Economic Analysis For Business
Economic Analysis For Business
Economic Analysis For Business
(FIRST YEAR-Semester-I)
BY:
dR. Rakesh KUMAR Bhati
Course Outcomes: On successful completion of the course the learner will be able to
CO# COGNITIVE ABILITIES COURSE OUTCOMES
CO103.1 REMEMBERING DEFINE the key terms in economics.
CO103.2 UNDERSTANDING EXPLAIN the reasons for existence of firms and their decision making goals.
CO103.3 APPLYING MAKE USE OF the basic concepts of Demand, Supply, Demand
Forecasting, Equilibrium and their determinants.
CO103.4 ANALYSING ANALYSE cost function and the difference between short-run and long-run
cost function and establish the REATIONSHIP between production function
and
CO103.5 ANALYSING cost function.
EXAMINE the effect of non-price factors on products and services of
monopolistic and oligopoly firms.
CO103.6 EVALUATING DESIGN competition strategies, including costing, pricing, product
differentiation, and market environment according to the natures of
products, the market structures and Business Cycles.
1. Managerial Economics: Concept of Economy, Economics, Microeconomics, Macroeconomics. Nature and Scope of
Managerial Economics, Managerial Economics and decision-making. Concept of Firm, Market, Objectives of Firm: Profit
Maximization Model, Economist Theory of the Firm, Cyert and March’s Behavior Theory, Marris’ Growth Maximisation Model,
Baumol’s Static and Dynamic Models, Williamson’s Managerial Discretionary Theory. (6+1)
2. Utility & Demand Analysis: Utility – Meaning, Utility analysis, Measurement of utility, Law of diminishing marginal
utility, Indifference curve, Consumer’s equilibrium - Budget line and Consumer surplus. Demand - Concept of Demand, Types
of Demand, Determinants of Demand, Law of Demand, Elasticity of Demand, Exceptions to Law of Demand. Uses of the
concept of elasticity. Forecasting: Introduction, Meaning and Forecasting, Level of Demand Forecasting, Criteria for Good
Demand Forecasting, Methods of Demand Forecasting, Survey Methods, Statistical Methods, Qualitative Methods, Demand
Forecasting for a New Products. (Demand Forecasting methods - Conceptual treatment only numericals not expected) (8+1)
3. Supply & Market Equilibrium: Introduction, Meaning of Supply and Law of Supply, Exceptions to the Law of Supply,
Changes or Shifts in Supply. Elasticity of supply, Factors Determining Elasticity of Supply, Practical Importance, Market
Equilibrium and Changes in Market Equilibrium. Production Analysis: Introduction, Meaning of Production and Production
Function, Cost of Production. Cost Analysis: Private costs and Social Costs, Accounting Costs and Economic costs, Short run
and Long Run costs, Economies of scale, Cost-Output Relationship - Cost Function, Cost-Output Relationships in the Short Run,
and Cost-Output Relationships in the Long Run.
4. Revenue Analysis and Pricing Policies: Introduction, Revenue: Meaning and Types, Relationship between
Revenues and Price Elasticity of Demand, Pricing Policies, Objectives of Pricing Policies, Cost plus pricing. Marginal cost pricing.
Cyclical pricing. Penetration Pricing. Price Leadership, Price Skimming. Transfer pricing. Price Determination under
Perfect Competition- Introduction, Market and Market Structure, Perfect Competition, Price-Output Determination
under Perfect Competition, Short-run Industry Equilibrium under Perfect Competition, Short-run Firm Equilibrium under
Perfect Competition, Long-run Industry Equilibrium under Perfect Competition, Long-run Firm Equilibrium under
Perfect Competition. Pricing Under Imperfect Competition- Introduction, Monopoly, Price Discrimination under
Monopoly, Bilateral Monopoly, Monopolistic Competition, Oligopoly, Collusive Oligopoly and Price Leadership, Pricing Power,
Duopoly, Industry Analysis. Profit Policy: Break Even analysis. Profit Forecasting. Need for Government Intervention in
Markets. Price Controls. Support Price. Preventions and Control of Monopolies. System of Dual Price.
5. Consumption Function and Investment Function: Introduction, Consumption Function, Investment Function, Marginal
efficiency of capital and business expectations, Multiplier, Accelerator. Business Cycle: Introduction, Meaning and Features,
Theories of Business Cycles, Measures to Control Business Cycles, Business Cycles and Business Decisions.
Suggested Text Books:
1. Managerial Economics, Peterson, Lewis, Sudhir Jain, Pearson, Prentice Hall
2. Managerial Economics, D. Salvatore, McGraw Hill, New Delhi.
3. Managerial Economics, Pearson and Lewis, Prentice Hall, New Delhi
4. Managerial Economics, G.S. Gupta, T M H, New Delhi.
5. Managerial Economics, Mote, Paul and Gupta, T M H, New Delhi.
Suggested Reference Books:
1. Managerial Economics, Homas and Maurice, Tata McGraw Hill
2. Managerial Economics - Analysis, Problems and Cases, P.L. Mehta, Sultan Chand Sons, New Delhi.
3. Managerial Economics, Varshney and Maheshwari, Sultan Chand and Sons, New Delhi.
4. Managerial Economics, D.M.Mithani
5. Managerial Economics, Joel Dean, Prentice Hall, USA.
6. Managerial Economics by H L Ahuja, S Chand & Co. New Delhi.
INTRODUCTION
The discovery of managerial economics as a separate course in management studies has been
attributed to three major factors:
1] The growing complexity of business decision-making processes, because of changing market
conditions and the globalization of business transactions.
2] The increasing use of economic logic, concepts, theories, and tools of economic analysis in business
decision-making processes.
3] Rapid increase in demand for professionally trained managerial manpower.
It should be noted that the recent complexities associated with business decisions has increased the
need for application of economic concepts, theories and tools of economic analysis in business decisions.
The reason has been that making appropriate business decision requires clear understanding of existing
market conditions market fundamentals and the business environment in general. Business decision-
making processes therefore, requires intensive and extensive analysis of the market conditions in the
product, input and financial markets. Economic theories, logic and tools of analysis have been developed for
the analysis and prediction of market behaviours. The application of economic concepts, theories, logic, and
analytical tools in the assessment and prediction of market conditions and business environment has
proved to be a significant help to business decision makers all over the globe.
Managerial economics comprises both micro- and macro-economic theories. Generally, the scope of
managerial economics extends to those economic concepts, theories, and tools of analysis used in analysing
the business environment, and to find solutions to practical business problems. In broad terms, managerial
economics is applied economics. The areas of business issues to which economic theories can be directly
applied are divided into two broad categories:
1. Operational or internal issues; and,
2. Environment or external issues.
Operational problems are of internal nature. These problems include all those problems which
arise within the business organization and fall within the control of management. Some of the basic internal
issues include: choice of business and the nature of product (what to produce); choice of size of the firm
(how much to produce); choice of technology (choosing the factor combination); choice of price (product
pricing); how to promote sales; how to face price competition; how to decide on new investments; how to
manage profit and capital; and, how to manage inventory.
Note that phases two and three are the most crucial in business decision-making. They put the
manager’s analytical ability to test and help in determining the appropriateness and validity of decisions in the
modern business environment. Personal intelligence, experience, intuition and business acumen of the
manager need to be supplemented with quantitative analysis of business data on market conditions and
business environment. It is in fact, in this area of decision-making that economic theories and tools of economic
analysis make the greatest contribution in business. If for instance, a business firm plans to launch a new
product for which close substitutes are available in the market, one method of deciding whether or not this
product should be launched is to obtain the services of a business consultant. The other method would be for
the decision-maker or manager to decide.
In doing this, the manager would need to investigate and analyze the following thoroughly:
a) production related issues; and, (b) sales prospects and problems.
With regards to production, the manager will be required to collect and analyze information or
data on:
(a) available production techniques;
(b) cost of production associated with each production technique;
(c) supply position of inputs required for the production process;
(d) input prices; (e) production costs of the competitive products; and,
(f) availability of foreign exchange, if inputs are to be imported.
Dr. Bhati Rakesh 4 | P a g e
Regarding the sales prospects and problems, the manager will be required to collect and analyse
data on:
(a) general market trends;
(b) the industrial business trends;
(c) major existing and potential competitors, as well as their respective market shares;
(d) prices of the competing products;
(e) pricing strategies of the prospective competitors;
(f) market structure and the degree of competition; and,
(g) the supply position of complementary goods.
The application of economic theories in solving business problems helps in facilitating decision-making
in the following ways:
First, it can give clear understanding of the various necessary economic concepts, including demand,
supply, cost, price, and the like that are used in business analysis.
Second, it can help in ascertaining the relevant variables and specifying the relevant data. For example,
in deciding what variables need to be considered in estimating the demand for two different sources of
energy, petrol and electricity.
Third, it provides consistency to business analysis and helps in arriving at right conclusions.
PROFIT MAXIMISATION
Usually, in economics, we assume firms are concerned with maximising profit. Higher profit means:
1. Higher dividends for shareholders.
2. More profit can be used to finance research and development.
3. Higher profit makes the firm less vulnerable to takeover.
4. Higher profit enables higher salaries for workers
Some important alternative objectives of business firms, especially of large business corporations are also
discussed.
The factors, which help in explaining these goals by the managers, are following:
Salary and other earnings of managers are more closely related to seals revenue than to profits.
Banks and financial corporations look at sales revenue while financing the corporation.
Trend in sale revenue is a good indicator of the performance of the business firm. It also helps in
handling the personnel problems.
Increasing sales revenue helps in enhancing the prestige of managers while profits go to the owners.
Managers find profit maximization a difficult objective to fulfill consistently over time and at the same
level. Profits may fluctuate with changing conditions.
Growing sales strengthen competitive spirit of the business firm in the market and vice versa.
In simple words, a firm’s growth rate is considered to be balanced when demand for its product and
supply of capital to the firm increase at the same rate. The two growth rates according to Marris, are translated
into two utility functions such as:
Manager’s utility function
Owner’s utility function
The manager’s utility function (Um) and owner’s utility function (Uo) may be specified as follows:
Um = f (salary, power, job security, prestige, status) and
Uo = f (output, capital, market-share, profit, public esteem).
Owner’s utility function (Uo) implies growth of demand for firms’ products and supply of capital.
Therefore, maximization of Uo mans maximization of demand for a firm’s products or growth of supply of
capital.
According to Marris, by maximizing these variables, managers maximize both their utility function and
that of the owner’s. The, managers can do so because most of the variables such as salaries status, job security,
power, etc., appearing in their own utility function and those appearing in the utility function of the owners
such as profit, capital market, share, etc. are positively and strongly correlated with the size of the firm. These
variables depend on the maximization of the growth rate of the firms. The managers, therefore, seek
to maximize a steady growth rate. Marris’s theory, though more accurate and sophisticated than Baumol’s sales
revenue maximization has its own weaknesses. It fails to deal satisfactorily with the market condition of
oligopolistic interdependence. Another serious shortcoming is that it ignores price determination, which is the
main concern of profit maximization hypothesis. In tbe opinion of many economists, Marris’s model too, does
not seriously challenge the profit maximization hypothesis.
Like Baumol and Marris, Williamson argues that managers are very careful in pursuing the objectives
other than profit maximization The managers seek to maximize their own utility function subject to a
minimum level of profit. Managers’ utility function (U) is expressed below:
U = f(S, M, ID)
where,
S = additional expenditure on staff
M = Managerial emoluments
ID = Discretionary investments
According to Williamson’s hypothesis, managers maximize their utility function subject to a satisfactory
profit. A minimum profit is necessary to satisfy the shareholders and also to secure the job of managers. The
utility functions which managers seek to maximize include both quantifiable variables like salary and slack
earnings anti non-quantitative variable such as prestige power, status, job security, professional excellence, etc.
The non-quantifiable variables are expressed in order to make them work effectively in terms of expense
preference defined as satisfaction derived out of certain types of expenditures.
Like other alternative hypotheses, Williamson’s theory too suffers from certain weaknesses. His model
fails to deal with the problem of oligopolistic interdependence. Williamson’s theory is said to hold only where
rivalry between firms is not strong. In case there is strong rivalry, profit maximization is claimed to be a more
appropriate hypothesis. Thus, Williamson’s managerial utility function too does not offer a more satisfactory
hypothesis than profit maximization.
Cyert-March hypothesis is an extension of Simon’s hypothesis of firms’ satisfying behavior Simon had
argued that the real business world is full of uncertainties. Accurate and adequate data are not readily
available. If data are available, managers have little time and ability to process them. Managers also work under
a number of constraints. Under such conditions it is not possible for the firms to act in terms of consistency
assumed under profit maximization hypothesis. Nor do the firms seek to maximize sales and growth. Instead
they seek to achieve a satisfactory profit or a satisfactory growth and so on. This behavior of business firms is
termed as satisfaction behavior.
Cyert and March added that, apart from dealing with uncertainty, managers need to satisfy a variety of
groups of people such as managerial staff, labor, shareholders, customers, financiers, input suppliers,
accountants, lawyers, etc. All these groups have conflicting interests in the business firms. The manager’s
responsibility is to satisfy all of them. According to the Cyert-March, “firm’s behavior is satisfying behavior
which implies satisfying various interest groups by sacrificing firm’s interest or objectives.” The basic
assumption of satisfying behavior is that a firm is an association of different groups related to various activities
of the firms such as shareholders, managers, workers, input supplier, customers, bankers, tax authorities, and
so on. All these groups have some expectations from the firm, which are needed to be satisfied by the business
firms. In order to clear up the conflicting interests and goals, managers form an objective level of the firm by
taking into consideration goals such as production, sales and market, inventory and profit.
These goals and objective level are set on the basis of the managers past experience and their
assessment of the future market conditions. The objective level is also modified and revised on the basis of
achievements and changing business environment. But the behavioral theory has been criticized on the
following grounds:
Though the behavioral theory deals with the activities of the business firms, it does not explain the
firm’s behavior under dynamic conditions in the long run.
It cannot be used to predict the firm’s activities in the future.
This theory does not deal with the equilibrium of the business industry.
This theory fails to deal with interdependence of the firms and its impact on firms behavior.
Rothschild suggested another alternative objective and alternative to profit maximization to a business
firm. According to Rothschild, the primary goal of the firm is long-run survival. Some other economists have
suggested that attainment and retention of a market share constantly, is an additional objective of the business
firms. The managers, therefore, seek to secure their market share and long-run survival. The firms may seek
to maximize their profit in the long run though it is not certain.
The evidence related to the firms to maximize their profits in the long run, is not certain. Some
economists argue that if management is kept separate from the ownership, the possibility of
profit maximization is reduced. This means that only those firms with the objective of profit maximization can
survive in the long run. A business firm can achieve all other subsidiary goals easily by maximizing its profits.
The motive of business firms behind entry-prevention is also to secure a constant share in the market. Securing
constant market share also favors the main objective of business firms of profit maximization.
UTILITY:
Why do you buy the goods and services you do? It must be because they provide you with satisfaction—you
feel better off because you have purchased them. Economists call this satisfaction utility. The term utility refers
to the want satisfying power of a commodity or service assumed by a consumer to constitute his demand for
that commodity or service.
• Utility is synonymous with "Pleasure", "Satisfaction" & a Sense of Fulfillment of Desire.
• Utility “WANT SATISFYING POWER" of a Commodity.
• Utility is a Psychological Phenomenon.
• Utility refers to Abstract Quality whereby an Object serves our Purpose. - Jevons
• Utility is the Quality of a Good to Satisfy a Want. - Hibdon
• Utility is the Quality in Commodities that makes Individuals want to buy them. Mrs. Robinson
FEATURES OF UTILITY:
• Utility is Introspective or Subjective: It deals with the Mental Satisfaction of a Man. For Example,
Liquor has Utility for a Drunkard but for a Teetotaler, it has no Utility.
• Utility is Relative: Utility of a Commodity never remains same. It varies with Time, Place & Person. For
Example, Cooler has utility in summer but not during Winter.
• Utility is Not Essentially Useful: A Commodity having Utility need not be Useful. E.g., Liquor is not
useful, but it Satisfies the Want of an Addict thus have Utility for Him.
• Utility is Ethically Neutral: Utility has nothing to do with Ethics. Use of Liquor may not be good from
the Moral Point of View, but as these Intoxicants Satisfy wants of the Drunkards, they have utility
THE LAW OF MAXIMUM SATISFACTION / THE LAW OF EQUI-MARGINAL UTILITY/ THE LAW OF
SUBSTITUTION:
This law is developed by H.H Gossen so it is also called the second law of Gossen. We know human wants are
unlimited but the resources to fulfill the wants are limited. A rational consumer always tries to maximize his
satisfaction by spending his limited money income. Consumer can maximize his satisfaction if he is able to
equalize the marginal utility derived from the consumption of different units of several commodities by
spending his all limited money income so that this law is known as law of maximum satisfaction or law of equi-
marginal utility.
This law is also known as law of substitution because consumer can maximize his/her satisfaction when he/she
substitutes the commodities having high marginal utility instead of commodities having the low marginal
utility. Mathematically it is expressed as:
CONSUMER SURPLUS
Dupuit originated the concept of consumer’s surplus. But, it was Marshall who popularized it by
presenting it in a most refined way. Marshall viewed that when a consumer buys a commodity, his satisfaction
derived from derived from it may be in excess of the dissatisfaction he has experienced in parting with money
for paying its price. This excess of satisfaction is called” consumer’s surplus”.
A consumer is willing to pay the price for a commodity upto its marginal utility compared with the
marginal utility of money which he has to pay. If the marginal utility of a commodity is high which is actual
market price is low, the consumer derives extra satisfaction, that is, consumer surplus. Consumer surplus
therefore can be measured as the difference between the maximum price the consumer is willing to pay for a
commodity and the actual market price charged for it.
As Marshall puts it, “the excess of the price which a consumer would be willing to pay rather than go
without the things over that which he actually does pay, is the economic measure of this surplus of satisfaction.
It may be called consumer’s surplus.”
This concept is based on the law of diminishing marginal utility. Prof. Marshall applies the phrase’
consumer’s surplus’ to the difference between the sum which measures total utility and that which measures
total exchange value(price paid). For, while the price that he has to pay for each unit is equal to the utility of
the marginal unit, the utility of each of the earlier units is more than that of the last. Therefore, he gains more
utility than he loses by making the payments. His gain is more than the loss. This is the source of his surplus
satisfaction. Thus: Consumer surplus=price prepared – actual price paid
Measurement of consumer surplus
Unit of marginal market consumer surplus
Commodity utility price price prepared-actual
X m.u market price
1 35 10 35-10 = 25
2 30 10 30-10 = 20
3 22 10 22-10 = 12
4 10 10 10-10 = 0
Total 4 units Total price/mu 57
Utility = 40
97
Thus,
CS = TU – (P x Q) 97 - (10 x 4) 97 – 40 CS = 57
Where, CS: Consumer surplus , TU: Total utility
P: Price , Q: Quantity
Consumer surplus can be diagrammatically represented:
If OP is price, OQ is the units purchased MU of OQ=price OP
total money paid=OP x OQ therefore, price paid OPQR
Price prepared to pay = total utility OMRQ
Therefore, OMRQ – OPRQ = MRP (CONSUMER SURPLUS)
ASSUMPTIONS:
This concept is based on the following assumptions.
(1) Cardinal measurement of utility.
(2) Constant marginal utility of money.
(3) The commodity in question does not have substitutes.
(1) The concept of consumer’s surplus does emphasize the amenities that we enjoy in a modern society.
Much of the consumer’s surplus, we enjoy depends on our surroundings and the opportunities of
consumption available to us, example, amenities of life in America as compared to Central Africa. It thus
clarifies conjectural importance. The concept enables us to compare the advantages of environment
and opportunities or conjectural benefits. The larger the consumer’s surplus, the better off is the
people. The concept, thus, serves as an index of economic betterment.
(2) It is useful in price policy of a monopoly firm. The monopolist can put a higher price on the goods if
consumer’s surplus is high, without causing any reduction in sales.
(3) It is of significance to the exchequer in determining indirect taxation. The finance minister can easily
levy more taxes where consumer’s surplus is high.
(4) By estimating the difference in consumer’s surplus resulting from a change in price, we can know and
compare the effects of a given change in the price of any commodity on the different classes of people.
It is, therefore, widely adopted in welfare economics.
(5) Gains from international trade can be measured in terms of consumer’s surplus obtained in the
imported goods.
ASSUMPTIONS:
Indifference curve approach has the following main assumptions:
(1) Rational Consumer: It is assumed that the consumer will behave rationally. It means the consumer
would like to get maximum satisfaction out of his total income.
(2) Diminishing Marginal rate of Substitution: It means as the stock of a commodity increases with the
consumer, he substitutes it for the other commodity at a diminishing rate.
(3) Ordinal Utility: A consumer can determine his preferences on the basis of satisfaction derived from
different goods or their combinations. Utility can be expressed in terms of ordinal numbers, i.e., first,
second etc.
(4) Completeness: In a comparison of any two bundles, A = (xA, yA) and B = (xB, yB), an individual should
be able to say either (i) “I prefer A to B”; or (ii) “I prefer B to A”; or (iii) “I am indifferent between A and
B”, i.e., “I like equally A and B”. This property of preferences is called completeness. Essentially the
consumer is not allowed to say “I don’t know” or “I am not sure.”
(5) Transitivity: If a person states, “I prefer A to B,” as well as “I prefer B to C,” then he/she also has to prefer
A to C. This assumption says that preferences are consistent, so that comparisons between bundles A and C
are consistent with comparisons between bundles A and B and between B and C. Transitivity in indifference
Indifference curves where Goods X and Y are Indifference curves for perfect complements
perfect substitutes. The gray line perpendicular X and Y. The elbows of the curves are
to all curves indicates the curves are mutually collinear.
parallel.
Given convex and smooth indifference curves, the consumer maximizes utility at a point A, where the slope of
the indifference curve (MRS) is equal to the slope of the budget constraint. At the chosen point A we have
tangency of the indifference curve and the budget constraint line (Figure),
px/py = MRS = MUx/MUy, i.e., MUx/px = MUy/py.
This means that the consumer receives equal satisfaction for the last dollar spent in each good.
Slope of indifference curve = (Y1-Y0)/(X1-X0)
BREAKING UP PRICE EFFECT INTO INCOME AND SUBSTITUTION EFFECT (WITH DIAGRAM)
A consumer chooses between good 1 and good 2. Giver her income, m, the prices of the goods, p 11 and p2, and
her preferences, she chooses that basket of goods that maximizes her utility. In Figure its means that she
initially chooses point A. If the price of good 1 falls from p11 to p12, the budget line rotates outwards from BL1 to
BL2. When the consumer chooses a new basket, she ends up in point B.
Her consumption of good 1 has consequently increased from q11 to q12, which is the total effect. It consists of
the income effect (i.e. on the increase in purchasing power) and substitution effect (i.e. on the change in the
slope of the budget line).
If the relative prices change, the slope of the budget
line changes. All budget lines that have the same
relative prices as BL2 must also have the same slopes
as that budget line. Furthermore, for the consumer to
have the same utility as before, she must consume on
the same indifference curve as she did before, i.e. on
I1. We therefore construct an imaginary budget line,
BL*, that has the same slope as BL2 and that, just as
BL1, is a tangent to I1. (However, since it has a
different slope than BL1, it must touch I1 at different
point than that budget line does.)
If this had been the real situation, the consumer
would have chosen point C. She had then increased
her consumption of good 1 from q11 to q1*. At the
same time, she would have decreased her consumption of good 2. This substitution from good 1 to good 2
depends on the change in the relative price, but it does not result in any change in the level of utility. This part
is the substitution effect.
The remaining change, from q1 * to q12, is the part that depends on the increase in the consumer’s purchasing
power. As she moves to a higher indifference curve, from I1 to I2, she increases her utility. This part is the
income effect.
LAW OF DEMAND:
The law of Demand is known as the “first law in market”. Law of demand shows the relation between price and
quantity demanded of a commodity in the market. Law of Demand states that the quantity demanded of a good
or service varies inversely with its price. In other words, when the price goes up, quantity demanded goes
down. Likewise, when the price goes down, quantity demanded goes up.
In the words of Marshall “the amount demanded increases with a fall in price and diminishes with a rise in
price”. According to Samuelson, “Law of Demand states that people will buy more at lower price and buy less at
higher prices”. So the relationship described by the law of demand is an inverse or negative relationship
because the variables (price and demand) move in opposite direction. It shows the cause and effect relationship
between price and quantity demand. The law of demand holds only in the short run.
ELASTICITY OF DEMAND
The concept of price-elasticity of demand was first of all introduced in economics by Dr. Marshall. It
refers to the degree of responsiveness of quantity demanded to the changes in the determinants of demand.
According to Alfred Marshall: "Elasticity of demand may be defined as the percentage change in quantity
demanded to the percentage change in price."
According to Kenneth Boulding: "Elasticity of demand measures the responsiveness of demand to changes in
price."
As a formula, this is: ε = Percentage Change in Quantity Demanded / Percentage Change in Price
It measures how much buyers respond to a percentage change in the price. Another way to write the formula is:
ε = (dq/q) / (dp/p)
This can be written as: ε = p .dq / q dp
For example: Quantity demanded is 20 units at a price of Rs.500. When there is a fall in price to Rs. 400 it
results in a rise in demand to 32 units. Therefore the change in quantity demanded is12 units resulting from the
change in price of Rs.100.
The Price Elasticity of Demand is = 500 / 20 x 12/100 = 3
Note that the law of demand implies that dq/dp < 0, and so ε will be a negative number. In some contexts, it is common to
introduce a minus sign in this formula to make this quantity positive. Slope (dq/dp) and elasticity (ε) are two different
concepts.
With linear demand curves, elasticity changes along the demand curve, however its slope does not. Elasticity is concerned
with responses in one variable to changes in the other variable. The slope of the curve is concerned with values of the
respective variables at each position along the curve (i.e., its' shape and direction). The elasticity can be measured
between two points on a demand curve (called arc elasticity) or on a point (called point elasticity).
DEMAND FORECASTING:
Today business enterprises are working under the conditions of uncertainties. Uncertainties can be
minimized through planning and forecasting. The success of a business firm depends upon its ability to forecast
future events. Future is uncertain. There is great deal of uncertainty with regard to demand. Since the demand
is uncertain, production, cost, revenue, profit etc. are also uncertain. Through forecasting it is possible to
minimise the uncertainties. Forecasting simply refers to estimating or anticipating future events. It is an
attempt to foresee the future by examining the past. Thus demand forecasting means estimating or anticipating
future demand on the basis of past data.
(A) SURVEY METHODS: Under this method surveys are conducted to collect information about the future
purchase plans of potential consumers. Survey methods help in obtaining information about the desires,
likes and dislikes of consumers through collecting the opinion of experts or by interviewing the
consumers. Survey methods are used for short term forecasting.
Important survey methods are (a) consumers interview method, (b) collective opinion or sales force
opinion methodic) experts opinion method, (d) consumers clinic and (f) end use method.
INTRODUCTION: SUPPLY
The supply of a good or service refers to the quantities of a good or a service that producers are willing
and able (ready) to produce (sell) at different prices in a given time period, ceteris paribus. Supply is the
“Quantity of a commodity, which a seller offers for sale, in the market, at a particular price and at a particular
time”.
The definition of supply includes the following three things:
(i) The quantity of a commodity offered for sale by a seller.
(ii) The price of the commodity given in the market at which the seller is willing to sell that quantity of the
commodity.
(iii) The time period during which the seller is willing to sell that quantity of the commodity.
Supply is derived from a producer's desire to maximize profits. Profit is the difference between revenues
and costs.
Resources and technology determine what it is possible to produce. Supply reflects a decision about which
technologically feasible items to produce.
Supply is an expression of seller’s plans or intentions – an offer to sell – not a statement of actual sales.
Supply Schedule: is a table showing how much of a commodity, firms can sell at different prices.
Individual Supply Schedule It is a table showing different quantities of a commodity that an individual
firm is ready to sell at different prices.
Market Supply Schedule It is a table showing different quantities of a commodity that all the firms in a
market are willing to sell at different prices of that commodity at a given time.
Supply Curve It is a graphical presentation of supply schedule, showing positive relationship between price
and quantity supplied of a commodity. A graphical representation of how much of a commodity a firm sells at
different prices. The supply curve is upward sloping from left to right. Therefore the price elasticity of supply
will be positive.
Factors are responsible for upward slope of the supply curve:
(i) A rise in price of the commodity causes rise in profits, as a result firms are induced to supply more
quantity of the commodity to increase profit.
(ii) A rise in price of the commodity induces the seller to dispose of at least a part of his stock. The
reverse happens when there is a fall in price of the commodity.
(iii) An increase in the price of the commodity causing higher profit attracts the new firms to enter the
market and this adds to the supply of the commodity leading to more quantity supplied at a higher
price.
DETERMINANTS OF SUPPLY:
1. The cost of factors of production: Cost depends on the price of factors. Increase in factor cost increases
the cost of production, and reduces supply.
2. The state of technology: Use of advanced technology increases productivity of the organization and
increases its supply.
3. External factors: External factors like weather influence the supply. If there is a flood, this reduces
supply of various agricultural products.
4. Tax and subsidy: Increase in government subsidies results in more production and higher supply.
5. Transport: Better transport facilities will increase the supply.
6. Price: If the prices are high, the sellers are willing to supply more goods to increase their profit.
7. Price of other goods: The price of other goods is more than ‘X’ then the supply of ‘X’ will be increased.
SUPPLY FUNCTION: Supply function studies the functional relationship between supply of a commodity and
its various determinants. It is expressed in the following equation: Sx = F (Px , Pr, Nf, G, Pf, T, Ex, GP)
Where,
(i) Own price of a commodity (Px) (vi) State of technology (T)
(ii) Price of related goods (Pr) (vii) Business confidence or expectation (Ex)
(iii) Number of firms in the industry (N f) (viii) Government policy (relating to taxation and
(iv) Goal of the firm (G) subsidies) (Gp)
(v) Price of factors of production (Pf)
LAW OF SUPPLY:
The law of supply states that ceteribus paribus (Latin for 'assuming all else is held constant'), the quantity
supplied for a good, rises as the price rises. The law of supply shows a positive (direct) relationship between
price and quantity supplied. The quantity of a good supplied in a given time period increases as its price
increases, ceteris paribus.
The law of supply results from the general tendency for the marginal cost of producing a good or service to
increase as the quantity produced increases. Producers are willing to supply only if they at least cover their
marginal cost of production. Because of the law of supply, supply curve has positive slope (is upward sloping.)
It states the positive relationship between price and quantity supplied, assuming no changes in other
factors.
It is a qualitative statement, as it indicates the direction of change in the quantity supplied, but it does not
indicate the magnitude of change.
It does not establish any proportional relationship between change in price and the resultant change in
quantity supplied.
Law is one sided as it explains only the effect of change in price on the supply, and not the effect of change
in supply on the price.
1. The supply curve of rare goods (such as the artwork of a dead painter) or non-reproducible goods is a
vertical straight line. An unchanged quantity is offered for sale at all possible prices. In this case, the
supply curve becomes perfectly inelastic. Land is also completely inelastic in supply.
2. The law of supply breaks down in the case of labour
supply curve. Labour supply curve is backward
bending due to the operation of income effect and
substitution effect of wage rate changes. Below the
wage rate OW1, as wage rate rises, supply of labour
tends to rise. Here substitution effect is stronger than
the income effect. But beyond OW1 wage rate, any rise
in it will cause labour to work less and will induce him
to take more leisure. Thus, income effect becomes
stronger than the substitution effect. As a result, the
supply curve of labour becomes backward bending.
3. If firms anticipate that the product prices will fall much
in the near future, they will sell more now just to clear
their stocks of goods. Such possibility may arise in the short run.
4. The supply curve may be negative sloping in the share market. As the share market is characterized by
uncertainty, people anticipate the change in prices of shares. When the price of a share falls, people may
expect that its price will fall further.
5. Perishable goods such as fruits, sea produce, and flowers have very short shelf life and they need to be
made available in the market before they perish. So for such goods the sellers cannot simply wait for a
longer time and supply these in the market even when the prices are not rising.
It is the responsiveness of quantity supplied due to change in price of own commodity. It is calculated as the
percentage change in quantity supplied caused by a given percentage change in price of the commodity.
Price elasticity of supply (Es) = Percentage Change in quantity supplied / Percentage change in Price
Where,
1. Percentage change in Quantity supplied
= Change in Quantity Supplied (∆Q) / Initial Quantity Supplied (Q) x 100
2. Change in Quantity (∆Q) = New Quantity (Q1) – Initial Quantity (Q)
3. Percentage change in Price = Change in Price (∆P) / Initial Quantity (P) × 100
4. Change in Price (∆P) = New Price (P1) – Initial Price (P)
ΔQ
100
Percentage Change in Quantity Supplied Q Q P
E8 =
Percentage Change in Pr ice ΔP P Q
100
P
1] Nature of the commodity: If the commodity is perishable in nature then the elasticity of supply will be
less. Durable goods have high elasticity of supply.
2] Time period: If the operational time period is short then supply is inelastic. When the the production
process period is longer the elasticity of supply will be relatively elastic.
3] Scale of production: Small scale producer’s supply is inelastic in nature compared to the large producers.
4] Size of the firm and number of products: If the firm is a large scale industry and has more variety of
products then it can easily transfer the resources. Therefore supply of such products is highly elastic.
5] Natural factors: Natural calamities can affect the production of agricultural products so they are relatively
inelastic.
6] Nature of production: If the commodities need more workmanship, or for artistic goods the elasticity of
supply will be high.
Apart from the above mentioned factors future expectations of the market, natural resources of the country and
government controls can also play a role in determining supply of a good. In the long run, supply is affected by
cost of production. If costs are rising, some of the existing producers may.
Production theory generally deals with quantitative relationships, that is, technical and technological
relationships between inputs, especially labour and capital, and between inputs and outputs. An input is a good
or service that goes into the production process. As economists refer to it, an input is simply anything which a
firm buys for use in its production process. An output, on the other hand, is any good or service that comes out
of a production process.
Economists classified inputs as (i) labour; (ii) capital; (iii) land; (iv) raw materials; and, (v) time. These
variables are measured per unit of time and hence referred to as flow variables. In recent times,
entrepreneurship has been added as part of the production inputs, though this can be measured by the
managerial expertise and the ability to make things happen.
Inputs are classified as either fixed or variable inputs. Fixed and variable inputs are defined in both
economic sense and technical sense. In economic sense, a fixed input is one whose supply is inelastic in the
short run. In technical sense, a fixed input is one that remains fixed (or constant) for certain level of output.
A variable input is one whose supply in the short run is elastic, example, labour, raw materials, and the like.
Users of such inputs can employ a larger quantity in the short run. Technically, a variable input is one that
changes with changes in output. In the long run, all inputs are variable.
Production refers to the manufacturing of goods and services with the use of various resources such as
labor, plant and machinery, land, raw materials etc. For example: when a firm produces cars or when a bank
produces financial services, the activity is called production. Hence, production includes making of goods as
well as services, using various inputs or resources, which people can buy and utilize.
Production means transforming inputs (Labour, Machines, Raw materials etc.) into an output.
“Production is the process by which the resources (input) are transformed into a different and more useful
commodity. Various inputs are combined in different quantities to produce various levels of output.”
CREATION OF UTILITY:
(i) Time Utility: Utility of a commodity changes from time to time. For example’ an umbrella has immense
utility in rainy season, but has no utility or relative less utility during winter time.
(ii) Form Utility: Utility of a commodity changes with the change in shape, size and formation.
PRODUCTION FUNCTION
Production function is a tool of analysis used in explaining the input-output relationship. It describes
the technical relationship between inputs and output in physical terms. In its general form, it holds that
production of a given commodity depends on certain specific inputs. In its specific form, it presents the
quantitative relationships between inputs and outputs. A production function may take the form of a schedule,
a graph line or a curve, an algebraic equation or a mathematical model. The production function represents the
technology of a firm.
An empirical production function is generally so complex to include a wide range of inputs: land, labour,
capital, raw materials, time, and technology. These variables form the independent variables in a firm’s actual
production function. A firm’s long-run production function is of the form: Q = f(Ld, L, K, M, T, t)
where Ld = land and building; L = labour; K = capital; M = materials; T = technology; and, t = time.
For sake of convenience, economists have reduced the number of variables used in a production
function to only two: capital (K) and labour (L). Therefore, in the analysis of input-output relations, the
production function is expressed as: Q = f(K, L) represents the algebraic or mathematical form of the
production function. It is this form of production function which is most commonly used in production analysis.
As implied by the production function, increasing production, Q, will require K and L, and whether the firm can
increase both K and L or only L will depend on the time period it takes into account for increasing production,
that is, whether the firm is thinking in terms of the short run or in terms of the long run. Economists believe
that the supply of capital (K) is inelastic in the short run and elastic in the long run. Thus, in the short run firms
can increase production only by increasing labour, since the supply of capital is fixed in the short run. In the
long run, the firm can employ more of both capital and labour, as the supply of capital becomes elastic over
time. In effect, there exists two types of production functions:
The short-run production function; and, The long-run production function
COST ANALYSIS:
When commodities and services are produced, various expenses have to be incurred, e.g., purchase of raw
materials, payment to labour, landlord, capitalist, etc. The sum total of the expenses incurred plus the normal
profit expected by the producer is called the cost of production. The various concepts of cost are discussed
below:
1] Nominal Cost and Real Cost: Nominal cost is the money cost of production. The real costs of production
are the pain and sacrifices of labour involved in the process of production.
2] Explicit and Implicit costs: Explicit costs are the accounting costs or contractual cash payments which
the firm makes to other factor owners for purchasing or hiring the various factors. Implicit costs are the
costs of self-owned factors which are employed by the entrepreneur in his own business. These implicit
costs are the opportunity costs of the self-owned and self-employed factors of the entrepreneur, that is, the
money incomes which these self-owned factors would have earned in their next best alternative uses.
3] Accounting Costs and Economic Cost: Accounting costs are the actual or explicit costs which are paid
by the entrepreneurs to the owners of hired factors and services. On the other hand, economic costs not
only include the explicit costs but also the implicit costs of the self-owned factors or resources which are
used by the entrepreneur in his own business.
4] Outlay cost and Opportunity Cost: Outlay costs involve actual expenditure of funds on, say, wages,
materials, rent, interest, etc. The opportunity cost (or transfer earnings) of any good is the expected return
from the next best alternative good that is forgone or sacrificed. For example, if a farmer who is producing
wheat can also produce potatoes with the same factors. Then, the opportunity cost of a quintal of wheat is
the amount of output of potatoes given up.
5] Business Cost and Full Cost: Business costs include all the expenses which are incurred in carrying out a
business. The concept of business cost is similar to the accounting or actual cost. The concept of Full cost
includes two other costs: the opportunity cost and normal profit. Normal profit is a necessary minimum
earning which a firm must get to remain in its present occupation.
6] Private costs and Social Costs: Private costs are the economic costs which are actually incurred or
provided for by an individual or a firm. It includes both explicit and implicit costs. Social cost, on the other
hand, implies the cost which a society bears as a result of production of a commodity. Social cost includes
both private cost and the external cost. External cost includes (a) the cost of free goods or resources for
which the firm is not required to pay for its used, e.g., atmosphere, rivers, lakes etc. (b) the cost in the form
of ‘disutility’ caused by air, water, and noise pollution, etc.
7] Total, Average and Marginal Costs: Total cost refers to the total outlays of money expenditure, both
explicit and implicit on the resources used to produced a given output. Average cost is the cost per unit of
output which is obtained by dividing the total cost (TC) by the total output (Q), i.e., TC/Q = average cost.
Marginal cost is the addition made to the total cost as a result of producing one additional unit of the
product. Marginal cost is defined as change in TC/ change in Q.
8] Fixed Costs and Variable Costs: Fixed costs are the expenditure incurred on the factors such as capital,
equipment, plant, factory building which remain fixed in the short run and cannot be changed. Therefore,
fixed costs are independent of output in the short run i.e., they do not vary with output in the short run.
Even if no output is produced in the short run, these costs will have to be incurred. Variable costs are costs
incurred by the firms on the employment of variable factors such as labour, raw materials, etc., whose
amount can be easily increased or decreased in the short run. Variable costs vary with the level of output in
the short run. If the firm decided not to produce any output, variable costs will not be incurred.
9] Short-run and Long-run Cost: Short-run costs are the costs which vary with the change in output, the
size of the firm remaining the same. Short-run costs are the same as variable costs. On the other hand, long-
run costs are incurred on the fixed assets, like plant, building, machinery, land etc. Long-run cost are the
same as fixed-costs. However, in the long-run even the fixed costs become variable costs as the size of the
firm or scale or production is increased.
Definition of Short Run: Short run is a period of time over which at least one factor must remain fixed. For
most of the firms, the fixed resource or factors which cannot be increased to meet the rising demand of the
good is capital i.e., plant and machinery.
SHORT RUN COSTS OF A FIRM IS NOW EXPLAINED WITH THE HELP OF A SCHEDULE :
The short run cost data of the firm shows that total fixed cost TFC (column 2) remains constant at100/-
regardless of the level of output. The column 3 indicates variable cost which is associated with the level of
output. Total variable cost is zero when production is zero. Total variable cost increases with the increase in
output. The variable does not increase by the same amount for each increase in output. Initially the variable
cost increases by a smaller amount up to 3rd unit of output and after which it increases by larger amounts.
Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for each level of output.
The rise in total cost is more sharp after the 4th level of output. The concepts of costs, i.e., (1) total fixed cost (2)
total variable cost and (3) total cost can be illustrated graphically.
ECONOMIES OF SCALE:
Internal economies of scale are those which arise from the growth of the firm independently of what is
happening to other firms. The broad divisions of internal economies of scale are
(1) Technical Economies (2) Marketing Economies (3) Financial Economies (4)Risk Bearing Economies.
EXTERNAL ECONOMIES:
In the words of Cairn cross, "External economies are those which are shared in by a number of firms or
industries when the scale of production in any industry or group of industries increases. They are not
monopolised by a single firm when it grows in size, but are conferred on it when some other firms grow larger.'
External economies of scale occur when a firm benefits from lower unit costs as a result of the whole industry
growing in size. The main types are:
(1) Economies of localization: All firms should be localized to have economies. Different production
department should be located at one place. This gives advantage in transportation and in timely labour
utilization in production.
(2) Economies of information and technical market intelligence: Industry enjoys research advantage,
when Management can get whatever the information they want with in short time when firms allocated
at one place.
(3) Economies of vertical integration: Some industries rather than producing spare parts by themselves,
they are purchasing from outside companies. This happens when company feels that buying of parts is
cheaper than they produce by themselves.
(4) (Make or Buy decision) E.g.: TATA Company purchased gear box for cars from kinetic Company,
Mahindra cars purchasing engine from Renault Company.
(5) Economies of Bi products: The firm using one raw material for manufacturing different other
products can give more returns (profits) to the firm. E.g. Amul India, Company producing different food
products from milk.
PRICING POLICIES
Pricing means the process of selecting the pricing objectives, determining the possible range of prices,
developing price strategies, setting the final price, and implementing and controlling pricing decision. The
determination of price is very important and crucial decision. It affects all parties involved in the production,
distribution, and consumption of goods. Price affects the volume of production and the amount of profit. It is a
source of income to distributors.
According to M.J. Jones and S.W. Jetty, “Pricing begins with an understanding of the corporate mission,
target markets, and the marketing objectives; then pricing objectives are developed; next management
estimates as to extent of flexibility in establishing prices by studying costs and profits internally and demand
and competition externally; prices are, then set between these two extreme ends by deciding price strategies in
the light of objectives so set; specific methods are used to set prices; final aspects in implementation and
control that includes effective monitoring to get feedback on consumer response and competitive reaction.”
According to W.J.Stanon, “Pricing is the functions of determining the products value in monetary terms.”
IMPORTANCE OF PRICING
The importance of pricing has been increasing substantially in the recent years. The role of the price is
crucial not only in the national economy but also in the marketing sector, especially to the marketing
organization or executives. Pricing is important to the economy, to the organization and to the customers. Some
of the importance’s of the pricing in the business can be :
(1) It is an effective tool for product differentiation & sales volume It helps to deal with market competition,
inter-firm rivalry, inflation in the economy etc.
(2) It acts as a tool to measure and compare products easily and qualitatively.
(3) It governs the type and quality of customers. It affects –
(4) The marketing programme
(5) Alteration of resources
(6) Consumer’s perception of product
(7) It regulates –
a. Promotional activities
b. Extent of advertising
c. New product development
d. Improvement of product in terms of Quality, Sales volume / Revenue
Mark-up / Cost plus pricing – Selling price includes total cost plus mark-up /margin that the firm
desires.
Mark up Price = Unit cost (VC + FC)/(1 – desired return on sale)
Full cost or Absorption cost pricing – Selling Price includes full cost of production and sales plus a
mark-up required (desired) by the firm. It makes use of standard costing techniques. The cost includes –
Fixed Cost + Variable Cost + Selling and administrative cost + Advertisement cost
Break even or Target return pricing – Firm determines the breakeven point i.e. the volume of sales
required to reach a no profit, no loss situation then sets prices in order to achieve a certain level of
return on investment.
T.R.P = Unit Cost + (Desired return X Invested Capital)/Unit Sales
What the traffic can bear – The seller sets the maximum price that the buyers are willing to pay under
given circumstances.
Skimming Pricing – The seller sets a relatively high price when the product is introduced and then
lowers the price over time.
Penetration Pricing – The product is introduced at low prices initially and the price is increased
subsequently with increase in demand and market share.
Going rate or parity pricing – Price is determined on the basis of price of competitor’s product price is
set similar to the price of competitor’s product.
Discount Pricing – Price of the product is set below the price of competitor’s product.
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Premium Pricing – Price is set above the price charged by the competitors for similar product.
Tender / Sealed bid pricing – A contract or tender for the production of the product is floated in the
market and many parties submit their proposals. The party with the lowest bid or quote gets the tender
and the quoted amount is the price.
Differentiated pricing – Different prices are charged from different customers on the basis of –
1] Customer segments
2] Time
3] Location/Area
4] Product Quantity
5] Product attributes
Affordability / Social welfare – In case of essential commodities, prices are set in such a way that all
sections of people in the society can afford it. Price may also be below the cost of product due to
subsidies provided by the government.
PRICING STRATEGIES
Product line pricing – Prices are set on the basis of well established price points of other products in
the product line.
Optional Pricing – A base price is set for the basic product and prices are set for optional features,
services along with the main product.
Bundle pricing – Sellers offer a bundle or package of different products or services for a lower price
than they would charge if the customer bought all of them separately.
Penetration Pricing – The seller tries to penetrate the market with a low price and increases the price
subsequently with increase in demand.
Skimming Pricing – The seller tries to skim the profit from the market by charging a high price in the
initial stages and lowers the price in the long run.
Value based pricing – Seller sets the prices according to the value perceived by the customer of the
product/service.
Loss leader Pricing – Prices are set very low, sometimes below cost to encourage sales of other
products or a retail outlet.
Captive pricing – A special price is offered to loyal customers.
Psychological pricing – Prices are set according to emotional appeals that influence buying decisions.
E.g. Prestige pricing, Odd/even pricing, Bata pricing, Leader pricing
Promotional pricing – Prices are set below MRP to stimulate purchases and increase awareness. It
includes – Pricing for Special events, Low Interest Financing, Cash rebates, Warranties & Discounts
Discount Pricing – It involves reduction of price from MRP for performing certain activities. It includes
cash discounts, quantity discounts and seasonal discounts.
Discriminatory Pricing – Seller sells a product at two or more prices based on Customer segments,
Location, Time and availability of product, Product or brand image.
Going Rate Pricing – Price is set on the basis of prevailing market rate.
EDLP (Every Day Low Prices) – Retail stores offer low prices to customers every day in comparison
with competitors to promote sales and increase footfall without any special occasion, event or discount.
COST PLUS PRICING: The most widely used method for determining prices involves setting prices
predominantly on the basis of the company’s costs. This method is referred to as ‘cost-plus’ pricing. In its
simplest form it involves a company calculating average costs of production and then allocating a specified
markup, which may be related to rate of return required by the company, to arrive at the selling price. The
major advantage of this method is its simplicity. However, despite its widespread use, it has been criticized.
Before we examine the basis of these criticisms we need to examine further the mechanics of cost-plus pricing,
as well as some of the reasons why this apparently ‘simple’ approach to pricing may be more complex than it
seems at first glance.
MARKUP PRICING is the most commonly employed pricing method. Given the popularity of the
technique, it behooves managers to fully understand the rationale for markup pricing. When this rationale is
understood, markup pricing methods can be seen as the practical means for achieving optimal prices under a
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wide variety of demand and cost conditions. Profit margins, or markups, are sometimes calculated as a
percentage of price instead of cost. Profit margin is the numerator of the markup-on-price formula, as in the
markup-on-cost formula. However, unit cost has been replaced by price in the denominator. The markup-on-
cost and markup-on-price formulas are simply alternative means for expressing the relative size of profit
margins. To convert from one markup formula to the other, just use the following expressions:
ROLE OF COST IN MARKUP PRICING : Although a variety of cost concepts are employed in markup pricing,
most firms use a standard, or fully allocated, cost concept. Fully allocated costs are determined by first
estimating direct costs per unit, then allocating the firm’s expected indirect expenses, or overhead, assuming a
standard or normal output level. Price is then based on standard costs per unit, irrespective of short-term
variations in actual unit costs. During peak periods, when facilities are fully utilized, expansion is required to
increase production. Under such conditions, an increase in production requires an increase in all plant,
equipment, labor, materials, and other expenditures. However, if a firm has excess capacity, as during off-peak
periods, only those costs that actually rise with production—the incremental costs per unit—should form a
basis for setting prices.
Successful firms that employ markup pricing use fully allocated costs under normal conditions but offer
price discounts or accept lower margins during off-peak periods when excess capacity is available. In some
instances, output produced during off-peak periods is much cheaper than output produced during peak
periods. “Early bird” or afternoon matinee discounts at movie theaters provide an interesting example. Except
for cleaning expenses, which vary according to the number of customers, most movie theater expenses are
fixed. As a result, the revenue generated by adding customers during off-peak periods can significantly increase
the theater’s profit contribution.
ROLE OF DEMAND IN MARKUP PRICING: Successful companies differentiate markups according to variations
in product demand elasticities. Foreign and domestic automobile companies regularly offer rebates or special
equipment packages for slow-selling models. Similarly, airlines promote different pricing schedules for
business and vacation travelers. The airline and automobile industries are only two examples of sectors in
which vigorous competition requires a careful reflection of demand and supply factors in pricing practice.
MARKUPS CHARGED ON A VARIETY OF GROCERY ITEMS: by Post and Kellogg’s competing with a variety of
local store brands. Cheerios and Wheaties, both offered only by General Mills, Inc., enjoy a markup on cost of 15
percent to 20 percent. Thus, availability of substitutes directly affects the markups on various cereals. It is
interesting to note that among the wide variety of items sold in a typical grocery store, the highest margins are
charged on spices. Apparently, consumer demand for nutmeg, cloves, thyme, bay leaves, and other spices is
quite insensitive to price. The manager interviewed said that in more than 20 years in the grocery business, he
could not recall a single store coupon or special offered on spices.
This retail grocery store pricing example provides valuable insight into how markup pricing rules can be used
in setting an efficient pricing policy. It is clear that the price elasticity concept plays a key role in the firm’s
pricing decisions. To examine those decisions further, it is necessary to develop a method for determining
optimal markups in practical pricing policy.
MARGINAL COST PRICING: Marginal or direct cost pricing is where prices are based not on full costs that
include fixed costs, but direct or marginal costs. Fixed costs are not charged to production as they are treated as
a period charge and written off to the profit and loss account. In this way, the problems associated with having
to cover costs, and the methods of having to allocate fixed costs, are avoided. This makes use of the notion of
‘contribution’ discussed earlier. Needless to say, in the long run all costs, including fixed costs, must be covered,
but marginal cost pricing does at least allow a company to take advantage of market opportunities and to use
CYCLICAL PRICING
Cyclical Pricing refers to appropriate pricing strategy at different stages of Business Cycle Every Business
Cycle consists of four phases: Recession, Depression, Recovery and Prosperity. Contraction comprises of the
first two phases and the last two phases constitute expansion.
Business Cycles cause decline in aggregate economic activity, which results in fall in purchasing power of the
consumers. As a result of this, it is argued that strategies are to be revised and appropriate pricing policies need
to be adopted depending on the phase of Business Cycle the economy passes through.
There lies a difference in opinion regarding appropriate pricing policy during various phases of Business Cycle.
Experts are polarized in terms of appropriateness of pricing policy. Here both the suggested policies are
presented:
(1) Rigid Pricing (2) Flexible Pricing
Let us examine justifications of both the options one by one:
1] Rigid Pricing: During contraction and depression of an economy, purchasing power of customers decline.
But so far as necessity items are concerned, customers do not have to find any choice but to purchase these
products irrespective of the condition of the economy. Thus, adjustment of price for different stages of
Business Cycle cannot show better results.
For the expensive durable goods, which are not so necessary, deliberate reduction in price, the advocates of
this pricing strategy believes, will cause postponement of purchase decision by prospective buyers with an
expectation of further decline in price. So, adjustment in price depending on phases of Business cycle in
unlikely to help the firms.
For the capital goods (machines used to manufacture other machines), price reduction during contraction
cannot improve business performance, since business of end product shows lackluster. Thus, if price is
reduced during contraction, it is unlikely that any improvement in business will be experienced. This logic
favours Rigid Pricing, which does not allow any adjustment of price depending on different stages of
business.
2] Flexible Pricing: Flexible Pricing, as a concept, is just opposite to Rigid Pricing. The justification of Flexible
Pricing is easier to understand if we consider the case of agricultural products. Since supply of agricultural
products is inelastic, (i.e., the supply curve is a vertical straight line), leftward shift in the demand curve of
these products reduces equilibrium price. Only a policy to recourse to Flexible Pricing, and by linking it to
the general price index, loss arising out of unsold products will have to be borne by the producers. This
adjustment in price is referred to as “General Price Index Pricing”.
For industrial products, the argument is different. Higher profit of firms can be generated by securing more
customers through reduction in price. That is, reduced per unit profit can more than offset increase in
quantity, provided price elasticity of demand for the product is high. There can be another possibility.
If a new type of car is invented, where a cheaper fuel can be used (say, bio-diesel), then that type of car can
be sold at a high price (assuming that there is a huge price gap between bio-diesel and ordinary diesel)
even during contraction phase of Business Cycle. Since this adjustment of price is totally dependent on
nature of demand, it is referred to as “Product Demand Linked Pricing”.
PENETRATION PRICING
With a marginal cost of $6 and a sale price of $6.05, Company A is making nominal profits per sale. However,
the company is comfortable with this decision as their overarching goal is to switch customers over, capture as
much market share as possible, and utilize economies of scale with their high production capacity.
Company A believes that its competitor will not be able to sustain itself in the long-term and will eventually exit
the market. When the competitor exits the marketplace, it will become the only seller of laundry detergent and
therefore be able to establish a monopoly over the market.
PRICE SKIMMING
Price skimming, also known as skim pricing, is a pricing strategy in which a firm charges a high initial
price and then gradually lowers the price to attract more price-sensitive customers. The pricing strategy is
usually used by a first mover who faces little to no competition. Price skimming is not a viable long-term pricing
strategy as competitors eventually launch rival products and put pricing pressure on the first company.
Rationale Behind Price Skimming
Price skimming is used to maximize profits when a new product or service is deployed. Therefore, the
pricing strategy is largely effective in a breakthrough product where the firm is the first to enter the
marketplace. In such a strategy, the goal is to generate the maximum profit in the shortest time possible rather
than maximum sales. It allows a firm to quickly recover its sunk costs before increased competition and pricing
pressure.
Consider the diffusion of innovation, a theory that explains the rate at which a product spreads throughout
a social system. Innovators are those who want to be the first to get a new product or service. They are risk
takers and price insensitive. A price skimming strategy tries to get the highest possible profit from innovators
and early adopters. As the demand from the two segments fills up, the price of the product is reduced to target
price-sensitive customers such as early majorities and late majorities.
Illustration and Example of Price Skimming
Company A is a phone manufacturing company that recently developed a new proprietary technology to be
released to the market. Company A follows a price skimming strategy and sets a skim price at P1 to recover its
research and development cost. After satisfying demand at P1, the company sets a follow-on price at P2 to
capture price-desensitive customers and to put pricing pressure on competitors that enter the market.
In the price skimming strategy above, Company A generates revenue = A + B with sales of Q1. With their follow-
on pricing, the company generates additional revenue = C with sales of Q2-Q1.
With the pricing strategy, the company generates total revenue of A + B + C with total sales of Q2.
Advantages of Price Skimming
a) Perceived quality: Price skimming helps build a high-quality image and perception of the product.
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b) Cost recuperation: It helps a firm quickly recover its costs of development.
c) High profitability: It generates a high profit margin for the company.
d) Vertical supply chain benefits: It helps distributors earn a higher percentage. The markup on a Rs.500
product is far more substantial than on a Rs.5 item.
Disadvantages of Price Skimming
a) Deterrence: If the firm is unable to justify its high price, consumers may not be willing to purchase the
product.
b) Limitation of sales volume: A firm may not be able to utilize economies of scale if a skim price
generates too little sales.
c) Inefficient long-term strategy: Price skimming is not a viable long-term pricing strategy as
competitors will eventually enter the market with rival products and pricing pressure.
d) Consumer loyalty: If a product that costs Rs.1,000 at launch has a follow-on price of Rs.200 in a couple
of months, innovators and early adopters may feel ripped off. Therefore, if the firm has a history of price
skimming, consumers may wait a couple of months before purchasing the product.
TRANSFER PRICING
CLASSIFICATIONS OF MARKETS
The term ‘market’ originated from Latin word ‘marcatus’ having a verb ‘mercari’ implying
‘merchandise’ ‘ware traffic’ or ‘a place where business is conducted’. For a layman, the word ‘market’ stands for
a place where goods and persons are physically present. For him, ‘market’ is ‘market’ who speaks of ‘fish
market’, ‘mutton market’, ‘meat market’, ‘vegetable market’, ‘fruit market’, ‘grain market’. For him, it is a
congregation of buyers and sellers to transact a deal.
However, for us as the students of marketing, it means much more. In a broader sense, it is the whole of
any region in which buyers and sellers are brought into contact with one another and by means of which the
prices of the goods tend to be equalized easily and quickly.
On the Basis of Area or Region: On the basis of area or region a market can be classified into the following
categories:
1. Local Market: When buyers and sellers of certain commodities are limited to an area or region then the
market is called local market. Heavyweight goods and perishable goods have the local market because
their demand is concerned with a particular area or region. For bricks, stones, milk, vegetables etc.
2. Regional Market: If the buyers and sellers of a commodity are concentrated in a certain region or state,
The market is called regional market. The area is wide than the local market. The market for Mexico
market is in Mexico.
3. National Market: When the demand for some goods is limited to the boundary of the country the
market is called national market. Gandhi cap and Nehru jacket are examples of such markets.
4. International Market: When the demand for goods crosses the boundary of a country, the market is
called international market. Gold, silver, food-grains, and medicines are bought and sold throughout the
world. Hence their market is international market.
Markets on the Basis of the Time Element: On the basis of the time management the market can be classified
into following categories:
1. Very short period market: The supply of goods in this market is limited to their stock only. We cannot
increase their supply. The demand determines the price of such commodities.
2. Short period market: During this period production can be increased to the productive capacity and
produces cannot adjust the supply according to the demand. demand plays an important role in price
determination.
3. Long period market: It is a market wherein the supply can be adjusted to the quantity demanded. All
the factors of production are variable and even the scale of productions can be changed. Supply plays an
important role in price determination. The price in this market is called ‘long-run price’ or ‘normal
price’.
4. Very long period market: Under this market both demand and supply can be changed. Demand
increases due to increase in population, change in tastes, habits, and fashions while supply can be
increased by increasing the variable inputs and even the scale of production can be changed. There is
price determination by the economic forces of demand and supply and the permanent equilibrium is
attained. Thus, The market price is called ‘very long run price.’
Markets Based on Competition: On the basis of competition prevailing in the market the following
classification is done:
1. Perfect market: The market where there is competition between sellers and buyers and within sellers
and within buyers the market is called perfect market or ‘Perfect Competition Market’.
2. Monopolistic Competition: Monopolistic competition is a market structure found in the industry
where there is a large number of small sellers selling differentiated but close substitute products.
3. Oligopoly: Oligopoly is one of the kinds of Imperfect competition. Such market structure is found when
the number of sellers is few. Oligopoly(Classifications of Markets) is a market situation in which the
number of sellers dealing in a homogeneous or differentiated product in small.
4. Duopoly: A market wherein there are two sellers or producers of a product is called do aDuopoly. They
have a complete hold over the supply of that product. A product of both the sellers is Homogeneous and
the prices are also the same.
5. Monopoly: A pure monopolist should be taken that who has full control out the supply of a particular
product.
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Market on the Basis of Functions: On the basis of functions, markets can be classified into following
categories:
1. Mixed or General Market: A market where all types of goods are bought and sold is called mixed or
general market. Markets in cities are found in this category.
2. Specialized Market: A Market where a particular commodity is sold is called up a specialized
market. Vegetable market, foods market, Cloth Market are examples of such marketing.
3. Marketing by Samples: When the goods are bought and sold on the basis of samples. The market is
called Marketing by samples. Oilseeds, food grains and raw cotton are bought and sold on the basis of
samples.
4. Marketing by Grades: When the goods are graded and then different buyers and sellers deal in such
goods on the basis of their grades, then the market is called Marketing by grades. Agricultural Products
are graded and then they are sold accordingly.Dalda, bath soap, edible oil etc. Are sold on the basis of
grading.
On the basis of Nature of Commodity: The market is also Classified on the basis of nature of commodity is
given below:
1. Product Market: A market where a particular product is bought and sold is called a product
market. For example, agricultural products are sold in agricultural markets is a market of this type.
2. Stock Market: A market where is stock and shares, bonds, securities, debentures etc. are bought and
sold is called the stock market. Bulls and bears are engaged in finalizing the transactions as per the
market rates.
3. Bullion Market: A market where silver and gold are bought and sold is called Bullion market. In this
market metallic trading takes place.
Markets Classifications based on Legality: On the basis of legality, markets can be put into two categories are
given below:
1. Legal Market: A market where legal transactions of goods and services take place between buyers and
sellers. It is recognized by the government. It is also called a fair market.
2. Illegal Market: A market where high prices are charged what has been fixed by the government and it
happens when the goods are in short supply. Businessman and traders earn profits by indulging in
black marketing, smuggling, and hoarding. Hong Kong market is an illegal market (Classifications of
Markets).
MARKET STRUCTURE: Market structure refers to the nature and degree of competition in the market for
goods and services. The structures of market both for goods market and service (factor) market are determined
by the nature of competition prevailing in a particular market.
The first order figure (1), the MC curve cuts the MR curve first at
point X. It contends the condition of MC = MR, but it is not a point of
maximum profits for the reason that after point X, the MC curve is
beneath the MR curve. It does not pay the firm to produce the
minimum output OM when it can earn huge profits by producing
beyond OM. Point Y is of maximum profits where both the situations
are fulfilled.
Amidst points X and Y it pays the firm to enlarges its
productivity for the reason that it’s MR > MC. It will nevertheless
stop additional production when it reaches the OM1 level of
productivity where the firm fulfils both the circumstances of
equilibrium. If it has any plants to produce more than OM1 it will be
incurring losses, for its marginal cost exceeds its marginal revenue
beyond the equilibrium point Y. The same finale hold good in the
case of straight line MC curve and it is presented in the figure (2).
An industry is in equilibrium, first when there is no propensity for the firms either to leave or either the
industry and next, when each firm is also in equilibrium. The first clause entails that the average cost
curves overlap with the average revenue curves of all the
firms in the industry.
They are earning only normal profits, which are
believed to be incorporated in the average cost curves of the
firms. The second condition entails the equality of MC and MR.
Under a perfectly competitive industry these two
circumstances must be fulfilled at the point of equilibrium i.e. MC =
MR…. (1), AC = AR…. (2), AR = MR. Hence MC = AC = AR. Such a
position represents full equilibrium of the industry.
Postulations
1. All firms use standardised factors of production
2. Firms are of diverse competence
3. Cost curves of firms are dissimilar
from each other
4. All firms sell their produces at the
equal price ascertained by demand
and supply of the industry so that the
price of each firm, P (Price) = AR = MR
5. Firms produce and sell various
volumes
The short run equilibrium of the firm can be
described with the helps of marginal study and total cost revenue study.
Marginal Cost, Marginal Revenue analysis – During the short run, a firm will produce only its price
equals average variable cost or is higher than the average variable cost (AVC). Furthermore, if the price
is more than the averages total costs, ATC, i.e. P = AR > ATC the firm will be earning super normal
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profits. If price equals the average total costs, i.e. P = AR = ATC the firm will be earning normal profits or
break even.
If price equals AVC, the firm will be incurring losses. If price drops even a little below AVC, the firm will
shut down since in order to produce it must cover atleast it’s AVC through short run. So during the short
run, under perfect competition, affirm is in equilibrium in all the above mentioned stipulations.
Super normal profits – The firm will be earning super normal profits in the short run when price is
higher than the short run average cost.
Normal Profits = The firm may earn normal profits when price equals the short run average costs.
Total Cost – Total Revenue Analysis – The short run equilibrium of the firm can also be represented
with the help of total cost and total revenue curves. The firm is able to maximise its profits when the
positive discrimination between TR and TC is the greatest.
SHORT-RUN INDUSTRY EQUILIBRIUM UNDER PERFECT COMPETITION,
An industry is in equilibrium in the short run when its total output remains steady there being no
propensity to enlarge or contract its productivity. If all firms are in equilibrium the industry is also in
equilibrium. For full equilibrium of the industry in the short run all firms must be earning normal profits.
But full equilibrium of the industry is by sheer accident for the reason that in the short rum some firms may be
earning super normal profits and some losses. Even then the industry is in short run equilibrium when its
quantity demanded and quantity supplied is equal at the price which clears the market.
BILATERAL MONOPOLY
Bilateral monopoly refers to a market situation in which a single producer (monopolist) of a product faces a
single buyer (monopolist) of that product.
Postulations
a. There is a solitary commodity with no close surrogates
b. The monopolist is its sole manufacturer or seller
c. The monopsonist is its only consumer
d. The monopolist and the monopsonist are equally liberated to optimise their own person profits
Price output Determination
Given these postulations, price and output ascertainment under bilateral monopoly is presented in the
sketch where D is the demand curve of the monopolist’s product and MR is its corresponding marginal revenue
curve of the monopolist. The MC curve of the monopolist is the supply curve S factoring the monopsonist. The
upward incline indicates that if monopsonist wants to buy more he will have to pay a higher price.
MONOPOLISTIC COMPETITION,
Monopolistic competition denotes to a market state of affairs where there are many firms selling a
distinguished produce. “There is competition which is keen though perfect, among many firms making very
similar products.” No firm can have any noticeable pressure on the price productivity strategies of the other
sellers or can it be inclined much by their performance. According to Salvatore, “Monopolistic competition
refers to the market organisation in which there are many firms selling closely related but not identical
commodities.”
CHARACTERISTICS
Monopolistically competitive markets exhibit the following characteristics:
(1) Each firm makes independent decisions about price and output, based on its product, its market, and its
costs of production.
(2) Knowledge is widely spread between participants, but it is unlikely to be perfect. For example, diners
can review all the menus available from restaurants in a town, before they make their choice. Once
inside the restaurant, they can view the menu again, before ordering. However, they cannot fully
appreciate the restaurant or the meal until after they have dined.
(3) The entrepreneur has a more significant role than in firms that are perfectly competitive because of the
increased risks associated with decision making.
(4) There is freedom to enter or leave the market, as there are no major barriers to entry or exit.
(5) A central feature of monopolistic competition is that products are differentiated. There are four main
types of differentiation:
a) Physical product differentiation, where firms use size, design, colour, shape, performance, and
features to make their products different. For example, consumer electronics can easily be physically
differentiated.
b) Marketing differentiation, where firms try to differentiate their product by distinctive packaging and
other promotional techniques. For example, breakfast cereals can easily be differentiated through
packaging.
c) Human capital differentiation, where the firm creates differences through the skill of its employees,
the level of training received, distinctive uniforms, and so on.
d) Differentiation through distribution, including distribution via mail order or through internet
shopping, such as Amazon.com, which differentiates itself from traditional bookstores by selling
online.
(6) Firms are price makers and are faced with a downward sloping demand curve. Because each firm makes a
unique product, it can charge a higher or lower price than its rivals. The firm can set its own price and does not
have to ‘take' it from the industry as a whole, though the industry price may be a guideline, or becomes a
constraint. This also means that the demand curve will slope downwards.
(7) Firms operating under monopolistic competition usually have to engage in advertising. Firms are often in
fierce competition with other (local) firms offering a similar product or service, and may need to advertise on a
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local basis, to let customers know their differences. Common methods of advertising for these firms are
through local press and radio, local cinema, posters, leaflets and special promotions.
(8) Monopolistically competitive firms are assumed to be profit maximisers because firms tend to be small with
entrepreneurs actively involved in managing the business.
(9) There are usually a large numbers of independent firms competing in the market.
As new firms enter the market, demand for the existing firm’s
products becomes more elastic and the demand curve shifts to
the left, driving down price. Eventually, all super-normal profits
are eroded away.
Clearly, the firm benefits most when it is in its short run and
will try to stay in the short run by innovating, and further product differentiation.
Examples of monopolistic competition
Examples of monopolistic competition can be found in every high street.
Monopolistically competitive firms are most common in industries where differentiation is possible, such as:
• The restaurant business
• Hotels and pubs
• General specialist retailing
• Consumer services, such as hairdressing
The survival of small firms
The existence of monopolistic competition partly explains the survival of small firms in modern economies. The
majority of small firms in the real world operate in markets that could be said to be monopolistically
competitive.
THE ADVANTAGES OF MONOPOLISTIC COMPETITION
Monopolistic competition can bring the following advantages:
1] There are no significant barriers to entry; therefore markets are relatively contestable.
2] Differentiation creates diversity, choice and utility. For example, a typical high street in any town will
have a number of different restaurants from which to choose.
3] The market is more efficient than monopoly but less efficient than perfect competition - less allocatively
and less productively efficient. However, they may be dynamically efficient, innovative in terms of new
production processes or new products. For example, retailers often constantly have to develop new
ways to attract and retain local custom.
THE DISADVANTAGES OF MONOPOLISTIC COMPETITION
There are several potential disadvantages associated with monopolistic competition, including:
1] Some differentiation does not create utility but generates unnecessary waste, such as excess packaging.
Advertising may also be considered wasteful, though most is informative rather than persuasive.
OLIGOPOLY
The word Oligopoly is derived from two Greek words – ‘Oligi’ meaning ‘few’ and ‘Polein’ meaning ‘to sell’. An
Oligopoly market situation is also called ‘competition among the few’.
CHARACTERISTICS OF OLIGOPOLY
Now that the Oligopoly definition is clear, it’s time to look at the characteristics of Oligopoly:
1] Few firms: Under Oligopoly, there are a few large firms although the exact number of firms is undefined.
Also, there is severe competition since each firm produces a significant portion of the total output.
2] Barriers to Entry : Under Oligopoly, a firm can earn super-normal profits in the long run as there are
barriers to entry like patents, licenses, control over crucial raw materials, etc. These barriers prevent
the entry of new firms into the industry.
3] Non-Price Competition: Firms try to avoid price competition due to the fear of price wars and hence
depend on non-price methods like advertising, after sales services, warranties, etc. This ensures that
firms can influence demand and build brand recognition.
4] Interdependence: Under Oligopoly, since a few firms hold a significant share in the total output of the
industry, each firm is affected by the price and output decisions of rival firms. Therefore, there is a lot of
interdependence among firms in an oligopoly. Hence, a firm takes into account the action and reaction
of its competing firms while determining its price and output levels.
5] Nature of the Product: Under oligopoly, the products of the firms are either homogeneous or
differentiated.
6] Selling Costs: Since firms try to avoid price competition and there is a huge interdependence among
firms, selling costs are highly important for competing against rival firms for a larger market share.
7] No unique pattern of pricing behavior: Under Oligopoly, firms want to act independently and earn
maximum profits on one hand and cooperate with rivals to remove uncertainty on the other hand.
Depending on their motives, situations in real-life can vary making predicting the pattern of pricing
behavior among firms impossible. The firms can compete or collude with other firms which can lead to
different pricing situations.
8] Indeterminateness of the Demand Curve: Unlike other market structures, under Oligopoly, it is not
possible to determine the demand curve of a firm. This is because on one hand, there is a huge
interdependence among rivals. And on the other hand there is uncertainty regarding the reaction of the
rivals. The rivals can react in different ways when a firm changes its price and that makes the demand
curve indeterminate.
Having agreed on the cartel price, the members may then complete each other using non price competition to
gain as big share of resulting sales OQ1 as they can.
There is another alternative also. The cartel members may agree to divide the market between them. Each
member would given a quota. The sum of all the quotas must add up to Q1. In case the quotas exceeded OQ1
either the output will remain unsold at OP price or the price would fall.
Explanation:
a) Price increase: So an increase in price above the prevailing level-shows that the demand curve to the
left of and above point B is fairly elastic.
b) Price reduction: The firm does not gain as the total revenue decreases with the price cut. The BD/
portion of the demand curve which lies on the right side and below point B is fairly inelastic.
c) Rigid Prices: The firms in the oligopolist market 'have no incentive to raise or lower the prices of the
goods. They prefer to sell the goods at the prevailing price level due to reaction function. The price BM
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(Rs. 10 per unit) will, therefore, tend to remain stable or rigid, as every member of the oligopoly does
not see any gain by lowering or raising the price of his goods.
If an industry is composed of only two giant firms, each selling identical products and having half of the
total market, there is every likelihood of collusion between the two firms. The firms may agree on a price, or
divide the market, or assign quota, or merge themselves into one unit and form a monopoly or try to
differentiate their products or accept the price fixed by the leader firm, etc., etc.
In case the duopolists producing perfect substitute engage in price competition, the firm having lower
costs, better goodwill and clientele will drive the rival firm out of the market and then establish a monopoly.
If the products of the duopolists are differentiate, each firm will have a close watch on the actions of its
rival firms. The firms manufacturing good quality products with lesser cost will earn abnormal profits. Each
firm will fix the price of the commodity and expand output in accordance with the demand of the commodity in
the market.
PROFIT POLICY:
In developing nations, the Public Sector Enterprises are required to play a dominant role in economic
development; PSEs follow the profit price policy. Such a policy would make the state utilise its own resources
rather than taxing its citizens. PSEs must be carried on a profit making basis not only in the sense that the
public enterprises must yield an economic price but also get for the community sufficient resources for
financing a part of investment and maintenance outlay of the government.
This involves a profit price policy regard to PSEs. The theory of no profit no loss in PSEs is particularly
inconsistent with a socialist economy and if followed in a mixed economy nations, it will hinder its
development. In support of this view, in USSR, PSEs made a double contribution to development finance;
reinvestment of profits for their own expansion and contribution to the state budget.
ARGUMENTS FOR A PROFIT PRICE POLICY
The following arguments are advanced in favour of a profit price policy.
(1) When the state makes large investments in establishing PSEs, it expects a return in the form of profits in
order to enhance its resources for the development of the economy.
(2) The main aim of every private enterprise is to earn profits. It is therefore essential that PSEs should also
earn profits and should not be dependant on the state for financial help and subsidy.
(3) When PSEs operate side by side with private enterprises and compete with them in such areas as oil,
steel, consumer goods, shipping, airways etc. they must earn profits like private enterprises.
(4) Even in the case of those PSEs where the state has a monopoly, it is not desirable to have a no profit no
loss policy or change a low price to consumers of the product or service. For there is no guarantee that
the users of the product or service will save more on this count. Therefore the best course is to change a
price which gives a minimum of profit to the PSE which will ultimately go to the state for capital
formation.
(5) The running of PSEs on profit price policy will contribute to the general revenues of the state. As
pointed out by Indian Planning commission “When taxation has its limits, public exchequer should
benefit by the surplus of public enterprise. When private sector pays a portion of its profits for general
revenues, there is no grounds and debt servicing and even dispenses with deficit financing.
(6) Further surpluses, accruing from profit making enterprises provide adequate funds for improvement,
modernisation and expansion of the plants in PSEs.
WHAT PROFIT PRICE SHOULD BE FOLLOWED?
Nevertheless, it is difficult to have a particular rate of profit for all the PSEs. Moreover, all PSEs cannot
earn profits simultaneously for the following reasons.
(1) Those PSEs which have not broken even cannot earn profits for the reason that their overhead costs
will be high.
PROFIT FORECASTING
Profit planning cannot be done without proper profit forecasting. Profit forecasting means projection of
future earnings after considering all the factors affecting the size of business profits, such as firm’s pricing
policies, costing policies, depreciation policy, and so on. A thorough study including a proper estimation of both
Government remedies refer to interventions in a market by central or local government. For example, these
may include, for each market failure, a selection from:
a) subsidies, taxes, regulations, property rights and government provision (consumption externalities)
b) subsidies, taxes, regulations, property rights and government provision (production externalities)
c) government provision (public goods)
d) regulation (imperfect information)
e) progressive taxes, welfare benefits, collective provision and minimum wage (inequitable income
distribution).
Government intervention is any action carried out by the government or public entity that affects the
market economy with the direct objective of having an impact in the economy, beyond the mere regulation of
contracts and provision of public goods.
Government intervention advocates defend the use of different economic policies in order to compensate
the flaws of the economic system that give way to large economic imbalances. They believe the Law of Demand
and Supply is not sufficient in order to ensure economic equilibriums and government intervention should be
used to assure a correct functioning of the economy.
There are four different types of government institutions which are operating in almost every country to
facilitate their people.
a) There are market-enabling institutions which help economic agents to manage conflicts, to secure
property rights and to help in recognizing their own rights and duties towards customers. They help in
sticking to long term contracts and avoid any kind of disputes.
b) The market-regulating institutions keep an eye over market players who are misusing their market
power and ensure a healthy competition among firms to control any firm from being the monopolist.
They also improve the market prices and make sure that they reflect the correct costs and benefits for
both the buyer and seller.
c) The market-stabilizing institutions are the independent banks working in the economy. The
governments’ central bank will serves as the lender of last resort so it may avoid banking crisis in
difficult situations. Another role for these institutions is to stabilize the state’s contribution towards the
macroeconomic activities.
d) The market legitimizing institutions boost up and sustain the public support for market economies.
They sort out and reorganize income and provide social insurances. They are also a vital source of social
stability in the economy. They encourage firms for long-term developments as they want to facilitate
economic development for their residents.
PRICE CONTROLS
Controversy sometimes surrounds the prices and quantities established by demand and supply,
especially for products that are considered necessities. In some cases, discontent over prices turns into public
pressure on politicians, who may then pass legislation to prevent a certain price from climbing “too high” or
falling “too low”. Laws that government enacts to regulate prices are called Price controls. Price controls come
b) PRICE FLOORS: A price floor is the lowest legal price that can be paid in a market for goods and services,
labor, or financial capital. Perhaps the best-known example of a price floor is the minimum wage, which is
based on the normative view that someone working full time ought to be able to afford a basic standard of
living. Price floors are sometimes called price supports because they support a price by preventing it from
falling below a certain level. Around the world, many countries have passed laws to create agricultural price
supports. Farm prices, and thus farm incomes, fluctuate—sometimes widely. So even if, on average, farm
incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these
swings. The most common way price supports work is that the government enters the market and buys up
the product, adding to demand to keep prices higher than they otherwise would be. Price floors
disadvantage consumers, who are forced to buy at a higher price if the good is demand inelastic. Some will
even switch to substitutes, meaning price floors must be carefully implemented if the supplier is actually to
benefit from it. Generally, they are applied to demand inelastic markets like food. Even so, there will usually
be a shortage as a result of an excess of producers. Depending on the nature of the market, the surplus
might be exported, donated, or destroyed.
PREVENTIONS AND CONTROL OF MONOPOLIES
As Adam Smith noted in the late 18th Century, '..people of the same trade seldom meet
together...without..the conversation ending in a conspiracy against the public, or in some contrivance to raise
prices.' (Wealth of Nations, 1776). This view dominated Classical and Neo-Classical theory for 150 years. The
Neo-Classical analysis of firms is deeply rooted in the belief that monopolies are inherently harmful, and that a
merger between competitive firms will reduce competition and increase monopoly power. The Neo-Classical
view was that monopolies would cause a misallocation of scarce resources, with prices rising well above
competitive prices. In short, regulatory authorities should be suspicious of the motives behind meetings of
firms, alliances and formal mergers, and closely monitor and control the anti-competitive behaviour of
monopolies.
The modern view is more pragmatic, and recognises that monopolies and mergers should be judged on
a case by case basis, and it should not be assumed that they are against the public's interest. The modern
approach accepts that monopolies can create economic benefits as well as costs, including the benefits of
economies of scale, innovation and dynamic efficiency, and export earnings.
In short, the two acts are different in a number of contexts. MRTP Act has a number of loopholes and the
Competition Act, covers all the areas which the MRTP Act lags. The MRTP Commission plays only advisory role.
On the other side, Commission has a number of powers which promotes suo moto and levies punishment to
those firms which affects the market in a negative way.
Consumption expenditure is the expenditure made by households on goods and services. The
consumption function shows the consumption expenditure of households at each disposable income. The
Keynesian consumption function can be expressed as
C = a + bYd
where C = consumption, a = autonomous consumption, bYd = induced consumption, b = marginal propensity to
consume out of disposable income and Yd = disposable income.
From the above equation, it can be seen that consumption is comprised of two components:
autonomous consumption and induced consumption.
Autonomous consumption refers to consumption that is independent of disposable income and is
determined by consumer sentiment, the wealth of households, interest rates, expectations of price changes,
the availability of credit and the distribution of income. Autonomous consumption is positive (a > 0).
Induced consumption refers to consumption that is dependent on disposable income. According to
Keynes, consumption will increase with an increase in disposable income (b > 0) but the increase in
consumption will be less than the increase in disposable income (b < 1).
CONSUMPTION FUNCTION: In the diagram, the consumption function (C) is upward sloping as consumption
expenditure increases with disposable income. The slope of the consumption function is (b) which is known as
the marginal propensity to consume out of disposable income (MPCYd). The marginal propensity to consume
out of disposable income is the proportion of an increase in disposable income that is spent on consumption
(ΔC/ΔYd).
INVESTMENT EXPENDITURES:
2] Fixed Capital: The expenditure made on new plants and machinery vehicles, houses facilities, etc., are
also included in investment. In the words of J.M. Keynes: "Investment means real investment which
refers to increase in the real capital stock of the economy".
1] Induced Investment: Investment in the economy is influenced by the income or output of the economy.
The large the national income, the higher is the investment. Induced investment is the change in investment
which is induced by the change in the national income. The investment function signifies that as the real
national income rises, the level of inducement investment also rises and as the real national falls. The level
of investment also down.
Shift in the Investment Curve: The induced investment is the increasing function of profit. If firm
expect profit, they are induced to invest. The profit expectation of firms depend upon aggregate demand for
goods and services in the economy. The level of aggregate demand itself depends upon the level of national
income. The higher the level of national income, the higher thus is the level of induced investment.
(2) Autonomous Investment: The investment which is not influenced by changes in national income is
autonomous investment. In other words an autonomous investment is independent of the level national
income. As regards the size of autonomous investment, it is influenced by many basic factors such as
increase in population. Manpower, level of technology, the role of interest, the expectations of future
economic growth and the role of capacity utilization etc. In case, there is an introduction of new
technologies, or the rate of interest falls or if the businessmen expect the sales to grow more, the
producer choose to operate to full capacity, the autonomous investment is influenced.
In a diagram, the savings function (S) is upward sloping as savings increase with disposable income. The
slope of the savings function is (1 – b) which is known as the marginal propensity to save out of disposable
income (MPSYd). The marginal propensity to save out of disposable income is the proportion of an increase in
disposable income that is saved (ΔS/ΔYd).
As any additional amount of disposable income will either be spent or saved, the sum of the marginal
propensity to consume out of disposable income and the marginal propensity to save out of disposable income
is equal to one (MPCYd + MPSYd = 1). The average propensity to consume out of disposable income (APCYd) is the
proportion of disposable income that is spent
S = Y – C, where C = a + bY Proof: on consumption (C/Yd). The average
S = Y – (a + bY) C = a + bY propensity to save out of disposable income
S = Y – a – bY S = – a + (1 – b) Y (APSYd) is the proportion of disposable
S = – a + Y – bY C + S = 0 + bY + (1 – b) Y income that is saved (S/Yd). As any amount of
S = – a + (1 – b) Y C + S = (b + 1 – b) Y disposable income will either be spent or
S=–a+sY C + S = Y and saved, the sum of the average propensity to
where: b = MPC and s = MPS b + s = 1 consume out of disposable income and the
average propensity to save out of disposable
income is equal to one (APCYd + APSYd = 1).
Marginal efficiency capital (MEC) is a Keynesian concept. According to J.M. Keynes, nations output
depends on its stock capital. An increase in the stock of capital increases output. The question is how much
increase in investment raises output? Well, this depends on the productivity of new capital i.e. on the marginal
efficiency of capital. Marginal efficiency of capital is the rate return expected to be obtainable on a new capital
asset over its life time.
According to J.M. Keynes, the behavior of investment in respect of new investment depends upon the various
stock of capital available in the economy at a particular period of time. As the stock of capital increases in the
economy, the marginal efficiency of capital goes on diminishing. The MEC curve is negatively sloped
Investment (Rs. in billion) Marginal Efficiency of Capital
20 10%
25 9%
40 7%
70 5%
100 2%
MULTIPLIER
a) In the graph above, the vertical double-headed arrow represents the size of the initial positive demand
shock. The vertical distance of the shift upward indicates the amount demand initially rises holding
income constant.
b) But output and income rise much more than the size of the initial demand shock. The change in output
is indicated by Y1 – Y0, also show by the horizontal double-headed arrow in the graph above.
ACCELERATOR
John Hicks was an economist early in the 1900s that took the work of Adams and Ricardo and joined
it with the work of many of his contemporaries to answer some remaining questions. Hicks thought
about how the multiplier effect and accelerator effect interact with one another.
The Multiplier Effect and Accelerator Effect
The multiplier effect is the total impact an incremental dollar in income could have
throughout the economy. You might think, ''Well, it's Rs.1.00.'' But think of the flow of money
through the economy. If you earn that extra dollar, you'll probably spend it on something. The
producer of that good will get the money, and it will end up - at least partially - as income for
someone else.
That person will then buy something, providing income for someone else. If, by the time that dollar is
'done' being spent, it has turned into Rs.4 in wages for you and other people down the supply chain,
then the economy has a multiplier of four.
The accelerator effect is a little easier to articulate. It's the expected increase in investment
as the economy grows. This doesn't happen at exactly the same time, but as the economy
grows and people's income increases, this also increases investments - either in savings
accounts or more aggressive investments.
Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering
the growth rate of real gross domestic product. Economies expand and contract - sometimes things are good,
sometimes not so much. The idea of this happening in a cycle is called a business cycle. This concept dates back
to economists from the 1800s like Adam Smith and David Ricardo. They identified the general growth and
decline of goods and services over the course of years. They would see economic growth, with signs such as
individuals accumulating more wealth and goods, saving more money, and unemployment dropping near to the
point of full employment. Then, after some time, things would change, and there would be fewer jobs, meaning
fewer people with extra money to buy things, meaning less output and production, which would lead to an
economic slowdown, or recession. Business cycles are identified as having four distinct phases: peak, trough,
contraction, and expansion. The timing of a cycle is not predictable, but its phases seem to be. Many economists
cite four phases - prosperity, liquidation, depression, and recovery - using the terms originally developed by the
American economist Wesley Mitchell, who devoted his career to studying business cycles.
IMPORTANT THEORIES
1] OVER-INVESTMENT THEORY:
According to this theory trade cycle occurs because of the over investment in investment industries.
The investment industries are building and construction, iron and steel, engineering etc. During every
boom investment increases. This statement is supported by the fact that during boom, investment goods
industries expand faster than consumption goods industries and during depression investment goods
industries suffer more than consumption goods industries. However, opinion among the writers differs on
the question as to why in the boom phase investment goods industries expand faster than consumption
goods industries.
Hayeis Machlup, Ropke and Ribbons hold banks responsible for it. Banks give credit at unduly low rates
of investment and in this way they encourage investment. Credits being cheap, all sorts of inefficient and
even uneconomical units are set up. The entrepreneurs adopt more and more rounds about methods of
production. Resources are withdrawn from consumer’s goods industries and invested in production goods
industries through the process of forced saving. This brings about the disparity in the growth rates of
consumption goods industries and investment goods industries.
At some points the banks feel that too much credit has been created. They raise the rate of
interest.Borrowing becomes a costly affair and the rate of investment falls this will bring about the
contraction of credit and hence contraction of economic activity leading to depression. But economists like
Cassel consider the process of production rather than the expansion of bank credit to be more important
cause of a trade cycle. According to them a revival in economic activity leading to boom takes place because
of real forces like new inventions. However, here also the assumption of ‘elastic money supply’ remains.
2] UNDER CONSUMPTION THEORY:
The chief exponent of this theory is I.S. Hobson. According to him, trade cycles appear due to mal-
distribution of national income.
This mal-distribution of national income takes place because during boom the entrepreneurs and
businessmen gather income with business activities and banks and become richer. Since they cannot
consume the whole income they save.
There is too much saving during the boom period. Reduction in the level of consumption means a fall in the
demand for consumers’ goods because the amount saved is not spent on consumption.
The supply of consumer’s goods will be far greater than the demand for them. Prices of these goods begin to
fall. The general outlook becomes pessimist. If this downward movement continues depression will set in.