manegerial economics for quick revision

8/11/2019 Manegerial Economics for Quick Revision

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MB0026- Unit 1- Meaning And

Importance Of Managerial Economics

Unit 1- Meaning And Importance Of Managerial Economics

Meaning

Managerial economics is a science that deals with the application ofvarious economic theories, principles, concepts and techniques tobusiness management in order to solve business and managementproblems. It deals with the practical application of economic theoryand methodology to decision-making problems faced by private,public and non-prot making organizations.

The same idea has been expressed by Spencer and Seigelman in the

following words. Managerial Economics is the integration of economic theorywith business practice for the purpose of facilitating decision making andforward planning by the management.According to Mc air and Meriam!Managerial economics is the use of economic modes of thought to analy"ebusiness situation. #righman and $appas de%ne managerial economics as!the application of economic theory and methodology to businessadministration practice.&oel dean is of the opinion that use of economicanalysis in formulating business and management policies is known asmanagerial economics.

eatures of managerial !conomics

'. (t is a new discipline and of recent origin). (t is a highly speciali"ed and separate branch by itself.3. It is basically a branch of microeconomics and as such it studies the problems of

only one firm in detail.

'. (t is mainly a normati*e science and as such it is a goal oriented andprescripti*e science.

). (t is more realistic! pragmatic and highlights on practical application of*arious economic

The theories to sol*e business and management problems.

It is a science of decision-making. It concentrates on decision-making process,

decision-

o models and decision variables and their relationships.

It is both conceptual and metrical and it helps the decision-maker by providing

measurement of various economic variables and their interrelationships.
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It uses various macro economic concepts like national income, inflation, deflation,

trade cycles etc to understand and adjust its policies to the environment in which thefirm operates.

It also gives importance to the study of non-economic variables having implications

of economic performance of the firm. For example, impact of technology,

environmental forces, socio-political and cultural factors etc. It uses the services of many other sister sciences like mathematics, statistics,

engineering, accounting, operation research and psychology etc to find solutions to

business and management problems.

SCOPE O MA!A"E#IA$ ECO!OMICS

he term !scope" indicates the area of study, boundaries, subject matter and width of a

subject. he following topics are covered in this subject.

1% OB&EC'I(ES O A I#M

2% )EMA!) A!A$*SIS A!) O#ECAS'I!"

+% P#O)UC'IO! A!) COS' A!A$*SIS

,% P#ICI!" )ECISIO!S PO$ICIES A!) P#AC'ICES

.% P#OI' MA!A"EME!'

6% CAPI'A$ MA!A"EME!'

/% $I!EA# P#O"#AMMI!" A!) 'E 'EO#* O "AMES

he term linear means that the relationships handled are the same as those represented by

straight lines and programming implies systematic planning or decision-making. Itimplies maximi#ation or minimi#ation of a linear function of variables subject to a

constraint of linear ine$ualities. It offers actual numerical solution to the problems of

making optimum choices. It involves either maximi#ation of profits or minimi#ation ofcosts. he theory of games basically attempts to explain what is the rational course of

action for an individual firm or an entrepreneur who is confronted with the a situation

where in the outcome depends not only on his own actions, but also on the actions ofothers who are also confronted with the same problem of selecting a rational course of

action. %oth these techni$ues are extensively used in business economics to solve variousbusiness and managerial problems.

% MA#E' S'#UC'U#E A!) CO!)I'IO!S

3% S'#A'E"IC P$A!!I!"


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It provides a framework on which long term decisions can be made which have an impact

on the behavior of the firm. he perspective of strategic planning is global. In fact, the

integration of business economics and strategic planning has given rise to a new area ofstudy called corporate economics.

10% O'E# A#EAS

&. 'acroeconomic management of the country relating to economic system, national

income, trade cycles (avings and investments and its impact on the working of afirm.

). *nowledge and information about various government policies like monetary,

fiscal, physical, industrial, labor, foreign trade, foreign capital and technology,'+s etc and their impact on the working of a firm.

3. Impact of international changes, role of international financial and trade

institutions in formulating domestic polices of a firm.

Importance of the study of Managerial !conomicsThe following points indicate the signi%cance of the study of this sub+ect in itsright perspecti*e.

'. (t gi*es guidance for identi%cation of key *ariables in decision,makingprocess.

). (t helps the business executi*es to understand the *arious intricaciesof business and managerial problems and to take right decision at theright time.

-. (t pro*ides the necessary conceptual! technical skills! toolbox ofanalysis and techniues of thinking and other such most modern tools

and instruments like elasticity of demand and supply! cost andre*enue! income and expenditure! pro%t and *olume of production etcto sol*e *arious business problems.

/. (t is both a science and an art. (n the context of globali"ation!pri*ati"ation! liberali"ation and marketi"ation and a highly competiti*edynamic economy! it helps in identifying *arious business andmanagerial problems! their causes and conseuence! and suggests*arious policies and programs to o*ercome them.

0. (t helps the business executi*es to become much more responsi*e!realistic and competent to face the e*er changing challenges in themodern business world.

1. (t helps in the optimum use of scarce resources of a %rm to maximi"e

its pro%ts.2. (t also helps in achie*ing other ob+ecti*es a %rm like attaining industryleadership! market share expansion and social responsibilities etc.

3. (t helps a %rm in forecasting the most important economic *ariableslike demand! supply! cost! re*enue! price! sales and pro%t etc andformulate sound business polices

4. (t also helps in understanding the *arious external factors and forceswhich a5ect the decision,making of a %rm.


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Thus! it has become a highly useful and practical discipline in recentyears to analy"e and %nd solutions to *arious kinds of problems in asystematic and rational manner.

"nowledge of decision making and forward planning

Managerial Economist is a specialist and an expert in analy"ing and %ndinganswers to business and managerial problems. A Managerial Economist hasto perform se*eral functions in an organi"ation. Among them! decision,making and forward planning are described as the two ma+or functions and allother functions are deri*ed from these two basic functions.

#. $ecision-making

%he word &decision' suggests a deliberate choice made out of severalpossible alternative courses of action after carefully consideringthem. $ecision-making is essentially a process of selecting the best

out of many alternative opportunities or courses of action that areopen to a management.

(. orward planning

%he term &planning' implies a consciously directed activity withcertain predetermined goals and means to carry them out. (t is adeliberate acti*ity. (t is a programmed action. #asically planning is concernedwith tackling future situations in a systematic manner.

orward planning implies planning in advance for the future. (t isassociated with deciding the future course of action of a %rm. (t is prepared

on the basis of past and current experience of a %rm.

)ummary

Managerial economics is a new and a highly speciali"ed branch of economics.(t brings together economic theory and business practice. (t assists inapplying *arious economic theories and principles to %nd solutions tobusiness and management problems.

It is applied economics and makes an attempt to explain how various economic conceptsare usefully employed in business management. It is a practical subject. It opens up the

mind of a managerial economist to the complex and highly challenging business world.he features of managerial economics throw light on the nature of the emerging subject

and the scope gives information about the wide coverage of the subject. he concepts of

decision- making and forward planning are the two basic functions of a managerialeconomist. In a way the entire subject matter of managerial economics is to be

understood in the background of these two functions


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MB0026- Unit-2-)emand Anal4sis

Unit- 2 )emand Anal4sis

Understand t5e concept of demand and its featres% *he term demand is different from desire, want, will or wish. In the language ofeconomics, demand has different meaning. ny want or desire will not constitute demand

emand / esire to buy

0 bility to pay

0 1illingness to pay

'5e term demand refers to total or gi7en 8antit4 of a commodit4 or a ser7ice t5atare prc5ased 94 t5e consmer in t5e mar:et at a particlar price and at a

particlar time

he following are some of the important $ualifications of demand-

It is backed up by ade$uate purchasing power.

It is always at a price.

It should always be expressed in terms of specific $uantity

It is created in the market.

It is related to a person, place and time.

onsumers create demand. emand basically depends on utility of a product. here is a

direct relation between the two i.e., higher the utility, higher would be demand and lower

the utility, lower would be the demand.

$emand +urve

A demand cur*e is a locus of points showing *arious alternati*e price 6uantity combinations. In short, the graphical presentation of thedemand schedule is called as a demand curve.

(t represents the functional relationship between uantity demanded andprices of a gi*en commodity. The demand cur*e has a negati*e slope or itslope downwards to the right. The negati*e slope of the demand cur*e clearlyindicates that uantity demanded goes on increasing as price falls and *ice*ersa.

%he aw f $emand
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ther things being equal, a fall in price leads to e/pansion indemand and a rise in price leads to contraction in demand0.

Important eatures of aw of $emand *

'. There is an in*erse relationship between price and demand.

). $rice is an independent *ariable and demand is a dependent *ariable

-. (t is only a ualitati*e statement and as such it does not indicateuantitati*e changes in price and demand.

/. 7enerally! the demand cur*e slopes downwards from left to right.

The operation of the law is conditioned by the phrase ther things beingequal0. (t indicates that gi*en certain conditions certain results would follow.

The in*erse relationship between price and demand would be *alid only when

tastes and preferences! customs and habits of consumers! prices of relatedgoods! and income of consumers would remains constant.

!/ceptions %o %he aw f $emand

7enerally speaking! customers would buy more when price falls inaccordance with the law of demand. !/ceptions to law of demand statesthat with a fall in price, demand also falls and with a rise in pricedemand also rises.This can be represented by rising demand cur*e. (nother words! the demand cur*e slopes upwards from left to right. (t is knownas an exceptional demand cur*e or unusual demand cur*e.

8ollowing are the exception to the law of demand

#. 1i2en's 3arado/

4 parado/ is a foolish or absurd statement, but it will be true. Sir9obert 7i5en! an (rish Economists! with the help of his own example :inferiorgoods; dispro*ed the law of demand. The 7i5enhen price of potatoes declined!customers instead of buying greater uantities of potatoes started buying

more of meat :superior goods;. Thus! the demand for potatoes declined inspite of fall in its price.

(. 5eblen's e2ect

Thorstein ?eblen! a noted American Economist contends that there arecertain commodities which are purchased by rich people not for their directsatisfaction! but for their


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arise in price and vice-versa.(n case of such status symbol commodities itis not the price which is important but the prestige conferred by thatcommodity on a person makes him to go for it. More commonly citedexamples of such goods are diamonds and precious stones! world famouspaintings! commodities used by world %gures! personalities etc. Therefore!commodities ha*ing hen serious shortages are anticipated by the people! :e.g.! during the warperiod; they purchase more goods at present e*en though the current price ishigher.

7. ear of future rise in price

(f people expect future hike in prices! they buy more e*en though they feel

that current prices are higher. therwise! they ha*e to pay a still high pricefor the same product.

8. )peculation

)peculation implies purchase or sale of an asset with the hope thatits price may rise of fall and make speculative prot. ormallyspeculation is witnessed in the stock exchange market. $eople buy moreshares only when their prices show a rising trend. This is because they getmore pro%t! if they sell their shares when the prices actually rise. Thus!speculation becomes an exception to the law of demand.

9 +onspicuous necessaries

+onspicuous necessaries are those items which are purchased byconsumers even though their prices are rising on account of theirspecial uses in our modern style of life.

(n case of articles like wrist watches! scooters! motorcycles! tape recorders!mobile phones etc customers buy more in spite of their high prices.

:. !mergencies

Buring emergency periods like war! famine! Coods cyclone! accidents etc.!people buy certain articles e*en though the prices are uite high.

;. Ignorance

Sometimes people may not be aware of the prices pre*ailing in the market.=ence! they buy more at higher prices because of sheer ignorance.


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ective ? 6

@nderstand the various determinates demand and demand function

Bemand for a commodity or ser*ice is determined by a number of factors. Allsuch factors are called as @demand determinants


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In economics the term elasticity refers to a ratio of the relative changes in two $uantities.

It measures the responsiveness of one variable to the changes in another variable. *

Elasticit4 of demand is generall4 defined as t5e responsi7eness or sensiti7eness of

demand to a gi7en c5ange in t5e price of a commodit4% It refers to the capacity of

demand either to stretch or shrink to a given change in price. 2lasticity of demandindicates a ratio of relative changes in two $uantities.ie, price and demand. ccording to

prof. %oulding. !2lasticity of demand measures the responsiveness of demand to changesin price".& In the words of 'arshall," he elasticity or responsiveness4 of demand in a

market is great or small according to as the amount demanded much or little for a given

fall in price, and diminishes much or little for a given rise in price" )

inds of elasticit4 of demand

%roadly speaking there are five kinds of elasticities of demand. 1e shall discuss each oneof them in some detail.

Price Elasticit4 Of )emand

5rice elasticity of demand is one of the important concepts of elasticity which is used to

describe the effect of change in price on $uantity demanded. In the words of

5rof. .(tonier and 6ague, price elasticity of demand is a technical term used byeconomists to explain the degree of responsiveness of the demand for a product to a

change in its price. It is measured by using the following formula.

7riginal demand / )8 units original price / 9 : 88

+ew demand / 98 units +ew price / ; : 88

In the above example, price elasticity is : 9.

%ased on numerical values of the co-efficient of elasticity, we can have the following five

degrees of price elasticity of demand.


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)ifferent )egree of Price Elasticit4 of )emand

&. Perfectl4 Elastic )emand=In this case, a very small change in price leads to an

infinite change in demand. he demand cure is a hori#ontal line and parallel to7< axis. he numerical co-efficient of perfectly elastic demand is infinity

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&. Perfectl4 Inelastic )emand=In this case, what ever may be the change in price,$uantity demanded will remain perfectly constant. he demand curve is a vertical

straight line and parallel to 7= axis. >uantity demanded would be &8 units,irrespective of price changes from ?s. &8.88 to ?s. ).88. 6ence, the numerical co-

efficient of perfectly inelastic demand is #ero. 2 / 8

&. #elati7e Elastic )emand=In this case, a slight change in price leads to more than

proportionate change in demand. 7ne can notice here that a change in demand is

more than that of change in price. 6ence, the elasticity is greater than one. Fore.g., price falls by 3 @ and demand rises by A @. 6ence, the numerical co-

efficient of demand is greater than one.


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&. #elati7el4 Inelastic )emandIn this case, a large change in price, say B @ fall

price, leads to less than proportionate change in demand, say ; @ rise in demand.

7ne can notice here that change in demand is less than that of change in price.his can be represented by a steeper demand curve. 6ence, elasticity is less than

one.

In all economic discussion, relatively elastic demand is generally called as Celastic

demandD or Cmore elasticD demand while relatively inelastic demand is popularly knownas Cinelastic demandD or Cless elastic demandD.

&. Unitar4 elastic demandE In this case, proportionate change in price leads to e$ual

proportionate change in demand. For e.g., @ fall in price leads to exactly @

increase in demand. 6ence, elasticity is e$ual to unity. It is possible to comeacross unitary elastic demand but it is a rare phenomenon.


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7ut of five different degrees, the first two are theoretical and the last one is a rare

possibility. 6ence, in all our general discussion, we make reference only to two terms-

relatively elastic demand and relatively inelastic demand.

)eterminants Of Price Elasticit4 Of )emand

he elasticity of demand depends on several factors of which the following are some

of the important ones.

1% !atre of t5e Commodit4

ommodities coming under the category of necessaries and essentials tend to be inelasticbecause people buy them whatever may be the price.

2% E


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"oods or ser7ices ;5ose demands are interrelated so t5at an increase in t5e price of

one of t5e prodcts reslts in a fall in t5e demand for t5e ot5er% Goods which are

jointly demanded are inelastic in nature. For example, pen and ink, vehicles and petrol,shoes and cocks etc have inelastic demand for this reason. If a product does not have

complements, in that case demand tends to be elastic. For example, biscuits, chocolates,

ice8creams etc. In this case the use of a product is not linked to any other products.

&. Prc5ase fre8enc4 of a prodct

If the fre$uency of purchase is very high, the demand tends to be inelastic. For e.g.,

coffee, tea, milk, match box etc. on the other hand, if people buy a product occasionally,

in that case demand tends to be elastic for example, durable goods like radio, taperecorders, refrigerators etc.

hus, the demand for a product is elastic or inelastic will depend on a number of factors.

Measrement of price elasticit4 of demand

here are different methods to measure the price elasticity of demand and among them

the following two methods are most important ones.

&. otal expenditure method.

). 5oint method.

3. rc method.

1% 'otal E#s%? t4 )emanded 'otal e


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).88 K888 &;888

II Case .88 )888 &8888

/ &;.88 )88 &8888

).88 888 &8888

III Case .88 )888 &8888

L &;.88 ))88 B888

).88 ;)88 B;88

!ote=

&. 1hen new outlay is greater than the original outlay, then 2 J &.

). 1hen new outlay is e$ual to the original outlay then 2 / &.

3. 1hen new outlay is less than the original outlay then 2 L &.

"rap5ical #epresentation

From the diagram it is clear that

&. From to % price elasticity is greater than one.

). From % to price elasticity is e$ual than one.

3. From to price elasticity is lesser than one.


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(. 3oint MethodK

$rof. Marshall ad*ocated this method. %he point method measures priceelasticity of demand. at di2erent points on a demand curve.=ence! inthis case attempt is made to measure small changes in both price anddemand.

"rap5ical representation

he simplest way of explaining the point method is to consider a linear or straight- line

demand curve. Met the straight : line demand curve be extended to meet the two axis & / original $uantity / )88 units

5) / +ew price 8 : 88 >) / +ew $uantity / 388units %y substituting the

values in to the e$uation, we can find out rc elasticity of demand. G


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In the diagram, in order to measure arc elasticity between two points ' P + on thedemand curve, one has to take the average of prices 75& and 75) and also the average

$uantities of >& P >).

Practical application of price elasticit4 of demand

1% Prodction planning

It helps a producer to decide about the volume of production. If the demand for hisproducts is inelastic, specific $uantities can be produced while he has to produce different

$uantities, if the demand is elastic.

2% elps in fi


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,% elps in determining t5e terms of trade

It is the basis for deciding the Cterms of tradeD between two nations. '5e terms of tradeimplies t5e rate at ;5ic5 t5e domestic goods are e


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7riginal demand / ;88 units 7riginal Income / ;888-88

+ew demand / K88 units +ew Income / 9888-88

Generally speaking, 2y is positive. his is because there is a direct relationship between

income and demand, i.e. higher the income higher would be the demand and vice-versa.7n the basis of the numerical value of the co-efficient, 2y is classified as greater than

one, less than one, e$ual to one, e$ual to #ero, and negative. he concept of 2y helps usin classifying commodities into different categories.

&. 1hen 2y is positive, the commodity is normal Rused in day-to-day lifeS

). 1hen 2y is negative, the commodity is inferior. .For example Qowar, beedi etc.

3. 1hen 2y is positive and greater than one, the commodity is luxury.

;. 1hen 2y is positive, but less than one, the commodity is essential.

. 1hen 2y is #ero, the commodity is neutral e.g. salt, match box etc.

Practical application of income elasticit4 of demand

&.elps in determining t5e rate of gro;t5 of t5e firm%

If the growth rate of the economy and income growth of the people is reasonablyforecasted, in that case it is possible to predict expected increase in the sales of a firm and

vice-versa%

2% elps in t5e demand forecasting of a firm%

It can be used in estimating future demand provided the rate of increase in income and 2yfor the products are known. hus, it helps in demand forecasting activities of a firm.

+% elps in prodction planning and mar:eting


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he knowledge of 2y is essential for production planning, formulating marketing

strategy, deciding advertising expenditure and nature of distribution channel etc in the

long run.

,% elps in ensring sta9ilit4 in prodction

5roper estimation of different degrees of income elasticity of demand for different types

of products helps in avoiding over-production or under production of a firm. 7ne should

also know whether rise or fall in come is permanent or temporary.

.% elps in estimating constrction of 5oses%

he rate of growth in incomes of the people also helps in housing programs in a

country. hus, it helps a lot in managerial decisions of a firm.

Cross Elasticit4 Of )emand

It ma4 9e defined as t5e proportionate c5ange in t5e 8antit4 demanded of a

particlar commodit4 in response to a c5ange in t5e price of anot5er related

commodit4%In the words of 5rof. 1atson cross elasticity of demand is the percentage

change in $uantity associated with a percentage change in the price of related goods.

Generally speaking, it arises in case of substitutes and complements. he formula for

calculating cross elasticity of demand is as follows.

2c / 5ercentage change in $uantity demanded commodity hen less uantity of 'I units are supplied at the same price of 9s./.II! weget a new point $. Similarly! when same uantity of )I units is supplied at ahigher price of 9s.1 ,II! we get a new point $. (f we +oin these new points $ is the e$uilibriumoutput. 75 is the e$uilibrium price. (uppose the price is higher than the e$uilibrium price

i.e. 75). t this price $uantity demanded is 5) ), while the $uantity supplied is 5) ().

hus ) () is the excess supply which the sellers want to push off in the market,competition among sellers will bring down the price to the e$uilibrium level where the

supply is just e$ual to the demand. t price 75&, the buyers will demand 5&& $uantity

while the sellers are prepared to sell 5&(&. emand exceeds supply. 2xcess demand for


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goods pushes up the price this process will go on until the e$uilibrium is reached where

supply becomes e$ual to demand.

C5anges In Mar:et E8ili9rim

'5e c5anges in e8ili9rim price ;ill occr ;5en t5ere ;ill 9e s5ift eit5er in

demand cr7e or in sppl4 cr7e or 9ot5%

Effects of s5it in demand

emand changes when there is a change in the determinants of demand like the income,

tastes, prices of substitutes and complements, si#e of the population etc. If demand raisesdue to a change in any one of these conditions the demand curve shifts upward to the

right. If, on the other hand, demand falls, the demand curve shifts downward to the left.

(uch rise and fall in demand are referred to as increase and decrease in demand.

change in the market e$uilibrium caused by the shifts in demand can be explained with

the help of a diagram

G

>uantity demanded and supplied is shown on 7< axis, 5rice is shown on 7= axis. (( is

the supply curve which remains unchanged. is the demand curve. emand andsupply curves intersect each other at point 2. hus 75 is the e$uilibrium price and 7> is

the e$uilibrium $uantity demanded and supplied. +ow, suppose the demand increases.

he demand curve shifts forward to &&. he new demand curve intersects the supplycurve at point 2&, where the $uantity demanded increases to 7>& and price to 75&. In

the same way, if the demand curve shifts backwards and assumes the position )), the

new e$uilibrium will be at 2) and the $uantity demanded will be 7>), price will be 75).


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hus the market e$uilibrium price and $uantity demanded will change when there is an

increase or decrease in demand.

Effects Of S5ifts In Sppl4

o study of the effects of changes in supply on market e$uilibrium we assume the

demand to remain constant. n increase in supply is represented by a shift of the supply

curve to the right and a decrease in supply is represented by a shift to the left. he generalrule is, if supply increases, price falls and if supply decreases price rises.1e can show the

effects of shifts in supply with the help of a diagram

In the diagram supply and demand curves intersect each other at point 2, establishinge$uilibrium price at 75 and e$uilibrium $uantity supplied and demanded at 7>.

(uppose, supply increases and the supply curve shifts from (( to (&(&. he new supply

curve intersects the demand curve at 2& reducing the e$uilibrium price to 5& and raisingthe $uantity demanded to 7>&. 7n the other hand if the supply decreases and the supply

curve shifts backward to ()(), the e$uilibrium price is pushed upwards to 75) and the

$uantity demanded is reduced to 7>). hus changes in supply, demand remaining

constant will cause changes in the market e$uilibrium.

Effects Of C5anges In Bot5 )emand And Sppl4

hanges can occur in both demand and supply conditions. he effects of such

changes on the market e$uilibrium depend on the rate of change in the two variables. If

the rate of change in demand is matched with the rate of change in supply there will be nochange in the market e$uilibrium, the new e$uilibrium shows expanded market with

increased $uantity of both supply and demand at the same price.

his is made clear from the diagram belowE


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If the increase in demand is greater than the increase in supply, the new market

e$uilibrium is at a higher level showing a rise in both the e$uilibrium price and the

e$uilibrium $uantity demanded and supplied. 7n the other hand if the increase in supplyis greater than the increase in demand, the new market e$uilibrium is at lower level,

showing a lower e$uilibrium price and a higher $uantity of good supplied and demanded.

(imilar will be the effects when the decrease in demand is greater than the decrease in

supply on the market e$uilibrium.


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Smmar4

he management should have a clear understanding of the supply and demand conditions

in the market to have an effective control on business. (upply refers to the $uantity of a

commodity offered for sale at a particular price during a given period of time. (upply isdifferent from production and stock.

(upply schedule is a tabular representation of different $uantities of a commodity

supplied at varying prices and the supply curve drawn on the basis of supply schedulewhich shows the direct relationship that exists between price and supply. hus the supply

curve will have a positive slope. he law of supply states that Cother things being

constantD, a rise in price causes extension of supply and a fall in price causes contraction

of supply .here are a few exceptions to this law.

here will be a shift or a change in supply when the determinants of supply like the

natural factors, techni$ues of production, cost of production, government policy,

monopoly power, prices of related goods, number of sellers etc., change.

In order to regulate production and supply efficiently management should have properknowledge of the concept of elasticity of supply. 2lasticity of supply refers to the

responsiveness of supply to a change in price. It is influenced by a number of factors like

the period of time under consideration, availability and mobility of factors of production,technological improvements, cost of production, number of sellers, prices of related

goods etc.

'odern economics is sometimes called e$uilibrium analysis. 'arket is in e$uilibrium

when there is a balance between supply and demand forces. he price and outputdetermined by the interaction of supply and demand forces are called the e$uilibrium

price and the e$uilibrium output. here will be a change in the e$uilibrium price and

output when there is a change in demand or change in supply or change in both demand


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output H is thus! a function of the factor inputs F P etc! employed by the%rm per unit of time.

actor inpts are of t;o t4pes%

1% iuants and Iso- ost curves.

2% $ong #n Prodction nction

In this case, the producer will vary the $uantities of all factor inputs, both fixed as well as

variable in the same proportion. For 2xample, he laws of returns to scale.

2ach firm has its own production function which is determined by the state of

technology, managerial ability, organi#ational skills etc of a firm. If there are anyimprovements in them, the old production function is disturbed and a new one takes its

place. It may be in the following mannerE-


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&. he $uantity of inputs may be reduced while the $uantity of output may remain

same.

). he $uantity of output may increase while the $uantity of inputs may remainsame.

3. he $uantity of output may increase and $uantity of inputs may decrease.

'E $A O (A#IAB$E P#OPO#'IO!S *

he law can be stated as the following. As t5e 8antit4 of different nits of onl4 one

factor inpt is increased to a gi7en 8antit4 of fi


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%otal 3roduct or utput K :T$; (t is the output deri*ed from all factors units!both %xed J *ariable employed by the producer. (t is also a sum of marginaloutput. G

4verage 3roduct or utputK :A$;. (t can be obtained by di*iding totaloutput by the number of *ariable factors employed.

Marginal 3roduct or utputK :M$; (t is the output deri*ed from theemployment of an additional unit of *ariable factor unit

'rends in otpt

8rom the table! one can obser*e the following tendencies in the T$! A$! J M$.

&. otal output goes on increasing as long as '5 is positive. It is the highest when '5 is

#ero and 5 declines when '5 becomes negative.

). '5 increases in the beginning, reaches the highest point and diminishes at the end.

3. 5 will also have the same tendencies as the '5. In the beginning '5 will be higher

than 5 but at the end 5 will be higher than '5.

)iagrammatic #epresentation


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(n the abo*e diagram along with R axis! we measure the amount of

*ariable factors employed and along L 6 axis! we measure T$! A$ J M$. 8romthe diagram it is clear that there are ((( stages.

Stage !m9er I% '5e $a; Of Increasing #etrns

he total output increases at an increasing rate 'ore than proportionately4 up to thepoint 5 because corresponding to this point 5 the '5 is rising and reaches its highest

point. fter the point 5, '5 decline and as such 5 increases gradually.

he first stage comes to an end at the point where '5 curve cuts the 5 curve when the

5 is maximum at +.

he I stage is called as the law of increasing returns on account of the following reasons.

&. he proportion of fixed factors is greater than the $uantity of variable factors. 1hen

the producer increases the $uantity of variable factor, intensive and effective utili#ation of

fixed factors become possible leading to higher output.


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). 1hen the producer increases the $uantity of variable factor, output increases due to the

complete utili#ation. of the !Indivisible Factors" 3. s more units of the variable factor is

employed, the efficiency of variable factors will go up because it creates moreopportunity for the introduction of division of labor and speciali#ation resulting in higher

output.

Stage !m9er II '5e $a; Of )iminis5ing #etrns

(n this case as the uantity of *ariable inputs is increased to a gi*en uantityof %xed factors! output increases less than proportionately. (n this stage! the

T.$ increases at a diminishing rate since both A$ J M$ are declining but theyare positi*e. The (( stage comes to an end at the point where T$ is the highestat the point E and M$ is "ero at the point #. (t is known as the stage ofBiminishing 9eturns because both the A$ J M$ of the *ariable factorcontinuously fall during this stage. (t is only in this stage! the %rm ismaximi"ing its total output.

)iminis5ing retrns arise due to the following reasonsE

&. he proportion of variable factors are greater than the $uantity of fixed factors.

6ence, both 5 P '5 decline.

). otal output diminishes because there is a limit to the full utili#ation of indivisiblefactors and introduction of speciali#ation. 6ence, output declines.

3. iseconomies of scale will operate beyond the stage of optimum production.

;. Imperfect substitutability of factor inputs is another cause. Op to certain point

substitution is beneficial. 7nce optimum point is reached, the fixed factors cannotbe compensated by the variable factor. iminishing returns are bound to appear as

long as one or more factors are fixed and cannot be substituted by the others.

'5e III Stage '5e Stage Of !egati7e #etrns%

(n this case! as the uantity of *ariable input is increased to a gi*en uantityof %xed factors! output becomes negati*e. Buring this stage! T$ startsdiminishing! A$ continues to diminish and M$ becomes negati*e. Thenegati*e returns are the result of excessi*e uantity of *ariable factors to aconstant uantity of %xed factors. =ence! output declines. The pro*erb Toomany cooks spoil the broth and Too much is too bad aptly applies to thisstage. 7enerally! the ((( stage is a theoretical possibility because no producerwould like to come to this stage.

The producer being rational will not select either the stage ( :because there isopportunity for him to increase output by employing more units of *ariablefactor; or the ((( stage :because the M$ is negati*e;. The stage ( J ((( isdescribed as ,Economic 9egion or neconomic 9egion. =ence! theproducer will select the (( stage :which is described as the most economic


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region; where he can maximi"e the output. The (( stage represents the rangeof rational production decision.

It is clear t5at in t5e a9o7e e


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map. (n other words! a number of Iso Duants representing di2erentamount of out put are known as Iso-quant map.

Marginal Bate of %echnical )ubstitution EMB%)F

(t may be de%ned as the rate at which a factor of production can besubstituted for another at the margin without a2ecting any changein the quantity of output.

Properties of Iso- ants%

&. n Iso->uant curve slope downwards from left to right.

). Generally an Iso->uant curve is convex to the origin.

3. +o two Iso-product curves intersect each other.

;. n Iso-product curve lying to the right represents higher output and vice-versa.

. lways one Iso->uant curve need not be parallel to other.

9. It will not touch either < or = : axis.

ISO-COS' $I!E O# CU#(E *


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(t is a parallel concept to the budget or price line of the consumer. (t indicatesthe di5erent combinations of the two inputs which the %rm can purchase at

gi*en prices with a gi*en outlay.

P#O)UCE#S EUI$IB#IUM >Optimm factor com9ination or least cost

com9ination?

he optimal combination of factor inputs may help in either minimi#ing cost for a given

level of output or maximi#ing output with a given amount of investment expenditure.

ong Bun 3roduction unction G+hange In 4ll actor Inputs In %he)ame 3roportionH

$AS O #E'U#!S 'O SCA$E

he concept of returns to scale is a long run phenomenon. In this case, we study the

change in output when all factor inputs are changed or made available in re$uired$uantity. n increase in scale means that all factor inputs are increased in the same

proportion. In returns to scale, all the necessary factor inputs are increased or decreased

to the same extent so that what ever the scale of production, the proportion among thefactors remains the same.

'5ree P5ases of #etrns to Scale

1hen the $uantity of all factor inputs are increased in a given proportion and output

increases more than proportionately, then the returns to scale are said to be increasingwhen the output increases in the same proportion, then the returns to scale are said to beconstant when the output increases less than proportionately, then the returns to scale are

said to be diminishing.


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Sl !o% Scale

'otal Prodct

in UnitsMarginal Prodct in nits

& & cre of land 0 3 labor

) ) cre of land 0 labor &) K

3 3 cre of land 0 K labor )& A

; ; cre of land 0 A labor 3) &&

cre of land 0 && labor ;3 &&

9 9 cre of land 0 &3labor ; &&

K K cre of land 0 & labor 93 A

B B cre of land 0 &K labor K8 K

It is clear from the table that the $uantity of land and labor (cale4 is increasing in the

same proportion, i.e. by & acre of land and ) units of labor through out in our example.

he output increases more than proportionately when the producer is employing ; acres

of land and A units of labor. 7utput increases in the same proportion when the $uantity of

land is acres and &&units of labor and 9 acres of land and &3 units of labor. In the laterstages, when he employs K P B acres of land and & P &K units of labor, output increases

less than proportionately. hus, one can clearly understand the operation of the threephases of the laws of returns to scale with the help of the table.

)iagrammatic representation

In the diagram, it is clear that the marginal returns curve slope upwards from to %,

indicating increasing returns to scale. he curve is hori#ontal from % to indicating

constant returns to scale and from to , the curve slope downwards from left to rightindicating the operation of diminishing returns to scale.


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I!C#EASI!" #E'U#!S 'O SCA$E=

Increasing retrns to scale is said to operate ;5en t5e prodcer is increasing t5e

8antit4 of all factors Lscale in a gi7en proportion otpt increases more t5an

proportionatel4%

Cases for Increasing #etrns to Scale


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Increasing returns to scale operate in a firm on account of several reasons. (ome of the

most important ones are as follows

&. 1ider scope for the use of latest tools, e$uipments, machineries, techni$ues etc toincrease production and reduce cost per unit.

). Marge-scale production leads to full and complete utili#ation of indivisible factorinputs leading to further reduction in production cost.

3. s the si#e of the plant increases, more output can be obtained at lower cost.;. s output increases, it is possible to introduce the principle of division of labor

and speciali#ation, effective supervision and scientific management of the firm etc

would help in reducing cost of operations.. s output increases, it becomes possible to enjoy several other kinds of

economies of scale like overhead, financial, marketing and risk-bearing

economies etc, which is responsible for cost reduction.

It is important to note that economies of scale outweigh diseconomies of scale in case of

increasing returns to scale.

CO!S'A!' #E'U#!S 'O SCA$E

Constant retrns to scale is operating ;5en all factor inpts Lscale are increased in

a gi7en proportion otpt also increases in t5e same proportion%

Cases for Constant #etrns to Scale

In case of constant returns to scale, the various internal and external economies of scaleare neutrali#ed by internal and external diseconomies. hus, when both internal and


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external economies and diseconomies are exactly balanced with each other, constant

returns to scale will operate.

)IMI!ISI!" #E'U#!S 'O SCA$E

)iminis5ing retrns to scale is operating ;5en otpt increases less t5an

proportionatel4 ;5en compared t5e 8antit4 of inpts sed in t5e prodction

process%

Cases for )iminis5ing #etrns to Scale

iminishing ?eturns to (cale operate due to the following reasons-

&. 2mergence of difficulties in co-ordination and control.

). ifficulty in effective and better supervision.

3. elays in management decisions.

;. Inefficient and mis-management due to over growth and expansion of the firm.. 5roductivity and efficiency declines unavoidably after a point.

no;ledge of economies of scale and diseconomies of sale and economies anddiseconomies of scope

Economies Of Scale

hey are gain to a firm. hey help in reducing production cost and establishing an

optimum si#e of a firm. hus, they help a lot and go a long way in the development and


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growth of a firm. ccording to 5rof. 'arshall these economies are of two types, vi#

Internal 2conomies and 2xternal 2conomics +ow we shall study both of them in detail.

I Internal Economies or #eal Economies

(nternal Economies are those economies which arise because of the actionsof an indi*idual %rm to economi"e its cost. They arise due to increaseddi*ision of labor or speciali"ation and complete utili"ation of indi*isible factorinputs. $rof. Dairncross points out that internal economies are open to asingle factory or a single %rm independently of the actions of other %rms.

They arise on account of an increase in the scale of output of a %rm andcannot be achie*ed unless output increases. The following are some of theimportant aspects of internal economies.

&. hey arise !with in" or !inside" a firm.

). hey arise due to improvements in internal factors.

3. hey arise due to specific efforts of one firm.

;. hey are particular to a firm and enjoyed by only one firm.

. hey arise due to increase in the scale of production.

9. hey are dependent on the si#e of the firm.

K. hey can be effectively controlled by the management of a firm.

B. hey are called as !%usiness (ecrets !of a firm.

inds of Internal Economies%

1% 'ec5nical Economies

a% Economies of sperior tec5ni8esE

9% Economies of increased dimension=

c% Economies of lin:ed process=It is $uite possible that a firm may not have variousprocesses of production with in its own premises. lso it is possible that different firms

through mutual agreement may decide to work together and derive the benefits of linked

processes, for example, in diary farming, printing press, nursing homes etc.


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d% Economies arising ot of researc5 and 94 H prodcts=

e% In7entor4 Economies% Inventory management is a part of better materials

management. big firm can save a lot of money by adopting latest inventorymanagement techni$ues.

). Managerial Economies%

hey arise because of better, efficient, and scientific management of a firm. (uch

economies arise in two different ways.

a% )elegation of detailshe general manager of a firm cannot look after the working ofall processes of production. In order to keep an eye on each production process he has to

delegate some of his powers or functions to trained or speciali#ed personnel and thus

relieve himself for co-ordination, planning and executing the plans. his will enable him

to bring about improvements in production process and in bringing down the cost of

production.

9% nctional Specialiation% It is possible to secure economies of large scale production

by dividing the work of management into several separate departments. 2ach departmentis placed under an expert and the rest of the work is left into the hands of specialists. his

will ensure better and more efficient productive management with scientific business

administration. his would lead to higher efficiency and reduction in the cost of

production.

3. Mar:eting or Commercial economiesE

'5ese economies ;ill arise on accont of 94ing and selling goods on large scale9asis at fa7ora9le terms%

;. inancial Economies

'5e4 arise 9ecase of t5e ad7antages secred 94 a firm in mo9iliing 5ge financial

resorces% large firm on account of its reputation, name and fame can mobili#e huge

funds from money market, capital market, and other private financial institutions at

concessional interest rates. It can borrow from banks at relatively cheaper rates. It is also

possible to have large overdrafts from banks. large firm can float debentures and issueshares and get subscribed by the general public.

$a9or Economies%

%hese economies will arise as a result of employing skilled, trained,qualied and highly e/perienced persons by o2ering higher wagesand salaries. As a %rm expands! it can employ a large number of highlytalented persons and get the bene%ts of speciali"ation and di*ision of labor.

9. 'ransport and Storage Economies


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'5e4 arise on accont of t5e pro7ision of 9etter 5ig5l4 organied and c5eap

transport and storage facilities and t5eir complete tiliation% large company can

have its own fleet of vehicles or means of transport which are more economical thanhired ones. (imilarly, a firm can also have its own storage facilities which reduce cost of

operations.

K. O7er ead Economies

'5ese economies ;ill arise on accont of large scale operations% he expenses onestablishment, administration, book-keeping, etc, are more or less the same whether

production is carried on small or large scale. 6ence, cost per unit will be low if

production is organi#ed on large scale. G

% Economies of (ertical integration

A firm can also reap t5is 9enefit ;5en it scceeds in integrating a nm9er of stages

of prodction%It secures the advantages that the flow of goods through various stages inproduction processes is more readily controlled. %ecause of vertical integration, most of

the costs become controllable costs which help an enterprise to reduce cost of production.

A. #is:-9earing or sr7i7al economies

'5ese economies ;ill arise as a reslt of a7oiding or minimiing se7eral :inds of

ris:s and ncertainties in a 9siness%

)i7ersification of otptInstead of producing only one particular variety, a firm has to

produce multiple products If there is loss in one item it can be made good in other items.

)i7ersification of mar:et=Instead of selling the goods in only one market, a firm

has to sell its products in different markets. If consumers in one market desert aproduct, it can cover the losses in other markets.

)i7ersification of sorce of sppl4=Instead of buying raw materials and other

inputs from only one source, it is better to purchase them from different sources.If one person fails to supply, a firm can buy from several sources.

)i7ersification of t5e process of manfactre=Instead adopting only one

process of production to manufacture a commodity, it is better to use different

processes or methods to produce the same commodity so as to avoid the lossarising out of the failure of any one process.

II. E


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growth of an industry or a region or a particular area. hey arise due to benefit of

locali#ation and speciali#ed progress in the industry or region. 5rof. (tonier P 6ague

points out that external economies are those economies in production which depend onincrease in the output of the whole industry rather than increase in the output of the

individual firm he following are some of the important aspect of external economies.

&. hey arise CoutsideD the firm.

). hey arise due to improvement in external factors.

3. hey arise due to collective efforts of an industry.

;. hey are general, common P enjoyed by all firms.

. hey arise due to overall development, expansion P growth of an industry or a region.

9. hey are dependent on the si#e of industry.

K. hey are beyond the control of management of a firm.

B. hey are called as !open secrets !of a firm.

inds of E


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'5ese economies ;ill arise de to t5e a7aila9ilit4 of fa7ora9le p54sical factors and

en7ironment%

Economies of elfare

'5ese economies ;ill arise on accont of 7arios ;elfare programs nder ta:en 94an indstr4 to 5elp its o;n staff%

)iseconomies Of Scale

1hen a firm expands beyond the optimum limit, economies of scale will be converted in

to diseconomies of scale. 7ver growth becomes a burden. 6ence, one should not crossthe limit. 7n account of diseconomies of scale, more output is obtained at higher cost of

production. he following are some of the main diseconomies of scale

&. inancial diseconomies. . s there is over growth, the re$uired amount of fiancWe

may not be available to a firm. onse$uently, higher interest rates are to be paidfor additional funds%). Managerial diseconomies 2xcess growth leads to loss of effective supervision,

control management, coordination of factors of production leading to all kinds ofwastages, indiscipline and rise in production and operating costs.

3. Mar:eting diseconomies%Onplanned excess production may lead to mismatch

between demand and supply of goods leading to fall in prices. (tocks may pile up,

sales may decline leading to fall in revenue and profits.;. 'ec5nical diseconomies 1hen output is carried beyond the plant capacity, per

unit cost will certainly go up. here is a limit for division of labor and

speciali#ation. %eyond a point, they become negative. 6ence, operation costs

would go up.. )iseconomies of ris: and ncertaint4 9earing% If output expends beyond a

limit, investment increases. he level of inventory goes up. (ales do not go upcorrespondingly. %usiness risks appear in all fields of activities. (upply of factor

inputs become inelastic leading to high prices.

9. $a9or diseconomies% n unwieldy firm may become impersonal. ontact

between labor and management may disappear. 1orkers may demand higherwages and salaries, bonus and other such benefits etc. Industrial disputes may

arise. Mabor unions may not cooperate with the management. ll of them may

contribute for higher operation costs.

II E


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It implies that a firm will convert certain external benefits created by the government or

the entire society to its own favor with out making any additional investments.

E


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detailed study of cost analysis is very useful for managerial decisions. It helps the

management :

&. o find the most profitable rate of operation of the firm.

). o determine the optimum $uantity of output to be produced and supplied.

3. o determine in advance the cost of business operations.

;. o locate weak points in production management to minimi#e costs.

. o fix the price of the product.

9. o decide what sales channel to use.

K. o have a clear understanding of alternative plans and the right costs involved in

them.

B. o have clarity about the various cost concepts.

A. o decide and determine the very existence of a firm in the production field.

&8. o regulate the number of firms engaged in production.

&&. o decide about the method of cost estimation or calculations.

&). o find out decision making costs by re-classifications of elements, reprising of inputfactors etc, so as to fit the relevant costs into management planning, choice etc.

)ifferent inds Of Cost Concepts.

&. Mone4 Cost and #eal Cost

5en cost is e


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+% Actal costs and Opportnit4 Costs

'5e4 are t5e actal e


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1% 'ec5nolog4

'odern technology leads to optimum utili#ation of resources, avoid all kinds of

wastages, saving of time, reduction in production costs and resulting in higher output. 7nthe other hand, primitive technology would lead to higher production costs.

2.#ate of otpt= >t5e degree of tiliation of t5e plant and mac5iner4?

omplete and effective utili#ation of all kinds of plants and e$uipments would reduce

production costs and under utili#ation of existing plants and e$uipments would lead to

higher production costs.

+%Sie of Plant and scale of prodction

Generally speaking big companies with huge plants and machineries organi#e production

on large scale basis and enjoy the economies of scale which reduce the cost per unit.

7. 3rices of input factors

. =igher market prices of *arious factor inputs result in higher cost ofproduction and *ice,*ersa.

8. !ciency of factors of production and the management

=igher producti*ity and eciency of factors of production would lead to lowerproduction costs and *ice,*ersa.

9. )tability of output

Stability in production would lead to optimum utili"ation of the existingcapacity of plants and euipments. (t also brings sa*ings of *arious kinds ofhidden costs of interruption and learning leading to higher output andreduction in production costs.

:. aw of returns

(ncreasing returns would reduce cost of production and diminishing returnsincrease cost.

;. %ime period(n the short run! cost will be relati*ely high and in the long run! it will be lowas it is possible to make all kinds of ad+ustments and read+ustments inproduction process.

Thus! many factors inCuence cost of production of a %rm.

earning ob>ective ? 8


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response of cost to changes in output. A hypothetical cost schedule of a%rm has been represented in the following table.

Otpt in

Units%+ %5+ %+ 4+ 45+ 4+ M+

8 -1I 6 -1I 6 6 6 6

& -1I '3I 0/I -1I '3I 0/I '3I

) -1I )/I 1II '3I ')I -II 1I

3 -1I )2I 1-I ')I 4I )'I -I

; -1I -'0 120 4I 23.20 '13.20 /0

-1I /)I 23I 2) 3/ '01 'I0

9 -1I 1-I 44I 1I 'I0 '10 )'I

7n the basis of the above cost schedule, we can analyse the relationship between changes

in the level of output and cost of production. If we represent the relationship between thetwo in a geometrical manner, we get different types of cost curves in the short run. In theshort run, generally we study the following kinds of cost concepts and cost curves.

1% 'otal fi'C?

%+ refers to total money e/penses incurred on /ed inputs likeplant, machinery, tools K equipments in the short run.


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2% 'otal 7aria9le cost >'(C?

%5+ refers to total money e/penses incurred on the variablefactors inputs like raw materials, power, fuel, water, transport and

communication etc, in the short run.

H curve slope upwards from left to right. H curve rises as output is expanded.

1hen out put is Xero, H also will be #ero. 6ence, the H curve starts from theorigin.

+% 'otal cost >'C?

'5e total cost refers to t5e aggregate mone4 e


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he total cost curve is rising upwards from left to right. In our example the curve

starts form ?s. 388-88 because even if there is no output, F is a positive amount.

and H have same shape because an increase in output increases them both by the sameamount since F is constant. curve is derived by adding up vertically the H and

F curves. he vertical distance between H curve and curve is e$ual to F and

is constant throughout because F is constant.

,% A7erage fiAC?

A7erage fi


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F and output have inverse relationship. It is higher at smaller level and lower at the

higher levels of output in a given plant. he reason is simple to understand. (ince F /

FN>, it is a pure mathematical result that the numerator remaining unchanged, theincreasing denominator causes diminishing product. 6ence, F spreads over each unit

of out put with the increase in output. onse$uently, F diminishes continuously. his

relationship between output and fixed cost is universal for all types of business concerns.

.% A7erage 7aria9le cost= >A(C? G

'5e a7erage 7aria9le cost is 7aria9le cost per nit of otpt% A(C can 9e compted

94 di7iding t5e '(C 94 total nits of otpt% hus H / HN>. he H will come

down in the beginning and then rise as more units of output are produced with a givenplant. his is because as we add more units of variable factors in a fixed plant, the

efficiency of the inputs first increases and then it decreases.

he H curve is a O-shaped cost curve.

6% A7erage total cost >A'C? or A7erage cost >AC?

Ac refers to cost per nit of otpt% AC is also :no;n as t5e nit cost since it is t5e

cost per nit of otpt prodced% is the sum of F and H. verage total cost oraverage cost is obtained by dividing the total cost by total output produced. / N>

lso is the sum of F and H.

In the short run curve also tends to be O-shaped. he combined influence of F andH curves will shape the nature of curve.


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It is necessary to note that ' is independent of F and it is directly related to H as

we calculate the cost of producing only one unit. In the short run, the ' curve also

tends to be O-shaped.

he shape of the ' curve is determined by the laws of returns. If ' is falling,

production will be under the conditions of increasing returns and if ' is rising,production will be subject of diminishing returns.

'5e ta9le indicates t5e relations5ip 9et;een AC N MC

Otpt inUnits

'C in #s% AC in #s%

)ifference in #s%

MC

& &8 &8 :

) &A8 A ;8

3 ))8 K3.3 38

; )39 A &9

)K8 ; 3;

9 3); ; ;

K ;& A.3 A&


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pushed up by the '. hus, 1hen is minimum, ' / . he point of

intersection indicates the least cost combination point or the optimum position of

the firm. t output > the firm is working at its !7ptimum apacity" with lowest. %eyond >, there is scope for !'aximum apacity" with rising cost.

Cost Otpt #elations5ip In '5e $ong #n

$ong rn is defined as a period of time ;5ere adstments to c5anged conditions are

complete% It is actually a period during which the $uantities of all factors, variable aswell as fixed factors can be adjusted. 6ence, there are no fixed costs in the long run. In

the short run, a firm has to carry on its production within the existing plant capacity, but

in the long run it is not tied up to a particular plant capacity. s all costs are variable inthe long run, the total of these costs is total cost of production. ence t5e distinction

9et;een fi


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Important featres of long rn AC cr7es

1% 'angent cr7e

ifferent ( curves represent different operational capacities of different plants in theshort run. M curve is locus of all these points of tangency. he ( curve can never

cut a M curve though they are tangential to each other. his implies that for any given

level of output, no ( curve can ever be below the M curve. 6ence, ( cannot belower than the M in the ling run. hus, M curve is tangential to various ( curves.

2% En7elope cr7e

It is known as 2nvelope curve because it envelopes a group of ( curves appropriate to

different levels of output.

+% latter U-s5aped or dis5-s5aped cr7e%

he M curve is also U s5aped or dis5 s5aped cost curve. %ut It is less pronounced

and much flatter in nature. M gradually falls and rises due to economies anddiseconomies of scale.

,% Planning cr7e%

he M cure is described as the Planning Cr7eof the firm because it represents theleast cost of producing each possible level of output. his helps in producing optimum

level of output at the minimum M. his is possible when the entrepreneur is selecting


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the optimum scale plant. 7ptimum scale plant is that si#e where the minimum point of

( is tangent to the minimum point of M.

.% Minimm point of $AC cr7e s5old 9e al;a4s lo;er t5an t5e minimm point of

SAC cr7e%

his is because M can never be higher than ( or ( can never be lower than

M. he M curve will touch the optimum plant ( curve at its minimum point.

rational entrepreneur would select the optimum scale plant. 7ptimum scale plant is that

si#e at which ( is tangent to M, such that both the curves have the minimum pointof tangency. In the diagram, 7') is regarded as the optimum scale of output, as it has the

least per unit cost. t 7') output M / (.

M curve will be tangent to ( curves lying to the left of the optimum scale or right

side of the optimum scale. %ut at these points of tangency, neither M is minimum nor

will ( be minimum. ( curves are either rising or falling indicating a higher cost

Smmar4

In this unit- we have discussed about the meaning of production, production function

and its managerial uses. 5roduction in economics implies transformation of inputs intooutputs for our final consumption. 5roduction function explains the $uantitative

relationship between the amounts of inputs used to.. get a particular physical $uantity of

outputs. he ratios between the two $uantities are of great importance to a producer to

take his decisions in the production process. here are two kinds of production functions: short run and long run. In case of short run production function we come across a

change in either one or two variable factor inputs while all other inputs are kept constant.he law of variable proportion explain how there will be variations in the $uantity of

output when there is change in only one variable factor inputs while all other inputs are

kept constant. 7n the other hand Iso->uants and Iso-cost curves explain how there willbe changes in output when only two variable inputs are changed while all other inputs are

kept constant. Onder long run production function, the laws of returns to scale explain

changes in output when all inputs, both variable as well as fixed changes in the same

proportion. 2conomies of scale give information about the various benefits that a firmwill get when it goes for large scale production. 2conomies of scope on the other hand

tells us how there will be certain specific advantages when one firm produces more thantwo products jointly than two or three firms produce them separately. iseconomies ofscale and diseconomies of scope tells us that there are certain limitations to expansion in

output ost analysis on the other hand, indicates the various amounts of costs incurred to

produce a particular $uantity of output in monetary terms. he various kinds of costconcepts help a manager to take right decisions. ost function explains the relationship

between the amounts of costs to be incurred to produce a particular $uantity of output.

(hort run cost function gives information about the nature and behavior of various cost


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curves. Mong run cost function tells us how it is possible to obtain more output at lower

costs in the long run. hus, the knowledge of both production function and cost functions

help a business executive to work out the best possible factor combinations to maximi#eoutput with minimum costs.

MB0026- Unit 6-O9ecti7es Of irmsUnit 6 O9ecti7es Of irms

Economists o*er a period of time ha*e de*eloped *arious theories andmodels to explain di5erent kinds of goals of modern %rms. #roadly speakingthey can be di*ed in to three groups. They are as follows,

'. The pro%t maximi"ation model.). Managerial theories or models-. #eha*ioral theories or models.

Fet us study some of the important theories under each category.

3rot Ma/imization Model

Main propositions of the prot-ma/imization model.

The model is based on the assumption that each %rm seeks to maximi"e itspro%t gi*en certain technical and market constraints. The following are themain propositions of the model.

'. A %rm is a producing unit and as such it con*erts *arious inputs intooutputs of higher *alue under a gi*en techniue of production.

). The basic ob+ecti*e of each %rm is to earn maximum pro%t.-. A %rm operates under a gi*en market condition./. A %rm will select that alternati*e course of action which helps to

maximi"e consistent pro%ts0. A %rm makes an attempt to change its prices! input and output

uantity to maximi"e its pro%t.

+riticisms

#. 4mbiguous term.The term pro%t maximi"ation is ambiguous in nature.There is no clear cut explanation whether a %rm has to maximi"e its net
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pro%t! total pro%t or the rate of pro%t in a business unit. Again maximumamount of pro%t cannot be precisely de%ned in uantitati*e terms.

(. 4lways it may not be possible. $ro%t maximi"ation! no doubt is thebasic ob+ecti*e of a %rm. #ut in the context of highly competiti*e businessen*ironment! always it may not be possible for a %rm to achie*e this

ob+ecti*e. ther ob+ecti*es like sales maximi"ation! market share expansion!market leadership building its own image! name! fame and reputation!spending more time with members of the family! en+oying leisure! de*elopingbetter and cordial relationship with employees and customers etc. also hasassumed greater signi%cance in recent years.

6. )eparation of ownership and management. (n many cases! to,day wecome across the business units are organi"ed on partnership or +oint stockcompany or cooperati*e basis. (n case of many large organi"ations!ownership and management is clearly separated and they are run andmanaged by salaried managers who ha*e their own self interests and as suchalways pro%t maximi"ation may not become possible.

7. $iculty in getting relevant information and data. (n spite ofre*olution in the %eld of information technology! always it may not bepossible to get adeuate and rele*ant information to take right decisions in ahighly Cuctuating business scenario. =ence! pro%ts may not be maximi"ed.

8. +onLict in inter-departmental goals. A %rm has se*eral departmentsand sections headed by experts in their own %elds. Each one of them willha*e its own independent goals and many a times there is possibility ofclashes between the interests of di5erent departments and as such alwayspro%ts may not be maximi"ed.

9. +hanges in business environment. (n the context of highly competiti*eand changing business en*ironment and changes in consumers< tastes andreuirements! a %rm may not be able to cope up with the expectations andad+ust its policies and as such pro%ts may not be maximi"ed.

:. 1rowth of oligopolistic rms. (n the context of globali"ation! growth ofoligopoly %rms has become so common through mergers! amalgamations andtakeo*ers. Feading %rms dominate the market and the small %rms ha*e tofollow the policies of the leading %rms. =ence! in many cases! there arelimited chances for making maximum pro%ts.

;. )ignicance of other managerial gains. Salaried managers ha*elimited freedom in decision making process. Some of them are unable toforecast the right type of changes and meet the market challenges. They aremore worried about their salaries! promotions! peruisites! security of +obs!and other types of bene%ts. They may lack strong moti*ations to make higherpro%ts as pro%ts would go to the organi"ation. They may be contented withonly satisfactory le*el of pro%ts rather than maximum pro%ts.


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MB0026- Unit /- #e7ene Anal4sis And

Pricing Policies

Unit / #e7ene Anal4sis And Pricing Policies

Meaning And )ifferent '4pes Of #e7enes

#e7ene is t5e income recei7ed 94 t5e firm . here are three concepts of revenue :

'otal re7ene A7erage re7ene and Marginal re7ene

1% 'otal re7ene >'#?=

'otal re7ene refers to t5e total amont of mone4 t5at t5e firm recei7es from

t5e sale of its prodcts i%e% %gross re7ene..

2%A7erage re7ene >A#?

A7erage re7ene is t5e re7ene per nit of t5e commodit4 sold. It can be obtained

by di*iding the T9 by the number of units sold. Then! A9 T9H A9 '0I'0 'I.

'5s a7erage re7ene means price. '5erefore a7erage re7ene cr7e of t5e firm is

t5e same as demand cr7e of t5e consmer%

herefore, in economics we use ? and price as synonymous except in the context of

price discrimination by the seller. 'athematically 5 / ?.

+% Marginal #e7ene >M#?
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'arginal revenue is the net increase in total revenue reali#ed from selling one more unit

of a product. It is t5e additional re7ene earned 94 selling an additional nit of

otpt 94 t5e seller%

'? / / where ? represents change in ?

nd indicates change in total $uantity sold.

lso '? / ?n : ?n-&

'arginal revenue is e$ual to the change in total revenue over the change in $uantity

'arginal ?evenue / hange in total revenue4 divided by hange in sales4

Onits 5rice ? ? '?

& )8 )8 )8 -

) &B 39 &B &9

3 &9 ;B &9 &)

; &; 9 &; B

&) 98 &) ;

#elations5ip 9et;een 'otal re7ene A7erage re7ene and Marginal #e7ene

concepts

In order to understand the relationship between ?, ? and '?, we can prepare a

hypothetical revenue schedule.

!m9er of Units sold '# >#s%? A# >#s%? M# >#s%?

& &8 &8 :


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!m9er of Units sold

3rice per @nit Bs.;.

4B %B MB

& 3 3 3

) 3 '1 3

3 3 )/ 3

; 3 -) 3

3 /I 3

9 3 /3 3

nder perfect market condition! the A9 cur*e will be a hori"ontal straight lineand parallel to R axis. This is because a %rm has to sell its product at theconstant existing market price. The M9 cure also coincides with the A9 cur*e.

This is because additional units are sold at the same constant price in themarket.

(. @nder Imperfect Market


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nder all forms of imperfect markets! the relation between T9! A9! and M9 isdi5erent. This can be understood with the help of the following imaginaryre*enue schedule.

!m9er of Units sold %B4B or price in

Bs. MB

& 'I 'I 'I

) '3 4 3

3 )/ 3 1

; )3 2 /

-I 1 )

9 -I 0 I

K )3 / ,)

8rom the abo*e table it is clear thatK

(n order to increase the sales! a %rm is reducing its price! hence A9 falls.

'. As a result of fall in price! T9 increase but at a diminishing rate.). T9 will be higher when M9 is "ero-. T9 falls when M9 becomes negati*e/. A9 and M9 both declines. #ut fall in M9 will be greater than the fall in

A9.0. The relationship between A9 and M9 cur*es is determined by the

elasticity of demand on the a*erage re*enue cur*e.


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@nder imperfect market, the 4B curve of an individual rm slopedownwards from left to right.This is becauseU a %rm can sell largeruantities only when it reduces the price. =ence! A9 cur*e has a negati*eslope.

The M9 cur*e is similar to that of the A9 cur*e. #ut M9 is less than A9. A9and M9 cur*es are di5erent. 7enerally M9 cur*e lies below the A9 cur*e.

%he 4B curve of the rm or the seller and the demand curve of thebuyer is the same

Since! the demand cur*e represents graphically the uantities demanded bythe buyers at *arious prices it shows the A9 at which the *arious amounts ofthe goods that are sold by the seller. This is because the price paid by thebuyer is the re*enue for the seller :ne man


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in:ed )emand cr7e and t5e corresponding Marginal #e7ene cr7e

In certain cases, the kinked demand curve may show a high elasticity in the lower portion

of the demand curve beyond the kink and low elasticity in higher portion of the demandcurve before the kink 'arginal revenue to such a demand curve will show a gap but

Instead of at a lower level, it will start at a higher level.

#elations5ip 9et;een A# M# '# and Elasticit4 of )emand


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In the diagram ? is the average revenue curve, '? is the marginal revenue curve and

7 is the total revenue curve. t the middle point of average revenue curve elasticity

is e$ual to one. 7n its lower half it is less than one and on the upper half it is greater thanone. '? corresponding to the middle point of the ? curve is #ero. his is shown by

the fact that '? curve cuts the x axis at > which corresponds to the point on the ?

curve. If the $uantity is greater than 7> it will correspond to that portion of the ? curvewhere eL& marginal revenue is negative because '? goes below the x axis. Mikewise for

a $uantity less than 7>, eJ& and the marginal revenue is positive. his means that if

$uantity greater than 7> is sold, the total revenue will be diminishing and for a $uantityless than 7> the total revenue ? will be increasing. hus the total revenue ? will be

maximum at the point 6 where elasticity is e$ual to one and marginal revenue is #ero.

Pricing Policies

detailed study of the market structure gives us information about the way in which

Pricing polic4 refers to t5e polic4 of setting t5e price of t5e prodct or prodcts and

ser7ices 94 t5e management after ta:ing into accont of 7arios internal ande


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&A. 2fficient management of resources.

)8. 5olicy towards percentage of profits and dividend distribution.

)&. dvertising and sales promotion policies.)). 1age policy and sales turn over policy etc.

)3. he stages of the product on the product life cycle.

);. Ose pattern of the product.). 2xtent of the distinctiveness of the product and extent of product differentiation

practiced by the firm.

)9. omposition of the product and life of the firm.

O9ecti7es Of '5e Price Polic4

&. Profit ma


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uncertain atmosphere in business circles. (ales plan becomes difficult

under such circumstances. 6ence, price stability is one of the pre re$uisite

conditions for steady and persistent growth of a firm. stable price policyonly can win the confidence of customers and may add to the good will of

the concern. It builds up the reputation and image of the firm.

;. acing competiti7e sitation

7ne of the objectives of the pricing policy is to face the competitivesituations in the market. In many cases, this policy has been merely

influenced by the market share psychology. 1herever companies are

aware of specific competitive products, they try to match the prices oftheir products with those of their rivals to expand the volume of their

business. 'ost of the firms are not merely interested in meeting

competition but are keen to prevent it. 6ence, a firm is always busy with

its counter business strategy.

. Maintenance of mar:et s5are

Mar:et s5are refers to t5e s5are of a firmFs sales of a particlar

prodct in t5e total sales of all firms in t5e mar:et% he economic

strength and success of a firm is measured in terms of its market share. Ina competitive world, each firm makes a successful attempt to expand its

market share. If it is impossible, it has to maintain its existing market

share. ny decline in market share is a symptom of the poor performanceof a firm. 6ence, the pricing policy has to assist a firm to maintain its

market share at any cost.

9. Captring t5e Mar:et

nother objective in recent years is to capture the market, dominate the

market, command and control the market in the long run. In order toachieve this goal, sometimes the firm fixes a lower price for its product

and at other times even it may sell at a loss in the short term. It may prove

beneficial in the long run. (uch a pricing is generally followed in pricesensitive markets.

K. Entr4 into ne; mar:ets%

part from growth, market share expansion, diversification in its activities

a firm makes a special attempt to enter into new markets. 2ntry into new

markets speaks about the successful story of the firm. onse$uently, it hasto bear the pioneering and subse$uent risks and uncertainties. he price set

by a firm has to be so attractive that the buyers in other markets have to

switch on to the products of the candidate firm.


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B. )eeper penetration of t5e mar:et

he pricing policy has to be designed in such a manner that a firm can

make inroads into the market with minimum difficulties. eeperpenetration is the first step in the direction of capturing and dominating the

market in the latter stages.

A. Ac5ie7ing a target retrn

predetermined target return on capital investment and sales turnover is

another long run pricing objective of a firm. he targets are set accordingto the position of individual firm. 6ence, prices of the products are so

calculated as to earn the target return on cost of production, sales and

capital investment. ifferent target returns may be fixed for differentproducts or brands or markets but such returns should be related to a

single overall rate of return target.

&8. 'arget profit on t5e entire prodct line irrespecti7e of profit le7el of

indi7idal prodcts%

he price set by a firm should increase the sale of all the products rather

than yield a profit on one product only. rational pricing policy should

always keep in view the entire product line and maximum total sales

revenue from the sale of all products% A prodct line ma4 9e defined as a

grop of prodcts ;5ic5 5a7e similar p54sical featres and perform

generall4 similar fnctions. In a product line, a few products are

regarded as less profit earning products and others are considered as more

profit earning. 6ence, a proper balance in pricing is re$uired.

&&. $ong rn ;elfare of t5e firm

firm has multiple objectives. hey are laid down on the basis of past

experience and future expectations. (imultaneous achievement of allobjectives are necessary for the over all growth of a firm. 7bjective of the

pricing policy has to be designed in such a way as to fulfill the long run

interests of the firm keeping internal conditions and external environment

in mind.

&). A9ilit4 to pa4

5ricing decisions are sometimes taken on the basis of the ability to pay of

the customers, i.e., higher price can be charged to those who can afford to

pay. (uch a policy is generally followed by those people who supplydifferent types of services to their customers.

&3. Et5ical Pricing


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%asically, pricing policy should be based on certain ethical principles.

%usiness without ethics is a sin. 1hile setting the prices, some moral

standards are to be followed. lthough profit is one of the most importantobjectives, a firm cannot earn it in a moral vacuum. Instead of s$uee#ing

customer, a firm has to charge moderate prices for its products. he

pricing policy has to secure reasonable amount of profits to a firm topreserve the interests of the community and promote its welfare.

%esides these goals, there are various other objectives such as promotion

of new items, steady working of p

manegerial economics for quick revision

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