To combat the problems of coordinating large-scale enterprises that are vertically integrated, separate profit centers are typically established for each important product or product line. Despite obvious advantages, this decentralization has the potential to create problems. The most critical of these is the problem of transfer pricing, or the pricing of intermediate products transferred among divisions. To maximize profits for the vertically integrated firm, it is essential that a profit margin or markup only be charged at the final stage of production. All intermediate products transferred internally must be transferred at marginal cost. TRANSFER PRICING FOR PRODUCTS WITHOUT EXTERNAL MARKETS Think of the divisionalized firm as a type of internal market. Like external markets, the internal markets of divisionalized firms act according to the laws of supply and demand. Supply is offered by various upstream suppliers to meet the demand of downstream users. Goods and services must be transferred and priced each step along the way from basic raw materials to finished products. For simplicity, consider the problem faced by a vertically integrated firm that has different divisions at distinct points along the various steps of the production process, and assume for the moment that no external market exists for transferred inputs. If each separate division is established as a profit center to provide employees with an efficiency incentive, a transfer pricing problem can occur. Suppose each selling division adds a markup over its marginal cost for inputs sold to other divisions. Each buying division would then set its marginal revenue from output equal to the division’s marginal cost of input. This process would culminate in a marginal cost to the ultimate upstream user that exceeds the sum total of marginal costs for each transferring division. All of the markups charged by each ransferring division drive a wedge between the firm’s true marginal cost of production and the marginal cost to the last or ultimate upstream user. As a result, the ultimate upstream user buys less than the optimal amount of input and produces less than the profit-maximizing level of output. For example, it would be inefficient if AOL, a major ISP, paid more than the marginal cost of programming produced by its own subsidiaries. If each subsidiary added a markup to the marginal cost of programming sold to the parent company, AOL would buy less than a profitmaximizing amount of its own programming. In fact, AOL would have an incentive to seek programming from other purveyors so long as the external market price was less than the internal transfer price. Such an incentive could create extreme inefficiencies, especially when the external market price is less than the transfer price but greater than the marginal cost of programming produced by AOL’s own subsidiaries.
- 57. Dr. Bhati Rakesh57 | P a g e An effective transfer pricing system leads to activity levels in each division that are consistent with profit maximization for the overall enterprise. This observation leads to the most basic rule for optimal transfer pricing: When transferred products cannot be sold in external markets,the marginal cost of the transferring division is the optimal transfer price. One practical means for insuring that an optimal amount of input is transferred at an optimal transfer price is to inform buying divisions that the marginal cost curve of supplying divisions is to be treated like a supply schedule. Alternatively, supplying divisions could be informed about the buying division’s marginal revenue or demand curve and told to use this information in determining the quantity supplied. In either case, each division would voluntarily choose to transfer an optimal amount of input at the optimal transfer price. TRANSFER PRICING WITH PERFECTLY COMPETITIVE EXTERNAL MARKETS The transfer pricing problem is only sightly more complicated when transferred inputs can be sold in external markets. When transferred inputs can be sold in a perfectly competitive external market, the external market price represents the firm’s opportunity cost of employing such inputs internally. As such, it would never pay to use inputs internally unless their value to the firm is at least as great as their value to others in the external market. This observation leads to a second key rule for optimal transfer pricing: When transferred products can be sold in perfectly competitive external markets, the external market price is the optimal transfer price. If upstream suppliers wish to supply more than downstream users desire to employ at a perfectly competitive price, excess input can be sold in the external market. If downstream users wish to employ more than upstream suppliers seek to furnish at a perfectly competitive price, excess input demand can be met through purchases in the external market. In either event, an optimal amount of input is transferred internally. Of course, it is hard to imagine why a firm would be vertically integrated in the first place if all inputs could be purchased in perfectly competitive markets. Neither Kellogg’s nor McDonald’s, for example, have extensive agricultural operations to ensure a steady supply of foodstuffs. Grains for cereal and beef for hamburgers can both be purchased at prices that closely approximate marginal cost in perfectly competitive input markets. On the other hand, if an input market is typically competitive but punctuated by periods of scarcity and shortage, it can pay to maintain some input producing capability. For example, ExxonMobil Corp. has considerable production facilities that supply its extensive distribution network with gasoline, oil, and petroleum products. These production facilities offer ExxonMobil some protection against the threat of supply stoppages. Similarly, Coca-Cola has long-term supply contracts with orange growers to ensure a steady supply of product for its Minute Maid juice operation. Both ExxonMobil and Coca-Cola are examples of vertically integrated firms with inputs offered in markets that are usually, but not always, perfectly competitive. TRANSFER PRICING WITH IMPERFECTLY COMPETITIVE EXTERNAL MARKETS The typical case of vertical integration involves firms with inputs that can be transferred internally or sold in external markets that are not perfectly competitive. Again, it never pays to use inputs internally unless their value to the firm is at least as great as their value to others in the external market. This observation leads to a third and final fundamental rule for optimal transfer pricing: When transferred products can be sold in imperfectly competitive external markets, the optimaltransfer price equates the marginal cost of the transferring division to the marginal revenuederived from the combined internal and external markets. In other words, when inputs can be sold in imperfectly competitive external markets, internal input demand must reflect the opportunity to supply input to the external market at a price in excess of marginal cost. If upstream suppliers wish to offer more input than downstream users desire to employ when input MC= MR from the combined market, excess supply can be sold in the external market. If downstream users want to employ more than upstream suppliers seek to furnish when MC = MR, excess internal demand can be met through added purchases in the external market. In both cases, an optimal amount of input is transferred internally. CLASSIFICATIONS OF MARKETS The term ‘market’ originated from Latin word ‘marcatus’ having a verb ‘mercari’ implying ‘merchandise’ ‘ware traffic’ or ‘a place where business is conducted’. For a layman, the word ‘market’ stands for a place where goods and persons are physically present. For him, ‘market’ is ‘market’ who speaks of ‘fish market’, ‘mutton market’, ‘meat market’, ‘vegetable market’, ‘fruit market’, ‘grain market’. For him, it is a congregation of buyers and sellers to transact a deal. However, for us as the students of marketing, it means much more. In a broader sense, it is the whole of any region in which buyers and sellers are brought into contact with one another and by means of which the prices of the goods tend to be equalized easily and quickly.
- 58. Dr. Bhati Rakesh58 | P a g e Ordinarily, the term “market” refers to a particular place where goods are purchased and sold. But, in economics, market is used in a wide perspective. In economics, the term “market” does not mean a particular place but the whole area where the buyers and sellers of a product are spread. According to Prof. R. Chapman, “The term market refers not necessarily to a place but always to a commodity and the buyers and sellers who are in direct competition with one another.” Market can be classified on different basis. There are different types of markets on the basis of geographical area, time, business volume, nature of products, consumption, competition, seller's situation, nature of transaction etc. They are discussed below: 1. On the Basis of Area or Region. 2. Markets on the Basis of the Time Element. 3. Markets Based on Competition. 4. Market on the Basis of Functions. 5. On the Basis of Nature of Commodity. 6. Markets Based on Legality. On the Basis of Area or Region: On the basis of area or region a market can be classified into the following categories: 1. Local Market: When buyers and sellers of certain commodities are limited to an area or region then the market is called local market. Heavyweight goods and perishable goods have the local market because their demand is concerned with a particular area or region. For bricks, stones, milk, vegetables etc. 2. Regional Market: If the buyers and sellers of a commodity are concentrated in a certain region or state, The market is called regional market. The area is wide than the local market. The market for Mexico market is in Mexico. 3. National Market: When the demand for some goods is limited to the boundary of the country the market is called national market. Gandhi cap and Nehru jacket are examples of such markets. 4. International Market: When the demand for goods crosses the boundary of a country, the market is called international market. Gold, silver, food-grains, and medicines are bought and sold throughout the world. Hence their market is international market. Markets on the Basis of the Time Element: On the basis of the time management the market can be classified into following categories: 1. Very short period market: The supply of goods in this market is limited to their stock only. We cannot increase their supply. The demand determines the price of such commodities. 2. Short period market: During this period production can be increased to the productive capacity and produces cannot adjust the supply according to the demand. demand plays an important role in price determination. 3. Long period market: It is a market wherein the supply can be adjusted to the quantity demanded. All the factors of production are variable and even the scale of productions can be changed. Supply plays an important role in price determination. The price in this market is called ‘long-run price’ or ‘normal price’. 4. Very long period market: Under this market both demand and supply can be changed. Demand increases due to increase in population, change in tastes, habits, and fashions while supply can be increased by increasing the variable inputs and even the scale of production can be changed. There is price determination by the economic forces of demand and supply and the permanent equilibrium is attained. Thus, The market price is called ‘very long run price.’ Markets Based on Competition: On the basis of competition prevailing in the market the following classification is done: 1. Perfect market: The market where there is competition between sellers and buyers and within sellers and within buyers the market is called perfect market or ‘Perfect Competition Market’. 2. Monopolistic Competition: Monopolistic competition is a market structure found in the industry where there is a large number of small sellers selling differentiated but close substitute products. 3. Oligopoly: Oligopoly is one of the kinds of Imperfect competition. Such market structure is found when the number of sellers is few. Oligopoly(Classifications of Markets) is a market situation in which the number of sellers dealing in a homogeneous or differentiated product in small. 4. Duopoly: A market wherein there are two sellers or producers of a product is called do aDuopoly. They have a complete hold over the supply of that product. A product of both the sellers is Homogeneous and the prices are also the same. 5. Monopoly: A pure monopolist should be taken that who has full control out the supply of a particular product.
- 59. Dr. Bhati Rakesh59 | P a g e Market on the Basis of Functions: On the basis of functions, markets can be classified into following categories: 1. Mixed or General Market: A market where all types of goods are bought and sold is called mixed or general market. Markets in cities are found in this category. 2. Specialized Market: A Market where a particular commodity is sold is called up a specialized market. Vegetable market, foods market, Cloth Market are examples of such marketing. 3. Marketing by Samples: When the goods are bought and sold on the basis of samples. The market is called Marketing by samples. Oilseeds, food grains and raw cotton are bought and sold on the basis of samples. 4. Marketing by Grades: When the goods are graded and then different buyers and sellers deal in such goods on the basis of their grades, then the market is called Marketing by grades. Agricultural Products are graded and then they are sold accordingly.Dalda, bath soap, edible oil etc. Are sold on the basis of grading. On the basis of Nature of Commodity: The market is also Classified on the basis of nature of commodity is given below: 1. Product Market: A market where a particular product is bought and sold is called a product market. For example, agricultural products are sold in agricultural markets is a market of this type. 2. Stock Market: A market where is stock and shares, bonds, securities, debentures etc. are bought and sold is called the stock market. Bulls and bears are engaged in finalizing the transactions as per the market rates. 3. Bullion Market: A market where silver and gold are bought and sold is called Bullion market. In this market metallic trading takes place. Markets Classifications based on Legality: On the basis of legality, markets can be put into two categories are given below: 1. Legal Market: A market where legal transactions of goods and services take place between buyers and sellers. It is recognized by the government. It is also called a fair market. 2. Illegal Market: A market where high prices are charged what has been fixed by the government and it happens when the goods are in short supply. Businessman and traders earn profits by indulging in black marketing, smuggling, and hoarding. Hong Kong market is an illegal market (Classifications of Markets). MARKET STRUCTURE: Market structure refers to the nature and degree of competition in the market for goods and services. The structures of market both for goods market and service (factor) market are determined by the nature of competition prevailing in a particular market.
- 60. Dr. Bhati Rakesh60 | P a g e PERFECT COMPETITION: Perfect competition refers to a market structure where competition among the sellers and buyers prevails in its most perfect form. In a perfectly competitive market, a single market price prevails for the commodity, which is determined by the forces of total demand and total supply in the market Characteristics/Features of Perfect Competition The following features characterize a perfectly competitive market: 1. A large number of buyers and sellers: The number of buyers and sellers is large and the share of each one of them in the market is so small that none has any influence on the market price. 2. Homogeneous product: The product of each seller is totally undifferentiated from those of the others. 3. Free entry and exit: Any buyer and seller is free to enter or leave the market of the commodity. 4. Perfect knowledge: All buyers and sellers have perfect knowledge about the market for the commodity. 5. Indifference: No buyer has a preference to buy from a particular seller and no seller to sell to a particular buyer. 6. Non-existence of transport costs: Perfectly competitive market also assumes the nonexistence of transport costs. 7. Perfect mobility of factors of production: Factors of production must be in a position to move freely into or out of industry and from one firm to the other. Under such a market no single buyer or seller plays a significant role in price determination. EQUILIBRIUM OF THE FIRM AND INDUSTRY UNDER PERFECT COMPETITION Meaning of Firm and Industry According to Miller, “Firm is an organisation that buys and hires resources and sells goods and services”. Lipsey has defined as “firm is the unit that employs factors of production to produce commodities that it sells to other firms, to households, or to the government.” Industry is a group of firms producing standardised products in a market. According to Lipsey, “Industry is a group of firms that sells a well defined product or closely related set of products.” Conditions of Equilibrium of the Firm and Industry A firm is in equilibrium when it has no propensity to modify its level of productivity. It requires neither extension nor retrenchment. It wants to earn maximum profits in by equating its marginal cost with its marginal revenue, i.e. MC = MR. Diagrammatically, the conditions of equilibrium of the firm are (1) the MC curve must equal the MR curve. This is the first order and essential condition. But this is not a sufficient condition which may be fulfilled yet the firm may not be in equilibrium. (2) The MC curve must cut the MR curve from below and after the point of equilibrium it must be above the MR.
- 61. Dr. Bhati Rakesh61 | P a g e This is the second order condition. Under conditions of perfect competition, the MR curve of a firm overlaps with the AR curve. The MR curve is parallel to the X axis. Hence the firm is in equilibrium when MC = MR = AR. The first order figure (1), the MC curve cuts the MR curve first at point X. It contends the condition of MC = MR, but it is not a point of maximum profits for the reason that after point X, the MC curve is beneath the MR curve. It does not pay the firm to produce the minimum output OM when it can earn huge profits by producing beyond OM. Point Y is of maximum profits where both the situations are fulfilled. Amidst points X and Y it pays the firm to enlarges its productivity for the reason that it’s MR > MC. It will nevertheless stop additional production when it reaches the OM1 level of productivity where the firm fulfils both the circumstances of equilibrium. If it has any plants to produce more than OM1 it will be incurring losses, for its marginal cost exceeds its marginal revenue beyond the equilibrium point Y. The same finale hold good in the case of straight line MC curve and it is presented in the figure (2). An industry is in equilibrium, first when there is no propensity for the firms either to leave or either the industry and next, when each firm is also in equilibrium. The first clause entails that the average cost curves overlap with the average revenue curves of all the firms in the industry. They are earning only normal profits, which are believed to be incorporated in the average cost curves of the firms. The second condition entails the equality of MC and MR. Under a perfectly competitive industry these two circumstances must be fulfilled at the point of equilibrium i.e. MC = MR…. (1), AC = AR…. (2), AR = MR. Hence MC = AC = AR. Such a position represents full equilibrium of the industry. SHORT-RUN FIRM EQUILIBRIUM UNDER PERFECT COMPETITION Short period is a period in which supply can be increased by altering the variable factors. In this period fixed costs will remain constant. The supply is increased when price rises and vice versa. So the supply curve slopes upwards from left to right. A firm is in equilibrium in the short run when it has no propensity to enlarge or contract its productivity and needs to earn maximum profit or to incur minimum losses. The short run is an epoch of time in which the firm can vary its productivity by changing the erratic factors of production. The number of firms in the industry is fixed since neither the existing firms can leave nor new firms can enter it. Postulations 1. All firms use standardised factors of production 2. Firms are of diverse competence 3. Cost curves of firms are dissimilar from each other 4. All firms sell their produces at the equal price ascertained by demand and supply of the industry so that the price of each firm, P (Price) = AR = MR 5. Firms produce and sell various volumes The short run equilibrium of the firm can be described with the helps of marginal study and total cost revenue study. Marginal Cost, Marginal Revenue analysis – During the short run, a firm will produce only its price equals average variable cost or is higher than the average variable cost (AVC). Furthermore, if the price is more than the averages total costs, ATC, i.e. P = AR > ATC the firm will be earning super normal
- 62. Dr. Bhati Rakesh62 | P a g e profits. If price equals the average total costs, i.e. P = AR = ATC the firm will be earning normal profits or break even. If price equals AVC, the firm will be incurring losses. If price drops even a little below AVC, the firm will shut down since in order to produce it must cover atleast it’s AVC through short run. So during the short run, under perfect competition, affirm is in equilibrium in all the above mentioned stipulations. Super normal profits – The firm will be earning super normal profits in the short run when price is higher than the short run average cost. Normal Profits = The firm may earn normal profits when price equals the short run average costs. Total Cost – Total Revenue Analysis – The short run equilibrium of the firm can also be represented with the help of total cost and total revenue curves. The firm is able to maximise its profits when the positive discrimination between TR and TC is the greatest. SHORT-RUN INDUSTRY EQUILIBRIUM UNDER PERFECT COMPETITION, An industry is in equilibrium in the short run when its total output remains steady there being no propensity to enlarge or contract its productivity. If all firms are in equilibrium the industry is also in equilibrium. For full equilibrium of the industry in the short run all firms must be earning normal profits. But full equilibrium of the industry is by sheer accident for the reason that in the short rum some firms may be earning super normal profits and some losses. Even then the industry is in short run equilibrium when its quantity demanded and quantity supplied is equal at the price which clears the market. LONG-RUN FIRM EQUILIBRIUM UNDER PERFECT COMPETITION “Long-run” period is a period of many years. Long period is the time during which the supply conditions are fully able to meet the new demand conditions. In the long-run both fixed as well as variable factors are variable. In this period, new plants can be installed and new firms can enter into the market and the old firms can leave the market. Long period price is called by Adam Smith as “natural price” and Marshall called it as ‘normal price’. According to Marshall, “The normal value or price of a commodity is that which economic forces would tend to bring about in the long-run.” Over the long run, positive economic profits attract competitors. Expanding industry supply puts downward pressure on market prices and pushes cost upward because of increased demand for factors of production. Long-run equilibrium is reached when all economic profits and losses have been eliminated and each firm in the industry is operating at an output that minimizes long-run average cost (LRAC). Long-run equilibrium for a firm under perfect competition is graphed in Figure. At the profit-maximizing output, price (or average revenue) equals average cost, so the firm neither earns economic profits nor incurs economic losses. When this condition exists for all firms in the industry, new firms are not encouraged to enter the industry nor are existing ones pressured into leaving it. Prices are stable, and each firm is operating at the minimum point on its short-run average cost curve. All firms must also be operating at the minimum cost point on the long-run average cost curve; otherwise, they will make production changes, decrease costs, and affect industry output and prices. Accordingly, a stable equilibrium requires that firms operate with optimally sized plants. PRICING UNDER IMPERFECT COMPETITION- MONOPOLY: Perfect monopoly lies at the opposite extreme from perfect competition on the market structure continuum. Monopoly exists when a single firm is the sole producer of a good that has no close substitutes; in other words, there is a single firm in the industry. Perfect monopoly, like perfect competition, is seldom observed. CHARACTERISTICS OF MONOPOLY MARKETS Monopoly exists when an individual producer has the ability to set market prices. Monopoly firms are price makers as opposed to price takers. Their control over price typically requires A single seller. A single firm produces all industry output. The monopoly is the industry. Unique product. Monopoly output is perceived by customers to be distinctive and preferable to its imperfect substitutes. Blockaded entry and exit. Firms are heavily restricted from entering or leaving the industry. Imperfect dissemination of information. Cost, price, and product quality information is withheld from uninformed buyers. As in the case of perfect competition, these basic conditions are too restrictive for monopoly to be commonplace in actual markets. Few goods are produced by single producers, and fewer still are free from competition of close substitutes. Even public utilities are imperfect monopolies in most of their markets. Even though perfect monopoly rarely exists, it is still worthy of careful examination. Many of the economic relations
- 63. Dr. Bhati Rakesh63 | P a g e found under monopoly can be used to estimate optimal firm behavior in the less precise, but more prevalent, partly competitive and partly monopolistic market structures that dominate the real world. PRICE/OUTPUT DECISION UNDER MONOPOLY Under monopoly, the industry demand curve is identical to the firm demand curve. Because industry demand curves slope downward, monopolists also face a downward-sloping demand curve. for example, 100 units can be sold at a price of Rs. 10 a unit. At an Rs. 8 price, quantity demanded rises to 150 units. If the firm decides to sell 100 units, it will receive Rs. 10 a unit; if it wishes to sell 150 units, it must accept an Rs. 8 price. The monopolist can set either price or quantity, but not both. Given one, the value of the other is determined along the demand curve. A monopoly uses the same profit-maximization rule as does any other firm: It operates at the output level at which marginal revenue equals marginal cost. The monopoly demand curve is not horizontal, however, so marginal revenue does not coincide with price at any but the first unit of output. Marginal revenue is always less than price for output quantities greater than one because of the negatively sloped demand curve. Because the demand (average revenue) curve is negatively sloped and hence declining, the marginal revenue curve must lie below it. When a monopoly equates marginal revenue and marginal cost, it simultaneously determines the output level and the market price for its product. LONG-RUN EQUILIBRIUM UNDER MONOPOLY In general, any industry characterized by monopoly sells less output at higher prices than would the same industry if it were perfectly competitive. From the perspective of the firm and its stockholders, the benefits of monopoly are measured in terms of the economic profits that are possible when competition is reduced or eliminated. From a broader social perspective, these private benefits must be weighed against the costs borne by consumers in the forms of higher prices and reduced availability of desired products. Employees and suppliers also suffer from the reduced employment opportunities associated with lower production in monopoly markets. Monopolies have an incentive to underproduce and earn economic profits. Underproduction results when a monopoly curtails output to a level at which the value of resources employed, as measured by the marginal cost of production, is less than the social benefit derived, where social benefit is measured by the price that customers are willing to pay for additional output. Under monopoly, marginal cost is less than price at the profit-maximizing output level. Although resulting economic profits serve the useful functions of providing incentives and helping allocate resources, it is difficult to justify above-normal profits that result from market power rather than from exceptional performance. PRICE DISCRIMINATION UNDER MONOPOLY Price discrimination implies charging different prices from different customers or for different units of the same product. In the words of Joan Robinson – “The act of selling the same article, produced under single control at different prices to different buyers is known as price discrimination.” Price discrimination is possible when the monopolist sells in different markets in such a way that it is not possible to transfer any unit of the commodity from the cheap market to the dearer market. Types and Examples of Price Discrimination: Price discrimination may be of various types. It may either be (i) personal (ii) trade discrimination (iii) local discrimination. (1) Price discrimination. It is persona!, when separate price is charged from each buyer according to the intensity of his desire or according to the size of his pocket. For instance, a doctor may charge Rs. 30000 from a rich person for an eye operation and Rs.2500 only from a poor man for the similar operation. (2) Trade discrimination. It may take place when a monopolist charges different prices according to the uses to which the commodity is put. For example, an electricity company may charge low rate for electric current used in an industrial concern than for the electricity used for the domestic purpose. (3) Place discrimination. It occurs when a monopolist charges different prices for the same commodity at different places. This type of discrimination is called dumping. In Economics, a monopolist sells the same commodity at a higher price in one market and at a lower price in the other. Dumping may be undertaken due to several reasons, (a) a monopolist may resort to dumping in order to dispose off the accumulated stock or (b) he may, dump the commodity with a desire to capture the foreign market, (c) dumping may also be done to drive the competitors out of the market, (d) the motive may also be to reap. the economies of large scale production, etc.
- 64. Dr. Bhati Rakesh64 | P a g e DEGREES OF PRICE DISCRIMINATION: There are three main degrees of price discrimination: (1) First degree price discrimination, (2) Second degree price discrimination and (3) Third degree price discrimination. (1) First degree price discrimination. The monopolist charges a different price equal to the maximum amount for each unit of the commodity from each consumer separately. The price of each unit is equal to its demand price so that the consumer is unable to enjoy any consumer surplus. Such prices are charged by doctors, lawyers etc. In fact, the first degree price discrimination manifests itself in the form of as many prices as many consumers. (2) Second degree price discrimination. Here the monopolist divides his market into different groups of customers and charges each group the highest price which the marginal consumer belonging to that group is willing to pay. The railway, airlines etc., charge the fares from customers in this way. (3) Third degree price discrimination. In the third degree price discrimination, the monopolist divides the entire market into a few sub-markets and charges different prices for the same commodity in different sub- markets. The division here is among classes of consumers and not among individual consumers. Third degree price discrimination is possible only if the classes of consumers can be kept separate. Secondly, the various groups of customers must have different elasticities of demand for his commodity. The segment with a less elastic demand pays a higher price than the segment with a more elastic demand. The consumer faces a single price in each category of consumers. He can purchase as much as desired at that price. It is the most common type of price discrimination. For example, movie theaters, railways, typically charge lower prices to senior citizens, students etc. CONDITIONS OF PRICE DISCRIMINATION: Price discrimination can only be possible if the following three essential conditions are fulfilled. . (1) Segregation by price. There should be no possibility, of transferring a unit of commodity supplied from the low priced to the high priced market. For instance, a rich patient cannot send a poor man to the doctor for his medical cheek up at a cheaper rate for him. Similarly, if you want to send a kilogram of gold by train to a relative of yours, you cannot get it converted into coal or iron simply because these metals are transported at a cheaper rate. (2) Segregation by market. Another essential characteristic of price discrimination is that there should be no possibility of transferring one unit of demand from the high priced to the low priced market. (3) Segregation by demand. Price discrimination can be possible if there is difference in the elasticity of demand in different markets. If the demand for a certain commodity is elastic in a particular market, the monopolist will charge lower prices. But if the demand is inelastic, the monopolist will fix higher prices for his product. Here, a question can be asked as to how far is a price discrimination beneficial to society. The answer is that if a monopolist charges low price for his product from the poor people and higher price from the rich, then certainly we can say that it increases economic welfare. But if a monopolist dumps his output in a foreign market at a low price and raises the price of his commodity in the home market, then such a price discrimination is certainly detrimental to society, if the production of certain commodity is subject to law of increasing returns, then price discrimination may be to the advantage of the society. The monopolist increases the sale of output in order to sell the commodities in the foreign market. The monopolist fixes a low price for his output both for the home market and the foreign market. It is from this point of view only that we say price discrimination is desirable and beneficial. BILATERAL MONOPOLY Bilateral monopoly refers to a market situation in which a single producer (monopolist) of a product faces a single buyer (monopolist) of that product. Postulations a. There is a solitary commodity with no close surrogates b. The monopolist is its sole manufacturer or seller c. The monopsonist is its only consumer d. The monopolist and the monopsonist are equally liberated to optimise their own person profits Price output Determination Given these postulations, price and output ascertainment under bilateral monopoly is presented in the sketch where D is the demand curve of the monopolist’s product and MR is its corresponding marginal revenue curve of the monopolist. The MC curve of the monopolist is the supply curve S factoring the monopsonist. The upward incline indicates that if monopsonist wants to buy more he will have to pay a higher price.
- 65. Dr. Bhati Rakesh65 | P a g e So when he buys more units of the product his marginal outlay or marginal expenditure increases. This is shown by the upward inclination ME curve which is the marginal expenditure curve to the total supply curve MC/S. The curve D is the marginal utility MU curve of the monopsonist. Let us first consider the equilibrium position of the monopolist. The monopolist is in equilibrium at point E where his MC curve cuts the MR curve from below. His profit maximising price is OP1 (=MS) at which he will sell OM quantity of the product. The monopsonist is in equilibrium at point B where his marginal expenditure curve ME intersects the demand curve D / MU. He buys OQ units of the product at OP2 (=QA) price, as determined by point A on the supply curve MC / S. So there is disagreement over price between the monopolist who want to charge a higher price OP1 and the monopolist who wants to pay a lower price OP2. From a theoretical viewpoint there is indeterminacy in the market. In actuality the actual quantity of the product sold and its price depends upon the relative bargaining strength of the two. The greater the relative bargaining strength of the monopolist the closer will price be to OP1 and the greater the relative bargaining strength of the monopsonist the closer will be to OP2. Thus the price will settle somewhere between OP1 and OP2. MONOPOLISTIC COMPETITION, Monopolistic competition denotes to a market state of affairs where there are many firms selling a distinguished produce. “There is competition which is keen though perfect, among many firms making very similar products.” No firm can have any noticeable pressure on the price productivity strategies of the other sellers or can it be inclined much by their performance. According to Salvatore, “Monopolistic competition refers to the market organisation in which there are many firms selling closely related but not identical commodities.” CHARACTERISTICS Monopolistically competitive markets exhibit the following characteristics: (1) Each firm makes independent decisions about price and output, based on its product, its market, and its costs of production. (2) Knowledge is widely spread between participants, but it is unlikely to be perfect. For example, diners can review all the menus available from restaurants in a town, before they make their choice. Once inside the restaurant, they can view the menu again, before ordering. However, they cannot fully appreciate the restaurant or the meal until after they have dined. (3) The entrepreneur has a more significant role than in firms that are perfectly competitive because of the increased risks associated with decision making. (4) There is freedom to enter or leave the market, as there are no major barriers to entry or exit. (5) A central feature of monopolistic competition is that products are differentiated. There are four main types of differentiation: a) Physical product differentiation, where firms use size, design, colour, shape, performance, and features to make their products different. For example, consumer electronics can easily be physically differentiated. b) Marketing differentiation, where firms try to differentiate their product by distinctive packaging and other promotional techniques. For example, breakfast cereals can easily be differentiated through packaging. c) Human capital differentiation, where the firm creates differences through the skill of its employees, the level of training received, distinctive uniforms, and so on. d) Differentiation through distribution, including distribution via mail order or through internet shopping, such as Amazon.com, which differentiates itself from traditional bookstores by selling online. (6) Firms are price makers and are faced with a downward sloping demand curve. Because each firm makes a unique product, it can charge a higher or lower price than its rivals. The firm can set its own price and does not have to ‘take' it from the industry as a whole, though the industry price may be a guideline, or becomes a constraint. This also means that the demand curve will slope downwards. (7) Firms operating under monopolistic competition usually have to engage in advertising. Firms are often in fierce competition with other (local) firms offering a similar product or service, and may need to advertise on a
- 66. Dr. Bhati Rakesh66 | P a g e local basis, to let customers know their differences. Common methods of advertising for these firms are through local press and radio, local cinema, posters, leaflets and special promotions. (8) Monopolistically competitive firms are assumed to be profit maximisers because firms tend to be small with entrepreneurs actively involved in managing the business. (9) There are usually a large numbers of independent firms competing in the market. EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION In the short run supernormal profits are possible, but in the long run new firms are attracted into the industry, because of low barriers to entry, good knowledge and an opportunity to differentiate. MONOPOLISTIC COMPETITION IN THE SHORT RUN At profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is above ATC at Q, supernormal profits are possible (area PABC). As new firms enter the market, demand for the existing firm’s products becomes more elastic and the demand curve shifts to the left, driving down price. Eventually, all super-normal profits are eroded away. MONOPOLISTIC COMPETITION IN THE LONG RUN Super-normal profits attract in new entrants, which shifts the demand curve for existing firm to the left. New entrants continue until only normal profit is available. At this point, firms have reached their long run equilibrium. Clearly, the firm benefits most when it is in its short run and will try to stay in the short run by innovating, and further product differentiation. Examples of monopolistic competition Examples of monopolistic competition can be found in every high street. Monopolistically competitive firms are most common in industries where differentiation is possible, such as: • The restaurant business • Hotels and pubs • General specialist retailing • Consumer services, such as hairdressing The survival of small firms The existence of monopolistic competition partly explains the survival of small firms in modern economies. The majority of small firms in the real world operate in markets that could be said to be monopolistically competitive. THE ADVANTAGES OF MONOPOLISTIC COMPETITION Monopolistic competition can bring the following advantages: 1] There are no significant barriers to entry; therefore markets are relatively contestable. 2] Differentiation creates diversity, choice and utility. For example, a typical high street in any town will have a number of different restaurants from which to choose. 3] The market is more efficient than monopoly but less efficient than perfect competition - less allocatively and less productively efficient. However, they may be dynamically efficient, innovative in terms of new production processes or new products. For example, retailers often constantly have to develop new ways to attract and retain local custom. THE DISADVANTAGES OF MONOPOLISTIC COMPETITION There are several potential disadvantages associated with monopolistic competition, including: 1] Some differentiation does not create utility but generates unnecessary waste, such as excess packaging. Advertising may also be considered wasteful, though most is informative rather than persuasive.
- 67. Dr. Bhati Rakesh67 | P a g e 2] As the diagram illustrates, assuming profit maximisation, there is allocative inefficiency in both the long and short run. This is because price is above marginal cost in both cases. In the long run the firm is less allocatively inefficient, but it is still inefficient. Inefficiency The firm is allocatively and productively inefficient in both the long and short run. There is a tendency for excess capacity because firms can never fully exploit their fixed factors because mass production is difficult. This means they are productively inefficient in both the long and short run. However, this is may be outweighed by the advantages of diversity and choice. As an economic model of competition, monopolistic competition is more realistic than perfect competition - many familiar and commonplace markets have many of the characteristics of this model. OLIGOPOLY The word Oligopoly is derived from two Greek words – ‘Oligi’ meaning ‘few’ and ‘Polein’ meaning ‘to sell’. An Oligopoly market situation is also called ‘competition among the few’. CHARACTERISTICS OF OLIGOPOLY Now that the Oligopoly definition is clear, it’s time to look at the characteristics of Oligopoly: 1] Few firms: Under Oligopoly, there are a few large firms although the exact number of firms is undefined. Also, there is severe competition since each firm produces a significant portion of the total output. 2] Barriers to Entry : Under Oligopoly, a firm can earn super-normal profits in the long run as there are barriers to entry like patents, licenses, control over crucial raw materials, etc. These barriers prevent the entry of new firms into the industry. 3] Non-Price Competition: Firms try to avoid price competition due to the fear of price wars and hence depend on non-price methods like advertising, after sales services, warranties, etc. This ensures that firms can influence demand and build brand recognition. 4] Interdependence: Under Oligopoly, since a few firms hold a significant share in the total output of the industry, each firm is affected by the price and output decisions of rival firms. Therefore, there is a lot of interdependence among firms in an oligopoly. Hence, a firm takes into account the action and reaction of its competing firms while determining its price and output levels. 5] Nature of the Product: Under oligopoly, the products of the firms are either homogeneous or differentiated. 6] Selling Costs: Since firms try to avoid price competition and there is a huge interdependence among firms, selling costs are highly important for competing against rival firms for a larger market share. 7] No unique pattern of pricing behavior: Under Oligopoly, firms want to act independently and earn maximum profits on one hand and cooperate with rivals to remove uncertainty on the other hand. Depending on their motives, situations in real-life can vary making predicting the pattern of pricing behavior among firms impossible. The firms can compete or collude with other firms which can lead to different pricing situations. 8] Indeterminateness of the Demand Curve: Unlike other market structures, under Oligopoly, it is not possible to determine the demand curve of a firm. This is because on one hand, there is a huge interdependence among rivals. And on the other hand there is uncertainty regarding the reaction of the rivals. The rivals can react in different ways when a firm changes its price and that makes the demand curve indeterminate. THREE IMPORTANT ECONOMIC MODELS OF OLIGOPOLY ARE AS: (1) Price and output determination under collusive oligopoly. (2) Price and output determination under non-collusive oligopoly. (3) Price leadership model.
- 68. Dr. Bhati Rakesh68 | P a g e (1) Price and Output Determination Under Collusive Oligopoly: The term 'collusion' implies to 'play together'. When firms under oligopoly agree formally not to compete with each other about price or output, it is called collusive oligopoly. The firms may agree on setting output quota, or fix prices or limit product promotion or agree not to 'poach' in each other's market. The completing firms thus from a 'cartel'. The members of firms behave as if they are a single firm. Assumptions of Price and Output Determination Under Collusive Oligopoly: For price output determination in a collusive oligopoly, we assume that (i) there are only three firms in the industry and they form a cartel, (ii) the products of all the three firms are homogenous (iii) the cost curves of these firms are identical. Under the assumptions stated above, the equilibrium of the industry under collusive oligopoly is explained with the help of a diagram. Diagram: In this figure 17.4, the industry demand curve DD consisting of three firms is identical. So is the case with the MR curve and MC curve which are identical. The cartel's MR curve intersects the MC curve at point L. Profits are maximized at output OQ1, where MC = MR. The cartel will set a price OP1, at which OQ1, output will be demanded. Having agreed on the cartel price, the members may then complete each other using non price competition to gain as big share of resulting sales OQ1 as they can. There is another alternative also. The cartel members may agree to divide the market between them. Each member would given a quota. The sum of all the quotas must add up to Q1. In case the quotas exceeded OQ1 either the output will remain unsold at OP price or the price would fall. (2) Price and Output Determination Under Non-Collusive Oligopoly: It will be explain with the help of kinked Demand Curve Model. (i) The Kinked Demand Curve Model: The Kinked demand curve model was developed by Paul Sweezy (1939). According to him, the firms under oligopoly try to avoid any activity which could lead to price wars among them. The firms mostly make efforts to operate in non price competition for increasing their respective shares of the market and their profit. An analytical device which is used to explain the oligopolistic price rigidity is the Kinked Demand Curve. This model operates on fulfilling certain conditions which, in brief, are as under: (a) All the firms in the industry are quite developed with or without product differentiation. {b} All the firms are selling the goods on fairly satisfactory price in the market. (c) If any one firm lowers the price of its product to capture a larger share of the market, the other firms follow and reduce the price of their goods in order to retain their share of the market. (d) If one firm raises the price of its goods, the other firms will not follow the price increase. Some of the customers of the price raising firm will shift to the relatively low priced firms. Mr. Paul Sweezy used two demand curve concepts to explain the model. These are reproduced below: Diagram: In the figure 17.5. DD/ is a kinked demand curve. It is made up or two segments DB and BD/. The demand curve is kinked Or has a bend at point B. The kink is formed at the prevailing market price level BM (Rs. 10 per unit). The segment of the demand curve above the prevailing price level (Rs. 10) is highly elastic and the segment of the demand curve below the prevailing price level is fairly inelastic. This is explained now in brief. Explanation: a) Price increase: So an increase in price above the prevailing level-shows that the demand curve to the left of and above point B is fairly elastic. b) Price reduction: The firm does not gain as the total revenue decreases with the price cut. The BD/ portion of the demand curve which lies on the right side and below point B is fairly inelastic. c) Rigid Prices: The firms in the oligopolist market 'have no incentive to raise or lower the prices of the goods. They prefer to sell the goods at the prevailing price level due to reaction function. The price BM
- 69. Dr. Bhati Rakesh69 | P a g e (Rs. 10 per unit) will, therefore, tend to remain stable or rigid, as every member of the oligopoly does not see any gain by lowering or raising the price of his goods. (3) Price Leadership Model: The firms in the oligopolistic market are not happy with price competition among themselves. They try various methods to maximize joint profits. Price leadership is one of the means which provides relief to the firms from the strains of price competition. The firms in the oligopolistic industry (without any formal agreement) accept the price set by the leading firm in the industry and move their prices in line with the prices of the leader firm. The acceptance of price set by the price leader firm maximizes the total profits of each firm in the oligopolistic industry. Assumptions: The main assumptions of price leadership model under oligopoly are as under: (a) There are two firms A and B in the market. (b) The output produced by the two firms is homogeneous. (c) The firm 'A being the low cost firm or a dominant firm acts as a leader firm. (d) Both of the firms face the same demand curve. (e) Each of the two firms has an equal share in the market. The price and output determination under price leadership is now explained with the help of the diagram below. Diagram: In this figure 1 7.6, DD/ is the demand curve which is faced by each of the two firms. MR is the marginal revenue curve of each firm. MCa is the marginal cost of firm A and MCb is the marginal cost of firm B. We have assumed that the firm A is a low cost firm than firm B. As such the MCa lies below MCb. The leader firm using the marginalistic rule of MC = MR is in equilibrium at point E. The firm A maximizes profits by selling output OM and setting price MP. The firm B is in equilibrium at point F where MCb = MR. The firm B maximizes profits by producing ON output and selling it at NK price. The firm B has to compete firm A in the market, if the firm B fixes the price NK per unit, it will not be able to compete with firm A which is selling goods at MP price per unit. Hence, the firm B will be compelled to follow the leader firm A. The firm B will also charge MP price per unit as set by the firm A. The firm B will also produce QM output like the firm A. Thus both the firms will charge the same price MP and sell each of them OM output. The total output will thus be twice of OM. The firm A being the low cost firm will maximize profits by selling OM output at MP price. The profits of the firm B is lower than of firm A because its costs of production is higher than of firm A. PRICING AND OUTPUT DETERMINATION UNDER DUOPOLY: If an industry is composed of only two giant firms, each selling identical products and having half of the total market, there is every likelihood of collusion between the two firms. The firms may agree on a price, or divide the 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., etc. In case the duopolists producing perfect substitute engage 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. If the products of the duopolists are differentiate, each firm will have a close watch on the actions of its rival firms. The firms manufacturing good quality products 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.
- 70. Dr. Bhati Rakesh70 | P a g e DUOPOLY MODELS: There are four main duopoly models which explain the price and quantity determinations in duopoly. These models are: 1] Cournot and Edgeworth Model: Cournot approach is based, on the assumptions that rivals output remains the same and one duopolists plans to change in his output. Edgeworth model assumes that rival's price of the good to remain unchanged as one duopolists plans a change in his price of the good. 2] Stackberg's Approach: It is based on the assumptions that one of the duopolists is a 'Leader' and the other is the follower. 3] Hotelling Spatial Equilibrium Model: In this model, the products of the duopolists are differentiate in the eyes of the buyers by virtue of the location of the duopolists. 4] Game Theory Approach: Whenever there are two or a few firms competing in an industry for profit, each firm can and dose react to the price, quantity, quality and product changes which other firm undertakes. The duopolists or oligopoly have a reaction function. As firms under duopoly are independent, they, therefore, employ strategies. The competing firm also make plans to contract and makes decisions about output and price of the good keeping in view the strategy of its rivals. The plans made by these firm, are known as game strategies. The game theory model describes the firms, interaction model. It is the analytical framework in which two or more firms compete for economics profits that depend on the strategy that the others employ. All games theory models have at least three common elements: (a) Players: Players in the game theory are the firms. (b) Strategies: Strategies are the plans, the possible choices of the firms for production of output, prices of goods, changes in the quality of the product. (c) Pay offs (economic profit): These are the profits or losses realized by the firm. PROFIT POLICY: In developing nations, the Public Sector Enterprises are required to play a dominant role in economic development; PSEs follow the profit price policy. Such a policy would make the state utilise its own resources rather than taxing its citizens. PSEs must be carried on a profit making basis not only in the sense that the public enterprises must yield an economic price but also get for the community sufficient resources for financing a part of investment and maintenance outlay of the government. This involves a profit price policy regard to PSEs. The theory of no profit no loss in PSEs is particularly inconsistent with a socialist economy and if followed in a mixed economy nations, it will hinder its development. In support of this view, in USSR, PSEs made a double contribution to development finance; reinvestment of profits for their own expansion and contribution to the state budget. ARGUMENTS FOR A PROFIT PRICE POLICY The following arguments are advanced in favour of a profit price policy. (1) When the state makes large investments in establishing PSEs, it expects a return in the form of profits in order to enhance its resources for the development of the economy. (2) The main aim of every private enterprise is to earn profits. It is therefore essential that PSEs should also earn profits and should not be dependant on the state for financial help and subsidy. (3) When PSEs operate side by side with private enterprises and compete with them in such areas as oil, steel, consumer goods, shipping, airways etc. they must earn profits like private enterprises. (4) Even in the case of those PSEs where the state has a monopoly, it is not desirable to have a no profit no loss policy or change a low price to consumers of the product or service. For there is no guarantee that the users of the product or service will save more on this count. Therefore the best course is to change a price which gives a minimum of profit to the PSE which will ultimately go to the state for capital formation. (5) The running of PSEs on profit price policy will contribute to the general revenues of the state. As pointed out by Indian Planning commission “When taxation has its limits, public exchequer should benefit by the surplus of public enterprise. When private sector pays a portion of its profits for general revenues, there is no grounds and debt servicing and even dispenses with deficit financing. (6) Further surpluses, accruing from profit making enterprises provide adequate funds for improvement, modernisation and expansion of the plants in PSEs. WHAT PROFIT PRICE SHOULD BE FOLLOWED? Nevertheless, it is difficult to have a particular rate of profit for all the PSEs. Moreover, all PSEs cannot earn profits simultaneously for the following reasons. (1) Those PSEs which have not broken even cannot earn profits for the reason that their overhead costs will be high.
- 71. Dr. Bhati Rakesh71 | P a g e (2) In the case of heavy industries, the gestation period is long. Therefore, it takes them a very long period to break even and start earning profits. At the most such PSEs pay their way and not run in losses. (3) in the case of public utilities, public welfare and not profitability is the principle objective. They try to equate MC with price. They lay stress on output rather on rate of return on investment. CRITICISM (1) Certain economists do not favour profit price policy in the case of all PSEs. Some advocate a no profit no loss policy for public utilities or the marginal cost pricing rule. Others accept the profit price policy with certain reservations. (2) In cases, where the product of a PSE is used as an input for production in the private sector, a profit price policy will adversely affect the development of the private industry. (3) If the price of products of PSEs is rigged up to provide a surplus, the pertinent question arises why consumers of those products should be made to pay a special tax through the back door for the benefit of the state. (4) In those PSEs where the government has a monopoly or semi monopoly , there is a great temptation on their part to deliberately create huge surpluses by charging the users of their products very high prices. (5) Such a profit price policy is therefore harmful to the society for the reason that high prices can lead to a high cost economy. BREAK EVEN ANALYSIS. The break Even analysis (BEA) indicates at what level total costs and total revenue are in equilibrium. It is an analytical technique that is used to identify the level of output and sales volume at which the firm ‘breaks- even’ i.e. the revenues are sufficient to cover all costs. BEA establishes the relationship among fixed and variable costs of production, value of output, sales value and profit. It is hence, also known as Cost Volume Project (CVP) analysis. Three approaches are commonly used to solve the BE problems. They are; the graphical method, the equation method and the contribution margin method. 1] The Graphical Method or Break Even Chart When the BEA is represented graphically, it is shown as the break even chart. The BEC shows the relationship of production costs and revenue to the volume of output. This relationship is determined by a BEP on a graph. The BEP is a specific level of output or volume of sales where total revenue and total costs of a firm are equal. It is the point of zero profit. This point is also known as no-profit, no loss or profit beginning point. 2] The Equation Method The same results can be arrived at by the equation method: Profit = TR – TVC – TFC Where TR = Price x Quantity TVC = AVC x Quantity TFC is a constant BE point is where profit = 0 And 0 = (Price x Quantity) – (AVC x Quantity) – TFC Rearranging the above equation: BE Quantity = TFC Price – AVC 3] Margin of Safety This type of BEA can be used to calculate the level of sales which most be attained to avoid less or to calculate the margin of safety MS. MS is the difference between the firm’s actual level of sales and sales at the BE point as represented in the diagram. It is expressed as MS = Actual sales revenue – BE sales. Nevertheless, firms compute the MS in terms of ratio are: MS Ratio= MS Actual Sales The MS is an indicator of the strength of a firm. If the margin is large, it represents that the firm can make profit even it has to face difficulties. On the other hand, if the margin is small, a small reduction in sales can lead to loss. MS is nil at the point BE point for the reason that actual sales volume is equal to the cost. PROFIT FORECASTING Profit planning cannot be done without proper profit forecasting. Profit forecasting means projection of future earnings after considering all the factors affecting the size of business profits, such as firm’s pricing policies, costing policies, depreciation policy, and so on. A thorough study including a proper estimation of both
- 72. Dr. Bhati Rakesh72 | P a g e economic as well as non-economic variables may be necessary for a firm to project its sales volume, costs and subsequently the profits in future. According to Joel Dean, a famous economist, there are three approaches to profit forecasting, which are as follows: a) Spot Projection: Spot projection includes projecting the profit and loss statement of a business firm for a specified future period. Projecting of profit land loss statement means forecasting each important element separately. Forecasts are made about sales volume, prices and costs of producing the expected sales. The prediction of profits of a firm is subject to wide margins of error, from forecasting revenues to the inter-relation of the various components of the income statement. b) Break-Even Analysis: It helps in identifying functional relations of both revenues and costs to output rate, keeping in consideration the way in which output is related to the profits. It also helps in doing so by relating profits to output directly by the usual data used in break-even analysis. c) Environmental Analysis: It helps in relating the company’s profits to key variable, in the economic environment such as the general business activity and the general price level. These variables are not considered by a business firm. All those factors that control profits move in regular and related patterns such as the rate of output, prices, wages, material costs and efficiency, which are all inter-related by their connections with the national markets and also by their interactions in business activity. NEED FOR GOVERNMENT INTERVENTION IN MARKETS Government remedies refer to interventions in a market by central or local government. For example, these may include, for each market failure, a selection from: a) subsidies, taxes, regulations, property rights and government provision (consumption externalities) b) subsidies, taxes, regulations, property rights and government provision (production externalities) c) government provision (public goods) d) regulation (imperfect information) e) progressive taxes, welfare benefits, collective provision and minimum wage (inequitable income distribution). Government intervention is any action carried out by the government or public entity that affects the market economy with the direct objective of having an impact in the economy, beyond the mere regulation of contracts and provision of public goods. Government intervention advocates defend the use of different economic policies in order to compensate the flaws of the economic system that give way to large economic imbalances. They believe the Law of Demand and Supply is not sufficient in order to ensure economic equilibriums and government intervention should be used to assure a correct functioning of the economy. There are four different types of government institutions which are operating in almost every country to facilitate their people. a) There are market-enabling institutions which help economic agents to manage conflicts, to secure property rights and to help in recognizing their own rights and duties towards customers. They help in sticking to long term contracts and avoid any kind of disputes. b) The market-regulating institutions keep an eye over market players who are misusing their market power and ensure a healthy competition among firms to control any firm from being the monopolist. They also improve the market prices and make sure that they reflect the correct costs and benefits for both the buyer and seller. c) The market-stabilizing institutions are the independent banks working in the economy. The governments’ central bank will serves as the lender of last resort so it may avoid banking crisis in difficult situations. Another role for these institutions is to stabilize the state’s contribution towards the macroeconomic activities. d) The market legitimizing institutions boost up and sustain the public support for market economies. They sort out and reorganize income and provide social insurances. They are also a vital source of social stability in the economy. They encourage firms for long-term developments as they want to facilitate economic development for their residents. PRICE CONTROLS Controversy sometimes surrounds the prices and quantities established by demand and supply, especially for products that are considered necessities. In some cases, discontent over prices turns into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing “too high” or falling “too low”. Laws that government enacts to regulate prices are called Price controls. Price controls come
- 73. Dr. Bhati Rakesh73 | P a g e in two flavors. A price ceiling keeps a price from rising above a certain level (the “ceiling”), while a price floor keeps a price from falling below a certain level (the “floor”). a) PRICE CEILINGS: In many markets for goods and services, demanders outnumber suppliers. Consumers, who are also potential voters, sometimes unite to convince the government to hold down a certain price. A price ceiling is designed to prevent a price from rising above a certain level, meaning a ceiling is always set lower than equilibrium price. Thus, the price ceiling benefits consumers by artificially lowering the cost of goods. At the same time, producers are disadvantaged, being forced to sell at a lower price. Some will withdraw from the market if it is supply elastic enough, causing a shortage. The government can impose a price ceiling and avoid a shortage by providing a subsidy. The consequences of a price ceiling also include the establishment of parallel markets, where individuals with early access to the market will buy inordinate quantities of the highly desirable good and resell it at an increased price. For example, when rents begin to rise rapidly in a city— perhaps due to rising incomes or a change in tastes— renters may press political leaders to pass rent control laws, a price ceiling that usually works by stating that rents can be raised by only a certain maximum percentage each year. b) PRICE FLOORS: A price floor is the lowest legal price that can be paid in a market for goods and services, labor, or financial capital. Perhaps the best-known example of a price floor is the minimum wage, which is based on the normative view that someone working full time ought to be able to afford a basic standard of living. Price floors are sometimes called price supports because they support a price by preventing it from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices, and thus farm incomes, fluctuate—sometimes widely. So even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings. The most common way price supports work is that the government enters the market and buys up the product, adding to demand to keep prices higher than they otherwise would be. Price floors disadvantage consumers, who are forced to buy at a higher price if the good is demand inelastic. Some will even switch to substitutes, meaning price floors must be carefully implemented if the supplier is actually to benefit from it. Generally, they are applied to demand inelastic markets like food. Even so, there will usually be a shortage as a result of an excess of producers. Depending on the nature of the market, the surplus might be exported, donated, or destroyed. PREVENTIONS AND CONTROL OF MONOPOLIES As Adam Smith noted in the late 18th Century, '..people of the same trade seldom meet together...without..the conversation ending in a conspiracy against the public, or in some contrivance to raise prices.' (Wealth of Nations, 1776). This view dominated Classical and Neo-Classical theory for 150 years. The Neo-Classical analysis of firms is deeply rooted in the belief that monopolies are inherently harmful, and that a merger between competitive firms will reduce competition and increase monopoly power. The Neo-Classical view was that monopolies would cause a misallocation of scarce resources, with prices rising well above competitive prices. In short, regulatory authorities should be suspicious of the motives behind meetings of firms, alliances and formal mergers, and closely monitor and control the anti-competitive behaviour of monopolies. The modern view is more pragmatic, and recognises that monopolies and mergers should be judged on a case by case basis, and it should not be assumed that they are against the public's interest. The modern approach accepts that monopolies can create economic benefits as well as costs, including the benefits of economies of scale, innovation and dynamic efficiency, and export earnings. RELEVANT INDIAN LEGISLATION MRTP Act or otherwise known as Monopolistic and Restrictive Trade Practices Act, was the first-time ever, competition law in India, that came into force in the year 1970. However, it underwent amendment in different years. It aimed at: Controlling and regulating the centralization of economic power. Controlling monopolies, restrictive, unfair trade practices. Prohibit monopolistic activities Further, the act makes a distinction between Monopolistic Trade Practices and Restrictive Trade Practices, summarized as under:
- 74. Dr. Bhati Rakesh74 | P a g e 1. Monopolistic Practices: The practices adopted by the undertaking, on account of their dominance, which harm the public interest. It includes: Charging unreasonably high prices. Policy the lessens existing and potential competition. Restricting capital investment and technical development. 2. Restrictive Practices: Acts that prevent, distort or restrict competition comes under restrictive practices. These are adopted by a few dominant firm with an agreement to hinder the growth of competition, called as cartelization. It includes: Restricting the sale or purchase of goods to/from specified persons. Tie-in-sale, i.e. forcing the customer to purchase a particular product, so as to purchase another product. Restricting areas of sale. Boycott Formation of cartels Predatory pricing COMPETITION ACT Competition Act, 2002 is meant to create a Commission that prevents activities which adversely affect competition and initiate and sustain competition in the industry. Further, it aims at protecting consumer interest and corroborating freedom of trade. The commission is empowered to: Ban certain agreements: Agreements which are anti-competitive in nature are prohibited. It includes: Tie-in arrangement, Refusal to deal , Exclusive Dealings, Resale price maintenance Abuse of dominant position: It includes activities such as limiting production of goods or services, the imposition of unfair conditions or engaging in such activities which lead to denial of market access. Regulation of combination: It regulates the activities of combinations, i.e. mergers, acquisition, amalgamation, which is likely to adversely affect competition. The act applies to whole India, except in Jammu & Kashmir. It was enacted to enforce competition policy in the country and also to stop and penalize anti-competitive trade activities of the undertaking and undue intervention of the government in the market. Key Differences Between MRTP Act and Competition Act Basis of Comparison MRTP Act Competition Act Meaning MRTP Act, is the first competition law made in India, which covers rules and regulations relating to unfair trade practices. Competition Act, is implemented to promote and keep up competition in the economy and ensure freedom of business. Nature Reformatory Punitive Dominance Determined by firm's size. Determined by firm's structure. Focuses on Consumer interest at large Public at large Offenses against principle of natural justice 14 offenses 4 offenses Penalty No penalty for offense Offenses are penalized Objective To control monopolies To promote competition Agreement Required to be registered. It does not specify any provision relating to registration of agreement. Appointment of Chairman By the Central Government By the Committee consisting of retired In short, the two acts are different in a number of contexts. MRTP Act has a number of loopholes and the Competition Act, covers all the areas which the MRTP Act lags. The MRTP Commission plays only advisory role. On the other side, Commission has a number of powers which promotes suo moto and levies punishment to those firms which affects the market in a negative way. SYSTEM OF DUAL PRICE Dual pricing is the practice of pricing the same product or service at a different price when it is offered in different markets. When implemented, the organization involved can take advantage of several different benefits which are only available with this pricing strategy. The practice of dual pricing can be implemented at several different levels. Even individual retailers can implement their own forms of dual pricing if they wish. At each level, the practice of dual pricing controls access to the goods or services being offered, which allows business owners to focus on specific demographics.
- 75. Dr. Bhati Rakesh75 | P a g e LIST OF THE PROS OF DUAL PRICING (1) It can be used to lower prices in a new market: When dual pricing is implemented, a company is able to offset a low price in a new market with an established higher price in a mature market. That allows the company to subsidize the losses in the new market while expanding its footprint. (2) It can be used to counter exchange rate issues: When there are currency retention requirements or detrimental currency exchange rates in a targeted market, then dual pricing can be used to offset the issues. That allows a business to stay competitive in each market while being able to meet their taxation and financial obligations. (3) It can be used to counter distribution cost variances.: Let’s say there is a company that is based in Maine. To get their products to the other coast, they have higher shipping fees, border fees, and distribution fees that must be paid. By offering their products at a higher price in one market, they can implement a dual pricing strategy which helps the company be able to maintain their required margins. (4) It can be used to meet higher demand levels.: Dual pricing is also used when there is scarcity within different markets for a specific product. An example of this method is used by the airline industry on a frequent basis. If you book a flight well in advance, there is a good chance that you’ll be rewarded with a low price. For someone attempting to book a flight last-minute, the price of their ticket will likely be higher than the ticket purchase by the customer who booked early. (5) It can be used to protect domestic businesses: Governments can implement dual pricing models too. They do this to protect domestic businesses who may be negatively impacted by a foreign competitor. Through tariffs, subsidies, and similar methods, a government is able to control the pricing of foreign goods or services to make them appear less competitive than domestic items of similar quality. This would potentially offer more local spending, which would then create the potential for more local jobs. (6) It can be used by consumers to save money.: In markets where competition is encouraged, dual pricing gives consumers an option when shopping for something specific. By comparing goods and services, consumers can choose the cheapest option if they wish, which allows them to meet their needs at a lower cost. That gives consumers more money to use for other purposes. LIST OF THE CONS OF DUAL PRICING (1) It is a practice that may be illegal.: If a business is using a dual pricing model as a way to gain an advantage in a targeted importing market, then it may not be permitted. Entering a new market to undercut domestic businesses may cause harm to the local economy and trigger the implementation of tariffs. (2) It can increase export costs. :To create a dual pricing model, there must be a loss somewhere within the economic chain taken by the company. They must have a way to offset that loss through their other markets if this strategy is to be successful. For many organizations, the cost of subsidizing a new market with a predatory pricing strategy tends to harm overall profitability. That means it is not usually a sustainable practice. (3) It can limit the number of goods available to consumers.: One of the easiest ways to deal with a dual pricing issue is to restrict the number of goods or services permitted at discount pricing through quotas. Once the quota has been met, the product or service is no longer permitted in that market. That means consumers affected by quotas may not have the same level of access to the goods or services they want or need. (4) It can limit wage growth in developing markets.: One of the top reasons for offshoring, from a U.S.- based perspective, is that labor costs in other nations are much lower. Because labor is one of the biggest expenses a business faces, reducing its cost can create much higher profits. Now imagine an overseas company in a low-cost labor market is able to produce a similar product. Then they export it to the high-value market. They’d be able to make better profits from a local perspective, undercutting the existing business offshoring labor. By allowing dual pricing, there is no incentive to encourage wage growth at a local level. (5) It can be used for discriminatory purposes. : Dual pricing models can be implemented at the retail level as well. Individual business owners can offer one group of consumers a lower price than another group. In a country like Thailand, this method of pricing is widely practiced in the markets. Tourists, ex- pats, and other foreigners are often charged 3 times more for the same product that someone from Thailand pays. The justification for this practice varies, though it can often be used to discriminate against a specific consumer base. It becomes easier to stop serving a specific group of people if you price your items much higher for only them. These dual pricing advantages and disadvantages show that businesses and consumers can benefit from the practice if it is carefully managed. It also shows that it can set off a pricing war where businesses end up fighting to generate revenues on thin margins as they attempt to gain a higher market share. For that reason, most trade agreements include restrictions or regulations which limit or prohibit the practice of dual pricing.
- 76. Dr. Bhati Rakesh76 | P a g e INTRODUCTION: CONSUMPTION FUNCTION Consumption expenditure is the expenditure made by households on goods and services. The consumption function shows the consumption expenditure of households at each disposable income. The Keynesian consumption function can be expressed as C = a + bYd where C = consumption, a = autonomous consumption, bYd = induced consumption, b = marginal propensity to consume out of disposable income and Yd = disposable income. From the above equation, it can be seen that consumption is comprised of two components: autonomous consumption and induced consumption. Autonomous consumption refers to consumption that is independent of disposable income and is determined by consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. Autonomous consumption is positive (a > 0). Induced consumption refers to consumption that is dependent on disposable income. According to Keynes, consumption will increase with an increase in disposable income (b > 0) but the increase in consumption will be less than the increase in disposable income (b < 1). CONSUMPTION FUNCTION: In the diagram, the consumption function (C) is upward sloping as consumption expenditure increases with disposable income. The slope of the consumption function is (b) which is known as the marginal propensity to consume out of disposable income (MPCYd). The marginal propensity to consume out of disposable income is the proportion of an increase in disposable income that is spent on consumption (ΔC/ΔYd). DETERMINANTS/FACTORS OF THE CONSUMPTION FUNCTION: There are a number of determinants/factors both subjective and objective which determine the position of consumption function. The factors or causes of shifts in consumption function are as fallows: (1) SUBJECTIVE FACTORS: Psychological Characteristics of Human Nature: The subjective factors affecting propensity to consume are internal to the economic system. The subjective factors include characteristics of human nature, social practices which lead households to refrain or activate to appending out of their income. For example, religious belief of the people towards spending, their foresight attitude towards life, level of education, etc. etc., directly affect propensity to consume or determine the slope and position of the consumptions curve. The subjective factors do not undergo a material change over a short period of time. These remain constant in the short run. (2) OBJECTIVE FACTORS: The objective factors are external to economic system. The undergo rapid changes and bring market in the consumption function. The main objective factors are as under: 1] Real Income: Real income is the basic factor which determines community’s propensity to consume. When real income of the community increases, consumption expenditure also increases but by a smaller amount. The consumption function shifts upward. 2] Distribution of wealth: If there is unequal distribution of wealth in a country, the consumption function will also be unequal. People with low income group have high propensity to consume and rich people low propensity to consume. An equal distribution of wealth raises the propensity to consume. 3] Expectation Change in Price: If people expect prices are going to rise in near future, they hasten to spend large sum out of a given income just after the promulgation of first Martial Law in our country. So we can say that when prices are expected to be high in future, the propensity to consume increases or the consumption function shifts upward. When they are expected to be low, the propensity to consume decreases or the consumption function shifts downward. 4] Changes in Fiscal Policy: Taxes also play an important part in influencing the propensity to consume. If the nature of taxes is such that they directly affect the poor people and reduce their income, then the propensity to consume is high and if rich persons are not taxed at a progressive rate and they accumulate more wealth, then the propensity to consume is low. 5. Consumption Function and Investment Function: Introduction, Consumption Function, Investment Function, Marginal efficiency of capital and business expectations, Multiplier, Accelerator. Business Cycle: Introduction, Meaning and Features, Theories of Business Cycles, Measures to Control Business Cycles, Business Cycles and Business Decisions. UNIT – 5
- 77. Dr. Bhati Rakesh77 | P a g e 5] Change in the Rate of Interest: A change in the rate of interest exercises influence on the propensity to consume. When the interest rate is raised, it generally induces people to decrease expenditure and save more for lending purposes. On the other hand, when the interest rate is reduced, it usually encourages expenditure as lending then becomes less attractive. So we conclude that an increase in the rate of interest generally reduces propensity to consume or shifts the consumption function downward and a fall in the rate of interest usually helps to the increase of propensity to consume or shifts the consumption function upward. 6] Availability of Goods: Propensity to consume is also affected by the availability of consumption goods. If the goods are available in abundance, then the propensity to consume increases. If they are scarce and are priced very high, then the propensity to consume will decline. 7] Credit Facilities: cheap credit facilities are available in the country, the consumption function will move upward. 8] Higher Living Standard: If the real income of the people increases in the country and people adopt the use of new produce like television, washing machines, refrigerators, care, etc., etc., the consumption function is high. 9] Stock of Liquid Assets: If the consumer have greater amounts of liquid assets; there will be more desire for the households to spend out of disposable income. The consumption function shifts upward and vice versa. 10] Consumer Indebtedness: In case the consumer are heavily indebted and they pay bigger monthly installments to replay the dept, then propensity to consume is low or the consumption function shifts downward and vice versa. 11] Windfall Gains: If there are unexpected gains due to stock market boom in the economy, it tends to shift the consumption function upward. They are windfall gains. The unexpected losses in the stock market lead to the downward shifting of the consumption curve. 12] Demographic Factors: The consumption function is also influenced by demographic factors like size of family, occupations, place of residence etc. Persons living in cities, for instance, spend more than those living in rural areas. 13] Attitude Towards Saving: If a community is consumption oriented, there will be less saving in the country. The consumption function shifts upward. In case, people save more and spend less, then the consumption function will shift downward. 14] (ix) Demonstration Effect: If people are easily influenced by advertisements on radio and television and seeing pattern of living of the rich neighbors, the level of total consumption will go up. HOW TO RAISE THE PROPENSITY TO CONSUME? The propensity to consume can raised by: 1] Transferring wealth from rich to the poor. 2] Increased wages. 3] Provision of cheap end easy credit facilities. 4] Advertisements. 5] Development of means of transport. 6] Urbanization and through advertisement. INTRODUCTION: INVESTMENT FUNCTION Investment is an important component of national income. It plays an important role in the determination of equilibrium level of national income and corresponding level of employment. When the term investment is used in economics, it refers to the: "Expenditure incurred by individuals an businesses on the purchase of new plant and machinery, the building of the houses, factories, schools, construction of roads etc. It is, in other words the acquisition of new physical capital". INVESTMENT EXPENDITURES: Investment, in brief, includes the following kinds of expenditures: 1] Stock or Inventories: The inventories expenditures incurred by businesses on the purchase of new raw material, semi finished gods and on stock of unsold goods (inventories) are counted as investment. 2] Fixed Capital: The expenditure made on new plants and machinery vehicles, houses facilities, etc., are also included in investment. In the words of J.M. Keynes: "Investment means real investment which refers to increase in the real capital stock of the economy".
- 78. Dr. Bhati Rakesh78 | P a g e TYPES OF INVESTMENT: There are two types of investment (1) Induced investment and (2) Autonomous investment. 1] Induced Investment: Investment in the economy is influenced by the income or output of the economy. The large the national income, the higher is the investment. Induced investment is the change in investment which is induced by the change in the national income. The investment function signifies that as the real national income rises, the level of inducement investment also rises and as the real national falls. The level of investment also down. Shift in the Investment Curve: The induced investment is the increasing function of profit. If firm expect profit, they are induced to invest. The profit expectation of firms depend upon aggregate demand for goods and services in the economy. The level of aggregate demand itself depends upon the level of national income. The higher the level of national income, the higher thus is the level of induced investment. (2) Autonomous Investment: The investment which is not influenced by changes in national income is autonomous investment. In other words an autonomous investment is independent of the level national income. As regards the size of autonomous investment, it is influenced by many basic factors such as increase in population. Manpower, level of technology, the role of interest, the expectations of future economic growth and the role of capacity utilization etc. In case, there is an introduction of new technologies, or the rate of interest falls or if the businessmen expect the sales to grow more, the producer choose to operate to full capacity, the autonomous investment is influenced. FACTORS AFFECTING INVESTMENT Main factors influencing investment by firms 1] Interest rates: The marginal efficiency of capital states that for investment to be worthwhile, it needs to give a higher rate of return than the interest rate. If interest rates are 5%, an investment project needs to give a rate of return of at least 5% or more. As interest rates rise, fewer investment projects will be profitable. If interest rates are cut, then more investment projects will be worthwhile. 2] Economic growth: Firms invest to meet future demand. If demand is falling, then firms will cut back on investment. If economic prospects improve, then firms will increase investment as they expect future demand to rise. There is strong empirical evidence that investment is cyclical. In a recession, investment falls, and recover with economic growth. The accelerator theory states that investment depends on the rate of change of economic growth. In other words, if the rate of economic growth increases from 1.5% a year to 2.5% a year, then this increase in the growth rate will cause an increase in investment spending as the economy is on an up-turn. The accelerator theory states that investment is dependent on economic cycle 3] Confidence: Investment is riskier than saving. Firms will only invest if they are confident about future costs, demand and economic prospects. Keynes referred to the ‘animal spirits’ of businessmen as a key determinant of investment. Keynes noted that confidence that wasn’t always rational. Confidence will be affected by economic growth and interest rates, but also the general economic and political climate. If there is uncertainty (e.g. political turmoil) then firms may cut back on investment decisions as they wait to see how event unfold. Confidence is often driven by economic growth and changes in the rate of economic growth. It is another factor that makes investment cyclical in nature. 4] Inflation: In the long-term, inflation rates can have an influence on investment. High and variable inflation tends to create more uncertainty and confusion, with uncertainties over the cost of investment. If inflation is high and volatile, firms will be uncertain at the final cost of the investment, they may also fear high inflation could lead to economic uncertainty and future downturn. Countries with a prolonged period of low and stable inflation have often experienced higher rates of investment. 5] Productivity of capital: Long-term changes in technology can influence the attractiveness of investment. In the late nineteenth century, new technology such as Bessemer steel and improved steam engines meant firms had a strong incentive to invest in this new technology because it was much more efficient than previous technology. If there is a slowdown in the rate of technological progress, firms will cut back investment as there are lower returns on the investment. 6] Availability of finance: In the credit crunch, many banks were short of liquidity so had to cut back lending. Banks were very reluctant to lend to firms for investment. Therefore despite record low-interest rates, firms were unable to borrow for investment – despite firms wishing to do that. 7] Another factor that can influence investment in the long-term is the level of savings. A high level of savings enables more resources to be used for investment. With high deposits – banks are able to lend more out. If the level of savings in the economy falls, then it limits the amounts of funds that can be channelled into investment.
- 79. Dr. Bhati Rakesh79 | P a g e 8] Wage costs: If wage costs are rising rapidly, it may create an incentive for a firm to try and boost labour productivity, through investing in capital stock. In a period of low wage growth, firms may be more inclined to use more labour intensive production methods. 9] Depreciation: Not all investment is driven by the economic cycle. Some investment is necessary to replace worn out or outdated equipment. Also, investment may be required for the standard growth of a firm. In a recession, investment will fall sharply, but not completely – firms may continue with projects already started, and after a time, they may have to invest on less ambitious projects. Also, even in recessions, some firms may wish to invest or startup. 10] Public sector investment: The majority of investment is driven by the private sector. But, investment also includes public sector investment – government spending on infrastructure, schools, hospitals and transport. 11] Government policies: Some government regulations can make investment more difficult. For example, strict planning legislation can discourage investment. On the other hand, government subsidies/tax breaks can encourage investment. INVESTMENT FUNCTION Savings are the excess of disposable income over consumption expenditure. The savings function shows the savings of households at each disposable income. The Keynesian savings function can be expressed as : S = -a + (1 – b)Yd Where, S = savings, -a = autonomous savings, (1 – b)Yd = induced savings, (1 – b) = marginal propensity to save out of disposable income and Yd = disposable income. From the above equation, it can be seen that savings are comprised of two components: autonomous savings and induced savings. Autonomous savings refer to savings that are independent of disposable income and are determined by consumer sentiment, the wealth of households, interest rates, expectations of price changes, the availability of credit and the distribution of income. Autonomous savings are negative (a > 0). Induced savings refer to savings that are dependent on disposable income. According to Keynes, savings will increase with an increase in disposable income [(1 – b) > 0] but the increase in savings will be less than the increase in disposable income [(1 – b) < 1]. In a diagram, the savings function (S) is upward sloping as savings increase with disposable income. The slope of the savings function is (1 – b) which is known as the marginal propensity to save out of disposable income (MPSYd). The marginal propensity to save out of disposable income is the proportion of an increase in disposable income that is saved (ΔS/ΔYd). As any additional amount of disposable income will either be spent or saved, the sum of the marginal propensity to consume out of disposable income and the marginal propensity to save out of disposable income is equal to one (MPCYd + MPSYd = 1). The average propensity to consume out of disposable income (APCYd) is the proportion of disposable income that is spent on consumption (C/Yd). The average propensity to save out of disposable income (APSYd) is the proportion of disposable income that is saved (S/Yd). As any amount of disposable income will either be spent or saved, the sum of the average propensity to consume out of disposable income and the average propensity to save out of disposable income is equal to one (APCYd + APSYd = 1). MARGINAL EFFICIENCY OF CAPITAL AND BUSINESS EXPECTATIONS, Marginal efficiency capital (MEC) is a Keynesian concept. According to J.M. Keynes, nations output depends on its stock capital. An increase in the stock of capital increases output. The question is how much increase in investment raises output? Well, this depends on the productivity of new capital i.e. on the marginal efficiency of capital. Marginal efficiency of capital is the rate return expected to be obtainable on a new capital asset over its life time. S = Y – C, where C = a + bY S = Y – (a + bY) S = Y – a – bY S = – a + Y – bY S = – a + (1 – b) Y S = – a + s Y where: b = MPC and s = MPS Proof: C = a + bY S = – a + (1 – b) Y C + S = 0 + bY + (1 – b) Y C + S = (b + 1 – b) Y C + S = Y and b + s = 1
- 80. Dr. Bhati Rakesh80 | P a g e The marginal efficiency of capital is the expected annual rate of return on an additional unit of a capital good. It is also described as the rate of return expected to be received on money if it were invested in a newly produced asset. According to J.M. Keynes: "The marginal efficiency of capital is the rate of discount which makes the present value of the prospective yield from the capital asset equal to its supply price. The marginal efficiency of capital will progressively diminish as investment in the asset increases. The marginal efficiency of capital (MEC) curve is, therefore negatively sloped". J.M. Keynes defines marginal efficiency of capital as the: “The rate of discount which makes the present value of the prospective yield from the capital asset equal to its supply price”. A businessman while investment in a new capital asset, examines the expected rate of net return (profit) on it during its lifetime against the supply price of capital asset (cost of capital asset) if the expected rate of profit is greater than the replacement cost of the asset, the businessman will invest the money in the project. Example: For example, if a businessman spends Rs.10,000 on the purchase of a new griding machine. We assume further that this new capital asset continues to produce goods over a long period of time. The net return (excluding meeting all expenses except the interest cost) of the griding machine expected to be Rs.1000 per annum. The marginal efficiency of capital will be 10%. (1000/10000) Χ (100/1) = 10% Formula: The following formula is used to know the present value of aeries of expected income throughout the life span of the capital assets. Sp = (R1/1+r) + (R2/1+r2) + ............ = (Rn/1+rn) Here: Sp = Stands for supply price of the new capital asset. R1 + R2 - Rn = Stands for returns received on yearly basis. R = It is the rate of discount applied each the years. According to J.M. Keynes, the behavior of investment in respect of new investment depends upon the various stock of capital available in the economy at a particular period of time. As the stock of capital increases in the economy, the marginal efficiency of capital goes on diminishing. The MEC curve is negatively sloped Investment (Rs. in billion)Marginal Efficiency of Capital 20 10% 25 9% 40 7% 70 5% 100 2% RELATIVE ROLE OF MEC AND THE RATE OF INTEREST: The MEC and the rate of interest are the two important factors which affect the volume of new investment in a country. An investor while making a new investment, weighs the MEC of new investment against the prevailing rate of interest. As long as the MEC is higher than the rate of interest, the investment will be made till the MEC and the rate of interest are equalized. For example, if the rate of interest 7%, the induced investment will continue to be made till the MEC and the rate of interest are equalized. At 7% rate of interest, the new investment will be Rs.40 billion. In case, the rate of interest comes down to 2%, the new investment in capital assets will be Rs.100 billion. Summing up, if investment is to be increased in the country, either the rate of interest should go down or MEC should increase. FACTORS AFFECTING MEC: The marginal efficiency of capital is influenced by short run as well as long run factors. These factors are now discussed in brief: SHORT RUN FACTORS: 1] Demand for the product. It the market for a particular good is expected to grow and its costs are likely to fall, the rate of return from investment will be high. If entrepreneurs expect a fall in demand of goods and a rise in cost, the will decline. 2] Liquid assets. If the entrepreneurs are holding large volume of working capital, they can take advantage of the investment opportunities that come in their way. The MEC will be high and vice versa. 3] Sudden changes in income. The MEC is also influenced by sudden changes in income of the entrepreneurs. If the business community gets windfall profits, or there are tax concession etc., the MEC
- 81. Dr. Bhati Rakesh81 | P a g e will be high and hence investment in the country will go up. On the other hand, MEC falls with the decrease in income. 4] Current rate of investment. Another factor which influences MEC is the current date of investment in a particular industry. If in a particular industry, much investment has already taken place and the rate of investment currently going on in that industry is also very large, then the marginal efficiency of capital will be low. 5] Wave of optimism and pessimism. The marginal efficiency of capital is also affected by waves of optimism and pessimism in the business circle. If businessmen are optimistic about future, the MEC will be overestimated. During periods of pessimism the MEC is under estimated. LONG RUN FACTORS: The long run factors which influence the marginal efficiency capital are as under: 1] Rate of growth of population. Marginal efficiency of capital is also influenced by the rate of growth of population. If population is growing at a rapid speed, it is usually believed that at the demand of various classes of goods will increase. So a rapid rise in the growth of population will increase the marginal efficiency of capital and a slowing down in its rate of growth will discourage investment and thus reduce marginal efficiency of capital. 2] Technological development. If investment and technological development take place in the industry, the prospects of increase in the net yield brightens up. For example, the development of automobiles in the 20th century has greatly stimulated the rubber industry, the steel and oil industry, etc. So we can say that inventions and technological improvements encourage investment in various projects and increase marginal efficiency of capital. 3] The quantity of capital goods of relevant types already in existence. If the quantity of any particular of goods is available in abundance in the market and the consumers can partially or full meet the demand, then it will not be advantageous to invest money in that particular project. So in such cases, the marginal efficiency of capital will be low. 4] Rate of taxes. Marginal efficiency of capital is directly influenced by the rate of taxes levied by the government on various commodities, When taxes are levied, the cost of commodities is increased and the revenue is lowered. When profits are reduced, marginal efficiency of capital will naturally be affected. It will be low. MULTIPLIER A) GRAPHICAL DEMONSTRATION OF THE MULTIPLIER EFFECT a) In the graph above, the vertical double-headed arrow represents the size of the initial positive demand shock. The vertical distance of the shift upward indicates the amount demand initially rises holding income constant. b) But output and income rise much more than the size of the initial demand shock. The change in output is indicated by Y1 – Y0, also show by the horizontal double-headed arrow in the graph above.
- 82. Dr. Bhati Rakesh82 | P a g e c) The fact that Y rises more than the size of the initial demand shock represents the multiplier. That is, the quantitative effect of a demand shock on equilibrium output is larger than the size of the shock. d) The existence of a multiplier explains why the effects of an AD shock are larger than the size of the original AD shock. For example, a $10 billion positive investment shock will have more than a $10 billion effect on equilibrium output. b) INTUITION BEHIND THE MULTIPLIER a) Let’s consider the intuition behind the multiplier. Suppose that there is a positive AD shock. This causes sales, expected sales, and output to rise. Higher output raises employment and income. Higher income causes higher consumption, which raises AD even more and the cycle continues again. Thus, the effect on output is larger than the size of the original demand shock. One could say that the multiplier process “magnifies” the effect of any initial demand shock. b) Note that the multiplier works in both directions. If the initial shock is negative, it will also be magnified. c) ALGEBRAIC ANALYSIS OF THE MULTIPLIER PHENOMENON Now we will use a simple algebraic version of the Keynesian Cross model to demonstrate the multiplier model with equations. Begin with the consumption function: o C = a + (MPC)(Y-T) o Think of “T” as the total income people pay in taxes. o After-tax or “disposable” income equals Y-T The definition of aggregate demand is: AD = C + I + G + Ex –Im In equilibrium, output equals aggregate demand, so Y = AD Hence, Y = C + I + G + Ex – Im or substituting the consumption function for C gives Y = [a + (MPC)(Y-T)] + I + G + Ex –Im Now, solve this equation for Y, the equilibrium level of output by collecting the terms that depend on Y on the left side o the equation: o Y – (MPC)Y = a –(MPC)T + I + G +Ex – Im o Y (1 – MPC) = a –(MPC)T + I + G +Ex – Im o Y = [ 1 / (1 - MPC) ] [a –(MPC)T + I + G + Ex – Im] The expression 1/(1 – MPC) is called The Multiplier. The multiplier is a measure of by how much an initial AD shock is magnified to get the total effect of the shock on equilibrium output. Since the MPC is always between 0 and 1, the multiplier is always greater than or equal to 1. Conceptually, this means that the value of the initial shock is multiplied by a number greater than one to get the total effect of the shock (ie: total effect > initial shock). If, however, the MPC equals 0 (or the tax rate is 100%), then we get a multiplier of 1. o You can show from the graph, that if the MPC is zero, the AD curve is horizontal. When AD shifts up in this special case equilibrium output rises just as much as the size of the initial shock, and no more. Thus, the graph gives the same answer as the algebra. o Intuitively, if the MPC is zero we would not expect any “magnification effect” because there is no feedback through income creation and consumption after the economy adjusts to the initial demand shock. o Notice that the multiplier is larger as MPC increases, this is because the bigger is MPC the greater the initial shock in demand will be magnified as higher incomes induce even more consumption. Example: Suppose that investment rises from I0 to I1. o Initial equilibrium output, Y0 is: o Y0 = [ 1/(1 – MPC) ] * (a –(MPC)T + I0 + G + Ex – Im) o Final equilibrium output, Y1 is: o Y1 = [ 1/(1 – MPC) ] * (a –(MPC)T + I1 + G + Ex – Im) o Subtract the Y0 equation from Y1 equation to obtain: o ΔY = Y1 – Y0 = [ 1/(1 – MPC) ] * (I1 – I0) = [1/(1 - MPC)] ΔI o As we can see, as long as 0 < MPC <1, the multiplier will be greater than 1. Multiply the multiplier by the size of the initial shock, ΔI, and you will get the size of the total effect of the AD shock on equilibrium output, ΔY
- 83. Dr. Bhati Rakesh83 | P a g e d) THE INVESTMENT ACCELERATOR Investment is highly procyclical, rising when output is high and falling when output is low. Therefore, the assumption in the basic Keynesian Cross model that investment is exogenous is not very realistic. We can improve the model by incorporating an investment equation that allows investment to vary with output. Economists call the positive link between investment and output “the accelerator” The accelerator measures the additional I generated from an increase in Y. (1) An equation capturing investment volatility The basic investment accelerator equation (which looks very similar to the consumption function) is I = b + (ACC)*Y b is determined exogenously, and is similar to a in the consumption function. The accelerator, ACC, is always between 0 and 1 (like the MPC) but it typically is low (possibly about 0.1) because I is a relatively small percentage of Y. With a positive ACC in this model, I will rise when Y rises and I will decline when Y falls, just as our theory predicts and the data demonstrate. (2) Effect on the multiplier Using the following equations, we will calculate equilibrium Y C = a + (MPC) (Y – T) I = b + (ACC)Y AD = C + I + G + Ex – Im Y = AD (which is true in equilibrium: Y = AS = AD) Y = [a + (MPC) (Y – T)] + [b + (ACC)Y] + G + Ex –Im Y – (MPC)Y – (ACC)Y = a –(MPC)T + b + G + Ex – Im Y [1 – MPC – ACC] = a –(MPC)T + b + G + Ex – Im Equilibrium Y = [ 1 / ( 1 – MPC – ACC )] [a –(MPC)T + b + G + Ex – Im] This is the equation for equilibrium output, taking into consideration the endogenous effects a change in Y has on consumption and investment. As we can see algebraically, an increase in the ACC will increase the value of the multiplier. This should make sense conceptually also. If we have any AD shock (change in the stock market, change in government spending, etc), we will see an increase in I. This is another way of saying that I is procyclical: any increase in Y will have an increase in I. In addition, in this model I rises just like C when income goes up, which makes the multiplier effect larger. Effect of the accelerator on the KC model graph: o The accelerator effect raises the slope of the AD curve. When ACC > 0, an increase of Y not only raises consumption, but it also raises investment. o As we have seen before, if the AD curve is steeper, the multiplier is larger. Thus, the graph above is consistent with our algebraic analysis of the accelerator. ACCELERATOR John Hicks was an economist early in the 1900s that took the work of Adams and Ricardo and joined it with the work of many of his contemporaries to answer some remaining questions. Hicks thought about how the multiplier effect and accelerator effect interact with one another. The Multiplier Effect and Accelerator Effect The multiplier effect is the total impact an incremental dollar in income could have throughout the economy. You might think, ''Well, it's Rs.1.00.'' But think of the flow of money through the economy. If you earn that extra dollar, you'll probably spend it on something. The producer of that good will get the money, and it will end up - at least partially - as income for someone else. That person will then buy something, providing income for someone else. If, by the time that dollar is 'done' being spent, it has turned into Rs.4 in wages for you and other people down the supply chain, then the economy has a multiplier of four. The accelerator effect is a little easier to articulate. It's the expected increase in investment as the economy grows. This doesn't happen at exactly the same time, but as the economy grows and people's income increases, this also increases investments - either in savings accounts or more aggressive investments.
- 84. Dr. Bhati Rakesh84 | P a g e INTRODUCTION: BUSINESS CYCLE Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering the growth rate of real gross domestic product. Economies expand and contract - sometimes things are good, sometimes not so much. The idea of this happening in a cycle is called a business cycle. This concept dates back to economists from the 1800s like Adam Smith and David Ricardo. They identified the general growth and decline of goods and services over the course of years. They would see economic growth, with signs such as individuals accumulating more wealth and goods, saving more money, and unemployment dropping near to the point of full employment. Then, after some time, things would change, and there would be fewer jobs, meaning fewer people with extra money to buy things, meaning less output and production, which would lead to an economic slowdown, or recession. Business cycles are identified as having four distinct phases: peak, trough, contraction, and expansion. The timing of a cycle is not predictable, but its phases seem to be. Many economists cite four phases - prosperity, liquidation, depression, and recovery - using the terms originally developed by the American economist Wesley Mitchell, who devoted his career to studying business cycles. IMPORTANCE OF BUSINESS CYCLES Every company must go through their share of ups and downs. And each trading cycle is characterized by its own unique features. There are four basic phases – expansion, peak, trough/depression, and recovery. A firm must always identify which phase it is currently in. It must also always be prepared for a sudden change in the cycles since these cycles are impossible to predict. Let us see the importance of business cycles and their relevance for firms. (Source: Economic Discussion) 1] Help Frame Appropriate Policies A business cycle will affect all the sectors of an economy. Similarly, it will also affect all sectors of a firm as well. Right from demand to supply to the cost of production every aspect will depend on the phase of the business cycle. So the firm must be able to correctly identify its current phase. This will help them frame appropriate business and trade policies. For example, if the firm is going through expansion it will be the correct time for aggressive investment policies or an expansion in the workforce. 2] Strategic Business Decisions The business cycle of a firm will also have a huge impact on their business decisions. Managers and entrepreneurs take strategic business decisions based on the phases of the trade cycle. A business cannot be stagnant it must constantly keep updating to stay with the times. So different phases of the cycle demand different actions from the firm. So if the economy is going through an expansion the management can make the strategic decision to expand the business or increase their output levels. But if the firm is in a trough then spending must be reined in and policies should be formed accordingly. Management may even decide to shut down some product lines temporarily or even permanently. Such important business decisions will depend on the trade cycle. 3] Greatly Affect Cyclic Businesses Changes in the economy affect all firms but not uniformly. There are certain businesses that are more vulnerable to a change in the phase of a trade cycle. Such firms have to keep a very close look at the changes in the economy at all times. Some examples are the fashion industry, electronics industry, food and beverage industry, real estate industry etc. For such firms when the economy is in a boom, they must capitalize. Because a depression in the economy will affect them the most. So this is one of the main importance of business cycles. 4] Entry and Exit from Market For the success of a product launch, the phase of the trade cycle for its introduction is a very important factor. It is much harder for a new product to survive a sluggish economy that is moving towards a depression. Even the prices, sales policy, promotions of the new product will depend on the phases of the business cycle. And on the other hand, if a product has to exit the market, again the conditions must be studied. If the economy is coming out of a depression and seeing a revival then perhaps the exit can be delayed. This is another importance of business cycles.
- 85. Dr. Bhati Rakesh85 | P a g e THEORIES OF BUSINESS CYCLES To seek an explanation of the causes of business cycle, various theories have been put forward from time to time to throw light on this highly complex phenomenon of the capitalist world. These theories can be classified broadly into: (a) Non-monetary theories. (b) Monetary theories. Among the non-monetary theories are- 1] Meteorological or Sunspot Theory; 2] Psychological Theory; 3] Over-production Theory, 4] Over Saving Theory; 5] Innovation Theory; and 6] Cobweb Theorem. Among the monetary theories of Business cycle the important ones are the following: 1] Howtrey’s Theory; 2] Dr. Hayek’s over-investment Theory; 3] Keynes’ Theory; 4] Prof. Hicks Theory of Business cycle. A full treatise is required to discuss in fuller details all these theories. A few of the old theories are no longer accepted now. 1] Climatic Theory Or Sun-Spot Theory: The theory has been presented by Jevons. According to him, the main cause of economic fluctuations is the changes in climatic conditions. He ‘says that spots appear on the surface of the sun after regular intervals which affect the emission of heat and conditions of rainfalls. Production in agriculture sector is adversely effected and incomes of the farmers are reduced. A low income in agriculture sector causes a decrease in the demand for industrial goods. So depression in agriculture sector is transferred to industrial and other sectors of the economy. When the spots disappear, rainfalls and climatic conditions become favorable, output in agriculture sector increases. Incomes of the farmers expand and they increase demand for industrial products. It means overall prosperity and depression occurs due to changes in climatic conditions. 2] Psychological theory : Professor Pigou explains trade cycle based upon human psychology. There are moods of optimism and pessimism which are responsible for the alternating phases of trade cycle. When business community is optimistic about earning profit, investment increases. Increase in investment expands the level of national income and employments. At prosperity fear of recession prevails among business community and they becomes pessimistic about earning profit without any sound reason. This behavior reduces investment and contracts the level of income and employment. 3] Over investment or Over production theory: According to this theory, business cycles emerge due to over investment. Over investment is the result of competition. This over investment will result in over production. Supply exceeds demand. Prices will fall. This will result in loss and this depression spreads from one industry to another. According to this theory. over investment is responsible for business cycles. 4] Over saving or under Consumption theory: This theory was stated by Malthus, Hobson etc. In a capitalistic country rich people have large incomes and they invest more. This will increase production. But in capitalistic society the majority of the people are poor. They cannot make effort to purchase more of goods. Hence the demand for goods will be less than supply. Then prices will fall. Finally it leads to depression. According to this theory, under consumption is responsible for business cycles. 5] Monetary theories : According to Hawtrey and Hayek the monetary factors are responsible for business cycle. According to them changes in money supply are causes for trade cycles. Many business people carry on businss with bank credit. By taking credit from banks in larger amount they will invest more in the business. Production, employment and incomes increase, leading to a further demand for bank credit. Banks multiply credit. Thus, it will lead to expansion of business. But banks cannot go on providing more and more credit. After a limit they adopt restrictive credit policy. They increase interest rate. They ask the people to repay loans. As a result, the business people cannot expand the business. This reduces the production leading to unemployment. Thus, depression sets into economy. 6] Innovation theory: According to Schumpeter, innovations cause business cycles. Introduction of a new product, new techniques creation of a new market, use of new type of raw-materials etc., are called as innovations. Organisers introduces these innovations. Innovations increases the demand for capital. Banks expand credit prices rise. Production, employment and incomes of the people increase. Thus, the introduction of an innovation leads to a spurt in economic activity and a period of prosperity. But the effect of an innovation gradually dies and the economic activity takes a downward turn. Again, after sometime another innovation takes place resulting in an upward movement of economic acitivity. 7] Keynes theory : Keynes’ “General Theory” also provides an explanation of trade cycle, because trade cycle is nothing more than the fluctuations in income, output and employment.
- 86. Dr. Bhati Rakesh86 | P a g e According to Keynes, “fluctuations in the level of national income and employment are due to changes in the volume of investment”. Investment is determined by two factors i.e., the rate of interest and expected rate of profit (MEC). Interest is relatively stable factor and it does not change in the short-run. Therefore it plays no significant role in cyclical fluctuations. The other factor, MEC (expected r.ite of profit) changes frequently because it is mostly dependent on expectations of earning profit when business community is expecting to earn abnormal profit and MEC exceeds the rate of interest, investment expands. An increase investment leads to many times more increase in income and employment through the positive effect of multiplier. So expansion phase of trade cycle is due to increase in investment resulting from a rise in MEC. On the other hand, a fall in MEC will reduce the volume of investment. Reduction in investment will contract income and employment through the inverse action of multiplier. It means the phase of i recession starts due to fall in MEC. The intensity of cyclical fluctuations depends upon the value of multiplier. In the end we may conclude that economic fluctuations are due to MEC. 8] Hicks theory: Keynes theory takes multiplier effect only into account. He neglects acceleration effect. Hicks taked both multiplier and acceleration effects into account. Modem theory explains trade cycle in terms of interaction between multiplier and accelerator. According to Hicks, intensity of economic fluctuations is much more due to combined effect of multiplier and accelerator.An increase in investment leads to many times more increase in national income through the working of multiplier. For example, if the value of multiplier is 5, an investment of Rs.100 will raise national income by Rs.500.The effect of accelerator increases the speed of investment in economy. An increase in.-national income by Rs.500 will raise aggregate consumption by Rs. 400 if marginal propensity to consume (MPC) is 4/5. Further investment will be required to meet the additional demand for consumption goods of Rs. 400 Suppose capital goods worth Rs. 10,000 can produce consumption goods worth Rs. 400 regularly. It means there will be further investment of Rs. 10,000 which will cause further increase in national. The accelerator like multiplier works in both directions. If the demand for consumer goods deceases, it leads to a fall in the demand for capital goods, As a result of this, national income will start contracting rapidly due to combined effect of multiplier and accelerator.Therefore modern theory of trade cycle explains reasonably the causes of trade cycle in the economy. IMPORTANT THEORIES 1] OVER-INVESTMENT THEORY: According to this theory trade cycle occurs because of the over investment in investment industries. The investment industries are building and construction, iron and steel, engineering etc. During every boom investment increases. This statement is supported by the fact that during boom, investment goods industries expand faster than consumption goods industries and during depression investment goods industries suffer more than consumption goods industries. However, opinion among the writers differs on the question as to why in the boom phase investment goods industries expand faster than consumption goods industries. Hayeis Machlup, Ropke and Ribbons hold banks responsible for it. Banks give credit at unduly low rates of investment and in this way they encourage investment. Credits being cheap, all sorts of inefficient and even uneconomical units are set up. The entrepreneurs adopt more and more rounds about methods of production. Resources are withdrawn from consumer’s goods industries and invested in production goods industries through the process of forced saving. This brings about the disparity in the growth rates of consumption goods industries and investment goods industries. At some points the banks feel that too much credit has been created. They raise the rate of interest.Borrowing becomes a costly affair and the rate of investment falls this will bring about the contraction of credit and hence contraction of economic activity leading to depression. But economists like Cassel consider the process of production rather than the expansion of bank credit to be more important cause of a trade cycle. According to them a revival in economic activity leading to boom takes place because of real forces like new inventions. However, here also the assumption of ‘elastic money supply’ remains. 2] UNDER CONSUMPTION THEORY: The chief exponent of this theory is I.S. Hobson. According to him, trade cycles appear due to mal- distribution of national income. This mal-distribution of national income takes place because during boom the entrepreneurs and businessmen gather income with business activities and banks and become richer. Since they cannot consume the whole income they save. There is too much saving during the boom period. Reduction in the level of consumption means a fall in the demand for consumers’ goods because the amount saved is not spent on consumption. The supply of consumer’s goods will be far greater than the demand for them. Prices of these goods begin to fall. The general outlook becomes pessimist. If this downward movement continues depression will set in.
- 87. Dr. Bhati Rakesh87 | P a g e 3] KEYNES’ SAVING AND INVESTMENT THEORY: In this ‘General’ Theory Keynes has given an explanation of business or trade cycle. Keynes never attempted an elaborate theory of business cycle as such. In fact business cycles show rhythmic fluctuations in the aggregate income, output and employment which is the main subject matter of Keynes’ ‘General Theory’. In Dillard’s words, “Keynes’ General Theory is not a theory of business cycle as such. It is much more and also much less than that, it is more than a theory of business cycle in the sense that it offers a general explanation for the level of employment quite independently by the cyclical nature of changes in employment. It is less than a complete theory of business cycle because it makes no attempt to give a detailed account of the various phases of the cycle and does not examine closely the empirical data of cyclic fluctuations, something which any complete study of the business cycle would presumably do.” According to Keynes’ business cycles appear as a result of the fluctuations in the rate of investment and the fluctuations in the rate of investment are due to the marginal efficiency of capital (MEC) Keynes’ has defined marginal efficiency of capital as the relation between the prospective yield of that type of capital and the cost of producing the units.” In simple words, we define marginal efficiency of capital as the expected rate of profit on new investment or capital goods. Thus, the fluctuations in economic activity are due to the marginal efficiency of capital or the expected rate of interest on new investment. The rate of interest which is the second determinant of investment is stable in short period and in the long period it cannot go beyond a maximum and minimum limit. It is, therefore, the marginal efficiency of capital which is always fluctuating due to complex variables viz.; expected trends of prices, element of risks in enterprise, the existing stock of capital goods. Therefore, fluctuations in investment are largely due to fluctuations in the marginal efficiency of capital. When the marginal efficiency of capital rises there will be burst in investment leading to a boom. The burning point from the boom to contraction is explained by saying that there is a decline in the prospective yields on capital (i.e. marginal efficiency of capital) due to growing increase of the capital goods. A wave of boom will set in and this will cause a further fall in marginal efficiency of capital. The result will be deciding production and consequent depression. Just as Keynes’ explains the turning point from boom to contraction, similarly, he explains that a change from depression to recovery is due to the revival of the marginal efficiency of capital. Along with the revival of marginal efficiency of capital, there will be the revival of business confidence which is more important. Because without the revival of business confidence even if the rate of Interest is reduced, investment will remain the same because in the absence of business confidence marginal efficiency of capital remains low. As the investment increases income increases more due to the multiplier effect so the overall business activity starts upwards. 4] HICKS’ THEORY OF TRADE CYCLE: Prof Hicks explains the phenomenon of trade cycles by combining the principle of multiplier and acceleration. According to Hicks, investment is of two types. (i) Autonomous investment and (ii) Induced investment. Autonomous investment is independent of the variations in income, output and consumption, while induced investment is determined by the fluctuations in income, output and consumption. The force of autonomous investment is expressed in multiplier while the force of induced investment is expressed in acceleration. Thus, according to Hicks, autonomous investment and induced investment cause cyclical fluctuations in economic activity via multiplier and accelerator respectively. Let us assume that the initial equilibrium position of the economy is disturbed by a change in autonomous investment. This will lead to increase in income and output to the extent indicated by the multiplier. Now this expansion of income and output will affect the induced investment via the accelerator. This gives rise to further expansion of income (multiplier) and investment (accelerator) of the economy and so on. In this way during this period of upswing, output increases faster than the equilibrium rate. Investment also increases faster than the normal rate. The expansion of income and output will continue till the economy reaches the upper limit or ceiling determined by full employment. After this ceiling, it starts declining. The rate of expansion in output and income is slowed down to the natural rate. This leads to decrease in the amount of induced investment. The multiplier and accelerator forces will work in the reverse order. A fall in investment reduces income at a faster rate and the reduced income again reduce the level of investment and so on. Now the level of output and income will not only reduce to the equilibrium level but rather below it. The reason is obvious as the multiplier and the accelerator work just in the opposite directions. This will go on declining till it reaches the minimum (lower) turning point. Thus, the cycle is complete the main limitation of this theory lies in the use of acceleration principle which the modern economists consider as a crude tool. This principle assumes that investment generated by a change in output is independent of the absolute size of the change.
- 88. Dr. Bhati Rakesh88 | P a g e CAUSES OF BUSINESS CYCLES The cyclic pattern of changes that occurs in the economy is caused by many factors in combination. There are internal factors within the economy that may be causing these changes. And there are also external factors which may lead to a boom or bust of an economy. Let us take a look at all the causes of business cycles. INTERNAL CAUSES OF BUSINESS CYCLES These endogenous factors can cause changes in the phases of the firm and the economy in general. Let us take a look at the internal causes of business cycles. 1] Changes in Demand: Keynes economists believe that a change in demand causes a change in the economic activities. When the demand in an economy increases the firms start producing more goods to meet the demand. There is more output, more employment, more income, and higher profits. This will lead to a boom in the economy. But excessive demand may also cause inflation. On the other hand, if the demand falls, so does the economic activity. This may lead to a bust, which if it continues for a longer period of time may even lead to depression in the economy. 2] Fluctuations in Investments: Just as fluctuations in demand, fluctuations in investment is one of the main causes of business cycles. The investments will fluctuate on the basis of a lot of factors such as the rate of interest in the economy, entrepreneurial interest, profit expectation, etc. An increase in investment will lead to an increase in economic activities and cause expansion. A decrease in investment will have the opposite effect and may cause a trough or even depression 3] Macroeconomic Policies: The monetary policies and the economic policies of a nation will also result in changes in the phases of a business cycle. So if the monetary policies are looking to expand economic activities by promoting investment, then the economy booms. On the other hand, if there is an increase in taxes or interest rates we will see a slowdown or a recession in the economy. 4] Supply of Money: There is another belief that says that business cycles are purely monetary phenomena. So changes in the money supply will bring about the trade cycles. An increase of money in the market will cause growth and expansion. But too much money supply may also cause inflation which is adverse. And the decrease in the supply of money will initiate a recession in the economy. EXTERNAL CAUSES OF BUSINESS CYCLES 1] Wars: During times of wars and unrest, the economic resources are put to use to make special goods like weapons, arms, and other such war goods. The focus shifts from consumer products and capital goods. This will lead to a fall in income, employment, and economic activity. So the economy will face a downturn during war times. And later post-war the focus will be on rebuilding. Infrastructure needs to be reconstructed (houses, roads, bridges, etc). This will help the economy pick up again as progress is being made. Economic activity will increase as effective demand will increase. 2] Technology Shocks: Some exciting and new technology is always a boost to the economy. New technology will mean new investment, increased employment, and subsequently higher incomes and profits. For example, the invention of the modern mobile phone was the reason for a huge boost in the telecom industry. 3] Natural Factors: Natural disasters like floods, droughts, hurricanes, etc can cause damage to the crops and huge losses to the agricultural sector. Shortage of food will cause a surge in prices and high inflation. Capital goods may see a reduction in demand as well. 4] Population Expansion: If the population growth is out of control that might be a problem for the economy. Basically of the population growth is higher than the economic growth the total savings of an economy will start dwindling. Then the investments will reduce as well and the economy will face depression or a slow down. Stabilization policies are also known as counter cycle policies. These policies try to counter the natural ups and downs of business cycles. Expansionary stabilization policies are useful to reduce unemployment during contraction and contractionary policies are used to reduce inflation during expansion. INSTRUMENTS OF STABILIZATION POLICIES 1] Monetary Policy: Monetary policy is employed by the government as an effective tool to promote economic stability and achieve certain predetermined objectives. It deals with the total money supply and its management in an economy. Objectives of monetary policy include exchange rate stability, price stability, full employment, rapid economic growth, etc. 2] Fiscal Policy: Fiscal policy helps to formulate rational consumption policy and helps to increase savings. It raises the volume of investments and the standards of living. Fiscal policy creates more jobs, reduces economic inequalities and controls, inflation and deflation. Fiscal policy as an instrument to
- 89. Dr. Bhati Rakesh89 | P a g e fight depression and create full employment conditions is much more effective as compared to monetary policy. 3] Physical Policy: When monetary policy and fiscal policy are inadequate to control prices, government adapts physical policy. These policies can be introduced swiftly and thus the result is quite rapid. Theses controls are more discriminatory as compared to monetary policy. They tend to vary effectively in the intensity of the operation of control from time to time in various sectors. Business Cycles and Business Decisions