MODULE-I: MANAGERIAL ECONOMICS

1.1 Introduction

Economics is the study about making choices in the presence of scarcity. The

notions, ‘Scarcity’ and ‘Choice’ are very important in Economics. If the things were

available in plenty then there would have been no choice problem, you can have anything

you want. The point is that problem of choice arises because of scarcity. The study of

such choice problem at the individual, social, national and international level is what

Economics is about. Thus, Economics as a social science, studies the human behaviour as

relationship between numerous wants and scarce means having alternative uses.

Economics, as a basic discipline, is useful for certain functional areas of business

management. Economics could be broadly classified into two categories: 1) Macro

economics and 2) Micro economics. Macroeconomics is the study of the economic

system as a whole. Microeconomics, on the other hand, focuses on the behaviour of the

individual economic activity, firms and individuals and their interaction in markets.

Managerial economics is an applied microeconomics. It bridges the gap between

abstract theories of economics in the managerial decision-making. So, managerial

economics is an application of that part of microeconomics, focusing on those topics of

the greatest interest and importance to managers. The topics include demand, demand

forecasting, production, cost, cost function, pricing, market structure and government

regulation. A strong grasp of the principles that govern the economic behaviour of firms

and individuals is an important managerial talent.

In general, managerial economics can be used by the goal-oriented manager in

two ways. First, given an existing economic environment, the principles of managerial

economics provide a framework for evaluating whether resources are allocated being

efficient within a firm. For example, economist can help the management to determine if

reallocating labour from marketing activity to the production line could increase profit.

Second these principles help managers respond to various economic signals. For

example, given an increase in price of output or development of new lower cost

production technology, the appropriate managerial response would be to increase output.

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Alternatively, an increase in the price of one input, say labour, may be a signal to

substitute other inputs, such as capital, for labour in production process.

1.2 Meaning and Definition of Managerial Economics

Managerial Economics is the application of economic theory and methodology to

decision-making processes within the enterprise.

Hailstones and Rothwell defined managerial Economics as “Managerial

Economics is the application of economic theory and analysis to practices of

business firms and other institutions.”

According to McNair and Merian say that “managerial economics consists of

the use of economic modes of thought to analyze business situations”.

Spencer and Siegelman defined Managerial Economics as “the integration of

economic theory with business practice for the purpose of facilitating decision-

making and forward planning by the management”.

According to Prof.Evan J.Douglas “Managerial Economics is concerned with

the application of economic principles and methodologies to the decision making

process within the firm or organization under the conditions of uncertainties”

In general, Managerial Economics could be defined as the discipline which deals

with the application of economic theory to business management.

1.3. Nature of Managerial Economics

Management is the guidance, leadership and control of the efforts of a group of

people towards some common objective. It tells about the purpose or function of

management. Koontz and O’ Donell define management as the creation and maintenance

of an internal environment in an enterprise where individuals work together in groups,

can perform efficiently and effectively towards the attainment of group goals. Thus,

management is coordination, an art of getting things done by other people. On the other

hand, economics due to scarcity of resources is primarily engaged in analyzing and

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providing answers to the various basic economic problems like what to produce? How to

produce? And for whom to produce? Science of Economics has developed several

concepts and analytical tools to deal with the problem of allocation of scarce resource

among competing ends. Close interrelationship between management objectives and

economic principles has led to the development of Managerial Economics. Managerial

Economics as a link between economic theory and decision science, its purpose is to

contribute to sound decision making not only in business but also in government agencies

and Non- profit organizations. In particular, managerial economics assists in making

decisions about the optimum allocation of scarce resources among competing activities.

The following chart shows the nature of Managerial Economics.

1.4. Scope of Managerial Economics

Scope of the subject is said to be an extent of coverage of the subject concerned or

boundaries within which subject is set in and also the importance of the subject.

Managerial Economics, among others, embraces following important aspects.

Demand Analysis and Forecasting

Production and Cost Analysis

Pricing Decisions, Policies and Practices

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EconomicsTools and Techniques

Business ManagementChoosing the best alternative

Managerial EconomicsApplication of Economics to

Solve business problems

SOUND BUSINESS DECISION

Capital Management, and

Profit Management

Though the above ones are treated as subject matter of Managerial Economics, in the

recent years some of the techniques like Linear Programming, Input-output analysis, etc.

are also become the part of the subject.

1.4.1 Demand Analysis and Forecasting

Demand is a starting force for any business firm to emerge. A business firm is an

economic organism, which transforms productive resources into goods, and services that

are to be sold in a market. So, a major part of managerial decision-making depends on

accurate analysis of demand. Demand analysis helps identify the various factors

influencing the demand for firm’s product and thus provides guidelines to manipulating

demand. Hence, Demand analysis and forecasting, therefore, is necessary for business

planning and occupies a strategic place in Managerial Economics.

1.4.2 Production and Cost Analysis

In the competitive environment, business firms are forced to produce goods and

services with cost effectiveness. Production function and cost analysis enable the firms to

achieve these goals. The factors of production may be combined in a particular way to

yield maximum output. In case the prices of inputs shoot up, a firm is forced to work out

a least cost combination of inputs in producing a particular level of output. Along with

the above, a study of economic costs, combined with the data drawn from the firm’s

accounting records can yield significant cost estimates that are useful for managerial

decisions. The suitable strategy for the minimization of cost could be evolved.

1.4.3 Pricing Decisions, Policies and Practices

The success of a business firm mainly depends on the sound price policy of the

firm. The price policy of the firms determines its sales volume as well as its revenue.

Price X Sales volume = Gross Revenue of the firm

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Therefore, pricing is very important area of Managerial Economics. Important aspects

dealt with under this area are: Price and output determination in various Market forms,

pricing methods, Differential pricing, Product line pricing and so on.

1.4.4 Capital Management

Capital is one of the most important factors of production. In developing countries

like India it is a limiting factor on the economic development. It is to be managed more

efficiently for the overall development of the economy as well as for the prosperity of the

firm. A firm’s capital management is most troublesome and complex activity of business

management. This kind of capital management implies planning and control of capital

expenditure. The major areas dealt here are: Cost of capital, Rate of return and selection

of projects.

1.4.5 Profit Management

All kinds of business firms generally organized for the purpose of making profits.

In the long-run profits provide the chief measure of success. An element of risk deserves

place at this point. Profit analysis becomes an easy task in the absence of risk. However

in the business it is difficult to assume something without risk. The important aspects

covered under this are: Nature and measurement of profit, Profit policies.

The above-mentioned aspects represent the major uncertainties, which a business

firm has to reckon with. Thus, Managerial Economics is application of economic

principles and concepts towards adjusting with various uncertainties faced by a business

firm.

1.5. Managerial Economics and its Relationship with Other DisciplinesManagerial Economics is an interdisciplinary course. In fact most of the

management courses are of that sort. Managerial economics is linked with various other

fields of study. Subjects like Economics, Statistics, Mathematics, and Accounting deserve

greater emphasis in this regard. However, the relation of Managerial Economics is not

confined only to them.

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1.5.1 Managerial Economics and Economics:

Managerial Economics is widely understood as economics applied to managerial

decisions. It may be viewed as a special branch of economics, functioning as bridge

between economic theory and managerial decisions. Microeconomics, one of the main

divisions of economics, is main source of concepts and analytical tools for managerial

economists. To illustrate, concepts such as elasticity of demand, elasticity of production,

demand forecasting, marketing forms, production function etc. are of great significance to

managerial economists. Thus, it is felt that the roots of managerial economics spring from

micro-economic theory. The chief contribution of macroeconomics is in the area of

forecasting of general business conditions. The modern theory of income and

employment has direct implications for forecasting general business conditions.

1.5.2 Managerial Economics and Statistics:

Economics in general, Managerial economics in particular deals with quantifiable

variables. Quantification and estimations plays crucial role in managerial economics.

Therefore, application of statistics in Managerial Economics helps in decision-making in

several ways. It helps in the estimation of demand function, which in turn helps in

demand forecasting. Similarly statistics is also useful in the estimation of production and

cost functions. Estimation of price index relays heavily on statistical tools. In this way

Managerial Economics is heavily rely on statistical methods.

1.5.3 Managerial Economics and Mathematics:

Mathematics is another important discipline closely related to Managerial

Economics. It is again because managerial economics is quantifiable. Knowledge of

geometry, calculus and matrix-algebra is not only essential but certain mathematical

concepts and tools such as Logarithms and Exponentials, Vectors and so on are the tool

kits of managerial economists. In addition, Operations Research is also closely related to

Managerial Economics, used to find out the best of all possibilities. Linear Programming

is an important tool for decision-making in business and industry as it can help in solving

problems like determination of facilities on machine scheduling, distribution of

commodities and optimum product mix etc. Input-output analysis is also very much

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useful in managerial economics. Thus, there is close relationship between Managerial

economics and Mathematics.

1.5.4 Managerial Economics and Accounting:

Accounting mainly deals with systematic recording of the financial reports of

business firms. As a matter of fact accounting information is one of the principle source

of data required by a managerial economist for his decision making purpose. For

example, the profit and loss account of a firm tells how well the firm has done and the

information it contains can be used by a managerial economist to throw light on the

present economic performance of the firm and future course of action. It is in this context

that the growing link between management accounting and managerial economics

deserve special mention. The main task of the management accountants now seen as

being to provide the sort of data which manager needs if they are to apply the ideas of

managerial economists to solve the business problem.

1.6. Fundamental Concepts of Managerial EconomicsManagerial Economics as explained earlier, it is the application of economic

theory to management decision-making. Economic theory offers a variety of concepts

and analytical tools, which can be of considerable assistance to the manager in his/her

decision-making process. These basic concepts or principles are fundamental to the entire

gamut of managerial economics. Some important basic concepts are discussed in this

section. The basic concepts discussed in this section includes:

1. Opportunity cost principle

2. Incremental principle

3. Time perspective principle

4. Discounting principle

5. Equi-marginal principle

1.6.1 Opportunity Cost Principle

Opportunity cost is of fundamental importance in decision-making process. The

opportunity cost principle may be stated as under: The cost involved in any decision

consists of the sacrifices of alternatives required by that decision. If there are no

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sacrifices, there is no cost. Decision implies making a choice from among the various

alternatives. By the opportunity cost of a decision is meant the sacrifice of alternatives

required by that decision. A decision is cost free if it involves no sacrifice. For example,

a businessman invests his own capital in business; its opportunity cost can be measured in

terms of interest, which he could have earned by lending that money to somebody.

Another illustration, when a businessman devotes his time in organizing his business, the

opportunity cost may be measured in terms of salaries he could have earned from some

employment from elsewhere. Thus, in above cases, businessman compares expected rate

of return (prospective yields) from business with current rate of interest/salary and if he

finds that prospective yields happen to be greater than the rate of interest/salary he would

take a positive decision for further investment, otherwise not. Thus, opportunity cost is

the benefit foregone by not selecting the best alternative.

1.6.2 Incremental Principle

The concept of incremental principle is related to the marginal costs and marginal

revenues concepts of economics. The incremental concept refers to the change in total. It

involves estimating the impact of decision alternatives on cost and revenues. The two

basic components of incremental reasoning are incremental cost and incremental revenue.

Incremental cost may be defined as the change in the total cost due to particular decision.

Incremental revenue is the change in total revenue caused by particular decision. Thus,

when incremental revenue exceeds incremental cost resulting from a particular decision,

it is regarded as profitable. This certainly helps arriving at a better decision comparing

between incremental costs and revenues of alternative decisions. For example table 1

illustrates the revenue and cost of producing commodity ‘X’ by ABC Company.

Table 1: Revenue and Cost of X Commodity Pertaining to ABC Company

Sl.No.(1)

Production of X commodity

(2)

Total Revenue

(3)

Incremental Revenue

(4)

Total Cost

(5)

Incremental Cost

(6)

Total profit7=(3-6)

1 1000 20000 - 18000 - 2000

2 2000 39500 19500 37000 19000 2500

3 3000 58500 19000 58500 21500 0

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Increase in production from 1000 units to 2000 units results higher incremental revenue

(Rs.19500) compared to incremental cost (Rs.19000). Therefore, it is advisable to

increase production from 1000 units to 2000 units. Incremental cost (Rs.21500) is more

than the incremental revenue (Rs.19000) when the producer increases his production

from 2000 units to 3000 units.

1.6.3 Time Perspective Principle

The economic concepts like short-run and long-run are part of every day

language. This time perspective of short and long-run period is important in business

decision-making. Managerial economists are also concerned with long and short – run

effects of decisions on revenues as well as costs. Important problem in decision-making

is to maintain the right balance between short-run and long-run considerations.

1.6.4 Discounting Principle

The concept of discounting is applied to future costs and returns as there are

variations in the time perspective underlying different decisions. Discounting originates

from the concept of opportunity cost and time perspective. A simple example would

make this point clear. Suppose a person is offered a choice to have Rs.1000 now or after

two years. He/She would be obviously choosing the first one, as the present value of

Rs.1000 is less after two years than it is available today. In business decision-making

process, thus, the discounting principle may be stated as: “If decision affects costs and

revenues at future dates, it is necessary to discount those costs and revenues to present

values before a valid comparison of alternatives is possible”

1.6.5 Equi-Marginal Principle

Equi-marginal principle deals with the allocation of the available resources among

the alternative activities. According to this principle, an input should be so allocated that

the value added by the last unit is the same in all uses. Suppose a firm has 100 units of

labour at its disposal. The firm engages in three economic activities, which need services

of labour viz. A, B, and C. It could enhance any of these activities by adding more of

labour only at the cost of other activity. Thus, It should be clear that if the marginal value

product is higher in one activity than another, an optimum allocation has not been

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attained. It would therefore, be profitable to shift labour from low marginal value product

activity to higher marginal value product activity. The optimum allocation of labour

could be ensured when:

(VMPL)a = (VMPL) b = (VMPL)c

Here, VMPL refers to the value of marginal product of labour; a, b, c are three activities.

Thus, this principle is greatly useful in the allocation of any of the resources among

alternative uses.

1.7. Objectives of the Firm

Each and every business firm strives to achieve some predetermined objectives. In

the conventional economics emphasis was given to the profit maximization objective. In

modern society, very few experts will argue that a firm is motivated by the sole objective

of maximization of profit. In the modern days a firm invariably pursues multiple

objectives even though one or some of them may receive priority over others. The

objectives of the modern firm could be summarized under the following headings.

1. Profit maximization

2. Long run survival

3. Sales maximization with Profit constraint

4. Cost minimization

1.7.1. Profit Maximisation: The success of any business is measured by the volume of

its net income. The Net Income is the residual income, which accrues to a firm after all

other costs have been met. In other words Net Income = Total Revenue –Total Cost. It

is considered to be the acid test of the performance of the individual firm. Emphasis has

been given to this objective in conventional economics.

1.7.2. Long Run Survival: Economists, in the modern days, however, do not accept

that profit maximisation is the only objective to be attained by the firm. K. Rothdchild

expressed that the primary objective of any business enterprise is long run survival. For

the long run survival to some extent firms compromise with their profit level. In the

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modern days, firms’ aims at limited instead of maximum profit for various reasons.

Professor Joel Dean mentioned some of the reasons for limiting profits viz. 1.To

discourage the potential competitors, 2. To maintain costumers good will, 3. To keep

market control undiluted 4. To maintain pleasant working condition etc.

1.7.3. Sales Maximization with Profit Constraint: Prof. William J. Baumol,

American economist, does not agree with the traditional view that firms aims at

maximizing profit. According to him, the objective of a modern firm is sales

maximisation with a profit constraint. Sales maximisation does not mean an attempt to

get largest possible physical volume of output. Here the sales means the revenue earned

by selling the product. Hence, sales maximisation refers to the maximisation of the total

revenue that measures the quantity of product sold in Rupee terms. It could be presented

with the Support of the figure No.1.1.

Figure 1.1: Sales maximization with Profit constraint

In this figure X-axis measures the output and Y-axis measures the Total Revenue

(TR), Total Cost (TC) and Total Profit (TP). OM is the minimum profit, which the firm

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intends to earn. With the increase in the output/sales level the TR goes on increasing up

to a certain extent then start falling. Similarly TC goes on increasing with the increase in

the sales level. TP is the difference between the TR and TC; hence TP is the vertical

distance between the TR and TC. If the firm intends to get maximum profit it has to

produce/ sale OA quantity of output because TP curve is maximum at point H. On the

other hand if the firm intends to maximize the sales it has to produce and sell OC amount

of the commodity because TR curve maximum at point R2. At OC level of output profit

level (CG) is less than intended level (CP). According to Baumol the firm produce/sell

OB amount of output. It maximizes the total revenue subjected to minimum profit shown

by ML curve. BE is the profit earned by the firm at OB level of output.

1.7.4. Cost Minimization: Whether a firm is pursuing the profit maximisation goal or

total revenue maximisation subjected to profit constraint goal or even long run survival

goal the firm has to produce the goods or render the service at the least cost through the

achievement of the technical efficiency. Cost minimization through the existing technical

efficiency is within the control of the firm. Total revenue, along with quantity of the

commodity sold, depends on the market price of the commodity, which is many a time

beyond the control of the firm. The cost minimization enables the firm to achieve the

objectives discussed above.

1.8 Factors Affecting Managerial Decisions

Managerial decision-making is not just only influenced by economics but also by

various other significant factors. Undoubtedly economic analysis contributes a great deal

to the problem solving in an enterprise, at the same time it is important to remember three

other variables, which have equal impact on the choices and decisions of managers.

Therefore, the major factors affecting managerial decisions are:

1. Economic factors

2. Human and behavioral factors

3. Technological factors, and

4. Environmental factors

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1.8.1 Economic Factors

Economic factor works as backbone for every decision-making particularly, in

case of commercial organizations .In the present day situation it is even extended to not-

for-profit organizations. In business organizations for the purpose of survival and growth

more than anything economic factors like, profit maximization and/or sales revenue

maximization play vital role.

1.8.2 Human and Behavioral Factors

It is proved beyond the doubt that economic factors occupy significant place in

decision-making process. However, economic rationality may not hold well all the times.

Ultimately economics is for the well-being of people concerned. So, management of any

organization will look into their personal comfort as well employees morale and

motivation. It can be observed with small entrepreneurs, who refuse to expand or

diversify their economic activity even though economic rational provides clear signal of

the opportunities ahead that await them. Yet many of them decide to remain small since

they feel that such expansion will tend to strain their lifestyles or threaten their control

over the management.

1.8.3 Technological Factors

Technological factors also play crucial role in managerial decision-making

process. In the resource allocation process management of an organization will assess the

technological alternatives, the technological moves of competitors and emergence of new

technologies and processes. No major investment decision is made without a close

scrutiny of relevant technological alternatives. This is applicable for new establishment,

expansion of an existing concern, modernization and diversification decisions.

1.8.4 Environmental Factors

It is impossible to imagine any business organization in isolation. It functions

amidst of turbulent environment consists of socio-economic, physical, political forces etc.

Environmental pressures operating on the enterprise have a bearing on managerial

decisions even when they are primarily economic in nature. For example, economic

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rationality might suggest a strong case for a price rise and yet the organization might be

forced by political, social hostility not to do the same. In the recent times the force of

environmental considerations is growing stronger. Public awareness about the impact of

firm level decisions on society is growing. Politicians, consumer activists, community

organizations and so on are increasingly concerned about the nature and consequences of

these decisions and constantly make their presence felt which may conflict with the

economic rationality.

1.9. Self Review Questions

1. Define Managerial Economics and discuss its nature and scope.

2. “Managerial Economics is economics applied to decision-making” Explain.

3. Explain how managerial economics is related to Economics, Mathematics, Statistics

and Accounting.

4.Discuss the objectives of a modern business firm.

5. Explain the factors influencing the managerial decisions.

6. Define opportunity cost? Explain its applications in management decisions.

7. Describe the importance of equi-marginal principle in Managerial decision making

process.

8. Explain the importance of incremental principle in the management science.

1.10. References/ Suggested Readings

1. Varshney RL, and Maheshwari K.L: “Managerial Economics”, Sultan Chand & Sons,

New Delhi-110002

2. Mote, V. L., Samuel Paul, Gupta,G. S: “ Managerial Economics: Concepts and Cases”,

Tata McGraw-Hill Publishing Company Limited, New Delhi

3. D.M.Mithani : “Managerial Economics: Theory and Applications”, Himalaya

Publishing House, Mumbai-400 004

6. Gopalakrishna, D.: “ A Study in Managerial Economics” Himalaya Publishing House,

Mumbai-400 004

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MODULE-II: DEMAND ANALYSIS AND FORECASTING

2.1 Introduction

The success or failure of a business depends primarily on its ability to generate

revenues by satisfying the demand of consumers. Firms that are failed to attract the

consumers are soon forced to be out of the business. Demand analysis is a source of

many useful insights for business decision-making. It serves the following managerial

objectives;

It helps in product planning and product improvement.

It gives direction for demand manipulation through advertising and sales

promotion strategies.

It is useful technique for demand forecasting with greater reliability.

It reveals the scope of business expansion.

It is, therefore, worthwhile to understand some of the concepts related to demand

analysis. Meaning, types, determinants of demand, demand functions, elasticity of

demand and demand forecasting are discussed in this chapter.

2.2 Meaning of Demand.

Demand, ordinarily, is defined as desire. But desire of a beggar to travel by air

could not be materialized for lack of his ability to pay. Desires come and vanish. So all

such desires could not be considered as demand. A desire to be called demand should be

backed by two things; one, ability to buy and two, willingness to buy. Thus, the demand

for any commodity is the desire for that commodity backed by willingness as well as

ability to pay for it and is always defined with reference to a particular time and at given

price. Demand = Desire + Ability to pay (purchasing power) + Willingness to pay. In

another way the demand for a product could be defined as the amount of it, which

will be bought per unit of time at a particular price. It is not out of context to

introduce some of the concepts pertaining to the concept demand. The concept of

Individual demand, Market demand, the law of demand, and change in quantity demand

versus change in demand.

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2.2.1 Individual Demand and Market Demand

An individual demand refers to, other things remaining the same, the quantity of a

commodity demanded by an individual consumer at various prices. Market demand is the

summation of demand for a good by all individual buyers in the market. The distinction

between individual demand and market demand has been explained with the help of

individual and market demand schedule as well as demand curves.

Tab-2.1:Individual Demand Schedule

Price (Rs.) Quantity demanded

(units)

6 10

5 20

4 30

3 40

2 60

1 80

Fig 2.1 Individual Demand Curve

An individual demand refers to the quantity of a commodity demanded by an

individual consumer at various prices, other things remaining same. An individual’s

demand for a commodity is shown on the demand schedule (Table-2.1) and demand

curve (Fig 2.1). A demand schedule is a list of prices and quantities and its graphical

representation is demand curve. It could be seen from the demand schedule that as the

price of the commodity goes on declining the quantity demand goes on increasing. Only

10 units of commodity are demanded when the price is Rs. 6 per unit whereas the

quantity demand increased to 80 units when the price declined to Rs.1 per unit. DD1, in

figure 2.1, is the demand curve drawn on the basis of the above demand schedule. The

dotted points D, Q, R, S, T and U are the ‘demand points’. They show the various price-

quantity combinations. The demand curve shows the effect of rise or fall in the price of

one commodity on the consumer’s behaviour.

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In a market, there will be many consumers for a commodity. Therefore, Market

demand shows the sum total of various quantities demanded by all the individuals at

various prices. The market demand of a commodity is depicted on a demand schedule

and demand curve. Suppose there are three individuals A, B, and C in a market who

purchase the commodity. The demand schedule for commodity is depicted in table-2.2.

The column 5 of the table represents the market demand for the commodity at various

prices. It is obtained by adding the column 2, 3 and 4 which represent the demand of the

consumers A, B and C respectively. The relation between column 1and 5 shows the

market demand schedule.

Table 2.2 Market Demand for the X Commodity

Price (Rs./Kg)

(1)

Quantity demand in Kgs.

Consumer A

(2)

Consumer B

(3)

Consumer C

(4)

Market Demand

(5) (2+3+4)

6 10 20 40 70

5 20 40 60 120

4 30 60 80 170

3 40 80 100 220

2 60 100 120 280

1 80 120 160 360

The market demand for the commodity at the price level of Rs.6 per unit is 70 Kg. The

market demand increased to 360 Kg with the fall in the price to Rs.1 per Kg. In the figure

2.2, Dm is the market demand. It is the horizontal summation of all the individual demand

curves DA+DB+DC. The market demand for a commodity depends on all factors that

determine an individual demand.

2.2.2. The Law of Demand

The law of demand describes the general tendency of consumers’ behaviour in

demanding a commodity in relation to the change in its price. The law of demand simply

states that the quantity demand of a commodity varies inversely to change in price.

“Ceteris paribus, the higher the price of a commodity, the smaller is the quantity

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demand and lower the price, larger the quantity demand”. The law of demand

relates the change in quantity of demand to the change in the price variable only. It is

always stated with the ceteris paribus i.e other things remaining same. It assumes other

determinants of demand to be constant. Thus the law of demand based on, among others,

the following major assumptions:

No change in the price of related goods

No change in the consumers income

No change in the consumers preference

No change in the advertisement strategies of business houses

Figure 2.2: Market Demand Curve

It is almost a universal phenomenon of the law of demand that the demand curve

slopes downward from left to right. In certain cases demand curve may slopes up from

left to right. It is because consumer may buy more when the price of a commodity rises

and less when price falls. Such circumstances are termed as exceptions to law of demand.

Exceptional cases may be categorized as;

1.Giffen found that in the 19th century, Ireland people were so poor that they spent a

major part of their income on Potatoes and small part on meat. For them potatoes and

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meat are inferior and superior goods respectively. When price of potatoes rose, they had

to economise on meat even to maintain the same consumption of potatoes. Further to fill

up the resulting gap in food supply caused by a reduction in meat consumption, more

potatoes had to be purchased because potatoes were still the cheapest food. Thus the rise

in the price of potatoes increased the demand for potatoes. Such goods are popularly

known as Giffen goods.

2. Some goods are purchased mainly for their snob appeal. When the price of such goods

rises, their snob appeal increases and they are purchased in large quantity and vis-à-vis.

Such goods are called Veblen goods. It is named after an American economist, Thorstein

Veblen, who advocated that some purchases were made not for the direct satisfaction,

which they yield, but for the impression, which they made on other people.

3. In the speculative market, a fall in price is frequently followed by smaller purchase and

a rise in price by larger purchases. When price of certain goods rises, people may expect

further rise and rush to buy. When price fall, they may wait for further falls, and stop

buying.

2.2.3. Change in Quantity Demand versus Change in Demand

The movement along the demand curve measures the change in quantity demand

in relation to the change in price while change in demand is reflected through shift in

demand curve. The phrase ‘Change in quantity demand’ essentially implies variation in

demand referring to ‘extension, or ‘contraction’ of demand which are quite distinct from

the term ‘increase or decrease in demand.

A. Extension and Contraction of Demand

A movement along a demand curve takes place when there is a change in the

quantity demand due to change in the commodity’s own price. The extension of demand

refers to a situation when more of a commodity is bought with the fall in the price.

Similarly, when a lesser quantity is demanded with a rise in price, there is a contraction

of demand. In short, demand extends when the price falls and it contracts when the price

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rises. The term extension and contraction are technically used in stating the law of

demand. Figure 2.3 illustrates the extension and contraction of demand.

Fig.2.3: Extension and Contraction of Demand

In the figure 2.3 D1D1 is the demand curve. When the price is OP1, the quantity

demand is OQ1. With the fall in price to OP2 the quantity demand rises to OQ2. Thus,

with the fall in price there has been a downward movement from A to B along the same

demand curve D1D1. This is known as extension in demand. On the contrary, if we take B

as the original price-demand point, then a rise in the price from OP2 to OP1 leads to a fall

in the quantity demand from OQ2 to OQ1. The consumer moves upwards from point B to

A along the same demand curve D1D1. This is known as contraction in demand.

B. Increase and Decrease in Demand

These two terms are used to indicate change in demand. A change in demand,

thus, implies an increase or decrease in demand. An increase in demand signifies either

more will be demanded at a given price or same quantity will be demanded at higher

price. It really means that more is now demanded than before at each and every price.

Similarly decrease in demand indicates either that less will be demanded at a given price

or the same quantity will be demanded at the lower price. The terms increase and

decrease in demand are graphically expressed by the movement from one demand curve

to another in figure 2.3A and B respectively.

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Fig. 2.3: Increase in Demand (A) and Decrease in Demand (B)

In the case of increase in demand, the demand curve shifted to the right. In figure

2.3 (A) the shift of demand curve from DD to D1D1 shows an increase in demand. In this

case a movement from point ‘A’ to ‘B’ indicates that the price remains same at OP, but

more quantity (OQ2) is now demanded instead of OQ1. Here, increase in demand is Q1Q2

which due to the factor other than price. Similarly the shifting of demand curve towards

its left depicts a decrease in demand. In the figure 2.3 (B) the decrease in demand is

depicted by the shift of demand curve from D1D1 to D2D2. In this case the movement

from point ‘A’ to ‘B’ indicates that the price remains same at OP but quantity demanded

decreased by Q1Q2.The decrease in demand by Q1Q2 quantity is due to the factor other

than price.

2.3 Types of Demand

The demand behaviour of the buyer or consumer is different with different types

of goods. Demand could be classified in to following types from managerial point of

view.

a. Demand for Consumer’s Goods and Producer’s Goods.

b. Demand for Perishable Goods and Durable Goods

c. Derived Demand and Autonomous Demand

d. Joint Demand and Composite Demand

e. Industry Demand and Company Demand

f. Demand by Total Market and by Market Segment.

g. Short-run Demand and Company Demand.

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a) Demand for Consumers’ Goods and Producers’ Goods.

Producer goods are those, which are used for the production of other goods.

Examples for such goods are machines, tools, raw materials, locomotives etc.

Consumers’ goods can be defined as those, which are used for final consumption.

Examples of consumers’ goods can be food items, tooth paste, ready-made cloth etc.

these goods satisfies the consumers’ wants directly. The distinction between consumers’

and producers’ goods is somewhat arbitrary. Whether a particular commodity is producer

good or consumer good depend upon who buys and what for. For example, sugar in the

case of a confectioner is a producer good, whereas in case of a household it is a consumer

good. However the distinction is useful because, among other factor, demand for

consumer goods depends on consumers’ income whereas demand for producer good

depends on demand for the products of the industries using this product as an input.

b) Demand for Perishable Goods and Durable Goods

Perishable goods are those, which can be consumed only once, while durable

goods are those, which can be consumed more than once over a period of time. Sweets,

ice cream, fruits, vegetables, edible oil, petrol etc. are perishable goods. Car, refrigerator,

machines, building are durable goods. It is important to note that perishable goods are

themselves consumed whereas only the services of durable goods are consumed. This

distinction is useful because durable products present more complicated problems in

demand analysis than the products of durable nature. Sales of perishable are made largely

to meet current demand, which depends on current conditions. Sales of durables, on the

other hand, add to the stock of existing goods whose services are consumed over a period

of time. Thus they have two kinds of demand Viz. replacement of old products and

expansion of the total stock. Their demand fluctuates with business conditions.

c. Derived Demand and Autonomous Demand

The demand for a product is said to be derived demand if demand for such

product is tied to the purchase of some parent product. For example the demand for

cement is a derived demand because it is needed not for it’s own sake but for satisfying

the demand for buildings. The demand for all producers’ good is derived. Autonomous

demand, on the other hand, is not derived. In case of autonomous demand, demand for a

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product is independent of demand for other goods. Today, it is difficult to find the

products whose demand is wholly independent of demand for other goods. However, the

degree of this dependence varies widely from product to product. For example, the

demand for petrol is fully tied up with the demand for vehicles using the petrol, while the

demand for sugar is loosely tied up with demand for drinks. Thus the distinction between

derived and autonomous demand is more of a degree than of kind.

d) Joint Demand and Composite Demand

When two goods are demanded in conjunction with one another at the same time

to satisfy a single want, they are said to be joint or complimentary demand. Examples are

pens and inks, bread and butter, sugar and milk and so on. A commodity is said to be

composite demand if it is wanted for several different uses. Electricity is needed for

lighting, cooking, ironing, boiling the water, lifting water, T.V, radio and many other

uses.

e) Industry Demand and Company Demand

At the outset let us understand the concept of industry and company. An industry

is a group of companies or firms, which produce similar goods or services. A company is

a single firm producing a particular type of goods or services. Sugar industry in India

consists of all the companies of the country, which produce the sugar. Shamanur sugars is

a company or a firm which produces the sugar. Industry demand denotes the demand for

the products of a particular industry while company demand means the demand for the

products of a particular industry. For example, demand for steel produced by TISCO is a

company (TISCO) demand while demand for steel produced by all companies in India is

industry demand for steel in India.

f) Demand by Total Market and by Market Segment.

Total market demand refers to the total demand for a product where as market

segment demand refers to a part of it. Demand for certain products has to be studied not

only in its totality but also by breaking it into different segments. Viz. different regions,

different use for the product, different customers, different distribution channels and also

its different sub products. Each of these segments may differ significantly with respect to

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delivery price, profit margin, competition and seasonal pattern. When these differences

are considerable, demand analysis should focus on the individual market segments.

Knowledge of these segments’ demand helps a unit in manipulating its total demand.

g) Short-run Demand and Company Demand.

Short-run demand refers to demand with its immediate reaction to price changes,

income fluctuations etc. Long-run demand is that which will ultimately exist as result of

change in pricing, promotion or product improvement after enough time has been

allowed to let the market adjust itself to new situation. For example, if electricity rates are

reduced, in the short run existing users of electric appliances will make greater use of

these appliances but in the long run more and more people might induced to purchase

these appliances ultimately leading to still greater demand for electricity.

2.4 Determinants of Demand

Demand for a commodity depends on various factors. Factors influencing the

demand could be classified into two groups. Factors influencing the individual demand

and market demand.

A) Factors Influencing the Individual Demand

Factors influencing the individual demand are explained as follows:

Price of the product: Normally, a large quantity is demanded at lower price and

vis-à-vis.

Income level of the consumer: Purchasing power of an individual consumer

depends on his income level. Therefore, income level is an important

determinant of demand. Consumers with higher income level demand more and

more goods compared to the consumers with lower income level.

Price of the related goods: Demand for a particular commodity depends on the

price of its related goods such as substitute and complementary goods. For

example if the price of tea increases the demand for coffee is expected increase

because tea and coffee are substitutes for many consumers. Similarly with the

increase in the price of petrol the demand for vehicles is expected to decrease

because car and petrol are complementary goods.

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Taste, Habit and Preferences of the consumers: People with different taste

and habit have different preference for different goods. Demand for several

products like beverages, ice cream, chocolates and so on are depending on the

individual’s taste. Similarly demand for tea, coffee, gutka betel, cigarette,

tobacco is a matter of habits of the consumers. A strict vegetarian will have no

demand for meat at any price whereas a non-vegetarian who has liking for

chicken may demand it even at higher price.

Expectation: Consumer’s expectations about the future change in the prices of a

given commodity influence the demand for such commodity. When he expects

its price to rise in the future, he will buy less at the prevailing price. Similarly, if

he expects its price to fall in future, he will buy less at present.

Advertisement: Nowadays advertisement plays crucial role in altering the

preferences of the consumers. Demand for products like toothpaste, toilet soaps,

cosmetics etc. are greatly influenced by the advertisements.

B) Factors Influencing the Market Demand

Market demand is the sum total of various quantities demanded by all the

individuals at various prices. Therefore, factors influencing individual demand are also

influencing the market demand. In addition to the factors explained above (in section A)

following factors influence the market demand.

Distribution of income and Wealth in the country: Market demand for goods

and services is more in countries with equal distribution of income and wealth

compared to the countries with unequal distribution.

Growth of population and number of buyers in the market: Market demand

for the products depends on the number of buyers. Number of buyers in the

market, among other factors, mainly depends on the population size and its

growth. A large number of buyers will usually constitute a large demand vis-à-

vis. Therefore, growth of population over a period of time increases the demand

for goods and services in the market.

Age and sex structure of the population: Age structure of population

influences the demand for various goods and services in the market. In the

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country with bottom heavy age structure (relatively more children), relatively

more children, the market demand for toys, school bags, chocolates etc. will be

relatively more. Similarly sex structure also influences the demand for goods and

services in the market. If sex ratio is favorable to females then the demand for

goods and services required for females will be relatively more. For example

demand for goods like saries, bangals, lipsticks etc. is more in the countries with

the sex ration favourable to females.

Climatic conditions: Demand for certain products is determined by climatic

conditions. For example, in rainy season, there will be more demand for

umbrellas, rain coats et. Similarly demand for cool drinks, ice creams, fans etc.

are more in summer season.

2.5 Demand Function

A demand function states the functional relationship between the demand for a

commodity or services and the factors or variables affecting it. The demand function for

commodity X can be symbolically stated as follows:

Dx = f(Px) 2.1

Where,

Dx = Demand for X

Px = Price of x commodity

The function 2.1 demand for commodity X depends on the price of the commodity. It

does not consider the demand influencing factors other than the price. This is a single

variable model. Multiple variable models are presented in the following function (2.2).

Dx = f (Px, I, Pr, A, U) 2.2

Where

Dx = Demand for X

Px = Price of X

I = Income of the consumer

Pr =Price of the related goods

A =Advertisement or sales promotional activities

U =Error term

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The demand function 2.2 shows that the quantity demand of X influenced by the

price of commodity X, income of the consumers, price of its related goods and

advertisement or sales promotion activities. The demand for commodity X might be

influenced by the factors other than these factors also. The influence of the variables

other than those included in the model is represented by error term (U). It is a general

form of demand function because the independent variables included in the model (RHS)

are considered to be influencing the quantity demand of commodity X but it does not

reveal in what direction and to what extent they are influencing. The empirical demand

function shows the quantitative relationship between the demand for a particular

commodity and its determinants. Empirical demand function also reveals the direction of

relationship between the dependent variables (Quantity demand of a commodity) and

independent variables (Demand determinants) through the sign (i.e + or -).

2.6 Elasticity of Demand

Demand usually varies with variation in the price. The law of demand states that

with the fall in the price of commodity, the quantity demand increases and vis-à-vis. But

it does not states by how much the quantity demand increases as a result of certain fall in

the price of the commodity. Elasticity of demand is a useful tool to understand the extent

of change in quantity demand due to change in price or other demand influencing factors

like income, price of related goods and advertisement.

2.6.1 Meaning of Elasticity of Demand.

The term elasticity of demand, very often, used as a synonymous of price

elasticity of demand. This is a loose interpretation of the term. In the strict sense of the

term the concept of elasticity of demand refers to the responsiveness of the quantity

demand to the change in demand determinants. It can be depicted as

Percentage change in quantity demand Elasticity of Demand = Percentage change in demand determinant

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The demand determinants mainly include the price of the commodity, price of related

good, income of the consumer.

2.6.2 Types of Elasticity of Demand.

There are as many types of price elasticity of demand as there are demand

determinants. However, considering its major determinants economists broadly classified

the elasticity of demand into following types.

Price elasticity of demand

Income elasticity of demand

Cross elasticity of demand

2.6.3 Price Elasticity of Demand.

In the words of Prof. Lipsey “Price elasticity of demand may be defined as the

ratio of the percentage change in quantity demand to the percentage change in price.”

Price elasticity of demand may be written as

Percentage change in quantity demand Price Elasticity of Demand = Percentage change in Price

In the algebraic form it could be presented as Ep = [ΔQ/Q] / [ΔP/P]

Where Ep = Coefficient of Price Elasticity of Demand ΔQ = Change in demand Q = Initial demand ΔP = Change in Price

Ep is the coefficient of price elasticity of demand. The coefficient of price elasticity of

demand is always negative because price and quantity demand varies inversely with the

change in the price of the commodity. It is, however, customary to disregard the negative

sign. Using the above formula, the numerical coefficient of price elasticity of demand can

be measured for any given data. Obviously, depending on the magnitudes and

proportionate changes involved in data on demand and prices, one can obtain various

numerical values ranging from zero to infinity. Price elasticity of demand depending on

the value of coefficient could classify into different types.

2.6.3.1 Types of Price Elasticity of Demand.

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A. Perfectly Elastic Demand

In case of perfectly elastic

demand, a slight or infinitely

small rise in price of a

commodity, consumers stop

buying it. The numerical

coefficient of perfectly elastic

demand is infinity (Ep=α) The

demand curve, in this

case, will be a horizontal

straight line. In figure

2.4 DD demand curve is

horizontal to OX axis.

Fig 2.4: Perfectly Elastic Demand

B. Perfectly Inelastic Demand

Perfectly inelastic demand is one

for whatever the change in price;

there is absolutely no change in

demand. In this case, the quantity

demand shows no response to a

change in price. Thus, perfectly

elastic demand has zero coefficient

(Ep=0). In figure 2.5 DD demand

curve is a vertical line. In this case,

whatever may be the price level the

quantity demand remains same at

OD.

Fig 2.5: Perfectly Inelastic Demand

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C. Relatively Elastic Demand

If a reduction in price leads to more

than proportionate change in quantity

demand, the demand is said to be

relatively elastic. For example if 5

per cent decline in price leads to 10

per cent increase in quantity demand,

the demand is said to be relatively

elastic. In this case coefficient of

elasticity of demand is greater than 1

but it is not infinite. In figure 2.6

DD1 demand curve is relatively

flatter.

Fig 2.6: Relatively Elastic Demand

D. Relatively Inelastic Demand

If a decline in price leads to less than

proportionate increase in quantity

demand, the demand considered to be

relatively inelastic. For example if a 5

per cent decline in price leads to 3 per

cent increase in quantity demand then

demand considered to be relatively

inelastic. In this case the coefficient

of elasticity of demand lies between

zero and one. DD1 demand curve in

figure 2.7 is relatively steeper.

Fig 2.7: Relatively inelastic Demand

E. Unitary Elastic Demand

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Price elasticity of demand is unity when the

change in demand is exactly proportionate

to the change in price. For example if a 5

per cent increase in price leads to 5 per cent

decrease in quantity demand then demand

considered to be unitary elastic. In this case

the coefficient of elasticity of demand is

one. DD demand curve in figure 2.8 is a

rectangular hyperbola.

Fig 2.8: Unitary Elastic Demand

2.6.3.2 Factors Influencing Price Elasticity of Demand.

a) The availability of substitutes: The demand for a commodity is more elastic if

there are close substitutes for the commodity.

b) The nature of the need that the commodity satisfies: In general luxury goods

are price elastic, while necessities are price inelastic.

c) The time period: Demand is more elastic in the long run than in the short run.

d) The number of uses to which a commodity can be put: The more the possible

uses of a commodity the greater its price elasticity will be.

e) The proportion of income spends on the particular commodity: The demand

is inelastic if a very small proportion of income is spent on a particular

commodity.

2.6.4 Income Elasticity of Demand.

The income elasticity is defined as a ratio of percentage or proportionate change

in quantity demand to percentage or proportionate change in income. The coefficient of

income elasticity of demand could be measured by the following formula:

Percentage change in quantity demand Income Elasticity of Demand = Percentage change in Income

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In the algebraic form it could be presented as Ey = [ΔQ/Q] / [ΔY/Y]

Where

Ey = Coefficient of Income Elasticity of Demand ΔQ = Change in demand Q = Initial demand ΔY = Change in income Y = Initial income

The coefficient of income elasticity of demand will be positive for the normal goods.

Some economists have used income elasticity in order to classify the goods into luxuries

and necessities. A commodity is considered to be a luxury if its income elasticity is

greater than unity. A commodity is a necessity if its income elasticity is small(less than

unity).

2.6.4.1 Factors Influencing Income Elasticity of Demand.

a) The nature of the need that the commodity covers: The percentage of income

spent on food declines as income level increases while the percentage of income

spent on the luxuries increases with increase in income level.

b) The initial level of income of a country: TV is a luxury in a poor country while it

is a necessity in a country with high per capita income.

c) Time period: Time period influence the income elasticity of demand because

consumption pattern adjust with a time lag to changes in income.

2.6.4.2 Uses of Income Elasticity of Demand.

a) Business planning: In India, per capita income is low and it has been slowly

increasing. Since income elasticity of income for luxury goods is more, the

prospect for long run growth in sales for these goods is very bright. The firms can

plan out its business accordingly.

b) Marketing strategy: Income elasticity of demand is helpful in developing the

marketing strategy.

2.6.5 Cross Elasticity of Demand.

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The cross elasticity of demand refers to the degree of responsiveness of demand

for a commodity to a given change in the price of some related commodity. The related

commodity may be substitute or complementary. The coefficient of cross elasticity of

demand could be measured by the following formula:

Percentage change in quantity demand of X Cross Elasticity of Demand = Percentage change in Price of Y

In the algebraic form it could be presented as Ey = [ΔQx/Qx/ [ΔPy/Py]

Where Ec = Coefficient of Cross Elasticity of Demand ΔQx = Change in Quantity Demand of x Qx = Initial Quantity demand of x ΔPy = Change in price of Y Py = Initial price of Y

The concept of cross elasticity of demand can be useful in determining competitive price

strategy and policy in the substitute goods or complementary goods such as coco cola or

Pepsi, tea or coffee. Coefficient of cross elasticity of demand here is taken, as a measure

of effect of a change in the price of coco cola on the demand for Pepsi. Similar is the case

with respect to tea or coffee.

2.7 Demand Forecasting

In the business production of goods or services is of no use if there is no demand for

goods or services produced by the business houses. Demand forecasting is an useful tool

in anticipating the future demand which enable the business house to take the appropriate

business decisions. In this section meaning, types, purpose and methods of demand

forecasting are discussed.

2.7.1 Meaning of Demand forecasting

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Demand forecasting means an estimation of the level of demand that might be

realized in future under given circumstances. It is not a speculative exercise into the

unknown. It is based on mathematical laws of probability. It can’t be hundred per cent

precise. But it gives a reasonable accuracy. Thus, demand forecasting involves

predicting future economic condition and assessing their effect on the operation of the

firm and its demand. The objective of demand forecasting is to predict the future demand.

2.7.2 Classification of Demand Forecasting

Demand forecasting can be classified into different types based on the different

criterion. Demand forecasting can be classified into short-run and long run demand

forecasting based on the time period. Similarly based on the role of the demand

forecasting firm demand forecast can be classified into active demand forecast and

passive demand forecast. Based on the level of demand forecasting it could be classified

into macro, industry and firm level demand forecasting.

a) Short-period and Long period demand forecast: Short-run forecasting, usually,

covers any period up to one year. Long period, on the other hand, will cover any

period more than one year. Normally it covers the period of 5, 10 or even 20

years. Short-run forecasting useful in taking decision concerning the day to day

working of the firm whereas long run forecasting facilitates major strategic

decisions.

b) Passive and active demand forecasting: Passive demand forecasting predicts the

future demand in the absence of any action by the firm. While active forecasting

estimate the future demand taking into consideration of the likely future action of

the firm. For example, Samsung electronic company takes no policy actions to

influence its future sales, what would be sales in the year 2010? Such forecasts

are passive demand forecasts. However, forecasted level of sales may not be

desirable level and so the company may be initiated some sales promotion actions

with a view to increase its future sales. The predicted sales if such planned sales

promotion activities are undertaken denote the active forecast.

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c) Macro, Industry and Firm level demand forecasting; Macro-economic forecasting

refers to the forecasting of business conditions over the entire economy.

Aggregate demand for goods and services in the entire economy can be

forecasted. Such forecast is called as macro-economic forecasting. Forecasting the

demand for the products of a particular industry is the industry level demand

forecasting. Generally, it is undertaken by the trade association and the results are

made available to the member firms. A firm can forecast the demand for its

products at its own level. It is called firm level demand forecasting. It is most

important from the point of view of managerial decisions.

2.7.3 Purpose of Demand Forecasting:

The purpose of demand forecasting could be classified into purpose of short-term

and long-term demand forecasting. They are separately explained hereunder:

A Purpose of Short-Term Demand Forecasting:

o It is useful in appropriate production Scheduling: To avoid the problem of

over production and the problem of short supply appropriate production

scheduling is essential for which demand forecasting is useful.

o It helps in purchase planning to reduce the cost of operation: Demand

forecasting enables the firms to understand the right quantity of resources

required to the firm at different points of time, which in turn, reduces the cost

of operation.

o It is useful in adopting suitable advertising and promotional programme. A

short-term demand forecasting is useful in evolving suitable sales policy in

view of the seasonal variation of demand.

o It is useful in forecasting short-term financial requirements. A firm’s need for

cash depends on its production level. Without sales forecasting a rational

financial planning is not possible.

o It is useful in determining appropriate price policy: Short-term sales

forecasting will help the firm in determination of a suitable price policy to

35

clear off the stocks during the off-season, and to take advantage in the peak

season.

B Purpose of Long-Term Demand Forecasting:

o Long-term demand forecasting is useful for planning of a new unit or

expansion of an existing unit.

o It is useful in planning long term financial requirements

o It is useful in planning the manpower requirements. Manpower development

requires long time. Manpower development process has to start well in

advance to meet the future manpower requirements.

2.7.4 Methods of Demand Forecasting

Demand forecasting mainly involves two important methodological aspects viz.

data collection and analytical methods. Demand for any goods or services could be

forecasted based on the available information or data on the related parameter. Demand

forecasting may be based on two types of data sources viz primary sources and secondary

sources. Primary data or information is original in nature which is collected for the first

time for the purpose of analysis. Secondary data, on the other hand, are those which are

obtained from someone else records. These data are already in existence in the recorded

or published form. In case of primary data, demand forecaster has to collect the data

through some sort of survey method. The collected data has to process through some

statistical technique. Method of demand forecasting, therefore, has been discussed under

two headings viz. 1 Survey Method and 2. Econometric Method

2.7.4.1. Survey Method.

In the demand forecasting survey plays vital role. The data required for the demand

forecasting could be collected through the survey method. For the purpose of demand

forecasting survey method could be classified into following types (Chart 2.1):

i) Experts Opinion Survey Method: In this method the future demand for a particular

commodity is estimated based on the opinions of experts in the marketing of that

particular commodity. Since salesmen are in close contact with customers in their

36

respective areas, they can forecast consumer behavior in the market in the future. Hence,

under this method salesmen are to estimate the expected sales in their respective area.

These estimates of individual salesmen are to be consolidated in order to obtain the total

estimated sales for the future.

Chart 2.1: Types of Survey Method of Demand Forecasting

Survey Method

The top executives of the firm are to further examine the total estimated sales in

the light of the factors like proposed change in the selling price, packaging design,

advertisement programme, change in macro variable like purchasing power of the people

etc. Through these processes a firm could come out with its final demand forecast. This

method is also known as the ‘collective opinion method’ because it takes the advantage

of the collective wisdom of the salesmen’s, corporate heads, dealers etc. This method is

cheaper and easy to handle. It is less time consuming also. The main limitation of this

method is that it tends to substitute opinion for analysis of the situation. It is purely

subjective and different experts may have significantly different forecasts.

37

Survey Meyhod

Experts’ Opinion Survey Consumers Interview

Census Method Sample Survey End Use Method

ii) Consumers Survey Method: Consumers, the potential future buyers are focal point for

the demand forecasting. Under this method, consumers are directly asked about their

future plan of purchase. This may be done in any of the following ways:

a) Complete enumeration method

b) Sample survey method

c) End use method

a) Complete Enumeration Method: Under this method forecaster has to collect

information from all consumers of the commodity for which he wishes to forecast the

demand. He asks every consumer the quantity of that commodity he would like to buy in

the forecasting period. Once this information is collected, demand could be forecasted by

simply adding the probable demand of all consumers. For example there are ‘n’ number

of consumers and their probable demand for commodity X in the forecast period are X 1,

X2, X3…Xn then the demand forecast would be

X = X1 +X2 + X3 +…Xn

In this method the forecasting agency could not introduce any bias of its own. Just it has

to collect the information and tabulate them. Report has to be prepared accordingly. But it

is an expensive and time-consuming method for the products having large number of

consumers.

b) Sample Survey Method: In sample survey method forecaster aimed to ascertain the

characteristics of parameter based on the characteristics of statistic. For example, ABC

company intended to forecast demand for its X commodity. Suppose ABC firm has

about one lakh consumers. Expected aggregate quantity demand of these one-lakh

consumers in the forecasting period (say in the year 2010) is parameter of this demand

forecasting. Demand forecaster can draw conclusion about this parameter by two

different methods. 1) Complete enumeration method and 2) Sample survey method.

In complete enumeration method forecaster collect information from all the one-

lakh consumers about their expected quantity demand for forecasting period and forecast

the demand based on this information (the details of this method discussed in the earlier

section). In case of sample survey method forecaster need not collect information from all

38

the one-lakh consumers. He has to choose some sample respondents out of one-lakh

consumers using appropriate sampling method and sample size. He may adopt simple

random sampling method or stratified random sampling method or cluster sampling

method or even snowball sampling method according to the nature of the population

distribution. Forecaster may choose 100 or 500 sample respondents or 1000 or more

sample respondents based on the available time, budget, expected level of accuracy of the

result etc. For this example let us assume that the forecaster has selected 500 respondents

using the simple random sampling method. After collecting information from the sample

respondents he can calculate the expected average demand of these selected respondents

for the forecasting period. The value calculated for the sample is known as the sample

statistics.

åXX1+X2+……….X500 = ------ = X

500Here, X is the sample statistics because it is estimated for the sample respondents. In this

example X .N = Aggregate demand for the forecasting period. In this example N refers to

the population size i.e. one lakh. Thus conclusion about the aggregate demand by the

one-lakh consumers is estimated by using the data collected from the 500 sample

respondents.

This method of demand forecasting is less expensive and requires less time when

compared to complete enumeration method. If sample is properly chosen the sample

survey method will yield good results. However it is not so simple to choose the

representative sample. If sample is not good representative of the population concerned

then the results will mislead the producers.

C) End use Method of Demand Forecasting: This method of demand forecasting is

suitable if the producer/firm desire to obtain use-wise or sector wise demand forecasts. In

this method of demand forecasting, the demand for a particular commodity is estimated

through a survey of its users of different uses. For example a commodity may be used

for:

i. Final consumption

ii. Production of some other commodity

39

iii. Export

In this method demand forecaster is to obtain separate demand forecast for these different

uses. For example a steel firm wants to forecast demand for steel in the year 2010. It can

be obtained as

Sd2010 = Sc2010 + Se2010 + asi.(Xi)2010

Where

Sd2010 = Total demand for the steel in the year 2010

Sc2010 = Consumption demand for steel in the year 2010

Se2010 = Export demand for steel in the year 2010

asi. = Steel requirement of ith industry per unit of its output

(Xi)2010 = Output of ith industry using steel as an input

Consumption demand and export demand could be directly estimated by using the

appropriate method. Demand for intermediate use could be forecasted through the survey

of its user industries regarding their production plan and input-output coefficients. The

principle advantage of this method is that it provides use-wise demand forecast. If the

number of end users of a product is limited it will de convenient to use this method. The

major weakness of this method is that the individual industry will have to relay on some

other method to estimate the final demand of its products for final consumption and

export.

2.7.4.2 Econometric Method

The term Econometrics means, literally, Economic measurement. Econometric

methods integrate statistics, mathematics and economic theory in order to measure

relationship among economic variables. Econometric models provide insights into the

relationship between the variables. These insights can be very useful to the managers in

evaluating the probable effect of alternative decisions. For example, an econometric

study that estimate the impact of advertising on the demand could be used to advertising

strategies. The important steps involved in the formulation of econometric models are: 1.

Development of a theoretical model, 2 Data collection, 3 Choice of functional form, and

4 Estimation and interpretation of results. Econometric method could be further classified

into:

40

i) Regression method

ii) Trend method

iii) Leading indicator method

i). Regression Method: Regression is a statistical devise with the help of which it is

possible to estimate the unknown value of one variable from the known value of another

variable. The variables which is/are used to predict the value of other variable is/are

called independent/explanatory variable/variables. The variable we tried to predict is

called dependent variable. Estimated regression equation reveals the cause and effect

relationship between the dependent and independent variables. It shows the extent to

which the value of dependent variable changes with the change in the value/s of

independent variable/s. In economic theory it is well-established fact that the quantity

demand of a commodity depends on various factors. In simple algebraic form it could be

shown as:

Dx = f (Px, I, Ps, Pc, A, U) 2.3

Where

Dx = Demand for X

Px = Price of X

I = Income of the consumer

Ps =Price of the substitute goods

Pc =Price of the complimentary goods

A =Advertisement or sales promotional activities

U =Error term/influence of other unexplainable/uncontrollable variables

Equation 2.3 reveals that the quantity demand of commodity depends on its own price,

income level of the consumers, price of its substitutes, price of complements, expenditure

on advertising X commodity, and uncontrollable or unexplainable variables. In this

equation U indicates the random error or the influence of other unexplainable or

uncontrollable variables. It is a general form of demand function because the independent

variables included in the model (RHS) are considered to be influencing the quantity

demand of commodity X but it does not reveal in what direction and to what extent they

41

are influencing. The above general form of function could be presented in any of the

following specific form of functions.

Dx = a - b1Px + b2I + b3Ps - b4Pc +b5A + U 2.4

Or

Dx = a - Px b1 + I b2+ Ps b3

- Pc b4 +A b5 + U 2.5

The equation number 2.4 and 2.5 are the linear and power function forms respectively for

the variables given in the equation number 2.3. They are nothing but different functional

forms of regression equations. In 2.4 and 2.5 equations Dx, Px, I, Ps, Pc, A and U refer to

the same meaning as in the equation 2.3. In the equation 2.4 b i’s are the coefficients of

the respective variables and ‘a’ is the value of intercept.

The estimated coefficient values show the extent to which quantity demand

changes with the change in the values of the respective variables by one unit. In this

equation some coefficients are having the + sign while others having the – sign. The

coefficient of the variables which are having the + sign are influencing the quantity

demand positively while the coefficient of the variables which are having the - sign are

influencing the quantity demand negatively. In the equation 2.5 all the symbols and

letters are used to indicate the same thing as in the equation 2.4. But the only difference is

that the estimated coefficient values show the extent to which quantity demand changes

with the change in the values of the respective variables by one percent.

In the regression equations estimated coefficients are of vital importance. They

show the extent of responsiveness of quantity demand to the change in the value of the

variables. In order to understand the regression method of demand forecasting let us take

the following numerical example. Table 2.3 provides the data on electric power

consumption (in billion K W)(Y) and GNP (in million Rupees)(X) for the period 1995 to

2004.

42

Table 2.3. Electric Power Consumption and GNP Year Electric consumption (Y)

(In Billion K W)G N P (X)

(In Million Rs.)1995 407 9441996 447 9921997 479 10771998 511 11851999 554 13262000 555 14342001 586 15942002 613 17182003 652 19182004 679 2163

Regression equation could be estimated for this example in order to understand

the extent to which the GNP influences the electricity consumption. With the help of the

estimated regression equation we could forecast the demand for the electricity for any

future date given the value of independent variable for any future date. For this numerical

example regression equation of Y on X of the following form could be estimated.

Y = a + bX + u 2.6

In order to estimate the values of constants i.e. a and b following normal equations are to be solved.

åY = Na + b åX 2.7 å XY = a åX + b åX2 Sum of variables, their products and squares given in table 2.4 are substituted for these

normal equations.

5483 = 10 a + 14351b …1

8185955 = 14351a +22103639 b …2

Equation 1 X 1435.1 – Equation 2

7868653.3 = 14351a + 20595120.1b8185955 = 14351a + 22103639b

(-) (-) (-) -317301.7 = -1508518.9b

-317301.7b = =0.210

-1508518.9

43

Substituting the value of b to equation 1

5483 = 10 a + 14351 (0.210)

5483 = 10 a + 3013.71

5483 - 3013.71 = 10a

10a = 2469.29

a = 2469.29/10 = 246.929

Table 2.4 Sum Variables, their Products and Squares.

Year Y X XY X2

1995 407 944 384208.0 891136.01996 447 992 443424.0 984064.01997 479 1077 515883.0 1159929.01998 511 1185 605535.0 1404225.01999 554 1326 734604.0 1758276.02000 555 1434 795870.0 2056356.02001 586 1594 934084.0 2540836.02002 613 1718 1053134.0 2951524.02003 652 1918 1250536.0 3678724.02004 679 2163 1468677.0 4678569.0

Sum 5483 14351 8185955.0 22103639.0

Y = 246.93 + 0.21X is the estimated regression equation. In this equation 246.93

is the value of the intercept. 0.210 is the regression coefficient of X (GNP) variable. It

shows that with the increase in the GNP by one million (i.e the unit taken in the

independent variable) the consumption or demand for electricity increases by the

0.210 billion K W. For this example the same results could be obtained by the most

widely used soft ware Microsoft Excel. The summary output of the Microsoft excel is

given in the table 2.5. Intercept and coefficient values are almost as same as we obtained

in the above calculation. Besides these values Microsoft excel generate the estimated

value of the R2, F value and also t value for each coefficients. The estimated R2 (0.9452)

reveals that the independent variable (GNP) explains the 94.52 per cent variation in the

dependent variable. F values are used to draw inference about the overall significance of

44

Y = 246.93 + 0.210X

the estimated regression equation. t values are used to know the significance of the

estimated coefficients.

Table 2.5 Summary of Output Obtained by Microsoft Excel Regression Statistics

Multiple R 0.9768R Square 0.9542Adjusted R Square 0.9485Standard Error 20.0028Observations 10ANOVA

  Df SS MS F

Regression 1 66741.20 66741

.200 166.806Residual 8 3200.89 400.112Total 9 69942.10    

 

Coefficient

sStandard Error t Stat P-value

Intercept 246.441 24.213 10.178 7.44E-06Coefficient of GNP (X) 0.210 0.016 12.915 1.22E-06

For same numerical example regression equation of Y on X of the following form could

be estimated.

Y = a Xb 2.8

Equation number 2.6 is linear regression equation whereas this one is power function. In

order to estimate the values of constants i.e. a and b it has to be converted into log linear

form of the following type

lnY = lna + blnX + u

The normal equations to estimate the constants (i.e. a and b) are as follows:

ålnY = Nlna + b ålnX 2.9

å lnXlnY = lna ålnX + b å(lnX)2

Sum of variables, their products and squares given in table 2.6 are substituted for these

normal equations.

45

62.9479 = 10.0000ln a + 72.3286 b …1

455.7061 =72.3286ln a +523.8631 b …2

Equation 1 X 7.23286 – Equation 2 we get

455.2933 = 72.3286ln a + 523.1426 b

455.7061 = 72.3286ln a + 523.8631 b (-) (-) (-)

-0.4128 = -0.7205b

-0.4128b = = 0.5729

-0.7205

Substituting the value of b to equation 1

62.9479 = 10 ln a + 72.3286 (0.5729)

62.9479 = 10 ln a + 41.43705

62.9479 – 41.43705 = 10 ln a

10 ln a = 21.51085

lna = 21.51085/10 = 2.151085

Table 2.6 Sum of Variables, their Products and Squares.

Year Y X lnY lnX lnXlnY (lnX)2

1995 407 944 6.0088 6.8501 41.1611 46.92421996 447 992 6.1026 6.8997 42.1060 47.60621997 479 1077 6.1717 6.9819 43.0904 48.74741998 511 1185 6.2364 7.0775 44.1379 50.09101999 554 1326 6.3172 7.1899 45.4199 51.69502000 555 1434 6.3190 7.2682 45.9277 52.82712001 586 1594 6.3733 7.3740 46.9969 54.37592002 613 1718 6.4184 7.4489 47.8099 55.48642003 652 1918 6.4800 7.5590 48.9829 57.13912004 679 2163 6.5206 7.6793 50.0735 58.9709

Sum 5483 14351 62.9479 72.3286 455.7061 523.8631

46

Y = 2.151 * X0.573 Or lnY = ln2.151 + 0.573 ln X

In this equation ln2.151 is the value of the intercept. 0.573 is the regression

coefficient of X (GNP) variable. It shows that with the increase in the GNP by one

percent the consumption or demand for electricity increases by the 0.573 per cent.

For this example the same results could be obtained by the most widely used soft wear

Microsoft Excel. The summary output of the Microsoft excel is given in the table 2.7.

Table 2.7:SUMMARY OUTPUT OBTAINED BY MICROSOFT EXCELRegression Statistics

Multiple R 0.9816R Square 0.9635Adjusted R Square 0.9590Standard Error 0.0334Observations 10ANOVA

  df SS MS FRegression 1 0.2362 0.2362 211.3931Residual 8 0.0089 0.0011Total 9 0.2451    

  Coefficients Standard Error t Stat P-valueIntercept (lna) 2.1518 0.2851 7.5465 0.0000663Coefficient of GNP (b) 0.5728 0.0394 14.5394 0.0000005

In the above example we consider only one independent variable model. In

practice, quantity demand of any commodity will not be influenced by only one variable.

It may be influenced by several variables. In the regression model we could use two or

more than two independent variables. If we use two or more independent variables in the

regression models such regression model is termed as multiple regression model. In case

of the multiple regression manual estimation of the coefficients is tedious job. Nowadays

various computer softwares are available to estimate the coefficients in case of multiple

regression models. The above example has been extended to two independent variable

model by incorporating one more independent variable i.e. price of the electricity. Table

2.8 provides the data on electric power consumption (in billion K W)(Y) and GNP (in

million Rupees)(X1) and price of the electricity (in Rs. Per unit) (X2) for the period 1995

to 2004. For this numerical illustration income elasticity and price elasticity of demand

for electricity could be estimated through the following form of equation.

47

Y = a X1 b1 X2 b2

2.10

In this equation a represent the intercept value, b1 and b2 shows the regression coefficients

of income and price on electric consumption, which are same as income and price

elasticity of demand for electricity. The value of these constants has been estimated by

using the Microsoft excel. The summary of output is given in table 2.9.

Table 2.8: Consumption, GNP and Price of Electric Power.Year Electric

consumption (Y)(In billion K W)

G N P (X1)(In Million Rs.)

Price of Electricity (X2)

(Rs./Unit)

1995 407 944 2.09

1996 447 992 2.10

1997 479 1077 2.19

1998 511 1185 2.29

1999 554 1326 2.38

2000 555 1434 2.83

2001 586 1594 3.21

2002 613 1718 3.45

2003 652 1918 3.78

2004 679 2163 4.03

Table 2.9: SUMMARY OUTPUT OBTAINED BY MICROSOFT EXCELRegression Statistics

Multiple R 0.9924R Square 0.9849Adjusted R Square 0.9806Standard Error 0.0230Observations 10ANOVA

  Df SS MS FRegression 2 0.2414 0.1207 228.6488Residual 7 0.0037 0.0005Total 9 0.2451    

  Coefficients Standard Error t Stat P-valueIntercept -0.496 0.8628 -0.5748 0.5834Coefficient of G N P (X1) 1.008 0.1408 7.1603 0.0002Coefficient of Price of Electricity (X2) -0.495 0.1572 -3.1512 0.0161

Y = -0.496 X1 1.008 X2 –0.495

48

In the summery of the regression output the income elasticity of demand for

electricity was worked out to be 1.008, which means for every one per cent increase in

GNP there will be 1.008 per cent increase in the demand for electric power. Similarly

price elasticity of demand for electricity was worked out to be -0.495 which means for

every one percent increase in the price of electric power there will be fall in the electric

power consumption or demand by 0.495 per cent.

The principle advantage of this method is that the variation in demand is

explained through the variation in its casual variables. Demand has varied by a certain

amount or percentage because its determining variables have varied by certain amount or

percentage. This is indicated by the regression equation itself. Any social scientist

possessing sufficient knowledge of economic theory and econometric methods can use

this method for forecasting purpose. The major limitation of this method is that it requires

the use of some other forecasting method to estimate the value of the explanatory

variables in the prediction period. The extent of reliability of the results depends on the

extent of the reliability of the estimated future values of explanatory variables.

ii. Leading Indicator Method: The previous section dealt with the relationship between

the two or more coincident series, which enables us to forecast the demand. Coincident

variables are those the values of which vary along with some other variables. For

example if X and Y are close substitutes, increase in the price of X leads to increase in

the demand for Y on the day itself. There are some variables the values of which move up

or down ahead of some other variable and such variables are called leading variables or

series. Agricultural income (harvest) in the year influences the demand for agricultural

inputs in the subsequent year. Here agricultural income is a leading indicator because it

indicates the fact that there will be more demand for agricultural input in the subsequent

year. Demand for agricultural input, in this example, is lagging variable because its value

moves up or down behind the value of agricultural income. This relationship could be

expressed in the following way:

Yt = a + bXt-1 2.11Where,Yt = Quantity demand of forecasting variable in time t

49

Xt-1 = Value of explanatory variable in time t-1

a & b represent the intercept and coefficient of independent variables

respectively

The value of intercept and coefficient value could be estimated by using the

method discussed in the previous section. But only difference is that the value of

explanatory variable pertains to time period t-1. If the calculated value of ‘b’ is 0.75 it

implies that every one-unit increase in the value of independent variable in this year leads

to increase in the quantity demand by 0.75 unit. The main advantage of this method is

that present period value of explanatory variable could be used to predict the demand for

(lagging variable) commodity in the next period, may be next month or year or decade.

The major limitation of this method is that it is not possible to find leading indicator for

variable under forecast.

iii. Trend Method: Time series analysis or the trend method is one of the most frequently

used methods of demand forecasting. Time series data refers to the values of a variable

arranged chronologically by days, weeks, months or years. Time series analysis attempts

to forecast future values of time series by examining the past observation of the data only.

This method is mainly based on the assumption that the time series will continue to move

as in the past. For this reason this method is also called naïve forecasting. Time series

data can be presented either in the tabular form or graphical form. The following table,

for example, shows the sales of the television sets of X company (in thousand units).

Table2.10 Sales of T V sets Pertains to X CompanyYear 1998 1999 2000 2001 2002 2003 2004

Sales of T. V. (in thousand) 80 90 92 83 94 99 92

The data shown in the table 2.10 presented through the graph 2.9. It is evident from the

graph that the sale of the T V sets of the above firm has been fluctuating over the years.

In spite of such fluctuation there is a general increasing trend . Time series fluctuation

can be explained through the different components.

Components of time series

50

Seasonal Variation: Changes that have taken place during a period of one

year as a result of changes in season i.e. change in the climate, weather

condition, festival etc.

Cyclical Variation: It refers to recurrent up and down movements of

business activities around some sort of statistical trend level or normal

business conditions.

Irregular variation: Changes that have taken place as a result of such

forces that could not be predicted like floods, earthquake etc. they are also

called erratic variations

Secular trend: Changes that have occurred as a result of general tendency

of data to increase or decrease is known as secular trend.

Changes that have taken place during a period of one year as a result of changes in season

i.e. change in the climate, weather condition, festival etc.

The most important aspect of time series analysis is the projection of trend of the

time series. A trend line can be fitted through series either visually i.e. freehand method

51

based on the personal judgment or by means of statistical technique. The most popular

statistical method that is used in the time series analysis is least square method. The

straight line could be represented by the following equation

Yt = a + bt 2.12

Here, Yt and t are the variables represent the value of the time series to be forecasted

for period t, and the time period respectively. , a is the intercept and b is the coefficient of

the trend equation which shows the absolute amount of growth per period. Trend

equation could be estimated as follows for the example given in the table 2.10.

The trend equation of the form 2.12 could be estimated to the example given in

the table 2.10 by solving the following normal equation.

åYt = Na + b åt 2.13

å tYt = a åt + b åt2

For fitting the straight-line trend by the least square method we must specify the year,

which is taken as the origin. We can measure t by taking either first year or the mid point

in the time period as the origin. Here the trend equation has been estimated by taking the

first year as the origin.

Table 2.11 Sum of Variables, their Products and Squares

Year Yt (000s) T (Year – 1998) t Yt t2

1998 80 0 0 01999 90 1 90 12000 92 2 184 42001 83 3 249 92002 94 4 376 162003 99 5 495 252004 92 6 552 36Sum 630 21 1946 91

Substitute the values to the normal equation 2.13 630 = 7a +21b …11946 = 21a + 91b …2

Equation 1 ( -3) – Equation 2

-1890 = -21a - 63b 1946 = 21a + 91b

52

56 = 28b

56b = = 2

28

Substituting the value of b to equation 1

630 = 7 a + 21 (b) 630 = 7 a + 21 (2) 630 = 7 a + 42 630 - 42 = 7 a588 = 7 a

a = 588/7 = 84

The trend equation reveals that for every one year there will be increase in the sales of T

V sets of the X Company by 2000 units. Using this coefficient demand could be

forecasted for any future period.

It is a very popular method of demand forecasting not only because of its

simplicity but also because it yields good results. Further, most of the time series data

follow a particular trend in the long run. Besides it is relatively easy to forecast the

demand through this method, as it does not require the knowledge of economic theory

and the market. It needs only time series data on the variable whose future value is to be

forecasted. This method is based on the assumption that the past rate of change of the

variable under consideration will continue in the future also which is a major limitation of

this method. Its assumption that the trend equation obtained by the best fit on the past

data holds good in the prediction period is not always appropriate. In the long run, it may

be good assumption but surely short run fluctuations in most time series do not warrant

this method. Therefore, this method quite often found appropriate for the long run

prediction not for the short run.

2.7.5 Demand Forecasting for New Products

53

Y = 84 + 2(t)

As we have discussed in the previous section, there are many different demand-

forecasting methods. We can make use of any of these methods while forecasting the

demand for existing product. Demand forecasting is very difficult for new products

because forecaster could not get previous data. No previous experience on the sales of

such product etc. In this regard Joel Dean has suggested some of possible approaches to

forecast demand for new products.

Project the demand for new product as an out growth of an existing old

product. It means when a product is evolved from the old one, the demand

condition of the old product should be taken into account while assessing

demand for a new product (evolutionary approach).

Analyze the new product as a substitute for same existing product. How

for a new product serves the purpose as substitute to an existing product?

If new product is close substitute for existing product. Demand for new

product can be forecasted based on the previous experience of sales trends

of already existing substitute products (substitute and growth)

Estimate the demand by making direct enquiry from the ultimate

purchasers, either by the use of samples or on a full scale i.e. Consumers

survey method.

Offer the new product for sale in a sample market. Total demand is

predicted on the basis of sale in the sample market i.e. Sales experience

approach.

Survey of consumer’s reaction to a new predict indirectly through the eyes

of specialized dealers who are supposed to be aware of consumers’ need

and alternative opportunity i.e. opinion survey method.

2.7.6 Criteria of a Good Forecasting Method

54

Different methods of demand forecasting shows considerable difference with

respect to procedure of forecasting, cost, level of accuracy, etc. Therefore, it is difficult to

choose a best method for a particular situation. There are certain criteria which could be

used to judge the suitable or not of a particular method of Demand Forecasting. Such

criteria are:

Accuracy: The accuracy of the forecast is measured by the degree of

deviation between forecasted and actual values of a parameter. Lesser the

deviation between these two accurate is the demand forecast vice-versa. It

is necessary to check the accuracy of past forecast against present

performance and of present forecast against future performance.

Simplicity: It should be simple to understand. Management must be able to

understand and have confidence in the techniques used. Clear

understanding is necessary for proper interpretation of the results.

Economy: Cost must be compared with the importance of the forecast to

the operation of the business. Cost must be less than the importance of the

forecast to the firm. It is not desirable to have a forecast in which cost is

greater than the importance of forecast to the firm.

Availability: The techniques employed should be able to produce

meaningful results quickly. Techniques, which take long time to work out,

may produce useful information. But it may be too late for management

decisions hence it is of useless information.

Flexibility: The techniques used for forecasting must be able to

accommodate and absorb frequent changes accruing in the economy.

The method of demand forecasting which poses the above qualities will have greater

usefulness. It is difficult to point out the method, which poses all the qualities. However,

demand forecasting functionaries prefer such method of demand forecasting which poses

more number of these qualities.

55

2.8. Self Review Questions

1. Define the concept of demand.

2. Distinguish individual demand and market demand

3. Distinguish extension and contraction of demand

4. What is derived demand? Give an example

5. What is demand function?

6. What is price elasticity of demand?

7. Define cross elasticity of demand.

8. What is demand forecasting?

9. Explain the law of demand

10. Discuss the different types of Demand

11. Describe the determinants of demand

12. Explain the factors influencing price elasticity of demand.

13. Critically examine the usefulness of Demand forecasting

14. Discuss the different methods of demand forecasting

15. Explain how do you forecast the demand for new products

16. Describe the criteria of a good forecasting method

17 Following table gives the data on the sales level of X commodity at different price

level. Given these data estimate the price elasticity of demand for X commodity,

assuming other things remaining same.

Price of X

Commodity

Quantity of X Commodity

Sold in the Market

10.0 20

10.5 22

11.0 25

12.0 28

13.0 31

2.9. References/ Suggested Readings

56

1. Varshney RL, and Maheshwari K.L: “Managerial Economics”, Sultan Chand & Sons,

New Delhi-110002

2. Mote, V. L., Samuel Paul, Gupta,G. S: “ Managerial Economics: Concepts and Cases”,

Tata McGraw-Hill Publishing Company Limited, New Delhi

3. D.M.Mithani : “Managerial Economics: Theory and Applications”, Himalaya

Publishing House, Mumbai-400 004

4. Dominick Salvatore: “Managerial Economics”, McGraw-Hill International Editions,

Singapore

5 Ahuja, H. L.: “Advanced Economic Theory”, S.Chand & Company Ltd. New Delhi-

110 055

6. Jhingan, M.L.: “Advanced Economic Theory”, Vrinda Publications (P) LTD,Delhi-110

091

MODULE III: PRODUCTION AND COST ANALYSIS

57

Profit maximization is one of the main objectives of all types of business firms.

Profit = Total Revenue-Total Cost. In order to maximize the profit, firm tries to increase

its revenue and lower its costs. Towards this end, they try to produce optimum level of

output and also to use the least cost combination of inputs. These aspects are studied in

production (theories) analysis.

Demand and supply are two sides of the market, which determines the price of the

commodities. In the last chapter we have discussed about the demand side of the market.

Production and cost analysis (this Chapter) concerned with supply side of the market.

Production analysis is done in physical terms while cost analysis is discussed in monetary

terms. Production analysis relates physical output to physical inputs in the production

and studies the least cost combination of factor inputs, factor productivity and returns to

scale. Cost analysis deals with various types of costs and their role in decision-making,

determinants of costs etc.

3.1 Production Function:

A production function expresses the technological (or engineering) relationship

between the output of a commodity and its inputs. In other words it can be defined as, a

technical, mathematical relationship that tells the maximum amount of output that can be

produced with a given set of inputs, given the current state of technical knowledge

symbolically it can be denoted as follows.

Y=f (X1, X2, X3)

Where,

Y = Quantity of output of a commodity.

X1 = Land used in the production of commodity

X2 = Labour used in the production of commodity

X3 = Capital used in the production of commodity

It is the general form of production function. Quantity of output of a commodity

produced depends on the quantity use of land, labour and capital. But it does not tell the

manner and extent to which output changes due to change in input use level. To know the

direction and extent to which output changes due to change in input use level we must

58

estimate the specific form of production function i.e. specific statistical production

function.

3.1.1 Statistical Production Function

Statistical production function can be estimated by statistical techniques or

econometric methods using either cross sectional data or time series data on inputs and

output. There are many different forms of production function. Cob Douglas production

function is most widely applicable form of production function.

Where,

Y = Quantity of output produced

L = Quantity of labour employed

C = Quantity of capital employed

K, α, and β = are constants

Cob-Douglas are pioneers in estimating a production function of this form for American

manufacturing industry using annual time series data for the period 1899 – 1922. Their

estimated statistical production function was;

Y = 1.01 L0.75 C0.25

In the logarithmic form it can be written as:

log Y= log 1.01 + 0.75 log L + 0.25 log C

In this production function 0.75 is production elasticity of labour. It shows every

1 per cent increase in labour leads to 0.75% increase in production. Similarly 0.25 is

production elasticity of capital. In this production function sum of production elasticities

is (0.75 + 0.25=1). It means, 1 per cent simultaneous increase in both inputs leads to 1per

cent increase in production. It shows that Cob – Douglas production function assumes

constant returns to scale. With this type of production function total output can be

estimated for any given value of L and C. For example, if unit of labour input used is

1000 units and units of capital input used is 2000 units then, output production will be:

log Y = 1.01 + 0.75 log1000 + 0.25 log 2000

= 1.01 + 2.25 + 0.8253

log Y = 4.0853

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Y=KLα C β

Y = Antilog 4.0853

Y = 12170

If input use level increased by 10% i.e labour input increased from 1000 units to 1100

units and capital input increased form 2000 units 2200 units then the resulting output

change is as follows.

log Y =1.01 + 0.75 log 1100 + 0.25 log 2200

=1.01 + 2.28104 + 0.83561

log Y = 4.12665

Y = Antilog 4.12665

Y = 13386

Due to increase in input use level by 10 per cent output has increased from 12170 to

13385 i.e approximately by 10 per cent increase in output. It shows that Cab Douglas

production function assumes constant returns to scale.

So production function is technological relationship describing the manner and

extent to which a particular product responds to change in quantity of input, at the given

level of technology. While estimating the effect of input use on the production level we

assume that technology remains constant. But in practice technological changes also

influences the production growth, for example improvement in seeds technology brought

about considerable growth in crop yield. Statistical production function clearly revealed

the fact that the production function is the technological relationship explaining the

maximum amount of output capable of being produced by each and every set of specified

inputs, in the given state of technical knowledge.

Producers have to face various production decision problems. Production function

is useful in such production decision-making process.

Producer has to decide what is the most profitable amount of resource to use

in the production of a commodity. Because with the change in the input use

level factor productivity goes on changing. This will be discussed in the factor

product- relationship or laws of production.

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Various combinations of two or more inputs can produce a particular output

level of a product. Hence, producer has to decide the least cost combination of

inputs to produce a specific amount of a given commodity. This we shall

discuss in the “least cost combinations of inputs”.

Having certain amount of resources a producer can produce various

combinations of output of different commodities. So he has to choose the

most profitable product mix to produce in order to maximize his profit.

The next section deals with the input-output relation (i.e. laws of production).

Production analysis (or theory of production) considers two types relationships viz.

Short-run relationships and long-run relationships. Short-run is long enough to alter the

variable but not the fixed resources for production. In this time period certain inputs are

fixed and others are variable. It is called laws of returns. Long run is long enough to

alter both the variable and the fixed resources for production; but cannot alter the

technology. In this time period all inputs are variable there will be no fixed inputs. It is

called laws of returns to scale.

3.2 Law of Returns

It is the input-output relationship when one factor of production (input) is variable

while others are kept constant. If we go on increase the use of variable input while

keeping the other factors of production constant, the proportion between variable input

and fixed input goes on changing and also the variable factor productivity goes on

changing. Therefore, It is also called the law of variable proportion. Since it deals with

input-output relationship in the short run it is also known as factor-product relationship in

the short run. This theory states that in the beginning variable factor productivity goes on

increasing after a certain point of variable input use level its productivity starts

diminishing. Production and productivity of an input can be expressed through the

following measures.

Total Physical Productivity (TPP): TPP of a factor is the total production a

producer can obtain by employing different amount of that factor, keeping all

other factors constant.

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Average Physical Productivity (APP): APP of a factor is the total physical

product divided by the quantity of that factor, with all other factors held

constant

Marginal Physical Productivity (MPP): MPP of a factor is the extra physical

product producer obtains by adding an extra unit of that factor, with all other

factors constant. In other words it is an addition made to total physical

productivity by using an additional unit of input.

The input output relation showing total, average, and marginal productivity, when one

input is variable, say for example labour, while others are constant can be dividend into

three stages in such a way that one can locate the rational stage of production in order to

ensure the resource use efficiency (Figure 3.1). In figure 3.1 TPL, APL and MPL shows

the Total, average and marginal physical product of variable input i.e. labour.

First Stage: (O to L1)

The first stage extends from the point of origin to point of maximum average

product. At this point APL =MPL. (APL =MPL when APL maximum)

MPL maximum at point ‘M’. The corresponding point on TPL is called point of

inflection. Inflection point indicates the change in rate of increase in TPL. Up

to this point TPL increase at increasing rate beyond this point at decreasing

rate.

Elasticity of production is more than unity in the I stage production (Ep>1).

APL increases throughout this stage, indicating the increasing efficiency of

variable inputs on the productivity with the increasing use of the variable

input.

Second Stage: (L1 to L3)

This stage ranges from the point of maximum average product to the point of

maximum TPL or the point of zero MPL.

In this stage TPL increases at decreasing rate

In the beginning of this stage i.e. when APP=MPL, EP =1, at the end of this

stage i.e. when TPL is maximum or MPL is zero EP = 0, between these two

points Ep will be less than one but greater than zero.

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Figure 3.1: Total, Average and Marginal Product of Variable Input (Labour)

Third Stage:(Beyond L3)

This stage extends from the point of zero MPL to over the entire range of

declining TPL.

MPL crosses zero point and become negative.

Ep is less than zero.

I and II stage are considered as irrational stage of production, In I stage, the

average productivity of variable input increasing continuously indicating the increase in

its efficiency with the use of additional unit of this input. It is not reasonable to stop using

an additional unit of an input when its efficiency on all units used is increasing. Hence if

a producer is interested in maximizing his profit it is advisable to use the variable input at

least to the point of highest APL. In the III stage of production function, the total product

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(TPL) is declining and MPL is negative. Hence, it is not profitable zone. Producers

operating in this zone will incur double losses. One is declining production and another is

unnecessary additional cost of inputs. Therefore, producer should prefer to produce in the

second stage of production where the O<Ep<1.The optimum level of input use within this

stage can be located with the help of factor product price.

The law of variable proportion is also called laws of returns because in these

different stages of production we have seen different returns level for the different level

variable input use. In the above figure we could find increasing returns, diminishing

returns and also negative returns. No rational would prefer to operate in the stage of

negative returns. In between increasing and diminishing returns we could also found

constant returns. Though it is not visible in the curve, the concept of constant returns is

very popular in practice. Three important laws of returns are elaborated in the following

section.

Increasing returns

Decreasing returns

Constant returns

I. Increasing Returns: If each additional unit of variable input adds more and more to the

total production than their previous unit of input, then it may be called as law of

increasing returns. In other words the law of increasing returns said to exist if MP goes

on increasing with the increase in the variable input use level.

rY1 /rX1 < rY2 /rX2 < rY3 /rX3< …………rYn /rXn

MP of second unit of input is greater than the MP of first unit of input and similarly MP

of 3rd unit of input is more than the marginal productivity of 2nd unit of input and so on.

Marginal productivity goes on increasing with use of additional unit of input under this

law.

ii Decreasing Returns: If each additional unit of variable input adds less and less to the

total production than their previous unit of input then it may be called as law of

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decreasing returns. In other words if marginal productivity goes on decreasing with the

increase in the variable input use level for that we called as low of decreasing returns.

rY1 /rX1 > rY2 /rX2 >rY3 /rX3> …………rYn /rXn

Marginal productivity of second unit of input is less than the marginal productivity of

first unit of input and similarly marginal productivity of third unit of input is less than the

marginal productivity of second unit of input and so on marginal productivity goes in

diminishing.

iii. Constant Returns: If the amount of output increases by the same magnitude for each

additional unit of input then it may be called as law of constant returns. Here MP remains

same at all levels of variable input use.

rY1 /rX1 = rY2 /rX2 =rY3 /rX3 = …………rYn /rXn

Marginal productivity of second unit of input is equal to the marginal productivity of first

unit of input and similarly marginal productivity of third unit of input is equal to the

marginal productivity of second unit of input and so on marginal productivity remains

constant for different level of variable input use level.

3.3 Laws of Returns to Scale

It refers to the behavior of output in response to the change in the scale of

production. Change in the scale of production means that all inputs or factors changed

simultaneously in the same proportion. In other words an increase in the scale of

production means that all inputs or factors are increased in the same proportion. The

study of change in output as a consequence of change in the scale forms the subject

matter of returns to scale. The concept of returns to scale is as old as economics itself.

However, they were not carefully defined till the time of Alfred Marshall. He used the

concept of returns to scale to capture the idea that firms may alternatively face

"economies of scale" (i.e. advantages to size) or "diseconomies of scale" (i.e.

disadvantages to size).

Laws of Returns v/s Laws of Returns to Scale

Laws of Returns Laws of Returns to Scale

Change in output in response to Change in the output in response to

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change in the variable inputs

Law of returns is a short run

phenomenon

In the short run they could not vary

all factors of production. They

could vary only variable factors of

production in order to vary their

output level.

change in the scale of production.

Law of returns to scale is a long-run

phenomenon

In the long run all factors of

production are variable. Even the

plant size can be varied in order to

vary the output level.

Returns to scale are technical properties of the production function, y = f (x1,

x2, ..., xn). If we increase the quantity of all factors employed by the same (proportional)

amount, output will increase. The question of interest is whether the resulting output will

increase by the same proportion, more than proportionally, or less than proportionally. In

other words, when we double all inputs, does output double, more than double or less

than double? These three basic outcomes can be identified respectively as increasing

returns to scale, constant returns to scale and decreasing returns to scale.

Increasing Returns to Scale: It is a situation where doubling of inputs leads to

more than doubling of output. i.e. if the increase in all factors without altering

the proportion between them leads to a more than proportionate increase in

output, returns to scale is said to be increasing. For example if all inputs are

increased by 25% and output increases by 30% then we consider this as

increasing returns.

Constant Returns to Scale: It is a situation where doubling of inputs leads to

exactly doubling of output. i.e. if the producer increases all factors in a given

proportion and the output increase in the same proportion, returns to scale is

said to be constant. For instance, if all inputs are increased by 25% and

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resulting output also increases by 25% then we can say that there is a constant

return to scale.

Decreasing Returns to Scale: It is situation in which doubling of inputs leads

to less than doubling of output. I.e. If the increase in all factors without

altering the proportion between them leads to a less than proportion increase

in output, returns to scale is said to be decreasing returns to scale. For

instance, if all inputs are increased by 25% and resulting output increases by

20% then we can say that there is a decreasing return to scale.

Although any particular production function can exhibit increasing, constant or

diminishing returns to scale throughout, it used to be a common proposition that a single

production function would have different returns to scale at different levels of output.

Specifically, it was natural to assume that when a firm is producing at a very small scale,

it often faces increasing returns because by increasing its size, it can make more efficient

use of resources by division of labor and specialization of skills. However, if a firm is

already producing at a very large scale, it will face decreasing returns because it is

already quite unwieldy for the entrepreneur to manage properly, thus any increase in size

will probably make his job even more complicated. The movement from increasing

returns to scale to decreasing returns to scale as output increases is referred to as the

ultra-passum law of production.

3.4 Least Cost Combination of Inputs:

There may be large number of resource combinations which will produces same

level of output. But cost of producing that particular level of output by different

combinations may not same. Producer has to incur different level of cost for different

combinations. In this topic we shall try to understand how to ascertain least cost

combination of inputs in producing a particular level of output. And also we shall try to

understand concepts related to least cost combinations.

The analysis of the multi-factor case requires mathematical tools, which is beyond

the scope of this course. For simplicity, we will assume that a firm produces output using

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two types of inputs: labor and capital. For now, we can think of labor as representing all

of the inputs that are variable in the short run and capital as representing all of the inputs

that are fixed in the short-run. Under this assumption, we can define as firm's short-run

production function as:

Q=f(L,K)

Where: Q = quantity of output produced

L = amount of labor input

K = amount of capital input

The production function, f, is a mathematical function that provides the maximum

quantity of output that can be produced for each possible combination of inputs used by

the firm. A convenient way of representing this production function is through the use of

a graph containing isoquant curves.

3.4.1:Isoquants:

An isoquant curve is a graph of all of the combinations of inputs that

result in the production of a given level of output Figure 3.1 shows a hypothetical

isoquant. In this diagram labour measured in horizontal axis and capital measured in

vertical axis. This isoquant suggests that the firm could produce 50 units of output per

day using either 20 units of labor and 5 units of capital at point C or 3 units of labor and

15 units of capital at point A. In fact, any combination of labor and capital along this

curve allows the firm to produce 50 units of output per day (for example point B). Note

that this curve is downward sloping because the firm can replace workers with machines

or replace machines with workers and still manage to produce the same level of output.

Figure 3.1: Isoquant Curve

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In this diagram, the firm can produce 50 units of output using any of the input

combinations given by points: A, B, or C. What happens if we compare points B and D?

At point D, the firm is using more labor and more capital than it is using at point B. If it

uses more of each input it could produce more total output. Thus, we know that this firm

can produce more output at point D than at point B. Since the firm produces 50 units of

output at points A, B, and C, the output level corresponding to point B is higher than at

any of the points on the isoquant. More generally, we can state that any point that lies

above and to the right of an isoquant curve corresponds to a higher level of output. Using

similar logic, the level of output will be lower if the firm selects a combination of inputs

that lies below and to the left of an isoquant.

The slope or the nature of isoquant depends on the Marginal Rate of Technical

Substitution (MRTS) or simply MRS. MRS shows the rate at which two resources can be

substituted i.e. how much the use of one resource can be given up in order to use an

additional unit of other input, in such a way as to maintain the same level of output.

r in the use of replaced resource rX1 MRSx1x2 = =

r in the use of added resource rX2

MRS of one input for the other in other words slope of an isoquant would depend on the

extent of substitutability of the two inputs. On the basis of the extent of the

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substitutability we can categories input-input relation into three main categories. Viz.

perfect non-substitutable, perfect substitutable and limited substitutable (substitutes but

not perfect substitutes).

Perfect Non-Substitutable: If inputs are perfectly non-substitute then such two

inputs are to be used in fixed proportion. Certain products can be produced only if

inputs are used in fixed proportion at all levels of production. Inputs are perfectly

non-substitute under such input-input relation. If input-input relation is such then

isoquant will be of rectangular type.

Perfect Substitutes: Perfectly substitutable can be replaced each other at a

constant rate in order to maintain the same level of output. If two inputs are

perfectly substitutable then isoquant in such input-input relation will be a straight

line which slopes downward from left to right.

Limited substitutable: In the production of some commodities there are some

inputs, which are substitutable but not perfect substitutable. In the production of

most of the commodities labour and capital are close but not perfect substitutable

their substitutability become more and more different as one factor is substituted

for another. When input-input relationship is such that isoquant will be convex to

the origin.

The isoquant that is convex to the origin shows the declining MRSX1X2.

Substitutability become more difficult as X1 input is substituted for X2 input. Here two

inputs are substitutable but not perfect substitutable because MRS x1 for X2 goes on

diminishing as the producer goes on substituting X1 for X2. Practically, in the production

of most of the commodities many inputs are substitutable within a certain limits. Hence,

this form of isoquants is widely applicable in the least cost combination analysis whereas

perfect substitutability and perfect non-substitutability is a very rare event. Hence,

straight-line isoquant and rectangular isoquants are not much useful in this analysis.

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The law of diminishing MRS states that the MRS declines as the level of labor

use rises along an isoquant. An equivalent way of stating this law is to state that isoquant

curves are convex. Let's consider the intuition underlying this law. This law suggests that

it takes a large amount of capital to replace a unit of labor when capital use is high but

little labor is used. As labor becomes more plentiful and capital becomes scarcer,

however, less capital is required to replace an additional unit of labor. Thus, the law of

diminishing MRS indicates that it is relatively difficult to replace additional quantities of

an input when the level of that input becomes relatively low. This seems to be

characteristic of most production processes. Consider, for example, the situation on a

farm. When a farm is highly mechanized and has only a small number of workers

operating the farm equipment, a very large amount of capital would be required to

replace a worker. If a firm, though, has many workers but few tools, the introduction of a

small amount of capital (such as a tractor) can replace a relatively large number of

workers.

3.4.2: Iso-Cost Curve:

The isoquant curve explains about the physical ways in which inputs can be

combined to produce output. Notice that it does not tell us anything about the costs

associated with alternative levels of input use. The next step towards the determination of

optimum/least cost combination of inputs is to add information on cost of those inputs.

This cost information introduced in the form of iso-cost line. Iso-cost line indicate all

possible combination of two inputs which can be purchased at a given outlay of

investment and the market price level of inputs. For example, given the per unit price of

capital(r) and labour (w), the total expenditure (C) on capital and labour is

C = rK + wL

Rewriting this equation by solving for K as a function of L

K = C/r – w/rL

This is an equation for straight line where C/r is the vertical intercept and –w/r is the rate

at which labour can be exchanged for capital in the market. For example, if w=2 and r=3,

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1 unit of capital can be traded for 1.5 unit of labour or 1 unit of labour can be traded for

2/3 unit of capital. The Iso-cost line for the given w=2, r=3 and C(outlay) =40 is;

K 40/3 – 2/3L

Or

K = 13.33 – 2/3L

If all the 40 rupees (outlay) is spent on the capital (L=0) 13.33 units of capital can be

purchased. Conversely if all the 40 rupees spent on labour (capital=0) 20 units of it could

be purchased. 13.33 units of capital and 20units of labour are the intercept on capital

and labour axis respectively, in between the two extreme values there will be large

number of combination of these two inputs. Figure 3.2 shows the iso-cost cost lines for

the outlay of rupees 30, 40 and 50 respectively.

Figure 3.2: Iso-Cost Line for Outlay of Rupees 30, 40 and 50

It is clear from the figure that as the outlay of investment on these two inputs goes on

increasing the iso-cost line shift outward but they remain parallel to each other. It is

because the input price ratios or the input prices remain constant.

3.4.3: Least Cost Combination of Inputs.

When both capital and labour are variable, determination of optimum/least cost

combination of these inputs requires that technical information from the production

function (i.e. the isoquant) be combined with the market data on the inputs price (i.e. the

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iso-cost curve). Consider the problem of minimizing the cost for a given level of out put.

Let us understand this problem with the help of figure 3.3.

Figure 3.3: Least Cost Combination of Inputs.

This figure consists of two isoquants. Specifically suppose that the firm’s

objective is to produce ten units of output at minimum cost. The infinite number of

capital and labour combinations could produce 10 units of output as shown by the

isoquant curve. Three of these combinations are indicated by a, b and c. point a and c are

on the iso-cost line representing the expenditure of rupees 150 and b is on the iso-cost

line representing the expenditure of rupees 100. Of these, clearly b is the best in the sense

of being the lowest cost. At point b 10 units isoquant is tangent to the iso-cost line

representing the outlay of rupees 100. All other input combinations shown on the 10-unit

isoquant would correspond to higher iso-cost curve and would cost more than 100 rupees.

It is important to note that the tangency between isoquant and iso-cost cure at point b

indicate that the MRSx1x2 is equal to the factor price ratio which is an important

criterion to decide the attainment of least cost.

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3.5. Economies and diseconomies of ScaleThe scale of enterprise or size of plant reflects the amount of investment made in

the relatively fixed factor of production, i.e., plant and fixed equipment. The concepts of

economies and diseconomies of scale are related to economic advantages or

disadvantages associated with the scale or size of the plant. The understanding of these

concepts enables the management to decide about the optimum scale or size of the plant.

Scale of production varies only in the long run and hence economies and diseconomies of

scale are associated with the long-run decisions.

When more units of a good or a service can be produced on a larger scale, yet

with less average input costs, economies of scale are said to be achieved. Alternatively,

this means that as a company grows and production units increase, a company will have a

better chance to decrease its costs. According to theory, economic growth may be

achieved when economies of scale are realized. Adam Smith identified the division of

labor and specialization as the two key means to achieve a larger return on production.

Through these two techniques, employees would not only be able to concentrate on a

specific task, but with time, improve the skills necessary to perform their jobs. The tasks

could then be performed better and faster. Hence, through such efficiency, time and

money could be saved while production levels increased. Just like there are economies of

scale, diseconomies of scale also exist. There are inefficiencies within the firm or

industry resulting in rising average costs as the company or production units grow

beyond a certain limit. In a nutshell economies of scale is said to be existing if average

cost falls as plant size increases and the diseconomies of scale prevail if the opposite is

the case.

Figure 3.4 depicts the economies and diseconomies of scale. In this figure

economies of scale is prevailing up to OM level of output. Up to OM level of output

average cost goes on declining and it reaches its minimum point at E and there afterwards

diseconomies of scale set into the production system hence average cost begins to

increase. Economies of scale is existing in the range of declining average cost curve and

similarly diseconomies of scale is operating in the range of increasing average cost curve.

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Figure 3.4: Economies and Diseconomies of Scale

3.5.1 Internal and External Economies of Scale

Alfred Marshall made a distinction between internal and external economies of

scale. When a company reduces costs and increases production, internal economies of

scale have been achieved. External economies of scale occur outside of a firm, within an

industry. Thus, when an industry's scope of operations expands due to, for example, the

creation of a better transportation network, resulting in a subsequent decrease in cost for a

company working within that industry, external economies of scale are said to have been

achieved. Thus internal economies and diseconomies arise due to the firm’s own

expansion. These include labour, technical, managerial, financial and marking economies

and diseconomies. External economies and diseconomies may arise due to the expansion

of the industry as a whole. With external economies of scale all firms within the industry

will benefit. From the managerial point of view, internal economies are more important

than external ones, for a while the former can be affected by managerial decisions of an

individual firm changing its size or scale, the latter are not subject to such influences

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3.5.2 Reasons for Internal Economies of Scale

These are economies made within a firm as a result of mass production. As the firm

produces more and more goods, average cost begins to fall. It is due to:

Labour economies arise in the beginning because expansion of output permits

specialization, which reduces per unit cost.

Technical economies made in the actual production of the good. Technical

economies arise because large output permits introduction of new methods of

production. Large firms can use expensive machinery, intensively.

Managerial economies made in the administration of a large firm by splitting up

management jobs and employing specialist accountants, salesmen, etc.

Financial economies made by borrowing money at lower rates of interest than

smaller firms.

Marketing economies made by spreading the high cost of advertising on television

and in national newspapers, across a large level of output.

Commercial economies made when buying supplies in bulk and therefore gaining

a larger discount.

Research and development economies made when developing new and better

products.

3.5.3 External Economies of Scale

These are economies made outside the firm as a result of the expansion of the industry as a whole:

A local skilled labour force is available.

Specialist local back-up firms can supply parts or services.

An area has a good transport network. Industry expansion may lead to the

construction of a railway line in a certain region resulting in a reduction in

transport cost for all the firms

An area has an excellent reputation for producing a particular good. For

example, Sheffield is associated with steel.

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3.5.4 Internal Diseconomies of Scale

These occur when the firm has become too large and inefficient. As the firm increases

production, eventually average costs begin to rise because:

Labour diseconomies of scale :Once the output has expanded to a reasonable

level, further expansion leads to problem of over-crowding, which renders control

and coordination of the labour force difficult, and lack a sense of responsibility,

which endangers efficiency. Thus, beyond a point, there are diseconomies of

labour.

Management becomes out of touch with the shop floor and some machinery

becomes over-manned.

Decisions are not taken quickly and there is too much form filling.

Lack of communication in a large firm means that management tasks sometimes

get done twice.

Poor labour relations may develop in large companies.

3.5.5 External Diseconomies of Scale

These occur when too many firms have located in one area. Unit costs begin to rise because:

Local labour becomes scarce and firms now have to offer higher wages to attract

new workers.

Land and factories become scarce and rents begin to rise.

Local roads become congested and so transport costs begin to rise.

The key to understanding economies and diseconomies of scale is that the sources

vary. A company needs to determine the net effect of its decisions affecting its efficiency,

and not just focus on one particular source. Thus, while a decision to increase its scale of

operations may result in decreasing the average cost of outputs, it could also give rise to

diseconomies of scale if its subsequently widened distribution network is inefficient.

Thus, when making a strategic decision to expand, companies need to balance the effects

of different sources of ES and DS so that the average cost of all decisions made is lower,

resulting in greater efficiency all around.

3.6 Cost Concepts

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Production analysis, discussed so far, relate physical output to physical inputs.

Cost analysis, to be discussed in this section, deals with various types of costs and their

role in decision-making, and the cost and output relationships. This analysis equips the

future mangers of business houses with various cost concepts suitable for various

business decisions. The kind of cost concept to be used in a particular situation depends

upon the business decisions to be made. Cost considerations enter in to almost every

business decision, and it is important, though sometimes difficult, to use the right kind of

cost. Hence an understanding of the meaning of various concepts is essential for clear

business thinking.

3.6.1. Actual Cost and Opportunity Cost

Actual costs mean the actual expenditure incurred for acquiring or producing a

good or service. These costs are the costs that are generally recorded in the books of

accounts, for example, actual wages paid, cost of materials purchased, interest paid, etc.

These costs are also commonly known as Absolute costs or Outlay costs. Opportunity

cost of a input or service is measured in terms of revenue which could have been earned

by employing that input or service in some other alternative uses. Opportunity cost can be

defined as the revenue forgone by not making the best alternative use. The opportunity

cost concept applies to all situation where a thing can have alternative use. Very often,

there are cases where a particular resource or factors of production has no alternative use.

Its opportunity cost will be nil irrespective of its utility in the existing use.

3.6.2 Economic Costs and Accounting Costs

Economists' idea of cost of production differs from that of an accountant. In

economics, the cost of production consists of remuneration to all factors of production

and the imputed value of the owner's owned resources used for the production of goods

and/ or services. An accountant on the other hand would include only the cash payments

to the factors of production, made by the entrepreneur, for the services rendered by these

factors in the production process. Such cash payments are called the explicit costs.

Accountants' classifications of costs are usually set up for legal, financial control and

auditing purpose while economists’ classification designed to provide decision-making

guideline for management to achieve the economic goals of the firm. Therefore, an

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accountant will include only explicit costs in his cost calculation where as economists

include not only explicit cost but also implicit cost. The difference between accounting

cost and economics cost could be better understood by the following relationship.

Economic Cost = Accounting Cost (explicit cost) + implicit cost

3.6.3 Short-Run and Long-Run Costs

In economics, short-run is defined as a period during which at least one input is in

fixed supply; the fixed factor input is plant and equipment. In the long run all factor

inputs are variables. The short and long run do not refer to any fixed units of calendar

time. Corresponding to this period classification, there are short run and long run costs. A

short run cost is that cost which varies with output when fixed plant and capital

equipment remain the same while a long run cost is that which varies with output when

all factor inputs, including plant and equipment, vary. In the long run, all costs are

variable. The plant may be fixed today, but in future company may decide to increase its

size to any level desired within the range of possible alternatives. Short run cost is

relevant when a firm as to decide whether or not to produce more or less with a given

plant. Long run cost analysis useful in investment decision.

3.6.4 Fixed and Variable Costs

Costs are placed in to two broad categories, fixed and variable cost. Fixed costs

are defined as those, which remain the same at a given capacity and do not vary with

output. These costs will exist even if no output is produced in the short run. Variable

costs, on the other hand, vary directly as output changes. Rent on factory and office

buildings, interest payments on bonds, and depreciation of building are examples of fixed

costs. Examples of variable costs are wages and expenditure on raw materials. There are

some costs, which fall between these two extremes. They are called semi variable costs.

They are neither perfectly variable nor absolutely fixed in relation to changes in output.

For example, electricity bills often include a minimum charge, which the firm is bound to

pay irrespective of its consumption and the actual bill increases if more than minimum

electricity is consumed.

3.6.5 Separable and Common Costs

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Costs are also classified on the basis of their traceability. Separable costs are

those, which can be attributed to a product, a department, or a process. On the other hand,

common costs are those, which cannot be traced to any one unit of operation. For

example, electricity charges may not be separable department wise in a single product

firm or even product wise in a multiple product firm. The separable and common costs

are also known as direct and indirect costs, respectively. This is because direct costs can

be identified while indirect costs cannot be attributed directly to any unit of operation.

Common costs may create problems in the case of joint products. The entrepreneur might

likes to know the total cost of each product line. This he may need for pricing purposes,

for deciding whether or not it is a profitable line of production, and whether to

discontinue or modify its production and so on. Thus, management may desire to

distribute the common costs into various product lines.

3.6.6 Past Costs and Future Costs

Past costs are actual costs incurred in the past and are generally contained in the

financial accounts. The measurement of past cost is essentially a record keeping activity

and is essentially passive function insofar as the management is concerned. These costs

can merely be observed and evaluated in retrospect. Just to find out the factors

responsible for the excessive costs if any, without being able to do anything for reducing

them. Future costs are costs that are reasonably expected to be incurred in some future

period or periods. Then future costs are the only costs that matter for marginal decisions

because they are the only cost subject to management control. Unlike past costs, they can

be planned for and planned to be avoided. If the future costs are considered too high the

management can either plan to reduce them or find out ways and means to meet them.

3.6.7 Sunk, Shutdown And Abandonment Costs

A past cost resulting from decisions, which can no more be revised, is called a

sunk cost. In other words a sunk cost is a cost once incurred cannot be retrieved. It is

usually associated with the commitment of funds to specialized equipment or other

specialties not readily adaptable to present or future use e.g. brewery plant in times of

prohibition. Shutdown costs may defined as those costs which would be incurred in the

event of suspension of the plant operation and which would be saved if the operations are

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continued. Examples of such costs are the cost of sheltering the plant and equipment and

construction of sheds for storing exposed property. Abandonment costs are the costs of

retiring altogether a plant from service. Abandonment arises when there is a complete

cessation of activities and creates a problem as to the disposal of assets. These costs

become important when management faced with alternatives of either continuing existing

plant suspending its operations or abandoning altogether.

3.6.8 Total Cost, Average Cost and Marginal Cost

Total cost includes all cash payments made to hired factors of production and all

cash charges imputed for the use of the owner’s factors of production in acquiring or

producing goods or services. In the production decisions average and marginal cost

concepts are playing important role. Average cost is the cost per unit of output. It could

be obtained by dividing the total cost by total quantity produced (AC = TC/Q). If TC =

150, and Q = 30 units, then AC = 150/30 =5. Marginal cost is the addition made to total

cost by producing an additional unit of output. It can be obtained by MCn = TCn – TCn-1.

If total cost for producing 100 units of output is say rupees 10000 and total cost of

producing 101 unit of output is rupees 10110 then Marginal Cost of producing 101 th unit

of output is (MC101 = TC101 – TC100 = 10110 –10000 = 110) 110. The average cost

concept is important for calculating per unit profit of a business concern. Marginal cost

concept is essential in deciding whether a firm needs to expand its production or not. The

relevant costs to be considered will differ from one situation to other depending on the

nature of problem faced by the organization.

3.7. Cost Output Relationship

The behavior of cost is of vital importance in the management decision-making

process. The cost of production depends on many factors and they vary from one firm to

another in the same industry and from one type of industry to another. The general

determinants of costs are; a) output level, b) prices of factors of production, c)

productivity of factors of production and d) technology. Of all, the relationships between

cost and its individual determinants, the cost-output relationship is the most important

one. Its significance is so great that in economic analysis the cost function usually refers

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to the relationship between cost and rate of output alone, and thus assumes that all of the

other independent variables are kept constant.

The cost and output relationship is mainly of two types. One is short run cost and

output relationship and another is long run cost and output relationship. The Short-run

costs are those costs, which are incurred by the firm during a period in which some

factors, especially, capital equipment, land and management are held constant. The short-

run costs are incurred on the purchases of raw materials, chemicals, fuel, casual labour

etc. Which vary with the changes in the level of output. On the other hand, the long-run

costs are the costs incurred during a period, which is sufficiently large to allow the

variation in all factors of production including capital equipment, land and managerial

staff to produce a level of output. In the beginning short run cost output relationship is

described followed by the long run cost output relationship.

3.7.1 Cost Output Relationship in the Short Run

The short-run cost-output relationship refers to a particular scale of operation or to

a fixed plant. That is, it indicates variations in cost over output for the plant of a given

capacity and this relationship will vary with plants of varying capacity. Thus, the short-

run function relating cost to output variations is of the following type:

TC = f(x) + A

Where: TC = total cost

X = output and

A = total fixed cost

The fixed cost is for a given plant size; for different plant sizes, its value will differ. f(x)

obviously denotes total variable cost. For decision-making, one needs to know not only

the relationship between total cost and output but also separately between various types

of costs and output. Thus, the short-run cost-output relationship needs to be discussed in

terms of; a) fixed cost and output, b) variable cost and output, c) total cost and output.

3.7.1.1 Total Fixed and Variable Costs in the Short Run

There are some inputs or factors, which can be readily adjusted with the changes

in the output level. Thus, a firm can readily employ more workers, if it has to increase

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output. Likewise, it can secure and use more raw material, more chemicals without much

delay if it has to expand production. Such factors are called variable factors. On the other

hand, there are factors such as capital equipment, factory building, top management

personnel that cannot be so readily varied. It requires a comparatively long time to make

variations in them. Such factors are called fixed factors.

Corresponding to this distinction between variable factors and fixed factors,

economists distinguish between the short run and the long run. The short run is a period

of time in which output can be increased or decreased by changing only the amount of

variable factors such as labour, raw materials, chemicals, etc. In the short run, quantities

of the fixed factors such as capital equipment, factory-building etc., cannot be varied for

making changes in output. If the firm wants to increase output in the short run, it can only

do so by using more labour and more raw materials, it cannot increase output in the short

run by expanding the capacity of its existing plant building a new plant with a larger

capacity.

On the other hand, the long run is defined as the period of time in which the

quantities of all factors may be varied. In the long run, the output can be increased not

only by using more quantities of labour and raw materials but also by expanding the size

of the existing plant or by building a new plant with a larger productive capacity. It may

be noted that the word 'plant' in economics stands for a collection of fixed factors, such as

factory building, machinery installed, the organisation represented by the management

and other essential skilled personnel.

Fixed costs are also known as overhead costs and include charges such as

contractual rent, insurance fee, maintenance costs, property taxes, interest on the

borrowed funds, minimum administrative expenses such as manager's salary, watchman's

wages etc. Thus fixed cost is the cost incurred towards the fixed factors of production.

Variable costs include payments to labour employed, the prices of the raw material, fuel

and power used, the expense incurred on transportation and the like. If a firm shuts down

its operation for some time in the short run, it will not use the variable factors of

production and will not therefore incur any variable costs. Variable costs are also called

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prime costs or direct costs. Thus variable cost is the cost incurred on the variable factors

of production. Total cost is the sum of these two costs.

TC = TFC + TVC

The short-run total fixed, variable and total costs curves are portrayed in Figure

3.5 where output is measured on X-axis and cost on Y-axis. Since the total fixed cost

remains constant whatever the level of output, the total fixed cost curve (TFC) is parallel

to the X-axis. It will be seen in the figure that the total fixed cost curve (TFC) starts from

a point on the y-axis meaning thereby that the total fixed cost will be incurred even if the

output is zero. On the other hand, the total variable cost curve (TVC) rises upward

showing thereby that as the output increased, the total variable cost also increases. The

total variable cost curve TVC starts from the origin which shows that when output is zero

the variable costs are also nil.

Figure 3.5 Short-Run Total Fixed, Variable and Total Costs.

It should be noted that total cost (TC) is function of the total output (q); the greater the

output, the greater will be the total cost. In symbol we write

TC = f (q)

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we can prove this as follows:

TC = TFC + TVC

Suppose TFC is equal to K, which is a constant amount whatever the level of output.

TVC is equal to the amount used of the variable factor say, L, multiplied by the given

price of the variable, say, W,

TVC = L.w

TC = K + L.w.

Now, L.w., that is, TVC must rise with the increase in output, because only by increase in

the amount of variable factor, that is, by increase in L, that the output can be increased.

From the above equation it is clear that with the increase in L.w. as output rises, TC must

also rise. In other words, total cost (TC) is function of total output (q) and varies directly

with it. It will be seen from the table that the vertical distance between the TVC and TC

curves is constant throughout. This is because the vertical distance between the TVC and

TC curve represents the amount of total fixed cost, which remains and changed as output

is increased in the short run.

As per economic theory, its nature is such that in the beginning as output

increases, total variable cost increases at a decreasing rate, then at a constant rate and

eventually at an increasing rate. Thus, the increase in total variable cost goes on

increasing at the diminishing rate up to a certain level of output, then remains constant for

some range of output, and then it starts rising at an increasing rate. This is so because the

need for variable factor inputs for increased output behaves in a similar fashion, and there

is the operation of the law of diminishing returns. Because, the requirement of labour

does not change linearly with quantity produced. Once the output has reached a

reasonable level, the increase in output may become increasingly costly because the

variable factor inputs may not be easily available or they may have to be paid higher

price than before. Yet another reason for a non-linear total variable cost and output

relationship is the operation of the law of diminishing returns. According to this law as

more and more units of a variable factor of production are used along with a fixed factor

of production, the marginal product of that variable factor first increased, then remains

constant and finally starts diminishing.

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3.7.1.2 Average and Marginal Cost Curves in the Short Run

The above section describes the total cost concepts and output relationship. In

practice businessmen and economists, very often, use the costs in the form of cost per

unit, or average costs rather than totals. Besides marginal cost is another important

concept, which is being, very widely used in practice. Important average cost concepts

used in the decision-making are Average Fixed Cost, Average Variable Cost and Average

Total Coast.

AVERAGE FIXED COST (AFC): Average fixed cost is the total fixed costs divided by

the number of units of output produced. Therefore;

AFC = TFC /Q

Where Q represents number of units of output produced.

Thus, the average fixed cost can be obtained by the dividing the total fixed cost by the

level of output. In the table 3.1, the column 6 gives the average fixed cost. Since total

fixed cost is a constant quantity (Rs.3000) average fixed cost steadily falls as output

increases. Therefore, average fixed cost curve, as shown in the figure 3.6, slops

downward throughout its length. As output increases, the total fixed cost spreads over

more and more units and therefore average fixed cost become less and less. When output

becomes very large average fixed cost approaches zero. The AFC curve gets very nearer

to but never touches either axis.

Table 3.1: Different Cost Concepts

Quantity of

Output(1)

Number of Workers

(L)(2)

Total Fixed Cost(3)

Total Variable

Cost(4)

Total Cost

(5)

A F C

(6)= 3/1

A V C

(7) = 4/1

A T C

(8) = 5/1

M C

(9) = ∆5/∆1100 10 3000 1000 4000 30 10 40 40200 15 3000 1500 4500 15 7.5 22.5 5300 23 3000 2300 5300 10 7.7 17.7 8400 40 3000 4000 7000 7.5 10 17.5 17500 73 3000 7300 10300 6 14.6 20.6 33

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Figure 3.6: Relationship between Output and Different Cost Curves

AVERAGE VARIABLE COST (AVC): Average variable cost is the total variable cost

divided by the number of units output produced. Therefore;

AVC = TVC /Q

Where Q represents the total output produced.

Thus, average variable cost is variable cost per unit of output. It will be seen that average

variable cost falls until 200 units of output and there after it increases. The average

variable cost will generally fall as the output increases from zero to the normal capacity

of output. Then afterwards average variable cost will rise steeply because of the operation

of diminishing returns. The average variable cost curve is shown in figure 3.6 by the

curve AVC which first falls, reaches minimum and rises.

AVERAGE TOTAL COST (ATC): The average total cost or what is called simply

Average cost is the total cost divided by the number of units of output produced.

ATC = TC /Q

Since the total cost is the sum of total variable cost and total fixed cost, the average total

cost is also the sum of average variable cost and average fixed cost. This can be proved as

follows:

ATC = TC / Q

Since TC = TVC + TFC

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Therefore, ATC = (TVC +TFC)/Q or AVC + AFC

It will be seen from table 3.1 that as output increases, in the initial stages, that is, until

400 units of output produced average total cost falls and thereafter it is rising. This impels

that short run ATC will have a U - shape, which is shown in figure 3.6. The behavior of

the average total cost curve will depend upon the behavior of the average variable cost

curve and average fixed cost curve. In the beginning, both AVC and AFC curves fall, the

ATC curve therefore falls sharply in the beginning. When AVC curve begins rising, but

AFC curve is falling steeply, the ATC continues to fall. This is because during this stage

the falls in AFC curve weighs more than the rise in the AVC curve. But as output

increases further, there is a sharp rise in AVC, which more than offsets the fall in AFC.

Therefore, the ATC curve rises after a point. Therefore, ATC like the AVC curve first

falls, reaches its minimum value and then rises. The ATC is, therefore, almost of a 'U'

shaped.

MARGINAL COST (MC): The concept of marginal cost occupies an important place in

the economic theory. Marginal cost is an addition made to the total cost by producing an

additional unit of output. In other words, marginal cost is the addition to the total cost of

producing 'n' units instead of n-1 units (i.e., one less). Where n is any given number. It

can be written as;

MCn = TCn - TCn-1

This formula is suitable when the output data available in individual units. When the

output data is in the aggregate form MC could be obtained form the alternative formula.

Since marginal cost is a change in total cost as a result of a unit change in output, it can

also be written as:

MC= ∆TC/∆Q

Where ∆TC represents a change in total cost and ∆Q represents change in the output. In

the table 3.1 when output increase form 100 units to 200 units the total cost increased

form rupees 4000 to 4500. Here change in quantity of output (∆Q) is 100 units and

similarly change in total cost is rupees 500. Therefore;

MC = 500/100 = 5

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Like other average cost curve, Marginal Cost curve also falls in the beginning and then

increase continuously. We can find some interesting relationship between average cost

and marginal cost. When marginal cost is below the average cost average cost is falling.

When MC is above the AC average cost is increasing. Similarly when MC = AC latter is

at its minimum point. It is worth to recall the fact from laws of returns. Marginal

productivity curve intersect the average productivity curve from the above. When

average productivity is equal to marginal productivity, average productivity is at its

maximum point. Productivity and cost moves in the opposite direction. Therefore we

can find such a relationship between AC and MC.

3.7.2 Cost Output Relationship in the Long Run

The long run, as already explained above, refers to time period during which full

adjustment could be made through varying all inputs including capital equipment and

factory building. In the long run, therefore, there is no fixed factor of production and

hence there is no fixed cost. The long run total cost function will be of the following

form:

TC = f (x, k)

Where k stands for the plant size and x stand for the output level. As k changes, TC also

changes. Thus, the above-mentioned long-run cost function contains a family of short-run

cost functions, one for each value of k. It is important to note that all production is done

in the short run during which the plant size is given. Thus, long run consists of all

possible short run situations among which the firm has to choose to produce a target level

of output. In the short run the firm tied with a given plant whereas in the long run the

firm moves form one plant size to another; the firm can make a large plant if it has to

increase its output level and a small plant if it has to reduce its output. Therefore, the long

run average cost curve depicts the least possible average cost for producing various levels

of output. In order to understand how the long run average cost is derived, consider the

three short run average cost curve as shown in the figure 3.7

The short run average cost curves are also called plant curves because in the short

run plant size is fixed and each of the short run average cost curve correspond to a

particular plant. SAC1, SAC2 and SAC3 shows the different plant size and the producer, in

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the long run, could choose any of these plant size according to his requirement. It is clear

form the figure that up to OB amount of output, the firm will operate on the SAC1 though

it could also produce with SAC2 because up to OB amount of output, production on SAC1

curve entitles lower cost than on the SAC2. For instance, if the level of output OA is

produced with SAC1 it will cost AL per unit and if it is produced with SAC2 it will cost

AH per unit. Obviously AL is smaller than AH. Similarly all other output levels up to OB

can be produced more economically with smaller plant SAC1 than with larger plant SAC2.

To produce exactly OB level of output average cost is same on both the plant size under

such circumstances it is rational to choose SAC2 because it contains reserved capacity at

that level. If the firm wants to produce an output, which is equal to or larger than OB,

then it will be economical to produce on SAC2. Plant size SAC1 is suitable size to

produce the OB level of output to OD level of output. If the firm further wants to produce

the output beyond the OD level then the firm needs to further expand its size.

Figure 3.7: Short Run Average Cost Curve for Different Plant Size.

Thus, In the long run the firm has a choice in the employment of a plant, and it

will employ that plant which yield minimum possible unit cost for producing a given

output. The long run average cost curve depicts the least possible average cost for

producing various levels of out put when all the inputs including the plant size is variable.

90

If the output is small, the total cost is less for a small plant size than for a large plant size

and quite the reverse holds good for large outputs. This is so because if a large plant is

installed it will remain under-utilized when output is small while a small plant will be

inadequate or insufficient for large outputs. Thus, the family of short-run total cost

curves, one for each plant size, will be of the type shown in Figure 3.8.

Figure 3.8: Long Run Average Cost Curve

In any case, there my be infinite number of shot run average cost curves. The

Long Run Average Cost (LAC) curve is to draw in such a way as to tangent to each of

the short run average cost curves. Therefore, the long run average cost curve is also

called envelope because it supports a family of short run average cost curves. Since an

infinite number of short run average cost curves are assumed, every point on the long run

average cost curve will be tangency point with some short run average cost curve. In fact,

long run average cost curve is nothing else but the louses of all these tangency points. If a

firm desires to produce a particular output in the long run, it will pick a point on the long

run average cost curve corresponding to that output and it will then build a relevant plant

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and operate on the corresponding shot run average cost curve. In this example plant size

indicated by SAC4 is an optimum plant size because the minimum point of this cure

tangent the minimum point of the LAC curve.

3.7.3 Modern Views on Cost Output Relationship

The U shaped cost curves of the traditional theory have been questioned by

various writers both on theoretical a priori and on empirical grounds. As early as 1939

George Stigler suggested that the short run average variable cost has a flat stretch over a

range of output, which reflects the fact that firms build plant with some flexibility in their

productive capacity. In the modern days plants, generally, will have a capacity larger than

the expected average level of sales, as organizations desire to have some reserved

capacity. Thus, the short run average variable cost in the modern version has a saucer

type shape. That is it is broadly U shaped but has a flat stretch over a range of output.

The shape of the long run cost curve has attracted greater attention in economic

literature, due to the serious policy implications of the economies of large-scale

production. According to the modern theory long run average cost curve is L shaped.

Several reasons have been put forward to explain the why long run cost curve is L shaped

rather than U shaped. It has been argued that managerial diseconomies can be avoided by

the improved method of modern management sciences.

3.8. Self Review Questions

1. Define production function

2. What is Isoquant?

3. Define iso-cost line with suitable example

4. Distinguish between laws of returns and laws of returns to scale

5. Distinguish between fixed cost and variable cost

6. Mention determinants of cost.

7. Mention the production decision problems. Explain the application of production

function analysis in solving these problems.

8 Critically examine the importance of isoquant and iso-cost curve in the

managerial decision making process.

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9. Explain the managerial uses of cost output relationship.

10. Explain Fixed Cost (FC), Total Variable Cost (TVC), Total Cost (TC), Average

Fixed Cost (AFC), Average Cost (AC) and Marginal Cost (MC) and complete the

following table

Units of Output

FC TVC TC AFC AVC AC MC

0 2000 0 2000 ... ... ... ... 10 2000 2800 8020 1400 10030 3860 4640 2200 10550 2000 2800 6060 5800 10070 2000 5000 7000

3.9. References/ Suggested Readings

1. Koutsoyiannis, A.: “Modern Micro Economics”, ELBS With Macmillan, Hong Kong.

2. Mote, V. L., Samuel Paul, Gupta,G. S: “ Managerial Economics: Concepts and Cases”,

Tata McGraw-Hill Publishing Company Limited, New Delhi

3. D.M.Mithani : “Managerial Economics: Theory and Applications”, Himalaya

Publishing House, Mumbai-400 004

4. Craig Petersen. H, and Cris Lewis.W: “ Managerial Economics”, Maxwell Macmillan

International editions, New York

5. Dominick Salvatore: “Managerial Economics”, McGraw-Hill International Editions,

Singapore

6. Ahuja, H. L.: “Advanced Economic Theory”, S.Chand & Company Ltd. New Delhi-

110 055

7. Jhingan, M.L.: “Advanced Economic Theory”, Vrinda Publications (P) LTD,Delhi-110

091

8. Varshney RL, and Maheshwari K.L: “Managerial Economics”, Sultan Chand & Sons,

New Delhi-110002

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MODULE-IV: MARKET STRUCTURE AND PRICE DETERMINATION

Determination of price is an important managerial function in all kinds of

business organizations. Preceding chapters described the demand and supply of goods

and services. This chapter brings these issues together in order to describe the

determination of the price of goods and services. It deals with the meaning and types of

market and theoretical market models of price and output determination. The last section

of this chapter describes the pricing method in practice.

4.1 Meaning of Market

A Market is an institutional arrangement under which buyers and sellers can

exchange some quantity of goods and services at mutually agreeable prices. A market

can, but need not, be a specified place or location where buyers and sellers actually come

face to face for the purpose of transacting their business. For example K. R. Market in

Bangalore is located in particular location. On the other hand, the market for management

faculty has no specific location; rather it refers to the entire formal and informal network

on teaching opportunity throughout the nation. In other words market can be described

as an arrangement whereby buyers and sellers come in close contact with each other

directly or indirectly to sell and buy goods or service at mutually agreeable prices.

Therefore, market may be physically identifiable e.g. K. R. Market in Bangalore. But

concept of market does not refer only to a fixed location. What is needed for a market is a

group of potential sellers and buyers are in close contact with each other through any

means so that transaction processes take place. Market, thus, refers to the conditions and

commercial relationships facilitating the transaction between buyers and sellers.

4.2 Types of Markets

Markets may be classified on the basis of geographical area, time element and

competition. Of all the criteria used for the classification of the market competition is

most important from the management decision point of view. Only a passing reference is

given about the market classification based on the other two criteria. Market

classification based on the competition is explained under the heading market structure.

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Based on the geographical area markets could be classified into Local

markets, Regional markets, national market and world market. Local market

has a narrow geographical coverage. It is confined to a particular village, town

or city only. Perishable goods like milk, vegetable, fruits, etc. are generally

traded in local markets. Goods or services, which have the regional

importance, will be traded in regional markets. Kannada films have wide

market in Karnataka because it is the language of this region. When goods are

demanded and sold on a nation wide scale, such goods said to acquire the

national market. Same is the case with the world market.

Based on the time element market could be classified into market period,

short period and long period. The market period is regarded as a very short

period during which it physically impossible to change the stock of the

commodity. In this period it is not possible to make any adjustment in the

supply to the changing demand condition. Similarly the short period is a time

period during which it is possible for a firm to expand output by using more of

variable inputs but not the fixed factors of production. In this time period

firms could make some adjustment in the supply according to the changing

demand condition. The long period refers to a time period during which firm

could adjust its scale of production in order to meet the changing demand

condition. In the long run firms could adjust their supply in the changing

demand condition.

4.2.1 Market Structures:

The nature of competition in market depends on the number of participants in

the market and nature of commodity, which together determine the extent of market

control of each participant. Perfect competition represents the benchmark market

structure that contains a large number of participants on both sides of the market, and

no market control by any firm. Three market structure models with varying degrees of

market control on the supply side of the market are: monopoly, monopolistic

competition, and oligopoly (table 4.1). Three lesser-known market structures with

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varying degrees of market control on the demand side of the market are: monopsony,

oligopsony, and monopsonistic competition.

Table 4.1. Classification of Markets (Based on Competition).

Kind of Competition Number of firms

Nature of Products

Degree of control over

price

Part of economy where prevalent

Perfect Competition

Perfect Competition Large number

Homogeneous None A few agricultural products

Imperfect competition

Monopolistic Competition

Large number

Differentiated but close substitutes

Some Tooth paste, soap etc.

Oligopoly Pure Few Homogeneous Some Steel, Aluminum

DifferentiatedFew Differentiated Some Automobiles

Monopoly One Unique Considerable A few public utilities

4.2.2. Supply-Side Market Structures

The structure of a Market primarily depends on the number of firms operating in

the market. Perfect Competition is the theoretical benchmark of efficiency achieved

because large number of participants in the market gives neither buyers nor sellers market

control. Other market structures have different amounts of market control due to different

numbers of competitors. In general, more competition means less market control.

Varying degrees of market control among sellers generate three alternative market

structures viz. Monopoly, Monopolistic competition and Oligopoly.

Perfect Competition: Perfect competition is an ideal market structure

characterized by a large number of participants on both sides of the market. The

product sold by each firm in the market is identical to that sold by every other

firm. Buyers and sellers have complete freedom of entry into and exit out of the

industry, and perfect knowledge of prices and technology. Perfect competition is

an idealized market structure that is not observed in its purest form in the real

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world. However, some of the agricultural products possess main feature of perfect

competition market. While unrealistic, its primary function is to provide a

benchmark that can be used to analyze real world market structures. In particular,

perfect competition efficiently allocates resources. It does this by exchanging the

quantity of goods that equate price and marginal cost. With a large number of

participants, both buyers and sellers are price takers. Individual participants must

exchange goods at the market price and none can influence the market in any

way. For this reason, the demand price buyers are willing to pay, based on the

satisfaction received, is equal to the supply that sellers are willing to accept, based

on the opportunity cost of production.

Monopoly: Monopoly, characterized by a single competitor and complete control

of the supply side of the market. Monopoly contains a single seller of a unique

product with no close substitutes. The demand for monopoly output is the market

demand. Monopoly is the worst-case scenario of inefficiency on the selling side

of the market and thus is often subject to government regulation.

Monopolistic Competition: Monopolistic competition residing closer to perfect

competition. It characterized by a large number of relatively small competitors,

each with a modest degree of market control on the supply side. A key feature of

monopolistic competition is product differentiation. The output of each producer

is a close but not perfect substitute to that of every other firm, which helps satisfy

diverse consumer wants and needs. While market control always means

inefficiency, monopolistic competition is not a serious offender.

Oligopoly: Oligopoly is closer to monopoly. It characterized by a small number of

relatively large competitors, each with substantial market control. Oligopoly

sellers exhibit interdependent decision-making, which can lead to intense

competition and the motivation to cooperate through mergers and collusion.

Oligopoly tends to have serious inefficiency problems, but also provides the

benefits of innovation and large-scale production. Further, It could be classified

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into two kinds, based on the nature of commodity viz. Pure Oligopoly and

Differentiated Oligopoly.

Besides these four markets, two other market structures that tend to appear in the analysis

of product and factor markets are duopoly and bilateral monopoly.

Duopoly: This is a special type of oligopoly that contains two firms. While the

duopoly market structure can and does exist in the real world, it is perhaps most

important as a tool used to analyze oligopoly.

Bilateral Monopoly: This is a market containing one seller and one buyer. In

effect, it is the merger of monopoly from the selling side with monopsony from

the buying side. This market structure provides a great deal of insight into

unionized labor markets, where the employer is the single monopsony buyer and

the labor union represents the monopoly seller.

4.2.3. Demand-Side Market Structures

While the focus of market structures usually falls on the supply-side of markets,

varying degrees of market control on the demand side generate three additional market

structures viz. Monopsony, Monopsonistic Competition and Oligopsony.

Monopsony: Monopsony characterized by a single competitor and complete

control of the demand side of the market. Monopsony contains a single buyer

in the market and represents the demand-side counterpart to monopoly on the

supply side. The supply facing a monopsony is the market supply. Monopsony

is the worst-case scenario of inefficiency on the buying side of the market.

Monopsonistic Competition: Monopsonistic competition characterized by a

large number of relatively small competitors, each with a modest degree of

market control on the demand side. Monopsonistic competition represents the

demand-side counterpart to monopolistic competition on the supply side. A

key feature of monopsonistic competition is product differentiation as each

buyer seeks to purchase a slightly different product. While market control

always means inefficiency, monopsonistic competition is not a serious

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offender. Monopsonistically competitive buyers are often on the other side of

a market containing monopolistically competitive sellers.

Oligopsony: Oligopsony characterized by a small number of relatively large

competitors, each with substantial market control. Oligopsony represents the

demand-side counterpart to Oligopoly on the supply side. Oligopsony buyers,

like their oligopoly counterparts, exhibit interdependent decision-making,

which can lead to intense competition and the motivation to cooperate.

Oligopsony tends to have serious inefficiency problems.

It is also clear from the above demand side market structures that, as the number of

participants on the demand side of the market increases market control decreases.

4.3. Perfect Competition

This is one of four basic market structures. It characterized by a large number

of small firms, producing and selling homogeneous products, without any restriction

of entry into and exit out of the industry, and perfect knowledge of prices. It is an

idealized market. In the strict sense of the term it is not observed in the real world.

While unrealistic, it does provide an excellent benchmark that can be used to analyze

real world market structures. In particular, perfect competition efficiently allocates

resources. Some important characteristic features of this market structure are

discussed hereunder.

4.3.1 Characteristics of Perfect Competition

The four characteristics of perfect competition are: (1) large number of small

firms, (2) identical products, (3) perfect resource mobility, and (4) perfect knowledge.

Large Number of Small Firms: A perfectly competitive industry contains a large

number of small firms, each of which is relatively small compared to the overall

size of the market. It ensures that no single firm can influence market price or

quantity. If one firm decides to double its output or stop producing entirely, the

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market is unaffected. The price does not change and there will be no change in the

quantity exchanged in the market.

Identical Products: Each firm in a perfectly competitive market sells an identical

product, what is often termed "homogeneous goods." The essential feature of this

characteristic is not so much that the goods themselves are exactly, perfectly the

same, but that buyers are unable to find any difference. In particular, buyers

cannot tell which firm produces a given product. There are no brand names or

distinguishing features that differentiate products.

Freedom of entry and exit: Perfectly competitive firms are free to enter and exit

an industry. Government rules and regulations or other barriers do not restrict the

firms. Likewise, a perfectly competitive firm is not prevented from leaving an

industry.

Perfect Knowledge: In perfect competition, buyers are completely aware of

sellers' prices, such that one firm cannot sell its good at a higher price than other

firms. Each seller also has complete information about the prices charged by other

sellers. So, they do not inadvertently charge less than the going market price. All

perfectly competitive firms have access to the same production techniques. No

firm can produce its good faster, better, or cheaper because of special knowledge

of information.

4.3.1.1 Pure Versus Perfect Competition

Competition is classified into Pure and Perfect competition. The market is said

to be pure competition if it possess only first three conditions. Contrary to it, the market

is considered to be pure competition if it possesses the six conditions listed below.

i) There are large number of buyers and sellers

ii) Goods produced and sold are homogeneous

iii) There is Free Entry or Exit for any producer or seller

iv) Perfect knowledge on the part of the buyers and sellers about market

conditions

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v) Perfect mobility of the factors of production, and

vi) Proximity to the market/ no extra transport cost

4.3.2. Demand and Revenue Curve of a Perfect Competitive Firm.

The conditions of perfect competitive market ensures that a single price must

prevail under perfect competition and the demand curve (or average revenue curve) faced

by an individual firm is perfectly elastic at the ruling price in the market. That is a

perfectly competitive firm faces a horizontal demand curve. It signifies that the firm does

not exercise any control over the price of the product. Each firm in a perfectly

competitive market is a price taker and can sell all of the output that it wants at the going

market price. A firm is able to do this because it is a relatively small part of the market

and its output is identical to that of every other firm. As a price taker, the firm has no

ability to charge a higher price and no reason to charge a lower one. It can sell all of the

output it wants at the going market price; hence, it has no reason to charge less. If it tries

to charge more than the going market price, then buyers can simply buy output from any

of the large number of perfect substitutes produced by other firms. Because the price

faced by a perfectly competitive firm is unrelated to the quantity of output produced and

sold, this price is also equal to the marginal revenue and average revenue generated by

the firm. If a firm is able to sell any quantity of output at the market price, then the

average revenue, revenue per unit sold, is also equal to market price. It could be

explained with the help of the figure 4.1.

In the perfect competitive market, market price determined by the market demand

and market supply curves. In the figure (4.1 A), Market price (OP) determined by the

Market demand (DD) and market supply curve (SS) at point E. At this market price level

an individual firm could sell any amount of the commodity. Therefore, the demand curve

(or average revenue curve) for an individual firm is horizontal to OX axis. At OP market

price, P AR=MR is the demand curve for an individual firm (in the panel B of the figure).

Since, the firm could sell any amount of commodity at the existing market price its

demand curve (AR curve) is horizontal to OX axis. When AR curve is horizontal to OX

axis naturally AR is equal to MR. Since demand curve is horizontal to OX axis an

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individual firm could not charge the price more than the market price level. Market price

will increase only if there is upward shift in the market demand curve. An individual firm

could sell its product at the higher price only if there is increase in the market price level.

Figure 4.1. Demand Curve of a Perfect Competitive Firm.

4.3.3 Price and Output Determination under Perfect Competitive Market.

Price and output determination under perfect competitive market in the short run

is quite different from that in the long run. Therefore a separate analysis has been made

for these time periods. As already explained in the preceding chapters, the short run

means a period of time within which the firms can alter their level of output only by

varying the level variable input use. Moreover, in the short run, new firms can neither

enter the industry nor the existing firms can leave it. Whereas in the long run firms can

adjust their scale of production according to the changing demand conditions. Besides, in

the long run new firms can enter the industry and also existing firms could exit the

industry depending upon the profit level in the industry. In the beginning price and output

determination in the short run is described followed by long run price and output

determination.

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As already discussed, Market price is determined by the market demand and

market supply forces. An individual firm is a price taker that is it has to accept the

prevailing price as given datum. The firm has to adjust output according to its cost

condition. The analysis of short-run production by a perfectly competitive firm provides

insight into market supply. The key assumption is that a perfectly competitive firm, like

any other firm, is motivated by profit maximization. The firm chooses to produce the

quantity of output that generates highest possible level of profit, based on price, cost

conditions, production technology, etc. An individual firm is said to be in the equilibrium

when it attains the maximum possible profit level. It attains the maximum possible profit

level at the point where Marginal Cost (MC) equals Marginal Revenue and MC is cutting

the MR curve from the below. It is worth to note that in the short run each firm need not

necessarily earn the normal profit. Some firms may be earning normal profits; some super

normal profit or even some may be incurring losses depending on their cost functions.

This means, firms making supernormal profit and maximum losses can coexist along

with the short run equilibrium of the Industry. The short-run production decision in

perfect competition is illustrated using the figure 4.2.

Figure 4.2 Price and Output Determination Under Perfect Competitive Market

In figure 4.2 (panel A) Market equilibrium price OP is determined by the

intersection of market demand curve (DD) with market supply curve (SS) at the point E.

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All the firms in the industry have to accept this price level and make adjustment in their

output level according to their cost conditions. Short-run Marginal Cost (SMC) curve of

the firm B intersected its Short-run Marginal Revenue (SMR) curve at the point E (in the

panel B of the figure). Therefore it is producing OM level of output. At this output level

Short-run Average Cost (SAC) per unit is MA whereas Average Revenuer per unit is

ME. Therefore, the firm B earning AE amount of profit per unit. The total amount of

profit is (AE * OM) indicated by the shaded area BAPE. Firm C producing ON amount

of output because its SMC curve intersects its SMR curve at the point E (in panel C).

Since it’s SAV is greater than SAR the firm incurring the loss. The total loss incurred by

the firm C is indicated by the shaded area PELS. For the given cost conditions, if the

market price increases profit level of the firms increase. Therefore, there is positive

relationship between price and supply level.

Thus, in the short run some firms may be earning normal profits; some super

normal profit or even some may be incurring losses but industry is said to be in the

equilibrium if there is no tendency for its total output to expand or to contract. In other

words on an average firms should earn normal profit. If there is supernormal profit it

attract the new firms to the industry contrary if it incur loss it encourage the existing

firms to quit the industry.

A key implication obtained from the short-run analysis of perfect competition is

positive relation between price and the quantity of output supplied. In particular, the

supply curve for a perfectly competitive firm is positively sloped. This relation is

generated for two reasons:

First, a perfectly competitive firm produces the quantity of output that equates

price and marginal cost.

Second, the marginal cost curve, guided by the law of diminishing marginal

returns, is positively sloped.

Taken together these two observations indicate that a higher price entices a perfectly

competitive firm to increase the quantity of output produced and supplied. In particular, a

perfectly competitive firm's marginal cost curve is also its supply curve. This conclusion,

however, only applies to perfect competition. Firms operating in market structures that do

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not equate price and marginal cost, but rather equate marginal revenue and marginal cost.

As such, the marginal cost curve is not the supply curve for the firm.

In the short run, as already explained above, firms could adjust their output level

only by varying the variable input use level. Short time period does not permit the new

firms to enter the industry and also existing firm could not quit the industry. Therefore, in

the short firms under perfect competitive condition could, on an average, earn

supernormal profit or even they may incur heavy loss depending on the demand

condition. But in the long run industry as a whole, all the firms together, could not earn

super normal profit and also there is no inevitability for them to incur the loss in the long

run. If there is super normal profit in the industry new firms will rush into the industry

resulting gradual disappearance of supernormal profit. On the other hand if there is heavy

loss in the industry as a whole some of the firms which are incurring heavy loss will

gradually quit the industry which results in gradual disappearance of heavy loss in the

industry.

In the long run, with all inputs variable, a perfectly competitive industry reaches

equilibrium at the output that achieves the efficient scale of production, that is, the

minimum of the long run average cost curve. This is achieved through a two-fold

adjustment process.

The first is entry and exit of firms into and out of the industry. This ensures that

firms earn zero economic profit and that price is equal to average cost.

The second is the pursuit of profit maximization by each firm in the industry. This

ensures that firms produce the quantity of output that equates price (and marginal

revenue) with short-run and long run marginal cost. The end result of this long-

run adjustment is:

P = AR = MR = MC = LRMC = AC = LRAC

This condition means that the market price (P) (which is also equal to a firm's

Average Revenue (AR) and Marginal Revenue (MR)) is equal to Marginal Cost (MC)

(both short run and long run) and Average Cost (AC) (both short run and long run). With

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price equal to marginal cost, each firm is maximizing profit and has no reason to adjust

the quantity of output or factory size. With price equal to average cost, each firm in the

industry earns only a normal profit. Economic profit is zero and there are no economic

losses, meaning no firm is inclined to enter or exit the industry.

4.4. Monopoly

The term Monopoly derived from the Greek monos, one + polein, to sell. Thus

Monopoly is defined as Market situation where there is only one provider of a kind of

product or service. Monopolies are characterized by a lack of economic competition for

the goods or service that they provide and a lack of viable substitutes. Since monopolist

produce unique product there is no close substitute for the product. The cross elasticity of

demand with every other product is almost zero. Monopoly should be distinguished from

the cartel. In a monopoly a single firm is the sole provider of a product or service; in a

cartel a centralized institution is set up to partially coordinate the actions of several

independent providers.

4.4.1. Primary Characteristics of a Monopoly

Single Seller: A pure monopoly is an industry in which a single firm is the sole

producer of a good or the sole provider of a service. This is usually caused by a

blocked entry.

Unique product/No Close Substitutes: The product or service is unique in ways,

which go beyond brand identity, and cannot be easily replaced.

Price Maker: In a pure monopoly a single firm controls the total supply of the

whole industry and is able to exert a significant degree of control over the price,

by changing the quantity supplied. It is not meant that monopoly firm is some

thing like dictator in the market. If it fixes the price for his product buyers

determine the quantity that they are willing to buy at that particular price level.

Monopoly firm could not determine the price and quantity simultaneously.

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Blocked Entry: The reason a pure monopolist has no competitors is that certain

barriers are kept for new firms to enter the market. Depending upon the form of

the monopoly these barriers can be economic, technological, legal (basic patents

on certain drugs), or of some other type of barrier that completely prevents other

firms from entering the market

4.4.2. Forms of Monopoly

Some important forms of monopoly are discussed here under:

Legal monopoly: A monopoly based on Laws explicitly preventing

competition is a legal monopoly or de jure monopoly. When such a monopoly is

granted to a private party, it is a government-granted monopoly; when

government itself operates it, it is a government monopoly. A government

monopoly may exist at different levels of government (e.g. just for one region or

locality or State).

Natural monopoly: A natural pool is a monopoly that arises in industries where

economies of scale are so large that a single firm can supply the entire market

without exhausting them. In these industries competition will tend to be

eliminated as the largest (often the first) firm develops a monopoly through its

cost advantage. Natural monopoly arises when there are large capital cost relative

to variable cost, which arises typically in network industries such as electricity

and railway. Whether an industry is a natural monopoly may change over time

through the introduction of new technologies. Government can also artificially

break up a natural monopoly industry, although (e.g. electricity liberalization).

Local monopoly: A local monopoly is a monopoly of a market in a particular area,

usually a town or even a smaller locality: the term is used to differentiate a

monopoly that is geographically limited within a country, as the default

assumption is that a monopoly covers the entire industry in a given country.

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Coercive monopoly: A coercive monopoly is one that arises and whose existence

is maintained as the result of any sort of activity that violates the principle of a

free market and is therefore insulated from competition, which would otherwise

be a potential threat to its superior status

4.4.3. Price and Output Determination under Monopoly

In monopoly we have just one firm in the industry. What distinguishes the

monopolist from the perfectly competitive firm is that the latter is a price taker, while the

former is not. A businessman with monopoly power can choose the price he wants to sell

at. If he sets it higher, he sells less. If he sets it lower, he could sell more. Thus, the

monopolist can exert some influence over the market price, because the demand curve he

faces is the market demand curve, which is downward-sloping. This contrasts with the

horizontal demand curve facing the perfectly competitive firm. This difference in the

demand curve is what distinguishes monopoly from competition. To find out which

price-output combination maximizes the monopolist's profits we need first to explore the

implications of its downward-sloping demand curve. We often assume that the demand

curve is linear

P= a-bq

Where p is price and q is quantity sold. This gives a straight line, downward-sloping

demand curve. From the point of view of the firm a demand curve indicates how much it

can charge for each unit of output varies as its output varies. The demand curve is, in

other words, an Average Revenue (AR) curve. When the AR curve is downward sloping

Marginal Revenue (MR) curve will also slopes downward but the rate of slope of the

latter is faster than the former. In order to maximize the profit level, monopolist produce

the output at the point where its Marginal Cost (MC) curve intersect the MR curve from

the below. The price (AR) level for any given output level is determined on the basis of

demand condition. This together with cost conditions determines the profit level of

monopolist. This can be explained with the help of the figure 4.3.

The Marginal Cost (MC) of the firm intersects its Marginal Revenue (MR) curve

at point E. The firm, therefore, is producing OM level of output. Buyers are prepared to

buy the entire OM level of output if the firm fixes the price OP. It could be understood by

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drawing a straight line from point M on the horizontal axis towards the demand curve.

Here, this line meets the demand curve at point S. It shows that the consumers are

prepared to buy this level of output at the price level OP. At this level of output Average

Cost (AC) per unit is MT where as the Average Revenue (AR) is MS per unit. Therefore,

the firm is earning TS amount of net income per unit. The total net income or profit

earned by the firm is shown by the shaded area i.e. HTSP.

Figure.4.3. Price and Output Equilibrium under Monopoly

4.5. Monopolistic Competition

Perfect competition and Monopoly are extreme cases, which are seldom found in

practice. But monopolistic competition and Oligopoly market situation could be very

widely found in practice. Monopolistic Competition refers to competition among large

number of sellers producing and selling close but not perfect substitutes.

4.5.1. Characteristics of Monopolistic Competition

This market condition possess the following characteristics:

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Large number of sellers: As in the perfect competitive market, there will be large

number of sellers in the monopolistic competitive market. No seller by changing

his price and output policy could have any perceptible effect on the sales of others

as in the oligopoly market.

Product Differentiation: A general class of product is differentiated if any

significant basis exists for distinguishing the goods of one seller from another.

Such basis may be real or imaginary. Product differentiation may be by: a) quality

of product such as durability, size, shape, design etc. or b) advertisement, which

could create imaginary uniqueness in the product.

Freedom of entry and exit: Individual firms/sellers and buyers are free to enter or

leave the market as in the perfect competitive market.

Nature of Demand curve: The demand curve of an individual firm under

monopolistic competition slopes downward from left to right. In the preceding

section you have understood that in the perfect competitive market demand curve

for an individual firm is perfectly elastic whereas in monopoly market it is

relatively inelastic. In this market condition, elasticity of demand is in between

the two. That is, in this market demand is highly elastic but not perfectly elastic.

Thus, the characteristics of a monopolistically competitive market are exactly the same as

in perfect competition, with the exception of the heterogeneous products. This gives the

company a certain amount of influence over the market; it can raise its prices without

losing all the customers, owing to brand loyalty. This means its demand curve is

downwards sloping, in contrast to perfect competition.

4.5.2 Price and Output Determination under Monopolistic Competition.

The market of an individual firm under pure competition is completely merged

with the general one; it can sell any amount of the good at the ruling market price. But,

under monopolistic competition, individual firm’s market is isolated to a certain degree

from those of its rivals with the result that its sales are limited and depend upon price,

the nature of its product and the sales promotion outlay it makes. Thus, the firm under

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monopolistic competition has to confront a more complicated problem than the purely

competitive firm. Equilibrium of an individual firm under monopolistic competition

involves equilibrium in three respects, that is, in regard to the price, the nature of the

product, and the amount of advertising outlay it should make.

Firstly, a firm under monopolistic competition has to decide about its price policy.

What price should it charge for its product? Because of the attachment of some

consumers to its particular brand or the product, it has some monopolistic influence over

the price of its product. If it raises the price of its product a little, it may lose many of its

customers but not all. On the other hand, if it reduces its price, it may attract more

customers of his rivals. Therefore, the demand curve confronting a firm under

monopolistic competition is not a horizontal straight line, but a downward sloping curve.

If it sets a higher price, it will be able to sell less; if it sets a lower price it will be able to

sell more. The firm will choose that price-output combination which yields maximum

total profits.

Secondly, the firm will try to adjust its product so as to confirm more to the

expectation of the buyers. The variation of the product may refer to an alteration in the

quality of the product itself, a new design, better materials, it may mean new package or

container, it may also mean more prompt or courteous service, a different way of doing

business, or perhaps a different location. The amount of the product, which a firm will be

able to sell in the market, depends in part upon the manner in which its product differs

from others. “Where the possibility of differentiation exists, sales depend upon the skill

with which the good is distinguished from others and made to appeal to a particular group

of buyers”. The profit maximisation principle applies to the choice of the nature of the

product as to its price.

Thirdly, a seller under monopolistic competition can influence the volume of his

sales by varying the amount of expenditure on sales promotion. The expenditure incurred

on advertisement is prominent among the various types of sales promotion expenditure.

The selling outlay changes the demand for his product as well as his cost. Like the

adjustment of price and product, a firm under monopolistic competition has to adjust the

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amount of his expenditure on sales promotion in such a way as to maximize his total

profit. The problem of adjusting his selling outlay is unique to the monopolistic

competition.

The demand curve for the products of an individual firm, as explained above, is

downward sloping. Since the various firms under monopolistic competition produce

products which are close substitutes of each other. The elasticity of demand curve for any

of them depends upon the availability of the competing substitutes and their prices.

Therefore equilibrium adjustment of an individual firm cannot be explained in isolation

to the general field of which it is a part. However, for the sake of simplicity in analysis,

conditions regarding availability of substitute products and their prices are assumed to be

constant while the equilibrium adjustment of an individual firm is considered in isolation.

With the assumptions, an individual firms equilibrium/production level and price

adjustment could be explained with the help of the figure 4.4.

Figure 4.4. Equilibrium of a Firm Under Monopolistic Competition

AR and MR are average and marginal revenue curves respectively. When the average

revenue slopes down ward marginal revenue will also decline but at the faster rate than

the former. AR or demand curve for an individual firm under monopolistic competition is

almost similar to that in the monopoly market condition but the only difference is that the

AR curve under the former is bit flatter than that in the latter. It means the elasticity of

demand is more in monopolist competitive market compared to the Monopoly market. In

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this figure Marginal cost curve (MC) intersects the Marginal Revenue (MR) at point E.

The firm, therefore, produces the OM level of output in order to earn maximum possible

profit. When it produces the OM level of output it could sell it at the MQ (OP) price. At

this level of output Average Cost (MS) is less than the Average Revenue (MQ). Thus,

could earn SQ amount of profit per unit. The shaded area RSPQ, therefore, indicates the

total profit level at this level of output.

4.6. OLIGOPOLY

Oligopoly is a market condition, which is most prevalent in majority of the

industrial countries. It is often referred to as “competition among the few”. This is a

market situation where few sellers involved in selling homogeneous or differentiated

products. If products of few sellers are homogeneous, then market referred to as pure

oligopoly. Where as if products of few sellers are differentiated, then market referred to

as differentiated oligopoly. Some important features of this market condition are

discussed under the following section.

4.6.1 Features of Oligopoly

Few sellers: Oligopoly is a market situation in which the number of sellers

dealing in homogeneous or differentiated product is very small.

Interdependency: In perfect competition, monopoly and monopolistic competition

each firm is more or less independent of the other, although each is dependent on

the market. But unique feature of the oligopoly market is that the policy of every

producer directly affects each other due to few number of firm and close

substitutability of the goods.

Advertisement: Advertising and selling costs have strategic importance to

oligopoly firm. Each firm tries to attract the consumers towards its product by

increasing expenditure on the advertisement.

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Uncertainty: Lack of certainty is another important feature of oligopoly market

condition. Under this market condition it is difficult to analyse the effect of price

change initiated by a firm on its own sales due to uncertain reaction by his rivals.

High Cross Elasticity of Demand: The firms under oligopoly have a high degree

of cross elasticity of demand for their products. There will be always the fear of

retaliation by rivals.

Nature of Demand Curve: Due to inter dependency the nature of demand curve is

unique under this market condition. According to Paul Sweezy, firms in an

oligopoly market have a kinked demand curve.

4.6.2: Price and Output Determination under Oligopoly Market:

No unique pattern of pricing behavior exists in the oligopoly market due to

interdependency among the firms. Broadly there are three types of pricing behavior viz.

Independent pricing, cartels and price leadership. Independent pricing refers to the

independent action of each seller within an oligopoly industry. Under independent pricing

behavior each and every firms try to maximize their profit. Since each firm trying to

maximize their profit it create rivalry among the firms. Such an independent pricing

behavior may result in price war or price rigidity.

4.6.2.1 Price War:

Price war may start when one seller reduces the price of his product line in order

to increase his sales. His rival apprehending a reduction in their sales retaliate and each

tries to undercut the others. Price war harms all the firms in the industry. Thus gradually

all the firms understand the futility of the price war and desire for the price stability. Such

desire gradually leads to price rigidity.

4.6.2.2. Price Rigidity/Kinked Demand Curve:

Oligopoly price that remains stable over a period of time are called rigid price.

Price rigidity is also popularly known as Sweezy Model. Because this model was

developed in the late 1930s by the American Paul Sweezy. The theory aims to explain the

price rigidity that is often found in oligopolistic markets. It assumes that if an oligopolist

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raises its price its rival will not follow suit, as keeping their prices constant will lead to an

increase in market share. The firm that increased its price will find that revenue falls by a

proportionately large amount, making this part of the demand curve relatively elastic

(flatter). Conversely if an oligopolist lowers its price, its rivals will be forced to follow

suit to prevent a loss of market share. Lowering price will lead to a very small change in

revenue, making this part of the demand curve relatively inelastic (steeper).

  The firm then has no incentive to change its price, as it will lead to a decrease in

the firm's revenue. This causes the demand curve to kink around the present market price.

Prices will further stabilize, as the firm will absorb changes in its costs as can be seen in

the figure 4.5.

Figure 4.5. Kinked Demand Curve

In this figure let us assume that the original price is OP. If the firm increases its

price its rivals will not follow hence its demand cure become more elastic i.e. it will

become R1E.On the other hand it decreases its price rivals will follow it thus its demand

curve become inelastic i.e. it becomes ED. Therefore, demand curve is kinked at point E.

There is discontinuity in Marginal Revenue curve at the corresponding position i.e A to

B. The marginal revenue jumps (vertical discontinuity) at the quantity where the demand

curve kinks, the marginal cost could change greatly - e.g., MC0 to MC1 (between prices a

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and b)- and the profit. In the light of this, the price rigidity could be attributed to the

following reasons

Individual sellers may understand the futility of price war and thus prefer price

stability

They may be content with the current price, output and profits and avoid any kind

of unnecessary insecurity and uncertainty.

The firms may intensify their sales promotion efforts at the current price instead

of reducing it. They may view non-price competition better than price rivalry.

After spending lot of money on the advertisement a seller may not like to raise the

price of his products to deprive himself of the fruits of his hard labour.

Ultimately, It is the kinked demand curve, which is responsible for the price

rigidity.

4.6.2.3. Cartel

Under oligopoly market condition firms may, gradually, form the cartels. A cartel

is an association of independent firms within the same industry. The purpose formulation

of cartel is to increase the profit level of the member firms by subjecting their

competitive tendency to some form of agreement. The cartels, normally, follow common

policies relating to prices, sales and profit. These cartels may be voluntary, compulsory,

opened or even it may be secrete depending upon the policy of the government relating to

cartels. There are mainly two types of cartels. 1) Perfect cartels or Joint profit

maximisation 2) Market sharing cartel. Perfect cartel is an extreme form of perfect

collusion. In this, firms producing a homogeneous products form a centralised cartel

board in the industry. The individual firms surrender their price output decisions to this

central board. Whereas in the market sharing cartel the firms enter into market sharing

agreement to form a cartel but keep a considerable degree of freedom relating to price

and output decisions.

4.6.2.4 Price Leadership

It is an imperfect collusion among the firms in the oligopoly market. It is a system

under which all the firms of an oligopoly industry follow the lead of one of the big firm

(Leader). There will be tactics agreement among the firms to sell the products at a price

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set by the leader of the industry. Some times there may be formal meetings and definite

agreement with the leader firm. Under this system leader initiate the price change and

then follower firm accepts the price change and make corresponding output adjustments.

4.7 RICING POLICIES

The previous sections of this chapter mainly dealt with the theoretical framework

for the pricing decisions. In this section an attempt has been made to explain how firms in

the real world set the prices. Pricing policies and methods in practice is focused in this

section. Formulating price policies and setting the price are the most important aspects of

managerial decision-making. Price, in fact, is the source of revenue, which the firm seeks

to maximize. Again, it is the most important device a firm can use to expand its market. If

the price is set too high, a seller may price himself out of the market. If it is too low, his

income may not cover costs, or at best, fall short of what it could be. However, setting

prices is a complex problem and there is no clear-cut formula for doing so. Whether to set

a low price or a high price would depend upon a number of factors and wide variety of

conditions.

4.7.1 Factors Involved in Pricing Policy

In economic theory, only two parties are generally emphasized, i.e., buyers and

sellers. In practice however, as pointed out by Oxenfeldt, certain other parties are also

involved in the pricing process. i.e., rival sellers, potential rivals, middle men and

government. All these parties also exercise their influence in price determination. Certain

general considerations, which must be kept in view while formulating the pricing policy,

are given below:

Market Structure: Pricing policy is to be set in the light of competitive situation in the

market. If the firm is operating under perfect competition it acts only as price taker

and there is hardly any choice left. The firm has a pricing problem, when there is

imperfect or monopolistic competition. Under monopoly the firm is a price maker. It

has to set its own price policy. Usually, a manufacturing firm today operates under

imperfectly competitive market condition, and hence it has to set its own price policy,

as may be feasible.

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Costs: Cost is an important element in price determination. Cost data serve as the

base. If price is below the cost of production it would mean losses. Thus, cost analysis

is important. Along with the total costs, average and marginal costs are to be

determined. For business decisions in the short run, direct or variable costs have

greater relevance. The firms seek to cover full-allocated costs. Economy in cost is

also important for setting a lower price for the product. A high cost of production

obviously calls for a higher price.

Demand: In pricing policy, demand can never be overlooked. Rather, demand is more

important for the effective sales. Demand for a firm’s product depends on consumer’s

preferences. So, the consumer psychology is very important. Through appropriate

advertising and sales campaign consumers’ psychology can be influenced and their

preferences may be altered. Thus demand can be manipulated. A low or high price

policy is to be set considering the elasticity of demand. If demand for the product is

highly inelastic, then only rising price policy would be a paying proposition to the

businessman. Further, in all cases demand is not price elastic. In some cases,

especially, consumer durables, i.e., TV set, car, etc. demand is income elastic. Thus,

when income of the buyers rises, the firm can expect to sell more such goods even at

high prices. In case of elastic demand for the goods, a price cut would be beneficial in

boosting the sale.

Profit: In determining price policy, profit consideration is also significant. In practice,

however, rarely there is a goal of profit maximization. Usually, pricing policy is

based on the goal of obtaining a reasonable profit. Further, most of the businessmen

would prefer to hold constant price for their products rather than going for a price rise

or a price cut, as far as possible. Thus, price rigidity may be the norm of the price

policy. But, rigidity does not mean inflexibility. Price fluctuations do conform to cost

changes.

Objectives of business: Pricing is not an end in itself but a means to an end. The

fundamental guides to pricing, therefore, are the firm’s overall objective. The

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broadest of these is survival. Very often companies fix a target rate of profit. Whether

the company will be able to achieve the target rate of profit, will depend upon the

forces of competition. The various objectives may not always be compatible and

hence the need for their reconciliation. A pricing policy should never be established

without full consideration as to its impact on the other policies and practices of the

firm.

Product and Promotional Policies: Pricing is only one aspect of market strategy and a

firm must consider it together with its product and promotional policies. The quality

of the product, sales promotion programmes and other such elements have to be

considered while formulating the pricing policies.

Nature of Price Sensitivity: Businessman often tends to exaggerate the importance of

price sensitivity and ignore the many identifiable factors at work, which tend to

minimize it. The various factors which may generate insensitivity to price changes are

variation in the effectiveness of marketing effort, nature of the product, importance of

service after sales which have to be taken into account while formulating the pricing

policies.

Conflicting Interests of Manufacturers and Middlemen. The interests of

manufacturers and middlemen through whom the former often sell are sometimes in

conflict. For instance, the manufacturer would desire that the middleman should sell

his product at a minimum mark-up, whereas the middleman would like his margin to

be large enough to stimulate him push up the product.

Government Policy: Pricing policy of a firm is also affected by the government

policy. If the government resorts to price control, the firm has to adopt the price as

per the formula and ceiling prescribed by the Government, then there is little scope to

pursue its own pricing. For instance, in India we have drug price control, etc

4.7.2. Objectives of Pricing Policy

Pricing is not an end in itself. Pricing is a means to an end. Therefore, the firm

must explicitly lay down its pricing objectives. The firm’s overall objectives serve as

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guiding principle to pricing. Thus, firm’s business objectives are normally spelled out as

the objectives of its price policy. Empirical evidences reflect that theoretical goal of profit

maximization is rarely taken in practice by the business firms in their price policy. The

following are the commonly adopted major pricing objectives of a business firm:

Survival: basically, in these days of monopolistic competition or dynamic

changes and business uncertainties, a firm is always interested in its continued

survival. For the sake of assuring continued existence, generally, a firm is

ready to tolerate all kinds of upheaval in product lines, organizational and

even personnel changes. Thus a firm may pursue the promotion of the long-

range welfare of the firm

Rate of Growth and Sales Maximization: A firm may be interested in setting a

price policy, which will permit a rapid expansion of the firm’s business and its

sales maximization.

Market Shares: By adopting a price policy the firm may wish to capture a

larger share in the market and acquire a dominating leadership position.

Maximization of profits for the entire product line: As Kotler has pointed out,

firms set price, which would enhance the profit from the entire product line

rather than yield a profit on one product only.

Preventing Competition: In pricing its product, the firm may keep an eye on

rival’s entry. So, it may fix up the price such that would prevent competition.

Market Penetration: Here, relatively low price may be set to stimulate market

growth and capture a large share thereof.

Market Skimming: Here, high initial price is charged to take advantage of the

fact that some buyers are willing to pay a much higher price than others as the

product has high value to them.

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Early Cash Recovery: Some firms try to set a price, which will enable rapid

cash recovery as they may be financially tight or may regard future as too

uncertain to justify patient cash recovery.

4.7.3 Pricing Methods In Practice

In the real world most of the business organisaitons are operating their business under

imperfect competitive condition. Thus it is the fundamental duties of the firms to fix the

suitable price for their products in such a way as to fulfill the overall objective of their

organization. Numbers of pricing methods have evolved over the period. There is no

clear-cut criterion to select a particular pricing method. But any business organization

will adopt the pricing method, which suits their objectives. Some of the important pricing

methods that are being practically adopted by one or the other firm are discussed below:

4.7.3.1. Cost-Plus or Full-Cost Pricing

Under this method, the price is set to cover costs and a predetermined percentage of

profit. The profit percentage will be determined on the basis of intensity of competition in

the market, rate of returns, cost base, risk etc. naturally the profit percentage differs

among industries, among member firms. Full cost pricing method is being very widely

adopted by the firms. This is mainly because;

Full-cost pricing offers a means by which fair and plausible prices can be found

with ease and speed, no matter how many products the firm handles.

Firms preferring stability use full cost as a guide to pricing in an uncertain market

where knowledge is incomplete.

In practice, firms are uncertain about the shape of their demand curve and about

the probable response to any price change. This makes it too risky to move away

from full-cost pricing

A major uncertainty in setting a price is the unknown reaction of rivals to that

price. When products and production process are similar, cost-plus pricing yield

acceptable profit to most other member so the industry also. Uncertainty could be

minimized to some extent.

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Limitations of Full Cost Pricing Method

Though it is relatively easy to adopt this method of pricing it is having certain limitations.

Most important limitations of this method are;

It ignores demand – it does not care for what people prepared to pay.

It does not reflect market forces.

Full cost pricing ignores marginal or incremental costs and uses average costs

instead.

4.7.3.2. Rate of Return Pricing

In this method the firms determine the average profit mark-up on costs necessary

to produce a desired rate of return on its investments say, for instance, a firm may set its

price of the product in order to get on an average a 8 per cent return on net investment.

Under the rate of return pricing policy, price is determined along a planned rate of return

on investment. The rate of return is to be translated into a percent mark-up as profit

margin on cost. The profit margin is determined on the basis of normal rate of

production. Rate of return pricing is a refined method of full cost pricing. Thus, pricing is

based on cost, which may not relevant to the pricing decision. Naturally, it has the same

inadequacy as the full cost pricing method.

4.7.3.3. Marginal Cost Pricing

Pricing methods discussed above are based on the total cost of production. Under

this method price is to be fixed based on the marginal cost of production. Marginal cost is

the addition made to total cost by producing an additional unit of output. It is the cost of

producing ONE extra unit of production. Under the marginal cost pricing, as per the

accounting approach, fixed cost considered to be ignored and prices are determined on

the basis of marginal cost. It is most appropriate method in the industries where fixed cost

is relatively high. It Allows variable pricing structure – e.g. on a flight from London to

New York – providing the cost of the extra passenger is covered, the price could be

varied a good deal to attract customers and fill the aircraft. Thus, it allows flexibility in

pricing.

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It could be explained with a numerical example. In Aircraft flying from Bristol to

Edinburgh – Total Cost (including normal profit) = £15,000 of which £13,000 is fixed

cost. Number of seats = 160, average price = £93.75. MC of each passenger = 2000/160 =

£12.50. If flight not full, better to offer last passengers chance of flying at £12.50 and fill

the seat than to fly with empty seats. In such situation Marginal cost pricing method is

suitable.

4.7.3.4. Going Rate Pricing.

Going rate-pricing policy found to be a rational method where it is difficult to

estimate the different cost of production. Under this method firms adjust its own price

policy to the general pricing structure in the industry. Going rate reflects the collective

wisdom of the industry. It is a kind of price leadership. Where price leadership is well

established, charging according to what competitors are charging may be the only safe

policy. In case of price leader, rivals have difficulty in competing on price – too high and

they lose market share, too low and the price leader would match price and force smaller

rivals out of market. Where competition is limited, ‘going rate’ pricing may be applicable

– banks, petrol, supermarkets, electrical goods – find very similar prices in all outlets

It must be noted that going rate pricing is not quite the same as accepting the price

impersonally set by near perfect market. Rather it would seem that the firm has some

power to set its own price and could be a price maker if it chooses to face all the

consequences. It prefers, however, to take the safe course and confirm to the policy of

others.

4.7.3.5. Penetration Price.

It is a method under which relatively low price is set in order to penetrate into the

new market. Thus, it is the Price set to ‘penetrate the market’ and ‘Low’ price to secure

high volumes. While introducing new products or entering in new geographical market,

firms may set relatively lower price in the hope of penetrating into the market. The idea is

to establish a market share first and than gradually move to a price which is more

desirable from the profit angle. This method is generally suitable to the new products or

to launch the product into a new market. It is typical in mass-market products. However,

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this strategy works well provided the demand is highly price elastic and the nature of the

product differentiation is such that many customers are in a position to get attracted by

low price.

4.7.3.6. Skimming Price.

It is a pricing method under which the firm starts with a high price appealing to

those customers who are willing to pay higher price for better quality or because they put

some additional value on the products. However, at the latter stage a slightly falling price

may attract the new customers. Each successive fall in price may bring in more and more

customers. But there is danger in letting the price to fall beyond a point because of the

perceived correlation between price and quality. This method is suitable for products that

have short life cycles or which will face competition at some point in the future (e.g. after

a patent runs out). Examples include: Play station, jewellery, digital technology, new

DVDs, etc

4.7.3.7. Administered Price.

Administered price is the price, which is fixed by the government and is

mandatory in character. In this method government fix the price for the products, which

should be strictly followed by the producers. However, while fixing the price the

government will consider the cost of production and also fair returns to the producer. The

rationality behind this method is that the essential commodities have to be made available

to the people at reasonable price. The price should not be prohibitive. If they become

monopoly products, the producers may charge heavy price, which prevents the weaker

section to purchase them. In such situation it is the duty of the government to make

products available at fairly reasonable price to the consumers.

Public utility concerns are managed by the government with the objective of

providing services to the people at reasonable price. Even in case of essential

commodities produced in private sector, the government intervenes and fixes the price at

which the producers sell those products. The major limitation of this method of pricing

does not allow the free play of market forces like supply and demand. Due to the

liberalised economic policy, this pricing method is loosing the importance.

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4.7.3.8. Loss-Leader Pricing.

It is method under which goods/services deliberately sold below cost to encourage

sales of the other products. A firm selling both razor and blade may charge the price of

razor, which is below the average variable cost if it is confident of selling a large volume

of the blades in order to over compensates the loss in the razor. Because of the loss

making product, customers are induced into buying other complimentary items in the line

and the whole set becomes profitable. It is typical in supermarkets, e.g. at Christmas,

selling bottles of Gin at £3 in the hope that people will be attracted to the store and buy

other things. Such a pricing strategy is suitable even in the capital goods with heavy

requirement of the replacement parts and consumables.

4.7.3.9. Discriminating Price.

In this method, the same product will have different price in different market

segments. In other words firms charging a different price for the same good/service in

different markets. Best example for this method is electric Power. Electricity board will

charge different price to the same power to different power users like agriculturists,

industrial units, domestic users, commercial users etc. However, its adoption requires

each market to be impenetrable. Requires different price elasticity of demand in each

market

Thus, there are many different pricing methods, which are being practically

adopted by one or the other kind of firms. However, while choosing a particular pricing

method a firm has to carefully analyse which method is suitable in perusing its

objectives.

4.8. Self Review Questions

1. What is market? How markets are classified?

2. Distinguish monopoly and monopsony

3. Define oligopoly

4. What is penetrating price? When this pricing strategy is suitable?

5. Define discriminating price? What are the conditions required to adopt this policy?

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6. What is kinked demand curve? Explain the reasons for kinked demand curve

7. Explain the features of monopolistic competition

8. Describe the price and output determination under perfect competitive market

9. Explain the pricing problems in oligopoly market condition

10. Discuss the factors involved in pricing policies

11. Explain the different pricing methods that are being practically followed by the

business organistions.

4.9. References/ Suggested Readings

1. Mote, V. L., Samuel Paul, Gupta,G. S: “ Managerial Economics: Concepts and

Cases”, Tata McGraw-Hill Publishing Company Limited, New Delhi

2. D.M.Mithani : “Managerial Economics: Theory and Applications”, Himalaya

Publishing House, Mumbai-400 004

3. Reddy,P. N. and Appanniah, H. R. : “Principles of Business Economics”, S.Chand &

Company Ltd. New Delhi-110 055

4. Dominick Salvatore: “Managerial Economics”, McGraw-Hill International Editions,

Singapore

5. Ahuja, H. L.: “Advanced Economic Theory”, S.Chand & Company Ltd. New Delhi-

110 055

6. Varshney RL, and Maheshwari K.L: “Managerial Economics”, Sultan Chand & Sons,

New Delhi-110002

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MODULE-V: PROFIT ANALYSIS

Profit is one of the main motives behind any kind of business activities.

Management students need to have proper understanding about the concept and

measurement of profit. So, this chapter focuses on the concept of profit. This module

deals with the break-even analysis also. The understanding of this tool equips the

management students in the profit planning of a firm. The last section of this module

deals with linear programming approach, which is most useful in optimization decisions.

5.1 Meaning and Nature of Profit

In economic theory, profits are payments for the work of the entrepreneur, as he is

a factor of production like other factors. But this concept of profit has become a vexed

and mixed one. Though profit is an income for the entrepreneur for his work, he is

getting the income called profits. Profits have been defined, as wages of management or

it is the reward for entrepreneur. It is also a reward for ownership of capital. Since the

entrepreneur gets his income in a variety of ways, profits have become a mixed income.

It is also a vexed one, as there is no unanimity among economists about the definition.

That is why; Prof. Knight has observed “no term or concept in economic discussion is

used with a more bewildering variety of well-established meaning than profit”. Profit is

the percentage of return on investment; it is the reward for taking risk in business. It is a

residual income for the entrepreneur after paying off other factors. It is the difference

between the total sale proceeds obtained and the total expense of production. Thus the

term profit has been interpreted in a variety of ways.

Profits when compared to other rewards of factors, is vitally important, as it is the

reward for the entrepreneur who undertakes the work of coordination of the factors and

produces the commodity. In the absence of profits, there would not be incentive for

production and profits act as a source of capital formation and economic progress.

However, Karl Marx has condemned profits as predatory income, branding it as legal

robbery. Contrary to it Joel Dean is of the opinion that “A business firm is an

organization designed to make profits, and profits are the primary measure of its

success.” and this brings the importance of profit in the context of managerial decisions.

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Theoretically, the definition of profit is that the reward for the entrepreneur is

acceptable, as he brings the three factors of production together for producing some

consumable commodity. But in the case of Modern Corporation, or the Joint-stock

Company, who should be identified as the entrepreneur? Is it the equity shareholders who

undertake the risk of investing their money, or the salaried managers who undertake

entrepreneurial functions? Vera Anstey believes that the term should cover both these

groups. Profit is the result of variety of influences in a business. As a result, many

theories of profits are emerged.

For the better understanding of the concept of profit one should understand the

difference between ‘profiteering’ and profit earning. The term ‘Profiteering’ is different

from ‘Profit-earning’. The former connotes “earnings which are excessive and beyond

the socially desirable and acceptable limit by questionable methods”. Profit earning, on

the other hand denotes making profits within socially desirable and acceptable limit.

Profiteering is a deliberate attempt to earn extra profits at the cost of even business ethics.

Hoarding is one prominent way of profiteering. Profiteering is socially unjust.

Similarly one should have the better understanding about the difference between

‘accounting’ and ‘economic profit’. There is a wide difference between profit in the

accounting sense and profit in the economic sense. In the accounting sense, profit is

regarded as the revenue realized during the period minus the cost and expenses incurred

in producing the revenue. This concept of profit is also known as Residual Concept. The

economists, however, do not agree with the accountant’s approach to profit. Economists

consider both explicit and implicit costs in arriving at profits. They deduct both explicit

and implicit costs from the total sales receipts in determining profits. According to

Accountants, the money-cost of producing an article includes only those costs which are

directly paid out or accounted for by the producer. These are wages, interest, rent,

depreciation charges on fixed capital, taxes paid and other sundry expenses. These items

together constitute Explicit costs of production. Economists think that in addition to

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these, there are other items, which ought to be included in the term, money-cost of

production. These are as follows:

Wages for the work performed by the entrepreneur;

Interest on capital supplied by him;

Rent on land and buildings belonging to him and used in productions;

Such profits are considered usual or normal in the line of business.

Economists call them implicit cost of production. Accountants do not include these items

in determining profit. They deduct only explicit or actual costs from the total revenue

earned while determining the profits.

Economic cost = Explicit Cost + Implicit Costs

Or

Economic Costs = Accounting Cost + Implicit Costs.

The firm will be earning Economic Profits only if it is making revenue in excess of the

total of accounting and implicit costs. Thus, when the firm is in no profit and no loss

position, it means that the firm is making revenue equal to the total of accounting and

implicit costs and no more. Therefore;

Economic Profit = Total Revenue – Economic Costs.

Economic profits are relevant from the managerial point of view, as they truly reflect the

profitability of a business concern. A business firm may be making profits in the

accounting sense; but it may be actually incurring losses in the economic sense. Such a

firm will not survive in the long run. Hence, economic profits are more useful than the

accounting profits, for managerial purposes.

Functional Role of Business Profits: According to Prof. Peter Ducker, business profits

play a functional role in three different ways.

They indicate the effectiveness of business efforts: The success or effectiveness of

the business is indicated through the profit it earns. Higher the profit of concern,

we generally consider that the business is more successful. Even though it may be

argued that profit is not a perfect measure of business efficiency, it is an easy and

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quick basis on which business performance can be compare among the various

firms.

They provide the premium to cover costs of staying in business: Profit is a source

of funds from which a business firm will be able to defray certain expenses like

replacement, obsolescence, marketing, etc. Business firms must generate profits

sufficient to provide for these costs.

They ensure supply of future capital: Profits are the principal source for a firm’s

future capital requirements for innovation and expansion. Business concerns help

themselves by generating profits in meeting part of their capital requirement apart

from raising funds through extraneous sources.

5.2 Theories of Profit

There are several theories of profit propounded by economists. None of these deal

with all aspects of profit. Each theory focuses on the different aspects of profit. We shall

study some of the theories of profit.

5.2.1. Hawley’s Risk Theory

An American economist Hawley advocated this theory. According to him, profits

arise because the entrepreneur undertakes the risk of the business and he has to be

rewarded for that. As per this theory, higher the risk, greater is the possibility of profit.

But this theory is criticized on the following grounds:

There is no relationship between risk and profit.

Insurable risks are no risk at all. Only uninsurable risks are real risks.

Profit is the result of not only risk bearing, but also due to other factors.

5.2.2 Knight’s Uncertainty-bearing Theory

This theory, advocated by Prof. Knight, agrees with Hawley’s theory that profit is

a reward for risk-taking. However, the term risk is clarified and there are two types of

risks: a) Foreseeable risks; and b) Unforeseeably risks. The latter risk is called

uncertainty bearing. If risk can be insured against, it is not risk at all. For instance, fire,

flood, theft, etc., are risks in business, which can be insured, and the loss arising out of

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these will be made good by the insurance company. The premium paid for insurance is

included in the cost of production. Insurable risk, thus, does not give rise to profit. So,

according to Prof. Knight, profit is due to non-insurable risk or unforeseen risk. Some of

the non-insurable risks:

Competitive risk;

Technical risk;

Risk of government’s intervention; and

Risk arising out of business cycle.

Since, these risks cannot be foreseen and measured, they become non-insurable

and uncertainties have to be borne by the entrepreneur. According to this theory, there is

a direct relationship between profit and uncertainty bearing.

Knight’s theory is criticized on the following grounds:

If profits are due to uncertainty bearing, what explanation could be given in cases

where profits do not accrue in spite of uncertainty bearing.

Uncertainty bearing is one of the determinants of profit, and that is not the only

determinant.

The theory emphasizes too much about uncertainty-bearing as to elevate it into a

separate factor of production

This theory does not separate the two functions in modern business, namely

ownership and control

The theory does not explain monopoly profit. How do profits arise, when there is

no question of uncertainty bearing in monopoly?

It is not possible to measure uncertainty in quantitative terms to ascribe profit.

5.2.3. Dynamic Theory of Profit

This theory advocated by J.B. Clark assumes that profits arise as a ‘Dynamic

Surplus’. According to this theory, in a static state, there is no change in demand and

supply and profits do not arise. This is because; under static conditions payments made to

the factors of production on the basis of marginal productivity exhaust the total output. In

this condition, in equilibrium, price of each commodity exactly equals its money cost of

production, including normal profits and there is no surplus of any kind. Profits result

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only when selling prices of goods exceed their cost of production. Therefore, in a static

state, there are no possibilities of getting profit and it arises only in dynamic condition. It

is a dynamic surplus. Profits arise due to disequilibria caused by the changes in demand

and supply conditions. Now, the question arises what Clark mentions about five changes,

which may occur in a dynamic economy to give rise to profits.

Changes in the quantity and quality of human wants

Changes in the methods and techniques of production

Changes in the amount of capital

Changes in the form of business organization

Changes in population

Such changes give some entrepreneurs advantages over other entrepreneurs and

they manage to earn surplus. This theory is criticized as follows:

This theory does not fully appreciate the nature of entrepreneurial functions. If

there are no profits in a static state, it means there is no entrepreneur. But without

an entrepreneur, it is not possible to imagine the coordination of factors of

production. Hence, Marshall solved this difficulty by his concept of normal

profit, which is earned in a static state also.

Mere change in an economy would not give rise to profits, if these changes were

predictable.

This theory has created an artificial distinction between ‘Profit’ and ‘Wages of

Management’.

5.2.4. Schumpeter’s Innovation Theory

This theory propounded by Schumpeter is more or less similar to Clark’s theory;

but this theory gives importance to innovations in the productive process. According to

this theory, profit is the reward for innovation. Innovations refer to all these changes in

the production process with an objective of reducing the cost of the commodity, so as to

create a gap between the existing price of the commodity and its new cost. Schumpeter’s

innovation may take any shape. It may be the result of introduction of a new technique or

a new plant, a change in the internal structure or organizational set up of the firm. It may

be a change in the quality of the raw material, a new form of energy, better method of

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salesmanship, etc. “Innovation is much more than invention. Invention is not innovation,

if it is stillborn, that is, if it is not used. An invention becomes an innovation only when it

is applied to industrial progress.” Innovation is brought about mainly for reducing the

cost of production and it is a cost reducing agent. Innovations are not possible by all

entrepreneurs. Only exceptional entrepreneurs with extraordinary abilities can innovate

and create opportunities through their imagination and bold action. Profit is the reward

for this strategic role. Further, according to Schumpeter, profits are of temporary nature.

The pioneer, who innovates, gets abnormal profits for a short period. Soon other

entrepreneurs swarm in clusters and compete for profit in the same manner. So, the

pioneer will make another innovation. Thus profit will appear and disappear and again

reappear. Profits are caused by innovation and disappear by imitation. The theory is

criticized on the following grounds:

Innovation is only one of the many functions of the entrepreneur and not the only

function.

It does not recognize the risk-taking functions of the entrepreneur. Now

innovations bear the element of uncertainty and risks.

Monopoly profits are permanent in nature while Schumpeter attributes the quality

of temporaries to profits.

5.2.5. Marginal Productivity Theory of Profit

The theory of marginal productivity is also applied in the case of profit.

According to Prof. Chapman, profits are equal to the marginal worth of the entrepreneur

and are determined by the marginal productivity of the entrepreneur. When the marginal

productivity is high, profits will also be high. But, the fundamental difficulty in this

theory is in measuring increasing or decreasing the units of factors can assess the

marginal productivity. In entrepreneurial function, it is not possible, as a firm will have

only one entrepreneur. To assume that all entrepreneurs are alike is highly unrealistic.

Thus theories of profits have become highly controversial and least satisfactory.

Managerial economics, though it makes use of the assumptions of profit

maximization, makes little direct use of the theories of profits. There is no single theory

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giving satisfactory explanation regarding profit. According to Briggs and Jordan, “It is

difficult to frame a simple theory of profits which would include the small independent

trader, the large employer, the small holder, and the shareholder, of a Joint-Stock

Company, whilst excluding responsible managers.” However, though none of these

theories is a correct explanation of profits, they are in sense complementary theories. It is

possible that monopoly, uncertainty and innovations are factors of vital importance, as

they affect profit-earning capacity of the firm. Hence, knowledge of these theories helps

businessmen in formulation of their profit policies.

5.3. Measurement of Profit

The measurement of the amount of profit earned by a business firm during a given

period, is not so simple as it may appear. Even in the accounting sense, measurement of

profit is not an easy task. Several practical difficulties are involved here. Some of them

arise out of conceptual differences with reference to costs, income, valuation of assets;

some differences arise due to the definition of profits by accountants and economists and

also due to financial accounting conventions, and legal requirements. In particular, the

problem arises in the question ‘what is included in the costs to be subtracted from

revenues to obtain profits, remains the crux of the problem’. There is wide variety of

generally accepted accounting principles, which provide for different methods of

treatment for certain items of revenuer of expenditure. The following methods are

generally considered while measuring profits; they are:

Depreciation Valuation of Stock Treatment of deferred expenses Capital gains and losses

5.3.1. Depreciation

We know that in every business, equipment, machines and building are used and

they wear out over a period due to frequent use. In course of time, these assets become

useless from the point of view of business and they have only scrap value. The use-value

of the assets of the firm goes on diminishing due to wear and tear. In due course their

value from the viewpoint of business declines. Therefore, to measure true income of the

business, accountants make periodic charges to income to recover the cost of equipment

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before its usefulness is exhausted. This charge is known as depreciation which represents

the decrease in the value of the assets due to use during a particular period, say a year.

This provision for depreciation charges will not be uniform in all firms. It varies in

importance from company to company. In the case of heavy industries like iron and steel,

railways, transport, etc., very heavy depreciation charges are provided. In the case of

firms like insurance companies, banks, financial institutions, wholesale business and

retail business, etc., the depreciation charges will be relatively lower.

Methods of measuring depreciation: There are a number of methods of measuring

depreciation for the purpose of reporting business profits to the shareholders and taxable

profit to the income-tax authorities. Depreciation is an important internal source of funds

and hence the method of depreciation becomes very significant as a tool of capital

formation. There are three commonly accepted methods of depreciation; they are:

Straight Line Method

Declining Balance Method

Sum of the years digits method

We shall discuss these methods of measuring depreciation in a greater detail.

5.3.1.1. Straight Line Method:

According to this method, an asset is supposed to wear out evenly during its

normal life. Hence depreciation is provided on a uniform basis regardless of the fact that

the asset depreciates more rapidly at some stages. This is calculated by using this

formula:

Initial cost of the assetDepreciation =

Estimated life span of the asset in years

The amount of annual depreciation is obtained by dividing the initial cost of the

asset by the estimated life in years, assuming that there is no scrap value. If the asset has

an estimated scrap value its amount will have to be deducted from the initial cost before

dividing it by the estimated life in years.

Illustration: suppose that an asset has an original value of Rs.10000 with a scrap value of Rs.1000 and its life span is estimated to be 10yrs. The annual depreciation charge on the asset will be:

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Rs.10, 000 – Rs.1000 = Rs.900 10

Under the working hours method, the life span of the asset is expressed in terms of

working hours, rather than in years. In those cases, depreciation is calculated by dividing

the initial cost less scrap value by the number of working hours. Suppose that an asset has

a working life of 10000 hours and its original cost is Rs.22000 and its scrap value is Rs

2000. The depreciation per working hour will be calculated as follows:

Rs. 22000 – Rs. 2000

= Rs. 2 Per working hour1000

The straight-line method is very simple in adoption. When there are no possibilities of

premature retirement of assets due to accidents, obsolescence or inadequate capacity.

This method does not take into account the increasing cost of repairs in the later years of

the life of the asset and as a result, the total cost of operation is likely to be

disproportionate in the later years.

5.3.1.2. Declining Balance Method

Under this method, depreciation is provided on a uniform rate on the written

down value of the asset at the beginning of the year. If the cost of the asset is Rs.5000

and the rate of depreciation is 10%, the depreciation for the first year would be Rs.500. in

this case the written-down value of the asset for the next year would be Rs5000- Rs.500 =

4500 and the depreciation for the second year would be calculated at 10% for Rs.4500

which would be Rs.4500 – Rs.450 = 4050. During the third year the depreciation would

be 10% of Rs.4050, i.e., Rs.405. Thus, the depreciation amount will show a declining

trend; Rs.500 in the first year; Rs.450 in the second year; and Rs.405 in the third year.

Under this method, the written down value however small, will never be zero. Hence, the

asset is assumed to have some scrap value. The formula for determining the fixed rate of

depreciation under ‘Declining Balance Method’ is as follows:

D =100 {1-n√s/c}

Where,

D = % of depreciation

s = Scrap or residual value of the asset

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c = Initial cost of the asset

n = Estimated life of the asset in the years.

The method of computing the fixed rate of depreciation as described above is

rather complicated. A similar and more widely used method is to use a uniform %, which

is double the reciprocal of the estimated life:

Uniform rate or d = 2 (1/n)

The basic idea behind this method is to provide for a more or less uniform total cost of

operation of the asset over different years of its life. On the other hand, under this

method, depreciation is higher in earlier part of the asset’s life, but it declines

progressively in the later years. The combined effect is that the total charge in the profit

and loss account so far as the asset is concerned, is equated over different years.

5.3.1.3. The Sum of the Year’s Digits Method:

The basic idea of this method is similar to that of the Declining Balance Method,

i.e., to provide for a uniform total cost of operation of the asset. The amount of

depreciation in the beginning of the life of the asset is higher and it progressively declines

with the passage of time. This method differs from the declining balance method in that

the base or book value remains constant while the annual rate of depreciation changes.

The variable rate of depreciation is calculated as follows:

Each digit of the years of the useful life of the asset is added up and the resulting

figure is the denominator of the fraction to find out the depreciation rate.

The numerator of the fraction for each year is the expected life of the asset in that

particular year and this declines by one each year. Thus the depreciation rate is

composed of a varying numerator and an unvarying denominator. And this rate is

applied each year to the asset’s original cost.

Illustration: The sum of the Year’s digit method can be explained with the following

illustration: Suppose the original cost of the asset is Rs.12000 and its scrap value is

Rs.2000 and its expected life is 4 years. In the beginning, the asset has an expected life of

4 years; one year later it has an expected life of 3 years and so on. Thus the expected life

periods of the asset are 4,3,2 and 1 years. The sum of these expected life periods is 10,

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which will be the common denominator of the annual rates. The numerators are

respectively 4,3,2 and 1. Thus the annual rates are 4/10, 3/10, 2/10 and 1/10 respectively.

The original value of the asset is Rs. 12000 and the scrap value is assumed to be Rs.2000;

the annual depreciation charge should be made for Rs. 10000. In the first year, the rate of

depreciation is 4/10 which is 40% and the depreciation amount is Rs.4000. in the second

year the rate of depreciation is 3/10 or 30% or Rs.3000. in the third year, the rate of

depreciation is 2/10 or 20% or Rs2000 and in the fourth year, the rate of depreciation is

1/10 or 10% which is equal to Rs.1000. These data can be tabulated as shown in the table.

TABLE –5.1 The Annual Depreciation

Age of the asset in years

Rate of depreciation

Annual depreciation

Accumulated depreciation

Book value of the asset

1234

4/10 or 40%3/10 or 30%2/10 or 20%1/10 or 10%

Rs4000300020001000

Rs.40007000900010000

Rs.8000500030002000

The Declining Balance Method and the Sum of the Year’s Digit method are useful, as

well as equitable in calculating depreciation, where the cost of repairs increase as

depreciation charges decrease.

Depreciation and Profit: We studied three methods of calculating depreciation of an

asset. Under the Straight Line Method, the charge of depreciation is the same throughout

the life of the asset. As a result, the profits are affected equally throughout. Under the

Declining Balance Method, and the Sum of the Year’s Digits Method, the charge for

depreciation is higher towards the end. In view of the fact that depreciation is higher in

the initial years, both these methods are called Accelerated Depreciation Methods. As

between the two methods, the charge is higher in the firs year in the case of Declining

Balance Method than under the Sum of the Year’s Digits Method. But in other years, the

depreciation is higher under the Sum of the Year’s digits method. From this, we can

understand that the amount of profit of a firm depends on the method of depreciation

adopted. With the same machine, equipment, plant, building, etc., different firms can

show different amounts of depreciation and consequently, different amounts of profit.

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For the young and growing firm, the ‘Accelerated Depreciation method’ offers

advantages as the new companies will have limited capital and they may need funds for

expansion. Even for well-established companies with excellent credit facilities, this

method is better suited than the ‘Straight-Line Method’ if the companies are engaged in

the programme of capital expansion and replacement of assets. The advantages are as

follows:

Taxable income and income-tax liability would be substantially larger towards

later years only under the declining balance method and the sum of year’s digit

method.

Under the accelerated depreciation method, the tax liability being lower in the

earlier years of the life of the asset, the company has the benefit of retaining a part

of the funds which would have been payable as tax under the straight-line method.

These funds, in effect, amount to an interest-free loan from the Government to the

company, since the accelerated methods result only in postponement of tax rather

than its permanent avoidance.

In the case of assets subject to rapid obsolescence, it is desirable to write-off the

asset as soon as possible in this respect, accelerated methods of depreciation are

more effective than the straight-line method.

The capacity of a firm to earn profits from the use of an asset is lower in the

earlier part of the life of the asset. Consequently, the capacity to pay tax is also

lower, under the accelerated depreciation methods; the tax liability is lower in the

beginning and higher towards the end. Thus, there is an adjustment in the capacity

to pay taxes and the tax liability is adjusted with the capacity to pay.

However, there are certain restrictions about the adoption of depreciation methods

by the tax rules of different countries, and these tax rules impose constraints on the

managerial choice about depreciation method. In the U.S.A. a company can choose any

one of the three methods we studied above and the Internal Revenue Act permits this.

Other countries such as Denmark, France, Holland and Sweden have introduced

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‘Accelerated Depreciation Method’ with the object of stimulating investment. In

Australia, the Straight-Line or the Declining Balance Method may be used. In India, there

are prescribed rates of depreciation to be applied to the written down value of the asset

under the declining balance method. For general machinery and plant, the depreciation is

10%. In the case of furniture and fittings, the depreciation is 15% when used in hotels,

restaurants, cinema theaters, etc. In the case of building it is 2.5%.

5.3.2. Valuation of StockIn business, the valuation of stock will influence the profit and the method

adopted in arriving at the valuation of the stock would have decisive impact on the profit.

There are three methods viz;

LIFO (Last In First Out) Method: According to this method, it is assumed that

the units acquired last are the units to be issued first. As a result, the inventory is

supposed to consist of materials purchased earliest.

FIFO Method (First In First Out): According to this method, it is assumed that

the units of stock acquired first should be issued first, i.e., First in stock should go

out first, and stock acquired very recently will be issued only later. Under this

method, the inventory is supposed to consist of goods purchased most recently.

The significance behind this is that the company may not have acquired the stock

at the uniform price throughout. With rising prices, at the beginning, the purchase

cost would have been lesser and later it would have been larger.

Weighted Average Method: This method assumes that it is not possible to

identify separately the materials purchased at different times at different prices.

Consequently the cost of one unit cannot be distinguished from the cost of

another. Units are issued at a cost of which is an average of the cost of each

purchase, weighted by the quantity purchase at that accost. The closing stock is

valued at the average cost.

Illustration: Let us take a hypothetical case to illustrate the three methods mentioned

above in the valuation of stock. Suppose a firm purchases for its factory production 500

Kgs, of a particular chemical at different times and at different prices as stated below:

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Purchased on February 18th : 100Kgs. At Rs. 3.25 per Kg

Purchased on March 20th : 250Kgs. At Rs. 3.50 per Kg

Purchased on March 31st : 150Kgs. At Rs. 3.75 per Kg

Suppose that on April 10, the materials department issued a quantity of 250kgs, of the

chemical to the production department. How will the stock on hand be valued under

different methods?

Under FIFO method, the quantity issued to the production department will be

valued at Rs.850/- and the stock on hand with the materials department will be valued at

Rs.912.50. According to this method, the first acquired should go out first. Hence the first

100kgs, are valued at Rs.3.25 and the subsequent 150kgs, are valued at Rs.3.50, which is

the purchase price. The total value of 250kgs comes to Rs.850. the total value of the stock

before issue comes to Rs.1762.50 on the basis of above purchase price and quantity.

Hence, the value of the stock on hand after issue to the Production Department will be

Rs.912.50. Under LIFO Method, the materials issued will be valued at Rs.912.50 and the

stock will be valued at Rs.850 after issue. Under this method, recently procured materials

should be issued first (Last In First Out). Hence, the first 150kgs should be valued at

Rs.3.50 per kg. This will work out to Rs.912.50. We know that the total procurement cost

under LIFO method is Rs.912.50. so; the stock on hand comes to Rs.850.

Thus, we can see that the stock on hand after issue is valued at Rs.912.0 under

FIFO method, and the stock on hand after issue is valued at Rs.850 under LIFO method.

In other words, the valuation of stock is higher under FIFO method and lesser under

LIFO method in this particular case. Under weighted average method, the materials

issued will be valued at Rs.881.25 and the stock will also be valued at Rs.881.25. Thus, it

will be seen tat the value of the stock is different under different methods.

Valuation of Stock and Profit: The impact of the method used in determining the value

of the stock depends on the movement of prices of the commodity in question. Generally,

in an inflationary period, the LIFO method or Average method. The reason is that during

the period of inflation, the costs are high and since most recent costs are taken into

consideration under LIFO method, the profits are determined accordingly. The stock is

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values at the earlier cost, i.e., under lower cost. Under FIFO method, these lower costs

would be debited to the Profit and Loss Account; the resultant profit will, therefore, be

higher. The inventory will be valued at the higher costs, i.e., later costs. This also will

lead to higher profits. The Average method lies somewhere in between LIFO and FIFO

methods. In period of deflation. LIFO method will tend to produce higher income than

FIFO method or Average method.

Our experience after the Second World War shows that in out economy, rising

prices due to inflation have become the general trend and deflation is a remote

possibility, or almost nil. So, the businessmen find it expedient to adopt LIFO method in

the valuation of stock. As LIFO method tends to show lower profits in an inflationary

period, it tends to reduce income-tax liability. It is stated that an American manufacturer

saved nearly 19,500,000 dollars in income tax, over a period of 19 years by adoption of

the LIFO method. In times of deflation the FIFO method is more beneficial. But, the

income-tax authorities would insist on using only one particular method and it should be

adhered to consistently and a departure from the method will not be allowed.

The Income Tax Act does not lay down any specific method about the valuation

of stock. But, Section 145 provides that profits shall be computed in accordance with the

method of accounting regularly employed by the assessed. A method regularly employed

will include the method of valuation of stock also and it cannot be changed to suit the

convenience of the assessee. Prof. Joel Dean has recommended the adoption of LIFO

method and the accounting bodies of UK have also recommended the same.

5.3.3. Treatment of Deferred Expenses – Allocation of expenses over Time Periods

The firm will have intangible fixed assets and the problems come in writing off

these intangible assets during their lifetime. Intangible fixed assets can be classified into

two categories.

Those having a limited life, e.g., Copyright, Leasehold, permits, etc., and

Those having no such limited life, e.g., Trade Marks, Good-Will of the

business, Preliminary Expenses, etc.

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Businessmen prefer to write off the intangible assets having limited life before their

useful life expires. This is based on conservatism, i.e. to eliminate these intangible assets

as soon as possible. The example of this type is provided in the case of ‘Copyrights’.

Legally, copyrights have life equal to author’s life plus 50 years thereafter. But

publications may not have an active market for such a long period. It is, therefore,

considered advisable to write off the cost of copyright against the income from the first

edition. Intangible assets with no limited life pose more complicated problems for two

reasons:

There is a difference of opinion whether the assets should be written off at

all or not

If they have to be written off, what should be the period for their

amortization?

This amortization can be done either gradually or by an immediate write off. To

illustrate this point, “Good-Will” can be taken for discussion. The conservative view is

that the good will is only a fancy asset having no place in the balance sheet. But this view

cannot be fully endorsed, as in some cases; good will may ensure certain decisive

advantages to the firm. Hence, a rational view would be to write off the good will over an

appropriate period of time.

5.3.4. Capital Gains and Losses

Capital gains and losses, or “Windfalls” may be defined as “unanticipated

changes in the value of property relative to other real goods. That is, windfall reflects a

change in someone’s anticipation of the property’s earning power. Fluctuations in stock

market prices are all almost of this nature”. Conservative companies may decide not to

include capital gains in the current profit. At the same time, they would like to write off

capital losses from the current profits of the year in which the loss occurs. On the other

hand, a company may decide to include the capital gains in the profits of the year.

Regarding capital losses, the company may decide to write it off out of retained earnings.

Thus the amount of profit would be affected by the treatment of capital gains and losses.

In the case of unrealized capital gains, there is unanimity that they should not be included

in the profits. If there is a revaluation of property, the gain resulting out of it is usually

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transferred to capital reserve. All these show that there can be discrepancies in the profit

reported by different companies because of the different approaches that they adhere to

the treatment of capital gains and losses.

5.4. Profit Planning

A firm has to face many uncertainties and risks. These uncertainties may arise due

to the dynamic nature of the consumer needs, the nature of competitions, continuous

change in technological developments and uncontrollable nature of cost of production.

The symptoms of a healthy business include making a reasonable profit consistent with

the risks it has to face. The profits cannot be left to chances and it has to be planned.

A firm faces unpredictable demand for its products. Barring the basic

requirements of life and other essential commodities, consumer preferences of

commodities are highly subjective and the firm may not be able to predict the demand

precisely and firm faces this uncertainty, viz.,

The pattern and quantum of demand is uncertain. This is a risk and the firm has

to take steps to forecast the demand for its products.

The firm has to face competition from the rival producers. The competition may

be price-competition or product competition or it may be both. Product

competition is more important till it reaches the stage of maturity.

In a period of continuous rising prices, no firm can be certain of its own cost

structure, as it cannot have control over the price of raw materials and wages

and transport cost, as well as taxes to be paid. This is another uncertainty.

Improvements and change in technological developments may make a firm’s

product obsolete and push the firm out of business, unless, the firm adopts the

new technology.

All these create a condition of risk and uncertainties for the firm to survive in the

business and to make profit in the enterprise. Unless the firm takes an extra ordinary care

to study all the above factors prone to risks, the profits would be left to chance. The firm

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has to plan for the profits by having a thorough knowledge of the relationship of cost,

price and volume in the enterprise .The knowledge of manipulation of these, viz., cost

price and volume will have a definite bearing on the profit making ability of the firm. If a

firm does this exercise elegantly and efficiently, the targeted profit can be ensured. If a

firm makes thorough study and exercise of COST- VOLUME PROFIT ANALYSIS and

takes decisions accordingly to decide the quantum of profit, then the firm is said to have

adopted ‘Profit Planning’ effectively. The most important method of determining the

cost-volume-profit relationship is that of Break- even- analysis.

5.5. Break Even Analysis A business unit breaks even with its total sales value if it is equal to its total

cost. The Break-even analysis helps in understanding the relationship between the

revenues and costs in relation to its volume of sales. It helps in determining the volume in

which the firm’s cost and revenue are equal. Break–even point (BEP), refers to that level

of sales volume at which there is neither profit nor loss, costs being equal to its sales

value and the contribution is equal to fixed expenses.

5.5.1 Differing Views on Break-Even Point

Accountants and Economists differ on break-even point. Economists assume that

revenue and cost vary over increasing volume of output. Accountants, on the other hand,

assume that variable cost varies in direct proportion to output and the break-even point is

constructed assuming linear cost and revenue functions. The comparison of the two views

is given in the figure by depicting the structure of the break-even chart according to

Economist and Accountants.

The figure 5.1 indicates the Economist’s viewpoint of break-even and the figure 5.2

shows the Accountants view point. In the Economists figure the firm should produce

OQ1 to maximize profits. Expansion of output beyond OQ1 results in decline in profits

due to diminishing returns and diminishing marginal revenue .The Total Revenue Curve

eventually drops down, as greater quantities can be sold only by lowering the prices .The

Total Cost Curve simultaneously continues to increase since extra output does not have a

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zero cost .The figure shows the level of output where profits are the maximum. This

situation corresponds to the distance between TR and TC.

Figure 5.1: The Break-even Chart According to Economist

Figure 5.2: The Break-even Chart According to Accountants

In the figure 5.2, the BEP is constructed assuming linear cost and revenue

functions. This view suggests that higher the output, higher is the profits. Break even

point is at B where TC=TR .In the Accountants figure, TR will be always at a higher

level beyond BEP showing increasing profits with the increase of output .TC in this

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figure will never drop down, as these are assumed to be linear .The Economist figure is

realistic and the Accountants figure is practical

5.5.2. Calculations of Break-even PointThe following formula could be used to find out the Break-even point

Total Fixed Cost BEP = Selling price- AVC

= Total fixed expenses Selling price per unit - Variable cost per unit

(a) Illustration: Find out the BEP from the following data: Variable cost per unit =Rs 30/-

Selling price per unit =Rs 40/-

Fixed expenses = Rs.1 lakh.

Answer:

Rs.1, 00,000 BEP =

Rs.40-Rs.30

1,00,000 = = 10,000 Units

10 For this illustration, calculate the selling price per unit if BEP is brought down to 8,000

Total fixed cost Fixed cost per unit =

Number of units

1,00.000= = 12.50

8,000

Selling price = Variable cost + Fixed Cost per unit = Rs.30 + Rs.12.50 = Rs.42.50

Break-even point in terms of sales value

147

(b) Illustration:Find out the BEP in terms of sales value on the basis of following data:

Sales =Rs.10,000Variable cost =Rs.6,000Fixed cost = Rs.3,000

In this case, we have to calculate the contribution ratio and then we have to calculate the BEP:

Total revenue minus Total variable costContribution ratio =

Total revenue

Sales minus variable cost =

Sales

= 10.000-6,000 = 210,000 5

Total fixed cost BEP=

Contribution Ratio

3,000

2/5

3,000 x 5 = = Rs. 7500

2

Break- even analysis helps the business firm in focusing on some important

economic leverage, which could be operated suitably to enhance its profitability. It helps

the business firm in

Calculating output or sales to earn a desired profit;

Margin of safety

Change in price

Make decisions; and

Change in cost and price etc.

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5.5.3. Calculation in Terms of Target Profit

(c) Illustration:Find out the target sales volume, if the desired profit is Rs.12.000 with the following data: fixed cost Rs.20, 000,Variable cost Rs.4 per unit; and selling price Rs. 8 per unit.

According to Break even Analysis the formula for

Fixed cost + Target profitTarget Sales volume =

Contribution margin per unit

Substituting the values to the formula, we get:

20,000+12,000Target sales volume=

8-4

32,000=

4

Target sales volume = 8,000 unites

5.5.4. Calculation in Terms of Safety Margin

(d) Illustration: If the present sales of a firm is Rs.40 lakhs and Break-even sales are Rs.30lakhs, find out percentage of margin of safety?

The formula for Safety margin is as follow:

(Sales-BEP)Safety margin= *100

Sales

40,00,000 - 30,00,000Safety margin = * 100

40,00,000

= 25%of present sales.

5.5.5. Calculation in Terms of Change in Price and New Sales Volume:Very frequently, the firm will be faced with problems of taking decisions for

reducing the price or not. A reduction of price will result in the reduction of contribution

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margin. Reduction in price need not necessarily result in the increased sales, as it depends

on the elasticity of demand of the commodity produced by the firm. Assuming that it

remains constant, the management has to take decision regarding the increase of volume

of output in order to maintain the same profit level in the context of reduction in price.

The formula for determining the new volume of sales with given reduction in price will

be as follows:

Total Fixed cost + Total profit

New sales volume = New selling price- Average variable cost

(e) Illustration: A firm sells 4,000 unites per month at a price of Rs.40per unit. Fixed cost works

out to Rs.10,000 per month and variable cost comes to Rs.24 per unit there is a proposal

to reduce the price of the commodity by 20 per cent. How many units should the firm sell

to maintain the present level of profit?

Sales value of 4,000 units at Rs.40 =1,60,000 Less

variable cost of 4,000 units at Rs. 24 = 96,000Contribution = 64,000 Less

fixed expenses = 10,000Present Profit Rs. 54,000

Old price is Rs.40 Reduction of price is 20 per cent, i.e., Rs.8. hence, the new sales price

is Rs.32. Sales needed to maintain the present profit of Rs.54, 000 at new price of Rs.32

per unit are:

Rs.10,000+5,4000New sales volume = = 64,000/8 = 8,000 units.

32-24

The firm has to increase the sales from 400 units to 8000 units. Price reduction of 20% is

justified if the management is confident of raising the sales to 8000 units.

Break-even analysis also helps to decide whether components, which are part of their

finished products, should be manufactured by them or brought from out side firms.

Illustration: A manufacturer of bicycles buys a certain part at Rs.40 each. If he decides to

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manufacture it himself, his cost would be as follows: Fixed costs Rs 48000; Variable cost

Rs.16 per unit. Find out if it is profitable for him to manufacture the parts instead of

buying.

F.CBreak-Even Point =

Purchase price- Variable cost

48000 = 48000/24 = 2000 40- 16

This shows that the manufacturer can produce the parts profitably, if he needs more

than 2000 components per year. If his requirement is less than 2000 units, it is better to

buy from outside firms. Thus the Break-Even analysis is useful to the management in

determining profit policies and profit planning.

5.6. Linear Programming There are many varieties of analytical techniques to solve constrained

optimization problem. We have linear programming, Integer Programming, Quadratic

Programming, and Non-Linear Programming. However, linear programming technique

has been developed more and used frequently. The origin of linear programming dates

back to 1920s when W. Leontief developed this for input-output analysis. The present

version is the work of mathematician George B. Dentzig in 1947. Originally, this

technique was used in planning the diversified operation of US Air-Force. Economists

like Koopmans, Cooper, Dorfman and Samuelson have made significant contributions.

5.6.1 Meaning of Linear ProgrammingLinear programming is a mathematical technique by which rational decisions are

taken in production to optimize output with the constraints of limited input, i.e.,

resources. To put it in a simpler way, it is useful in allocating the limited resources in an

optimal manner in production. We know that resources are very limited and there are

constraints in getting adequate resources and also in the process of production. A

producer has to take decisions to make use of the little resources in order to get maximum

output, or to make a unit output with minimum cost. The problem before the management

is the allocation of firm’s resources, viz, money, material, space, time, labour etc., so as

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to get maximum profit. The linear programming technique helps in realizing the objective

of optimal utilization of resources for getting maximum returns or profits. Hence, this is

an important tool in decision-making and it is comparatively a new tool in decision-

making.

Linear Programming is defined as “a mathematical technique of study where in

we consider the maximization (or minimization) of a linear expression (called the

objective function) subject to a number of a linear equalities and inequalities (called

linear restraints)”. The term ‘linear’ denotes that it is mathematically involving linear

function, and the word ‘programming’ denotes mathematical procedures to get the best

solution to a problem utilizing limited resources.

5.6.2 Need for Linear Programming TechniqueIn economics, we have studied about Marginal Analysis and Least Cost

Combination Techniques, etc. in the production analysis. When we have these methods,

where is the need for the linear programming technique? Marginal analysis and calculus

and other usual methods cannot be used in a situation, where the problem is to obtain an

optimum solution with constraints. The usual methods are useful only in the context of

resource allocation to achieve a particular goal, rather than with the efficiency with which

the resources are to be employed. Realizing a particular objective in production is

different from utilizing the resources most efficiently subject to certain constraints. For

example, if it is a problem of suitable choice of combination of outputs so as to maximize

National income, with the constraints that no more than a given amount of resources

should be used, then, it is a problem of not only optimization. This means that we can use

only a given amount of resources and that the output level of each product has to be non-

negative. This, connotes, that we are required to choose amongst a host of possible

combinations of different outputs, that combination which does not violet the given

constraint conditions, and at the same time, it should maximize National Income.

Moreover, the constraints may be precise or specific; instead they may impose

only upper or lower limits on the decision-maker. For instance, the given limitations may

state only the maximum amounts of the inputs that are available or it may be only certain

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minimum requirements that must be met. Such constraints can be expressed only as

inequality relationships. These problems cannot be solved by means of marginal analysis.

We have to necessarily depend on a new technique of analysis, which has been provided

by linear programming.

5.6.3 Assumptions of Linear Programming Technique The linear programming technique is based on certain assumptions in the process

of obtaining the optimal solution. Some of the important assumptions are discussed

below:

Assumption of Linearity: The main assumption in the technique is the linear

relationship of the variable used in it. The various relationships should be expressed

in the form of equations or inequalities and they must be linear. This means a

proportional relationship, i.e., the exponents of all variable must be one. For

example, the raw materials used, the number of hours of work and the units of

products are proportional. By assuming linearity, we mean that a 20% change in the

productivity hours of work will lead to 20% change in raw materials and 20%

change in output. Similarly, the basic relationship between cost functions, revenue

function and their composite, i.e., profit function are directly proportional, i.e.,

linear. This assumption of linearity implies the constancy of product prices. If costs,

output and prices have to rise linearly, necessarily there must be constant returns to

scale, i.e., the production function must be linear, i.e., homogeneous production

function of first degree. This further leads to the assumption of constancy of factor

prices remain constant, such a situation can be obtained only under perfect

competition. So, the entire analysis rests on a condition of perfect competition. Thus

the technique assumes linearity relationships, which leads to the assumption of

Constancy of product prices Constant returns to Scale Constancy of factor prices Perfect competition

5.6.4. Characteristic Features of Linear Programming Problems

All problems where linear programming is applicable have the following

characteristic features;

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The Objective Function: This clearly defines the objective of the programme in

quantitative terms. This tells about the determinants of the quantity optimized.

Generally, in business, the objective will be maximization of profit or

minimization of cost. If it is planning at the national level, the objective may be

maximization of national income as the sum of outputs of different products. The

objective sought after is known as the ‘objective function’. For example, suppose

a manufacturer produces three commodities, R, S, and T. The quantities produced

are QR, QS, QT respectively. Let the profit per unit in case of these commodities be

PR, PS, PT respectively. The producer wants to maximize profit ‘P’ for them. The

objective function would then be stated as follows:

QRPR + QSPS + QTPT = Maximum

Constraints: This is an algebraic statement of the limits of a resource or input.

This expression is usually in the form of inequalities, which state the things that

are possible or not possible to be done. If a firm is trying to maximize profits, then

it has to take account of the fact that they are limited by number of machines it

has, the warehousing capacity and the amount of raw material available, etc.

suppose the commodities R, S, and T, each require per unit of product X,Y and Z

hours of machine time and only ‘H’ hours of machine time is available. The

constraints on the production of R, S and T, then will be as follows:

XQR + YQS + ZQT ≤ h

The constraints like and objective function must be capable of arithmetical or

algebraic expression. For example, a requirement that any solution shall not lower

the quality of the product is not a constraint in the linear programming sense, as

this cannot be expressed numerically.

Non-Negativity condition: Linear Programming technique is a mathematical tool

for solving constrained optimization problems. Hence we would get any answer

with any algebraic sign attached with it. Some answers may be even negative and

as such absurd. When we get such a negative solution, like negative quantity, it

will be a practical impossibility. For example, in distribution problems, the

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optimal solution arrived at by the technique may be ‘negative shipments’ from

one place to another. Of course, this is an impossible solution. In order to

eliminate such impossible and non-sensual results, it is necessary to include the

non-negativity conditions. Thus in any production problem, we would be required

to include conditions that any factor-input or the quantity produced cannot be

negative. Thus, the non-negativity condition merely states the fact that all variable

in the problems must be equal to, or greater than zero. In our example, if the firm

makes three products, R, S and T, the quantity of production should be either zero

or positive. There would be no negative production, which means that the

commodity is ‘reproduced’ or ‘dismantled’ which is absurd. So, in the illustration,

the non-negativity conditions would be:

QR ≥ 0 QS ≥ 0 QT ≥ 0

Linear relationship: As has been indicated already, the various relationships to

be expressed in the form of equations or inequalities must be linear, i.e.,

proportional relationship.

5.6.5. Methods of Linear ProgrammingA problem related to linear programming can be solved by two methods. The first

one is called the ‘graphical method’ and the second one is known as ‘simplex method’.

The latter requires advanced mathematical techniques involving extensive use of

algebraic equations and manipulations. Further, the computational procedure is very

wearisome, and without electronic computer, it will be difficult to cope with the volume

of data and calculations to find solutions to actual business problems. But the Graphical

Method is a simpler one having a close resemblance to indifference curve analysis. This

method can be used very elegantly where there are a few decision variables.

5.6.6. Graphical methodProblem: Suppose the objective of a firm is to maximize profit in the production of

product ‘R’ and/or product ‘S’. Both these products require two machines, namely,

machine ‘a’ and machine ‘b’ for purposes of processing. Product ‘R’ requires 4 hours on

both the machines ‘a’ and ‘b’, while product ‘S’ requires 6 hours on machine ‘a’, but only

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2 hours on machine ‘b’. There are only 24 and 16 hours available on machine ‘a’ and ‘b’

respectively. The profit per unit is estimated at Rs.12/- and Rs.14/- in the case of ‘R’ and

‘S’ respectively.

Now, we have dependent variable, viz, profit which is to be maximized and this is

the function of two independent variables ‘R’ and ‘S’ the production of which is

restricted by the time available in the machines.

First Step: (Formulation of problem)The above stated information has to be formulated in mathematical form. We

have the objective function. This is an equation showing relationship between output and

profit.

P = Rs. 12R + Rs.14S

If P = Profit; Rs.12R = Total profit from sale of product ‘R’

Rs.14S = Total profit from sale of product ‘S’

The time taken in processing the products in the machines must not exceed the

total time available on each. It may be less or equal to the time available on the machine.

These are the constraints and the constraints can be expressed mathematically as follows:

A: 4R + 6S ≤ 24

B: 4R + 2S ≤ 16

This means, the first inequality states that the hours required to produce one unit

of ‘R’ (4 hours) multiplied by the number of units of ‘R’ produced plus the hours

required to produce one unit of ‘S’ (6 hours) multiplied by the number of units of ‘S’

produced must be equal to or less than 24hours available on machine ‘a’. A similar

explanation holds good for the second inequality. Both these inequalities represent

capacity restrictions on output and hence on profit.

Finally, to get meaningful answers, the values of R and S must be positive i.e.,

producing negative quantities of R and S may not convey any meaning. Thus solutions

for R and S must be either zero or greater than zero, i.e., R ≥ 0; S ≥ 0.

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To sum up we get: Maximize subjects to constraintsP = 12R + 14S4R + 6S ≤ 244R + 2S ≤ 16R ≥ 0; S ≥ 0.

Second Step :(Plot the constraints on Graph)The next step is to plot the restraints of the linear programming problem on a

graph paper; products ‘R’ to be shown on ‘X’ axis and product ‘S’ on ‘Y’ axis (Figure

5.3). The inequality 4R + 6S ≤ 24 may be drawn on the graph first locating its two

terminal points, and then joining these two points by a straight line. This is done in the

following manner. If we assume that all the time available on machine ‘a’ is used for

making product ‘R’, then it would mean that the production of product ‘S’ is zero. Then 6

units of product ‘R’ would be made. Thus, if S = 0, then R ≤ 6. If we produce the

maximum number of product ‘R’, then R = 6. so the first point is (6,0) to be plotted in the

graph, i.e., zero product of S and 6 units of R.

In order to find the second point, we assume that all the time available on machine

‘a’ is used in making ‘S’; i.e.., production of ‘R’ is zero. Under this assumption, we get 4

units of ‘S’. Thus, if ‘R’ is zero, then S = 14. The maximum number of ‘S’ would be 4.

So, the second point is (0,4). This denotes 4 units of ‘S’ and zero unit of ‘R’.

Locating these points, viz., (0,4) and joining them, we get a straight line AB as shown in

figure –5.1. This line shows the maximum quantities of product R and S that can be

produced on machine ‘a’. The area AOB is the graphic representation of inequality 4R +

6S ≤ 24 It can be drawn graphically as shown in the figure.

Similarly if the output of ‘S’ is zero, the maximum output of ‘R’ on machine ‘b’

will be 4, i.e., (4,0). If the output of ‘R’ is zero, the maximum output of ‘S’ on the

machine ‘b’ will be 8. i.e., (0,8). Locating these two points and joining them, we get

straight line CD, as shown in the figure. This line again represents the maximum

quantities of products R and S that can be produced on machine ‘b’. The area COD the

graphic representation of inequality 4R + 2S≤ 16

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Figure 5.3 Graphical Representation of Linear programming Problem

Third Step: Finding out Feasibility Region and Co-ordinates of its Corner Points.The third step is to identify the cross-shaded portion are OAED in the figure. This

is generally known as feasibility region. This is formed with the following boundaries; X

axis; Y-axis; AED boundary is formed by the intersection of lines AB and CD at point

‘E’. If a point is to satisfy both the constraints and the non-negativity conditions, it must

fall inside the cross-shaded area or on its boundaries. All points outside the feasibility

region are inadmissible. For example, if we begin at the origin O, we cannot travel

beyond point ‘D’. If we were to proceed further, the capacity restriction of machine ‘b’

will be violated. Similarly on the Y-axis, we cannot proceed beyond ‘A’. Moving beyond

‘O’ leftward or downward would not satisfy non-negativity conditions

In this feasibility region, we have to study the corner points, as the optimum

solution invariably must lie in one of the corner points. We know the co-ordinates of

three corner points, viz.,

Corner point R S

O (0, 0)A (0, 4)D (4, 0)

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The co-ordinates of point ‘E’ however, are yet to be ascertained. One method is to

read the co-ordinates in the figure itself, if it is drawn accurately and to the scale in the

graph sheet. Another method is to solve simultaneously the equations of the two lines,

which intersects to form point ‘E’. The equations to be solved are:

4R + 6S = 244R + 2S = 16

Solving these two equations we get the value of R or S

4R + 6S = 244R + 2S = 16

- - -4S = 8 S = 2

Now, substitute the value of S in the equation 4R + 6S = 24. We get value of R =

3. So, the co-ordinates of point ‘E’ are (R=3: S=2)

Fourth Step: Find Most Profitable Corner Point

The final step is to test the four corner-points, viz., O, A, D; E. Of the feasible region

OAED and to see which corner- point yields the maximum profit.

Corner-point O; (0,0) = 12(0) + 14(0) = 0 Corner-point A; (0,4) = 12(0) + 14(4) = 56 Corner-point D; (4,0) = 12(4) + 14(0) = 48Corner-point E; (3,2) = 12(3) + 14(2) = 64

The corner-point which yields the maximum profit is ‘E’ and the maximum profit

is Rs.64/- Thus, the graphical method of linear programming consists of formulating the

problem, plotting the capacity restraints on the graph; identifying the feasibility region

and its corner-points and finally testing which corner point gives the maximum profit.

5.6.7. Simplex Method

Another method of liner programming is the Simplex method. The simplex

method offers a means of solving the more complicated programming problems. The

simplex method, however, is more complex than simple’ and involves somewhat

unsophisticated, complex mathematics. The complexity lies in the manipulation of

numbers. The simplex method for solving linear programming problems was developed

by G.B. Dentzig.

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5.6.7.1 Characteristic features

Simplex method possesses two worth mentioning characteristic features. First, in

the simplex method, the computational routine is an iterative process. To iterate means to

repeat; hence in working towards the optimum solution, the computational routine is

repeated over and over, following a standard pattern. Successive solutions are developed

in a system at pattern until the best solution is reached. Secondly, each new solution will

yield a profit as large as or larger than the previous solution. This important characteristic

assures us that we are always moving closer to the optimum solution.

5.6.7.2. Linear programming problem

Let us take linear programming problem. A manufacturer makes two products,

tables and chairs, which must be processed through two machines. On machine1, 30

hours are available and on machine 2, 24 hours are available. Each table [X1] needs 2

hours on machine 1 and 1 hour on machine 2. Each chair [X2] requires 1 hour on machine

1 and 2 hours on machine 2. The profit is Rs. 4 per table [X1] and Rs. 3 per chair [X2].

The problem is to determine the best possible combination of tables and chairs to produce

and sell in order to earn the maximum profit.

Stating mathematically, the linear programming problem is:

Maximize profit =Rs.4X1+Rs.3X2

Subject to 2X1+X2 ≤ 30 hours

X1+ 2X2≤ 24 hours

Solving a problem by the simplex method requires (1) arranging the problem

equations and inequalities in a special way and then (2) Following systematic procedures

and rules in calculating a solution.

I Step: Develop Equations from the Inequalities (Adding SLACK Variables)

The first step is to change the inequalities for the two constrains in our problem

into equations. We cannot use the simplex method unless all the inequalities are

converted into equations by adding slack variables. Let us explain what a slack variable

is. A slack variable represents costless process whose function is to ‘use up’ otherwise

unemployed capacity, say machine time or warehouse capacity. In effect, the slack

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variable represents unused capacity and it will be Zero only if production facilities are

fully used. The slack variable makes the right-hand side of an inequality and up the left-

hand side.

To take an example: Let

S1=Slack variable (unused time) on Machine 1.

S2= Slack variable (unused time) on Machine 2.

S1 is equal to the total time available on machine 1(i.e., 30 hours) less any hours used

there in processing tables and chairs. Similarly, S2 is equal to the total time available on

machine 2 (i.e., 24 hours) less any hours used there in processing tables and chairs.

Mathematically, we can restate the equations for the slack variable S1and S2 as under:

S1=30-2X1-X2…machine 1

S2=24-X1-2X2…. machine2

We may also see that by adding the slack variables, we could change the constraint

inequalities in our problem into equations. Thus, by adding the slack variable S1, the

inequality 2X1+X2 ≤ 30 hours is changed into the equation

2X1+X2+S1=30 hours

Likewise by adding the slack variable S2, the inequality X1+2X2 ≤ 24 hours is changed

into the equation

X1+2X2+S2=24 hours

In other words, the slack variable on each machine takes on whatever value is required to

make the equation relationship hold. Two examples will make this point clear.

Example1. Suppose that on machine 1, we process 3 tables (X1) and 2 chairs (X2).

S1=30 hours – 2(3)-1(2)

30-6-2=22

Example 2. Suppose that on machine 2, we process 3 tables (X1) and 5 chairs (X2).

S2=24-1(3) -2(5)

= 24-3-10=11

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We can now restate our linear programming problem in the from in which it will be used

in the simplex method. It is:

Maximize Profit (P)=Rs.4X1+Rs.3X2.

Subject to 2X1+X2+S1=30 hours

X1+2X2+S2=24 hours

The above form is referred to as the equality form of the programme the only changes we

have made are the introduction of slack variable into the constrains. It may be pointed out

that whereas S1 and S2 are the slack variables, X1 and X2, in contrast, are called structural

or ordinary variables. Further, the slack variables must be non-negative. In the simplex

method, any unknown that appears in one equation must appear in all equations. The

unknown that do not affect an equation are written with a Zero coefficient. For example,

since S1and S2 represents unused time, which yields no profit, these variables are added to

the profit function with Zero coefficient. Furthermore, since S1 represents unused time on

machine 1 only, it is added to the equation-representing machine 2 with Zero coefficient.

For the same reasons, S2 is added to the equation representing the time constraint on

machine 1. Thus we get the following equation:

Maximize Profit =Rs.4X1+Rs.3X2 +0S1+0S2

Subject to 2X1+X2+S1+0S2=30 hours

X1+2X2+0S1+S2=24 hours

II Step: Develop Initial Simplex Tableau

We can now set out whole problem in what is known as a simplex tableau. The

simplex tableau is a table consisting of rows and columns of figures and is also known as

simplex matrix. It will be helpful here to describe the simplex tableau and to identify its

various parts. We illustrate below the form of simplex tableau or matrix and explain its

various parts (Table 5.2).

(1) Cj row: In the simplex tableau, the first row is the Cj row, also known as

objective row. In this row, we insert the coefficients in the objective equation. Thus, the

Cj row appears as follows in the initial simplex Tableau (Table 5.2):

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Rs.4 Rs.3 Rs.0 Rs.0 Cj row

X1 X2 S1 S2 Variable row

Note that the coefficients in the objective equation are listed above the corresponding

variables, i.e., 4 above X1, 3 above X2, 0 above S1 and 0 above S2. The Cj row shows the

profit made per unit of each variable; Rs. 4 per unit of X1, Rs. 3 per unit of X2, Rs. 0 per

unit of S1 and Rs. 0 per unit of S2. Thus, the Cj row or the objective row is put above the

variables row to remind us of how much profit we make for each item produced.

Table 5.2 –Parts of Initial simplex Tableau

Cj Profit per unity

Product mix column

Constant column (i.e., quantities of product in the mix)

Variable columns

Cj Product mix Quantity Rs.4 Rs.3 Rs.0 Rs.0

X1 X2 S1 S2

Rs.0 S1 30 2 1 1 0

Rs.0 S2 24 1 2 0 1

(2) Restraint Equations: The two restraint equations are shown in the simplex

tableau as follows:

Quantity X1 X2 S1 S2

30 2 1 1 0

24 1 2 0 1

Note that on the top we have first listed the products whose outputs we are determining,

viz., X1, we write all the coefficients of this variable; for example, under X1 we write all

the coefficients of this variable; for example, under X1 we write 2/1. Similarly, under X2

we write 1 and 2; under S1 we write 1 and 0, and under S2 we write 0 and 1. At the

extreme left-hand, we write that constant 30 in the first row and constant 24 in the second

row corresponding to the two restraint equations. Thus, the first row represents the

coefficients of our first equation and the second row represents the coefficients of our

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second equation. We have in this way simply rearranged the terms in the constraint

equations to form the simplex tableau.

(3) Product-mix column: Under the graphical method, we have already seen that all

solutions to linear programming problems will be found amongst the corners of the

feasible region. One such corner and in fact the most easily found corner is the origin.

Under the simplex method, this origin (or corner point O) provides the starting point

solution. At this point, note that no tables or chairs will be produced and all the capacity

will be unused. Finally, with no production and all unused capacity, there will be no

profit. In other words, the starting solution will be the zero-profit solution. This solution

is the worst possible and is also known as trivial solution. We can see that if no tables or

chairs are produced, i.e., if X1=0 and X2=0, then the first solution would be:

X1=0 X2=0

S1=30. S2=24

The first feasible solution then is shown in the initial simplex tableau 5.2. It may be noted

that the product-mix column shows the variables in the solutions. The variables in the

first solution are S1 and S2 (the slack variables representing unused capacity). In the

quantity column we find the quantities of the variables that are in the solution:

S1=30 hours available on Machine 1

S2=24 hours available on Machine 2

As the variables X1 and X2 do not appear; in the product-mix, they are equal to zero.

(4) Cj column: We may now add Cj column at the left end. This shows the profit per

unit for the variables S1 and S2. For example, the zero appearing to the left of theS1 row

means that profit per unit of S1 is zero. Likewise, the zero to the left of S2 row means that

profit per unit of S2 is zero.

(5) Zj row : The Zj may be defined as: “The Zj is the Cj for a row times the coefficient

for that row within the tableau, summed by column.” In other words, to arrive at the Zj

value for a particular column we first multiply each coefficient in the column by the Cj

against the coefficient, and then add up the products so obtained. This may better be

understood by actually computing Zj row.

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Let us take the value in the Zj row under the Quantity column. The figures under this

column are 30 and 24. The Cj against co-efficient 30 is 0. So they are to be multiplied:

0 X 30 = 0

Again, the Cj against co-efficient 24 is 0. So they are also to be multiplied:

0 X 24 = 0

Now, the products are to be added, i.e.,

0 + 0 = 0

This is the value of Zj under the Quantity column. It may be noted that this represents the

total profit from this particular solution, zero in this case. The Z j value for the different

variables viz X1, X2, S1 and S2 could be obtained through this method. The Zj values

represent the amounts by which profit would be reduced if one unit of the respective

added to the product mix.

(6) Cj-Zj Row

Now Cj-Zj is the net profit that will occur from introducing –from adding-one unit of a

variable to the production schedule or solution. For example, if 1 unit of X1 adds Rs.4 of

profit to the solution and if its introduction causes no loss, then Cj-Zj for X1=Rs.4. Net

income from the introduction of any variable could be obtained by following this

procedure. The values obtained for different variable shown in Cj-Zj row in initial simple

table.

5.3 Completed Initial Simplex Tableau

Cj Rs. 4 Rs. 3 Rs. 0 Rs. 0

Product Mix Quantity X1 X2 S1 S2

Rs. 0 S1 30 2 1 1 0

Rs. 0 S2 24 1 2 0 1

Zj 0 Rs. 0 Rs. 0 Rs. 0 Rs. 0

Cj – Zj 4 3 0 0

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By examining the initial numbers in the Cj – Zj row of the initial simplex tableau,

we could find that total profit can be increased by Rs. 4 for each unit of X1 added to the

mix or by Rs. 3 for each unit of X2 added to the mix. This Cj – Zj value for any particular

variable indicate the extent to which profit could be increased by adding 1 unit of that

particular variable to the product mix. On the other hand, a negative number in the Cj –

Zj row would indicate the amount by which profit would decrease if one unit of the

variable heading that column were added to the solution. Hence, optimum solution is

reached when no positive number remain in the Cj – Zj row. Thus, looking at this row

one could determine whether any improved solution is possible.

III Developing Improved Solutions

(1) Chose the Entering Variable: Whichever variable replaces S1 or S2 will be known

as the entering variable. The number in Cj – Zj row tell exactly which product will

increase the profits most. Thus, Entering Variable is one for which Cj – Zj value is the

highest. As is seen in the table 5.2 adding one unit of X1 will add profit of Rs 4.

Therefore, X1 column is called optimum column or pivot column.

(2) Chose the Departing Variable: In order to determine which variable to be replaced

following procedure has to follow. Firstly, divide each number in the quantity column

that is 30 and 24 by the corresponding number in the pivot column.

S1 row 30 hours/2hours per unit = 15 units of X1

S2 row 24 hours/ 1 hour per unit = 24 units of X2

Secondly, select the row with the smallest ratio as the row to be replaced. As the S1 row

has the smallest positive ratio it is called the replaced row. This row will be replaced in

the next solution by 15 units of X1. This row is also known as the pivot row.

(3) Developing Second Simplex Tableau: After choosing the entering and departing

variable, a second simplex tableau can be developed, providing an improved solution.

The first part of the new tableau to be developed is the X1 row. The X1 row of the new

tableau is computed as follows. A) Divide each number in the replaced row (S1 row) by

the intersectional element (2) of the replaced row i.e. pivot number

30/2 = 15, 2/2=1, ½=½ ½=½ 0/2=0

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Thus, the new X1 row would be: (15, 1, ½, ½, 0). These values appear in the second

simplex tableau (table 5.5).

4) New Values for rows other than pivot row: To compute the second tableau, we

compute new values for the remaining row by using the formula shown in the 4 th column

of the table5.4.

Table 5.4: Computation of New Values for the Rows other than Pivot Row.

Element in

old S2 row

(1)

Intersectional

element of S2 row

(2)

Corresponding element

in replacing row

(3)

New S2

= (Column 1 – (Column 2*Column3)

(4)

24 1 15 9

1 1 1 0

2 1 ½ 1 ½

0 1 ½ -1/2

1 1 0 1

Thus, the new S2 row will be (9, 0, 1 ½, -1/2, 1). These values appeared in the second row

of the table 5.5.

Table 5.5: Second Simplex Table

Cj Rs. 4 Rs. 3 Rs. 0 Rs. 0

Product Mix Quantity X1 X2 S1 S2

Rs. 4 X1 15 1 1/2 1/2 0

Rs. 0 S2 9 0 1 1/2 -1/2 1

Zj 60 Rs. 4 Rs. 2 Rs. 2 Rs. 0

Cj – Zj 0 1 -2 0

Zj value under quantity column was estimated to be Rs.60. Thus, the producer

could earn total profit of Rs. 60 from this solution or product mix. The existence of

positive number in the Cj-Zj row of table 5.5 indicates the existence of further improved

solution. Third simplex table has to develop by repeating the procedure discussed above

167

(III Developing Improved Solutions). This procedure has to continue as long as there

are/is positive number/s in the Cj-Zj row.

5.7. Self Review Questions

1. Define the concept of profit

2. What is slack variable?

3. Explain the concept of break even point

4. Distinguish between ‘Profiteering’ and ‘Profit-earning’

5. Explain the important steps involved in the simplex method of

linear programming problem

6. The following information is given by the cost accountant of X co.

Ltd. Bangalore for 2005

Sales 100000

Variable Cost 60000

Fixed Cost 30000

i) Calculate BEP and Margin of Safety

ii) The Effect of 10% increase in selling price

7. A firm producing either P or Q. It can produce one unit P by using 2 units of

chemicals and 1 unit of compound. Similarly it could produce one unit of Q by

using 1 unit of chemicals and 2 units of compound. Only 800 units of chemicals

and 200 units of compound are available in the firm. The profit per unit available

to the firm is Rs. 30 and Rs. 20 respectively. Given this information estimate the

optimum combination of P and Q to be produced by using the graphical method in

order to produce and earn maximum profit.

5.8 References/ Suggested Readings

1. Dominick Salvatore: “Managerial Economics”, McGraw-Hill International Editions,

Singapore

168

2. Varshney RL, and Maheshwari K.L: “Managerial Economics”, Sultan Chand & Sons,

New Delhi-110002

3. Sankaran: “ Managerial Economics”, Margham Publications, Madras

3. Dwivedi, D. N.: “Managerial Economics”, Vikas Publishing House Pvt. Ltd.,

Ghaziabad.

5. D.M.Mithani : “Managerial Economics: Theory and Applications”, Himalaya

Publishing House, Mumbai-400 004

169