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NOTES ON MANAGERIAL
ECONOMICS

SUBJECT CODE: MGT103

Prepared by:
Dr
...
R
...
It is coordination, an activity or an ongoing process, a
purposive process and an art of getting thing, done by other people
...
With the way of society chooses its limited
resources, which have alternative uses, to produce goods and services for present and future
consumption, and to provide for economic growth
...
Scarcity of resources results from two fundamental facts of
life
...


ii)

Economic resources to satisfy the human wants are limited
...

a) What to produce?
b) How to produce?
c) For whom to produce?
The three choice problems have become the three central issues of an economy
...
Understanding these
principles will help to develop a rational decision making perspective and will also sharpen the
analytical frame work that the executive must bring to bear on managerial decisions
...
The application of principle of Managerial Economics will help manager ensure that
resources are allocated efficiently within the firm and that the firm makes appropriate reactions
to changes in the economic environment
...


Study of Managerial Economics essentially involves the analysis of certain major subject
like
...

Demand Analysis and Forecasting help a manager in the earliest stage in choosing the product
and in planning output levels
...
The theory of cost also forms an essential part of this subject
...
The firm works for profits
and optional or near maximum profits depend upon accurate price decisions
...
The optimal decision making is
an act of optimal economic choice, considering objectives and constraints
...

Objective of the firm:Firms are a useful device for producing and distributing goods and services
...
Traditionally, the
objective of a firm is to maximize profit
...
They make decisions that reduce current year profits, so as to
increase profits in the future years
...
Thus, given that both the
current and future profits are important, it is assumed that the goal of a firm is to maximize the
present or discounted value of all future profits [PV (πt)]
...
Using the Greek letter ∑ indicates that each of the terms on the
right hand side of the given equation have been added together
...
Demand is one of the most important aspects of Business Economics, since a firm
would not be established or survive if a sufficient demand for its product didn‘t exist or couldn‘t
be created
...

Demand is the quantity of a good or service that customers are willing and able to
purchase during a specified period under a given set of economic conditions
...
Conditions to be considered include the price of the
good in question, prices and availability of related goods, expectations of price changes,
consumers‘ incomes, consumers taste and preferences, advertising expenditures and so on
...

The ability of goods and services to satisfy consumer wants is the basis for consumer
demand
...

Consumer behavior theory rests upon three basic assumptions regarding the utility tied to
consumption
...

It is often being referred to as the ―non satiation principle‖
...

Third, ―Preferences are transitive‖ :- When preferences are transitive, consumers are able to
rank/order the desirability of various goods and services
...
The utility of a basket of goods depends on the quantities of
the individual commodities
...
The relationship between demand and marginal utility can explain the behaviour of
demand in relation to price
...
Infact, the law of demand is based on the law of diminishing
marginal utility
...

Equilibrium of the consumer :Let‘s begin with the simple model of a single commodity X
...
Under these conditions, the consumer is in equilibrium when
the marginal utility of X is equated to its market price (pX)
...
Similarly, if the marginal utility of X is less than its price, the
consumer can increase his total satisfaction by cutting down the quantity of X and keeping more
of his income unspent
...

Mathematical derivation of the equilibrium of the consumer :The utility function is
U = f (qX)
Where utility is measured in money terms
...

Presumably the consumer seeks to maximize the difference between his utility and his
expenditure
...
Thus,
–

=0

Rearranging we obtain,
= pX
MUX = pX
Individual Demand and Market Demand
Individual demand refers to the demand for a commodity from the individual point of view
...
Individual demand is considered from one person‘s
point of view or from that of a family or household‘s point of view
...
Individual demand is determined by the value associated with
acquiring and using any good or service and the ability to acquire it
...
Market demand is an aggregate of the quantities of a product demanded by all the
individual buyers at a given price over a given period of time
...
In other
words, the quantity demanded in the market at each price is the sum of the individual demands of
all consumers at that price
...
)

10
12
14
16
18
20

Quantity
demanded
consumer A
(in units)
15
12
10
08
06
04

Quantity
by demanded
consumer B
(in units)
20
15
12
10
08
06

Quantity
by demanded
consumer C
(in units)
15
13
10
08
06
05

Market demand
by (in units)

50
40
32
26
20
15

Direct demand and Derived demand :
Direct demand is the demand for goods and services that directly satisfy consumer desires
...
The value or
worth of a good or service, its utility, is the prime determinant of direct demand
...
This optimization process requires that consumers focus on
the marginal utility of acquiring additional units of a given product, product characteristics,
individual preferences and the ability to pay are all important determinants of direct demand
...
Such goods and services which are demanded not for direct
consumption but rather for their use in providing other goods and services
...
Input demand is derived from the demand for the products they are used to
provide
...
In a nutshell, demand for inputs used in
production is called derived demand
...
The demand function may be expressed as follows:DX = f(PX,PY,M,T,W)
Where DX= quantity of commodity X demanded per unit of time,
PX= Price of X,
PY= Mean price of all other substitute commodities,
M= consumer‘s income
T= consumer‘s Taste
W= Wealth of the consumer
Of the variables mentioned, Tables are difficult to quantify, whereas wealth does not have a
direct influence on the demand DX
...

Demand functions are generally homogenous of degree zero
...
If the degree of a
homogenous function is zero, then it would imply that when all prices and income change in the
same proportion, DX would remain unchanged
...
For simplicity, the demand for X is
assumed to be a function of only PX
...
The traditional
demand theory deals with this demand function specially
...
e
...
In other words, the statement, ―the amount demanded is a functional of price‖
implies that for each possible price, there is a different quantity demanded
...

Determinants of Demand:Demand is a multivariate function and it is determined by many variables
...
In reality, however, demand depends upon numerous factors
...
The more the price of a
commodity, the less will be its quantity demand and vice-versa
...
However, the direction of such
depends upon the nature of relationship between the two goods, namely X and Y:
X and Y are complementary goods, when both goods satisfy a single want
...
g
...
When prices of Y rises, the consumer will buy less of Y and
also less of X, although the price of X remains unchanged
...

X and Y are substitutes, if the consumer can use more of X at the cost of Y, or vice-versa
...
Therefore the demand for X will fall and that of Y will increase
...
g
...
Besides, many buyers of
orange may switch over to apple, even though price of orange has not changed
...
When X and Y have no relationship, the two commodities are said to be independent
...
g
...
Under such a situation, even if the
price of X(PX) falls significantly, demand for Y(DY) remains unchanged
...
However, for
an inferior good, an increase in income would result in buying smaller quantities of it
...
They have to maintain certain level of living
standards, regardless of the problems like that of incidence of loans taken, etc
...
This is
also called as the ―Bandwagon effect‖
...
On the other hand,
there are also consumers who like to behave differently from the others
...

This is known as the ―Snob Effect‖
...
Demand for ice creams, cold drinks, Air conditioners, etc
...

(G) Spatial variations in demand:Demand for a good also varies according to the place or profession in which a consumer
is engaged
...
Other things remaining constant, a consumer would buy more or less of a good
depending upon his/her choice or preference function
...
Thus a consumer‘s taste is also an important
determinant of demand for a commodity
...
To illustrate, what is involved, assume
that the demand function for the automobile industry is
Q= x1P + x2PA + x3Y + x4N + x5r + x6Pr

-------------------------- (1)

Equation (1) indicates that, Q, i
...
the quantity demand of automobiles, is a linear
function of the average price of new automobiles (P)(in rupees), the average price of substitutes
(PA)(in rupees), per capital income (Y)(in rupees), population (in crores)(N), average interest
rate on automobile loans(r)(in percent), industry advertising expenditure(Pr)(in ―lakhs‖ rupees)
...
x6 are the parameters of the demand function
...

The law of Demand:The purpose of the theory of demand is to establish the law of demand
...
The law of demand states that:

―Other things remaining the same (ceteris parables), the quantity demanded of a
commodity is inversely related to its price‖
...

Thus,
1
...

2
...
To put it differently, among
the various determinants of demand, the price of the commodity is the only variable
...
The term ―Ceteris parables‖ associated with the law of demand, implies that taste and
preferences, income, the prices of related goods, and social status, all remain constant
over the period in which the impact of price variation on the quantity demanded is being
analysed
...
The law of demand is a partial analysis of the relationship between demand and price, in
the sense that it relates to the demand for only one commodity, say X, at a time or over a
period of time
...
The Demand schedule and a Demand curve can be drawn for an
individual consumer, for a particular firm, as also for the entire industry
...
It is the tabular representation of the different combinations of price and the
corresponding quantity demanded of a commodity
...


The following table gives one hypothetical Demand schedule for an individual
consumer ‖A‖, showing different price levels of a commodity that A is interested in and their
corresponding quantities demanded by A, ceteris paribly
...
When the price falls to Rs 8, he purchases 30 units of
the commodity
...

DEMAND CURVE:The graphical presentation of the Demand schedule of any commodity is known
as the DEMAND CURVE
...

The graph in fig
...
By convention, the prices of the commodity is on the vertical axis and the quantities
demanded is on the horizontal axis
...


Y

10

Price

8
6
4
2
20

30

40

X

50
Quantity

Fig-1
By plotting 20 units of the commodity against price Rs 10, we get a point in fig-1
...
Similarly, other points are plotted representing other combinations of price and
quality demanded of the commodity and are shown in fig-1
...
Thus, the Demand Curve is a graphic
representation of quantities of a good which will be demanded by the consumer at various
possible prices in a given period of time
...
Thus, the market demand curve is found by adding horizontally the
individual demand curves
...
In this way, we can obtain the Market Demand Curve for
the commodity which like the individual consumer‘s demand curve will sloped downward to the
right
...


Suppose there are three individual(s) buyers of a good in the market
...
Now the
Market Demand Curve can be obtained by adding together the amounts of the good(s) which
individuals wish to buy at each price
...
The total
quantity of the good that the three individuals plan to buy at price P1 is therefore 2+3+5=10
which is equal to OQ1 in fig-2(a)
...
So, the market
demand at the price OP2 of the good is 5+7+8=20 units or OQ2
...
(DmDm as shown in fig-2(d))
...
Whatever be the
number of individuals in the market, their demand curves can be added together to get a market
demand curve for the good
...
Besides, as the price of the good falls, it is very likely that the new buyers will enter the

market and will further raise the quantity demanded of the good
...

Why demand curve slopes downwards?:Demand curve shows the relation between price of a commodity and demand at that
price, ceteris paribus
...
A consumer, who is assumed to be a
rational one, always tries to seek maximum total utility when he buys goods
...
Hence, the consumer
would purchase only as many units of the commodity, where the marginal utility of the
commodity is equal to its price and accordingly maximize his satisfaction
...

B) Substitution effect:When the price of a commodity falls, the consumer is induced to substitute more of the
relatively cheaper commodity (one whose price has fallen) for the dearer one (whose
price has remained unchanged)
...
Hence, to
increase his total satisfaction he finds it worthwhile to purchase more of the cheaper
commodity as against the dearer one
...
Since, substitution effect is always positive, a larger quantity of the
commodity will be purchased at a lower price and vice-versa
...

Real income may be defined as total units of goods purchased with a given amount of
money
...
Thus, with the fall in the price of the

commodity, the purchasing power of the real income of the consumer will rise, i
...
the
consumer can now purchase the same amount of commodity with less money or he can
now purchase more with the same money
...

Exceptions to the Law of demand:Although the law of demand is generally applied to all situations, yet there are a
few number of cases where the law of demand does not hold good
...
Some exceptions to the law of demand are explained below:
Giffen goods:Giffen goods are such goods which display direct price-demand relationship
...
Sir Robert Giffen was the first who pointed out such situation
...
The reason given for this is that these
British workers consumed a diet of mainly bread and when the price of bread went up, they were
compelled to spend more on given quantity of bread
...
Thus, they substituted even bread for meat in order to maintain their
intake of food
...
It is important to note that with the rise in the
price of a Giffen good, its quantity demand increases and with the fall in its price its quantity
demand decreases, hence the demand curve will slope upward to the right and not downward
...

When a person‘s behaviour is influenced by observing the behavior of other‘s activities, this is
known as demonstration effect
...
That means demand of an individual is conditioned by the
consumption of others, hence the price becomes a minor consideration in this case
...
For example,
desire or demand for wearing Jeans by girls has been influenced by the number of other girls
purchasing and demanding Jeans
...

Snob effect/Veblen effect:The snob effect refers to the desire of a person (usually the rich one) to own
exclusive or unique product- called Snob good or Veblen good
...
Such goods serve as a status symbol
...
The existence of snob effect tends to make the demand
steeper or less elastic than indicated by the horizontal summation of individual demand curves
...
Diamonds, an
antique work of art, RayBan goggles, latest model of mobile phones, sports car like Ferrari etc
...
The snob effect is also referred to as Veblen effect, for the snobbish
goods are sometimes also known as Veblen goods after the economist Thorstein Veblen
...
In marketing and advertising strategies of such exclusive type
of goods, demand has to be made effective by creating a snob effect
...
As a result, this demand curve
need not be stable overtime
...


So, when there is change in any other determinant of demand, price remaining
unchanged, a new demand curve has to be drawn
...
Any change that lowers the quantity that buyers wish to
purchase at a given price shifts the demand curve to the left
...


Fig-3
D2
D1

Price

D3

Increase in
demand
D2
Decrease
in demand
D2
D3

o

Quantity

TABLE
VARIABLE
Prices
Income
Prices of Related Goods
Tastes and preferences
Future Expectation
Number of Buyers

A CHANGE IN THIS VARIABLE
Represents a movement along the demand
curve
Shifts the demand curve
Shifts the demand curve
Shifts the demand curve
Shifts the demand curve
Shifts the demand curve
-*-

CHANGED DEMAND and CHANGE IN DEMAND:Movement along the same demand curve is known as a contraction or expansion in
quantity demanded i
...

Supply analysis:Any discussion on demand cannot be complete without understanding supply
...
Just as demand is the relation between the
price and the quantity demanded of a product, supply is the relation between price and quantity
supplied
...

Meaning of supply:Supply is the amount of the goods or service, producers are willing and able to
offer for sale at each possible price during a period of time, everything else held constant
...
It is always referred to inrelation to price and time
...

Supply should be distinguished from the ―Quantity supplied‖
...
Thus, the term supply refers to the
entire relationship between the price of a commodity and the quantity supplied at various
possible prices
...
First, supply is a
flow concept, that is, it refers to the amount of a commodity that the firms produce and offer for
sale in the market per period of time, say a week, a month or a year
...
Second, the quantity supplied of a
commodity which the producers plan to produce and sell at a price is not necessarily the same as
the quantity actually sold
...

Supply and stock:The ability of a seller to supply a commodity, depends primarily on stock
available with him
...
Supply and stock are related but
distinct terms:
a) Supply comes out of the stock:- Supply is the amount of stock offered for sale at a
given price
...
Without stock, supply is not possible
...
Evidently, the limit to maximum supply, at a time is set by the given stock
...
Thus, the
stock can exceed supply, but supply cannot exceed the given stock, at any time
...
Sometimes, increase in actual supply can
exceed the increase in current stock, when along with the fresh stock, old
accumulated stock is also released for sale at the prevailing price
...

Determinants of supply:The supply of a product is largely determined by a number of factors, some of which are
enumerated below:
A) The price of the commodity:Supply is positively related to the price of the commodity
...
Thus, price has a positive effect on
quantity supplied
...
If the price of extensive factor(s) of production rises, the
production costs would be higher for the same level of output
...
In both cases, the
supply will be affected
...

C) State of technology:Technology bears a positive relationship with supply
...


D) Government Policies:Government Policies are related to taxes and subsidies on certain products
...
A subsidy,
on the other hand, provides an incentive to production and augments supplies
...
do cause fluctuations in
the supply of goods, particularly of agricultural goods
...

Supply Function:The functional representation of the relationship between supply and its various
determinants, is termed as supply function
...
The supply function of a
commodity represents the quantity of the commodity that would be supplied at a price, levels of
technology, input prices and all other factors that influence supply
...

E = Factors outside the Economic Sphere
...
The intercept ―a‖ represents the quantity supplied when the
price is Zero
...

The Law of Supply:The purpose of theory of supply is to establish the law of supply
...
The law reflects the general
tendency of the sellers in offering their stock of a commodity for sale in relation to the varying
prices
...
‖
The formal statement of the law of supply consists of five phrases:

1
...
Producers are willing and able to offer for sale
3
...
Increases as the price of the good or service increases and decreases as the price
decreases
5
...

Explanation of the Law of supply:The law of supply can be well explained and better understood with the help of ―Supply
Schedule‖ and ―Supply curve‖
...
In otherwords, the tabular representation of the different combinations
of price and corresponding quantity supplied of a commodity, is known as the supply schedule of
that particular commodity
...
The schedule lists are quantities
that the tea seller is willing and able to supply at each price, everything else held constant
...


Table – 1
Supply Schedule
Price
(Rs per cup)
1
2
3
4
5

Supply
(―00‖ cups per week)
20
30
40
50
60

Price and output determination
For demand and supply to determine price, a competitive situation must exist in the market
...
Competition, by
definition, exists when no single economic agent, whether buyer or seller, can control the price in
the market
...
The new
agents can enter the market at will if they feel there are profits to be made
...
In theory each agent must simply accept that price
...
Since, in perfect competition, it is upto the agent to decide the
quantity traded, sellers and buyers are all quantity fixers and price takers
...

Relationship between Demand and Supply:The relationship between demand and supply underlie the forces behind the allocation of
resources
...
In market economy theories, demand and supply theory
will allocate resources in the most efficient way possible
...

Equilibrium:When supply and demand are equal (i
...
when the supply function and demand function
intersect) the economy is said to be at equilibrium
...
Thus, everyone (individuals, firms or countries) is satisfied with the
current economic condition
...


Fig
...
At this point, the price of the goods will be P
and the quantity will be Q
...

In the Real market place, equilibrium can only be reached in theory
...

Disequilibrium:Disequilibrium occurs whenever the price of quantity is not equal to P or Q:-

1
...

Fig :D
S
P1
S
D
O

Q1

Q2

At the price P1 the quantity of goods that producers wish to supply indicated by Q2
...
Because Q2 is greater than Q1, too much is being produced and too little is
being consumed
...

2
...
Because the
price is low, too many consumers want the good while producers are not making enough
of it
Fig :D
S
P
S
D

O

Q1

Q2

In this situation, at price P1 the quantity of goods demanded by the consumers at this
price is Q2
...
Conversely the quantity of goods that producers are willing to produce at this price is
Q1
...
However, as consumers have to compete with one other to buy the good at
this price, the demand will push the price up making suppliers want to supply more and
bringing the price closer to its equilibrium
...

1
...
The
movement implies that the demand relationships remains consistent
...
In other
words, a movement occurs when a change in the quantity demanded is caused only by a
change in price and vice versa
...
Therefore, a movement along the supply
curve will occur when the price of the good changes and the quantity supplied changes in
accordance to the original supply relationship
...

Fig :-

Y
S (Supply Curve)
P1
P2
P3
S

X
(Quantity Supplied)

2
...
For instance, if the price for a bottle of milk
was Rs 20 and the quantity of milk demanded increased from Q1 to Q2, then there would
be a shift in the demand for milk
...

Fig :D2

Shift in Demand

D1
(Price)P1
D1
O

Q1

D2

Q2

x

Conversely if the price for a bottle of milk was Rs 20 and the quantity supplied decreased
from Q1 to Q2, then there would be a shift in the supply of milk
...
A
shift in the supply curve would occur if, for instancea natural disaster caused a mass
shortage of cows, milk producers would be forced to supply less milk for the same price
...
Elasticity of
demand (ED) is a technical term which helps in determining the magnitude of change in quantity
demand for a rise or fall in the price of the product
...

It depends primarily on the percentage changes and is independent of the units used to measure
the quantity and price
...

Types of Elasticity of demand: Basically, there are 3 types of elasticity of demand as follows:
1) Price elasticity of demand (PED)
2) Income elasticity of demand (IED)
3) Cross elasticity of demand (CED) i
...
ED for inter related goods
...

B) Complementary elasticity of demand
...
Thus the change in quality will in the opposite direction to the
change in price
...
The value of price elasticity varies between 0 and

, i
...
0 < PED < 
...


If PED > 1, demand is elastic

ii
...


If PED = 1, demand is unitary elastic

In case (i), a given percentage change in price will result in an even greater percentage change in
sales
...
Therefore the
percentage change in quantity demand will be greater than the percentage change in price
...

Demand is then said to be inelastic with respect to price
...

The absolute value of the coefficient of price elasticity is equal to one (1) in such cases
...

1) Point price elasticity
2) Arc price elasticity
...
In such case, the
point on the demand curve after the change help in measurement of elasticity of demand
...

But in case of Arc elasticity, we can measure elasticity of demand by finding average of price
and quality demand after and before change of it
...

Consider the hypothetical prices of some product and the corresponding quantity demand, as
given below:
Demand schedule to demonstrate price elasticities
Price (P) in Rs
...
00

9
...
50

2
...
67

1
...
25

0
...
11

The algebraic equation for the demand schedule given above
P = 100 -
...
Let‘s
select the point at which P = 10, and Q = 360

Now,

80 10
1
1
ep = dq P 

 4 

 0
...
10/-
...
70/-
...
70

ep

=

Since

-2
...


This example shows that the price elasticity of demand may (and usually does) vary along only
demand function, depending on the portion of the function for which the elasticity is calculated
...
Intuitively, this is so because lowering price from very high levels is like to stimulated
and much are compared to lowering prices when price is already low
...
e
...
30/- and Rs
...
25
640 20 16

The demand is inelastic in this range
...
25 means that a 100% change in

price results in a 25% change in quantity demand (in the opposite direction of the price change)
over this region of demand function
...
5
320 20
4

We would say that demand is price elastic in this range because the percentage change in sales is
greater than the percentage change in price
...
They are as follows :
1) Availability of Substitutes:
The main determinant of elasticity is the availability of substitutes
...
Movies are a good example
...
When ticket price at the movie
theatre increase, these substitute activities replace movies
...
Thus, the product with close substitutes tends to have elastic demand;
product with no close substitutes tends to have inelastic demand
...


2) Proportion of Income Spent:
Demand tends to be inelastic for goods, and services, that account for only a small
proportion of total expenditure
...
2 Kg of salt will meet the need, of
typical household for months and costs only a few rupees
...
As a result, price
changes have little effect on the house hold demand for salt
...
Thus,
demand for holiday travel, luxury cars take up a considerable portion of the family‘s budget and
therefore tend to have higher elasticities
...
For example, the demand for insulin is probably very inelastic because it is necessary
for diabetics who rely on this drug
...
The explanation is
that, given more time, the consumer has more opportunities to adjust to changes in prices
...
Alternatively reducing the price of a product with elastic
demand would cause revenue to increase
...
However, if demand is unitary elastic, price changes will not change total
revenue
...

The decision must also take into account the impact on the Firm‘s costs and profits
...
It is defined as the percentage change in sales divided by the
corresponding percentage change in income
...
If the income elasticity of demand for a product
is greater than one (1), the product is said to be income elastic; if it is less than one, the product
is income inelastic
...

Normal goods are indicated by

EI or eI

Inferior good, are indicated` by

EI or eI < 0

>0

If

EI or eI

>1, the good is income elastic

If

EI or eI

<1, the good is income inelastic

If

EI or eI

= 1, the good is unitarily income elastic

To illustrate just one way in which income elasticity may be useful, consider the following
situation
...
has obtained a fairly reliable estimate of the projected percentage increase in
income for its market area for the next years, let‘s say 4
...
Manager knows that sales are
currently running at an annual rate of 200,000 units, and the marketing analysis group has
estimated the Arc income elasticity of demand for the product at 1
...
If other factors are expected
to remain relatively constant, we can use this information as one input into projecting sales for
the next years, as follows:

EI 

%dQ
%dI

, subsequently,

%dQ   EI  %dI 

 %dQ  1
...
5  %dQ  5
...
4% above the current level, or 1
...
e
...
054 200000  210800units
Cross price elasticity:
The sales volume of one product may be influenced by the price of either substitute or
complementary products
...
It is defined as ―The ratio of the percentage change in sales of one product to the
percentage change in price of another product‖ the Relevant Arc (Ec) and point (Cc) cross price
elasticities are determined as follows:

EC 

Qb 2  Qb1
Pa 2  Pa1

X

Pa 2  Pa1
Qb 2  Qb1

, where

Qb1 : - original demand for product ―b‖
Qb 2 : - changed demand for ―b‖
Pa1 : - original price for product ―a‖
Pa 2 : - changed price for product ―a‖
eC 

dQa
dPb

X

Pb

, where d: - a change in

Qa

If a decrease in the price of product ―a‖ results in an increase in sales of product ―b‖ or viceversa, we can conclude that the products are complementary to each other
...
Similarly, if an increase in the price of ―a‖ results in an

increase in sales of product ―b‖ or vice-versa, we can conclude that the products are substitutes
to each other
...

Many large corporations produce several related products
...
If Maruti reduces the price of its Alto Models, sales of its old warhorse the
Maruti 800 may decline
...

Demand Estimation:
The firm needs to have information about likely future demand in order to pursue
optional pricing strategy
...
The more accurate information, the firm has, the less likely it is to take a decision which
will have a negative impact on its operations and profitability
...
The basic
methods which are used to estimate the demand function are:
1) Market experimentation
2) Survey of consumption intentions
...
These localities are chosen with a mix of customers with different levels of income,
sex, age, education level etc
...

(B) Market simulation Method: Also known as consumer clinic or laboratory experiment
technique, it involves giving a sum of money to each consumer with which he is asked to shop
around in a simulated market
...
In survey of consumers‘ intentions method,
consumers are contacted personally to disclose their future purchase plans
...
In case of the former all consumers
are contacted while in case of the latter only a few consumers out of the population are selected
...

With the help of the census method (also known as complete enumeration method), the
probable demand to all the consumers is summed up
...

Under the sample survey method, the forecasted demand for the sample unit is blown up
to find the total demand in the market
...

A variant of the survey technique is test marketing this is done mainly for estimating
demand of new products of estimating sales potential of existing products in new geographical
areas
...
The product is
launched in this are exactly in the manner in which it is intended to be launched in the market
...

Regression Analysis is a statistical technique by which demand is estimated with the help
of certain independent variables (like income price of the commodity, price of related goods,
advertisement etc
...

The regression method involves five steps:
1) Identifying demand function for the commodity i
...
selecting the variables which are
expected to influence the demand for the product
...

5) Analysing the estimated demand function and suggesting the marketing policy
...
It tries to find out
expected future sales level, given the present state of demand determinants
...
All firms need
to forecast their sales, but it is not possible to forecast them exactly
...
Forecast can broadly be classified into two
categories
...

Active Forecasts: Where forecasting is done under the condition of likely future changes in the
action by the firm
...

Forecasting is done both for the long run as well as short run
...
Besides, given an idea of likely demand short run forecasts
also help in arriving at suitable price for the product and in deciding about necessary
modifications in advertising and sales techniques
...


Long run forecasts are helpful in proper capital planning
...
are included
...

The following steps are necessary to have an efficient forecast of demand:
1) Identification of objective
2) Determining the nature of goods under consideration
3) Selecting a proper method of forecasting
4) Interpretation of Results
Methods of demand forecasting:
There is no easy method or a simple formula which enables the manager to predict the
uncertainties of future and escape the hard process of thinking
...
The critical problem is to
choose the most efficient technique given the objective of forecast, nature of available
information and the availability of finance and expertise
...
To obtain information about the intentions of consumers by means of market research,
survey, economic intelligence etc
...
To use past experience as a guide and by extrapolating past trend to estimate the level of
future demand
...

Demand for established product, therefore, may be forecasted by two broad methods:
1) Opinion Polling Method
2) Statistical Method
Opinion polling method can be of three types:-

a) Consumer‘s Survey Method
b) Sales Force Opinion Method
c) Expert‘s Opinion Method
Consumer‘s Survey Method is further of three types:
i
...
Sample Survey and Test Marketing
iii
...
Mechanical Extrapolation or Trend Projection Method
b
...
Regression Method
d
...
Fitting trend line by observation
II
...
Moving Average and Annual Difference
IV
...
ARIMA (Auto Regressive Integrated Moving Averages) Method
LEARNING OUTCOMES
1 Explain how the law of demand affects market activity
Demand is a relationship between the price of a product and the quantity consumers are willing
and able to buy per period, other things constant
...
A demand curve slopes downward
because a price decrease makes consumers (a) more willing to substitute this good for other
goods and (b) more able to buy the good because the lower price increases real income
...
According to the law of supply, price and quantity
supplied are usually positively, or directly, related, so the supply curve typically slopes upward
...

3 Describe how the interaction between supply and demand create markets
Demand and supply come together in the market for the good
...
In doing so, a market reduces the transaction
costs of exchange—the costs of time and information required for buyers and sellers to make a
deal
...

4 Describe how markets reach equilibrium
Impersonal market forces reconcile the personal and independent plans of buyers and sellers
...

5 Explain how markets react during periods of disequilibrium
...

6
...
More elastic means more responsive
...
If
demand is price elastic, a price increase reduces total revenue and a price decrease increases total
revenue
...
If demand is price inelastic, a higher price increases total
revenue and a lower price reduces total revenue
...

7 Identify the determinants of the price elasticity of demand
Demand is more elastic (a) the greater the availability of substitutes; (b) the more narrowly the
good is defined; (c) the larger the share of the consumer‘s budget spent on the good; and (d) the
longer the time period consumers have to adjust to a change in price
...

Price elasticity of supply depends on how much the marginal cost of production changes as

output changes
...
Also, the longer the time period producers
have to adjust to price changes, the more elastic the supply
...
Income elasticity is positive for normal goods and negative for inferior goods
...
Two goods are defined as substitutes, complements, or unrelated,
depending on whether their cross-price elasticity of demand is positive, negative, or zero,
respectively
...
Given the following market demand function for the commodity ―A‖
...

II
...


If the price of commodity C rises,

IV
...


The firm producing A increases its advertisement expenditure
...
The demand for apples in a small town was 200 kg when the price was Rs 20 per kg
...
When the price was reduced to Rs 18 per kg
...
For each of the following equations, determine whether demand is elastic, inelastic or
unitary elastic at the given price:
a) Q = 100 – 4P and P = Rs 20
b) Q = 1500 – 20P and P = Rs 5
c) P = 50 – 0
...
A consumer purchases 80 units of a commodity when its price is Rs 1 per unit and
purchases 48 units when its price rises to Rs 2 per unit
...
eP = 0
...
The price elasticity of demand of colour TVs is estimated to be -2
...
If the price of colour
TVs is reduced by 20 percent how much percentage increase in the quantity of colour
TVs sold to do you expect? [Ans
...
Suppose that your demand schedule for T-Shirts is as follows:
Price

Quantity Demanded

Quantity Demanded

(in Rupees)

(income = Rs 12,000)

(income = Rs 15,000)

5

20

25

8

16

22

11

12

19

14

8

16

17

4

13

a) Use the mid point method to calculate your price elasticity of demand as the price
of T-Shirts increases from Rs 5 to Rs 8 if (i) Your income is Rs 12,000 and (ii) If
your income is Rs 15,000
b) Calculate your income elasticity of demand as your income rises from Rs 12,000
to Rs 15,000 if (i) the price is Rs 14 and (ii) the price is Rs 17
...
Two goods have cross elasticity of demand equal to 1
...

a) Would you describe the two goods as substitutes or complements?
b) If the price of one of the goods rises by 5 percent, what will happen to the demand
for the other good, holding other factors constant?
8
...
1Y, where Q = Quantity demanded of

its burgers, P = Price of its burgers, Pi = Price of burgers of Jumbo Burgers (the closest
rival of Tasty Burgers), Y = Disposable income of consumers of Mumbai
...
(a) eP = 0
...
5405, (c) eC =

0
...
Using the following schedule, define the equilibrium price and quantity
...
What will occur? Describe the situation at a price of Rs 2,
what will occur?
Price

Quantity demanded

Quantity Supplied

(in Rs)

Qd

QS

1

500

100

2

400

120

3

350

150

4

320

200

5

300

300

6

275

410

7

260

500

8

230

650

9

200

800

10

150

975

10
...

I
...


Find the equilibrium price and quantity
If there is an increase in consumer‘s income QdX = 14,000 – 2,000PX, derive the
new market demand schedule and state the new equilibrium price and quantity
...


Suppose there is an improvement in the technology of producing commodity, the
new market function is QSX = 4,000 + 2,000PX
...


11
...
Find
out the cross elasticity of demand and when the price of Tea rises from Rs 50 per 250 g
pack to Rs 55 per pack
...
5Pt
Where Q is quantity demanded of coffee in terms of 250 g and Pt is the price of tea per
250 g pack
...
Colgate sells its standard size toothpaste for Rs 25
...
Recently its close competitor Pepsodent reduced
the price of its same standard size toothpaste from Rs 35 to Rs 30
...

I
...


Calculate the cross elasticity between the two products
...


13
...
At price Rs 30, the seller
offered to sale 12 p
...
more
...
Assume that the average price of a new model of Maruti car in Delhi is Rs 4,60,000 and
90,000 cars are sold out at this price in a year
...
7 what will be the effect on annual sales when the average price of this new
model declines to Rs 4,15,000
...
Estimate the elasticity of supply at price Rs 20 per unit of the commodity, given the
supply function:
QS = 90 + 15P
16
...
The price of
the substitute good is Rs 20
...
Now what is the price
elasticity of demand? What is the cross-price elasticity of demand?
17
...
If a 50 p
...
increase in the
price of good X doesn‘t change the amount consumed of good Y, what is the price
elasticity demand for good X?
18
...
2
...
c
...
Samsung pvt
...
Is planning to reduce the price of its refrigerators by 10%
...
The price
and income elasticity are estimated to be -1
...
0, respectively
...
How much can Samsung hope to sell after the above
changes in price and income?
20
...
The dairy sells
2000 packets of flavoured milk and 1000 packets of buttermilk everyday
...
A market survey estimates the cross-price elasticity
(both ways) to be +1
...
3
...
Should it go ahead
with the price reduction? Show your working
...

b) Buyers purchase less in hopes that the price will fall in the future
c) Buyers purchase less in part because their real income has fallen
d) Buyers purchase more in part because the price of a substitute has risen
...



The difference between normal and inferior goods is that

a) Normal goods are of better quality than inferior goods
b) An increase in price will shift the demand curve for a normal good rightward and the
demand curve for an inferior good leftward
c) If the price of a normal good increases individuals who buy it are poorer, for inferior
goods, the opposite is true
d) An increase in income will shift the demand curve for a normal good rightward and the
demand curve for an inferior good leftward
...




Supply curves generally slope upward because of all of the following reasons except one
...



Which of the following is the reason supply curves typically slope upward?
a) Opportunity cost of production increases as quantity supplied increases
b) Supply increases as opportunity cost decreases
c) Price increases as supply decreases
d) Quantity supplied is unrelated to price



If the supply curves for the following goods were plotted, they all would slope upward
except one
...
If saccharin is found
to cause cancer
a) The price of Aspartame will increase
b) The price of sugar will decrease
c) The price of saccharin will increase
d) The demand curves for Aspartame and sugar will shift leftwards
...
Which of the following will happen?
a) Quantity demand will increase
b) A surplus will develop

c) A shortage will develop
d) The market will remain in equilibrium
...
Be it in
the field of engineering (IITs), medicine (AIIMS) or management (IIMs) education comes at a
much lower price than in a country like the US
...


However, the recent trend of privatization initially meant for the industrial sector has spread its
wings to core social sectors like education, especially higher education
...
Of late, the UGC has been saying
that he burden of subsidy has to be reduced for which, colleges have to hike their fees and
quality education will in future, come at quality price
...

The managing committee of the college in discussion with the principal and the patrons
decided, if the same quality of education had to be maintained, the fees of the students had to
be increased on an average by 75 per cent, i
...
General Science students who were earlier
paying Rs 500, would now have to pay Rs 875 per month
...
This on a
monthly basis amounted to a 100 per cent hike in the fee structure, which pinched middle-class
parents‘ pockets
...


In a meeting between the students‘ union and the managing committee, student leaders
protested by arguing that most of them could not afford to pay more than what they were
already paying
...
The principle
also argued that with increased revenue, the college could start new popular courses like
insurance, financial journalism, etc
...
The

faculty, partly because the fee hike meant a probable hike in their salaries and partly as a promanagement policy, were in favour of the new fee structure, more so, because the new situation
would not lead to a loss of jobs for some of them
...
During the lull, a group of students of managerial economic came
up with a brilliant idea
...
This group of students studied the fee structure for all the subjects carefully and also
made a study of all the colleges in that area
...


Further investigation showed that students from all course could be divided into three broad
groups—Group 1 consisting of commerce, economics and management, Group 2 consisting of
English, mathematical statistics, mathematics and applied psychology and Group 3 consisting
of all other subjects
...
Group 2 students showed more of an
inclination to leave if the fees were hiked
...

The Group 3 consisted of 60 per cent of the students in the college who were ‗fee sensitive‘ and
showed a positive correlation with the ‗economical‘ courses being offered in the college
...


Since a majority of the students were in Group 3, it was studied further
...
2 per cent fall in the enrolment number with every 1 per cent hike in the fee
...
they
could thus convince the college authorities that the college will be a loser if there was a general
fee hike
...
Assuming that the students are consumers availing of educational service, how will you
differentiate between the behaviours of the Group 1, Group 2 and Group 3 consumers?
Hint: Explain in terms of elasticity
...
Explain the law of demand that the managerial economics students were talking about to
stop the fee hike
...
Can you think of certain arguments in the case study which the college authority could
pick up to counter-argue with the students?
4
...


CASE-II
Demand Function in the Indian Auto Industry
In an economy, growing with the rapid growth of the middle class, the consumption of
consumer durables is an indicator of the level of urbanization, modernization and lifestyle
...
Moreover, the contribution of auto-industry to the
GNP has been increasing steadily ever since the sector had been delicensed in 1993
...
The size of the passenger car is about 4 lakh at present,
which is miniscule when compared to the US, Europe or the Japanese market
...
Global car manufactures are
paying heed to it and have flocked to the country
...
We will start our
discussion with the greatly untapped market—the non-urban car market in India, which
contrary to popular belief, has potential
...

More appropriately, per capita real GNP itself
...
There has been a huge
increase in the real per capita non-urban (specifically non-metro) income
...
But can
we treat the whole non-urban/no-metro society as a uniform group exhibiting a similar kind of
demand in the market? Certainly not, because the non-urban area is divided into rich farmers,
plantation owners and absentee landlords who have diversified into other kinds of businesses,
including exports
...
Thus we
get the first kind of market segment, on the basis of income group, and within the segment the
sub-segment, i
...
from where the income is generated, rural or urban area, local or global
market, income is generated, rural or urban area, local global market
...

Car manufactures have already divided the car market on the basis of income
...
The premium segment is likewise, divided into the luxury
segment and super-premium segment
...
Let us take the case of a rich sugar farmer form UP
...
Further market
research proves that people from semi-and non-urban India envisage heavy-looking, brightly
coloured goods as a sign of strength, durability and sturdiness
...

The next crucial question is, how price sensitive are the buyers? Here the approach that
has to be followed will vary greatly between urban and non-urban areas
...
Heavy advertising and easier B2C communication in urban areas are
helping auto-manufacturers develop a brand image easily, educating the customer on brand
equity and acquiring brand loyalty
...
Thus, an urban buyer tends to be less price sensitive
...
This makes the metro buyers price-insensitive as a car is treated
more like an essential commodity
...
Further, in the cities one finds and equal number of women drivers who prefer
delicate-looking cars
...
The reason being that price itself becomes a function of lifestyle
...


Studying the demand pattern of the buyers for proper positioning of the car and gaining
market share becomes more important as the supply of the passenger car, ever since the sector
has been deregularized, has far outstripped the actual demand for cars making this a ‗buyer‘s
market‘
...
Discuss in detail the various determinants of demand for passenger cars in India
...
What role does non-urban India play in forming the demand in the auto-market?
3
...

4
...
List the
various demand aspects you think are important
...


MODULE-4: MACRO ECONOMICS VARIABLES

Macro Economic policies – An overview
The term Macro Economics applies to the study of relation between broad economic
aggregates
...
It‘s the study of economic
system as a whole
...
It thus becomes the study of aggregates and is often called ―Aggregative
Economics‖ as it studies the behaviour of these aggregates over time and space
...
The days of
―Laissez-faire‖ are over and govt
...

Government deals not with individuals but with groups and masses of individuals, thereby
establishing the importance of macro economic studies
...
We are led to analyse the
cause of fluctuations in income, output and employment, and make attempts to control them or at
least to reduce their severity
...
This process takes place continuously through the activities like
production and sale of final product and generation of income
...
sector and the rest of the world sector or foreign trade sector
...
These are inflows into the economy
...
When households buy goods from the rest of the world, the
expenditures for it constitutes imports of the economy
...

Thus households buy imported goods from abroad and make payments for them
...
Similarly the business sector exports goods to the rest of the world and also renders
services like shipping, banking, insurance etc
...
For these they receive
payments from abroad and also receive royalties, interests, dividends, profits etc
...
Thus, the payments of business sector to abroad constitute leakages and its
receipts constitute the inflows into the circular flow
...
Besides, it
lends to foreign governments and also borrows from them
...
It also receives payments when foreigners visit the country
as tourists or when it supplies services like education, shipping, insurance etc
...

When it invests abroad, it receives royalties, interests, dividends etc
...
When govt
...

Thus in an open economy savings, taxes and all types of imports of goods and services
form leakage from the circular flow
...
purchases and exports of goods
and services form inflows into the circular flow
...

When exports exceed imports, the economy has a surplus income and when imports
exceed exports economy has a deficit income from foreign sector
...

Through this circular flow, all the economic activities in the economy continue and gradually it
raises the national income
...

There are three ways to look at the level of economic activity, viz
...
Depending upon the way we look at them, we call them Gross National Product
(GNP), Gross National Income (GNI) and Gross National Expenditure (GNE)
GNP – Sum of the market value of all final goods and service produced in an economy during a
given time period
...

National income data is quite helpful for business
...
National income data in the
hands of an expert managerial economist can prove a life-line for business
...
The national income data can also be
successfully used for determining the product diversification programme and undertaking
technological innovations
...

Percapita income = Total National income/ Total population of the country
Methods of measuring National income:
National Income can be measured by any of the three ways
i)

As an aggregate of expenditure of consumption, saving and investment during a year
(Expenditure method)

ii)

As an aggregate cost of factor services in the economy during a year (Income
method)

iii)

As an aggregate of goods and services produced during a year (Net product method)

Expenditure Method: According to this method, the total national expenditure is the sum of
expenditure incurred by the society in a particular year
...
expenditure on
goods and services (G) and the net foreign investment (i
...
imports & exports)
Therefore GNE = C + I + G + (M-X), where M = Imports, X = Exports
To estimate National Income using expenditure method, we basically use the following steps:
1) The first step is to find out the number of units of each of the varieties of goods and
services produced during a given year
...

2) The second step is to prepare the price list of all the goods that are listed
...

4) Lastly, by adding up each of these multiplications, the aggregates are obtained
...

Income Method: According to this method, the incomes received by all the basic factors of
production used in the production process are summed up
...
In those cases where both labour and capital are supplied by same
individual, it is not possible to know what part of income of the individual is an account of
labour services and what part on account of capital services
...
Thus, there are three components of national income in this
method
...

B) Capital Income: Includes dividends, pre-tax retained earnings, interest on savings and
bonus, rent, royalties and profits of govt
...

C) Mixed Income: Comprises the earning from professions, farming enterprises etc
...

Net Product (or Value Added) Method: It is basically known as the product method
...

Three steps are involved in calculation of national income through this method
...


ii)

The money value of raw material and services used and the amount of depreciation of
physical assets involved in the production process are summed up
...
These categories of output are known as sectors
...
) is subtracted to get the
sectoral value added
...

Aggregate demand and Aggregate Supply:
These two parameters greatly influence the level of economic activity
...
The income, thus, received by the firms and households is
used in the following manner:
i)

A part is paid to Govt
...


iii)

A part may be paid for goods imported from abroad (M)

iv)

The major part used for the purchase of consumer goods and services (C)

Thus, the aggregate supply or aggregate income = C + S + T + M
The tax revenues received by the government are used to pay for goods and services bought by
the govt
...
Foreign countries use the money
received from the export of commodities to this country to import goods and services from this
country
...
So, on the demand side,
we have four basic things:
i)

Personal consumption expenditure (C)

ii)

Private Investment spending (I)

iii)

Govt
...
That is
C+S+T+M=C+I+G+X
S+T+M=I+G+X
Consumption Function:
Consumption refers to the part of income spent by households on the purchase of final
consumer goods and services in the economy
...
F) is expressed by C = F (y) –––––– (1)
It show that consumption increases as income increases, but less than proportionately
...

To explain the relationship between income and consumption we can divide the
consumption function (C
...

1) Average Propensity to Consume (APC): It refers the ratio between the absolute
consumption (C) and the absolute income (y)
...
In short run, APC
declines as income increases
...

ΔY

The value of MPC is a positive constant but always less than one (1)
...

Both APC and MPC can be explained with the help of a table:
Income (Y)

Consumption (C)

APC (C/Y)

0
100
200
300
400

40
100
160
220
280

-1
0
...
73
0
...
6
0
...
6
0
...

Savings: It refers to that part of income which a consumer does not spend on the current
purchase of final goods and services
...
Therefore, savings constitute the Non-consumption part of income
...
That is, it
refers to the ratio between absolute savings (S) and absolute income (Y)
...
That is, MPS is a ratio of the change in saving to the corresponding change in income
...

The subjective factors include all the factors related to human psychology, social
arrangements and practices etc
...
They
are also concerned with family education, home ownership and other unforeseen
contingencies
...
Hence level of consumption
falls
...

2) Conspicuous Consumption: It refers to the type of consumption which are mostly
determined by clever advertising and emulation of others
...


3) Desire for Improvement: There is a common instinct to look forward to a
gradually improving standard of living the stronger the instinct the higher the
desire for improvement
...

4) Financial Prudence: The motive for financial prudence mainly influences the
propensity to save of corporation and other business units
...
Such
prudence offsets the propensity to consume
5) Motive for precaution: It implies the desire of every individual to withhold some
funds so as to face uncertain situations which may come in future
...
Wealth generates income which helps in fulfilling his varities
of wants
...
Thus most of the
individuals try to save so as to be independent
...

7) Motive for pride : If an individual wants to maintain its pride of having influence
in the society, it wants to save more to be a rich man in the society
...

The objective factors are mostly external to the behavior or psychology, of individuals
and influence their level of consumption
...
But in communities where there are
large inequalities in the distribution of income, the propensity to consume remains low
...
Thus, MPC
will be higher
...
These mostly influence the level of consumption
function in a no
...
If they save more, it reduces the disposable income of the share
holders
...


C) Windfall gains: Consumption is also influenced by wind fall gains and losses
...
But these are less
likely to occur in short run
...
If they expect a fall in price level, they will postpone
their consumption
...
bonds in their hands
...
The real value of these liquid assets increase as a result of either lower
general prices with constant liquid assets or larger liquid assets with constant general
prices
...

F) Rate of interest: A rise in interest rates might lead to drop in insurance premium rates
through its favourable effects on life insurance companies‘ investment earnings
...
A rise in interest rates will lead to a fall in the money
value of bonds
...
But the rate
of interest may be a relatively unimportant factor when there is a rigid public policy for
maintaining a stable interest rate structure
...
When public expenditure
will be high and taxation will be less, then the level of consumption will increase
...
In general, investment means real
investment which adds to capital equipments and leads to increase in the level of employment
and output
...


Real investment is of two types
1) Autonomous investment
2) Induced investment
Autonomous Investment: It is the type of investment which is independent of the level of
income
...
Therefore, it‘s otherwise known as public investment or govt
...
The investment
in economic and social overheads made by govt
...

Autonomous investment can be expressed with the help of a diagram
...
It shows that at all levels of income along x axis the level
of investment is OI
...

The

factors

that

determine

Autonomous

investment are many
...
These include:
1) Innovations and inventions
2) Growth of population and labour force
3) Social and legal institutions
4) Weather changes
5) WAR etc
...
Business cycles are wave like movements
found in the aggregate economic activity of a nation
...
There is always some measure
of regularity in respect of the duration and the time sequence of the upward and downward
movements of the business cycle
...


A normal business cycle consists of four closely inter-related phases:

i) Revival / Recovery
ii) Expansion / Prosperity
iii) Recession / Down turn
iv) Contraction / Depression

i)

The “Peak” or “Ceiling” on the one
hand and the “Trough” or “Floor”, on
the otherhand, represents critical
turning points in the Trade/Business
cycle
...
Stocks of good remain below the normal with the
shopkeepers
...
The result is that demand orders pour in and the produces get
stimulus and encouragement to produce more
...
In other words
during prosperity, economic affairs and activities are at the optimum level and
there is no wastage of resources of any kind
...
But with the passage of time,
resources which are fully employed become scarce, output becomes less
elastic, bottlenecks appear, costs rise, deliveries become difficult – all these
combine to give a boost to the rising volume of money
...
These lags and
distortions bring about an end of cumulative expansion or prosperity phase of
the cycle and the recession begins giving way to contraction, depression or
regular slump
...
Recession though
spread over a short span of time, marks the turning point during which the
forces that make for regular slump or depression finally win over and come to
prevail
...
The recession generates such complex forces as lead the entire system
to a head long crash
...
The collapse of
confidence and weakening of expectations pave the way for recession
iv)

Depression: It‘s a natural consequence of the recessionary crisis
...

which can sustain investment at a high level, recession may give way to even
a more grave situation, called depression
...
It
gives rise to panic and collapse of confidence
...
The collapse of confidence and weakening of
expectations which pave the way for recession brings about a fall in prices,
reduction in output, false in profits, fall in employment, fall in bank credit
...
The recession when carried to extremes gives rise to
depression – the symptoms are the same
...
The cycle shows fluctuations in total output and not of any single commodity or a group
of commodities
...


Causes of Business Cycle :
The general factors causing swings in Business activity are as follows:
i)

Banking operations by expanding and reducing credit creation, changing
discount rates, and the ratio between deposits and cash reserves, the Banks can
change the volume of money supply in the economy, and thus contribution to
the cyclical phenomenon
...
This results in business cycles
...

iv)

Profit motive: The profit mania of producer makes him to optimistic
...

The result is that if the retail trade is little high, the producer magnifies the
tendency by expanding production considerably and himself causing a mild
boom in the labour and raw material markets
...
This behaviour
tends to intensify the process of rise or fall in prices
...
Optimism and pessimism
give birth to one another in an endless chain
...
The turn
in the reverse direction occurs at the bottom of the depression
...


vi)

Cyclical changes in Weather: These changes affect agricultural production
and the prices of those basic goods which the working class in a society
consumes
...
thereby
contributing to the fluctuation in the economic activity
...
And during recession and depression, firms lose due to the
opposite effects
...

At the advanced stage of expansionary phase, the firms find markets highly competitive
...
e
...
Demand falls and old
orders are cancelled, prices fall and inventory level goes up significantly during this phase
...
Many a time, firms have to sell their goods even at a loss so as to
meet their obligations
...
can be relatively easily
adjusted to changes in demand
...

Since business can not be eradicated, all that is possible is to reduce the ill-effects to
cyclical fluctuations
...

It includes the following
...
This will be a good check on
over-optimism and over-pessimism which play a vital role in creating cyclical
fluctuations
...

c) The overhead cost per unit of output should not be allowed to go up
...

2) The curative or relief measures that improve upon the ill-effects of business cycle
...

b) Changes in quality and nature of product, which is likely to give fillip the sagging
demand
...

d) In order to compensate for the loss of market suffered during the period of
depression, the firm can take a positive approach
...

In order to tide over the difficult time of depression the firm can utilize a part of its retained
profits
...
Inflation is therefore ―a self

perpetuating and irreversible upward movement of the price level caused by an excess of demand
over capacity of supply‖
...

ii)

Demand Pull Inflation: It‘s a situation where the aggregate demand exceed the
economist ability to supply the goods and services at the current prices, so that the
prices are pulled upward by the upward shift of the demand function
...


iii)

Cost Push Inflation: The inflation which arises by the change in supply or cost is
known as cost push inflation
...
It arises mostly due to inadequacy of aggregate demand, resource
unemployment and excess capacity, which may occur because of wage rise, profit rise
and rise in material cost
...
Therefore the factors causing excess demand and the factors
causing reduction in supply are the basic causes of inflation
...

3) Increase in Govt
...

8) Generation of Black Money
...

1) Scarcity of factors of production
...

5) Operation of the law of diminishing return
...
It also affects interest rates, and has
powerful influences on investment and employment, in the short run
...
Monetary policy has two broad
objectives – price stability and growth
...
If growth is promoted, inflation cost mounts up and if
inflation is controlled (for price stability) growth is sacrificed
...

In India, RBI, being the central bank, adopts monetary policy, in order to control the
credit situation, on the fact of business fluctuations
...
They aim at regulating the overall level of credit in the economy through
the commercial banks
...
By raising the bank rate, central bank make borrowing costlier,
consequently commercial banks borrow less from the central bank
...
It reduces the money supply in the economy
...
On the other hand, by lowering the bank rate, the RBI can make
borrowing by commercial banks cheaper
...
This would encourage investment, output,
employment, income and demand
...

Open Market Operations: It refers to the sale and purchase of securities by the central bank
...
This reduces credit in the market
...
Similarly in recessionary conditions, the central bank
should buy securities thereby raising money supply in the economy, whose impact would be an
increasing in investment, output, income, employment and prices
Varying Reserve Ratios: Changes in reserve ratio can help combat inflation and recession
...
In order to reduce credit by the commercial banks many a
time the central bank increases the percentage of such deposits
...

Selective credit controls are used to encourage or discourage specific types of credit for
particulars purposes
...

When recession is in some specific sectors of economy the central bank can use some selective
credit control measures particularly lowering margin requirements which would help in
encouraging greater business activity
...

During inflationary conditions fiscal policy aims to drain away excess purchasing power
by taking rupees out of the income expenditure stream
...
There are two approaches for accomplishing
this:
1) To reduce government spending and create a surplus budget (where tax revenue exceeds
govt
...
The reduction in govt
...

2) To increase taxes on business and consumers without increasing government expenditure
...

Depending on which of the approaches are used, there will be differential impact on
public and private sectors
...
The expenditure approach to GDP adds up the market value of all final goods and
services produced in the economy during the year
...

Discuss the circular flow of income and expenditure
The circular-flow model summarizes the flow of income and spending through the economy
...
These leakages equal the injections
into the circular flow from investment, government purchases, and exports
...
Most household production
and the underground economy are not captured by GDP
...
In other ways GDP may overstate production
...


Explain how to account for price changes
Nominal GDP in a particular year values output based on market prices when the output was
produced
...
The
consumer price index, or CPI, tracks prices for a basket of goods and services over time
...
No adjustment for price changes is perfect,
but current approaches offer a reasonably good estimate of real GDP both at a point in time and
over time
...
An increase in aggregate demand can cause
demand-pull inflation
...
Prior to
World War II, both inflation and deflation were common, but since then the price level has
increased virtually every year
...
Unanticipated inflation arbitrarily creates winners and losers, and forces people to
spend more time and energy coping with the effects of inflation
...
Unexpected inflation makes long-term planning more difficult and
more risky
...
The real interest rate is the nominal interest rate minus the inflation rate
...

Explain the role of consumption
The most predictable and most useful relationship in macroeconomics is between consumption
and income
...
The consumption function shows the link between consumption and income in the
economy
...
The slope of the saving
function reflects the marginal propensity to save, which is the change in saving divided by the
change in income
...

Discuss gross private domestic investment
Investment depends on the market interest rate and on business expectations
...
We‘ll
assume for now that investment in the economy is unrelated to income
...
Government purchases are based on the public choices of elected
officials and are assumed to be autonomous, or independent of the economy‘s income level
...

Explain how net exports affect aggregate expenditure
Net exports equal the value of exports minus the value of imports
...
S
...
S
...
Imports increase with U
...
income
...
For simplicity, however, we initially assume that net exports are
autonomous, or unrelated to domestic income
...
The share reflected by government purchases fell from
about 22 percent to 18 percent
...
Net exports‘ share turned negative, meaning that imports
exceeded exports
...
Automatic
stabilizers, such as the federal income tax, once implemented, operate year after year without
congressional action
...
If that legislation becomes permanent, then
discretionary fiscal policies often become automatic stabilizers
...
Thus, the simple multiplier for a change in government
purchases is 1/(1 - MPC)
...
The multiplier for a change in autonomous net
taxes is -MPC/(1 - MPC)
...
Because the short-run aggregate supply curve slopes
upward, an increase in aggregate demand raises both output and the price level in the short run
...
Fiscal policy that reduces aggregate demand to close an
expansionary gap reduces both output and the price level
...
Consider the following data for the selling price at each stage in the
production of a five-pound bag of flour sold by your local grocer
...

Stage of Production
Farmer
Miller
Wholesaler
Grocer

Sale Price
$0
...
50
$1
...
50

The expenditure approach adds up the total spending on new production, while the income
approach adds up all of the income earned by the resource suppliers in producing flour
...
The sum of the value added at each
stage equals the final market price of the good
...
The final market
value of the bag of flour, for example, is calculated as $0
...
20 + 0
...
50 = $1
...

2

(Expenditure Approach to GDP) Given the following annual information about a

hypothetical country, answer questions a through d
...

b
...

d
...

b
...

d
...

Gross investment  depreciation = 4010 = $30 billion
XM = 3040 = $10 billion

(Investment) Given the following annual data, answer questions a to c
...
What is the value of gross private domestic investment?
b
...
Are any intermediate goods included in the measure of gross investment?
a
...


$1
...
4 trillion (gross investment) – 200 ( depreciation)

c
...
4 trillion = 500 (new residential construction) + 800 (new physical capital) +
100 (net changes in firms‘ inventories)
Any intermediate goods that were produced during the year but not yet
reprocessed or resold are included in the figure for net changes in firms‘
inventories
...
Injections consist of investment spending,
government purchases, and exports
...


5

(Limitations of National Income Accounting) Explain why each of the following should be
taken into account when GDP data are used to compare the ―level of well-being‖ in different
countries:
a
...
The distribution of income
c
...
The length of the average work week
e
...

a
...


Distribution is ignored in calculating GDP, yet distribution is clearly relevant in
using GDP to measure the degree to which the economy is meeting people‘s
needs
...


GDP includes only goods and services sold in markets (with minor exceptions)
...
In countries where many
goods and services are produced outside the official marketplace, the GDP will
underestimate the true amount of annual production
...


d
...
Increased leisure
may lead to an improved quality of life

e
...
To the extent that rising GDP occurs with rising pollution levels, GDP
statistics overstate the level of well-being
...
Assume that current year prices of Twinkies, fuel oil, and cable TV are
$0
...
25/gallon, and $15
...
Calculate the current year‘s

cost of the market basket and the value of the current year‘s price index
...
89/
package
1
...
00/month

Cost of
Basket in
Base Year
$324
...
00
360
...
85

Prices in
Current Year

$
...
25/gallon
$15
...
75
625
...
00
$1,151
...
75 for Twinkies, $625
...
00 for
cable TV
...
75, and the new price
index is 97—the average price level has fallen by 3 percent since the base year
...
The fall in the price of cable TV outweighed the effect
of the increases in the prices of fuel oil and Twinkies
...
The CPI equals 200 in 2010 and 240 in 2011
...
The CPI equals 150 in 2010 and 175 in 2011
...
The CPI equals 325 in 2010 and 340 in 2011
...
The CPI equals 325 in 2010 and 315 in 2011
...

a
...

c
...


20
...
7 percent
4
...
1 percent (the price level fell)

MODULE-2: PRODUCTION AND COST ANALYSIS
Theory of Production:
Production is an activity that transforms inputs into output
...
and the output could be goods or services
...
Therefore, production is any
activity that increases consumer usuability of goods and services
...

Three things are necessary in the production process
...
It
indicates the maximum amount of output that can be produced with the help of each possible
combination of inputs
...
The production function rests on two main assumptions
...
If technology changes, it would result in alternation of the input –
output relationship, resulting in another production function
...
In other
words, the production function includes all the technically efficient methods of
production
...

Although a firm often uses several inputs, for simplicity we use a two-input case (Whose
result can be generalized to the situation of more than two inputs)
...

It must noted that the form of production function is taken a given, by a managerial
economist, because formulation of a production function falls, in fact, under the purview of
production engineering
...

A hypothetical production function is displayed in the following table where different
amounts of output (Q) resulting from various combinations of labour (L) and capital (K) are
given
...
B – Technical efficiency and economic efficiency –
We say that a firm is technically efficient when it obtained maximum level of output
from only given combination of inputs
...
A producer can not decrease the amount of one input and at the

same time maintain the output at the same level without increasing one or more inputs
...

On the other hand, we say a firm is economically efficient, when it produces a given
amount of output at the lowest possible cost for a combination of inputs provided the prices of
the inputs are given
...
e
...
On the other hand, when
input prices are also given in addition to the combination of inputs, we deal with the problem of
economic efficiency, i
...
how to produce a given amount of output at the lowest possible cost
...
These are total product (TP), Marginal product
(MP) and Average product (AP)
...
e
...
If we assume labour (L) to be the variable input
(Capital (K), held constant), then Marginal product of labour (MPL) is defined as the change in
the total product per unit charge in labour, i
...


MPL =

dQ

where d – A change in
...
Marginal product can be found only when the factor input is a variable factor
...


So, APL =

Q
L

Law of variable proportions (Reproduction function with one variable input):
Under this law, we study the effect on output of variation in factor proportions
...
If there is improvement in technology, then marginal and average product
may rise instead of diminishing
...

3) The fixed factor can be adapted to the change in quantity of the variable factor
...
e
...


The law of variable proportion can be explained a better way with the help of the following
table
...
It is observed
that each of them rises upto a certain limit beyond which each of them falls downs
...
5
7
...
75
10

1

6

58

08

9
...
85
8
...
22

1

10

60

-5

6

1

11

54

-6

4
...
We
may use the following figure to explain these stages
...
e
...

It‘s obvious that no ―Rational Firm‖ will change to operate either in Stage I or in Stage
III
...
e
...
In Stage III, the firm grossly over utilizes its fixed capacity
...
It‘s therefore unadvisable to
use any additional unit
...
It can, thus, be concluded that Stage II is the only relevant range for a ―Rational Firm‖
in a competitive situation
...

Long Run production Function: A case of returns to scale:
A situation where all inputs are subject to variations is a case of Long-Run production
function
...
Consequently, the contribution of the variable input declines
...
In the long run all inputs can change,
let‘s consider two inputs, labour (L) and capital (K), these can change in two ways:
1) Both L and K can change in the same portion, implying that (K/L) ratio or technique of
production remains the same
...

The percentage increase in output when all inputs vary in the same proportion is known as
―Returns to Scale‖
...
When Returns to Scale occurs, three alternatives situations are
possible
1) Constant Returns to Scale – Out put increases in the same proportion as the
increase in inputs
...

3) Decreasing Returns to Scale – Output increases by a lesser proportion than the
increase in inputs
...

A Hypothetical Example to slow returns to scale

Units of
Labour (L)

Units of
Capital (K)
(Rs
...
33

500

42
...
66

860

14
...
29

940

9
...
5

1,000

Returns to
scale

6
...
It‘s a curve which shows the different combinations of the two inputs
producing a given level of output
...
along the ray, the proportion in which labor and
capital are employed, remains constant, the ratio being 10 labour to 5 capital, here
...
Between points C and E, there are constant returns to scale – input
increases by the same percentage as does the output
...
So, the
figure shows that spacing of iso-quants along a ray indicates whether returns are increasing,
constant or decreasing
...

2) There are some industries in which it is not possible to undertake production at a small
scale, e
...
blast furnaces, earth moving equipments etc
...
This is
important especially for those industries where storage is an important activity, like
chemical industries, cold storage etc
...

This is so because,
1) Coordination and control become increasingly difficult
...


Producer‘s Equilibrium:
The production manager always confronts with the following two choice decisions, in the
process production
...

2) Choose the input combination that leads to the lowest cost of producing a given level of
output
...
e
...
Therefore,
produces Equlibrium is the position of opeimal input combination – optimal output
...
e
...

To analyse producer‘s equilibrium, it‘s necessary to be familiar with the concept of
production isoquants and isocost line
...
With two variable inputs, capital and labour, the
isoquant gives, the different combinations of capital and labour, that produces the same level of
output
...
The isoquant depicts various combinations of
capital and labour inputs that can produce 100 units of output
...
The rate at which one input can be substituted for another input, if output remains
constant is called the marginal rate of technical substitution (MRTS)
...


MRTSL forK =

ΔK
ΔL

It is customary to define MRTS as a positive number, since  ΔK ΔL  the slope of the isoquant,
is negative
...
That is more and more labour
is distributed for capital, while holding output constant, the absolute value of  ΔK ΔL  decreases
...
In other words along an isoquant,
ΔL  MPL = ΔK  MPK



ΔK
ΔL



MPL
MPK

However, as we have seen earlier  ΔK ΔL  is equal to MRTSL, K and hence we get the following
expression for MRTSL, K as the ratio of the corresponding marginal products

MRTSL, K =

MPL
MPK





MPL

i
...
slope of isoquant MRTSL, K =

MPK

Iso Cost line –
An iso cost line shows various combination of the factor inputs that the firm can buy with a
given outlay (expenditure) and factor prices
...

Algebrically, the isocost or the budget line can be expressed
C = (PL x L) + (PK x K)
Where C = Total budget allocation for inputs labour and capital
PL and Pk = Prices of labour and capital respectively
...

Since prices of inputs are taken as constant, the budget line acquires a straight line shape
...

Now, the budget equation

C = (PL x L) + (PK x K)
K=

C
PK

-

PL


...


PK

If only labour is purchased then the maximum amount of labour that can be brought is OB =
C


...
This straightline is called the Iso Cost line
or Equal Cost line, which shows the alternative combination of (K, L) that can be purchased for
the given expenditure level
...
That is, for optimization the cost must be tangent to the iso quant
...
e
...
That is quantitative estimates of the parameters of
the production function are required for some decisions
...
The short run
production estimates are helpful to production managers in arriving at the optimal mix of inputs
to achieve a particular output target of a firm
...
Estimation of the long run production function may help a
manager in understanding and taking decisions of long term nature such as capital expenditure
...

Cobb-Douglas Production Function:
The general form of C-D function is expressed as Q = ALαKβ where A, α and β are
constants that, when estimated, describe the quantitative relationship between the inputs (K and
L) and output (Q)
...

That is
α +β =1  Constant returns to scale
α +β>1  Increasing returns to scale
α +β<1  Decreasing returns to scale

In a C–D function the exponent of a factor gives the ratio between the marginal product and
average product
...

Similarly we find that MPK = β
...
The C–D function
is a power function which can be converted into a linear form by taking it in a logarithmic form:

α β
Q= AL K
Log Q = log A + α log L + β log K
In a C-D production function if one of the inputs is zero, output is also zero
...
In such a

function, if one input takes the value zero, the output becomes zero
...

Importance of Cobb-Douglas production function –
C-D production function is most popular in imperial research
...
Since α
and β are pure numbers, (i
...
independent of units of measurements) they can be easily
used for comparing results of different samples having varied units of measurement
...
The log-linear function becomes
linear its parameters, which is quite useful to a managerial economist for his analysis
...
For example, the sum of (α+β) shows the returns to scale in the production
process
...

4) This function can be used to investigate the nature of long-run production function, viz –
increasing, constant and decreasing returns to scale
...
g
...

THEORY OF COSTS
Every Business has two side: Income and Expenditure
...
The analysis of cost
is important in the study of Managerial Economics because it provides a basis for two
important decisions made by Managers :

a) Whether to produce or not; and
b) How much to produce when a decision is taken to produce
COST CONCEPTS :Some of the cost concepts that are frequently used in the Managerial decision making
process, may be classified as follows :
1) Actual Cost and Opportunity Cost:Actual costs are those cost which a firm incurs while producing or acquiring a good or
service like payment for labor, rent etc
...
100 per day to a worker
when we employ for 10 days, then the cost of labour is Rs 1000
...
It is otherwise known as Accounting
Cost or Acquisition Cost or Outlays Cost
...
It‘s the cost for the next
best alternative use
...
For example, consider a firm that owns a building and the firm do not pay rent
for its use
...
The
foregone rent is an opportunity cost of utilizing the office space and should be included
as part of the cost of business
...

2) Explicit Cost and Implicit Cost:Explicit costs are those cost that involve an actual payment to other Parties
...
Explicit costs are also referred to by accounting costs
...
Other types of explicit
costs include renting a building, amount & rent on advertising etc
...
Implicit cost are just as important as explicit costs but are sometimes
neglected because they are not as obvious
...

Therefore, an implicit cost generally is not included in accounting statements, since it is
the opportunity cost of using resources that are owned or controlled by the owners of
the firm, who could have received it had they used their own resource in their best
alternative use rather than using the resources for their own firm‘s production
...
These costs point out how much
expenditure has already been incurred on a particular process or on production as such
...
The accounting costs are useful for managing
taxation nuds—as well as to calculate profit or loss of the firm on the other hand,
economists take forward looking view of the firm
...
They must therefore be concerned with
opportunity cost along with explicit cost
...
It is the economic costs that are used for decision making
...

Non-controllable costs are those which cannot be subjected to administrative control
and supervision
...
The level at which such control can be exercised,
however, differs; some costs (like capital costs) are not controlled at the shop level
...

For example, wages and salaries paid to the employees are Out-of-Pocket Costs
...
On
the other hand, Book Costs are those business costs which do not involve any cash
payments but for them a provision is made in the book of account to include them in
profit and loss accounts and take tax advantages
...

Private Costs & Social Cost:Private Costs are those that accrue directly to the individuals or firm engaged in relevant
activity
...
e
...
be paid in
the future a part of contractual agreement of previous decision
...
In
general, Sunk costs are not relevant to economic decisions
...

Incremental costs refer to total additional cost of implementing a managerial
decision
...
are examples of incremental costs
...
Moreover, since incremental costs
may also be regarded as the difference in total costs resulting from a contemplated
change, they are also called differential costs
...


Relevant costs and Irrelevant costs :The relevant costs for decision making purposes are those costs which are
incurred as a result of decision under consideration
...
They are there main categories of relevant or incremental
costs
...


On the other hand, costs that have been incurred already and the costs that will be
incurred in future, regardless of the present decision are irrelevant costs as far as the
current decision problem is concerned
...
In other words the costs which are
directly and definitely identifiable are the direct costs
...
So, the costs incurred by the firm on all these things, referred to
as direct costs
...
For example, stationery and other office
administrative expenses, electricity charges, depreciation of plant and buildings, and
other such expenses that cannot easily and accurately be separated and attributed to

individual units of production, except on orbitarily basis
...

Fixed cost and Variable cost :Fixed costs are that part of the total cost of the firm which does not change with
output
...

For given a capacity fixed costs remain the same irrespective of actual output
...
Examples of
variable costs are wages and expenses on raw materials
...
It represents the money
value of the total resources required for production of goods and services
...

and the amount he/she charges for his/her services and funds invested in the business
...
e
...
This cost concept is significant to short term decisions about profit maximizing
rates of output
...
The Ac concept is significant for calculating the per unit
profit
...
In fact, the Relevant costs to considered will
depend upon the situation or production problem faced by the manager
...
Ratio is a yard

stick which provides a measure of relation between the two figures compared
...
g cost of material as a percent of total
production cost), as a proportion (e
...
g sales per Rupees of total assets)
...
Ratio analysis is mainly used as an
external standard i
...
for comparing performance with organization in the industry
...

Revenue Analysis :Revenue represents the income side of business
...
It‘s denoted as Px X Qx, where x: The
Product; Px: Price of x; Qx: Quantity of x sold in the market
...

It‘s arrived at by dividing Total Revenue with total output sold in the market
...
equal to the price of the product
...
It is equal to the ratio between change in Total revenue
and change in total output sold in the market MR=∆TC/∆TO
LEARNING OUTCOMES
1
Explain the relationship between cost and profit
Firms try to earn a profit by transforming resources into salable products
...
Accounting
profit equals total revenue minus explicit costs
...


2

Identify the elements that affect production in the short term

Output can be changed in the short run by adjusting variable resources, such as labor, but the
size, or scale, of the firm is fixed in the short run
...


Eventually, the law of

diminishing marginal returns takes hold, thus restricting a firm‘s ability to affect production in
the short term
...
Variable cost is the cost of variable
resources, such as labor, that do vary with output in the short run
...


4

Describe how firms use the long-run average cost curve to make choices about
production

For any given firm, the long-run average cost curve is formed by connecting the points on the
various short-run average cost curves that represent the lowest per-unit cost for each rate of
output
...


These points of tangency represent the least-cost way of producing each

particular rate of output
...
A larger
scale of operation allows a firm to use larger, more efficient techniques and machines and to
assign workers to more specialized tasks
...

SOME IMPORTANT TERMINOLOGIES IN PRODUCTION AND COST ANALYSIS:Fixed and Variable Resources


Variable resources: Can be varied quickly to change the output rate
...




Short run: At least one resource is fixed; the size or scale of the firm is fixed
...

 Production function: The relationship between the amount of resources employed and total
product or output
...

Increasing Marginal Returns: As marginal product increases, the firm experiences increasing
marginal returns from labor because additional workers can specialize and make more
efficient use of the fixed resources
...

The Total and Marginal Product Curves: When marginal product


Rises, total product increases at an increasing rate
...




Is negative, total product is decreasing
...

 Implicit costs: Opportunity costs of using resources owned by the firm or provided by the
firm‘s owners
...

 Variable cost: Cost of variable resources
Total Cost and Marginal Cost in the Short Run
Total Cost: The sum of fixed cost and variable cost
...

Marginal Cost: The change in total cost divided by the change in output
...


 Changes in marginal cost (MC) reflect changes in the marginal productivity (MP) of the
variable resource
...

 When marginal returns are diminishing, the marginal cost of output increases
...


Average Cost in the Short Run
 Average Variable Cost: Variable cost divided by output or VC/q
 Average Total Cost: Total cost divided by output or TC/q
The Relationship Between Marginal Cost and Average Cost: Marginal cost pulls down average
cost where marginal cost is below average cost and pulls up average cost where marginal cost is
above average cost
...

 When marginal cost is less than average cost, average cost falls
...

Costs in the Long Run: Long run is best thought of as a planning horizon
...



Each short-run average cost curve is tangent to the long-run average cost curve
...


Economies of Scale


Forces that reduce a firm‘s long run average cost as the scale of operation increases
...
However, if he raised soybeans, he could
earn $200 per acre
...
This is so, because the accounting profit calculation does not take into
account an important implicit cost—the opportunity cost of not raising soybeans
...
According to our theory, he should get out of the
corn business and begin growing soybeans
...

2

(Explicit and Implicit Costs) Determine whether each of the following is an explicit cost or
an implicit cost:
a) Payments for labor purchased in the labor market
b) A firm‘s use of a warehouse that it owns and could rent to another firm
c) Rent paid for the use of a warehouse not owned by the firm
d) The wages that owners could earn if they did not work for themselves
a) éxplicit; b) implicit; c) éxplicit; d) implicit

3(Production in the Short Run) Complete the following table
...
Diminishing marginal returns occur after the second unit of
the variable resource is employed
...

5

(Total Cost and Marginal Cost) Complete the following table, assuming that each unit of
labor costs $75 per day
...
50
___
25
37
...
Graph the fixed cost, variable cost, and total cost curves for these data
...
What is the marginal product of the third unit of labor?
c
...
50
18
...
50

a
...
The marginal product is 4
...
The average total cost is $33
...

6
...

L
0
1
2
3
4
5

Q
0
6
15
21
24
26

MP
____
____
____
____
____
____

VC
$ 0
3
6
9
12
15

TC
$12
15
___
___
___
___

MC
$__
___
___
___
___
___

ATC
$__
___
___
___
___
___

a
...

c
...


What is the average variable cost when Q = 24?
What is this firm‘s fixed cost?
What is the wage rate per day?

to diminish?

This question demonstrates the relationships between marginal product and marginal
costs as well as between marginal and average total costs
...

b
...

d
...


Q
0
6
15
21
24
26
27

MP
—
6
9
6
3
2
1

VC
$ 0
3
6
9
12
15
18

TC
$12
15 $0
...
33
21 0
...
0
27 1
...
0

MC
—
$2
...
2
1
...
0
1
...
11

Diminishing MP occurs with the third unit of labor
...
Thus, average variable cost is $0
...

Since total cost is $12 when output is zero, fixed cost must be $12
...


(Relationship Between Marginal Cost and Average Cost) Assume that labor and capital
are the only inputs used by a firm
...

Workers can be hired for $200 each
...

Quantity of
Labor
0
1
2
3
4
5

Total Output
0
100
250
350
400
425

Quantity of
Labor

Total OutputAVC (VC/Q) ATC(TC/Q)

AVC
$___
____
____
____
____
____

ATC
$___
____
____
____
____
____

MC
$___
____
____
____
____
____

MC(∆TC/∆Q)
0
1
2
3
4
5

0
100
250
350
400
425

—
$2
...
60
1
...
00
1
...
00
3
...
14
3
...
53

—
$2
...
33
2
...
00
8
...

MODULE-3:- MARKET STRUCTURE AND PRICING STRATEGIES
PERFECT COMPETITION MARKET:Market structures describe important features of the economic environment in which firms
operate
...


A perfectly competitive market is characterized by (a) a large number of buyers and sellers, each
too small to influence market price; (b) firms in the market supply a commodity, which is a
product undifferentiated across producers; (c) buyers and sellers possess full information about
the availability and prices of all resources, goods, and technologies; and (d) firms and resources
are freely mobile in the long run
...
Each firm then faces a demand curve that is a horizontal line at the
market price
...
Firms in perfect competition are said to be price takers because
no firm can influence the market price
...

For a firm to produce in the short run, rather than shut down, the market price must at least cover
the firm‘s average variable cost
...

That portion of the marginal cost curve at or rising above the average variable cost curve
becomes the perfectly competitive firm‘s short-run supply curve
...
As long as price covers average variable
cost, each perfectly competitive firm maximizes profit or minimizes loss by producing where
marginal revenue equals marginal cost
...
In the long run, however, firms enter or leave the market and otherwise adjust their
scale of operation until any economic profit or loss is eliminated
...
At this rate of output, marginal revenue equals marginal cost and each also
equals the price and average cost
...

In the short run, a firm‘s change in quantity supplied is shown by moving up or down its
marginal cost, or supply, curve
...

As the industry expands or contracts in the long run, the long-run industry supply curve has a
shape that reflects either constant costs or increasing costs
...
In equilibrium, a perfectly competitive
market allocates goods so that the marginal cost of the final unit produced equals the marginal
value that consumers attach to that final unit
...
Voluntary exchange in competitive markets maximizes the sum of
consumer surplus and producer surplus, thus maximizing social welfare
...




Sells a commodity or standardized product
...




Has firms and resources that are freely mobile
...

 Demand Under Perfect Competition: Horizontal line at the market price

Short-Run Profit Maximization
Total Revenue Minus Total Cost: The firm maximizes economic profit by finding the rate of
output at which total revenue exceeds total cost by the greatest amount
...

 The firm increases output as long as marginal revenue exceeds marginal cost
...

Economic Profit in the Short Run
Market price = Marginal revenue = Average revenue
Minimizing Short-Run Losses
Short run: A period too short to allow existing firms to leave the industry
...
A firm
produces if total revenue exceeds the variable cost of production
...
This minimizes the
short-run loss
...

 Fixed costs are a sunk cost in the short run
The Firm and Industry Short-Run Supply Curves
Short-Run Firm Supply Curve: That portion of a firm‘s marginal cost curve that intersects and
rises above the low point on its average variable cost curve
...

Firm Supply and Market Equilibrium: Each perfectly competitive firm selects the short-run
output that maximizes profit or minimizes loss
...

 The Long-Run Adjustment to a Change in Demand
 Effects of an Increase in Demand: Increase in demand results in an increase in market price
...

 Effects of a Decrease in Demand: Decrease in demand results in a decrease in market prices
...
Short run losses will eventually drive firms out of industry causing a
reduction in supply
...

 Constant-Cost Industries: Horizontal supply curve; resource prices and other production costs
remain constant as output expands
...

Perfect Competition and Efficiency
 Productive Efficiency: Produce output at the minimum of the long-run average cost curve
...

 Allocative Efficiency: Produce the output that consumers value most
...
Not only making stuff right but making the right stuff
...




Producer Surplus: Total revenue minus variable costs
...
A firm‘s decisions about how much to produce or what price to charge depend on the

structure of the market
...
Price is determined by market demand
and supply
...
Firms
maximize profit by controlling their rate of output
...
Another way to find the profit-maximizing rate of
output is to focus on marginal revenue and marginal cost
...

3

Identify ways firms minimize short-run losses

Firms that have not identified a profitable level of output can either operate at a loss or shut
down
...
In the short run, even a firm that
shuts down keeps productive capacity intact by continuing to pay fixed costs, which are sunk
whether the firm produces or shuts down
...

4

Explain how firms manage short-run supply

If price exceeds average variable cost, the firm produces the quantity at which marginal revenue
equals marginal cost
...
As long as
the price covers average variable cost, the firm supplies the quantity at which the upward-sloping
marginal cost curve intersects the marginal revenue, or demand, curve
...
A perfectly competitive
firm supplies the short-run quantity that maximizes profit or minimizes loss
...
Given
the conditions for perfect competition, the market converges toward the equilibrium price and
quantity
...
Short-run economic profit attracts new entrants in
the long run and may cause existing firms to expand
...
When market demand decreases, firms
incur short-run losses and may go out of business in the long run
...


6

Describe how different cost structures influence an industry‘s long-run supply curve

In a constant-cost industry, each firm‘s long-run average cost curve does not shift up or down as
industry output changes; each firm‘s per-unit costs are independent of the number of firms in the
industry
...
Expanding output bids up the prices of some resources or otherwise increases
per-unit production costs, and these higher costs shift up each firm‘s cost curves
...
In equilibrium, a perfectly competitive
market allocates goods so that the marginal cost of the final unit produced equals the marginal
value that consumers attach to that final unit
...
Voluntary exchange in competitive markets maximizes the sum of
consumer surplus and producer surplus, thus maximizing social welfare
...
Short-run economic profit earned by a
monopolist can persist in the long run only if the entry of new firms is blocked
...

Because a monopolist is the sole supplier of a product with no close substitutes, a monopolist‘s
demand curve is also the market demand curve
...
Where demand is price elastic, marginal revenue is positive and total revenue increases
as the price falls
...
A monopolist never voluntarily produces where demand is
inelastic because raising the price and reducing output would increase total revenue
...
At the
profit-maximizing quantity, the price is found on the demand curve
...
In the long run, a monopolist, unlike a
perfect competitor, can continue to earn economic profit as long as entry of potential competitors
is blocked
...
Monopoly usually results in a deadweight loss when compared
with perfect competition because the loss of consumer surplus exceeds the gains in monopoly
profit
...

A perfect price discriminator charges a different price for each unit sold, thereby converting all
consumer surplus into economic profit
...
Yet perfect price
discrimination is as efficient as perfect competition because the monopolist has no incentive to
restrict output, so there is no deadweight loss
...

Legal Restrictions
Patents and Invention Incentives

 Patent: Awards exclusive right to produce a good or service for 20 years
...


Economies of Scale: Natural monopolies emerge from the nature of costs
...




A single firm can satisfy market demand at a lower average cost per unit than could two or
more firms
...




Revenue for the Monopolist



Demand, Average Revenue, and Marginal Revenue: the demand curve for the monopolist‘s
output slopes downward; the demand curve is also the monopolist‘s average revenue curve
...
Thus, marginal revenue is
less than price
...



Marginal revenue: As price declines, marginal revenue falls because:
– The amount of revenue received from selling an additional unit declines
...


Revenue Curves: Total revenue reaches a maximum where marginal revenue is zero
...

– Total revenue increases as price falls
...

– Total revenue decreases as price falls
...
‖
– Profit Maximization:
– Total Revenue Minus Total Cost: Production rate where total revenue exceeds total cost by
the greatest amount
...
The price the
monopolist can charge is limited by consumer demand
...
Shutdown if the price does not cover average variable cost
...

– Monopoly and the Allocation of Resources
– Price and Output Under Perfect Competition: Marginal benefit that consumers derive from
a good equals the marginal cost of producing that good
...

– Price and Output Under Monopoly: While producing to maximize profit where marginal
cost equals marginal revenue, the monopolist charges a higher price and supplies less output
than a perfect competitor
...
Social
welfare is not maximized
...
Some of
this loss in consumer surplus is redistributed to the monopolist, but some is a deadweight
loss, or welfare loss, that is gained by no one
...
However, fear of public scrutiny and
political pressure may not let monopoly price rise as high as it could
...
Insulated from competition, the monopolist may become
inefficient
...

Conditions for Price Discrimination: The monopolist must:
 Be a price maker
...

 Be able, at little cost, to charge each group a different price for essentially the same product
...

A Model of Price Discrimination: Profit is maximized by charging a lower price to the group
with the more elastic demand
...

 IBM laser printer for business versus home
...
Photoshop Elements
Perfect Price Discrimination: The Monopolist‘s Dream


Charge a different price for each unit of a good
...


LEARNING OUTCOMES
1 List and describe barriers to market entry
A monopolist sells a product with no close substitutes
...
Three barriers to
entry are (a) legal restrictions, such as patents and operating licenses; (b) economies of scale over
a broad range of output; and (c) control over a key resource
...
Because a monopolist that does not price
discriminate can sell more only by lowering the price for all units, marginal revenue is less than
the price
...
Where demand is price inelastic, marginal revenue is negative and total
revenue decreases as the price falls
...

3 Describe a firm‘s costs and its opportunities for profit maximization
If the monopolist can at least cover variable cost, profit is maximized or loss is minimized in the
short run by finding the output rate that equates marginal revenue with marginal cost
...

4 Explain monopoly and the allocation of resources
If costs are similar, a monopolist charges a higher price and supplies less output than does a
perfectly competitive industry
...

5 Describe the problems that interfere with estimating the deadweight loss of a monopoly
Deadweight loss can be difficult to estimate
...

The price, or at least the cost of production, could be lower under monopoly than under
competition and deadweight loss may overstate the true cost of monopoly
...
If
resources must be devoted to securing and maintaining a monopoly position, monopolies may
impose a greater welfare loss than simple models suggest
...
A perfect price discriminator charges a different price for each unit sold,
thereby converting all consumer surplus into economic profit
...


MONOPOLISTIC COMPETITION AND OLIGOPOLY:Whereas the output of a monopolist has no close substitutes, a monopolistic competitor must
contend with many rivals
...

Sellers in monopolistic competition and in oligopoly differentiate their products through (a)
physical qualities, (b) sales locations, (c) services offered with the product, and (d) the product
image
...
In the long run, easy entry and exit of firms means that a monopolistic competitor
earns only a normal profit, which occurs where the average total cost curve is tangent to the
downward-sloping demand curve for the firm‘s product
...
In undifferentiated oligopolies, such as
steel or oil, the product is a commodity—meaning that it does not differ across firms
...

Because an oligopoly consists of just a few firms, each may react to another firm‘s changes in
quality, price, output, services, or advertising
...
No single approach characterizes all oligopolistic markets
...

The prisoner‘s dilemma game shows why each player has difficulty cooperating even though all
players would be better off if they did
...
Yet each
faces incentives that encourage noncooperation
...

Characteristics of Monopolistic Competition: A market structure characterized by a large
number of firms selling products that are close substitutes, yet different enough that each firm‘s
demand curve slopes downward
...
Barriers to entry are low and
firms can enter or leave the industry in the long run
...

Product Differentiation
Physical Differences: Physical appearance and qualities
...

Services: Accompanying services provided
...


Short-Run Profit Maximization or Loss Minimization: Elasticity of demand for a monopolistic
competitor depends on the number of rival firms and the firm‘s ability to differentiate its product
...
Profit maximizing quantity is where marginal revenue equals
marginal cost; profit maximizing price for that quantity is found on the demand curve
...


Zero Economic Profit in the Long Run: Because market entry is easy, monopolistically
competitive firms earn zero economic profit in the long run
...

Monopolistic Competition and Perfect Competition Compared: If the two types of firms have the
same cost curves, the monopolistic competitor produces less and charges more than the perfect
competitor, exhibiting excess capacity in the long run
...

Varieties of Oligopoly: In some industries the product is homogeneous; in others, it is
differentiated across producers
...

 Differentiated Oligopolies: Sells products that differ across producers
...

High Cost of Entry: High start-up costs and established brand names deter new entrants
...

Models of Oligopoly: Because oligopolists are interdependent, no one general theory of
oligopoly explains their behavior, but several theories have been developed
...

 A cartel is a group of firms that agree to collude, thus they act as a monopoly
...

Number of Firms in the Cartel: Consensus becomes harder to achieve as the number of firms in the
cartel grows
...

Therefore, a cartel’s success depends on barriers that block entry of new firms
...


 Price Leadership: A price leader is a firm whose price is adopted by the rest of the
industry
...
S
...

Game Theory: a model that analyzes oligopolistic behavior as a series of strategic moves and
countermoves by rival firms
...




Payoff matrix: In game theory, a table listing the payoffs that each player can expect based
on the combination of strategies that each player pursues
...


Dominant–strategy equilibrium: the outcome achieved when each player‘s choice does not
depend on what he thinks the other player will do
...

One shot versus repeated games
One shot: Prisoner‘s dilemma strategy
...

Coordination Game: Nash equilibrium

Summary of Oligopoly Models: Each model helps explain a phenomenon observed in
oligopolistic markets
...


Price Is Usually Higher under Oligopoly: Price is usually higher and output lower under an
oligopoly
...


LEARNING OUTCOMES
1
Discuss factors that lead to monopolistic competition
Monopolistic competition describes a market in which many producers offer products that are
substitutes but are not viewed as identical by consumers
...
Because barriers to entry are low, there are
enough sellers that they behave competitively and act independently
...

Monopolistic competition is like monopoly in the sense that firms in each industry face demand
curves that slope downward
...

2

Explain the concept of oligopoly

An oligopoly is an industry dominated by just a few firms
...
The formation of an oligopoly can often be traced to some form of barrier to entry,
such as economies of scale, legal restrictions, brand names built up by years of advertising, or
control over an essential resource
...
The theories that are used to explain oligopoly
behavior are collusion, price leadership, and game theory
...

4

Explain how game theory helps predict cartel behavior

Game theory examines oligopolistic behavior as a series of strategic moves and countermoves
among rival firms
...
While participation in a cartel would result in higher economic
profits, game theory explains why the incentives to cheat are so great that firms often act in ways
that result in lower profits
...
But with oligopoly, there are so few firms in the market that each must consider

the impact its pricing, output, and marketing decisions will have on other firms
...
In general, price and
profits are usually higher under oligopoly
...
(Market Structure) Define market structure
...
These factors include (a) the number of buyers and sellers, (b) the product's
degree of uniformity, (c) the ease with which new firms enter or old firms exit the market,
and (d) the ways in which firms in the industry compete with each other—such as through
prices or advertising
...

(Demand Under Perfect Competition) What type of demand curve does a
perfectly competitive firm face? Why?
The perfectly competitive firm faces a demand curve that is horizontal at the prevailing
market price
...
No
individual firm would want to raise its price above its competitors' prices—which is the
market price
...

3
...
The market price for the firm‘s product is $150
...
Complete the table
...
At what output rate does the firm maximize profit or minimize loss?
c
...
What can you say about the relationship between marginal revenue and marginal cost
for output rates below the profit-maximizing (or loss-minimizing) rate? For output rates
above the profit-maximizing (or loss-minimizing) rate?

a
...
Profit is maximized at four units of output
...
Both marginal revenue and average revenue equal $150 at all output levels above zero
...
Have students calculate marginal cost and marginal revenue so they can see where
marginal revenue exceeds the marginal cost
...


4
...

A firm in the short run is limited in its options, as the short run by definition is not enough
time for that firm to leave the industry
...
The decision depends on the two types of costs a firm faces in the
short run: fixed costs and variable costs
...
A firm will
continue to produce rather than shut down if total revenue exceeds the variable cost of
production
...
(The Short-Run Firm Supply Curve) Use the following data to answer the questions below:
Q
1
2
3
4
5
6
7
8
9

VC
$10
16
20
25
31

MC
___
___
___
___
___
38
46
55
65

AVC
___
___
___
___
___
___
___
___
___

___
___
___
___

a) Calculate the marginal cost and average variable cost for each level of production
...

d) Assuming that its fixed cost is $3, calculate the firm‘s profit at each of the production
levels determined in part (b)
...
00
8
...
67
6
...
20
6
...
57
6
...
22

b
...
When price (P) equals $5, producing where MC = P means that Q = 4
...
So the firm is better off shutting
down and producing nothing because, if Q = 0, losses are only its fixed costs
...
At $10, MC = P when Q = 9
...

d
...

When P = $7, profit = $42 – 41 = $1
...

6
...
In each case, indicate whether the firm should produce in the short run or
shut down in the short run, or whether additional information is needed to determine what it
should do in the short run
...
Total cost exceeds total revenue at all output levels
...
Total variable cost exceeds total revenue at all output levels
...
Total revenue exceeds total fixed cost at all output levels
...
Marginal revenue exceeds marginal cost at the current output level
...
Price exceeds average total cost at all output levels
...
Average variable cost exceeds price at all output levels
...
Average total cost exceeds price at all output levels
...
Need additional information
...
If a
portion of the firm‘s FC is being covered, it can remain open but operate at a loss
...

b
...

c
...
Information regarding how much the TR exceeds TC is
required
...

d
...

e
...

f
...

g
...
Information regarding FC and/or VC is required
...
If
none of the FC are being met, the firm would need to shut down
...


(The Long-Run Industry Supply Curve) A normal good is being produced in a constantcost, perfectly competitive industry
...


a
...
Be sure to discuss any changes in output levels,
prices, profits, and the number of firms
...
Next, show on your graph and explain the long-run adjustment to the income change
...

a
...
This lowers the market price from P1 to P2 and market
output from Q1 to Q2, as the market adjusts from point a to point b
...
Assuming that a firm can still cover
its variable costs (as shown in the left panel), it continues to operate, but at a loss
...
In the
short run, there is no change in the number of firms
...
In the long run, economic losses cause some firms to exit the industry, decreasing market
supply
...
In a constant-cost
industry, the market price returns to its original level of P1
...
The firm‘s demand curve
returns to its original position as the price rises
...
Market output drops to Q3 due to a decrease in the number of firms
...


(Long-Run Industry Supply) Why does the long-run industry supply curve for an
increasing-cost industry slope upward? What causes the increasing costs in an increasingcost industry?
The long-run supply curve in an increasing-cost industry is upward sloping because
resource prices rise as existing firms increase their scale of operation and as new firms
enter
...
These economic profits attract new firms to the market, and existing firms may
expand
...
If the total demand for resources
increases significantly, resource prices are bid up for each firm in the industry
...


9
...
Indicate the long-run equilibrium price and
quantity
...
Discuss the firm‘s short-run response to a reduction in the price of a variable resource
...
Assuming that this is a constant-cost industry, describe the process by which the
industry returns to long-run equilibrium following a change in market demand
...
A reduction in a resource price shifts all cost curves downward
...

b
...
This
encourages the entry of new firms into the industry
...
This lowers each firm‘s demand, average revenue, and marginal revenue
curves
...

10
...
Determine which supply curve
indicates a constant-cost industry and which an increasing-cost industry
...
Explain the difference between a constant-cost industry and an increasing-cost industry
...
Distinguish between the long-run impact of an increase in market demand in a constantcost industry and the impact in an increasing-cost industry
...
A constant-cost industry uses such a small portion of the resources available that
increasing output does not increase production costs
...
In an increasing-cost industry, the entry of new firms drives up
resource prices and increases production costs
...

b
...
Because the
amount of resources employed is such a small portion of what is available, the increase
in demand will not cause resource prices to rise
...

11
...

Quantity
0
1
2
3
4
5
6
7
8

Marginal Cost

Marginal Benefit
—
—
$2
$10
$3
9
$4
8
$5
7
$6
6
$8
5
$10
4
$12
3

a
...
Construct a demand and supply diagram for the product and indicate
the equilibrium price and quantity
...
On the graph, label the area of consumer surplus as f
...

c
...


c
...


12
...


If a firm‘s long-run average cost curve slopes downward throughout the range of
market demand, a single firm can produce at a lower average cost than any other firm
that tries to enter the market
...
Any new firm trying to enter the market is unable to match the monopolist‘s
economies of scale and, therefore, is unable to match the monopolist‘s price
...
(Monopoly) Suppose that a certain manufacturer has a monopoly on the sorority
and fraternity ring business (a constant-cost industry) because he has persuaded the
―Greeks‖ to give it exclusive rights to their insignia
...

Using demand and cost curves, draw a diagram depicting the firm‘s profitmaximizing price and output level
...


Why is marginal revenue less than price for this firm?

c
...

d
...


Profit is maximized at point e, where Qm units are sold at a price of Pm each
...

With a downward-sloping demand curve, additional units can be sold only
by lowering the price on all units
...

The deadweight loss is the area of triangle bce
...
Consumer surplus would equal the area of the
triangle acf
...
The portion pmbef of the lost consumer surplus is redistributed to the
monopolist as economic profit
...

d
...

Therefore, the new MC curve would intersect the MR curve at a lower output level,
leading to a higher price
...
(Short-Run Profit Maximization) Answer the following questions on the basis of
the monopolist‘s situation illustrated in the following graph
...


At what output rate and price does the monopolist operate?

b
...


What is the firm‘s economic profit or loss in equilibrium?

a
...

c
...
(Monopoly and the Allocation of Resources) What is the problem with
monopoly? Compare monopoly to the benchmark of perfect competition established in
the previous chapter
...

When there is only one firm in a market, the price that firm charges determines
the market quantity for its product
...

At that quantity, the consumer‘s marginal benefit exceeds the monopolist‘s marginal
cost
...
Though the consumer may
still derive some benefit in a market controlled by a monopolist, market forces under
perfect competition drive the equilibrium price down, and increase social welfare as a
whole
...
(Allocative and Distributive Effects) Why is society worse off under monopoly
than under perfect competition, even if both market structures face the same constant
long-run average cost curve?
Part of the reduction in consumer surplus under monopoly is considered a
deadweight loss because it is a loss to consumers and no one reaps the benefits
...
In a monopoly, price
always exceeds marginal costs, so society would be worse off under a monopoly
...
(Welfare Cost of Monopoly) Explain why the welfare loss of a monopoly may be
smaller or larger than the loss shown in the exhibit above
...
A monopolist may charge a lower price to discourage entry of new firms or in
response to political pressure
...
Lack of
competition may eliminate pressure for the monopolist to maximize efficiency or to be
innovative
...
(Conditions for Price Discrimination) List three conditions that must be met for a
monopolist to price discriminate successfully
...
Second, it must be able to separate consumers into two or more groups
with different elasticities of demand
...

19
...

This is a simple price discrimination problem
...
This assumption is
reasonable if the U
...
market has more substitutes
...
S
...
Price discrimination calls for a higher price
in Korea, where the price elasticity of demand is lower
...
)
20
...
By increasing output by one unit, the perfectly
discriminating monopolist loses no revenue from previous output since the prices
attached to previous units do not change
...

21
...

b
...

d
...


Price
$100
90
80
70
60
50
40
30

FC
$100
____
____
____
____
____
____
____

VC
$ 0
50
90
150
230
330
450
590

TC
____
____
____
____
____
____
____
____

TR
____
____
____
____
____
____
____
____

Profit/Loss
________
________
________
________
________
________
________
________

Complete the table
...
The lowest loss is $30
...
The firm should continue to produce up to and including 2 units because marginal
revenue still exceeds marginal cost
...
] In addition, at that
quantity, price exceeds average variable cost
...
Specifically, the firm should produce 2 units
...
Through 2 units of output, marginal revenue exceeds marginal cost
...

22
...

a
...

b
...

c
...
Label the price and quantity p2 and q2
...
How do the monopolistically competitive firm‘s price and output compare to those of the
perfectly competitive firm?

e
...

(e) Both types of firms earn zero long-run economic profits
...


(Varieties of Oligopolies) Do the firms in an oligopoly act independently or
interdependently? Explain your answer
...
This means that the demand for one firm‘s
output depends on the actions of its rival firms
...
Oligopolists try to reduce uncertainty about their demand
by engaging in behavior that makes their rivals‘ actions more predictable (colluding,
forming cartels, using price leadership) or by assuming certain actions by their rivals
...
(Price Leadership) Why might a price–leadership model of oligopoly not be an effective
means of collusion in an oligopoly?
Price leadership is subject to a variety of obstacles
...
The greater the
product differentiation among sellers, the less effective price leadership becomes
...
Some firms may cheat on the price
...

25
...

b
...

d
...

The number of cartel members doubles from 11 to 22
...

Expectations grow that some members will cheat
...
Many of the OPEC countries are less developed and need oil revenues to help diversify
their economies
...

b
...
As the size of the cartel increases,
motivation to cheat increases, and it becomes more difficult to track each member‘s
output
...
To pay their loans expeditiously, such countries may resort to increased production and
sales, thus cheating on the quotas
...
Each member expects that other members will cheat, and therefore cheats also
...
(Collusion and Cartels) Use revenue and cost curves to illustrate and explain the sense in
which a cartel behaves like a monopolist
...
Given the market demand curve, D, the
cartel must maximize its profit
...

Because a cartel acts like a monopoly that runs many plants, the marginal cost curve for the
cartel (MC) is the horizontal sum of each firm‘s marginal cost curve
...
This intersection yields quantity Q
...


27
...

Ford believes that Chevrolet will match any price it sets, but Chevrolet too is interested in
maximizing profit
...

Ford's
Selling
Price
$ 4,000
4,000
4,000
8,000
8,000
8,000
12,000
12,000
12,000

Chevrolet's
Selling
Price
$ 4,000
8,000
12,000
4,000
8,000
12,000
4,000
8,000
12,000

Ford‘s
Profits
(millions)
$ 8
12
14
6
10
12
2
6
7

Chevrolet‘s
Profits
(millions)
$ 8
6
2
12
10
6
14
12
7

a
...
What price will Chevrolet charge once Ford has set its price?
c
...
If the two firms collaborated to maximize joint profits, what prices would they set?
e
...
$8,000
...

e
...

f
...

g
...
Any other price combination lowers joint profit
...
Chevrolet could increase its profits to $12 million by cutting its price to $4,000 (if
undetected)
...

28
...
She is convinced the two cheated but cannot
prove it
...
If both students sign the statement, each will
receive an ―F‖ for the course
...
If neither signs, both receive a ―C‖ since the professor
does not have sufficient evidence to prove cheating
...
Draw the payoff matrix
...
Which outcome do you expect? Why?
a
...
While it would be best for both students if each refused to sign, the most likely outcome
is that both students sign and receive an ―F
...
Unless each student can somehow ensure the other will not sign, the threat
of expulsion will most likely lead to each signing the statement
...
(Market Structures) Determine whether each of the following is a characteristic of perfect
competition, monopolistic competition, oligopoly, and/or monopoly:

a
...

c
...

e
...
Perfect competition and monopolistic competition
b
...
Monopolistic competition and oligopolies with differentiated products; some
monopolies
d
...
Monopolistic competition, oligopoly, and monopoly
PRICING STRATEGIES:Pricing decisions are equally important for a new product and an existing product, for
entering into a new market or a new market segment and are affected by a host of
factors like objective of the firm, cost of production, market structure, competitor‘s
strategy, elasticity of demand, government policy, etc
...

i
...
Marginal cost pricing
This is used when demand is slack and market is highly competitive
...
This method is used by firms to enter into a new market as well
as to beat competitors
...

iii
...


PRICING BASED ON FIRM‘S OBJECTIVES:If we consider pricing in the light of objectives of a firm, a profit maximizing firm
considers total cost of production for determination of price and hence will adopt Mark
up pricing
...

COMPETITION BASED PRICING:(A) PENETRATION PRICING
When a firm plans to enter a new market which is dominated by existing players,
its only option is to charge a low price, even lower than the ongoing price
...
The principle of marginal costing may be used
to determine penetration price
...

(B) ENTRY DETERRING PRICING
Under this method of pricing the price is kept low, thus making the market
unattractive for other players
...
This practice is also known as Limit Pricing
...
This pricing strategy is
popular in monopolistic and oligopoly markets where product differentiation is
minimal or only cosmetic, and consumer‘s switching cost is almost negligible
...

PRODUCT LIFE CYCLE BASED PRICING:Product life cycle pricing refers to different pricing for a product at different
stages of its life cycle (viz
...


(A) PRICE SKIMMING:Under price skimming producers charge a very high price in the beginning to
skim the market and earn super margins on sales
...
Nokia has
been using this strategy successfully for its products
...
This strategy is often used as a double edged weapon, for
propagating a new product, as well as for selling a product in its stage of
decline
...

(C) PERCEIVED VALUE PRICING:According to this pricing, value of goods for different consumers depends
upon their perception of utility of the good
...
Such pricing is
normally adopted during the growth and maturity stage so as to differentiate
the product from that of competitors‘ and retain the quality conscious
customers
...

CYCLICAL PRICING:(A) RIGID PRICING:Rigid pricing suggests that firms should follow a stable pricing policy
irrespective of the phase of the economic cycle (i
...
inflation and
recession)
(B) FLEXIBLE PRICING:Under flexible pricing firms keep their prices flexible to meet the
challenges of change in demand
...

(B) TRANSFER PRICING:Transfer prices are the charges made when a company supplies
goods, services or financials to its subsidiary or sister concern
...
e
...

RETAIL PRICING:(A) EVERY DAY LOW PRICING(EDLP):Under EDLP a low price is charged throughout the year and
none or very few special discounts are given on special
occasions
...

(B) HIGH-LOW PRICING:This method involves high prices on a regular basis, coupled
with temporary (or occasional) discounts as promotional
activity
...
This method is adopted
by those firms which have high overhead expenses and cannot
afford everyday low pricing
...
This is a strategy suitable for
the maturity and saturation stage when demand can be
maintained by keeping focus on higher quality and lower cost

---