Managerial economics

AP Shareef MBA, M.Phil,NET,M.Com
Asst. Professor & Head, Department of Management
Studies, Markaz Law College, Markaz Knowledge City

Module 1- Introduction
Chapters
1. Introduction to Managerial
Economics
2. Decision making and forward
planning
3. Basic economic tools in
Managerial Economics
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MANAGERIAL ECONOMICS FOR UG-LECTURES BY AP
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Introduction to Managerial
Economics
Chapte
r1
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Meaning
Managerial Economics is
the application of
economic theory into
management practice.
The way economic
analysis can be used
towards solving
business problems,
constitutes the subject-
matter of Managerial
Economics. 4/5/20194
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Definition
“The integration of economic theory with
business practice for the purpose of facilitating
decision making and forward planning by
management”
Spencer and Siegleman
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Objectives of Managerial
Economics
1. Reconciliation of traditional economic theory
to the actual business behaviour and
conditions
 Pure economic theory includes assumptions
which are unrealistic.
 Managerial Economics modifies those unrealistic
assumptions to fit into the real business scenario.
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2. Estimating economic relationships
 Price elasticity, income elasticity, cross elasticity,
promotional elasticity etc.
 Cost out put relationships. It is used for the
purpose of forecasting.
3. Predicting relevant economic quantities
 E.g. Profit, demand, production, costs, pricing,
capital etc. In numeric terms.
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4. Using economic quantities in decision making
and forward planning
 Business manager chooses the best strategy
after thorough analysis
 Economic quantities help him in this process
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5. Understanding external
factors
 Business cycles,
fluctuations, national
income, government
policies on public finance.
 These fall in macro
business environment.
They are studied in
macro economics
 The business manager
may decide on how those
factors/ forces affect the
business.
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Characteristics
Managerial economics is Micro economics
Managerial Economics is pragmatic
Managerial Economics is normative
economics
Managerial Economics uses largely the
concepts of “theory of the firm”
Managerial Economics is using macro
economics for understanding the environment
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Scope of Managerial
Economics
1. Demand analysis
2. Cost analysis
3. Production and supply analysis
4. Profit management
5. Capital management
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Decision making and forward
planning
Chapte
r2
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Decision making- meaning and
definition
 Decision making is the process of selecting
one action from two or more alternative
courses of action.
 Decision-making is the selection based on
some criteria from two or more possible
alternatives. George R.Terry
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Stepsindecisionmakin
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Step 1: Identification of the purpose of the decision
In this step, the problem is thoroughly analyzed.
There are a couple of questions one should ask
when it comes to identifying the purpose of the
decision.
1. What exactly is the problem?
2. Why the problem should be solved?
3. Who are the affected parties of the problem?
4. Does the problem have a deadline or a specific
time-line?
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Step 2: Information gathering
A problem of an organization will have many
stakeholders. In addition, there can be dozens
of factors involved and affected by the
problem.
In the process of solving the problem, you will
have to gather as much as information related
to the factors and stakeholders involved in the
problem. For the process of information
gathering, tools such as 'Check Sheets' can be
effectively used.
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Step 3: Principles for judging the alternatives
In this step, the baseline criteria for judging the
alternatives should be set up. When it comes to
defining the criteria, organizational goals as well
as the corporate culture should be taken into
consideration.
As an example, profit is one of the main concerns in
every decision making process. Companies
usually do not make decisions that reduce profits,
unless it is an exceptional case. Likewise,
baseline principles should be identified related to
the problem in hand.
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Step 4: Brainstorm and analyse the different choices
For this step, brainstorming to list down all the ideas is
the best option. Before the idea generation step, it is
vital to understand the causes of the problem and
prioritization of causes.
For this, you can make use of Cause-and-Effect
diagrams and Pareto Chart tool. Cause-and-Effect
diagram helps you to identify all possible causes of
the problem and Pareto chart helps you to prioritize
and identify the causes with highest effect.
Then, you can move on generating all possible solutions
(alternatives) for the problem in hand.
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Step 5: Evaluation of alternatives
Use your judgment principles and decision-
making criteria to evaluate each alternative. In
this step, experience and effectiveness of the
judgement principles come into play. You need
to compare each alternative for their positives
and negatives.
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Step 6: Select the best alternative
Once you go through from Step 1 to Step 5, this
step is easy. In addition, the selection of the
best alternative is an informed decision since
you have already followed a methodology to
derive and select the best alternative.
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Step 7: Execute the decision
Convert your decision into a plan or a sequence
of activities. Execute your plan by yourself or
with the help of subordinates.
Step 8: Evaluate the results
Evaluate the outcome of your decision. See
whether there is anything you should learn and
then correct in future decision making. This is
one of the best practices that will improve your
decision-making skills.
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Types of decisions
1. Programmed and non-programmed decisions:
Programmed decisions are concerned with the problems
of routine type matters.
A standard procedure is followed for tackling such
problems. These decisions are taken generally by
lower level managers. Decisions of this type may
pertain to e.g. purchase of raw material, granting
leave to an employee etc.
Non-programmed decisions relate to difficult situations
for which there is no easy solution. For example,
opening of a new branch of the organisation or a large
number of employees absenting from the organisation
or introducing new product in the market, etc.,
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2. Routine and strategic decisions:
Routine decisions are related to the general
functioning of the organisation. They do not
require much evaluation and analysis and can be
taken quickly. Ample powers are delegated to
lower ranks to take these decisions within the
broad policy structure of the organisation.
Strategic decisions are important which affect
objectives, organizational goals and other
important policy matters. These decisions usually
involve huge investments or funds. These are
non-repetitive in nature and are taken after careful
analysis and evaluation of many alternatives.4/5/201924
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3. Tactical (Policy) and operational decisions:
Decisions pertaining to various policy matters of the
organisation are policy decisions. These are taken
by the top management and have long term
impact on the functioning of the concern. For
example, decisions regarding location of plant,
volume of production and channels of distribution
(Tactical) policies, etc.
Operating decisions relate to day-to-day functioning
or operations of business. Middle and lower level
managers take these decisions. E.g. Decisions
concerning payment of bonus to employees are a
policy decision. On the other hand if bonus is to
be given to the employees, calculation of bonus in
respect of each employee is an operating
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4. Organisational and personal decisions:
When an individual takes decision as an executive
in the official capacity, it is known as
organisational decision. If decision is taken by the
executive in the personal capacity (thereby
affecting his personal life), it is known as personal
decision.
Sometimes these decisions may affect functioning
of the organisation also. For example, if an
executive leaves the organisation, it may affect
the organisation. The authority of taking
organizational decisions may be delegated,
whereas personal decisions cannot be delegated.4/5/201926
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5. Major and minor decisions:
Another classification of decisions is major and
minor. Decision pertaining to purchase of new
factory premises is a major decision. Major
decisions are taken by top management.
Purchase of office stationery is a minor
decision which can be taken by office
superintendent.
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6. Individual and group decisions:
When the decision is taken by a single individual, it
is known as individual decision. Usually routine
type decisions are taken by individuals within the
broad policy framework of the organisation.
Group decisions are taken by group of individuals
constituted in the form of a standing committee.
Generally very important and pertinent matters for
the organisation are referred to this committee.
The main aim in taking group decisions is the
involvement of maximum number of individuals in
the process of decision- making.
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Basic Economic tools in
Managerial Economics
Chapte
r3
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Fundamental concepts or basic economic tools
in managerial economics help management to
take correct decisions. There are six
fundamental concepts.
1. Principle of opportunity cost
2. Principle of incremental cost and revenue
3. Principle of time perspective
4. Principle of discounting
5. Equi-Marginal Principle
6. Optimization.
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1.Principle of opportunity cost
 Opportunity cost is the cost of the next best
alternative which is given up. It is the cost of
sacrificing the alternatives to a decision. When
we choose the best, we automatically leave
behind all the remaining alternatives.
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2.Principle of incremental cost and
revenue
 This principle is also known as marginal
analysis.
 It may be either incremental cost or
incremental revenue.
 The former refers to a change in total cost
resulting from a decision. But the latter
denotes change in total revenue resulting from
a decision.
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3. Principle of time perspective.
 Managerial economics believes that time has
considerable effect on decisions. That’s why
Marshal differentiated the markets into very
short period, short period, long period and
secular period.
 The cost and revenue are largely affected by
time.
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4.Principle of discounting
 Here we are taking time value of money into
consideration. Returns of different period
should be differentiated in terms of value. The
1 rupee of today is more valuable than 1 rupee
of tomorrow.
 Costs and revenue should be discounted
accordingly.
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5. Equi-Marginal Principle
 It is one of the popular concepts in Managerial
Economics. It is otherwise known as the
principle of maximum satisfaction. This
principle states that an input should be
maximum exploited. A resource should be
used where it is most productive. More over it
is used in reducing waste.
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6.Optimization
 Optimization may be either maximization or
minimization. In terms of profit it may be
maximization, but in terms of cost it is
minimization.
 Marginal analysis, calculus, linear
programming etc. are some of the techniques
of optimization.
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Unit II- Concepts of Demand and Demand
forecasting
Chapters
4. Fundamentals of Demand and
Law of Demand
5. Elasticity of Demand
6. Demand Estimation and
forecasting
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Fundamentals of Demand and Law of
Demand
Chapte
r4
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Meaning and Definition of
Demand
 Demand is the core of all the major decisions
of a firm i.e. planning production, inventory
control and management, distribution and
channels, manpower planning, planning of
finance etc.
 According to Yogesh Maheshwari “Demand
may be defined as the quantity of goods or
services desired by an individual, backed by
the ability and willingness to pay.”
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Law of Demand
 Law of demand explains the relationship
between price and quantity demanded of a
commodity. It states that when the price of a
commodity decreases demand for the same
increases and when the price increases,
demand decreases. We call it an inverse
relationship.


QdP
QdP
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Basic assumptions of the Law of
Demand
 Size of population, income, tastes and
preferences remain constant
 Price of substitutes and compliments remain
constant.
 There is no hope of change in the price of
commodity in recent future.
 Prestige commodities are not considered
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Demand schedule
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 The tabular representation of Law of Demand
is called Demand Schedule. Both individual
demand and market demand can be
expressed in tabular form.
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Demand curve
0
1
2
3
4
5
6
1 3 5 7 9
Demand…
Priceoforanges
Quantity Demanded
D
D
X
Y
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 Demand curve is the graphical representation
of law of demand. It is a downward sloping
curve from left to right.
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Why demand curve slopes
downwards?
Law of diminishing marginal utility.
Income effect
Substitution effect
Price effect
Different uses of a commodity
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Exceptions to the law of
demand
Inferior or Giffen Goods
Prestige goods.
Demand for necessaries
Emergency
Speculation effect
Fear of shortage
Ignorance
Out of fashion goods
Festival, marriages other special events.
Brand loyalty
cosmetics.
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Determinants of demand
A. Individual Demand
1. Price of the commodity
2. Nature of the commodity. Necessity, luxury or
prestigious.
3. Income and wealth of consumers
4. Tastes and preferences of consumers
5. Price of related goods.
1. Substitute goods
2. Complementary goods
6. Consumers expectations
7. advertisement
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B. Market Demand
1. Price of Product
2. Changes in population
3. Distribution of income and wealth
4. Change in the quantity of money in circulation
5. Change in climate
6. Technological progress
7. Govt. policy
8. Business cycle
9. Demonstration effect or contact effect
10. Availability of credit
11. Social customs and ceremonies.
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Demand function
 A function expresses relationship between two
variables i.e. dependent and independent.
 Demand function means the algebraic
expression of the relationship between price
and demand of a product.
D=f(P, Y, T, Ps, U)
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Extension and contraction of
demand
a) If the other factors of demand remain
constant, change in demand due to a change
in price only may be either extension or
contraction of demand. When demand raises
due to a fall in price, it is called extension and
when demand falls due to a rise in price, it is
called contraction of demand.
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Shifts in demand
 As we have already stated, demand for a
product depends upon various factors. Shifts
in demand refers the change in demand due to
change in factors other than price. It may be
an upward shift or a downward shift. Upward
shift indicates increase and downward shift for
decrease in demand. It can be
diagrammatically expressed as under.
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Elasticity of Demand
Chapte
r5
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Elasticity of demand
 Elasticity refers to the degree of
responsiveness of demand to change in a
factor. It is based on the law of demand. The
concept was first introduced by Marshall to
measure the change in demand. Following are
the types of elasticity.
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Types of elasticity
Elasticity
• Price elasticity: change in demand due to a change
in price
• Income elasticity: change in demand due to change
in income of the consumer
• Zero elasticity
• Negative elasticity
• Positive elasticity
• Cross elasticity: change in demand due to a change
in price of substitutes or complements.
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Types of price elasticity(degree of
price elasticity)
 1.Perfectly elastic demand: Here, a small
change in price leads to a substantial change
in quantity demanded. It is an extreme
situation of hyper sensitivity. The demand
curve in this case is a horizontal straight line.
Elasticity in this case is denoted bye
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 2.Perfectly inelastic demand: It is a case of
zero sensitivity. Demand for the product
remains constant at any change in price.
Demand curve in this case is a vertical straight
line as shown below. Elasticity is denoted by
0e
0e
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 3.Unitary elastic demand: In this case, change
in price causes for an equal change in quantity
demanded. i.e. % of change in price will be
equal to the % of change in demand. The
demand curve takes the shape of a
rectangular hyperbola in this case. Here e=1
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4. Relatively elastic demand: It is also called
highly elastic demand. Here, a proportionate
change in price causes for a more than
proportionate change in demand. Demand
curve in this case is a flat line. Elasticity is
denoted by e= >1
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5. Relatively inelastic demand: Here, the case is
just opposite to elastic demand. Change in
quantity demanded is less than the percentage
of change in price. Demand curve takes the
shape of a steep line in this case. Inelastic
demand is denoted by e=<1.
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Measurement of elasticity of
demand
1. Proportional or percentage method or formula
method: In this method, the percentage
change in demand and price is compared to
find out the elasticity.
ED=
Proportionate change in
Quantity Demanded
Proportionate change in
price
PriceOriginal
priceinChange
demandofquantityOriginal
demandinChange
ED
Q
P
P
Q
OR
P
P
Q
Q
OR
P
P
Q
Q
ED 








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example. A particular product is sold at Rs.20.
The demand for the same is 10Kg. Price falls
to 15 and demand increases to 12Kg. Find out
the elasticity.
8.0
5
4
50
40
10
20
5
2
10
20
5
2











ED
ORED
ED
Q
P
P
Q
Q
P
P
Q
ED
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2. Expenditure or outlay method: Using this
method, elasticity is calculated by measuring
the changes in total expenditure as a result of
changes in price and quantity demanded. It is
clear from the following example.
Price of
Pen
Quantity
Demanded
Expenditur
e
Elasticity
of demand
Case 1
5.00 30 150
E>1
4.75 40 190
Case 2
4.00 75 300
E=1
3.75 80 300
Case 3
3.50 84 294
E<1
3.25 87 286
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The above table can be explained with the help of a diagram as
follows
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 The method is summerized as follows
1. There is elastic demand if total expenditure
moves in the opposite direction of change in
price. i.e. when price decreases expenditure
increases and when price increases expenditure
decreases.
2. There is unitary elastic demand when there is
no change in expenditure to a change in price.
3. Demand in inelastic when both price and
expenditure move in the same direction.
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3. Geometric or Point method: We use a
demand curve to measure the elasticity of
demand at any point on a straight line
demand curve.
curvedemandtheofsectionUpper
curvedemandtheofsectionlower
ED
0
10
0
)(
133.0
5.7
5.2
)(
0
10
)(
13
5.2
5.7
)(
1
5
5





NM
N
NED
BM
BN
BED
M
MN
MED
AM
AN
AED
PN
PM
ED
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 If the curve is not a straight line as in the
previous example, elasticity is measured with
the help of a tangent. A tangent is drawn at the
point where we want to measure the elasticity
and use the following formula.
tangenttheofsectionUpper
tangenttheofsectionLower
ED
To determine the elasticity at
point T of demand curve DD
the tangent PM is drawn.
The tangent P’M’ is drawn to
find out the elasticity of T’
This method is applicable only when there is very
small change in price and demand
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4. Arc method: This method is used when the
change in demand and price is very large.
Elasticity in such case can’t be measured at a
point on a demand curve. Elasticity between
two points are measured here. The formula
used is  
 












2
1
2
1
21
21
P
P
Q
Q
P
Q
QQ
PP
P
Q
ED
Change in quantity
Change in price
Original quantity
New quantity
Original price
New price
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Factors affecting Elasticity of
Demand
 Nature of commodity: comforts, luxuries,
necessaries
 Availability of substitutes
 Income of consumers
 Proportion of income spent.
 Habit of consumers
 Number of uses of the commodity
 Postponement of the use of commodity
 Demand of complementary product
 Durability of a commodity
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Practical importance of
elasticity
 Price determination
 Helpful in price discrimination
 Demand forecasting
 Helpful to the government in taxation policy
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Demand estimation and
forecasting
Chapte
r6
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Demand Forecasting
 Demand forecasting is the process of
ascertaining the expected level of demand
during the period under consideration with a
view to minimize the risks associated with the
future by making reasonable assumptions
about the course that the future is likely to
take.
 Business organizations always try to use the
most accurate forecasting technique among
many available techniques. An overview of
forecasting techniques is done below.4/5/201975
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Forecastin
g
techniques
Qualitative
Technique
s
Expert
opinion
Method
Survey
Methods
Complete
Enumerati
on Survey
Sample
Survey
Sales
Force
Opinion
Survey
End use
Survey
Quantitative
Techniques
Trend
Projection
Method
Barometric
Technique
s
Econometr
ic
Technique
s
Regressio
n Method
Simultaneous
Equations
Method
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 Qualitative techniques depend upon information
about the likes and dislikes of the consumers, but
the latter methods uses quantitative data from the
past and extrapolate it to project future demand
I. Expert Opinion Method/Delphi method: There are
experts in every field, and they are the bank of
information and embodiment of enriched
experience. Future demand can be developed on
the basis of expert insights. Biased and vested
interests is the most important disadvantage of
this method. Advantages are
a) Simple to conduct.
b) Suitable where quantitative data is not available
c) Reliable.
d) inexpensive
e) Time saving
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II. Survey method: Under survey method, we will
approach different people connected to the product
under consideration such as consumers, sales force
etc. Each method is discussed one by one.
1. Consumers complete enumeration method: In
this case, interviews and questionnaires are
used to ask all the consumers about the quantity
of commodity they would like to buy during a
particular period.Advantages
A. It is accurate as it
surveys all the
consumers
B. Simple to use
C. No personal bias
D. It is based on collected
data
Disadvantages
A. It is costly and time
consuming
B. Many practical
difficulties are involved
C. Useful only for products
with limited customers
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2. Consumers Sample Survey: It is an extension
of complete survey. A sample of customers
are selected and their views are collected. A
sample is considered as a true representation
of the population.
Advantages
A. Suitable for short term
projections
B. Simple and cost effective
C.Time saving
D.Gives excellent results if
used properly
Disadvantages
A. Conclusions are made on
the basis of a few
B. Sample selection is very
difficult
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3. Sales force opinion survey: We are using our
sales force for data on demand. Sales force
are the people who come in contact with the
customers. They have real information on
likes and dislikes of people.
Advantages
A. Simplest form of demand
forecasting
B. Less costly
Disadvantages
A. Opinion of sales force may be
erroneous since the tastes and
preferences may change over
time
B. There is a possibility of biased
opinions since demand
projection may affect their future
sales targets.
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4. Consumer’s end use survey: This method is
used in case of intermediary goods which are
used for final consumption as well as for
production of some other finally consumable
goods. For example, Milk is an intermediary
goods which is used for final consumption as
well as for production of other final goods
such as ice cream, milk peda etc.
industryPedaofoutputTotal
industrypedaoftrequiremenmilkunitPer
industrycreamiceofoutputTotal
industrycreamiceoftrequiremenmilkunitPer
milkfordemandImport
milkfordemandExport
milknconsumptiofinalforDemand
......








p
p
i
i
m
me
mc
nnppiimmemcm
O
x
O
x
I
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D
OxOxOxIDDD
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Quantitative Techniques
1. Trend projection method: We can project
future trend of demand by analyzing the past
data. Here, we assume the past behavior will
continue in future also. There are two ways to
project future trend
1. Graphical method
2. Algebraic method
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 In graphical method, we plot the trend in a
graph as shown below. The past trend line will
be extended into future.
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 Algebraic method: This method is also known
as least square method. The demand and time
data are fitted into a mathematical equation. If
there is a constant change in demand
depending on a change in time, then there is a
linear relationship between both. This is
algebraically expressed as follows.
Y=a+bX, a and b are constants. Two normal
equations are to be solved for finding the value
of a and b.
∑Y=na+b∑X
∑XY=a ∑X+b ∑X2
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Following data is taken from the sales particulars of a
watch company for the past five years.
Estimate the demand for watches in the year 2019. If the
present trend will persist.
Year 2010 2011 2012 2013 2014
Sales in
thousands
12 13 15 14 16
Year X Y X2 Y2 XY
2010 1 12 1 144 12
2011 2 13 4 169 26
2012 3 15 9 225 45
2013 4 14 16 196 56
2014 5 16 25 256 80
Total 15 70 55 990 219
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2. Barometric techniques: Some economic
variables change consistently over time.
Others depend upon those variables. Here ,
we can say some leading indicators or
barometers. The time series of first variables
is called the leading series and the following
series is called the lagging series. This lead
lag relationship could be used for predicting
future demand for a particular product. This
technique is called barometric techniques.
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c) Econometric techniques: These methods
combine economic theory and mathematical
or statistical tools and systematically analyze
economic relations to forecast demand.
a) Regression method
b) Simultaneous equation method
a) Regression method: According to this
method, we are using regression equations to
estimate the relationship between demand
and other independent variables. The
relevant equation is
YsubstituteofPriceP
outlayentAdvertisemA
incomeConsumers
XofPrice
XforDemand
y 





I
P
D
ePdAcIbPaD
x
x
yxx
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 Advantages
 Method is based on causal relationship
 It forecasts and explains the economic phenomenon
 Disadvantages
 It uses complex calculations
 Costly and time consuming
b) Simultaneous equation method: This method is
useful when the relationship between demand
and other variables is complex. It is a complex
statistical process that uses multiple
simultaneous equations
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Unit III- Production, Cost and Revenue
Chapters
7. Production function and laws of
production
8. Concept of cost and revenue
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Introduction
Production function
Laws of Production
Isoquants and Isocosts
Economies and diseconomies of scale
Production function and laws of
production
Chapte
r7
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Introduction to Production
Production is a process of transforming inputs
into more valuable output. The production
theory focuses on efficient use of inputs for
producing the desired output. It may be either
maximizing the use of an input or minimizing
the cost of an output.
Definition : According to Mayers, “ production is
an activity that results in goods or services
intended for exchange”
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Factors of production
 Any output is a result of some inputs. The inputs for
production is known as factors of production.
Typically, Land, Labour, Capital, Management and
Technology are the five major factors of production.
Following slide shows a pictorial representation.
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Land
Labour
Capital
Management
technology
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Fixed and variable inputs.
Inputs which remain fixed in the short period is
called fixed inputs. They don’t vary according to
production. But variable inputs, as the name
implies, varies according to the volume of
production. For example- land, machinery,
factory building etc. are fixed inputs. Raw
materials, ordinary labour, power fuel etc are
variable inputs as they vary in tune with the
volume of output.
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Production function
 A production function is the technological
relationship between the factors of
production and outputs. It shows the
relationship between dependent variable (Q)
and independent variables (Ld, L, K, M, T).
This can be shown by the following equation.
Q=f(Ld, L, K, M, T)
Where, Q=Output, Ld=Land, K=Capital,
M=Management, T=Technology
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Cobb Douglas Production
Function
 This is the statistical production function
formulated by the two Americans Paul H
Douglas and CW Cobb. It is the most
commonly used production function in the field
of economics. It is stated as follows.
 Q= K La C(1-a)
 Q= Output
 L= Quantity of Labour
 C= Quantity of Capital
 K and a are positive constants
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 Assumptions of C-D production function
 3/4th of the increase in output is due to labour and
1/4th is due to capital
 Therefore the function can be expressed as
Q=KL3/4 C1/4
 It indicates constant returns to scale. There will
be no economies or diseconomies of scale.
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Laws of Production
 As we have seen in production function,
production is the relationship between inputs
and outputs. There are two important laws of
production
1. Law of diminishing returns/ Law of variable
proportion.
2. Laws of returns to scale.
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Law of diminishing returns/ Law of
variable proportion
 The law was first proposed by Sir, Edward
West. Later, Adam Smith and Ricardo Malthus
related this law with agriculture.
 According to the Law of variable proportion, if
one factor is used more and more by keeping
others constant, the total output increases at
an increasing rate in the initial stage and then
at a declining rate and later it declines
absolutely.
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 There are three important divisions related
with the above stated law. They are.
 Total Physical Product (TPP): This is the total
production achieved by employing different
quantities of a factor input, while keeping all the
other factors constant.
 Average Physical Product (APP): This is the Total
Physical Product (TPP) of a factor divided by the
quantity of that factor by keeping all the other
factors constant.
 Marginal Physical Product (MPP): It refers to the
change in TPP when an additional unit of the
factor input is used.
 These are clear from the following table and
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I1st stage
I2nd stage
I3rd stage
I3rdstage
-------------------------------------
2ndstage
---------------------------------
I1ststage
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 As explained by law there are three identifiable stages
in short term relationship.
 In the first stage, TPP increases at an increasing rate
up to 3 units of labour. But in the second stage, rate of
increase start decreasing. In the third stage, it
absolutely diminishes.
 APP first increases, attains peak value at 3 units of
labour and then decreases thereafter.
 MPP’s behavior is also similar to that of APP. But in
the case of MPP as compared to the APP curve, the
rate of rise and fall is more pronounced. Thus it first
remains above the APP curve, achieves higher peak
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Laws of returns to scale
 In the previous law, the discussion was
confined to production function, when one of
the inputs change while all others are kept
constant.
 The relation between the output and variation
is all the inputs taken together is known as
returns to scale. We change all the factors of
production in the same proportion and the
same direction. It is a long term phenomenon.
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Types of returns to scale
 Increasing returns to scale, decreasing returns to
scale and constant returns to scale.
 Suppose, we’re using two inputs say, Labour and
Capital.
 There is increasing returns to scale if the increase in
Labour and Capital causes for a more than
proportionate change in outputs.
 The returns is said to be decreasing if the change in
output is less than proportionate change in labour and
capital.
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Input
Combination
L&C
Total Output % Change in
Input
% Change in
Output
Marginal
Returns
2+2 8 - - -
4+4 38 100 375 30
8+4 92 50 142 54
9+5 108 17 17 16
10+5 124 7 14 16
10+6 135 20 7 9
11+7 140 12.5 4 5
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 From the above discussion it can be
summerized
Suppose ‘r’ is a measure of returns to scale, then
 If r>1, it means there is increasing returns to
scale. This is non linear homogenous production
function.
 If r<1, it refers to decreasing returns to scale. This
is also non linear homogeneous production
function.
 If r=1, then there is constant returns. This is linear
homogeneous production function.
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Linear Homogeneous Production
function
 If r=1, then the production function is Linear
Homogeneous producing constant returns to
scale. Here, the elasticity will be equal to one.
 It can be mathematically expressed as
nP = f(nK , nL)
Where, n = number of times
nP = number of times the output is increased
nK= number of times the capital is increased
nL = number of times the labor is increased
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In the case of a linear
homogeneous
production function,
the expansion is
always a straight line
through the origin, as
shown in the figure.
This means that the
proportions between
the factors used will
always be the same
irrespective of the
output levels.
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Isoquants
 It is a production function with two variable
inputs which are substitutes for each other.
 Isoquants means equal output. It refers to the
output produced by various combination of two
inputs are same.
 The following Isoquants schedule makes it
clear.
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Combinations of
Labor and
Capital
Units of Labor (L) Units of Capital
(K)
Output of Cloth
(meters)
A 5 9 100
B 10 6 100
C 15 4 100
D 20 3 100
The above table is based on the assumption that only two
factors of production, namely, Labor and Capital are
used for producing 100 meters of cloth.
Combination A = 5L + 9K = 100 meters of cloth
Combination B = 10L + 6K = 100 meters of cloth
Combination C = 15L + 4K = 100 meters of cloth
Combination D = 20L + 3K = 100 meters of cloth
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The above table can be shown diagrammatically as
under.
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Diminishing marginal rate of technical
substitution
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113
 Input substitution is an important assumption
in the concept of Isoquants. If units of one
input reduced, then the units of the other must
be added to maintain equal production level.
 Marginal rate of technical substitution-MRTS is
defined as the amount one input factor that
must be substituted for one unit of another
input in order to maintain a constant output. It
is calculated using the following formula.

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114
2inputinChange
1inputinChange





X
Y
X
Y
MRTS
Consider our table of Isoquants. Initially we use 5 units of
Labour(input 1) and 9 units of Capital (input 2). In case B,
we substitute 5 units of labour in place of 3 units of
capital. Therefore the MRTS is 5/3 or 5:3. For the cases C
and D MRTS is 5:2 and 5:1 respectively.

Isoquants map or equal product
map
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 An Isoquants map is a diagrammatic
representation of a number of Isoquants. An
Isoquants map is shown below.

Properties or features of
Isoquants
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1. Isoquant slopes downward from left to right. It
is because the substitution of more of one
input for deduction in the other.
2. A distant isoquant from zero represents larger
output. Shown in figure A.
3. Same amount of two inputs will never
produce two levels of outputs. Therefore
there will not be intersection of two isoquants.
Hence figure B shown below will never exist.

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4. Isoquants may not be always
parallel to each other. The rate of
substitution may not be same in
all schedules. Figure C
5. Isoquant is convex to the origin.
The curve diminishes
accordingly with DMRTS. Figure
D
Figure A
Figure B
Figure C
Figure D

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118
6. Isoquants will not touch X axis
or Y axis. If it touches, it means
that production is possible without
the presence of a second input.
That’s impossible. So, an
isoquant as shown in figure E will
not exist.
Figure E
The producer will implement the combination that
maximizes his profit at minimum cost. Such a
combination of inputs is called optimum input
combination or least cost combination or producers
equilibrium. The average cost at this point will be
minimum. To study the cost function, we may have to
prepare isocost curve

Isocost curve
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119
 In an isoquants curve, we take the quantity of
inputs but in an isocost curve, the price of
factors are considered. An isocost line shows
all the combinations of two inputs that are
available for a given total cost to-the producer.
Lower the isocost curve, better it is since the
producer would like to minimize the cost.
Following figure makes it clear.

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120
If a firm spends $500 on two factors labour and capital,
if the weekly wages of an employee is $10, then the firm
can employ 50 employees. Similarly, if one unit of
capital costs $100, then the firm can use 5 units of
capital. The case means that the firm may spend the
whole amount either on labour or capital or partly on
both. The slope of the isocost
line is based on the firms
decision on investment
and price of inputs. Price
of inputs refers to the
ratio of both i.e.
The decision on
increasing or decreasing
the outlay also
determines the slope.
labourofPrice
capitalofPrice


Selecting the least cost
combination
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 Least cost combination is determined by
consolidating isoquants and isocosts. The firm
is said to be at equilibrium point where the
isoquants touches isocosts.

Economies and diseconomies of
scale
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Economies
Internal
Economies
Specialized labour
Specialized managers
New better quality
machines
Purchase discounts
Low cost funds
Marketing and
distribution
External
Economies
Better transport facilities
Better repairs and
maintenance
Common research and
development
Training and development

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Diseconomies
Internal Diseconomies
Loss of coordination
Difficulties in team work
Labour unions
Difficulties in raising
funds
External Diseconomies
Transportation costs
Higher purchase costs
Unhealthy practices
Social problems

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 What’s economies/diseconomies
of scale?
Economies of scale is a term used to describe the
benefits which a business gains from increasing
levels of production. It’s about increasing the
scale of business to make cost savings.
Compared to smaller organizations, large scale
business gain many advantages. Here the term
economy refers to cost advantage.
Diseconomies of scale are the disadvantages of
large scale operations

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 Economies of scale
 Internal economies
 Specialized labour: Large organizations can acquire
skilled and potential human resource for their
operations. It leads to improved productivity and
reduction in the average cost of production.
 Specialized managers: Efficient and experienced team
of managers lead a large firm to better results. This in
turn results in managerial economies.
 New better quality machines: Large scale
manufactures can use highly sophisticated and quality
machines which improve productivity.

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 Internal economies contd…
 Purchase discounts: High volume of raw materials are
required to produce on large scale. This in turn
enables such organizations get more discount on
purchase.
 Low cost funds: Investors expect high returns from
bigger firms. Therefore, the business will be in a
position to make use of plenty of funds at low cost and
easy terms.
 Marketing and distribution: Advertising is an important
factor in bringing sales for any business. A firm
producing high volume of outputs can spend much on
advertisements. Similarly distribution channels also
could be expanded.

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 External economies
 Better transport facilities: If a number of firms are
engaged in same industry, they can enjoy many facilities.
Since such areas will be growing rapidly, the
transportation facilities improve.
 Better repairs and maintenance: As a result of rapid
industrial growth, technical aids such as repairs and
maintenance come up to utilize the opportunities created
by industry.
 Common research and development: As a particular field
of business grow, the research and development in the
same field also clutch simultaneously.
 Training and development: As a field of industry grow,
the need for trained manpower increase rapidly. As a
result various institutes for imparting education and
training are set up. Business firms ultimately benefit from
these developments

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 Diseconomies of scale
 Internal diseconomies
 loss of coordination: Quality will usually decrease
when quantity increases. A large scale concern is
always tougher to coordinate than a small one.
 Difficulties in teamwork: Span of control increases
when scale is large. If not effectively lead, there will be
haphazard in the organization
 Labour unions: More of the time may be spent on
discussions and negotiations with labour unions if the
labour relation is poor
 Difficulties in raising funds: Huge amount of funds are
required for fixed and working capital. Its not easier to
raise funds.

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 External diseconomies
 Transportation costs: Inbound and outbound logistics
costs for large scale organizations is very high. It will
lead to higher average cost.
 Purchase costs: Huge volume of raw materials require
sufficient funds. The process of procurement also
takes comprehensive steps.
 Unhealthy practices: Increased costs push large scale
firms to resort into unhealthy practices such as black
market, hoarding and profiteering.
 Social Problems: Expansion of an industry may cause
environmental pollution and such social problems.

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Concept of Cost and
Revenue
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131
Chapte
r8

Introduction to costs
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 Cost here refers to the cost of production.
Cost is the value of money that has been used
up to produce something. It is the expenditure
incurred on producing products or rendering
services. In order to ascertain the relevant cost
to be considered for a particular situation, we
need to discuss the various possible cost
concepts in detail.
132

Types of costs
 Actual costs and opportunity cost
 Fixed costs and variable costs
 Explicit costs and implicit costs
 Total, Average and Marginal costs
 Historical and replacement costs
 Short run costs and long run costs
 Accounting costs and economic costs
 Private costs and social costs
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 Actual costs and opportunity costs: Costs that
are incurred in acquiring or producing a good
or service are known as actual costs. They are
the real cash outflows and are shown in the
books of accounts. They are also known as
accounting costs or acquisition costs. E.g. rent
for land, wages for labour, interest for capital.
opportunity cost is the cost of sacrificing the
alternatives. It is the cost forgone for next best
alternative.

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 Fixed cost and variable cost: Fixed costs are
defined as the costs that remain constant with
respect to the output. They exist even if the
production is not done. E.g. rent of building and
factory, interest on borrowed capital, cost of plant
and machinery. On the other hand, variable costs
are the costs that vary according to the output.
Costs on current assets are variable costs. Some
costs that cant be easily distinguished to fixed or
variable are called semi variable costs. They are
fixed for a particular level of use and variable
thereafter. E.g. Expense on Telephone, electricity
etc.

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 Explicit costs and implicit costs: Those costs
for which a cash payment is made are called
explicit. E.g. payment for raw materials,
utilities, wages etc.
but some costs don’t involve a cash payment.
They are termed as implicit costs. E.g. cost of
depreciation, rent of owned building etc.
usually firms ignore such costs. They may be
useful in effective decision making.

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 Total, Average and Marginal Costs: Total cost
is the sum total of all costs that are incurred on
production.
Average cost is the cost per unit of output. It is
obtained by dividing the total cost by total outputs
Marginal cost is the change in total cost due to the
production of an additional item.

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 Historical costs and replacement costs:
Historical cost is the cost that’s incurred for
purchase of an asset. When an asset
becomes obsolete, we will purchase new.
Replacement cost is the current cost of
purchasing the asset now.

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 Short run costs and long run costs: Short run
is a period during which one or more inputs of
the firm are fixed. But all the inputs are
variable during the long run. A short run cost is
the cost which varies with output when plant
and equipment remain the same. Long run
cost is the cost that varies with output when all
the factor inputs change. Decisions on the
former type relates to production with a given
plant size. But the latter type needs an
analysis of the long run.

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 Accounting costs and Economic costs: The costs
that are used by accountants for recording ,
financial analysis and control and auditing
purposes are referred to as accounting costs. But,
there are costs that may be useful in decision
making but are not recorded or analyzed by the
accountants. Such costs are called economic
costs. E.g. actual cost, fixed cost, variable cost,
explicit cost, implicit cost etc. are accounting
costs. Average cost, marginal cost, short run cost,
long run cost, opportunity cost etc. are economic
costs.
Contd..

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 Unlike accounting costs, economic costs consider
both the explicit and implicit costs to the company
that occur during the fiscal year. Implicit costs are
associated with resources that are provided to the
company with no price tag. For example, if a
company operates out of a building it owns, it
experiences an implicit cost from the rent it could
earn from leasing the building to another
company. The building could earn $3,000 a month
from a commercial renter, so the company has an
implicit cost of $3,000 to add to its economic
costs.
Contd.

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 Accounting costs come from the total explicit
costs of the company during the fiscal year.
Accounting costs do not include implicit costs
resulting from unused resources. Explicit costs
with defined monetary values are factored into
the accounting costs of the company to
calculate net income at the end of the fiscal
year. For example, if the company spends
$100,000 on employee wages, $50,000 on
equipment purchases and $20,000 on
inventory, the total accounting costs are
$170,000 for the year.

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 Private costs and social costs: Private costs
are those costs which are incurred by the firm
privately. But the costs as a whole will not be
confined to private firms only. There are social
implications for production. Since the firm is
using resources which belong to society and
therefore society also bears cost. Such costs
are called social costs. Social costs include
private cost and external cost. E.g. pollution
caused while production. Environmental
degradation. Etc.

Cost output relationship(cost
function)
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 Cost is determined by many factors such as
 Rate of output
 Size of plant
 Prices of input factors
 Technology
 Efficiency of management and labour etc.
 Of all the above, volume of output is the most
important. Hence, the cost function is the
technical relationship between cost and output
TC=f(Q)
The following table illustrates the cost and its
breakups.

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Concepts of revenue
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 Income earned through sales of products or
rendering of services by a firm is called
revenue.
 revenue also may be categorized into Total,
Average and marginal. The relation among the
three will be more clear from the following
table

Incremental revenue
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 Incremental revenue refers to increase in
revenue. It happens as a result of many
decision alternatives such as change in price,
new managerial decisions etc. It should be
differentiated from MR because MR is the
additional income from additional sales. IR is
the increase in revenue irrespective of the
sales
 IR=R2-R1

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Chapters
9. Fundamentals Pricing and forms of market.
10. Price and output determination under various
market forms.
Unit IV- Market Structures and Price-output
determination

Fundamentals of pricing and market
forms
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Chapte
r
9

Introduction to Price and Pricing
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 The selling value of a product or service
expressed in monetary terms is called price.
The process of fixing the price is called pricing.
Pricing decisions are important for a firm
because of the following reasons.
 Pricing affects profit.
 Pricing decision is most sensitive.
 Pricing is a complex process.

Determinants of Price
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 Demand: Demand is one of the most important
determinant of price. High price can be
charged for a product with great demand. But
low price only will be acceptable for products
with low demand
 Cost of production: Cost of production is
recovered from price. Therefore, cost of
production is an important criterion in pricing.
Price of the product in most cases will be
greater than the cost.

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 Objective of the firm: Firms may have many
objectives. Some firms try to maximize their
profit, on the other hand some firms like to
maximize their sales. Price in both the cases
may be fixed accordingly.
 Government policy: Government may exercise
control over the price of some products.
Business men should be aware of
Government policy regarding price.
 The nature of competition: Perhaps the most
important factor governing price is the nature
of competition that a firm’s products face.

Market and forms of market
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 A market is one of the many varieties of
systems, institutions, procedures, social
relations and infrastructures whereby parties
engage in exchange. While parties may
exchange goods and services by barter,
most markets rely on sellers offering their
goods or services (including labor) in
exchange for money from buyers.

Different Market Structures
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 Perfect competition
 Monopoly
 Monopolistic competition
 Oligopoly

Perfect competition
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 The market situation in which large number of
buyers and sellers exchange homogeneous
product. The price determined by the market
forces will be accepted by all sellers.
 Neo-classical economists argued that perfect
competition would produce the best possible
outcomes for consumers, and society.

Monopoly
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 It is a market situation where only one seller
sells the product which has no close
substitutes. he, the monopolist has complete
control over the price also.

Monopolistic Competition
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 The model of monopolistic competition
describes a common market structure in which
firms have many competitors, but each one
sells a slightly different product.
 Monopolistic competition as a market structure
was first identified in the 1930s by American
economist Edward Chamberlin, and English
economist Joan Robinson.

Oligopoly
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 It is a market situation in which there are only
few sellers producing homogeneous or
differentiated products.
 When a market is shared between a few firms,
it is said to be highly concentrated. Although
only a few firms dominate, it is possible that
many small firms may also operate in the
market.

Price determination under different market
forms
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Chapter
9

Price Mechanism
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 Price mechanism refers to the system in which
the market forces i.e. demand and supply
determine the prices of commodities and
changes in prices. It means that the price is
actually determined by the buyers and sellers.
Price mechanism is the result of the free play of
market forces of demand and supply. However,
sometimes the government controls the price
mechanism to make commodities affordable for
the poor people too.

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 Price mechanism is an economic phenomenon
of three elements. They are Equilibrium Price,
Demand and Supply. If the laws of supply and
demand are worked out, automatically the
price is fixed. Equilibrium price is the price at
which demand is equal to supply. It is clear
from the following diagram.
Demand and Supply
O

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 It is clear from the above diagram that the
price is determined at the point where supply
is equal to demand.
 Two possible changes may occur in such a
case. Firstly, there may be a shift in demand
curve when supply remains the same as
shown in the following diagram.
0

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 Secondly, supply may shift when demand
remains the same. This is shown in the
following figure.
0

Perfect Competition
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Characteristics
 Large number of buyers and sellers
 Homogeneous product
 Uniform price
 Free entry and exit
 Perfect knowledge of market conditions
 Perfect mobility of factors of production
 Absence of selling and transportation cost

Price determination by the firm
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<
Under perfect competitive market, firms are not price
makers. But they determine the output. Price
determined by the market forces will be applied to all
firms.

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 Two conditions have to be satisfied for the firm
to be in equilibrium. They are
 Marginal Cost (MC) should be equal to Marginal
Revenue (MR).
 MC curve must be cutting MR curve from below.
i.e. MC curve should slope upwards from left to
right.

Effect of time upon supply
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 In a factory, it takes time to make adjustments
in the organization and size of the factory.
Therefore, time has considerable effect upon
supply. According to Marshall, there are three
periods of time. Viz., Market period, short
period and long period.
 Market period is a single day or a few days.
During this period supply remains fixed as the
entrepreneur is not in a position to make
adjustments. Contd…

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 During short period, supply of the product can
be altered. But this period is not sufficient to
make changes in fixed assets such as building
or machinery. So, short run cost curve remains
the same and supply curve slopes upwards
from left to right.
 In the case of long period, fixed and variable
inputs can be changed as intended by the firm.
Supply curve in this case would be more flatter
than in short period.
 In addition to the above three periods, there is
very long period in which all the internal as
well as external factors change. E.g. changes
in population, supplies of raw materials, supply
of capital etc.

Price determination by the
industry
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 Marshall observed price determination in three
periods. Market period, short period and long
period.
 Price determination During Market Period
 There may be two types of commodities.
1- Perishable
2- Durable
Perishable commodities cannot stay fresh for many
days, e.g. fruits, vegetables, fish etc. therefore the
entire supply will have to be sold in a day or two.
Contd…

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The vertical shape of MPS
curve indicates that the
supply is inelastic at any
price. This is because the
industry is not willing to
waste the commodities.
They sell them whatever the
price is. Price therefore
depends upon demand only.
In this diagram, at D’D’ price
is P’’ to form equilibrium of
E’. Similarly other cases also
shown in the diagram.

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 Incase of commodities which are durable. The
supply curve should not be a vertical straight
line. The mechanism is clear from the below
diagram. At OS price, the industry is not at all
selling anything, but starts selling M’ quantity
at OP’’ to form equilibrium E. when customers
are
ready to by more at a higher
price, supply is increased to OM.
at price P’ supply is constant
because the industry cant make
immediate adjustments.

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 Price determination during the short period.
firms are able to adjust the supply during short
period but not in large scale because plant size
can’t be changed. So expansion is limited to the
extent of existing plant capacity.

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 The price determined by the market forces as
shown in the first diagram is adopted by the
firm which is shown in the second diagram.
Firm is adjusting its output by OM to OP price.
The firm earns equilibrium profit where
MC=MR. The demand curve of a firm in a
perfect competition market is a straight line
parallel to X axis. Therefore D=AR=MR=P.
SMC, SAC and AVC refer to Short run
Marginal Cost, Short run Average Cost and
Average Variable Cost. At OM quantity SMC
cuts the AR curve from below. So this is the
equilibrium quantity(E). Profit of the firm is
shown by the shaded area. This is arrived at

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 Profit of from a single unit = AR-AC
Total profit from whole = AR-ACxQ
AR= EM
AC= NM
Total Production = OM
Profit= EM-NMxOM
= ENxOM
 In the above diagram there is a second case
where E changes to E1. The mechanism is
same as the first. But the firm can continue
production if it recovers AVC at least. The point
at which AVC = AR and where AVC cuts AR
from below is called the Shut-down Point. The
firm will have to stop production below this
price level.

Price determination in the long period( long-
run equilibrium)
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 During the long period, the existing firms can expand
their production by installing new plants and
machineries. Some new firms may enter or existing
ones may leave the industry during this period. If the
firms are earning supernormal profit (AR>AC)during
short period, new firms are attracted in the long run.
The entry of new firms causes for increase in factors
of production and thus increase in cost. Increased
supply causes for reduction in price (AR). Long run
supernormal profit absconds like this. Similarly if the
firm is suffering losses during short run (AR<AC),
such firm may leave the industry. This causes for
decrease in production factors and hence costs come
down. The supply also decreases and price increases.
Thus the long run loss disappears.

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Monopoly
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 One seller and large number of buyers
 No close substitutes for the product
 Fuller control over the supply of the commodity
 Monopolist fixes the prices, he is a price maker
 Other sellers cant enter into the market
 The firm and industry are the same.

Monopolist’s Demand, Revenue
and Cost Curves
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 There is no separation from industry in a
monopoly market since there is only one seller
who himself is both the firm and industry. A
monopolist’s demand curve is also his AR
curve. The MR curve and AR curve slope
down wards from left to right because the
monopolist can sell more only at low prices.
But the MR curve lies below the AR. The
reason is clear from the below table and
diagram.

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Price and output determination
under monopoly
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 A monopolist firm is a price maker. He fixes
both the price as well as the output. It fixes
both in a way as to gain maximum profit.
 We analyze price and output determination
during short run and long run. In the short run,
monopolist cant install new plant and expand
output. The profit will be maximum if MC=MR,
this is the equilibrium point beyond which the
production cant move because he suffers loss.

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 In the figure, MC is
lesser than MR till
OQ. Then it moves
up. Therefore any
quantity beyond OQ
will lead to loss for
the monopolist. This
is the equilibrium
profit. QP1 is the
Average Revenue at
this point and QL is
the Average Cost.
Profit= Qp1-
QL=P1L. Total
profit=OQxP1L.

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 A monopolist may sometimes earn normal profit or he
may incur loss as shown in the figure.

Price determination in the long run
(long run equilibrium)
 The case is same as
in the short run.
Monopolist
maximizes profit
until his MR=LMC.
The price and output
determination in the
long run is shown in
the figure.
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Price discrimination
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 Price discrimination is the practice of charging
a different price for the same good or service.
In the words of Mrs. John Robinson “ the act of
selling the same article, produced under single
control at different prices to different buyers is
known as price discrimination”. The
discrimination may be of following kinds.
•Personal
discrimination
•Local discrimination
•Trade discrimination
•Time discrimination
•Age discrimination
•Size discrimination

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 Degrees of Price Discrimination: There are
three types of price discrimination – first-
degree, second-degree, and third-degree price
discrimination.
 First-degree price discrimination, alternatively
known as perfect price discrimination, occurs
when a firm charges a different price for every
unit consumed.
 Second-degree price discrimination means
charging a different price for different quantities,
such as quantity discounts for bulk purchases.
 Third-degree price discrimination means charging
a different price to different consumer groups. For
example, rail and tube travelers can be
subdivided into commuter and casual travelers,
and cinema goers can be subdivide into adults
and children. Third-degree discrimination is the

Price and output determination
under price discrimination.
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 There are three diagrams above. First one
denotes market A, second represents market
B and third is the total of both. Marginal
revenue in both the cases is equal. The
horizontal line reflects it. The monopolist
adjusts his output in such a way as his MR is
same in both the markets.

Dumping
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 According to Mrs. John Robinson “ Price
dumping is selling at a lower price in an export
market and at a high price at home”.
Monopolist enjoys monopoly in the home
market, thus he sells at a higher price. But in
the foreign market he faces competition,
therefore he’s to cut down prices to maximize
revenue.

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 ARH denotes Average
revenue in the home
market and MRH
denotes marginal
revenue in the home
market. Both these
curves slope
downwards. In the
foreign market
monopolist faces stiff
competition and
therefore ARF = MRF .

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 Monopolistic competition, as the name implies is
the combination of monopoly and competition.
Perfect competition is a myth and is not existing in
the real world. Monopolistic competition is an
imperfect competition.
 According to Prof. E. Chamberlin (USA)
“monopolistic competition refers to a market
situation in which competition is imperfect. It is a
market structure in which relatively many firms
supply a similar but differentiated product, with
each firm having a limited degree of control over
price.

Features of Monopolistic
Competition
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 Large number of sellers (25,35,60 or 75)
 Differentiated products
 No barriers on entry and exit
 Elastic demand
 Importance of advertisement and selling costs
 There is no combination of firms
 Competition is based on product features
 Lack of perfect knowledge

Demand or AR curve under
monopolistic competition.
 Dpc/ARpc denotes
AR curve under
perfect competition.
Dmc/ARmc stands for
monopolistic
competition and
Dm/ARm curve for
monopoly. It is clear
from the graph that
the Dmc/ARmc lies in
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Price-Output Determination under
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 Short-Run Equilibrium of a firm: Short Run
Equilibrium of a firm is almost same as in the
case of a monopolist. There are three cases in
the short run, they are the cases of
 Abnormal profit
 Normal profit or zero profit and
 Loss.
 These case are explained with diagrams in the
following pages.

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 Possibility of Super
normal profit: The
firm can fix high
price and get
abnormal profit If the
demand is very high
and there is no
close substitutes.
More over no new
firms can enter into
the market. Firm
maximizes profit
until its MC=MR.

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 Normal profit or zero
profit occurs when
the demand is not
high. Normal profit is
earned when AR is
slightly higher than
AC. If AR=AC, then
there is no profit.

 Loss of a firm in
Monopolistic
competition occurs if
AC>AR. It happens
if the demand is
very low. The firm
sells only less
quantity in this case.
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 Long Run
Equilibrium under
Monopolistic
Competition: There
is no supernormal
profit or loss in the
long run. Firms earn
only normal profit in
this case.
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Oligopoly
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 Oligopoly also comes under imperfect
competition. It comes in between monopoly
and monopolistic competition. It is a market
situation in which only few sellers sell
homogeneous or differentiated products.

Features of oligopoly
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 Few sellers
 Homogeneous or differentiated products
 Interdependence of firms
 Price rigidity
 Element of monopoly
 Excessive expenditure on advertisement
 Uncertainty of demand curve

Pricing in oligopoly
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 Pricing in oligopoly can be explained on the
following three models. Even though there are
many such models, these are the popular.
They are
 Cournot’s Model
 Collusion Model
 Leader-Follower Model

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Cournot
’s Model
 This model is named so because it
was proposed by Augustin Cournot.
The model assumes that the
competitors do not react to the
change in prices of goods of other
firms. The decisions on price and
out-put of each firm is taken
independently. It negates the most
important factor i.e. the
interdependence of pricing
decisions.

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Collusion
model/Collu
sive
oligopoly
 Price-output decisions under this
model are taken by recognizing the
interdependence of firms. Firms may
enter into an agreement on pricing
and output for this purpose. If such
an agreement is formal and overt,
then the group formed is known as a
cartel. If the agreement is illegal,
firms make an informal agreement.
This agreement is called collusion.
There will be centralized decision
making in both the cases.

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 Price and output determination in a cartel or
collusion is shown in the figure.

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Leader -
follower
model
 This model is also called Price
Leadership. It is a situation where
one firm is leading the industry and
others are following it and accepting
its pricing policy. The leader will be
probably the biggest and strongest
among others in the industry. For
example, Honda in the scooter
industry. Camlin in writing ink etc.

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 Price output decision under leader-follower
model

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 Kinked Demand Curve Model: Once a
decision on pricing is arrived by a firm in an
oligopoly market following any of the above
three models, it remains fixed for an extended
period. This is called price rigidity in an
oligopoly market. The theory explaining this
phenomenon is called Kinked Demand theory.

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Other market forms
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 Duopoly: It is a market situation in which there are
only two sellers. It’s a limiting case of oligopoly. There
are two possibilities between them. Either cooperation
or competition.
 Monopsony: Here, there is only a single buyer for a
product or service. Prof. J.K. Mehta opines that
monopsony buyer succeeds in playing lower price for
the product without purchasing it in bulk quantities.
 Dupsony: There are only two buyers in this case.
 Oligopsony: Here, there are many sellers and a few
buyers.
 Bilateral monopoly: In bilateral monopoly, there are
only one seller and one buyer.

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Chapters
10. Pricing Policies and Practices.
11. Macro Economics and Business Decisions.
Unit V- Pricing Policies and Practices; Macro
Economics and Business decisions

Meaning of Price
Factors Governing Price
Pricing Methods
Pricing policies and practices
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10

Meaning of Price
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 Price is the exchange value of goods and
services expressed in monetary terms.
 Price sometimes may be perceived as an
indicator of quality. But, charging high prices
may not be always good for an organization.
This chapter presents a detailed discussion on
price.

Factors governing price
 Costs
 Objectives
 Organizational factors
 Marketing Mix
 Product differentiation
 Product life cycle
 Characteristics of the
product
 Demand
 Competition
 Distribution
channels
 General economic
conditions
 Govt. Policy
 Reactions of
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Internal factors External factors

What’s a pricing policy?
 The policy adopted
by an organization
regarding price is
called their pricing
policy. Following are
the objectives of a
pricing policy.
 Profit maximization
 Market share
 Return on
investment
 Manage competition
 Cash collection
 Survival in the
market
 Goodwill of the
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Pricing methods
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 Cost Plus Pricing: Majority of firms price their
products on the basis of cost. Total cost is
arrived at by adding variable and fixed costs.
This method is also known as margin pricing
or average cost pricing or full cost pricing or
mark up pricing. This method guarantees
recovery of cost at the same time it ignores the
effect of demand.

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 Target pricing: Here, a target rate of return on
investment is fixed and cost is added to this
figures. The target rate is decided by taking
into account
a) Nature of business b) type of market c)
degree of competition d) average target of
previous years. A predetermined rate of return
on investment is guaranteed by this method.
This method, like the cost plus pricing ignores
the effect of demand.

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 Marginal Cost Pricing: In both the above
methods, the price is fixed on the average cost
of product. But in this method, marginal cost is
taken into consideration. Fixed costs are
totally excluded here. It is attractive in a
competitive market but the firm has to be
always vigilant on recovery of fixed costs.
During long run, this method is not suitable.

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 Differential Pricing: This method is what we
call as “ Price discrimination”. This is the act
of charging different prices to different
customers in different places and at different
periods.
 Going rate Pricing: As the name implies, prices
are maintained parallel to the average price of
existing market rates. It enables the brand to
cop-up with competition. A market leader may
have economies of scale, therefore a beginner
may not always resort to going rate pricing.

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 Customary Pricing/Conventional Pricing: Tea
or Coffee prices are good examples for
customary pricing. These type of products are
conventionally priced. The change in such
products occurs only when there is a
significant change in the cost of its ingredients.
A similarity and stability is seen in the case of
such products. Current market conditions are
not considered in this method.

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 Follow-up Pricing: Price is determined according
to the competitors under this policy. It is suitable
for new products. Cost is not considered here.
 Barometric Pricing: Barometric price leadership
refers to situations in which a price leader acts as
a barometer of prevailing market conditions for
other firms in the industry. The price leader may
not be the largest firm or dominant but he acts as
a barometer in forecasting changes in cost and
demand conditions in the industry and economic
conditions in the economy as a whole.

Pricing of new products
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 Pricing of new products is a key issue to many
organizations. Following methods are usually
followed in such cases
 Skimming price policy: This is to skim the cream by
charging higher prices. The objective of the policy is
to bag the sale to the customers who are ready to pay
higher prices. This policy is suitable when the demand
is relatively inelastic. Mobile Handset companies and
some automobile manufactures follow this method.
 Penetration Price Policy: This is to drive away
competitors by charging a low price initially. It enables
the organization to grab a good market share.

Other pricing strategies
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 Psychological Pricing: This is the act of pricing
which creates a feeling that the price is low. E.g.
some foot wear brands like Bata fix price as
599.50, 990 etc.
 Mark-up Pricing: usually wholesalers and retailers
follow this method. This is to add an additional %
to the price of the product to sell to the ultimate
customers.
 Administered Pricing: Pricing exclusively on the
basis of managerial decisions is called
administered pricing.
 Geographic pricing, base-point pricing, zone
pricing, dual pricing, product line pricing etc. are

I. Macro Economics
II. National Income Concepts
III. Business cycles and Stabilization
policies
IV. Inflation: Meaning and Control
measures
Macro Economics and Business
Decisions
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Chapter
11

I-Macro economics
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 According to Dr. DN Dwivedi, Macro
Economics is the study of economy as a
whole. It discusses aggregates such as GDP,
GNP, general employment level, general price
level etc. The ultimate aim of Macro Economic
studies is to formulate macroeconomic policies
for macroeconomic management.

II-National income concepts
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 National Income is the final result of all
economic activities of an economy expressed
in terms of money.
 GDP, GNP, NNP and NDP are the mostly
discussed issues in national income concepts.
Of the various measures of National Income,
GNP is the most important and widely used. All
these terms are defined below.

Gross National Product- GNP
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 In an open economy, GNP is the most
comprehensive measure. GNP is defined as
“the value of all final goods and services
produced during a specific period, usually by
one year, plus incomes earned abroad by the
nationals minus incomes earned locally by the
foreigners.” GNP = GNI(Gross National
Income). The difference between GNP and
GNI is in procedure only. Former is estimated
on product flows and the latter on income
flows.

Gross Domestic Product- GDP
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 GDP is defined as the market value of all final
goods and services produced in the domestic
territory of a country during a period of one
year, plus income earned locally by the
foreigners minus incomes earned abroad by
the nationals. When compared to GNP, the
case of income earned by nationals abroad
and foreigners locally is reversed. Nominal
GDP estimates are commonly used to
determine the economic performance of a
whole country or region, and to make
international comparisons.

Depreciation, NNP and NDP
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 Depreciation is the term used to denote the part of
total stock of capital used up in the process of
creating goods and services.
 NNP= GNP- Depreciation. NNP is the net output
available for consumption by the society (including
consumers, producers and the government).
NNP=NNI (Net National Income). But it includes
indirect taxes also. Therefore to obtain real
national income the method NNP-Indirect Taxes is
used.
 NNP- income from abroad gives NDP(Net
Domestic Product)

III-Business Cycle and Business
Policies.
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 The term “Cycle” in business context refers to
fluctuations in economic activity. Economic
activity of a community can be reflected by
several indicators, viz., the level of
employment, output and income and the price
level. These measures show ups and downs
when plotted in a graph.
 These trade cycles have to be differentiated
from seasonal economic movements which
are regular and relatively easy to predict.

Phases of the business cycles
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Prosperity: Expansion and Peak
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 Prosperity happens when there is rise in
 National output.
 Prices of raw materials and finished goods.
 Level of employment.
 Debtors can pay their debts more conveniently.
 Bank loans increase even though bank rate is
higher.
 Idle funds are productively invested since share
prices increase.
 The conditions continues following the multiplier
effect
Contd…..

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 In the ending stages of prosperity, following
trends prevail
 Inputs start falling short of their demand. Hence
their prices increase.
 Workers become harder to find and they use
bargaining capacity.
 Cost of living increases at a higher rate and it
forces fixed income earners to review their
spending habit.
 All these leads to the Peak

Turning-Point and Recession
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 Once the economy reaches the peak, increase
in demand stops and it starts to decrease. But
producers are not aware of these conditions,
they continue existing levels of production and
investment. It causes for mismatch between
supply and demand. Subsequently, future
investment plans are given up.
 Decrease in demand leads to decrease in
wages, interest etc.
Contd….

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 producers lower the prices of their products to
meet their financial obligations. But customers
postpone their consumption expecting a
further decline in price.
 All the above leads to recession. The process
is exactly reverse to the process of expansion.
 Finally when recession process takes an end
and the economy enters the phase of
depression

Depression and Trough
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 Depression happens in the form of
 Negative growth rate
 Decline in national income and expenditure
 Decline in consumer and capital goods
 Lose of job for workers
 Less attractive and less profitable investments
 Trough is the stage where depression sinks to
depth and all economic activities touch the
bottom.

Reversal of the process
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 Basically, there is a limiting point to which an
economy can sink. The process starts to
reverse when pessimism ends and optimism
starts.
 Spreading unemployment makes it necessary
for workers to work at available rates.
Producers offer jobs to workers. Consumers
begin consumption expecting no further
decline in price. Banks with extra cash reserve
makes up their financial position by lending
and investing even if the rate is very low.
Contd…

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 Private investors follow the same action that of
the banks. Optimism is shown in the stock
market.
 Besides all these, price mechanism is
operated as a self-correcting force in a free
economic system.
 Investment slowly picks up and employment
increases simultaneously. The multiplier again
operates and the phase of recovery gets
underway.

Recovery stage
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 Following are the characteristics of this stage
 Some firms plan additional investment and
renovation programs.
 Employment is generated from construction of
houses which was postponed earlier. Wages also
moves upward
 Businessmen earn quick and higher returns.
 A number of related developments begin to take
place.
 Finally the economy comes up and enters the
phase of expansion and prosperity.

Economic Stabilization Policies
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 Violent fluctuations in economy is harmful to
business community and general people in a
country. It causes for unemployment and
poverty during the depression period. The
great depression of 1930s has rewritten the
misconceptions that the invisible market forces
would automatically bring back the economy to
a normal condition. Interventions from the part
of government plays a vital role in it. Major
stabilization policies are discussed below.

Objectives of stabilization
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I. Tackling with heavy fluctuations and making
allowance for necessary fluctuations for a
long term. Sustained economic growth.
II. Providing a conducive environment for
efficient utilization of labour and other factors
of production
III. Encouraging free competitive firms with
minimum interference to function in the
economy and
IV. Reduce the conflict between the internal and
external interests of the economy

Policies for stabilization
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 The widely used policies fall under two categories.
They are
1. Fiscal policy and
2. Monetary policy
 Fiscal policy means the policy of government on
taxation and public expenditure programs. Both
has unique effects i.e. taxation transfers funds
from the private purses to the public coffers;
Public expenditure on the other hand increases
the flow of funds in the economy. These policies
are also called budgetary policies.
Contd…

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 The relevance of fiscal policy as a stabilization
instrument lies on the fact that government
activities in modern economies rise tax
revenue and expenditure which in turn form a
considerable portion of GNP, ranging from 10
to 25%.
 If fiscal policy of the government is so
formulated that it generates additional
purchasing power during depression and it
contracts purchasing power during the period
of expansion , it is known as “Counter-cyclical
fiscal policy”

Managerial economics

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