business managerial) economics

M P BIRLA INSTITUTE OF MANAGEMENTASSOCIATE BHARATIYA VIDYA BHAVAN

BUSINESS ECONOMICS

(MANAGERIAL ECONOMICS)

SYNOPSIS

DR. S. BISALIAH*

* Support for computerising the material by Mrs. R. Kalavathi is gratefully acknowledged. Dr. N. S. Viswanath was of great help in providing the basic framework for developing this material. His help is hereby acknowledged.

ORIENTATION IN ECONOMICS(FOR I YEAR MBA STUDENTS)

Instructor: Prof. S. BISALIAH

Module 1: Introduction

1. Economics: Science of Scarcity, Choice and Efficiency.

Scarcity of resources Choice. Scarcity of resources Efficiency.

Question: How to organize the system which promotes the most efficient use of resources?

2. Three Fundamental Problems of Economic Systems:

What commodities shall be produced and in what quantities? How shall these commodities be produced? For whom shall these commodities be produced?

3. Micro and Macro Economics:

Micro Economics: Concerned with the behaviour of individual economic units and their interactions – consumers and producers/business firms.

Major type of interactions in the market

Three major components of Microeconomics:

Product pricing Input (Factor) pricing Welfare economics

Major uses of Microeconomics:

Provides basic tools of economic analysis for application in special areas like Business (Managerial) Economics, Industrial Economics etc.

Helps in understanding how the economic units operate, and whether they operate efficiently or not.

Helps in making conditional prediction/forecasting.

Macro Economics:

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Study of aggregates: Deals not with individual income, but with national income, not with individual prices, but with general price levels, not with individual output but with national output.

Study of forest rather than of individual trees.

Specific issues to be addressed:

Rising prices Rising unemployment Falling GDP Balance of payments crisis

Macro Economic goals:

Output, employment, price, stability and equity

Tools of Macroeconomic Policy and Management:

Fiscal policy Monetary policy Trade policy Etc

4. Ten Principles of Economics Transferency.

5. Logic of Science and Economics:

The Scientific Method:

Observation (Newton’s apple) Theory (Theory of gravitation) Validation of theory (More observations)

Scientific Method in Economics:

The interplay of observation and theory in economics Impossible/difficult to conduct laboratory experiments in

economics. But natural experiments of history: The impact of war in Middle East on oil flow, prices, production, employment etc.

Role of assumptions in Physical Sciences and in Economics:

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Throwing a stone and a feather from the top of a building and in a vaccum.

Friction and no-friction. Two-country and two-commodity model to understand the

economic benefits of international trade.

6. Model Building in Economics:

Model: Simplification of reality Functioning of Planetary System in Physics: Simplification of

reality Economic Model: Simplification of economic relationships

Example1: Market Equilibrium Consumer behaviour (Demand) Producers/sellers behaviour (Supply) Interactions of consumers and sellers in the market.

DX = f (PX, PR, M, T, E …….)DX = f (PX), OR CDX = a – b PX

DX = 110 – 10 PX

SX = f (PX, PR, t, E ……..)SX = f (PX), OR CSX = - C + d PX

SX = - 100 + 20 PX

Market Equilibrium:DX = SX

110 – 10 PX = - 100 +20 PX

P* = 7 Q* = 40

Diagram

Example 2: The Circular Flow Diagram

Transferency

A visual model of the economyAssumption: Two sectors

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Module – 2: Mechanics of Individual Prices

1. How are prices of goods/services determined in a market? The forces of demand and supply.

2. Demand Analysis:

Determinants and kinds of demand: DX = f (PX, PS, PC, M, T, E ……..)

Price demand:DX = f (PX), OR C

Cross demand:DX = f (PS), OR CDX = f (PC), OR C

Income demand:DX = f (M), OR C

Price Demand and Law of Demand:

Demand: A schedule (Table) which shows various amounts of a product which consumers are willing and able to purchase at various levels of prices during a particular period of time, OR C.

Demand Schedule: An individual Buyer’s demand for X

Price/Kg. Q – demanded/ (Rs.) week (Kg.)

5 104 203 352 551 80

Demand Curve:

Diagram

Law of Demand:An inverse relationship between price and quantity

demanded, OR CWhy the inverse relationship?

Later

Giffen Paradox: Direct relationship between price and quantity demanded.

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Diagram

Movement along a given demand curve (change in quantity demanded) and shift in demand curve (change in demand).

Diagrams

Market Demand: Summing horizontally the individual demand curves of all

consumers in the market.Details Later

Price elasticity of demand:

Point E.D: EP = % change in quantity demanded % change in price

Change in Q-demanded X 100 Original Price

= Change in Price X100Original Price

ΔQ= QO = ΔQ PO

ΔP ΔP QO

PO

Arch E. D: EP = ΔQ P1+PO/2ΔP Q1+QO/2

= ΔQ P1+PO

ΔP Q1+QO

Average price elasticity between two points.

Income elasticity of demand:

EM = % change in quantity demanded % change in income

ΔQ = QO = ΔQ MO

ΔM ΔM QO

MO

Cross price elasticity of demands:

EXY = % Change in quantity of X demanded % Change in price of Y

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ΔQX

= QXO = ΔQX PYO

ΔPY ΔPY QXO

PYO

3. Supply Analysis:

Determinants of Supply:

SX = f (PX, PR, PI, t, E ……)SX = f (PX), OR C

Law of Supply:

Supply: A schedule (Table) which shows various amounts of a product which producers are willing and able to sell at various levels of prices during a particular period of time, OR C.

Supply Schedule:

PX SX

4 3 6 6 8 910 1212 15

Supply Curve Diagram

Law of Supply: Direct relationship between price and quantity supplied, ORC

Supply Curve can move off in different directions.

Diagram

Movement along a given supply curve (change in Q-supplied) and shift in supply curve (change in supply).

Diagram

Market Supply: Summing horizontally the individual supply curves of all firms in the market.

Price Elasticity of Supply:

EPS = % change in quantity supplied% change in price

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ΔS= SO = ΔS PO

ΔP ΔP SO

PO

Price and Quantity Effects of Shifts in Supply and Demand Curves:

Market Equilibrium Diagram

Right and Left Ward Shifts is S and D (Different situations)

Module 3: Theory of Production

1. Factors of Production: Resources or inputs

Four factors of Production: Land, labour, capital and organization.

Fixed and Variable inputs:

Fixed inputs do not vary with output. Variable inputs vary with output.

Production Function:

PF: Relates inputs to output Y = f (L, K),

Maximum quantity of output (Y) with a specific combination of L & K.

Total, Marginal and Average Product:Y = f (L), OR CTP = YMPL = ΔY

ΔL APL = Y

L

Observe the behaviour of TP, MP and AP

TP, MP AND AP OF Labour, ORC

L – input TP MP AP

1 15 15 15

2 31 16 15.5

3 48 17 16.0

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4 59 11 14.8

5 68 9 13.6

6 72 4 12.0

7 73 1 10.4

8 72 -1 9.0

9 70 -2 7.8

10 67 -3 6.7

Law of Diminishing Marginal Returns

Change in Technology including Managerial Technology: Shift in Product Curves => Increased efficiency of labour.

Laws of Returns: Returns to Scale

How a proportionate increase in all inputs will affect total production?

A business firm:Using: L units of labour

K units of capitalProducing: Y units of outputL + K Y

Increase both L and K by “a” proportion. By how much Y increases?

Let Y increase by b:aL + aK b Y

Case 1: b = a Constant Returns to Scale

Case 2: b > a I R S

Case 3: b < a D R S

Output Elasticity:

= % change in Y % change in all inputs (I)

= Y IO YO

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Case 1: >1 % change in Y > % change in I I R S

Case 2: =1 % change in Y = % change in I C R S

Case 3: <1 % change in Y < % change in I D R S

Module 4: Cost Analysis

1. Concepts and Kinds of Costs:

Importance of cost estimation and cost control: = P – C

Profit is the difference between price per unit of product and cost per unit of product.

Explicit and Implicit Costs:

E. C: Paid-out or out-of-pocket expenditures incurred to buy/hire inputs.

I. C: Costs of inputs owned and used by the business firm.Ex: Cost of equity capital, rent on company owned facilities.

To estimate : Which one (ones) should we use?

Opportunity Cost: O.C to a firm in using any input is what the input could earn in its best alternatives.Ex 1: Max salary an entrepreneur could earn working for some one

else.Ex 2: O.C of attending college includes not only the explicit costs of

tuition books, and so on, but also the foregone earnings of not working.

Fixed and Variable Costs: F. C: Also called overhead costs do not vary with output

Ex: Property taxes, insurance. V. C: Vary with output

Ex: Payments for raw materials, fuel, excise tax etc. Short Run: Both F.C and V.C incurred. Long Run: All costs are variable.

Private and Social Costs:

P. C: Incurred by firms in the process of producing goods and services.

S. C: Incurred by society as a wholeEx: S.Cs of noise, environmental pollution etc.

Total and Unit Costs:

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TFC and TVC TC = TFC + TVC AFC = TFC

Q AVC = TVC

Q AC = AFC + AUC MC = TC

Q

Total and Unit Costs of Production

Output (Y)

TFC TVC TC MC AFC AVC AC

0 55 0 55 - - - -

1 55 30 85 30 55 30 85

2 55 55 110 25 27.5 27.5 55

3 55 75 130 20 18.33 25 43.33

4 55 105 160 30 13.75 26.25 40.0

5 55 155 210 50 11 31 42

6 55 225 280 70 9.17 37.5 46.67

7 55 315 370 90 7.86 45 52.86

8 55 425 480 110 6.88 53.13 60.01

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Module 5: Market Structure and Price Determination

1. How to characterize market structure? Number of sellers Degree of product differention Conditions of entry and exit Control over price.

2. Different Market Models:

Market ModelNo. of Sellers

Nature of Product

Entry Barriers to

Sellers

Degree of Control

Over Price1. Perfect Competition

Large, small, independent

Homogeneous

None None

2. Monopoly One

Homogeneous, but no

close substitutes

Insurmountable

Considerable

3. Monopolistic Compn.

Many, small virtually

independent

Differentiated, but very

close substitutes

None Some

4. OligopolyFew,

interdependent

Homogeneous or

differentiated

Substantial Some

3. Kinds of Revenue: T R = P. Q A R = TR = P.Q =P

Q Q M R = TR

Q

4. Behaviour of AR (Price), TR and MR under P/C and I/C

Quantity

Price TR MRP/C I/C P/C I/C P/C I/C

1 16 16 16 16 16 162 16 15 32 30 16 143 16 14 48 42 16 124 16 13 64 52 16 105 16 12 80 60 16 86 16 11 96 66 16 67 16 10 112 70 16 48 16 9 128 72 16 29 16 8 144 72 16 010 16 7 160 70 16 -2

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Module 6: National Income Accounting

1. Basic Measure of National Output: GDP: Market value of all final goods and services produced during a

given year. GDP: Sum of all factor payments.

2. Two Methods of Measuring National Output: Income received approach:

Y = Yw + Yr + Yi + Y r + Y d Expenditure approach:

Y = C + I + G + (X – M)

3. Problems of Measuring GDP

Later

4. Nominal and Real GDP

Commodity

Quantity

(1992)

Price (1992

)

NGDP (1992)

Q (1998

)

P(1998

)

NGDP (1998)

RGDP (1998

)X 1 1.0 1.0 2 2.0 4.0 2.0

Y 1 0.50 0.5 3 0.75 2.25 1.5

Total 1.50 6.25 3.5

5. Other Measures of National Output: GNP = GDP + Factor payments from abroad

- Factor payments to abroad NNP = GNP – Depreciation NI = NNP – indirect business taxes DPI = PI – Personal income tax and non-tax payments.

6. Is GDP an adequate measure of overall Social Welfare?“If should be no surprise that national prosperity does not guarantee a

happy society, any more than personal prosperity ensures a happy family……………… Still, prosperity is a precondition for success in achieving many of our aspirations”

Arthur Okun

7. Inflation Measure: (%) = Pt – Pt – 1 X 100 = Rate of inflation

Pt – 1>= Stable P, rising P and falling P.<

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Module 7: Two Sector Macroeconomic Model

1. Divide economy into four sectors:

Household sector : C Business sector : I Government sector : G Foreign trade sector : X & M.

2. Two Sector Macroeconomic Model:

Assumptions:

Only two sectors: Household and Business Sectors Investment already given.

The Model:

Y = C + I - - - - - - - - - (1)C = a + bY - - - - - - - - - (2)I = Io - - - - - - - - - (3)

Y = N.I C = Consumer expenditure I = Investment expenditure, independent of current income.

I

Io I = Io

o Y

Value of output = AD Exogenous variable: I Endogenous Variables: Y & C

Consumption Function:

C = f (Y)C = a + bY: Linear function

Mathematically: a = intercept b = slope

Economic interpretation:

C = a, when Y = o

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‘a’ is the minimum amount of consumer expenditure, even when

Y = 0 b = MPC = The increase in C per unit of increase in Y

dc = b C = bdY Y o < b < 1

Consumption demand increases with the level of income.

C = a + bY

Income (Y)

Recall (1), (2) & (3)Y = C + I - - - - - - - - - - (1)C = a + bY - - - - - - - - - (2)I = Io (3)

Substitute (2) and (3) into (1)Y = (a+bY) + IoY – bY = a + IoY (1-b) = a + IoY (E) = 1 [a + Io] - - - - - - (4)

1 – b Equilibrium income: AD = AS

Ex: C = 50 + 0.8 Y I = Io = 50Find out Y (E) and consumption expenditure.

Y = C + I C, I C + I (AD)

C

Io

a o Y

Y (E) Can you put numerical values to a, Io and Y(E), using the

values from the previous example?

Investment – Income Multiplier:

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Consumption (C)

ao

450

Y (E) = 1 [a + Io]1 – b

Let I = Change in investment expenditure Y = Corresponding change in income

Y (E) + Y = 1 [a + Io + I] 1 – b

Y (E) + Y = 1 [a + Io ] + 1 I 1 – b 1 – b

Y = 1 I 1 – b

Y = 1 = Investment/Income Multiplier = K. I 1 - b

K = Ratio of changes in equilibrium income to changes in I

K > o, because o < b < 1

Can you get the value of K, by using:C = 50 + 0.8 YK = ?

Interpretation of value of K?

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BUSINESS (MANAGERIAL) ECONOMICS

Module 1.1: Nature and Scope of Managerial Economics.

1. Business Issues and Economic Theory

Operational or Internal Issues:

O Choice of business (What to produce?)O Choice of size of the firm (How much to produce)O Choice of technology (How to produce ie choice of factor/input

combinations)O How to price the commodity, how to promote sales, how to face

price competitions, how to decide on new investments, how to manage profits, how to manage inventory etc.

Microeconomic theory: Deals with some of these operational issues theory of demand, theory of production and cost, market structure and product/factor pricing, profit management etc.

Environmental or External Issues:

O Economic system of the country.O General trends in production, employment, income, price level,

saving and investment.O Structure of financial institutions.O Nature and magnitude of foreign trade.O Monetary and fiscal policies, and industrial and labour policies.O Social factors like the value system of the society, property

rights, and political environment.O Degree of openness of the economy and the influence of MNCs

on the domestic market.

These are all the macroeconomic issues relevant to business decision – making: Trends in GDP, price trends, saving, investment, consumption, foreign trade, other economic policies.

Hence: Prominent role of micro and macro economics in the process of business decision – making.

2. B/M Economics: Subject Matter.

O B/M Economics: Economics applied to decision making.

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Use tools of economics to identify the problems, to organize and evaluate information, to compare alternative courses of action, to choose the best course of action, and to implement it.

Provides the link between traditional economics and the decision sciences (Mathematics and Statistics) in management decision making.

Also relevant to the management of non-profit organisations: Hospitals etc.

Microeconomics in character, but macroeconomics, equally important for decision making by the business firm.

More normative than positive: More prescriptive than descriptive.

3. Association of B/M Economics with other Sciences:

Mathematical Tools:

o Cost minimization, sales maximization and profit maximization etc.

Statistical Tools:

o Most of business decisions based on probable economic events.o Use theory of probability and forecasting techniques.

Operational Research Theory:

o An interdisciplinary solution – finding techniques.o Combines economics, mathematics and statistics to build models

for solving specific business problems.o Ex: L.P – widely used in business decision – making.

Management Theory:

o Behaviour of the firm to achieve certain predetermined objectives.

Accountancy: Data on functioning and performance of the firm.

4. Functions of a Managerial / Business Economist:

Demand forecasting by formulating econometric models. Cost analysis and supply forecasting – focusing on input prices,

product prices, technology flow etc. Product pricing and competitive strategies. Study and anticipation of government policies and planning

business strategies accordingly. Risk analysis to suggest alternative courses of action to cope with. Capital Budgeting: Investment criteria and decisions, and

profitability analysis.

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Module 1.2: Basic Concepts, Principles, Decision Rules and Tools of Analysis in B/M Economics.

1. Time Perspective in B-Decision-Making.

Decision Making: A task of coordination along the time scale, past, present and future.

Maintain the right balance between the long-run, short-run and intermediate-run perspective.

Building inventories of finished products: Need short-run time perspective.

Investment in plant, building, land and introduction of a new product: Need long-run time perspective.

2. Opportunity Cost Principle:

Most economic resources have more than one use Have opportunity costs scarcity and alternative use of the resources opportunity costs.

Opportunity cost of a decision:Sacrifice of the alternatives.

O. C of availing an opportunity is the expected income foregone from the second best opportunity of using the resources.

O. C Concept: Can be applied to all kinds of business decisions where there are at past two alternative options involving costs and benefits.

Examples:

Invest ones own capital in once own business O. C: Interest that could have been earned through investment in other ventures.

The O. C of managing once own business: Salary that be could have earned in other occupations.

The O. C of watching cricket match by a student?

3. Discounting and compounding principle:

Time Value of money and decision analysis

Future value of the present sum:

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Compounding

o Let PV = Rs.95.24 γ = 0.05FV1 = 95.24 + (95.24 X 0.05) = 100 at the end of first year.

o To generalize:PV = present value γ = rate of interestFV1 = amount received at the end of first yearFV1 = PV + PV(γ) = PV (1+γ)FV2 = PV (1+γ) (1+γ) = PV (1+γ)2

FVn = PV (1+γ)n

If γ = 0 FVn = PV.

Present value of future sum:DiscountingPV = Present ValueFV1 = Amount receivable at the end of one year from now (Rs.100)γ = 0.05 = Rate of discountPV = FV1 = 100 = 95.24

(1+γ) 1+0.05FV2 = Amount receivable two years from now (Rs.100)PV = FV2 = 100 = 90.70 (1+γ)2 (1+0.05)2

For N Years:PV = FV1 + FV2 + … + FVN

(1+γ) (1+γ)2 (1+γ)N

Relationship between PV and γ PV

Higher γ, Lower PV Lower γ, higher PV

γ

If γ = O, PV of Rs.100 receivable one year from now: Rs.100 NO time value for money.

If γ → ∞, PV → O.

Suppose a company is considering buying a new machine. It should estimate the discounted value of net added earnings from that machine before venturing to buy it.

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4. Marginal Principle and Decision Rule: Concept of M.P widely used in business decision making: M U, M C,

M R, M P and M П.

M C = TCn – TCn – 1TCn = total cost of producing n unitsTCn-1 = total cost of production of n-1 unitsM C = TCn – TCn – 1 = 2550 – 2500 = 50Similarly: MR = TRn – TRn -1

The decision rule:MR > MC: Carry on business activityMR < MC: ?MR = MC Necessary Condition for П – maximization.

To apply Marginal Principle: Need TC and TR data for each and every unit of output.

Equi – Marginal Principle:

A rational decision – maker: Decision RuleThe ratio of marginal returns and marginal costs of various uses of a given resourceorVarious resources in a given use is the same.

Ex1: Consumption basketMU1 = MU2 = … = MUn Equi – marginalMC1 MC2 MCn

MU1 > MU2 → Decision Rule?MC1 < MC2

Ex2: Input useMRP1 = MRP2 = … = MRPnMC1 MC2 MCn

MRP1, MRP2: MRP1 from input 1 (say labour) MRP2 from input 2 (say capital)

MC1, MC2: Marginal cost of Labour and Capital

MRP1 > MRP2 → Decision Rule?MC1 < MC2

Contribution Analysis and Incremental Concept:

IC = Change in total cost due to a specific decision

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IR = Change in total revenue caused by a decision

IR > IC → Decision, profitable

The contribution of a business decision: Difference between IR and IC.

Difference between marginal and incremental concepts:

M – Principle: Change in revenue, cost or profit with respect to change in output only. Change in output is infinitesimally small.

IC: Applicable with respect to any variable and for any extent of change.

5. Profits:

Accounting Profit and Economic (pure) Profit:

AP = TR – Explicit Costs.

EP = TR – (Explicit Costs + Implicit Costs).

EP: Makes provision for insurable risks, depreciation, and necessary minimum payment to shareholders to prevent them from withdrawing their capital.

Theories of Profit: Sources of Profit.

Innovation Theory:o Innovation in new products, new production techniques, new

marketing strategieso Cost of innovationso Profits: Reward for innovation.

Risk – Bearing Theory:o Companies bear risks – Non-availability of inputs and

adequate market for products.o Profit: Reward for risk-bearing

Monopoly Theory of Profit:o Powers to control supply & priceo Powers to prevent the entry of competitorso Sole ownership of certain crucial raw materialso Legal sanction and protection.

Monopoly is the source of pure profit.

Friction Theory of Profit:

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Ex: Severe and prolonged winter companies producing woolen garments, and those producing items like ice cream and fans.

Managerial Efficiency Theory:o Profits – Reward for exceptional managerial skillso Hence profit for good performance.

Same element of truth in all these theories. Profit is a reward for innovation, risk – bearing, monopoly power and managerial efficiency.

6. Plant, Firm and Industry:

Plant: A technical unit of production Technical similarity in the production processes of goods

production within a plant A body of persons working at a given place.

Firm: May own one or more than one plant Exercises a unified control over its plants Separate legal entity Undertakes production to maximize profits.

Industry:

A group of firms

Some common factor among all the firms:o The raw material used and production technique employed –

supply side.o Products produced – Demand side.o Firms compete more for same raw material raw material use

criterion to classify industries.o Firms compete more for capturing the market for their goods

substitutability of goods.o Standard industrial classifications (SICs): Raw material used

and similar production processes rather than the substitutability among products.Ex: Plastic buckets in the plastic industry, and metal bucket in metal working industry.But: On the demand side, these two are substitutes.

To identify degree of competition among the firms in the market, define industry as a group of firms producing closely substitutable products.

Concept of cross elasticity of demandEXY = % change in quantity of X demanded

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% change in price of YHow do you decide degree of substitutability?

Can we use cross elasticity of supply also to classify industries?

Module 1.3: Demand Analysis:

Read Section 2 of Module 2 in the hand out on “Orientation In Economics”.

Importance of demand analysis to a decision – maker: Existing potential demand for the product of the company Business strategies to augment the demand for the company’s

product.

Demand Effective demand.

Three characteristics of effective demand: Desire for the product Ability to pay for the product Willingness to pay for the product.

See Module 2 in the handout on “Orientation In Economics” for definition of demand, demand schedule, demand curve and law of Demand.

Types of Demand:

Demand for consumer’s goods and producer’s goodso Goods/services used for final consumption → Consumer’s

goodso Producer’s goods: Machines, buildings, raw materials etc.o Study consumer’s goods under demand and producer’s goods

under supply.

Perishable and durable goodso Perishable goods: Can be consumed only once. Ex:?o Durable goods: Only services are consumed. Ex:?o Implications to business decision-analysis.

Autonomous (Direct) and Derived (Indirect) Demand:o A (D) Demand: Demand not tied down with demand for some

other goods.o D (I) Demand: All produced goods.

Individual and Market Demand.

Milk Price Rs/Lit

Milk Demand (Litr.)

Market Demand

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B – 1 B – 2 B – 38 5 10 0 15

7 8 12 4 24

6 12 15 7 34

5 20 19 12 51

4 30 25 20 75

3 45 30 30 105

Assignment: Draw individual and market demand curves.

Demand by Market Segments and Total Market:o Domestic and Foreign Marketso Rural and Urban Markets.

Firm and Industry Demand:o Demand facing an industry (Say car industry)o Demand facing a firm (Demand for Maruti Car)o Refrigerators Industry and Godrej Refrigerator firm.

Price, Income and Cross Demand: Refer to Section 2 of Module 2 in the hand out on “Orientation In Economics”.

Determinants of Demand and Demand Function:

Determinants of Market Demand:

DX = fCPX, PS, PC, M, T, E, A.E, C.F, NB, POP. IDo PX, PS, PC, M, T, E: As in orientation handouto A.E = Adv. expenditureo C.F = Credit facilityo N.B = Member of buyerso POP. = Population of the countryo I.D. = Income distribution pattern in the country.

Postulate demand for X and determinants i.e Explanatory Variables.For Ex: ∂DX < O

∂PX

: ∂DX < ? ∂PS <

: ∂DX > ? ∂PC <

: - - - - - - - - - - : - - - - - - - - - -

Individual Consumer Demand Function:

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DX = fCPX, PS, PC, M, T, E, A.E ……)

Three Kinds of Demand:o Recall: PD, CD & ID

o P. D:DX = f(PX), OR C

o C. D: DX = f(PS), OR CDX = f(PC), OR C→ Substitutes, Complements and independent goods→ Draw diagrams.

o I. D:DX = f(M), OR C→ Normal, inferior and neutral goods.

Why the inverse relationship between price and quantity demanded?

Substitution effect:o PX↓, prices of its substitutes remaining constanto Hence more of X is demanded with a fall in its priceo PX↑, PS

o Hence less of X is demanded with a rise in price of X, because the substitutes are cheaper.

Income Effect:o PX↓ RI↑ → An increase in his purchasing power. Buy more of

X, if it is a normal good.o PX↑ RI↓ → A decrease in his purchasing power. Buy less of X,

if it is a normal good.o Note: In case of inferior goods:

PX↓ → RI↑ - Buy less of X.PX↑ → RI↓ - Buy more of X. Because still cheaper compared to other goods.

Exceptions to Law of (Price) Demand:o Giffen Goodso Articles of snob appealo Speculation.

Movement (Change in equality demand or extension and contraction of demand) and shift in demand (change in demand or increase and decrease in demand).

Why movement and why shift?

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Module 1.4: Price Elasticity of Demand:

Recall from the handout on “Orientation in Economics”.

EP = Price Elasticity of D = % change in quantity of X demanded % change in price of X

o Point EP = ∆Q . PO ∆P QO

o Arc EP = ∆Q . P1 + P2 Average price elasticity between

∆P Q1 + Q2 two pointsAlso called Mid – Point Formula

o Sign of price elasticity coefficient: Negative, but consider the size and ignore the sign, i.e│ EP │.

o Five Kinds of Price Elasticity of Demand: Elastic D: │EP│> 1 % ∆Q >% ∆P

QO PO

Inelastic D: │EP│< 1 % ∆Q <% ∆P QO PO

Unitary el. D: │EP│= 1 % ∆Q =% ∆P ∆O PO

Perfectly ine. D: │EP│= 0 % ∆Q = 0 for a QO

given % ∆P PO

Perfectly /infinitely el. D: EP = ∞ All output is sold at the same price % ∆P = 0

PO

o Draw diagrams for all five kinds of PED.

o Total Revenue (Total Expenditure) Test and Price el. of D:

Recall:│EP│> 1 A Price change leads to more than

proportionate change in Q – demanded.

│EP│= 1 Price and quantity change in the same proportion.

│EP│< 1 A price change leads to a less than proportionate change in Q – demanded.

Price Elasticity and Revenue Relations

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Price (P)

Quantity (Q)

TR = P.Q

MR MR= ∆TR ∆Q

Arc. E │EP│

100 1 100 - -

90 2 180 80 6.33

80 3 240 60 3.40

70 4 280 40 2.14

60 5 300 20 1.44

50 6 300 0 1.00

40 7 280 -20 0.69

30 8 240 -40 0.47

20 9 180 -60 0.29

10 10 100 -80 0.16

Observe:

Q: 1 to 5: │EP│>1 → P↓TR ↑ MR > 0 __

Q: 5 to 6: │EP│=1 → P↓TR MR = 0

Q: Greater than 6: │EP│< 1 → P↓TR↓MR < 0

│EP│

Effect of P ↓on

Effects of P ↑on

TR MR TR MR

>1 ↑ > 0 ↓ < 0

=1 Constant = 0 Constant = 0

<1 ↓ < 0 ↑ > 0

Do you agree with this analysis?Module 1.5: Determinants of Price Elasticity:

Nature of the commodity:

Luxury/Comforts: Price Elastic Necessary Goods: Price Inelastic.

Availability of substitutes:

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More number of substitutes: More ElasticEx: Beverages

Less/no substitutions: Less elastic/inelasticEx: Salt, Onion.

Number of uses:Single – use commodities: Less elastic

Ex: ?Multi – use commodities: More elastic

Ex: Aluminum used inConstruction of airplanes automobiles, boats and buildings.

Consumer’s income:Poor Consumers: More elasticRich Consumers: Less/inelastic.

The products position in buyersBudget: The proportion of income spent on the commodity.

Module 1.6: Practical Significance of the Concept of P. E. D:

Questions facing a business firm:

5% P ↑ → Expected impact on sales?

Sales to increase by 10% → How much of reduction in price?

Whether reduced prices attract sufficient additional customers to offset lower revenue per unit.

o Discounts to different customer groups like in airlines, restaurants etc to students, senior citizens, vacation travelers.

Taxation.

Demand for higher wages: can be met when EP for the product is inelastic.

International trade: Decision to devalue a country’s currency is based primarily on the price elasticities of imports and exports.

Product pricing strategy by business firm:o Does it pay to reduce the price of a product the demand for

which is inelastic or demand for which is elastic?

o Does a price rise yield a rise in TR when demand is elastic or inelastic?

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Module 1.7: Cross Elasticity of Demand:

Recall:

DX = f (PR) Let related good by Y

DX = f (PY)

d DX = 0 X & Y are ……………….. ?d PY

d DX > 0 X & Y are …………………. ?d PY

d DX < 0 X & Y are …………………. ?d PY

Draw diagrams for all the three situations:

EXPY = ∆QX PYO

∆PY QXO

EXPY O when? <

Consider the following examples: Monthly Demand of a Household

CommodityOriginal New

P Q P Q

Tea 3 50 3 60

Coffee 4 30 5 20

Bread 2 80 2 90

Butter 75 30 6 40

Question: Calculate cross elasticity efficients for Tea & Coffee and Bread and Butter and interpret results with respect to nature of relationships between commodities.

Cross Elasticity of Demand in Transport System

Fare (Rs)Daily No. of Passengers

Rail Bus Rail Bus1. Before fare change

45 40 500 200

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2. After fare change 45 35 400 300

3. Percentage change

… … … …

Compute: ERFB = % change in Rail Service % change in Fare of Bus Service

Significance of C E D in Business Management:

To define substitutes:o C E Coefficient > 0 Goods are substituteso Greater the C E C → Closer the substituteso Smaller the C E C → - - - - - -

Similarly to define complements:o C E C < 0 Goods are complementso Higher the negative C E C → Higher the degree of

complementarily.

To define independent goods?

To measure the degree of threat due to competition in the market.

To define market structure:o Lower the value of CEC, higher the monopoly powero Higher the value of CEC?

To forecast demand for its products, consider price change by competing firms.

To define cluster of products: Substitutes, compliments and independ goods?

Module 1.8: Income Elasticity of Demand:

Recall:DX = f (M), OR Cd DX O Normal Goodd M < Neutral Good

Interior Good.

Draw diagrams to illustrate three kinds of goods.

EM = ∆QX MO

∆M QO

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EM O N. G < Neu. G

I. G.

EM = 1 → Unitary I. EEM = 0 → Zero I. EEM > 1 → I D curve flatterEM < 1 → Steeper I D CurveEM < 0 → Downward sloping I D curve.

MDraw other types of ID Curvein the same diagram.

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Business Applications of IED:

Long – term business planning for luxuries & comforts: High IED.

High IED: A major determinant of construction industry and real estate business.

Taxation policy:High IEC Luxury goodsImpose higher excise or sales tax.

Sectoral Production Plans: Usefulness of estimates of IED coefficients.

Module 1.9: Additional Demand Elasticity Concepts:

Advertising elasticity.

Interest rate elasticities to forecast demand for housing, automobiles etc.

Weather elasticity of demand for public utilities like electricity.

Module 1.10: Demand Estimation and Forecasting:

Methods of Estimating Demand Function: Consumer interviews (Surveys)

o Interview consumers on their consumption habitso Census and sample methods

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IDC (EM=1)

Q

o Information on quantities of the concerned good bought at different periods at various prices of the product, prices of related goods, income of the consumer ……..

Market Experiments Method:

o Actual Experiment:Record consumer’s reactions in different shop locations with respect to income, estimated religion, sex, age group etc.

o Market simulation (Consumer clinic or laboratory experiment) method: Provide token money to a set of consumers. Vary prices of various goods, their quality, packaging etc

and record shopping behaviour of consumers. Too costly and consumer’s may not take the experiment

seriously.

Regression Method: Identify variables which influence demand for a particular

commodity Collect data Select appropriate functional form Estimate the function

Ex: Demand Function for Groundnut OilDg = f (Y, Po, Pv, Pg, U)Where: Dg = demand for groundnut oil

Y = national income Po = price of groundnut oil Pv = price of vanaspathi Pg = price of pure ghee U = ‘other’ determinants of g.n.o

Time series or cross section data. Demand Forecasting

D. Forecasting: An estimate of the future demand, based on laws of probability.

Levels of D. F:

o Micro Level: Forecast by an individual business firm.o Industry Level:o Macro Level: Ex: Country consumption function.

Why D. F?

o Production planningo Sales forecastingo To control business and inventory

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o To plan long term growth and investment programmes.

Demand Forecasting Methods:

o Consumers’ survey

o Experts’ opinion Simple expert opinion poll Delphi Method: An extension of the simple expert opinion

poll Use Delphi Method (DM) to consolidate the divergent

expert opinion and to arrive at a compromise estimate of future demand.

Under DM: Collect opinions from experts. Instead of taking averages, try to match the opinions by bringing experts to-gether and to arrive at a consensus.

Statistical Methods:

Trend method to extrapolateDg = f (T)Where: Dg = demand for groundnut oil

T = Time (Years)

Barometric Method of Forecasting

o Meteorologists use the barometer to forecast weather conditions on the basis of movements of mercury in the barometer.

o So use relevant economic indicators such as GDP, prices, lending rate for loans.

Econometric Method: Regression Method

o Simple or Bivariate Regression Technique:Y = f (X)Y = Sugar consumedY = Population

o Multivariate RegressionDx = f (Px, Ps, M, A)Where: Dx = Quantity of x demanded

Px = Price of X Ps = Price of substitutes M = Consumer’s income A = Advertisement expenditure

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Module 1.11: Theoretical Foundation of Consumer Behaviour:

1. Cardinal and Ordinal numbers and C and O Utility Concepts

Cardinal numbers:1, 2, 3, 4, - - - - -

o The number 2 is twice the site of number 1o Measure utility of commodities A & B by utilis:

A: 20 utilsB: 40 utils

B Yields twice the utility of it.

Ordinal numbers:I, II, III, . . . . . . . .

o II > I, but II less than IIIo Don’t know, by how much size relation of number not knowno Rank utility, and explain consumer behaviour without the

assumption of measurable utility.

2. The Marshallian Cardinal Utility Theory:

Assumptions:o Maximization of satisfaction.

o Rationality: Buys the commodity yielding highest amount of utility per rupee.

o Utility is cardinally measurable. Measurable by the price that the consumer is prepared to pay.

o Utility function exists:TU = (G, S) TU = M U of G, S G TU = M U of S, G S

o Constant marginal, utility of money: Sine, money is used as a measure of utility.

o Diminishing M U.

Law of Diminishing M U:

No. of oranges

consumedT U M U

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0 0 -

1 20 20

2 35 15

3 45 10

4 50 5

5 53 3

6 55 2

7 56 1

8 56 0

9 55 -1

10 53 -2

o Develop both TU and MU curves from this data.

o Observe how behaviour of TU and MU related.

o The LDMU:As an individual increases consumption of a given product (say orange) holding consumption of other products constant, MU derived from consumption eventually diminishes.

o What are the implications of this law to a business manager?

Consumer Equilibrium and the Marshallian Proportionality Rule:MUA = MUB ……… = MUZ = K PA PB PZ

o Can we say that K is the MU of money i.e MUM?

o How does a consumer behaviour when: MUA MUB ?

PA < PB

LDMU and Demand Curve:

o Co ↑ MU ↓ → P ↓ D ↑Co ↓ MU ↑ → P ↑ D ↓

o Hence inverse relationship between P and Quantity demanded.

o Consumer Equilibrium:

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MUX = PX

o If MU of X is measured in terms of money, then the MU curve becomes the demand curve of the good.

P MU/Price

P1

P2 MU/Demand O Q

Q1 Q2

At P1 → Q1

At P2 → Q2

o MU curve could enter IV Quadrant whether D. C could enter IV Quadrant?

3. Ordinal Utility Theory: The Hicksian Theory of Indifference Curve

Assumptions of O. U Theory:

U is Ordinal:

o Measurement of U → Unrealistic and not needed to explain consumer behaviour.

o Ordinal ranking to rank preferences according to the satisfaction of each basket.

Rationality:

o Maximize satisfaction, given income and product prices.

The Axiom of consistency and transitivity:

o Consistency: of A > B, then B > Ao Transitivity: of A > B, B > C, then A > C.

Axiom of non – satiability:The Consumer: Not oversupplied with either commodity. Consumers do not have enough of all things.

Indifference Schedule and Indifference Curve:

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o Five different combinations of X & Y yielding the same level of

satisfactory (U1) Indifferent towards different combinations.

Indifference Curve: Diagramatic representation of indifference schedule.

Y 30 E

25

20 D

15 C

10 B

5 A IC1 (U1) O X

5 10 15 20 25Units of X

Indifference Map: Y

IC3

IC2

IC1

IC0

O X

o IC0 → U0

IC1 → U1

IC2 → U2 Different satisfaction levelsIC3 → U3

o U3 > U2 > U1 > U0

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Combination

Units ofX

Units ofY

Total Utility

A 25 3 U1

B 15 6 U1

C 8 9 U1

D 4 17 U1

E 2 30 U1

Units of Y

Properties of I. Curves:

Negative Slope:Along an IC: -(MUX) (∆X) = (MUY) (∆Y)- MUX = ∆ X = MRS = Slope of an IC MUY ∆Y

o Why not positive slope? Why not horizontal? Why not vertical?

Convex X to the origin:

o Marginal rate of substitution (MRS) between two goods decreases as a consumer moves along a given I. C. The slope of an I. C curve decreases as we move from point E to A DMRS.

o Consider the following indifference schedule:

CombinationApples

(X)Bananas

(Y)

MRS∆ Y ∆X

a 1 12 -

b 2 8 - 4/1 = - 4

c 3 5 - 3/1 = - 3

d 4 3 - 2/1 = - 2

e 5 2 - 1/1 = - 1 DMRS: The consumer assigns a lesser and lesser significance of the extra unit of a commodity in a larger stock, and relatively a higher significance for the one which is a smaller stock. Movement from a to e quantity of X becomes larger and that of Y smaller. → Each time, the consumer will sacrifice a lesser and lesser amount of Y in exchange for X.

o Why not an Indifference curve be concave to the origin?

o Why not an I. C a straight line?

I. Cs do not intersect:

Y

A IC2 (U2)

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IC1 (U1) X

U2 > U1, but at A, U2 = U1

o Can one I. C tangent to another?

Upper I. Cs represent a higher level of satisfaction than the lower ones.

Y

b c

dY* a IC2

IC1

XX*

o Vertical movement from a to b More of Y, same amount of Xo Horizontal movement from a to d: Same amount of Y, more of

Xo Diagonal: Larger quantity of X & Y.

Budgetary constraint and Budget Line:

B = PY Y + PX X = Exp. on Y + Exp. on X

Solving for Y:Y = B - PX X → Eqn. for B. Line

PY PY

o B = Qy that can be purchased PY When QX = ?

o B = QX …………… ? PX

o Slope of B. Line: dY = - PX

dX PY

→ Price ratios of two commodities.

o Diagram:

Y B/PY

B QY A B. L or Price Line

O X

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QX B/PX

B.L: The market opportunities available to consumer, given his income and the prices of X and Y.

Feasibility Area: Budget line and area under B. L (A) Non-feasibility Area: Area beyond the B. L (Ex. B).

Shifts in B. L: B = PYY + PXX __ __o PY, PX, B↓ B↑ Parallel shift in B. L no change in slope

__ __o PY, B, PX↑ PX↓ Change in slope of B.L. But shift in B.L?

__ __o PX, B, PY↑ PY↓ Change in slope of B.L. But shift in B.L?

o PX and PY change proportionately No. Change in slope P↓ PY↓ An increase in B P↑ PY↑ A decrease in B.

o PX and PY change disportionately

o Draw diagrams to illustrate all these cases. Total Effect of a Price Change = I.E + S.E __ __

o Let PY↓, B and PX

o Buy more of Yo Reasons: S.E: Substitute cheaper Y for X

__ I.E: With B, PY↓ → Real I↑ Inducement to buy more of Y

(of Y is a …………. Good).

The consumer’s Equilibriumo I. Map: Preference of taste factorso B.L or P.L: Power to satisfy themo The point of consumer equilibrium or utility maximizing rule:

Y B/PY Q

P IC4(U4) R IC3(U3) IC2 (U2) IC1(U1) O X

B/PX

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Q, P, R: 3 of the infinite number of attainable combinations on B.L

Q: Move towards right → point P on U3

Move towards left: Lower IC R: Move upward to hit point P

Shift from U2 to U3

Point of C Equilibrium at P IC3 (U3) tangent to B.L

Slope of IC (U3) = slope of BL MRSXY = Price Ratio

MRSXY: Rate at which consumer is willing to substitute X for Y

Price Ratio: Rate at which he can substitute X for Y Point P: Two sets of forces those of the market operating

through BL and those of tastes operating through IC are brought into balance.

o MRSXY = Price Ratio

∆X = - MUX = - PX Slope of IC = Slope of BL∆Y MUY PY

MUX = MUY Does this imply the Marshallian PX PY Proportionality Rule?

Deriving Demand Curve from Price Consumption Curve (PCC):

P C C:

o Keep money income (M) constanto Keep price of Y constanto Allow decrease in PX.

Y

M

E1 E3 PCC E2 IC3 IC1 IC2

O X X1 N1 X2 N2 X3

N3

Quantity of X consumed.

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Mo

ney

Income

o Original BL: MN1 →Quantity of X bought X1 →Point of equilibrium: E1

o Allow PX↓ → New BL: MN2 → Q of X bought: X2 → New point of equilibrium: E2

o Allow further fall in PX↓ → New BL: MN3→ Q of X bought: X3 → New point of equilibrium: E3

o Connect successive equilibrium points E1, E2 and E3: called PCC

o Thus, PCC is a locus of points of equilibrium on indifference curves, resulting from the change in the price of a commodity. In this case, PCC shows the change in consumption basket due to fall in PX.

Derive individual consumer demand curve for commodity X from PCC.

PX

P

O X X1 X2 X3

D for Xo Slope of B. Line: MN1 → Quantity of X bought: X1

o Fall in PX → New BL: MN2 → Q of X bought: X2

o Further fall in PX → New BL: MN3 → Q of X bought: X3

When price consumption relations are taken out and plotted separately, that gives the demand curve depicting inverse relationship between price and quantity demanded, ORC.

Distributed Lag Models for estimating demand function:Qt = f (Pt, Pt-1, Pt+1, Yt, Yt-1, Yt+1, Qt-1, Qt-2)Qt = Quantity purchased in period 1Pt = Actual present price of the itemPt-1 = Observed past price of the itemPt+1 = Expected future price of that itemYt = Current incomeYt-1 = Past income (generating savings)Yt+1 = Future income (expected capacity to pay back)Qt-1 = Quantity of item purchased earlier in t-1Qt-2 = Quantity of item purchased earlier in t-2.

o Why Qt-1 and Qt-2: In case of consumer durables (Music set)o Why Qt-1 and Qt-2: Non-durable items (like cigaretters): Proxy

for habit.

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Linear Ex-penditure System: Reinterpretation of Budget Constraint (B.L or P.L)B = PX X + PY Y → Budget constraint, reinterpreted as LES

PX X = The expenditure on purchase of X PY Y = The expenditure on purchase of Y B – PX X = Surplus to be spent on Y B – PY Y = Surplus to be spent on X Consider X as a subsistence item or a basic necessity Then consider Y as comforts or luxuries The buyer’s pattern depends on the proportion spent on X & Y in

total budget → Implications to Strategic Sales Management.

Different dimensions of Demand:

Demand as seen by the buyer Demand as seen by the seller Demand for goods and for services Retailers demand, wholesalers demand and manufactures

demand for products.

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Module – 2: Production and Cost Analysis

1. Fundamental Questions Facing Business Managers:

How to maximize output from a given quantity of inputs? How to minimize cost for producing a given level of output? How does output behave with a change in inputs? Does technology matter in cost minimization or output

maximization? How to achieve least – cost combination of inputs?

Theory of production and theory of cost to address these questions.

2. Production Analysis (Theory):

The concept of production: P: A process of transforming inputs into output (goods and

services)Ex: Manufacturing, farming, transportation, packaging, wholesaling, retailing, legal/medical/consultancy services etc.

Four factors of production Fixed and variable inputs Short-Run: Increase production by increased use of variable inputs Long-Run: Increase production by increased use of both variable

and fixed inputs.Very Long Run: Change in technology also → More output from a given quantity of inputs or same amount of output from less quantity of inputs.

3. Production Function:

P.F: Technological relationship between inputs and output

o P.F: determined by technology, labour, materials, equipment and so on

o Any improvement in technology (including managerial technology) would create a new P.F.

Diagram

o Y = f (L,K), O R C (including T) Max quantity of output (Y) with a specific combination of L & K

o S.R.P.F: Y = f (L), Single Variable P.F, O R C

o L.R.P.F: Y = f (L,K), Multi Variable P.F

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o Widely used P.F:Y = A Lα Kβ

Y = Quantity of outputL = Quantity of labourK = Quantity of capital

α = output elasticity of labour = % change in Y = ∆Y L % change in L ∆L Y

β = output elasticity of capital = % change in Y = ∆Y K % change in K ∆K Y

Hint: Given your knowledge of MPL, MPK, APL and APK (Recall from orientation course), prove that:Output elasticity of Labour = αOutput elasticity of Capital = β

o TP, MP, AP:TP = Y∆Y , ∆Y = Marginal Products of L and K∆L ∆KY , Y = Average Products of L and KL K

4. Laws of Production:

L O P: Relationship between output and input

Output can be produced by:

o Keeping one/some inputs constant, by changing other inputso Changing only one input and keeping other inputs constant →

Law of Diminishing Marginal Returns (LDMR) or Law of Variable Proportions

o Changing quantities of all inputs → Law of Returns to Scale.

5. The Law of Variable Proportions (LDMR):

o Vary only one input (say labour), and keep other inputs (Ex: Capital) constant

o Keep technology constanto All units of input varied are homogeneous – All units have

identical characteristics.

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LVP (LDMR): Stages of Production

LabourInput

TP MP AP Stages of Production

1 20 20 20 S – I: TP↑ at an increasing rate

2 50 30 25→ MPL↑ APL↑ Max MPL

3 90 40 30 → APL↑, but lower than MPL

4 120 30 30S – II: TP↑ at a decreasing rate. Then Max.

5 135 15 27 → MPL↓, but +ve,

6 144 9 24 → APL↓, but +ve

7 147 3 21 → MPL = APL, then APL > MPL

8 148 1 18.5

9 148 0 16.4→TP constant, MPL=0→APL, +ve

10 145 -3 14.5S – III: TP↓ MPL, -ve APL, +ve

Note: S – I: Fixed input (K), under – utilized : S – II: Fixed input (K), properly utilized : S – III: Fixed input (K), inadequate : S – I: Increasing Marginal Returns : S – II: Diminishing Marginal Returns : S – III: Negative Marginal Returns

→ Draw diagram to illustrate the behaviour of TP, MP and AP.

The LDMR (LVP):As more and more of the input (L) is employed, OR C, a point will eventually be reached, where additional quantities of variable input (L) will yield diminishing marginal returns.

LVP (LDMR) and Business Decisionso How much to produce?o How many units of V-inputs to employ?o Would a business firm like to operate either in S – I or S – III?

Why or why not?o Do you consider S – I or S – III as rational zones? Why or why

not?o Do you consider S – II as the rational zone? Why or why not?

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o Once you decide rational zone (stage), how many workers to be employed and how much of output to be produced?

6. Optional (∏ - maximizing) use of Variable Input:

How many units of V – I (Self Labour) should the business firm employ for profit maximization?

Recall the Decision Rule:MRPL = MCL (Necessary Condition)

o Extra revenue generated from the sale of the output produced by extra labour equals the extra cost.

o MRPL = The extra revenue generated by the use of an extra unit of

labour= MPL (MR)= MPLX price of output per unit

o MR = Price = AR, if all the units of output are sold at the same price (as under P/C market)

o MCL = W (Price of Labour) if all the units of labour are employed at the same wage rate.

MRP&MCL

MRP = MCL

MCL = W

O L L* (units of L)

MRP

7. P. F with Two V – Inputs: Isoquant Approach:

L & K: Two inputs → vary quantity of both ⇒ LRPF

Two-Input and one output (Y) Model

Isoquant Approach: Assumptionso Two-input and one-output production systemo Isoquant (Iso-product curves)

Iso → equal, Quant → Quantity (of output) Different input combinations to produce a specified quantity of

output Two inputs (L&K) can substitute each other, but at a

diminishing rate Constant technology.

Isoquant and Isoquant Map

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o Combinations of L and K to produce equal amount of Y (say 5 units of output)

Combination

Unit of L

Units of K

MRTSLK = ∆K

∆L

1 1 16 -

2 2 11 5

3 3 7 4

4 4 4 3

5 5 2 2

6 6 1 1

o Isoquant and Isoquant Map

K

Y = 15 Y = 10Y = 5

O L

o Different combinations of L & K producing the same levels of Y.

o Isoquant Curve: Locus of all input combinations to produce a given level of Y.

8. Properties (characteristics) of Isoquants:

o Isoquants have –ve slope⇒ Substitutability between L & K⇒ Employ more of L → and less of K and Vice-Versa to produce the same level of Y.

o Isoquants are convex to the origin

Convexity ⇒ Not only the substitution between L & K, but also diminishing marginal rate of technical substitution (MRTS, Column 4 of the above Table).

DMRTS ⇒ As quantities of one input (say labour) is increased, the less of another factor (say K) will be given up.

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Thus MRTS ⇒ The amount of one input (K) substituted for one unit of another input (L) for producing a constant level of output.⇒ MRTSLK = - ∆K = Slope of an I.Q.

∆L As we move down an isoquant (towards right) MRTS of L for K

diminishes

Refer to Table:Combination 1: K is too much in comparison to labourCombination 6: K is less in comparison to LMRTSLK: Diminishes from 5 to 1 from combination 1 to 6

Loss = GainLoss: Loss in output by using less amount of K: - ∆K(MPK)Gain: Gain in output by using a larger dosage of L input: ∆L(MPL)- ∆K(MPK) = ∆L(MPL) MPL = - ∆K = (Negative) slope of an I.Q MPK ∆Lor- MPL = ∆K = Slope of an I.Q = -ve slope MPK ∆L

o Isoquants cannot intersect

o Isoquants cannot be tangent to other

o Upper isoquants represent higher level of output:

K

b c

dK* a Y = Y1

Y = Y0

O LL*

Point a on Y0: OL* & OK* Point b: More of K (a b) and same an out of L Point c: More of both K & L Point d: More of L (a d), but same about of K

⇒ Y1 > Y0, Point a on Y0, but points b c d on Y1

Hence ‘a’ represents Y0, but b, c & d represent Y1

with different combinations of L & K.9. Different Kinds of Isoquants:

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o Linear Isoquant: L & K are perfect substitutes

K

⇒ MRTSLK remain constant throughout

L⇒ A given quantity of Y can be produced by using only K or L or by using both Linear I.Q not realistic

o L – shaped (Fixed proportion) Isoquants: L& K are perfect complements

K B

K2 Y2

K1 Y1

O L L1 L2

⇒ Zero substitubility between L & K⇒ A given quantity of Y can be produced by one and only combination of

L & K (L1+K1 for Y1, and L2+K2 for Y2)⇒ If quantity of K is increased holding L constant, no change in Y⇒ Y can be increased by increasing both inputs proportionately

Ex: Car and Driver.

o Why not Isoquants be concave to the origin? Why not vertical or horizontal?

10. Isocost Lines: The Budgetary Constraint and Budget Line:

o Isocost Line or curve represents a line of constant costC = ωL + γKWhere: C = Total cost ω = Wage rate of labour

L = Quantity of labour γ = Rental price of K K = Quantity of K

ωL = -----------------------γK = -----------------------

--Solving for K:K = C - ω L

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γ γ

C = Maximum quantity of K, which can be purchased, when L = 0 γ

ω = Slope of I-C-Line = ∆K γ ∆L

→ -ve slope, and the slope of BL is the ratio of input prices (viz ω & γ)

K C/γ

K = C - ω L γ γSlope: ω = Relative input prices.

γ

O LC/ω

Let C = 1,000 γ = 250 ω = 500 Buy K = 4, L = 0 Buy L = 2, K = 0 Slope = - ω = - 500 = - 2

γ 250 Multiple combinations in between C/γ (intercept for K), and

C/ω (intercept for L)

What happens to location of I – C – Line (B.L) when: C alone changes (↓, ↑), OR C ω, γ (↓↑ proportionately and disproportionately), OR C

When the parallel shift in I – C – L, and change in slope of I – C – L? When change in slope and when no change?

11. Optimal Input (Factor) Combinations: Equilibrium of The Firm:

o Bring to-gether I.Q map and B.L or I.C.L to determine the optimal input combinations for the firm to reach equilibrium

o I.Q: Various combinations of L & K to produce a given level of Yo I.C.L: Various combinations of L & L that a firm can purchase at a

given cost

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o Superimpose the budget line (I.C.L) on I.Q map to determine optimal input combination for minimizing cost or maximizing output:

K A Are points A, B, C and D points of

equilibrium of the firm? B

K* E

Y3

C Y2 D Y1

O L L*Fig: Least – cost input combination.

Point E: Point of equilibrium of the firm Point of tangency between ICL and I.Q ⇒ Equal slope of

both I.C.L and I.Q (Y3) - MPL = slope of I.Q

MPK

- ω = slope of I.C.L γ⇒ Rule for optimal input combination: Ratio of marginal products of inputs in equal to ratio of input prices:

- MPL = - ω or MPK γ

MP L = ω orMPK γ

MP L = MPK

ω γ⇒ Optimal input combination (for the firm to attain equilibrium) when: an additional unit of money on any input by the business firm yields the same increase in output.

Is this rule for optimal input combination comparable to that of MU1 = MU2 under consumer equilibrium i.e equi-marginal P1 P2

utility principle? Are the following situations optimal or sub-optimal?

MPL > MPK

ω γMPL < MPK

ω γ If suboptimal, what changes a business firm should

effect to reach the optimal point of input combination?

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MPL = MPK Is this rule, a rule of Π – maximization? ω γ

o Optimal input combination: cost minimization or output maximization.MPL = MPK : Considers only: input prices and marginal productivities ω γ of inputs.

o Rule for Profit Maximization:MC = MR

MC = Supply related factor MR = Demand related factor⇒ Hence consider both supply related and demand related factors to optimize Π.

o Hence optimal input combination (cost minimization/output maximization) is a necessary but not a sufficient condition for max. Π sufficient conditions come from demand – related MR of output (Y).

12. Expansion Path:

o Case of a firm: Y1 = 1000 ω = 2 K = 10 units γ = 2 L = 10 units

K C3

C2

C1 c

a b Y3 = 1750 10 Y2 = 1500

Y1 = 1000 O L

10 C1 C2 C3

o Point a: Y = 1000 L = 10 K = 10C = (2) (10) + (2) 10 = 40⇒ C1C1 = 40 Iso cost line tangent to Y1 = 1000⇒ Optimal input combination to produce Y1.

o Expand output to Y2 and Y3:⇒ New I.C Lines: C2C2 and C3C3, assuming ω & γ remain constant (parallel shift)⇒ New points of optimal input combinations: b and c.

o The firm expands by moving from one tangency or efficient production point to another (a → b → C).

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o Connect all these efficient production points to represent expansion path.

13. Returns to Scale:

To explain the behaviour of output in response to proportionate and simultaneous changes in input use ⇒ Expansion/Contraction in the scale of production.

Technical possibilities of proportionate and simultaneous increase in the use of both L & K:o Y (output) increases more than proportionately ⇒ IRSo Y increases proportionately ⇒ CRSo Y increases less than proportionately ⇒ DRSo Y = (L, K)o Firm uses L units of Labour in combination with K units of capital

to obtain an output of Y: L + K → Yo Let us change both L and K by a proportion, call it λ.

By how much Y increases?

Let output increase by b:λL + λK → bY bYb = λ ⇒ CRSb > λ ⇒ IRSb < λ ⇒ DRS

Diagram:

IRS (Increasing Slope Curve) CRS (Constant Slope Curve)

DRS (Decreasing Slope Curve)

Units of L & K

Why IRS?: Due to specialization – use of specialized labour and machinery (Details later under Economics of Scale).

Why DRS?: With increased scale of operation, increased problems of co-ordination (Details later under Economies of Scale).

Output elasticity and R to S: = % change in output (Y)

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Tota

l outp

ut

% change in all inputs (L & K) = ∆Y . IO ∆I YO

Case1: > 1 ⇒ % change in Y >% change in inputs ⇒ IRS

Case2: = 1 ⇒ % change in Y = % change in inputs ⇒ CRS

Case3: < 1 ⇒ % change in Y < % change in inputs ⇒ DRS

R to S In Iso – Quant Framework:

K3L + 3K → Y1 = 100

6 B 6L + 6K → Y2 = 200A Y2 = 200⇒ C R S

3 Y1 = 100

O L 3 6

K⇒ ?

6 CA Y2 = 300

3 Y1 = 100

O L 3 6

K⇒ ?

6 DA Y2 = 150

3 Y1 = 100

O L 3 6

14. Technology and P.F:

Technical Change: Economic InterpretationY↑, IY, I↓

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Technical change for facing global competiveness.

Labour – intensive technology: L ratio ↑ K

Capital – intensive technology: L ratio ↓ K

Neutral technology: L ratio remains constant.K

Impact of technology change on TP, MP and AP: TP↑ with same amount of input. MP↑ and AP↑ with same amount of input.

Upward shifts in product curves & shifts in iso-quant.

Embodied technology change & P.F shift: Embodied in inputs (say a new and more efficient machine).

Disembodied technology change: P.F shifts due to improved efficiency in input-combination, and improved managerial efficiency etc. Do you contest this difference?

15. Derivation of cost functions from production function: Duality Theorem.

16. Production Theory and Managerial Decision Making:

Careful planning by a company to use its resources in a rational manner. (Recall three stages of production where do you want the company to operate)

Managers must understand the marginal benefits and cost of each decision on resource allocation.

Use the concept of trade – offs in decision making:Ex: K – L trade off: Install a new voice messaging system

Reduce the need for receptionists, operators or secretaries Question: Cost of installing such a system outweighed by cost

of saving resulting from the elimination of certain support personnel.

Ex: Similarly, L – L trade – off, K – K trade – off, etc.17. Theory of Costs:

Role of Cost Management in Profit Maximization:Π = P – C.

C o P provides the floor to pricing.

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A basis for managerial decision on product pricing Whether to abandon an old product line or establish a new one Whether to increase the volume of output or not Whether to use idle capacity or rent facilities to outsiders. Proper calculation of costs: Basis for decision making.

18. Kinds and concepts of costs:

Historical and Current Costs:o H.C: Market value of an asset at the time of purchaseo C.C: Market value of an asset at the present time

Current Costs: Determined by replacement cost – outlay required for replacing an old asset.

o Usually C.Cs exceed historical costs but in case of computers and electronic equipments, C.C<H.C due to technological progress.

Explicit and Implicit Costs (Imputed Costs):o E.C: Actual expenditure of the firm to hire, rent or purchase

the inputs required in production.Ex: Wages to hired labour, rental price (interest) of capital, equipment, purchase of raw materials.

o I.C: Costs of input owned and used by the business firm – Imputed Costs.Ex: Cost of equity capital, rent on company owned facilities.

o To estimate Π: Which one (ones) should we use.o Usually, I.Cs, not considered while calculating the loss or gains

of the company.o E Costs: Also called paid-out costs. I.Cs: Book Costso Economic Costs = E.Cs + I.Cso Accountants consider Explicit Costs (E.Cs also called

Accounting Costs), but economists consider both for profitability analysis.

Opportunity Cost (Alternative Cost):o O.C: Value of a resource/input in its next best alternative useo Ex 1: Maximum salary an entrepreneur could earn working for

some one else.Ex 2: O.C of attending college includes not only the explicit costs of fees, books and so on, but also foregone earnings of not working.

o O.C and efficient resource allocations A producer with some amount of resources – he can

produce either scooters or cars. Let O.C of one Car is 6 Scooters PS = 30,000 PC = 2,00,000 Which one should be produced? Basis for efficient use of resources.

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o O.C: Relevant for managerial decision making. Consider the O.Cs of all the inputs-purchased and used and owned and used.

Production and Selling Costs:o P.Cs: Costs of all inputs used in productiono S.Cs: Expenditure on advertisement, display, cost of transport

etc.

Incremental and Sunk Costs:o I Costs: Change in cost due to a given managerial decision.

Ex 1: An additional departure of an air career.Ex 2: I.Cs due to introduction of a new product, replacement of old technique of production.

o S.Cs: Cannot be altered, these S.Cs due to prior commitment.o I.Cs vary with the decision.

S.Cs are not variable with the present decision.o I.Cs: Relevant for decision-making.

S.Cs: Do not depend on the decision at present.

Private and Social Costs:o P.Cs: Incurred by firms in the process of producing goods and

services. P.Cs internalized costs incorporated in the firms total cost of production.

o S.Cs: Incurred by society as a whole.Ex 1: Mathura Oil Refinery discharging its wastage in Yamuna River → water pollution.Ex 2: Factories located in a city causing air pollution.

o An alternative interpretation of S.C: Social Costs to include both private and external costs (Costs of Water, Air Pollution etc). S.C: Total cost borne by the society due to production of a commodity.

Fixed and Variable Costs:o F.C: (overhead, prime or supplementary cost): Do not vary

with output.Ex: Property taxes, insurance etc.

o V.C: Vary with output.Ex: Payments for raw materials, fuel, excise tax etc.

o S.R: Differentiate between F.C and V.C.o L.R: All costs are variable.

Engineering Costs:o Important from the view point of project management.o Pre-investment Phase: Planning costs.

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o Investment Phase: Project execute on costs including drawing/designing, procurement and construction, commission etc.

o Post-investment (operation phase): Running/operation costs, maintenance costs, replacement costs etc.

Total and Unit Costs:o TFC and TVCo TC = TFC + TVCo AFC = TFC

Qo AVC = TVC

Qo AC = AFC + AVCo MC = ∆TC

∆Q.

19. Short – Run Cost – Output Relations:

S.R: Some costs are fixed (TFC) and some costs variable (TVC). AFC, AVC, AC and MC: Relevant Unit Costs.

Cost Function: Symbolic statement of the technological relationship between the cost and output.TC = f (Q)

T. Costs, Unit Costs and Output Relations.

Output (Y)

TFC TVC TC MC AFC AVC AC

0 55 0 55 - - - -

1 55 30 85 30 55 30 85

2 55 55 110 25 27.5 27.5 55

3 55 75 130 20 18.33 25 43.33

4 55 105 160 30 13.75 26.25 40.0

5 55 155 210 50 11 31 42

6 55 225 280 70 9.17 37.5 46.67

7 55 315 370 90 7.86 45 52.86

8 55 425 480 110 6.88 53.13 60.01

o TFC, TVC and TC: TFC: Constant (55) althrough in the short run, even thought

output (Y) ↑.

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TVC: Increases althrough with an increase in output (Y). TC: Increases althrough with an increase in output (Y). TVC and TC do not increase at the same rate with Y ↑

althrough. Can you observe the rate of change in TVC and TC with an increase in Y.

Diagrammatic Representation of TFC, TVC and TC. TFC, TVC & TC TC TVC

TFC

O Output TC = TFC + TVC

o Behaviour of unit costs with change in Y: AFC: Decreases althrough with an increase in Y, because....

constant AFC

AFC Y (output)

AVC: First decreases, reaches the point of minimum and then increases.

AVC AVC

O Y (output)↑ ← Y* → ↑

Relate AVC to APL: APL = YL

AVC = TVC = PL.L = PL (L) = PL ( 1 ) Y Y Y APL

APL ↑ → AVC ↓

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Max. APL → Min. AVC APL ↓ → AVC ↑

AVC curve is the mirror image of the shape of APL curve.

AC: First decreases, becomes minimum and then increases.

AC AC

Y (output)

o The behaviour AC depends on the behaviour of AFC and AVC:

When AFC and AVC fall, AC↓

When AFC falls, but AVC increases, change in AC depends on the rate of change in AFC & AVC If Decrease in AFC > Increase in AVC, then AC - - - - - - - If Decrease in AFC = Increase in AVC, AC - - - - - - - If Decrease in AFC < Increase in AVC, AC - - - - - - -

MC: First decreases, becomes minimum and then increases

MC MC

O Y (output)MC ↑ ← Y* → MC ↑

Behaviour of MC related to behaviour of MPL: MPL = ∆Y ∆L

MC = ∆TC = ∆TFC + ∆TVC , but ∆TFC = O∆Q ∆Q ∆Q ∆Q

MC = ∆TVC = ∆PLL = PL (∆L) ∆Q ∆Q ∆Q

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MPL ↑ → MC ↓Max MPL → Min MC MPL↓ → MC↑

MC curve is the mirror image of the shape of MPL curve.

Assignment: Use Data on Total and Unit Costs of page 16→ Plot TFC, TVC and TC in one graph sheet→ Plot all Unit Costs in an other graph sheet→ Record the behaviour of each one of Total and Unit Costs→ Record how AFC, AVC, AC and MC related.

20. Long – Run Cost – Output Relations:

L R: All inputs are variable scale of the firm changes. The length of the time of the LR depends on the industry

Ex1: Service industry like dry – cleaning LR may be a few months or weeksEx2: Construction of a new electricity – generating plant LR may be many years.

The firms LR total cost (LTC) is derived from the firm’s expansion path LR is composed of a series curve of short run production functions.

LTC shows the min LR costs of producing various levels of output. The firms LAC and LMC curves derived from the LTC. Expansion Path, LTC, MC and LAC. Capital

(K)

Expansion Path

IQ5

IQ3 IQ4

IQ2

IQ1

Labour (L) LTC

LTC

Derived fromExpansion Path

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Y (output)

LMC & LAC LMC

LAC

LAC = LTC Y

LMC = ∆LTC ∆Y

Y (output)

o LTC: To produce different levels of output indicated by Iso-Quants.

o LAC: First decreases, becomes min and then increases. Does this have relationship with returns to scale.

o LMC: Slope of the LTC curve intersects the LAC curve from below at the lowest point on LAC curve.

Possible Shapes of LAC Curve: LAC

LAC

O Y (output)

Fig. A LAC

LAC O Y

Fig. B

LAC

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O Y Fig. C

Fig A: IRS (LAC) ↓ and DRS (LAC) ↑Fig B: IRS (LAC) ↓ Constant CRS (LAC) → DRS (LAC) ↑Fig C: Althrough decreasing with an increase in Y.

Plant size, SRAC Curve (SRAC) and Long RAC Curve (LRMC):

LRAC Curve derived from SRAC Curves.

LRAC Curve is also called Planning Curve or Envelope Curve.

Average cost in

SRAC1 SRAC2

SRAC3 SRAC4 SRAC5

LRAC

O Q1 Q2 Q3 Q4 Quantity of output

per period of timeThe Long – Run Average Cost Curve for Alternative Plant Sizes

o Wants to produce OQ1 level of output → plant size represented by SRAC1: The most efficient.

o Forecast more demand for output OQ2 → plant represented by SRAC2: the most efficient. OQ2 could reproduced with SRAC1

also, but AC with SRAC1 > AC with SRAC2.

o Level of demand, further to OQ3 → go for plant size SRAC3. Why not to stay with SRA2?

o Level of demand, further to OQ4 → go for plant size SRAC4. Why not to stay with SRA3?

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o SRAC4 plant size is called the optimum or least cost (least AC) size.

o The LRAC curve is an envelope of the SRAC curves and is tangent to each of the SRAC curves.

o LRAC curve is not tangent to the SRAC curves of their minimum points except in the case of optimum plant size i.e SRAC4.

o Note: LRAC curve is U-shaped due to economies and diseconomies of scale.

21. Economics and Diseconomics of Scale: Real and Pecuniary Economics.

o Economics of Scale: Decreasing segment of LRAC curve.

o Diseconomics of Scale: Increasing segment of LRAC curve.

Economics of Scale:

o Internal (internal to the firm) Economies:

Economies of Production: Technological advantages and advantages of division of labour and specialization.

Economies in Marketing: Large scale purchase of inputs and sale of output.

Managerial Economies: Specialised management in production, HRD, Marketing, Finance etc.

Economies in Transport and Storage: Fuller utilization of transport and storage facilities.

o External or Pecuniary Economies of Scale: Large scale purchase of inputs: Concessions and discounts. Large scale acquisition of external finance. Massive advertisement campaigns.

Declining portion of LRAC due to economies of scale due to output expansion.

Diseconomics of Scale: Rising portion of LRAC curve:o Overcrowding of labouro Managerial inefficiencieso With full in demand for the product, underutilization of

capacity.

Impact of Technological Change on LRAC Curve.

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Economies of Scope:

o Not the same as economics of scale.

o Many times, companies/firms produce more than one product to lower the cost of each operation alone.Ex1: Automobile companies producing cars and trucks product diversification.Ex2: A smaller commuter airline providing cargo services.Ex3: Use the byproducts arising from the production of the first product – sugar industry.

o Economies of Scale: Total of point production of cars and trucks < Total cost of producing cars and trucks independently by different firms.TC(C,T) < TC(C) + TC(T) Less expensive to produce jointly.

o Diseconomies of Scale: TC(CT) > TC(C) + TC(T) Less expensive to produce independently.

22. Learning of Curves (Experience Curves).

Decline in AC of inputs with rising cumulative output over time.

Take 1,000 hours to assemble the 100th aircraft, but only 700 hours to assemble 200th aircraft workers and managers become more efficient with passage of time.

AC

F

G

Learning Curve

O Cumulative Qt 2Qt Total Output

o Otth output (like 100th aircraft)o 2Qtth output (like 200th aircraft)

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Economies of Scale: Declining AC of input due to output expansion. But Learning Curve: Cumulative experience and decling AC of input

for different units of output. Learning Curve: Experienced in manufacturing airplanes,

appliances, ship building, refined petroleum products and operation of power plants.

Learning Curve: Used to forecast the requirement of personnel, machinery and raw materials and scheduling product and determining the price at which to sell output.Ex: Texas instruments has followed an aggressive price policy for computer chips, based on the learning curve.

Comparison of E of S and Learning Curve: Know:

o Technical Progress: Downward shift in LRAC Curve.o Managers and workers gaining experience: Downward shift in

LRAC Curve.

LRAC

C B

A LRACt LRACt+1

O Output Qt Qt+1

Observations:o Two periods: t and t+1o Qt and Qt+1 levels of output during t and t+1o LRAC at t: OC for Qt level of outputo LRAC at t+1: OB

Lower LRAC during t+1 period BC = Unit cost saving.

o Expand output from Qt to Qt+1 Economics of Scale: LRAC at Qt+1: OA OA < OB < OC

o Learning Curve Effect: BCo E of Scale Effect: ABo Downward shift due to learning and movement along a given

LRAC curve due to E of scaleo Remember: Downward shift in LRAC curve (AC reductions)

may be due to Learning Experience, Economies of Scale, technology and input price decline.

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Hold other things constant to sort out net effect of L.C (Previous Diagram)

23. Cost – Value – Profit Analysis: Break – Even Point and Operating Leverage.

Examine the relationship among TR, TC and total profit at various levels of output (Q).

C – V – P analysis or B – E – A: used by business executives to determine volume of sale required for the firm to break even and the total profits and losses at other sales levels. At what output level B – E, Losses and Profits?

Use C – V – P or B – E Analyse.

B – E Analysis: Linear Cost and Revenue FunctionCF: TC = 100 + 10 QRF: TR = 15 Q.→ 100 = TFC V.C varies with output (Q) and varies at a constant rate of 10 per unit.→ Sale Price = 15

Algebraic Calculation of B – E – P:→ TR = TC→ 15Q = 100 + 10Q→ Q = 20 20 is the B – E output→ Beyond 20: operating profit→ Below 20: operating loss.

Diagrammatic Representation: Costs

Revenue TR Operating Π

700 Π>0 TC 600 TVC 500 400 Operating 300 loss B 200 100 Π<0 TFC

O Q (output)10 20 30 40

o TFC = 100o TVC: Variable Cost

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o TC = TC function i.e TFC + TVCo TR = Total Revenue: P.Qo Point B: Point of intersection between TR & TC lines Q=20, B.E

level of outputo Thus Point B: B – E – Pointo Below Q=20, TC > TR operating losso Above Q=20, TR > TC operating profito B.E.P: TR=TC Π=0 losses cease to ever and profits yet to

begin.

Limitation of L – C and L – R functionso C and Revenue functions may be non – linear: Because AVC

and price of output vary at different rates with variations is output.

o Under non – linear conditions, there might be two B – E points, instead of one.

B – E – Analysis: Non – Linear Cost and Revenue Functions. Costs

and Revenue

TC

B2 B1 TR

A TFC

O Q (output) Q1 Q2

o TFC = Total Fixed Cost (OA)o TVC = TC – TFC = The vertical distance between TC and TFCo TC = Total Cost = TFC + TVCo B1 & B2: Points of intersection between TR & TC TR = TCo B1: Lower B – E point at Q1 output level

B2: Upper B – E point of Q2 output level Firm, producing more than OQ1 and less than OQ2 will make profit Profitable range of output:

More than OQ1

Less than OQ2.

Producing less than OQ1

more than OQ2

→ losses.o Contribution Analysis:

Recall: IC = Incremental Cost of a business decision IR = Incremental Revenue from a business decision.

“Contribution”: TR – TVC, TFC not considered

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At B – E Point “Contribution” = Fixed Costs.

Uses of B – E Analysis:

o To Know: Level of sales required to cover all costso To Know: What happens to overall profitability, when the

company incurs higher or lower fixed or variable costso To Know: Between two alternative investments, which one

offers the greater margin of profito To Know: What happens to overall profitability when a new

product is introducedo To forecast Π, when revenue and cost estimates are available.o To Know: Margin of safetyo Useful for production planningo Useful for deciding when to start paying dividend to its share

holders.

Degree of operating leverage:

Percentage change in profits that results from percentage change in number of units sold i.e elasticity of profit with respect to output sold.

∆Π DOL = %∆Π = Πo = ∆Π . Qo %∆Q ∆Q ∆Q Πo

Qo

24. Estimation of Cost Function:

Forward Planning: Basis for decision – making.

SR Cost Function: Necessary for the firm determing the optimum level of output and the price to charge.

LRC Function: Essential in planning for the optimal scale of plant for the firm.

Methods for obtaining appropriate information of its future cost – output relationship.

o Engineering Method: Based directly on the production function, input prices and

the optimum input combination for producing a given quantity of output.

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Using this information, engineers provide least – cost estimates.

Based on given technology and input prices. When technology and input prices are changing, difficult to

obtain accurate estimates.

Survivorship Method (Survival Technique)

Classify various firms of an industry into size groups: small, medium and large

Most efficient size group: share in the industry in creases

Least efficient size group: share in the industry decreases

Industry Share (%) Site group Base Year Current Year

S 10 12M 30 50L 60 38

M – Size group: Most efficient L – Size group: Most inefficient Competition will eliminates inefficient firms Firms with lower average cost will survive.

Limitation: The method does not yield the cost function. Does not allow the measurement of degree of economies and diseconomies of scale.

Statistical Method: Regression Method

Short Run Cost Function:C = TC = f (Q)C = total cost = TFC + TVCQ = output

Linear Cost Function:

TC = a + b QTC = 100 + 0.5 Q TFC = 100 TVC = 0.5 QLet Q = 10 TVC = (0.5) (10) = 5 TC = 100 + 5 = 105 AC = ----------------- MC = ----------------

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Quadratic Cost Function:TC = a + b Q + CQ2

TC = 100 + 60Q + 3Q2, TFC = 100

Cubic Cost Function:TC = a + b Q – CQ2 + dQ3

TC = 100 + 60Q – 5Q2 + 0.7 Q3, TFC = 100

Long Run Cost Functions:o To determine the “best” scale of plant for the firm to build in

order to minimize the cost of producing the anticipated level of output in the long run.

o Can use either time series data or cross section data.o Can estimate L – R Cost Functions with engineering and

survival techniques.

Managerial Uses of Estimated Cost Functions:o To determine the optimum scale or size of the fixed plant and

equipment.o To determine the optimum output for a given plant size.o To determine the supply schedule/curve.

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MODULE 3: Market Structure and Theory of Firm.

1. Markets and Market Structure:

Markets:o Four components of a market: Buyers, sellers, a commodity and

a price.o Personal contact between buyers and sellers: Not necessary.o Contact between buyers and sellers: May be through telephonic

conversion or teleprinter or any such modern device.o Does not necessarily mean a place.

Structure – Conduct – Performance Paradigm:

Definition of Market Structure: Use market characteristics.o In terms of number and size of the buyers and sellers of the

product.o In terms of type of product sold (standardized/homogeneous or

differentiated products).o The degree of mobility of resources: Entry and exit of firms.o The degree of knowledge of economic agents (firms, suppliers of

inputs and consumers): About prices and costs and demand and supply conditions.

Two Broad Market Models:o Perfect Competitiono Imperfect Competition

Monopoly Monopolistic Competition Oligopoly.

Nature of industry where prevalent:P/C: Financial markets (to some extent) and some farm productsMonopoly: Public utilitiesM/C: Manufacturing: Toothpaste, TV sets, Refrigerators etcOligopoly: Aluminium, Cigarettes etc.

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MarketStructure

Business Conduct or

Industry Behaviour

Corporate Performance (Price Profit Output etc)

Different Market Models: Some Broad Characteristics

Market ModelNo. of Sellers

Nature of Product

Entry Barriers to

Sellers

Degree of Control

Over PricePED CED

1. Perfect Competition

Large, small, independent

Homogeneous

None NoneInfinit

eInfinit

e

2. Monopoly One

Homogeneous, but no

close substitutes

Insurmountable

Considerable

VerySmall

Zero or

Very Low

3. Monopolistic Compn.

Many, small virtually

independent

Differentiated, but very

close substitutes

None Some LargeVery High

4. OligopolyFew,

interdependent

Homogeneous or

differentiated

Substantial Some Small Low

Kinds of Revenue and Their Behaviour under P/C and I/C T R = P. Q A R = TR = P.Q =P

Q Q M R = TR

Q

Behaviour of AR (Price), TR and MR under P/C & I/C: A Test of Market Structure

Quantity

Price TR MRP/C I/C P/C I/C P/C I/C

1 16 16 16 16 16 16

2 16 15 32 30 16 14

3 16 14 48 42 16 12

4 16 13 64 52 16 10

5 16 12 80 60 16 8

6 16 11 96 66 16 6

7 16 10 112 70 16 4

8 16 9 128 72 16 2

9 16 8 144 72 16 0

10 16 7 160 70 16 -2

Assignment: Draw diagrams and interpret the Behaviour of Revenues.

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Algebraic Presentation of Behaviour of TR, AR and MR under P/C and I/C:

o TR = P.Q

o Let TR = 55QMR = d(TR) = 55

dQAR = TR = 55Q = 55 Q Q MR = AR → under P/C

o Let TR = 55Q – 2Q2

MR = d(TR) = 55 – 4Q dQAR = TR = 55Q – 2Q 2 = 55 – 2Q Q Q

o AR = 55 – 2Q Falling AR (P) with an increase in QMR = 55 – 4Q2 Falling MR at twice the rate of AR → under I/C.

Assignment: Consider the following TR and TC functions:1) TR = 55Q. TC = 100 – 5Q + Q2 under P/C2) TR = 55Q – 2Q2. TC = 100 – 5Q + Q2 under I/C3) Definition: Π = TR – TC

Max Π: MR = MC: Necessary Conditions4) Calculate Π – maximizing output (Q) and volume of Π under

P/C and under I/C.

2. Pricing Under Perfect Competition:

Characteristics of P/C:

o A large number of sellers and buyers of the product. Small share of each buyer and seller in total demand and total supply. → No individual buyer and seller can influence the price. → A firm: price – taker and not a price – maker.

o Homogeneous Products: Product of each firm is a perfect substitute for the product of other firms.

o Perfect mobility of factors of production: No control of any firm on factors of production. Inputs can respond to incentives.

o Free entry and free exit of firms. No restriction on entry or exit. No patents or copy rights.

o Perfect knowledge among buyers and sellers about costs, prices, quality of products etc.

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Price differences, quickly eliminated Prevalence of a single price Resources sold to the highest bidder.

o Absence of collusion: No sellers’ union or buyers’ associations. Each buyer or seller acts independently.

o No government intervention: No licensing system, no control over inputs, no fixation of lower or higher prices etc.

P/C: uncommon

o May be in stock market and agricultural commodities

o Even though uncommon, useful as a reference point for an “ideal” market situation. Can evaluate the efficiency of other market models with the characteristics of P/C as denominators.

Price Determination under P/C:

Price Determined by Market Demand and Market Supply: A Firm – Price Taker

Industry Price S P

Firm

E P*

MR=P=AR

P O Q O Q

Q* Market Supply Demand Curve facing

and Demand an individual firm

o Price Determined by MS and MD: → P = P* Q = Q*.

o A perfectly Competitive Firm: A price – taker.

o Hence, a P/C firm has to determine quantity to sell at P* MR = P* = AR

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When P is constant, TR changes proportionately to change in Q → MR is constant and equal to price.

o AR curve is the demand curve facing of a firm. A firm faces horizontal or infinitely elastic demand curve.

Pricing in Market Period:

o Each firm has fixed stock of commodity to be sold. The stock with all the firms. → Fixed Supply in the market vertical supply curve.

o Given fixed supply, price determined by demand.

P S

P2

P1

D2

D1

O Q Q*

o Examples:

Pricing in Short – Run and Equilibrium of a Firm:Case 1: Supernormal ProfitCase 2: Belownormal ProfitCase 3: Normal Profit.

Case 1 SMC SAC

E P AR=MR T C

O QOutput

Case 2 SMC SAC AVC

C T

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← Price, Costs →


P E AR’=MR’

O QOutput

Case 3 SMC SAC

E P AR=MR C

O QOutput

o Observations:

Case 1: ECTP = Supernormal Π, because P > SAC. Excess supply of output in the market → P↓. Excess demand for inputs →. An increase in input prices. The process of adjustment till normal profit is restored.

Case 2: ECTP = Belownormal Π Exit of firms Excess supply of inputs, decreasing input prices Excess demand for products, increasing product price The process of adjustment, till normal profit is reached.

Case 3: Normal profit situation P = SAC = SMC Normal profit is included in cost of production.

Reproduce Case 3 by relabelling cost/revenue curves to create long – run equilibrium conditions.

Pricing in Long Run: Equilibrium Conditions

o LR : All inputs and costs of production variable.: Optimum plant size to produce least – cost output i.e the “best level” of output. Condition for “BLO”: AR = P = MR = LMC = lowest LAC.

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: All supernormal profits and losses eliminated, only normal profit accrued.: Firm produces at the lowest point on its LAC.: The firm operates the scale of plant given by SATC at its lowest point SMC = LMC.

o Conditions of equilibrium of a firm in the LR:

P = AR = MR = LMC = LAC

Price LMC & Costs

LAC

E P AR = MR

O Q Output

E = Point of equilibrium P = AR: By definition AR = MR: By the nature of market (P/C) MR = MC: By equilibrium condition MC = AC: By optimum output scale.

o Normal Profit: Free entry and exit of firms critical to the operation of a highly competitive market. Supernormal profit and losses in the short run Normal profit in the LR, due to process of market

adjustment.

o LR Equilibrium at the point E:P = AR = MR = LMC = LAC: Both the individual firms and industry are in Long – run equilibrium.

3. Pricing and Output Determination Under Monopoly:

Meaning of M:

A single firm to produce and sell a product. No close substitutes for the firm’s product. Cross elasticity of demand: Zero for a monopoly product. Firm and industry: Identical.

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A monopolist: Price – maker. Downward sloping demand curve for the monopoly product

Downward sloping AR Curve MR Curve, below AR Curve. Bilateral Monopoly: One seller and one buyer.

Reasons for Monopoly Market Power:

Control over key raw materials: Called “raw material monopolies”. Before II World War: Aluminium company of America: Monopoly in Aluminium production, because of control over bauxite supply.

Patent or copy right ownership: Ex: Polaroid on instant camera.

Economies of scale and efficiency: Ex: Public utilities (water, gas etc.) called natural monopoly.

Monopoly established by government franchise i.e by Government Law called franchise monopolies.Ex: Indian Railways. Barriers to entry of new firms. But even though a sole producer and distributor of service, regulated by government.

Pure monopoly power rare monopolist faces indirect competition. Substitutes still exist. (Steel, plastics as substitutes for aluminium).

Short – Run Price and Output Determination under Monopoly:

Recall price and output are determined based on revenue and cost conditions under P/C.

Under monopoly, AC and MC Curves are generally identical with that of P/C, but AR and MR Curves differ.

AR Curve (same as demand curve) slopes downward To sell more reduce price MR Curve lies below the AR Curve.

Slope of the MR: Twice the slope of AR Curve. AR function: P = a – b TR function: TR = Q.P = Q (a – b Q)

= a Q – b Q2

MR = dTR = Q – 2bQ dQ

Slope of AR: - bSlope of MR: - 2b.

Short – Run Price – Output Determination:

SMC

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Unit Costs & Revenues

P P1 SAC P2 M

N

MR AR = D O Output

Q*

o AR = Average revenue curve or D C.o MR = Marginal revenue curve.o Observe = MR < AR. Reason?o SAC = Short run AC curve.o SMC = S – R MC curve.o Profit maximization decision rule for a monopoly firm:

MR = SMC Same as that of P/C firm.o O Q* = П – maximizing output.o P Q* = Price per unit of output.o M Q* = Average cost.o Profit per unit of output: PQ* - MQ* = PMo Total П: O Q* X PM

O Q* = P2M : P1 P M P2

→ Shaded area.

Does a monopoly firm always earn economic or supernormal П?

o Not necessary, depends on AR and AC levels: AR = AC → Normal П AR > AC → Economic or supernormal П AR < AC → Losses.

o Scope for earning economic or super normal profit: High in case of monopoly.

o Assignment: Draw diagrams to illustrate all the three conditions.

Long – Run Monopoly Pricing and Output Determination:

o Monopolist: An opportunity to expand the size of its firm to increase its long – run profits.

o Utilization and size of the plant: Determined by market demand.

o Market demand: Determines whether to operate at minimum LAC, falling part of LAC, or increasing part of LAC.

o Equilibrium condition: MR = LAC.o Three possible cases:

Case 1: Monopolist operating at falling segment of LAC

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Case 2: Operating at increasing segment of LACCase 3: Operating at minimum point of LAC.

o But in all these cases: Makes supernormal profit.o Which of these cases: Determined by market demand, given

the technology.

Case 1: Operating at falling segment of LAC.

LMC

A P LAC C B

M E AR (D)

O Output Q*

MR

Observe: MR = LMC at Point E point of equilibrium O Q* = Equilibrium output LAC per unit of output: B Q* Price per unit of output: A Q* (= O P) П per unit of output: A B (AQ* - BQ*) Total П for O Q*: A B C P → shaded area Operating at falling segment of LAC: Market size does not

permit to expand to the minimum point of LAC (Point M) There is excess capacity.

Case 2: Operating at increasing segment of LAC.

LMC

LACP A

E C M B

MR AR (D)O Q (output)

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Q*

o MR = LMC at Point E Point of equilibriumo O Q* = Equilibrium level of outputo Price per unit of output: AQ*(= O P)o П per unit of output: AB (AQ* - BQ*)o Total П for O Q*: A B C P → Shaded areao Operating at increasing segment of LAC the minimum LAC

at M, earlier to O Q* Market demand permits to expand output beyond the

point of minimum LAC (M) Capacity, over utilized.

Case 3: Operating at minimum point of LAC.

LMC LAC

P A

C E

MR AR (D)O Q (output)

Q*

o M R = LMC at point E Point of equilibriumo O Q* = Equilibrium level of outputo A Q* (= O P): Price per unit of outputo E Q* (= O C): LAC per unit of outputo A E: П per unit of outputo A E P C: Total П for O Q* level of output (shared area)o Operating at minimum point of LAC

Market size enough to permit the optimum plant size Optimal capacities utilization.

Monopoly & Perfect Competition: Compared

o MR = AR = P under P/C. But MR < AR under Monopolyo AR curve is a straight line to the horizontal axis under P/C .

Demand is perfectly elastic.AR curve is downward sloping under Monopoly Elastic demand.

o Monopoly price, higher than competitive price, generallyo Monopoly output, lower than competive outputo P/C firm: Normal П in the LR

M: Supernormal П even in the LR

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o Monopolist: Slow to introduce technological changeP/C: Efficient or exit introduce technological change as and when possible.

Price Discrimination Under Monopoly (Discriminating Monopolist):

Simple versus discriminating monopoly

o S M: Same price for all consumers, in all markets and for all uses of the same commodity.

o D M: Different prices for different consumers, in different markets and for different uses of the same commodity.Ex 1: Physicians, Lawyers, Consultants charging different rates

for customersEx 2: Railways charging different tariffs for senior citizens,

students and othersEx 3: Different prices in domestic and international marketsEx 4: Electricity tariff for commercial purposes and for

domestic use.

o Some other basis for P.D: Size discrimination

Ex: Retail and wholesale Sex discrimination Special service or comfort

Ex: In Railways Age Quality variation discrimination

Ex: Price of deluxe edition and paper back of a book.

Conditions essential for P.D

o Must be a Monopolist: Only a necessary conditiono Market segmentationo Different Markets: Separable to prevent resale or re–exchange

of goodso Different elasticity of demand in different markets.

Same price elasticities in different markets. → Reduction in П by reducing demand in the high price markets.

P.D by Degrees:

o First Degree P.D (perfect P.D):

Charge different prices to different buyers for each different unit of the same product. Price charged for each unit, in each buyer’s case, is set in accordance with the

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marginal utility to the buyer and charges maximum price be is willing to pay for it. The entire consumer surplus is converted into monopoly revenue and profit.

Difficult to implement.

o Second Degree P.D:

Block wise different pricesBlocks: Rich, middle and low income blocks of consumers.

Charge higher price to the rich, lower to middle class and still lower to the poor.Ex: Public utilities like electricity supply.

o Third Degree P.D:

Set different prices in different markets with different demand curves and elasticities.

Possible in markets separated from each other by geographical distance, transport barriers, legal barriers etc.

Third Degree P.D: Very practical method. The practice of P.D in foreign trade is called “dumping”.

o Necessary conditions for Monopoly equilibrium under P.D:

Two separate markets with different elasticities of demand. MR from all the markets must be the same:

MR1 = MR2 = …… = MRn. Marginal revenue of all markets must be equal to M C of

producing entire output:MR1 = MR2 = …… = MRn = MCMC = M.C of producing entire output.

The Measures of Degree of Monopoly Power:

o Triffin’s cross elasticity criterion: Lower the value of C.E coefficient, greater the degree of monopoly power. Higher C-E Coefficient smaller degree of monopoly market power.

o Lerner index of M-Power:

Measure M-Power by the deviation between price and MC. Under Monopoly:

P = A RA R > M RM R = M C P > M C.

Degree of M-Power (MP)MP = P – MC , MP = Lerner Index

P Under P/C: MP = O

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Larger the value of L-Index, greater the market power.Recall: Under monopoly: P > MC. Measure of monopoly power.

Higher the degree of price elasticity of demand for a firm’s product, lower is the degree of monopoly power.Question: When do you expect higher price elasticity of demand? When there are large number of firms in the industry?

o Bain’s Excess Profit Criterion.

Excess profit → profit in excess of opportunity cost. Higher the excess profit, greater the monopoly power. MP = R – OC

R MP = The Degree of Monopoly Power

R = Actual ProfitOC = Opportunity CostMP = O No MonopolyHigher the value of MP, greater the degree of monopoly

power. Is Bain’s criterion comparable to that of Lerner’s index?

o Refer Dwivedi (PP 320 – 321) for other two measures of monopoly power:→ Number – of – Firms criterion→ Concentration Ratio.

4. Pricing and output Determination under Monopolistic Competition:

Features of M/C:

o Blend of both competition and monopoly.

o Large/many sellers/firms in the market. scope for competition.

o Product differentiation: Products – similar, but not identical. Product of each seller – branded. Limited degree of monopoly over a group of consumers.

o Product differentiation may be real or imaginary.

o Large number of Buyers: But preference for a particular brand.

o Free – entry: No barriers for entry, but produce a differentiated product with a new brand name.

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o Selling Costs: Product differentiation Adversement and other forms of sales promotion.

o Downward sloping demand curve (A R Curve) as under monopoly. But flatter Demand is more elastic than under monopoly, because of the availability of close substitutes.

o A firm under M/C does not lose all consumers by increasing price as under P/C. This firm is like a monopolist over a brand – loyal consumers.

o Two – Dimensional Competitions: Price Competition and Non-Price Competition (product variation and selling costs for sales promotion).

o The Group: Non homogeneous products Difficult to define industry. A group is a cluster of firms producing very related but

differentiated products.Ex. of product groups: Automobiles, computers, soap, footwear, cosmetics, vegetable oil etc.

Price and Output Determination: Short and Long Run Equilibrium.

o Theory of M/C: Essentially a long run theory.

o In the short run: Virtually no difference between monopoly and M/C, excepting flatter AR & MR curves under M/C.

o Short – Run Equilibrium.

MC

AC P A

C B

E M

AR (D) MR O Q (output)

Q* MR = MC at point E Equilibrium OQ* = Equilibrium level of output AQ* (=OP) = Price per unit of output BQ* (=OC) = AC per unit of output AB = П per unit of output

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Unit

Costs & Revenues

ABCP = Total П for OQ* level of output (shaded area) A firm under M/C:

Supernormal П when: P > ACNormal П when: P = ACLoss when: P < AC.

May not be operating at the point of minimum AC Excess Capacity Socially suboptimal level of output.

o Long Run Equilibrium:

LMC LAC

A P*

M E

AR (D)

LMR O Q (output)

Q* Q**

LMR = LMC at point E Equilibrium OQ* = Equilibrium level of output OP* = Price per unit of output AQ* = LAC per unit of output OP* = AQ* No supernormal П

Supernormal profits competed away. Not operating at M i.e minimum average cost, and not

producing socially optimum level of output (OQ**). Excess output capacity even in the long run (Q* Q**).

o Wastes of M/C: Excess output capacity

Waste through advertisements, fancy packaging etc

Wastes due to freedom of choice of consumers for variety

Not operating at minimum AC even in the long run Excess output capacity Socially suboptimal level of output underemployment of resources and lesser output.

Wastes due to selling costs

Define Combined Average Costs: Combined AC (ACC) = Production Cost (APC) + Selling Costs

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Unit

Costs & Revenues

A firm under M/C has to cover both APC and selling costs to remain in business.

A B ACC

Selling Costs D C

APC O Q (output)

Q*

APC = Average Production Cost Curve ACC = Average Combined Cost Curve Vertical distance between APC and ACC: Selling Costs For OQ* level of output:

CQ* = APC per unit of outputBQ* = ACC per unit of outputBC = Average Selling Cost.

OQ* CD = Total Product Cost OQ* BA = Total Combined Cost ABCD = Total Selling Cost.

5. Pricing and Output Decisions Under Oligopoly:

Characteristics/Features of Oligopoly Market:

o A few sellers or a few big sellers if there are many. Ex: 15 industries out of 84 surveyed in India have 75% of market share.

o Homogeneous or differentiated productsEx: Oligopoly with homogeneous or almost homogeneous products (Homogeneous Oligopoly): Steel, Aluminium, Copper etc.Ex: Oligopoly with differentiated products (Heterogeneous Oligopoly): Kitchen Appliances, Cigarettes, Specialists in Medical Service, Five Star Hotels, Management Consultants etc.

o Interdependence: In business policies about fixing of price and determining output.

o High cross elasticity of demand: Fear of retaliation by rival firms.

o Excessive expenditure on adversement.o Constant struggle to survive: Because of unique competition.o Difficult, but possible entry/exit.o Lack of uniformity in size of firms.o Indeterminate price and output: Interdependence of Oligopoly

firms, derivation of demand curve difficult. But price and output are derminate under collusive oligopoly.Ex: OPEC – Organization of Petroleum Export Countries.

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Costs

Oligopoly is a market which contains the features of the most other market structures, particulars P/C and M/C.

Demand Function for a firm under oligopoly market structure: Major determining variables:

Product price Prices of rival firms goods Advertising budget of rival firms Style and qualities of rival firms goods

Ex.1: The impact of price reduction on Godrej Refrigerator on Kelvinator brand.Ex.2: The impact of price cut by Maruti Udyog on demand for Ambassodor, Fiat etc. Reaction of rivals to Godrej and Maruti Udyog.

Sources of Oligopoly:

o Huge capital investment. Possible barrier to entry.o Economies of scale. Huge investment → cost advantage due to

economies of scale.o Patent rights under differentiated oligopoly. → Limited number of

firms under oligopoly.o Control over certain raw materials.o Merger and takeover:

→ Oligopolistic tendency in modern industries.

The Oligopoly Models:

o Complicated behavioural patterns of actions, reactions and counteractions. Difficult to undertake a systematic analysis of price and output determination under oligopoly. Hence variety of oligopoly models.

MODELS

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Perfect CollusionModel (Cartels)

Non – CollusionModels

CournotModel

Tacit CollusionModels

Leader – Follower Models

Cost-basedPricingModel

GameTheory

Fixed MarketShare Model

Residual MarketShare Model

Some of the Major Oligopoly Models:

Perfect Collusion Model:

o All firms producing a homogeneous product like Petrole to form a Cartel.Ex: O P E C for pricing.

o Pricing similar to monopoly with multiplant operations.

o One market demand function and as many AC and MC functions as number of firms in the cartel.

o Sum of MC curves of various firms to get combined MC curve (CMC)

o Determine joint П – maximizing output for the industry by following the rule: MR = CMC

o Given the equilibrium level of output, AR curve would give the equilibrium price

o Decide distribution of output to firms by equating MR to each of the MC curve

o All firms of the cartel sell at the same price, but output and profits not equal

o Cost efficient firms will make more profits than others

o To prevent breakdown of the cartel, the more cost efficient firms to transfer part of their profits to the less efficient firms

o The cartel system of pricing can prevail even under differentiated oligopoly. Analytically, difficult to handle.

Advantages of perfect collusion:

o To avoid price wars among rivalso Gain to members of cartel, but higher price to consumers.

Difficulties of perfect collusion:

o Problems of high price to consumers and restricted quantityo If number of firms in cartel larger, greater difficulty in arriving

at consensus on output and pricing

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o Hence cartels, rare.

Cournot Model of Oligopoly:

Behavioural Assumptions:

o Only two firms (Duopoly), owning mineral water wellso Wells operated at Zero MCo Demand curve facing both: negatively slopingo Each seller acts on the assumption that his rival will not react

to his decision to change price and output.

But different to accept the assumptions of non-reaction.

Zero MC assumption: Unrealistic.

Cournot Solution: Each seller ultimately supplies one-third of the market and price charged by both the firms is the same. One-third of the market remains unsupplied. Stable equilibrium in Cournot’s Model.

Sweezy’s Kinked Demand Curve Analysis of Price Stability:

o Two segments of kinked d.c or AR curve: Relatively elastic and inelastic segments.

D

P K

D O Q (output)

o DD = Demand Curve

o OP = Price per unit of output

o K = Kink on the d.c

o DK = Elastic segment of d.c

o KD = Inelastic segment of d.c

o DC=AR curve→Kinked AR Kinky MR curve (Discontinuous MR curve)

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Indeterminate: To sell at the prevailing price or to increase Raising of price: Reduction in demand due to elastic nature of

demand loss of market to rivals who would not raise their prices

Lowering of price: An immediate retaliation by rivals. Hence not much of increase in his sales with price reduction

Price rigidity over a period of time due to price interdependence implied in Kinky d.c (AR curve).

o The K – D – Curve: Does not deal with price and output determination

o Once a price – quantity combination is determined, an oligopolistic firm does not find it profitable to raise prices Price rigidity Desirable to maintain price and output at the existing level.

o S – Model does not explain how one price is determined. It explains stability of output and price

o S – Model: Does not pass the test of empirical verification.Monopoly prices: Found to be more stable than oligopoly prices.

Tacit Collusion Models: Leader – Follower Models

o Based on agreement: “Live and Let Live”.

o Two versions of leader – follower model Fixed Market Share Model (Efficient Firm Model) Residual Market Share Model (Dominant Firm Model).

Fixed M – Share or Efficient Firm Model:

o Elect the efficient firm as the leadero Follower firms to take a fixed share of the total marketo The residual to the leader.

Residual M – Share or Dominant Firm Model:

o Elect the dominant firm as the leadero Leader to set the priceo Allow each follower to sell as much as he wisheso Leader to inherit the residual market onlyo Strategy possible under homogeneous oligopoly (Ex: Steel,

Aluminium).

Cost – Based Pricing Model:

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o When failed to form a Cartel or to agree on leader – follower model, go for Cost – Based Pricing Model or Game Theory Model

o Under C – B – P Model, each oligopolist to recognize mutual inter dependence

o Each firm not to aim at profit – maximizing price for itselfo Each firm to determine floor price based on its A C, and

experiments with alternative margins over costo Depending on competition from rivals, raise or lower its price.

No equilibrium price for any oligopolists product.

Game Theory:

o Oligopolists to set their prices through the business game they play

o An extreme case of non-cooperation among rivalso Each firm decide its business strategy by ascertaining the

alternative strategies of its rivalso Depending on the strategies each adopt, there will be pay-offs

(say market share). Concluding Remarks:

o Difficult to determine profit-maximizing prices under oligopoly.

o Instead of competing through price, compete through non-price means-product quality, service to the customers, fancy packaging, selling on credit, guarantee against their products.

o Good things about oligopoly: Availability of variety of products R & D activities to face competition from rivals.

o Undesirable things about oligopoly Socially suboptimal output: P > MC Excess capacity: P > min AC Wastes through promotional activities.

Pricing Methods In Practice:

o Profit – Maximizing Price: MR = MC

o But difficult to follow this Rule: Difficult to get accurate knowledge of demand and cost conditions facing the firm

o Hence to follow alternative pricing methods

PRICING METHODS

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Cost Competition Demand Strategy Based Based Based Based

Full Cost Marginal Going Sealed Dual Price Price PriceCost Plus Cost Rate Bid Pricing Disoci- Penetra- Skim

minoty tion -ming

o Cost – Based Pricing: Three Methods Full Cost or Break Even Pricing

P = ATC (AC) Cost – Plus Pricing or Mark – Up Pricing or Full Cost Pricing

P = AC + mark up (Fair profit i.e a fixed percentage) Marginal Cost Pricing:

P = MC C – Based Pricing: Ignores consumer’s preference and

demand. Do not realize difficulties of estimating cost. But, simple and acceptable.

o Competition – Based Pricing: Two Methods

Going Rate Methods: Pricing according to the prevailing prices of comparable products. Price: Less than AC or more than AC.

Sealed Bid Pricing Method: Ex: Construction activities and disposal of used products. Prospective buyers (sellers) to quote their prices through a

sealed cover Open the bids in sealed covers in the presence of all the

competitors Usually, to accept the one who quotes the least in case of

buyers and most in case of sellers.

o Demand – Based Pricing:

Dual Pricing and Price Discrimination: Possible when the market of a commodity is distinctly divisible into two or more segments. Each segment with different price elasticities of demand.

o Strategy Based Pricing: Two Methods of Pricing a New Product

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Price Penetration: To sell more of a new product, low price (even less than cost of production) in the beginning. Jack up the price once product credibility is established.Ex: Rin Washing Soap Low price in the beginning. Now quite an expensive brand.

Price – Skimming Method: Price a new product high in the beginning Reduce price gradually as it faces dearth of buyers Ex: Fancy products, but of poor quality.

o Bain’s Limit Pricing Theory A monopolist or an oligopolist to charge a price lower than the

profit maximizing price to discourage new firms entering the market.

But difficult for incumbents to make credible commitment to limit prices.

o Peak Load Pricing: Ex. Telephone Service higher rates during the peak load period and lower rates during period of peak.

o Prudent Producer: To follow a good mix of various pricing methods, depending on the situation.

6. Alternative Theories of Firm:

Consider some models/theories of firm’s economic behaviour.

Three broad groups of theories of firm:

o Economist’s Theory of Firmo Behavioural Models of Firmo Managerial Models of Firm All the three groups are mutually related.

Economist’s Theory of Firm:

o A firm: Transforms inputs/factors into productso A firm: Rational economic unito Aims at profit maximizationo Perfect knowledge about market conditionso Max – П Rule: MR = MC. But: 1) Firms: Aim at satisfactory level of profit

2) The assumption of certainty: Not tenable3) Perfect knowledge assumption: Not tenable.

Behavioural Models of Firm:

o Underplay the economic content of the firm.

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o Consider the “behaviour” content to explain firm’s conduct and performance.

o Ex: Simon’s Behavioural Model of Rational Choice, Banmol’s Sales – Maximizing Firm, Stack-leberg’s Reaction – Oriented Firm, Cyert and March Behavioural Model.

o Critical Ideas of Behaviourist Model:

A firm: Coalition of various vested interest groups: Different departments, different levels of management, different groups of workers, shareholders, suppliers, consumers etc.

Multiple objective of the firm: Production Goal: Output to be in certain satisfactory range Sales: Satisfactory levels of sales Market Share: Satisfactory size of market Profit Goal: Still import, but one of the multiple goals.

Study of human behaviour in terms of their relationship with the environment.

Behaviour: Compromise between conflicting views and interests.

Hence satisfying behaviour: More realistic than “maximizing” behaviour.

Managerial Models of Firm:

o Consider the difference between organization behaviour and managerial behaviour.

o Organization: An entity.

o Professional Managers: Individual personalities.

o Organizational Goals: Aim at profit, net worth, growth and diversification.

o Managers: Aim at pay, perks, promotions job security and career progression.

o Managers: One of the vested interest groups. But there are others like owners, workers, suppliers, financiers and so on.

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o Conflicts of manager’s interests with others: → organisation to “satisfy” all coalition partners, instead of maximizing any goal variable.

o Ex: Marris’ Model of Managerial Enterprise and Williamson’s Model of Managerial Discretion.

Some Important Models of Firm Behaviour:

1. Baumol’s Theory of Sales Revenue Maximization:

o Sales maximization rather than profit maximization as the goal.

o Modern Business: Management separated from ownership. Hence Manager’s discretion to pursue goals other than profit maximization.

o Managers: Choose sales maximizations.

o Why Sales Maximization Goal: To financial institutions: Sales as index of firm’s

performance. Salaries and slack earnings of top management: Linked

more closely to sales than to profits Sales maximization: Positively linked to market share Profits known at the end of the year. Hence sales: A better

performance indicators.

o Baumol considers both static and dynamic models with and without advertising.

2. Marris’s Theory of Maximization of Growth Rate:

o Maximize the firm’s balanced growth rate of demand for the firm’s product and of the growth of its capital supply.

o Define growth rate maximization as follows:Gr = GD = GC

Gr = Firms growth rateGD = Growth rate of demand for firm’s productGC = Growth rate of capital supply to the firm. A firm achieves a balanced growth rate when the growth

rate of demand for its product equals the growth rate of capital supply to the firm.

Maximize firm’s growth rate subject to two constraints viz managerial constraints (manager’s ability to achieve efficiency and manager’s own job security) and financial

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constraints (conflict between manager’s own utility function and owner’s own utility function).

Manager’s Utility Function:Um = f (Salary, Power, Status, Job Security)

Owners U – Function:Uo = f (Profit, Capital, Output, Market Share, Public Reputation)

Observe divergence between Um and Uo. But convergence into one variable viz a steady growth in the size of the firm.

For Managers: GD, importantFor Owners: GC, important

Um = f (GD)Uo = f (GC).

o Under Oligopolistic Condition: Interdependence of firm’s decision. When all firms try to maximize their growth rate simultaneously, limitation on the growth in demand for firm’s product and the supply of capital.

3. Williamson’s Model: Maximization of Managerial Utility Function.

o Recall: In modern business companies, management separated from ownership.

o Owners look for high dividends, interested in profit maximization.

o Managers have different motives: Their own interest.

o Since management is divorced from ownership, managers set the goals of the firm they manage.

o Managers: To maximize their own utility function rather than maximizing profit.

o Managerial utility function:Max. Um = f (S, M, ID), subject to a minimum profitS = Staff SalaryM = Managerial EmolumentsID = Discretionary Investment S, M & ID are important decision variables in managerial utility function (Um).

o ID = П – Пo – TП = Actual Profit

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Пo = Owner’s Minimum ProfitT = Tax Payment ID = Balance of actual profit available for the purpose of

discretionary investment (ID) ID = ПD = Discretionary Profit.

o Simple Version of Williamson’s Model: Recall: Um = f (S, M, ID) Assume: M = O Um = f (S, ПD), since ID = ПD

Substitutability between S and ПD

S can be increased only by reducing ПD and vice – versa Select an optimum combination of S & ПD → point of firm’s

equilibrium.

o Model holds good: When rivalry (from other firms) is not strong. Cannot deal satisfactorily with the problem of

interdependence as under oligopoly.

4. The Behavioural Model of Cyert and March:

o This Model: An extension of Simon’s hypothesis of firms’ “satisfying behaviour” model.

o Recall: A firm is a coalition of different but related interest groups: Owners, managers, workers, input suppliers, customers, bankers and tax authorities.

o All these groups have their own interests.

o Conflicting interests/goals.

o Managers to formulate a goal for the firm that reconciles the conflicting interests, by considering aspiration levels of partners.

o Hence top management to set the following 5 diversified goals Production goal Inventory goal Sales goal Market share Profit goal.

o Top management to achieve an overall satisfactory performance, called “satisfying behaviour”.

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o Question: How does a firm read its equilibrium level in its “satisfying behaviour”? The model is silent about this question.

Conclusion:

o Conventional Theory of Firm: П – Maximizing Goal. Has greater explanatory and predictive power.

o Alternative Theories of Firm: Not much of empirical evidence available. Still in the stage of testable hypothesis. Not possible to replace totally the conventional theory of

firm, emphasizing profit maximization behaviour.

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MODULE 4: Macro Economic System and its Management.

1. Macro Economic Concerns:

Micro vs Macro Economics.

Major Building Blocks of Macro Economics:1) AD & AS2) Four Sectors: HHS, BS, GS & FTS3) Two Markets: Commodity Market and Money Market.

Specific issues to be addressed in Macro Economics:o Rising Priceso Rising Unemploymento Falling GDPo Balance of Payments Crisis.

Tools of Macro Economic Policy and Management:o Fiscal Policyo Monetary Policyo Other Policies: Trade, Price and Labour Policies.

2. The Key Macro Economic Concepts:

Aggregate Supply (AS) Curve:

o Describes, for each given price level, the quantity of output firms are willing to supply.

o AS: Upward Sloping Firms willing to supply more output at higher prices.

P AS

O Y Output

o ADC: Shows the combinations of the price level and level of output at which the goods and money markets are simultaneously in equilibrium.

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Price Level

o ADC: Downward Sloping At higher prices, reduction in the Value of money supply, demand for output is reduced.

P

AD

O Y Output

o Equilibrium level of output and the equilibrium price level.

AS

P0 E

AD

O Y Y0 Output

P0 = Equilibrium Price LevelY0 = Equilibrium Level of Output.

o Shifts in ADC and ASC:

Case 1: A Rightward shift in ADC due to an increase in nominal money stock.

AS

P1 E1

P0 E AD1

AD

O Y Y0 Y1 Output

Observe new point of equilibrium (E1) and new levels of equilibrium price (P1) and output (Y1).

Case 2: A leftward shift in ASC due to oil price hike or due to drought.

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Price Level

Price Level

Price Level

P AS1

AS E1

P1 P0 E

AD

O Y Y1 Y0 Output

Observe an increase in P and decrease in output.

The Keynesian and Classical ASC:

o Short run horizontal ASC (The Keynesian):

P

Assumption:Unemployment

A S of resources

O Y Output

The Classical vertical ASC:

P AS AS*

Assumption: Fullemployment ofresources

O Y Y* Y**

Output

ASC: Shifts right right due to growth of output overtime.

Consider shifts in AD due to an increase in money supply (monetary expansion) and an increase in government expenditure (G) – fiscal expansion.

Case 1: The Keynesian Case:

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Price Level

Price Level

Price Level

P

An increase in E E1 output, but no

A S change in AD1 price level AD

O Y Y0 Y1 Output

Case 2: The Classical Case:P

AS P1 E1 An increase in

P, but no P0 E E11 change in

AD1 output AD

O Y Y* Output

If prices fixed(P0)→horizontal supply curve, economy would move to E11→ The Keynesian Equilibrium.

Long run, medium run and short run situations:

o Long run: Growth of productive capacity.

o MR: Output determined by a given productive capacity. Prices determined by fluctuations in AD.

o SR: AD determines the use of available productive capacity.

o Medium run: AS and AD Diagram: P

AS

P0

ADO Y

Y0 Output The position of ASC depends on productive capacity of the

economy.

The position of ADC depends of monetary and fiscal policies.

o Long run AS – AD Diagram:

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Price Level

Price Level

Price Level

AS

P0

AD O Y

Y0 Output

Vertical ASC: Assumption – Full employment of resources.

ADC with –ve slope.

Output determined by AS alone, prices determined by both AS and AD.

Given vertical ASC, high inflation rate due to changes in AD alone.

Changes in AD due to changes in monetary and fiscal policies.

o Short Run AS – AD Diagram:

P

P0 AS

ADO Y

Y0 Output

Assumptions: Prices constant horizontal AS curve.

AD: Determines level of output and employment.

Growth of output (say GDP), Inflation and unemployment:

o Potential output (Trend level of real GDP): Max amount of output that an economy can produce while maintaining price stability.

o Output fluctuates around potential output or the trend level of real GDP.

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Price Level

Price Level

o Output Gap (O G) = PO – AO PO = Potential Output AO = Actual Output.

> o O G = O ?

<o Inflation and output gap:

λ = Pt – Pt-1 = Inflation rate Pt-1

λ = O ?

o Inflation rate and output gap: Inverse relationship?

o Rate of unemployment and rate of inflation:

Philips Curve

O U E Rate (%)

o Unemployment rate and GDP relationship: Okun’s Law

Inverse relationship. Vital link between output and labour market.

O Change in unemployment rate (%)

o U E R (%) = No. Unemployed X 100 Labour Force

o Labour Force = No. Employed + No. Unemployed.3. National Income Accounting:

Formal structure for Macroeconomic Models:o Production Side: ASo Demand Side: AD

A measure of overall price level: Study of inflation.

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Rate of

change in

Inflation

Growth Rate

of real GDP

A measure of performance of Macroeconomy: GDP – The most comprehensive measures of total output in the economy.

Two definitions of GDP:o GDP: Market value of all final goods and services and total

expenditure on nation’s output.o GDP: Sum of all factor payments Total income.

Two amplifications to the definition of GDP:o Value of output currently producedo Include only the value of final goods and services – value of

intermediate goods not included.

Product

SaleValue(Rs./Unit)

Value addedby each industry

(Rs.)

Incomegenerate

d

Bread →Baking industry

20 9 9

Flour →Milling industry

11 5 5

Wheat →Agriculture

6 5 5

Fertilizers, seeds etc. →Chemical industry

1 1 1

Total 38 20 20

Value of output = 20 Value of income = 20.

Compare this with two definitions of GDP.

Three Methods of Measuring National Output:

o Income Received Approach:Y = Yω + Yγ + Yi + YΠR + YΠD

o Expenditure Approach:Y = C + I + G + X – M Aggregate Demand.

o Value of Product Approach:Y = P1Q1 + P2Q2 + - - - + PnQn

n = Σ PiQi

i=1

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Nominal and Real GDP:o NGDP: GDP at current prices

Commodity1992 1998

Q P NGDP Q P NGDP

X 1 1.00 1.00 2 2 4.00

Y 1 0.5 0.50 3 0.75 2.25

1.50 6.25

Why change in NGDP from 1.50 to 6.25? Quantity effect Price effect.

To make valid comparisons between 1992 and 1998, compute GDP at constant prices – called Real GDP.

Commodity Q (1998) P (1992) RGDP (1998)

X 2 1.00 2.00

Y 3 0.50 1.5

Total 3.50

Change in GDP in 1998 due to price increase is eliminated by estimating GDP at constant prices viz price of 1992.

GDP Deflator: A useful measure of inflation.GDPD = (NGDP) 1998 = 6.25 = 1.785

(RGDP) 1998 3.50 = 1998 GDP at current prices 1998 GDP at constant prices

GDPD:Measures the change in prices→79% increase in NGDP is due to inflation. Other Measures of National Output/Income

o GNP = GDP + factor payments from abroad – factor payments to abroad

o NDP = NNP = GDP – Depreciationo NI = NDP = NNP – indirect business taxes (Sales Tax, Excise Tax,

Custom Duties)o PI = NI – Corporate Π – Social Insurance Contributions +

Dividends + Government Transfer Payments + Personal Interest Income

o DPI = PI – Personal Income Tax and Non-Tax Payments.

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4. Building Blocks of Macroeconomics: A D and A S Four Sectors: Household, Business, Government and Foreign Trade

Sectors Two Markets: Commodity Market and Money Market Simultaneous equilibrium both in C M and M M.

5. Macroeconomic Models: Two, Three and Four Sector Models:

Divide economy into four sectors: Household sector : C Business sector : I Government sector : G Foreign trade sector : X & M.

Two Sector Macroeconomic Model:

Assumptions:o Only two sectors: Household and Business Sectorso Investment already given.

The Model:Y = C + I - - - - - - - - - (1)C = a + bY - - - - - - - - - (2)I = Io - - - - - - - - - (3)

o Y = N.Io C = Consumer expenditureo I = Investment expenditure, independent of current income.

I

Io I = Io

O Yo Value of output = ADo Exogenous variable: Io Endogenous Variables: Y & C

Consumption Function:C = f (Y)C = a + bY: Linear function

Mathematically: a = intercept b = slope

Economic interpretation:

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C = a, when Y = o ‘a’ is the minimum amount of consumer expenditure, even

whenY = 0

b = MPC = The increase in C per unit of increase in Ydc = b C = bdY Y o < b < 1

Consumption demand increases with the level of income.

C = a + bY

Income (Y)

Recall (1), (2) & (3)Y = C + I - - - - - - - - - - (1)C = a + bY - - - - - - - - - (2)I = Io (3)

Substitute (2) and (3) into (1)Y = (a+bY) + IoY – bY = a + IoY (1-b) = a + IoY (E) = 1 [a + Io] - - - - - - (4)

1 – b

Equilibrium income: AD = AS

Ex: C = 50 + 0.8 Y I = Io = 50Find out Y (E) and consumption expenditure.

Keynesian CrossY = C + I

C, I C + I (AD)

C

Io

a O Y

Y (E)

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Consumption (C)

ao

450

Fig: Equilibrium Income under Two Sector Model.

Can you put numerical values to a, Io and Y(E), using the values from the previous example?

Investment – Income Multiplier:Y (E) = 1 [a + Io]

1 – b Let I = Change in investment expenditure

Y = Corresponding change in income

Y (E) + Y = 1 [a + Io + I] 1 – b

Y (E) + Y = 1 [a + Io ] + 1 I 1 – b 1 – b

Y = 1 I 1 – b

Y = 1 = Investment/Income Multiplier = K. I 1 - b

K = Ratio of changes in equilibrium income to changes in I

K > o, because o < b < 1

Can you get the value of K, by using:C = 50 + 0.8 YK = ?

Interpretation of value of K? The Impact of Change in I on Y (E):

Diagramatic Repretation

C&I Y=C+I E1 C+I1 (AD2), I1>I0

C+I0 (AD1)

E1

AD2 > AD1, since I1 > I0

a O Y

Y(E) Y(E)Fig: Change in equilibrium Income with change in I under Two Sector Model.

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Three Sector Model:

o Government Sector: G, Tx, Tr → influence the economy.

Aggregate Demand:Y = C + I + G - - - - - - (1)C = a + bYd - - - - - - - (2)Yd = Y – Tx + Tr - - - - - (3)I = Io - - - - - - - - - - - - - - (4)G = Go - - - - - - - - - - - - (5)Tx = Txo - - - - - - - - - - -(6)Tr = Tro - - - - - - - - - - - (7)

G, Tx & Tr: Fiscal Variables. Endogeneous Variables:Y, C and Yd

Exogeneous Variables:I, G, Tx and Tro

Equilibrium Income Equation:Substitute (3) into (2)C = a + b (Y – Tx + Tr)C = a + bY – bTx + bTr - - - - - (8)

o Substitute (8), (4) and (5), into (1)Y = a + bY – bTx + bTr + Io + Go - - - - - - (9)Simplify (9)Y – bY = a – bTx + bTr + Io + GoY (1-b) = a – bTx + bTr + Io + GoY (E) = 1 [a – bTx + bTr + Io + Go) - - - (10) 1-b Equilibrium Income Equation Value of Y = AD.

AS

C,I&G C+Io+Go(AD2) E2

C+Io(AD1)

E1

Go

C+Io O Y

Y(E)1 Y(E)2

Fig: Equilibrium Income under Three Sector Model.

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45

Impact Multiplier:∂Y = 1 = Investment/Income Multiplier = KI

∂ I 1-b∂Y = 1 = Government Expenditure Multiplier = KG

∂ G 1-b ∂Y = -b = Tax Multiplier = KTx

∂ Tx 1-b ∂Y = b = Transfer Payment Multiplier = KTr

∂ Tr 1-b

Observations:KI = KG Change in G affects Y

KTr > O Tr ↑ Y↑. Tr ↓ Y ↓ the same way as I.

KG > KTr G brings about increased production of goods and services, whereas transfer payments do not.

KTx < O Tx ↑ Y ↓ Tx ↓ Y ↑ (Argument of supply side Economics)

Symmetry between KTx and Tr -b = KTx. b = KTr Difference only in sign.1-b 1-b

Change in Y(E) with change in G:Diagrammatic Representation:

AS

C,I&G C+Io+G1(AD2)

C+Io+Go(AD1)

G1 > G0

∆G

O Y

Y(E) Y(E)1

Fig: Impact of change in G, keeping C & I constant.

6. Aggregate Demand and Aggregate Supply Curves:

Recall the definitions of A D and A S Curves:

o A D C:

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45

ADC depicts the level of output (Y) for each given price (P) level.

The level of output (Y) at which commodity and money markets are in equilibrium.

P and Y are inversely related.

o A S C:

ASC depicts the quantity of output (Y) firms are willing to supply at each given price level.

P and Y are directly related.

P AS

P*

AD Y

Y* Outputo The classical AS and AD curves:

Vertical AS curve, because of assumption of full employment of resources in the long run.

P AS

P1

P0

AD1

AD0

O Y Yf Output

In the long run, output is determined by AS alone, and prices are determined both both AS and AD.

Inflation, due to rightward shifts in AD, and deflation due to leftward shifts in AD.

In the classical case, shifts in AD due to change in money supply.

Inflation/deflation due to change in money supply.

o The Keynesian Case: AD and AS in the Short Run.

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Horizontal Supply Curve: Price pegged at a particular level, and output can take any value.

Downward Sloping AD Curve:

P

P0 AS

O Y Y0 Y1 Output

Fluctuations in output due to shifts in AD curve alone. Prices are unaffected by the level of output in the S. R. Establishes the dominant role of AD (in the Keynesian

Macroeconomic Model) in influencing output and employment.

7. IS – LM Analysis:

Two main markets in Macroeconomic System → commodity or goods market and Money Market.

Commodity Market Equilibrium: Value of national output = Value of spending by functional sectors.

Money Market Equilibrium: Demand for real money balances = Supply of real money balances.

Composition of Money Stock.

o M1 = Can be used directly and instantly for making payments.

M1 corresponds mostly closely to the traditional definition of money as the means of payment M1 is perfectly liquid.

Needed for day to day transactions.

M1 = Currency + demand deposits (non-interest bearing checking accounts) + traveller’s checks + other checkable deposits (interest-earning checking accounts).

o M2 = M1 + claims not instantly liquid (Ex: time deposits, mutual fund shares etc).

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AD0AD1

o Now stock of money undergoing change.

o Commodity Market Equilibrium Curve (IS-Curve) and Money Market Equilibrium Curve: Simultaneous General Equilibrium:

γ LM

γ*

IS O Y

Y* Output (Income)

γ* = Equilibrium rate of interestY* = Equilibrium output/income.

IS – Curve Shifters and LM – Curve Shifters:

o IS – Curve Shifters: O R C

I, G and Tx: Major ones

An increase in I, due to optimistic expectations of business firms → R.W.S in IS – Curve (IS1). A decrease in I, due to pessimistic expectations of business firms → LWS in ISC (IS2).

γ LM0

γ** E2

γ* E1 γ*** E3

IS1

IS0

IS2

O Y Y*** Y* Y**

Observe: Shifts in points of equilibrium and changes in γ and Y.

An increase/decrease in G alone: RW/LW shift in IS Curve Changes in γ and Y.

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Rate of interest

Draw Diagrams

An increase/decrease in Tx alone: LW/RW shifts in IS Curve Changes in γ and Y.

Draw Diagrams

o LM Curve Shifts: An Increase/Decrease in Stock of Money

An increase in stock of money alone RWS in LMC

A decrease in stock of money alone LWS in LMC

LM2

γ LM0

LM1

E3

γ*** γ* E1 γ** E2

IS0

O Y Y** Y* Y**

Observe: Shifts in points of equilibrium and changes in γ and Y.

o Changes in both Fiscal and Monetary Policies.

γ LM0

LM1

E1 γ* E2

IS1

IS0

O Y Y* Y*

Fig: Expansionary F P and M P

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γ LM1

LM0

γ** γ*

IS1

IS0

O Y Y*

Fig: Expansionary F S and contractionary M P

8. Crowding Out In The Classical Macroeconomic Model:

Recall the classical AS and AD curves:

P AS

P** P*

AD1

ADO Y

Y* Output

o Y* = Full employment level of output output does not change at f. E. level.

o With fiscal expansion (G↑), AD shifts to right side → AD1.

o With an increase in G, private sector spending less → private spending fallen by precisely the amount that government spending has risen.

o Full crowding out effect. Every rupee increase in G is offset by a rupee reduction in

private spending.

Crowding out in IS – LM Model:

γ LM

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γ1 E1

E γ0 E11

IS1 IS

O Y Y0 Y1 Y2

o Let there be an increase in G → Expansionary fiscal policy.

o Rightward shift in IS curve (Commodity Market Equilibrium Curve) → Increase in Y from Y0 to Y1 (E1= New equilibrium point).

o → Increase in γ from γ0 to γ1.

o If γ remains at γ0, increase in Y from Y0 to Y2. But Y increase from Y0 to Y1 only.

o Reason: γ ↑ → I ↓ crowding out of investment spending.

o Why crowding out effect?

o Expansionary fiscal policy causes γ to rise, thereby reducing private spending, particularly investment.

o How to prevent fall in investment by business sector? Keep γ constant at γ0 by shifting LM curve (Money Market Equilibrium Curve) to right side → Increase in Y from Y0 to Y2.

o Message: Expansionary fiscal policy to be accompanied by expansionary monetary policy to realize the full impact of expansionary fiscal policy.

9. Supply – Side Economics:

The Keynesian prescription for changing GDP and Employment: Management of aggregate demand.

S – S – Economics: Shift in emphasis from AD to AS.

o Make the “suppliers” (corporate sector) happy to make the economy better.

Lower taxes Less government spending Less government regulation Less labour union power in wage determination.

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Every thing that promotes profit.

o S.S.E: Possible to lower rates of inflation and unemployment.

o Ex: Lower tax rates

An increase in consumer demand due to increased disposable income

Lower corporate tax rates inducement to increase AS.

o Diagrammatic representations of S.S.E:

P AS AS1

Lower price level P* Higher R G D P P** More employment (Recall

Okun’s Law). AD

O Y Y* Y** Output/R G D P

o Similarity and dissimilarity between Keynesian prescription and the S.S.E prescription:

Both Keynesian and S.S.E prescription: Government policy needed.

Difference:K – Model: Emphasise AD ManagementSSE – Model: Emphasise AS Management.

10. Unemployment:

Unemployment and GDP growth:

Types of U. E:

o Voluntary U. E: Lack of willingness to accept the available jobs More of a psychological problem than an economic problem.

o Involuntary U. E: Lack of jobs Occurs during the period of economic depression

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Also called cyclical U. E or depressionary U. E. Also called Keynesian unemployment

Deficiency of AD: Cause of this kind of U. E.

Kinds of Involuntary U. E:

o Structural U. E: Deficiency of stock of capital in relation to needs of growing

labour force Capital formation lags behind availability of labour force.

o Seasonal U. E: Seasonal character of certain production activities like

agriculture, rice mills etc. Not sufficient work available during slack season.

o Frictional U. E: Out of work, due to lack of perfect mobility of workers Also called unemployment between jobs Due to decline in some activities and expansion of some other

activities. Ex: Earthern pot / Vessel makers.

o Disguised U. E or underemployment: Common in overpopulated countries Low/zero marginal productivity of labour Underemployment due to underdevelopment Ex: Labour force in Agriculture: Not fully employed.

11. Inflation: Kinds, Causes and Remedies:

The Concepts:

o Inflation: Persistent general rise in price level or persistent fall in purchasing power of money.

o Rate of Inflation: The percentage change in overall level of prices. Recall: λ=

o Hyper Inflation: Rate of inflation exceeds 50% per month. In 1923, rise in price by 500% per moth in Germany.

o Deflation: Persistent fall in price level or persistent rise in purchasing power of money.

o Creeping Inflation: A single digit inflation → Encouraging to faster growth of output.

o Galloping Inflation: Double or treble digit rates per annum – say from 20% to 100% per annum.

o Stagflation: Combination of high and accelerating inflation and high unemployment and low GDP.

Causes and Kinds of Inflation:

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o May get generated either from demand or supply side or both.o On the demand side: Due to availability of more money income

(expenditure) for a given volume of output.o On the supply side: Due to wagepush, profitpush and supply

shocks (like drought and oil price hike by OPEC).o Price expectations also contribute for inflation: Higher the

elasticity of price expectations, larger the marginal rate of inflation.

Demand – Pull Inflation:

o AD > AS P ↑ due to excess demand

o An increase in AD: Due to G ↑, C↑ or I↑

o A diagrammatic representation of D – P – I:

P

AS

P2

P1

AD1

AD0

O Y YF Output

Observe two segments of AS curve:First segment: +ve relationship between output (Y) and price levelSecond segment: Vertical AS curve Full employment level of output (YF) Shift in AD to right side (AD1) (Due to an increase in: G or I

or decrease in Tx) → P ↑ from P1 to P2.

o Monetarist view of D – P – I:M > M → AD↑ → P↑ P S P DSupply of real money balances >Demand for real money balances.

Milton Friedman:“Inflation is always and every where a monetary phenomenon. It can be produced only by a more rapid increase in the quantity of money than in output”.

Cost – Push Inflation:

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o No increase in AD, still P↑ when wage rate ↑ without any corresponding increase in productivity.→ Wage push inflation.

o Aggressive increase in wage rates and or material prices.

o Diagrammatic representation of Cost-push inflation:

P AS1

AS0

P** P*

AD0

O Y Y** Y* Output

o Profit-push inflation under monopolistic and oligopolistic market situations cost-push inflation occurs due to non-wage factors also.

Effects of Inflation:o Erosion of real income or purchasing powero Effects on debtors and creditorso Effects on fixed income group (pensioners)o Effects on wealth holders of cash, deposits etco Effects on government income: An increase in tax income – both

personal and corporate income taxeso Inflation and labour productivity: Inflation → Labour unrest → Low

labour productivityo Inflation and Marketing:

Consumers, becoming more sensitive to rise in price A reduced rate of growth in real demand for goods and

services A shift in expenditure away from non-essential goods and

services.o Inflation and interest rate: Inflation → High rate of interest.

Control of Inflation:o Monetary Policy: Use bank rate policy, open market operations,

cash reserve ratio and selective credit controls to control inflation. Credit Squeeze.

o Fiscal Policy: Reducing Budget DeficitG↓ Tx↑

o Income Policy: Wage Control

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o Price Control: of essential commoditieso Increase utilization of productive capability to raise A So Enlarge imports to tide over shortage of some commodies

All these measures to bridge the gap between AS and AP.o Indexation: Make adjustments in monetary returns to offset

losses in real income due to inflation (Indexing introduced in Brazil for wages etc.).

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MODULE 5: Indian Economy

1. Economic Reforms and Structural Adjustments In India Since 1991.

Paradigm Shifts In Macroeconomic Policy:

Adam Smith: Laissez faire → Market Economy Alfred Marshall: Glorification of capitalism and market economy Karl Marx: Destruction of capitalistic system and market economy J. M. Keynes: Market economy with government interference 1950’s and 1960’s: Planning and public sector fundamentalism 1970’s: Decade of the development of the poor 1980’s onwards: Revival of market economy paradigm Back to

Adam Smith?

Four Decades of Economic Policy Regime In India: 1950 – 1990:

Planning – Public Sector – Regulation Fundamentalism Planning: A panacea Public sector dominance Protection of agriculture, industry and trade Self – reliance and import substitution Inward looking development strategy.

Performance Record During Old Policy Regime:

Respectable GDP growth Good performance in agriculture: Green Revolution India: On the industrial map of the world Development of science and technology and a large pool of

scientific and technological manpower But three dark spots of development.

Economic Reforms During 1980’s: The First Wave:

Improvement in productivity Absorption of modern technology Fuller utilization of production capacity Larger scope to private sector Foreign equity capital Remove controls and restrictions gradually.

Economic Reforms Since 1991: The Second Wave:

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U – turn from planning – Public Sector Fundamentalism to Market-Private Sector Fundamentalism.

Huge budget deficit Balance of payments crisis: Foreign exchange reserves (About

$15 billion) to meet two weeks imports Low global credit rating Over 13 ½ rate of inflation Western ideologies and propaganda Collapse of planned economies in the Soviet Block Problem of demand management in developed economies Prescriptions of IMF & World Bank Ideology of Indian elite Disenchantment with 40 years of inward looking development

strategies Hence change of track in July, 1991.

Contours of New Economic Policy Since July, 1991:

Stabilization and Demand Management: Reduce budget deficit Control inflation Reduce deficit in balance of payments.

Structural Adjustment Programme (SAP) and Supply Management: Liberate economic agents Delicense, dereserve and deprotect industry, agriculture and

trade Dismantle import license Reduce tariff rates and remove quantitative restructions Privatize and allow FDI Disinvest in public sector industries Reduce taxes Allow market forces to govern Exchange Rates.

Performance of Indian Economy Since 1991:

Major Performance Variables: GDP growth rate Employment generation Reduction of population living below poverty line Promotion of equity leading to a better deal for the poor and less

well-off sections of our society Reduction in regional disparities between the rich and the poor

states of India.

GDP Growth Rate:

1993 – 94 to 1997 – 98: More than 7% growth rate per annum.

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GDP growth rate slowed down after:2000 – 01: 5.2%2001 – 02: Around 5%2002 – 03: 4.3After: Some recovery

Alternatively:1980/81 – 1990/91: 5.6% GDP growth rate1990/91 – 2000/01: 5.6% GDP growth rate

Question: Has E.R accelerated GDP growth rate substantially.

Economic Reforms and Employment Growth

Rate of unemployment: 6.03% (1993 – 94)Rate of unemployment: 7.32% (1999 – 00)

Employment Elasticity of Output:1980’s and early 1990’s: 0.52%Late 1990’s: 0.16 Job – creation per unit of output has decreased

Downsizing of public sector

Increased capital intensity per unit of output

Growth pattern moving in favour of capital intensive sectors.

Economic Reforms and Reduction of Poverty Poverty reduction over 1983 to 1990/91: 3.1% per annum Poverty reduction in 1990’s: 1% per annum In rural sector the rate of reduction in poverty: Almost zero

and in urban sector higher rate of reduction in poverty Rural–Urban divide.

Neglect of Agriculture SectorThe emphasis of reform process, more on service and manufacturing sectors and lesson agricultural sector. 3.8% growth rate in agriculture during eighties and 1.73%

during nineties.

HD Report (2003): India’s rank 127th out of 175 Countries

Foreign Exchange Reserves: $5.83 billion in 1990 – 91. Now: $143 billions

Rate of inflation: From about 13% in 1990 – 91 to a little over 4% now.

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Economic Reforms and increased development disparities between states

Economic Reforms: Mixed Results.

LPG regime: Profit motive dominant, equity goal less emphasised.

To illustrate:

Millions of Indians are connected to the internet, but millions more are not yet connected to fresh water: India accounts for 30% of the World’s software engineers but also 25% of the World’s malnourished.

India has one of the World’s largest reservoirs of technical personnel but also the World’s largest pool of illiterates and poor people.

Paradox: Proud of 311 Indian billionaries? But about 300 million people below poverty line A Country of super rich and super poor.

Hence the Challenge:

o Tap the benefits of LPG regime, but address the problems of equity such as unemployment, poverty and inequalities.

o Any development paradigm which ignores the many poor for the few rich is not sustainable.

o Remember: Micro level success stories would obscure the macro picture – the picture of dark spots of Indian development.

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