CONTENTS

Unit Contents Page No.

Nature and Importance of Managerial Economics

1.1 Objectives
1.2 Meaning and Concept of Managerial economics
1.3 Nature and scope of Managerial economics
1 1.4 Objectives of firm 11-21
1.5 Theories of firm
1.6 Role of Managerial Economist
1.7 Summary
1.8 Exercise

Demand Analysis
2.1. Objectives
2.2. Meaning and Law of Demand
2.3. Demand Schedule
2.4. Determinants of demand
2 22-39
2.5. Law of demand
2.6. Elasticity of Demand
2.7. Summary
2.8. Self-Assessment Questions
2.9. Answers

Supply Theory
3.1 Session Objectives
3.2 Concept of Supply
3.3 Law of supply
3.4 Factors affecting Supply
3 40-46
3.5 Production cost and analysis
3.6 Production function
3.7 Productivity
3.8 Summary
3.9 Exercise
Unit Contents Page No.

Cost and Production Analysis

4.1 Objectives
4.2 Cost Concepts
4.3 Classification of Cost
4.4 Short run and long run costs
4 4.5 Production functions 47-70
4.6 Law of Variable Proportion
4.7 Iso-Quants and Iso-Cost Lines
4.8 Economies of scale
4.9 Summary
4.10 Exercise

Market Structure
5.1. Objectives
5.2. Meaning and Concept of Market Structure
5.3. Perfect Competition
5.4. Monopoly Competition
5 71-85
5.5. Monopolistic Competition
5.6. Oligopoly
5.7. Price discrimination
5.8. Summary
5.9. Exercise

National Income
6.1. Objectives
6.2. Meaning and Concept of National Income
6.3. Methods of Measurement of National Income
6 6.4. Inflation and its types 86-106
6.5. Theories of Profit
6.6. Fiscal Policy and its impact on decision making
6.7. Summary
6.8. Exercise
 Managerial Economics

Unit – 1 NOTES
Nature and Importance of
Managerial Economics

STRUCTURE
1.1 Objectives
1.2 Meaning and Concept of Managerial economics
1.3 Nature and scope of Managerial economics
1.4 Objectives of firm
1.5 Theories of firm
1.6 Role of Managerial Economist
1.7 Summary
1.8 Exercise

1.1 OBJECTIVES

After studying this chapter, students shall be able to:

• Understand the concept of Managerial Economics
• Explain the nature and scope of Managerial Economics
• Understand the role of Managerial Economist and theories of firm.

1.2 MEANING AND CONCEPT OF MANAGERIAL ECONOMICS

Managerial economics is specialised branch of economics. Sometimes it is

interchangeably used with business economics. Managerial economics is
concerned with decision making at the level of firm. It has been described as an
economics applied for decision making. It is viewed as a special branch of
economics bridging the gap between pure economic theory and managerial
practices. It is defined as an application of economic theory and methodology
for decision making by the management of the business firms. Nature and
Importance of
Managerial Economics 11
 Managerial Economics Managerial economics is the study of economic theory and its applications
by business managers for taking informed decisions. This can further be
explained with the help of simple example: An important event that is
NOTES demonetisation took place in Indian economy on 8th Nov 2016 and as a result
the Maruti auto Ltd has to reconsider the production of cars during the quarter
ending Dec 2016. Thus, the forecasting as to how much to produce keeping in
view the immediate effect of demonetisation is the part of managerial economics.
The decision has been taken by managerial economist using economic theory
that is the change in demand due to demonetisation.
Managerial economics is the integration of economics, decision science and
business management. Managerial economics is a specific discipline of
management studies which deals with application of economic theory and
techniques of business management.
Definitions: Managerial economics is the application of various economic
theories, techniques and principles to solve managerial problems by managerial
economist.
“Managerial economics is the integration of economic theory with business
practice for the purpose of facilitating decision making and forward planning by
the management.”- Spencer and Seigelman
According to Mc Nair and Meriam, “Managerial economics is the use of
economic models of thought to analyse business situation”.
D.C. Hague describes Managerial Economics as “a fundamental academic
subject which seeks to understand and analyse the problems of business decision
making.”
In the opinion of W.W. Haynes “Managerial Economics is the study of the
allocation of resources available to a firm of other unit of management among
the activities of that unit.”
According to Floyd E. Gillis, “Managerial Economics deals almost
exclusively with those busi¬ness situations that can be quantified and dealt with
in a model or at least approximated quantitatively.”

1.3 NATURE OF MANAGERIAL ECONOMICS

Managerial economics is a science applied to decision making. It bridges

the gap between abstract theory and managerial practice. It concentrates more
on the method of reasoning. In short, managerial economics is “Economics
applied in decision making”.
• Managerial economics deals with business problems using economic
Nature and theories and techniques.
Importance of
12 Managerial Economics
 • Managerial economics is a science which uses specified knowledge for Managerial Economics
taking business decisions.
• The Managerial economics is more of micro-economics that is the firm,
demand, production etc. NOTES
• Managerial economics also comprises of macro-economic concepts such
as inflation, monetary policy, national income etc for adjusting the
business policies to the environment.
• Managerial economics helps to take ideal decision pertaining to pricing
and promotion strategies.
• Application of managerial economics determines the projected demand,
projected output and accordingly the business managers are able to take
decision related to production, expansion etc.

Nature of Managerial economics

Scope of Managerial Economics

The scope of managerial economics refers to its area of study. Managerial
economics has its roots in economic theory. The empirical nature of manage¬rial
economics makes its scope wider. Managerial economics refers to those aspects
of economic theory and application which are directly relevant to the practice of
manage¬ment and the decision making process within the enterprise. Managerial
economics deals with all the problems and concern areas of manager and includes
demand analysis, demand forecasting, production function, cost analysis,
inventory management, pricing systems etc.
1. Demand forecasting
Managerial economics is essentially micro-economics but uses
econometrics and statistical tools to project the demand in future. A
firm is involved in the production of goods and services. The common Nature and
economic problems are how much to produce, for whom to produce Importance of
Managerial Economics 13
 Managerial Economics and where to produce. Therefore, the role is to predict the demand in
future to decide as to how much is to be produced in different
locations/areas. Thus, different techniques are used to forecast the
NOTES demand and accordingly take a decision.

2. Production and Cost Analysis

Production means converting of inputs into output and cost estimates
are essential for taking business decisions. Pricing decisions also play
important role in the amount of revenue, the level of income and the
volume of profits earned by firm. An element of cost uncertainty exists
because all the factors determining costs are not always known or
controllable. Firm is basically looking towards mechanism to reduce
the cost by maximising the output. Managerial economics touches
these aspects of cost analysis as an effective knowledge and the
application of which is corner stone for the success of a firm.

3. Pricing decisions
Pricing decision is important aspect of managerial economics. The
control functions of an enterprise are not only productions but pricing
as well. When pricing a commodity, the cost of production has to be
taken into account. Business decisions are greatly influenced by
pervading market structure and the structure of markets that has been
evolved by the nature of competition existing in the market. The
decision of pricing may be different for different markets that is for
perfect competition, monopolistic and monopoly markets. The firm is
particularly interested in reducing the cost and increasing the output
using suitable pricing policies. Thus, price setting is one of the
important policies of the firm. Therefore, the study of different markets
is done to determine the price-output keeping in view the objectives
and policies of firm. The determinants of estimating costs, the
relationship between cost and output, the forecast of cost and profit
are very important for a firm.

4. Profit Management
Firm is a commercial unit and the success of firm is determined
through the amount of profit generated during a specific period. Profit
forecasting is an essential function of any management. It relates to
projection of future earnings and involves the analysis of actual and
expected behaviour of firms, the sales volume, prices and
com¬petitor’s strategies, etc. The main aspects covered under this area
are the nature and measurement of profit, and profit policies of special
significance to managerial decision making.
Nature and
Importance of
14 Managerial Economics
 5. Capital Management Managerial Economics
Cost-benefit analysis is integral part of firm. It involves the equi-
marginal principle. The objec¬tive is to assure the most profitable use
of funds, which means that funds must not be applied when the NOTES
managerial returns are less than in other uses. The main topics dealt
with are: Cost of Capital, Rate of Return and Selection of Projects.
The firm has to study the cost of employing capital and the rate of
return expected from such investment. Thus, sufficient capital should
be available to deploy the resources and optimum allocation of capital
is required in order to earn return on capital.

6. Market structure and conditions

The knowledge of different types of markets plays a vital role in any
business. The number of sellers, buyers, nature of competition, and
the role of Government determines the nature of policies to be adopted
by a firm in the market.

1.4 FIRM AND ITS OBJECTIVES

A firm is intended to do business and organises the factors of production to

produce goods and services. The firm is therefore formed for converting inputs
into outputs or providing services. The firm can have the following objectives.
• To maximise the profit of the organisation.
• To maximise the sales.
• To maximise the Output.
• To maximise the shareholder’s return on investment.
• To increase the market share.
• To maximise the growth of the organisation.

1.5 THEORIES OF FIRM

Economists have developed various theories of firm based on the different

kinds of goals of modern firms. The important theories of firm are discussed
below:
1. The Profit Maximisation Model (Traditional Theory)
2. Sales Maximization Theory (Baumol’s Theory)
Nature and
Importance of
Managerial Economics 15
 Managerial Economics Profit Maximisation Theory
Traditional economic theory assumes that the aim of the firm is to maximise
profits in the short run by MR = MC approach. That is Marginal revenue is equal
NOTES to Marginal cost. Both small and large firms do compete to maximise their profit
by using modern techniques in business. The firms are making efforts for cost
reduction, cost cutting and cost minimisation in order to maximise profits.
Propositions of Profit-Maximisation Model are as follows:
1. A firm is producing unit and converts various inputs into outputs of
higher value under a given technique of production.
2. Basic objective is to maximize the profit.
3. Firm operates under a given market condition.
4. Firm will select that alternative course of action which helps to
maximize consistent profits.

Firm also considers various factors into account to maximize its profits.
1. Firm makes an attempt to change its prices, input and output quantities
to maximize its profits.
2. Pricing and business strategies of rival firms and its impact on the
working of given firm.
3. Aggressive sales promotion policies adopted by rival firms in the
market.
4. Without inducing the workers to demand higher wages and salaries
leading to rise in operation cost.
5. Maintaining the quality of products & services to customers.
6. Maintaining a reputation, name and fame in the market.
7. The firms having perfect markets as well as imperfect markets tend to
maximize their profits. A firm is price taker under perfect competition
markets whereas it is price-searcher under imperfect markets.

Assumptions of Model
1. Profit Maximisation is the main goal of the firm.
2. Rational behavior on the part of the firm to achieve its goal of profit
maximization.
3. The firm is managed by owner (Entrepreneur).
4. Profit maximization is the objective of firm for both perfect
competition and imperfect competition.
Nature and
Importance of
16 Managerial Economics
Criticism of Profit Maximisation Theory Managerial Economics
1. Dynamics of Business Environment
Environment is turbulent and therefore it may not always be possible
NOTES
to maximise the profit due to changes in policy and other
uncontrollable variables.

2. Conflict with other theories like sales maximisation model

An organisation has multiple objectives like increasing the market
share, achieving a set growth rate, maximisation of sales which
contradict the theory of profit maximisation.

3. Personal interest of Managers/Directors

The directors and managers also have their own interest to focus more
on sales since their salaries and incentives are linked to the sales.

4. Focus on non-profit goals

Organisations give preference to non-profit goals that is customer
satisfaction, efficiency, good quality and services. Thus, the objectives
of firm are different than that of profit making.

Determination of Profit -Maximisation

1. Marginal Revenue and Marginal Cost Approach
2. Total Revenue and Total Cost Approach
The Profit Maximizing Firm: MR-MC Approach

Nature and
Fig-1 (Profit Determination using MR-MC Approach) Importance of
Managerial Economics 17
 Managerial Economics Explanation – Here, MR = MC at pint N (MC must cut MR from below)
At point N the output is Q∏.
Objective of business is generation of the largest amount of Profit = (Total
NOTES
Revenue-Total Cost)
Traditionally, efficiency of a firm measured in terms of its profit generating
capacity

Criticism
a. Confusion on measure of profit
b. Confusion on period of time
c. Validity questioned in competitive markets

Baumol’s Theory of Sales Revenue Maximization

The sales maximisation model has been developed by an American
economist Prof Boumal. The objective of the model is maximisation of sales and
not the profit maximisation. The theory can be understood with the help of
suitable example: In this model the business is managed by the Managers or
Directors who are different from the owners. The objective of Manager or
Director is to maximise sales and not profit due to various reasons.

Arguments for Sales Maximisation Model

• Maximization of Sales does not mean maximization of physical sales but
maximization of total sales revenue.
• Managers are more interested in maximizing sales rather than profit.
• Increase in sales and expansion in its market share is a sign of healthy
growth of a normal company.
• It increases the competitive ability of the firm and enhances its influence
in the market.
• The salaries of top management are directly linked to it.
• It helps in enhancing the prestige and reputation of top management,
distribute more dividends to share holders and increase the wages of
workers and keep them happy.
• The financial and other lending institutions always keep a watch on the
sales revenue of a firm as it is an indication of financial health of a firm.

Nature and
Importance of
18 Managerial Economics
 Managerial Economics

NOTES

Explanation – at output Q2 -TR is Max and at Output Q1 Sales is

Maximised.
Owner is of the opinion that TR should be maximum and prefers Q2 output;
Whereas the directors (running the business) are interested in sales
maximisation at output of Q1;
However with the profit satisficing approach they decide to have a profit in
between sales max and TR max at output of Q3;
Therefore, the theory proposes that Q3 should be the output to be produced.

Marris Growth Maximisation Model –Managerial Theory of Firm

Prof Marris’s model states that the firm aims towards the growth
maximisation. Therefore, the model has been explained with an object of
balanced growth over a period of time.
Maximise g =gD = gc
G= balanced growth rate
gD = growth of demand for the products (maximises the utility of managers)
gc = growth of supply of capital (Shareholders aim at maximisation of
growth of corporate capital, which is taken to be measure of size of firm)
Utility function of Managers and shareholders –Utility function includes
variables such as profit, market share and capital while the utility function of
managers includes variables such as salaries, power and job security. More in
detail the utility function of owners (shareholders) and mangers can be put
up as:
Uo =f(capital, output, profit, market share, public esteem) Nature and
Um =f(Status, power, salaries, job security etc) Importance of
Managerial Economics 19
 Managerial Economics As stated in the Marris model the difference is there between manager and
shareholder but then the common thing is the size of firm. Further, the theory
argues that the managers do not maximise the absolute growth but the rate of
NOTES growth of firm. Marris further added that utility of manager is a function of
growth rate of capital and not of profits. Also, the growth rate of capital includes
the total volume of assets, inventory levels, cash reserves. Moreover, the utility
function of owners can be expressed as Uo =f(gc). On the other hand the utility
function of managers can be expressed as Um =f(gD,s).
gD = growth rate of demand (Marris assumes that variables like salaries,
power and status are positively related to gD.
s= job security

Demerits of Marris Model

1. Simultaneously achieving the growth maximisation and profit
maximisation is not possible.
2. Simultaneously maximising the utility functions by manager and
owner may not be possible.

1.6 ROLE OF MANAGERIAL ECONOMIST

Managerial economist is expected to analyse and resolve the managerial

problems. He has in depth knowledge of the subject and is expected to perform
multiple functions which are listed below:

• Demand estimation and Forecasting

Managerial economist is required to predict the demand for production
planning and decision making. Thus, planning in advance is done based on
forecasting for deciding the future course of action. Moreover, sales forecasting
is another important function of managerial economist. Based on the sales
forecast decisions are taken for production and marketing.
• Managerial economist is responsible for the analysis of market survey
to determine the nature and extent of competition. Managerial economist also
analyses the issues and problems of concerned Industry and assists the business
planning process of the firm.
• Advising on pricing, investment and capital budgeting policies
• Directing economic research activity
Briefing the management on current domestic and global economic issues
and emerging challenges.
Nature and Managerial economist is expected to have knowledge of entire economy.
Importance of
Managerial economist is expected to work in harmony with policymakers,
20 Managerial Economics
because the business economist identifies constraints and alternatives, which Managerial Economics
would help in decision making. Moreover, he also takes decision based on the
monetary policy, fiscal policy and industrial policy.
NOTES

1.7 SUMMARY

Managerial economics is specialised branch of economics and helps in

decision making using various applications and theoretical models. Managerial
economics is practised by business managers and economist for taking decisions
related to demand and sales forecasting, production, pricing, output etc. The
environment is turbulent and therefore routine decisions cannot be taken without
considering the business dynamics. Therefore, an economist needs to have
updated knowledge of markets, fiscal policy, monetary policy etc to take decision
on managerial issues. Most important functions of managerial economist are
taking informed decisions and planning for future.

1.7 EXERCISE

1. Discuss the nature and scope of managerial economics?

2. Define Managerial economics and its importance?
3. Discuss the role and functions of managerial economist?
4. Explain the profit maximisation theory of firm?
5. Discuss the Baumol’s theory of sales maximisation with the help of
suitable diagram?

*****

Nature and
Importance of
Managerial Economics 21
 Managerial Economics

NOTES
Unit -2 Demand Analysis

STRUCTURE
2.1. Objectives
2.2. Meaning and Law of Demand
2.3. Demand Schedule
2.4. Determinants of demand
2.5. Law of demand
2.6. Elasticity of Demand
2.7. Summary
2.8. Self-Assessment Questions
2.9. Answers

2.1 OBJECTIVES

After studying this chapter, students shall be able to:

• Understand the concept of demand and its determinants.
• Explain the concept of elasticity of demand and its types.
• To analyse the practical importance of elasticity in business economics.

2.2 MEANING AND LAW OF DEMAND

The term demand signifies the willingness and ability to buy at a given point
of time. In day to day life the demand of the product means the product having
some utility for satisfying human wants. Demand for a product depends on the
utility and the product may have utility for one person but may not be used by
others for e.g. Pizza, burger, Pepsi etc. Health conscious persons may not use
products like Pizza, burger and therefore these products would not be of use to
them. Mr Raj wants to own Mercedes car since he has a desire for Mercedes.
The desire towards Mercedes car is reflecting the consumer attitude towards the
Mercedes car but it cannot be said to be the demand. Thus, desire for a
commodity does not constitute demand. A consumer must be having purchasing
power (ability to pay) as well as willingness to buy at a particular price and time
22 Demand Analysis to constitute demand. Let’s understand it with an example:
 Mr Senior Citizen goes to E-zone electronics to search for Smart Phone. Managerial Economics
The salesperson offered him I-phone 7 and explained the features of product. Mr
Senior citizen has desire to own a mobile at the same time his purchasing power
is also there. He has sufficient cash available to buy that mobile. NOTES
Do you think that Mr Senior citizen has created the demand for I-Phone 7?
Of course he has desire as well as purchasing power but is not willing to buy i-
Phone 7 and thus the process of demand is not completed. Thus, demand of a
product or service means that there should be desire to own a particular
commodity or service along with willingness to buy and also having the
purchasing power.
Demand is the quantity of a commodity that a consumer is willing and
ablility to buy at each possible price during a given period of time.
The essential elements of demand are
a) Willingness to buy
b) Price of commodity
c) Time period
d) Quantity of commodity
e) Ability to buy (Purchasing power)

2.3 DEMAND SCHEDULE

Demand Schedule
Tabular representation of price and quantity for an Individual consumer is
known as individual demand schedule.

Table 2.1 Demand Schedule for Apples

Thus, we can see from table 2.1 that when the price is Rs 70 per kg the
consumer is having demand of 4 kg and with the increase in price the demand is
reducing that is when price is Rs 140 per kg the demand has reduced to 1 Kg.
This inverse relationship of demand and quantity shall be dealt in this unit as law
of demand.
Demand Analysis 23
 Managerial Economics Individual Demand Curve
The tabular representation (table 2.1) can be depicted through graph as sown
in Fig 2.1. Individual demand curve is the combination of the price and quantities
NOTES shown in demand schedule. At point A, (fig 2.1) consumer is buying 1 Kg of
Apple for a price of Rs 140, as the price reduces to Rs 120 the quantity demanded
increases to 2 Kg at point B and when price reduces to 95 Rs the quantity
demanded at point C increase to 3 Kg and with the decrease in price to Rs 70 the
quantity demanded at point D increases to 4 kg of Apple as shown in Fig 2.1. It
shows the quantity demanded at each point with the change in price. The demand
curve shows the relationship between price and quantity and therefore known as
price demand curve. The demand curve is downward sloping which indicates
that with the fall in price, quantity demanded increases (other things remaining
the same i.e. ceteris paribus).

Fig – 2.1 Individual Demand Curve

Market Demand Schedule and Market Demand Curve

Market demand is the sum total of demand of all the individuals in the
market. Market demand schedule is the tabular representation of all the
individuals in the market. Thus, market demand is the sum total of all the
individuals in the market. Let us take the case of two individuals as shown in
table 2.2.
Table 2.2 Market Demand Schedule for Apples

24 Demand Analysis
 Managerial Economics

NOTES

Fig – 2.2 Market Demand Curve

We can see from the demand schedule that for two individual quantity
demanded Q1 and Q2 are shown that is the quantity demanded is 1 Kg at a price
of Rs 140 by both and amounting to 2 Kg for market. The demand schedule has
been depicted in the graphical form in Fig 2.2. Market demand curve is
downward sloping, showing the negative relationship between price and quantity.
Thus, as the price decreases the quantity demanded increases.

2.4 DETERMINANTS OF DEMAND

Determinants of Demand
The quantity demanded further depends on factors such as price, Income,
taste and preference, nature of commodity, future expectations etc.

a. Price of a given commodity

There is inverse relationship between quantity demanded (Q)and price
(P) for a given product. Demand (D) is a function of price (P) and can
be expressed as D = f (P). The inverse relationship is known as ‘Law
of Demand’. Thus, if the price of product increase from Rs 120 to Rs
180 than the quantity demanded shall reduce provided other things
remains the same. Thus, an increase in price lads to fall in quantity
demanded.

b. Price of related goods

Demand can further be understood with the change in price of related
goods. Related good refers to either substitute goods or complimentary
goods. Substitute goods are those which can be used in place of one
another for e.g. tea and coffee. Let us understand the case of substitute
goods with the help of an example:

Demand Analysis 25
 Managerial Economics

NOTES

Suppose the price of coffee increases from Rs 50 per unit to Rs 80 per

unit than the demand for tea (substitute product) will increase due to
the reason that tea becomes relatively cheaper than that of coffee. Thus,
there is direct relationship between substitute products for price (x)
and demand (y).
The related goods may be used together and are known as
complimentary for e.g. Car and Petrol, Pen and Refill, Pizza and Pizza
base. Let us assume that the price of petrol increases as a result the
demand for car will decrease. Similarly, if the price of pizza base
increases than the demand for pizza will decrease so there is inverse
relationship between the complimentary products.

c. Income of consumer
The quantity demanded is also affected with the increase in Income or
decrease in income. The normal goods are those which are of relatively
good quality/standard quality for which the acceptance in high further
they can be national products or private label products. The other type
of goods can be inferior goods which are generally used by poor people
having low income and thus substandard quality or coarse grain might
be used due to low income. Thus, if income increases for e.g. for a
service class if 7th Pay commission is implemented the income will
eventually increase and thus the quantity demanded for normal goods
shall increase. Similarly for a person having low wages if Minimum
wages act is implemented where Minimum salary is 15000 per month
so the person is likely to shift his consumption from inferior goods to
standard goods may be some private label brands owing to increase in
income. However, in this case the demand for inferior goods will not
increase with the increase in income since the person is shifting to
other types of products.

d. Taste and Preference

The demand for a product depends on the taste and preference of
consumer. For e.g. McDonalds introduced different products including
burger to Indian market but for the first year of inception they could
not get market share and the customers visiting to this store were
limited. However, they studies the taste and preference of customers
in India and found that Indians do prefer vada pao and Aloo tikki as a
result they renamed the burger as Aloo tikka burger which was well
26 Demand Analysis accepted and the people started using burger. Thus, developing the
 taste of the people will lead to the increase in demand for e.g. trend of Managerial Economics
Jeans in India has been accepted widely thus leading to the increase
in demand of Jeans by Indians.
NOTES
e. Future expectation for change in price
The demand of a product is likely to be affected by the possible change
in price of a commodity. For e.g. If there is possibility of increase in
the Gold price than the customers will start buying gold due to the
reasons that prices are likely to increase. Thus, if there is news, rumour
or possibility of increase in price of a commodity the demand will
increase at present. Similarly, if there is news that global stock market
is likely to slide that people will start selling with the belief that the
prices will slash. Thus, if there is any reason for decrease in the prices
than people will start selling it.

2.5 LAW OF DEMAND

Law of demand states the inverse relationship between price and quantity
demanded, other things remaining the same (ceteris paribus). In general the
economics laws are hypothetical in nature that is we understand the relationship
between two variables keeping other factors constant and the economic laws
cannot be proved experimentally. Therefore, there is inverse relationship between
price and quantity demanded provided other factors such as income, taste and
preference, price of related goods do not change.

Assumptions of Law of Demand

The law of demand hold true provided other things remain the same (Ceteris
Paribus). The assumptions are based on no change in other factors.
a. Income of consumers do not change
b. Price of substitute goods and complementary goods do not change
c. Taste and Preference of the consumer remain the same
d. There is no expectation of change in price in future

Facts about Law of Demand

a. Inverse Relationship
The law of demand states the inverse relationship between price and
quantity demanded. The law of demand affirms that an increase in
price tends to reduce the quantity demanded and a fall in price will
lead to an increase in the quantity demanded.

Demand Analysis 27
 Managerial Economics b. No Proportional relationship
The relationship of price and demand is not proportionate that if price
increases by 20 % than the quantity demanded may fall by any
NOTES proportion.

c. Qualitative and not Quantitative

Law of demand does not provide any solution to the magnitude of
change in quantity demanded with the change in price. Hence, it is
qualitative in nature.

Reasons for the operation of Law of Demand

The various reasons for the Law of Demand are as follows

a. Law of Diminishing Marginal Utility

Law of diminishing marginal utility states that as we consume more
and more units of a commodity the utility derived from each successive
unit goes on decreasing. Therefore, the demand for a commodity
depends on its utility ultimately leading to the satisfaction. If a
consumer gets more utility and satisfaction he pays more and as the
utility starts decreasing he will pay less to buy additional units of the
commodity. The consumer will buy more and more units of
commodity when he has to pay lesser price for additional unit.

b. Substitution effect
Substitution is another reason for the operation of Law of demand. If
the price of commodity falls, than it becomes relatively cheaper than
that of substitute products whose price has not fallen. Therefore, the
demand for commodity rises due to this substation effect also known
as complementary effect. For eg the price of Maruti cars reduces in
comparison to immediate competitor Hyundai cars than the demand
for Maruti cars will increase due to substitution effect.

c. Income effect
Income effect can be understood through real income and purchasing
power. Let us understand it with the help of an example. Suppose,
Ashok is fond of consuming tea during office hours and spends 100
Rs per day for a Price of Rs 10 per tea leading to consumption of 10
cups per day. Now, the price of tea per cup reduces to 8 Rs which
means that if he consumes 10 cup per day his real income increases to
Rs 20. He can use this increased income (real income) to purchase
additional units of tea since his purchasing power has increased.
Income effect means effect of change in quantity demanded when real
income of consumer changes due to change in price of a given
Demand Analysis commodity.
28
 d. Number of consumers Managerial Economics
The number of consumers for a commodity increase due to reduce in
price of a commodity. For eg. With the reduction in the price of Maruti
cars the consumers are more likely to purchase Maruti car therefore NOTES
leads to increase in quantity demanded of cars. The price of Mobile
phones (smart phone) has reduced over period of time and the
consumers are buying more of mobile phones (smart phones) in India.

e. Diverse use of commodity

If a commodity can be put to several uses its demand increase for eg
Milk, electricity etc. If the price of Milk reduces than the usage of milk
for different purposes like tea, drinking, sweet, curd etc also increases.
However, when the price of milk increases its demand will be for most
important purposes.

Exceptions to the Law of Demand

Law of demand
1. Status Symbol
Status symbol has become a way of leading life in its own especially
by the rich class people. The status symbol is attitude to spend more
amounts on Luxury goods and the rich class feel pride in
differentiating themselves with other class of income group. Thus, the
rich class will buy the products for which prices are high or are
increasing and shall stop spending if the prices are reducing or the
product falls within the reach of common man.

2. Necessity of Life
Law of Demand shall not operate for necessity goods. For e.g.
Commodities like rice, sugar, flour, pulses shall be bought even if the
price increases.

3. Change in weather
Weather plays an important role in changing the sentiments of human
being towards demand. For e.g. during summers if the temperature
increases to 47 degrees than people will prefer to buy air conditioner
even if the prices are rising. Similarly, we often see that the prices of
ice-creams are high during summers but still people prefer to buy in
summers.

4. Giffen goods
The concept is known as Giffen paradox as it was first being observed
by Sir Robert Giffen.
Demand Analysis 29
 Managerial Economics

2.6 ELASTICITY
NOTES

Elasticity of demand
Elasticity measures the sensitivity (responsiveness) of quantity demanded
to changes in price and income. Law of demand states that with the increase in
price of goods, quantity demanded decreases, but how much does it decrease?
We did not consider the magnitude of the price change on demand. Elasticity is
the degree to which demand of good or service varies with that of price. Thus, if
there is change in the price of Air-conditioners, Fast-food products, Mobile than
there is change in the quantity demanded. This change of quantity demanded to
that of change in price is said to be the price elasticity of demand. Therefore with
an increase in price or decrease in price there is a change in the quantity
demanded and we have to measure that how much change in quantity is
demanded with that of change in price. Let us understand it with the help of given
example.

2.6.1 Types of Elasticity

Price Elasticity of Demand

Price elasticity of demand is the quantitative measure of consumer behavior
that indicates the quantity of demand of a product or service depending on its
increase or decrease in price. Price elasticity of demand can be calculated by the
percent change in the quantity demanded by the percent change in price.
Price elasticity of demand (PED) measures the sensitivity of quantity
demanded to changes in price. PED is defined as the percentage change in the
quantity of a good demanded divided by the corresponding percentage change
in its price.

Income elasticity of demand

Income elasticity of demand is defined as the percentage change in the
quantity of a good demanded divided by the percentage change in consumer’s
income:

Consider demand for salt, mobiles and air tickets. Which one do you think
has a larger income elasticity of demand? Consider the case when your income
rises from 1000 Rs a month to 5000 Rs a month. How much does your demand
30 Demand Analysis for salt increase? How much does your demand for air tickets? How about
mobiles? Luxury goods have an IED larger than one. Airline travel is a luxury Managerial Economics
good. Necessity goods have an IED less than one. Salt, flour, clothing are
necessity goods.
Normal goods have a positive income elasticity of demand. Most goods are NOTES
normal. Inferior goods have a negative income elasticity of demand (IED).

Cross-price elasticity of demand

The Cross-price elasticity of demand for good i with respect to changes in
the price of good j is:

• Cross-price elasticity is defined as the percent change in the demand

of one good divided by the percent change in the price of another good.
Substitute goods have positive cross-price elasticity of demand. LPG
and benzene are substitute goods. When price of benzene goes up,
quantity of LPG demanded increases. Complement goods have a
negative cross-price elasticity of demand. Cars and benzene are
complement goods. When price of benzene goes up, all other things
kept constant, demand for cars decreases.
• If an increase in the price of one good leads to an increase in the
demand for another good, their cross-price elasticity is positive → the
two goods are substitutes.
• If an increase in the price of one good leads to a decrease in the
demand for another, their cross-price elasticity is negative → the two
goods are complements.

2.6.2 FACTORS DETERMINING ELASTICITY OF DEMAND

FOR DIFFERENT GOODS
We have studied that the change in demand arises due to change in price of
goods. The demand for good may be elastic, unit-elastic or inelastic. There are
number of reasons and we shall explore some of the important factors influencing
elasticity of demand for different goods. Some of the important factors are
discussed for determining the elasticity of demand for different products.
A) Nature of commodity
The elasticity of demand depends on the nature of commodity. The
commodity might be the goods which are necessities like food grains
and the ones those are luxury goods eg. Air-conditioner might be
luxury for lower-middle class, Mercedes car is luxury for Middle class
and so on. Thus, for necessity goods there will be demand whatever
may be the price. In the case of luxury goods if there is small change
in the price of goods the demand is likely to increase that is the demand Demand Analysis 31
 Managerial Economics for luxury goods is elastic in nature. Thus, necessities have inelastic
demand and luxury goods have elastic demand. The income of the
individuals is also to be taken into account to ascertain the goods are
NOTES of luxury nature to class of people.

B) Number of substitutes
If the number of substitute for a product is less than the elasticity will
be low for eg salt and wheat but if close substitutes are available in
the market than the elasticity will be high. Therefore, with the
availability of close substitute there is sensitivity to the change in price.
Thus, if there is increase in the price of Nestle coffee than the
consumers might be looking towards other close substitutes of coffee.
However, if there are no substitutes available for a product than its
said to be perfectly inelastic eg salt.

C) Number of uses of a commodity

If a product can be put to use for different purposes than its elasticity
shall be high for e.g. electricity and milk. If the price of electricity
increases than the use of electricity shall be for important aspects.
Similarly, if the price of milk increases the consumers will be using it
for most essential purposes for childrens or for health reasons
(consuming medicine using milk). However, if the price decreases than
the product can be put to use for multiple purposes eg Milk for eg can
be used for tea, coffee, curd, sweets etc.

D) Level of Price
At very high and at low prices elasticity of demand is usually very low.
If the price of a commodity is very high or very low a slight change in
it will not effect its demand significantly. Pencils, for example, which
are already selling at low prices will not be purchased in larger
quantities if prices fall still lower. On the other hand, slight fall in the
price of cars, for example, will not bring them within the reach of
average consumers. Cars will still be purchased only by the rich who,
in any case, buy them whether the price is somewhat higher or lower.
Therefore, elasticity of demand is usually low at very high and at very
low prices.

E) The period of time under consideration

In the event of a rise in price of a good a consumer’s real income is
reduced and he is compelled to readjust his consumption pattern. He
does so by changing his consumption habits and by finding cheaper
substitutes. Since it takes time to find suitable substitutes and to change
one’s consumption habits, elasticity of demand for any good will tend
to greater the longer the period of time allowed for these adjustments.
32 Demand Analysis
 Elasticity of demand for a good will tend to be lower shorter the period Managerial Economics
of time under consideration.

F) Postponing the use of a commodity NOTES

The demand for a product shall be inelastic if there is no possibility to
postpone the demand of a commodity since the people have to buy it
irrespective of the price e.g. Medicine. On the other hand if there is
possibility to postpone the purchase of commodity than in that case
the demand is elastic e.g. car, washing machine etc.

G) Expenditure on a commodity
The demand shall be inelastic if the amount spent on buying a product
is too small or too high. For example, in case of salt, matchbox the
amount spent is too small and therefore the demand tends to be
inelastic. The demand shall be elastic for the moderate amount spent
on commodity like groceries, cloths etc.

2.6.3 Uses of Elasticity of Demand

Elasticity of demand helps in taking decisions related to change in the price
of goods or services. The most important role is to ensure that change in price is
done keeping in mind other factors such as substitute goods, competitor and
expected change to take place in terms of quantity.
a) Determination of price
The key objective of any firm is to increase revenue as well as profit.
In order to increase the revenue, firms increases the price of its
products to maximize profit. On the other hand, during the course of
increasing price, the producers must not forget that demand and price
share inverse relationship. Producers must be aware that demand falls
with rise in price. And thus, they must increase price of their
commodity to that level where the optimal profit is still achievable.

b) Monopoly price determination

The situation where a single seller controls the entire market for a
specific good or service is known as monopoly. It is assumed that due
to lack of competition. the monopolist charges high prices in the
market. Whereas, monopolist while fixing the price of the market has
to determine whether its product is of elastic or inelastic nature. If the
product is inelastic, the producer can earn profit by setting high price.
However, if the product is elastic, the producer must set low price so
that the consumers are willing to buy the goods.
For example: Mobile data services is necessity of consumers.
Therefore, monopolist who runs the market of mobile data services
can charge high price of data services and earn lucrative profits.
Demand Analysis 33
 Managerial Economics On the other hand, laptop is a luxury good. If the monopolist who
produces laptop, set high price of its product, he may not be able to
sell its products. But, with a reduction in the price he can attract large
NOTES number of consumers and increase the profit of the company.

c) Pricing of joint products

Some goods are produced jointly due to some reasons such sugar and
wine production in a sugar industry. It is difficult to separate the cost
of production of these two goods. This makes it difficult to determine
the price on the basis of cost. In such a situation, the price is
determined on the basis of the elasticity of demand of these two
products i.e. high price is set up for the good having inelastic demand
and low price for the good having elastic demand.

d) Price discrimination
Price discrimination is the act of selling the technically same products
at different prices to different section of consumers or in different in
sub-markets. The policy of price discrimination is profitable to the
monopolist when elasticity of demand for his product is different in
different sub-markets. Those consumers whose demand is inelastic can
be charged a higher price than those with more elastic demand.

e) International trade
Based on the available knowledge it can be stated that change in price
cannot be the cause of major change in demand of the product in case
of inelastic commodity. But even a slight change in price can be the
reason for major change on demand of elastic commodity. Thus, it can
be said that higher price can be charged for inelastic goods and lowest
possible price must be set for elastic goods. Taking into account the
above information, a country may fix higher prices for goods of
inelastic nature. However, if the country wants to export its products,
the nature (elasticity/inelasticity) of the commodity in the importing
country should also be considered.

f) Government Policies
Price elasticity of demand can also be used for formulation of the
taxation policy. One of the ways would be for the government to raise
tax revenue in commodities which are price inelastic. Therefore,
government imposes higher tax on the goods with inelastic demand
and less tax for elastic demand goods.
For example: Government could increase the tax amount in goods
like cigarettes and alcohol. Given how these are the commodities
people choose to purchase regardless of the price tag, the tax revenue
34 Demand Analysis would ¬significantly rise.
 g) Output decisions Managerial Economics
The elasticity of demand helps the firm to decide about production. A
firm chooses the optimum product- mix on the basis of elasticity of
demand for various products. The products having more elastic NOTES
demand are preferred by the firm. The sale of such products can be
increased with a little reduction in their prices.

h) Paradox of poverty
Good harvest (bumper crop), brings poverty to the farmers and this
situation is called ‘Paradox of Poverty’. This paradox is due to the
inelastic nature of demand for most farm products. Since the demand
is inelastic, prices of farm products fall sharply as a result of large
increase in their supply in the year of bumper crops. Due to sharp fall
in prices, the total income of farmers goes down.

2.6.4 Elasticity of Demand –Solved Problems

Ex-1 When Price of a commodity falls by 80%, the quantity demanded of
it increases by 100%. Find out its price elasticity of demand.
Sol-1 Ed = Percentage Change in quantity demanded
Percentage change in price

Ed = 100% = (-)1.25 Demand is highly elastic since Ed >1

-80%

Ex-2 The following information on price and quantity is given. AT price Rs

4, the demand for the good is 25 units. Suppose price of the good increases to Rs
5, and as a result, the demand for the good falls to 20 units. Calculate the price
elasticity.
Sol-2

Price Elasticity of demand Ed = ΔQ x P1

ΔP x Q1
Ed = -5 x 4 = (-).8
1 x 25

Demand Analysis 35
 Managerial Economics

2.7 ELASTICITY OF DEMAND

NOTES
We can further discuss the elasticity of demand under five types based on
the magnitude and ranging from 0 to less than 1 and 1 to infinity. The five
different diagrams are shown in Fig-1

Fig- 2 Elasticity of demand

A) There is no change in quantity means that the required amount of
quantity is needed for the price. Eg Life saving drugs. (Perfectly
inelastic demand or vertical demand).
B) This type of demand means that there is no change in price and
quantity change is infinite. Also known as perfectly elastic demand or
horizontal demand.
C) Unit elastic demand- The change in quantity demanded is equal to
change in price.
D) The change in quantity demanded is more than that of change in price.
Elasticity is more than one. Ed >1 for the goods which are expensive
or luxury products, even with minor change in price the change in
quantity demanded is high.
E) Inelastic demand – With the change in price the change in quantity
demanded is proportionately less. Thus, for e.g. change in price is 20%,
36 Demand Analysis
 and the change in quantity demanded is 10%. Elasticity in this case is Managerial Economics
less than one. Inelastic demand can be seen for necessary goods of for
the goods where price is low (insignificant).
NOTES

2.8 SUMMARY

Demand infers to the quantity demanded by the consumers and includes the
willingness to buy the goods along with purchasing power. Demand is inversely
proportional to price that is as the price increases, quantity demanded decreases
keeping all other factors to be constant i.e ceteris paribus. Elasticity is defined
as the percentage change in the quantity with the change in price. Elasticity varies
from -1 to +1 and has theoretical and practical applications in solving business
problems.

2.9 SELF-ASSESSMENT QUESTIONS

A .Fill in the blanks

1. In demand schedule, quantity demanded varies ...................with Price.
2. If demand changes as a result of price changes, then it is a case of
.................and ..............................in demand.
3. In case of Veblen goods, a fall in price leads to a .............in demand.

B. Solve the given problems

1. Given that 50 units of a good are demanded at a price of 1 per unit. A
reduction in price to 0.20 results in an increase in quantity demanded
to 70 units. Show that these data yield a price elasticity of 0.50. By
what percentage would a 10 percent rise in the price reduce the
quantity demanded, assuming price elasticity remains constant along
the demand curve?
2. Fill in the blanks for each price-quantity combination listed in the
following table. What relationship have you depicted?

Demand Analysis 37
 Managerial Economics C. Long questions
1. Define the concept of demand. Explain the law of demand with the
help of suitable diagram?
NOTES
2. Discuss the determinants of demand and exceptions to the Law of
demand?
3. Discuss the price and income elasticity of demand with the help of
suitable diagram?
4. The demand function of a commodity x is given by Qx =20 – 3Px.
Find out the values of Px, when corresponding values of Qx are given
as: 5,8,11 and14.
5. State with reasons, whether the following items will have elastic or
inelastic demand:
a) Electricity b) Matchbox c) Coke d) Butter for a poor person

2.9 ANSWERS

A. Fill in the blanks

1. Inversely
2. Expansion, contraction
3. Fall

B. Solution
Solution -1
ED = A/B, where A = (70 – 50)/[( 50)] = 0.4 and B = (0.20 – 1.0)/(1.0) =-
0.8 and therefore ED = –0.5 (use absolute value 0.5). A 10 percent price increase
(such as from 1.00 to 1.10) causes a 5 percent reduction in quantity (from 50 to
47.5 units).
Alternatively

So
Ed = Percentage change in quantity / Percentage change in price
Ed = x/10 =.50 or x = 10 *.5 = 5% Thus 5 percent of 50 =2.5

38 Demand Analysis Or final quantity is 50-2.5 =47.5

 Solution- 2 Managerial Economics

NOTES

Thus, when the price elasticity is greater than 1.0 in absolute value, a
reduction in price increases total revenue, and when price elasticity is less than
1.0, a reduction in price decreases total revenue.

*****

Demand Analysis 39
 Managerial Economics

NOTES
Unit - 3 SUPPLY THEORY

STRUCTURE
3.1 Session Objectives
3.2 Concept of Supply
3.3 Law of supply
3.4 Factors affecting Supply
3.5 Production cost and analysis
3.6 Production function
3.7 Productivity
3.8 Summary
3.9 Exercise

3.1. OBJECTIVES

After studying this chapter, students shall be able to

• Understand the concept of Supply.
• Explain the nature and scope of Managerial Economics
• To understand the law of supply and the factors affecting supply.
• To understand the concepts of production and cost and productivity.

3.2. MEANING AND CONCEPT OF SUPPLY

Supply is a relative concept. It is related to price and time.Higher the price

results into higher profits.Hence,higher the price-higher is the supply.
Normally,higher the price,higher is the supply and lower the price,lower is the
supply. Supply means the actual quantity which is brought in the market for sale.
Supply can never exceed stock.

40 Supply Theory
 Managerial Economics

3.3. LAW OF SUPPLY

NOTES
Law of supply shows a direct relationship between price and supply. It is
from producer’s point of view. The producer is happy to make more supply at
higher price as he can earn more profits. The law of supply states that, other
things remaining the same, higher the price, larger is the supply and lower the
price, lower is the supply.

ASSUMPTIONS OF LAW OF SUPPLY

All the factors which affect supply in reality are assumed to be constant
.only one factor changes in law of supply that is price.
1) Cost of production does not change.
2) Technique of production does not change.
3) Government policies does not change.
4) Transport cost does not change.
5) Prices of other related goods does not change.
6) Taxes does not change.

CRITICISMS OF LAW OF SUPPLY

In reality all the factors which are assumed to be constant in law of supply
changes.
• Cost of production changes.
• Technique of production changes.
• Government rules changes.
• Transport cost changes.
• Prices of related goods changes.
• Taxes changes.
In this way, law of supply shows direct relationship between price and
supply ,other things remaining the same. (Ceteris Paribus)

Exceptions to the law of supply

“It shows the indirect relationship between price and supply”. It means even
if the price is high,then also producer is not ready to make the supply.even when
the price is low,then also producer is ready to make supply.
1) Urgent need of cash
If the producer is in urgent need of cash .then even at lower prices he
is ready and willing to make the supply.Thus,he behaves opposite of
law of supply. Supply Theory 41
 Managerial Economics 2) Out of fashion
If the producer feels that his goods may go out of fashion in near
future,then he is ready to make supply even at lower prices because
NOTES he fears that if his goods really are out of fashion then there will be no
demand for his products in the market.

3) Expectations of producer
If the producer expects that there will be rise in prices of his products
in near future then he will wait for tomorrow to earn more money and
thus even if prices are high in current conditions then also he is not
ready to make supply. And vice versa.

4) Backward sloping supply curve of labor

It is general tendency of people to work less and earn more and thus
the supply curve slopes backwards.

SUPPLY SCHEDULE
It shows the tabular representation of price and supply. The figures of prices
and supply are shown in columns in table.

SUPPLY CURVE
It shows the graphical representation of supply curve.
X—QUANTITY SUPPLIED
Y---PRICE
The supply curve slopes upwards from left to right showing the direct
relationship between price and supply.

42 Supply Theory
SUPPLY CURVE Managerial Economics

NOTES

Fig- 1 Supply Curve

In this way, supply curve shows direct relationship between price and
supply. Higher the price higher the supply and lower the price lower the supply.

3.4. FACTORS AFFECTING SUPPLY

All the factors which affect supply in reality are assumed to be constant in
law of supply.
1) Prices of factors of production.
When the prices of factors of production increases then the cost of
production also increases and thus,eventually there is fall in profit
margin for producers.this will result into fall in supply.

2) The state of technology (T)

If a producer makes utilization of modern and advanced technoly,it
helps to reduce the cost of production.Thus it helps to increase the
profit margins.Therefore,supply increases.

3) Expectations of producers.
If the price of the good is expected to rise in near future then producer
may decide to reduce the amount they supply in the current period.

4) Taxes.
If there is increase in taxes by government then the cost of production
increases and eventually there is fall in production and supply.

Supply Theory 43
 Managerial Economics
5) Subsidy.
If subsidy is given to the producer then it is like incentive to the
production and thus due to discounts or concessions available. There
NOTES
is rise in supply.

6) Natural calamity
Due to floods or earthquakes or droughts the supply of goods gets
affected especially agricultural products.

3.5. PRODUCTION CONCEPTS AND ANALYSIS

Let us discuss the relationship between production and cost , concept of

production function and concept of productivity. Cost functions are closely
related to production function. A firm has to pay for its inputs it needs in the
process of production. Inputs relates to the cost of production. The cost of
supplying the product is determined by productivity and the prices of inputs. Cost
Function relates to the functional relationship between output and cost incurred
to make the production of final goods.
It can be expressed as— C= f (Q)
WHERE— C=COST OF PRODUCTION
f= functional relationship ; Q= OUTPUT
When input is greater than output then it indicates loss. When input and
output are exactly same,then it indicates the neutral condition. When input is
smaller than output ,then it indicates profit. There is an inverse relationship
between cost and profit. It means when cost increases, then profit margin falls
down and vice versa. Each producer should try his level best to reduce his cost
of production. Thus, when the cost is reduced then eventually there is rise in
profit levels.

3.6. PRODUCTION FUNCTION

It refers to the functional relationship between the physical rates of inputs

and outputs. Inputs relates to the raw materials which are utilized in the process
of production. Whereas the output relates to the final goods or finished products.
The algebraic statement of production function---
Q= f ( a,b,c,d ….n,T )
WHERE---
44 Supply Theory
 Q = OUTPUT Managerial Economics
f= functional relationship
a,b,c,d……..n = Quantities of various inputs needed in the process of
NOTES
production.
T = Technology.
( one bar is drawn on the top of T which says that technology is assumed to
be constant.)

Equation of production function---

Qx= f ( K,L )
Qx= Quantities or rate of output of commodity X per unit of time.
F = functional relationship
K = Capital used
L= Labor employed.
In this way, the rate of output is dependent on the rate of inputs utilized.

3.7. CONCEPT OF PRODUCTIVITY

Productivity is a relative concept. It refers to the capacity or ability of the

country to convert inputs into outputs. The total factor productivity can be
calculated as total output divided by total inputs. It can be explained as the ratio
of output to the ratio of inputs in the process of production. It refers to the output
per unit of input. When all outputs and inputs are included in the productivity
measure then it is called as total productivity. When input is greater than
output,then it results into loss. When input and output are same,then it is a neutral
condition,which states as no profit and no loss condition. When input is smaller
than output,then it results into profit. A measure of the efficiency of a
person,machine,factory,system etc in converting inputs into useful outputs is
termed as productivity. Productivity is a determinant of cost efficiency.
Productivity is calculated by dividing average output per period by total costs
incurred or the resources consumed in that period.
PRODUCTIVITY =
OUTPUT
INPUT
LABOR PRODUCTIVITY =
OUTPUT OF GOODS AND SERVICES
LABOR HOURS
Supply Theory 45
 Managerial Economics In this way, productivity explains the ratio between output which means
final goods and input which means raw material.

NOTES
3.8. SUMMARY

Supply has a direct relationship with price other things remaining the same.
That is the supplier is interested to sell more units of product with the increase
in price. The supply is dependent on price of commodity, cost (factors of
production), state of technology, Government policies and the expectation of the
producer. Production implies conversion of inputs into outputs for final
consumption. Two types of production function are dealt to understand the
dynamics of firm. Short run production refers to the change in one variable
keeping all other constant whereas in long run all the factors can be varied.

3.9. EXERCISE

Q-1 ) What is the concept of supply.

Q-2) Explain the relationship between price and supply in law of supply.
Q-3) State The Factors Affecting The Supply.
Q-4) Discuss the relationship between cost and production
Q-5) What is the meaning of production function.
Q-6) Describe the concept of productivity.
Q-7) Explain why supply curve moves upwards from left to right.

*****

46 Supply Theory
 Managerial Economics

Unit – 4 NOTES
Cost and Production Analysis

STRUCTURE
6.1 Objectives
6.2 Cost Concepts
6.3 Classification of Cost
6.4 Short run and long run costs
6.5 Production functions
6.6 Law of Variable Proportion
6.7 Iso-Quants and Iso-Cost Lines
6.8 Economies of scale
6.9 Summary
6.10 Exercise

4.1 OBJECTIVES

After studying this chapter, students shall be able to

• Understand the concept of cost and types of cost.
• Explain the relevance of short-run cost and long-run cost.
• Understand the Law of Variable proportion and its stages.

4.2 COST CONCEPTS

Producer requires various inputs for producing a commodity. The cost

incurred for producing goods implies the cost of production. Cost here implies
both monetary and non-monetary cost involved in the business. An entrepreneur
is paying the cost for raw-material, wages; transportation cost etc in the form of
money is one form of cost engaged in business. On the other hand an entrepreneur
might be using his own premises to run the business for which no monetary
transaction has been done also form a part of cost said to be implicit cost in the
Cost and
business. Similarly, the money invested in business by an entrepreneur might
Production Analysis 47
 Managerial Economics have earned interest, if it had rented to others. More in detail, we shall study the
different types of cost related to the cost of production.

NOTES Cost Function

• Cost of production depends on quantity of output. Cost of production
increases with an increase in output. The relation between cost and output
is known as cost function.
C=f(q)

4.3 TYPES OF COST

Kinds of Cost
1. Money Cost and Real Cost
2. Explicit cost and Implicit Cost
3. Direct Cost and Indirect Cost
4. Opportunity Cost and Actual Cost
5. Fixed and Variable Cost
6. Private and Social Cost

1. Money Cost
Money cost is expressed in money and implies the money outlays by
a firm for various factors of production. In other words, money cost
refers to the total Money expenses incurred by a firm for producing a
commodity. Money cost arises due to transaction between a firm and
other parties. Firm makes payment to other parties for use of their
physical inputs or services. These costs are also known as accounting
cost. Examples – Production cost like wages and salaries, selling cost
like advertisement, other cost like taxes, insurance etc.

Real Cost
Real cost means the cost incurred in terms of mental or physical effort
made by an individual in producing a product. Real cost refers to the
discomfort and disutility involved in providing factor services to
produce a commodity. It is computed in terms of discomfort involved
in the production process. For eg. Physical and mental efforts by labour
in doing the work. The concept of real cost has no practical
significance as it is psychological and unrealistic in practice.

2. Explicit cost and Implicit Cost

Cost and Explicit cost refers to the actual payment made to outsiders for hiring
48 Production Analysis services of the factors of production. E.g. wages, rent, interest etc.
 They can be estimated and calculated and therefore recorded in the Managerial Economics
books of accounts.
Implicit costs are implied costs and also known as imputed costs.
Implicit cost refers to the cost of self supplied factors. For e.g. Interest NOTES
on capital, Salary of entrepreneur etc. In other words, implicit costs
do not take the form of cash outlays and therefore do not appear in the
books of accounts.
The sum of explicit and implicit cost is the total cost of production of
a commodity.

3. Actual Cost and Opportunity cost

Actual costs are also known as absolute cost, acquisition costs and
outlays cost. Actual cost implies the actual expenditure incurred for
producing goods or services. For e.g. wages paid to workers, expenses
on raw-material etc.

Opportunity cost
Opportunity cost is the cost of the next best alternative forgone. When
a firm decides to produce a particular commodity, then it always
considers the value of the alternative commodity, which is not
produced. The value of the alternative commodity is the opportunity
cost of the good that the firm is now producing. For eg –A farmer can
produce 50 units of wheat or 40 Units of Rice. Hence, to produce rice,
farmer has to forego the opportunity of producing 50 units of wheat.

4. Direct costs and Indirect costs

Direct cost are those costs which are incurred on a specific product,
department or process of production. For e.g. expenses incurred in
promotion of product can be allocated to marketing department. On
the other hand, when the cost can not be allocated to a specific product
or department than it is said to be indirect cost. For e.g. electricity
expenses, administrative expenses which cannot be divided and are
incurred on the overall unit are indirect expenses.

5. Fixed Cost and Variable Cost

Fixed costs are those which do not vary with the output that is the
output may be 20000 units or 50000 units the cost remains the same.
Fixed cost remains constant and is positive even if there is no
production. Variable costs are those which vary with the level of
output.

Cost and
Production Analysis 49
 Managerial Economics 6. Private and Social Cost
Private cost refers to the cost of production incurred by an individual
firm in producing a commodity. It is the cost incurred by a firm on
NOTES hiring and purchasing inputs for producing a commodity. This cost has
nothing to do with the society. Social cost refers to the cost of
producing a commodity to the society as a whole. Social cost is not
borne by firm and is passed on to the person not involved in the activity
in the direct way. Noise pollution and air pollution are social costs due
to increase in traffic in metro cities.

4.4 SHORT RUN COSTS AND LONG RUN COSTS

The short run is a period of time of production is fixed; we tend to assume

that capital is fixed and labor is variable. If demand changes in the short run, a
company can easily employ or fire people to manage that demand, but if they
need to expand because of the growing demand they cannot easily build a new
office, therefore capital is fixed in the short run. But labor could also be fixed in
the short run if a company works with contracts. The long run is a period of time
when all factors of production are variable. We cannot really give a definition of
how long the long run is, because it depends very much on the industry. In the
internet industry the long run may be a week, while in the power sector and
manufacturing sector industry the long run may be ten years.
Short run cost varies with output while in long run cost, all the factors are
variable. Moreover, short run is relevant when a firm has to decide to produce or
not to produce in the immediate future. In the short run there are certain costs
which are fixed, while others are variable. Similarly, short run costs are divided
into two kinds of costs:
1) Fixed cost
2) Variable Cost
The total cost (TC) of producing output in the short run is the sum of total
of costs incurred on fixed factors (TFC) and TVC.

4.4.1 TFC or fixed cost

Fixed costs refer to those costs which do not vary directly with the level of
output. For eg. Rent, Insurance Premium, Salary of permanent Staff etc. Fixed
cost is incurred on fixed factors like machinery, land, building etc which cannot
be changed in the short run. The payment to these factors remains fixed
irrespective of the level of output, that is fixed cost remains the same, whether
output is large, small or even zero.

Cost and
50 Production Analysis
 Fixed Cost Schedule Managerial Economics

NOTES

4.4.2 Total Variable Cost

Variable cost refers to those costs which vary directly with the level of
output. For eg. Payment for raw material, power, fuel, wages of casual labour
etc. Variable costs are incurred on variable factors like raw material, power etc
which changes with the change in level of output. It means VC, rise with increase
in output and fall with decrease in output. Such costs are incurred till there is
production and become zero at zero level of output. Variable Cost- VC is also
known as prime cost, direct cost or avoidable cost.

Cost and
Production Analysis 51
 Managerial Economics

NOTES

Difference between TC AND TVC

Cost and
52 Production Analysis
 Managerial Economics

NOTES

Total Cost
• TC is the total expenditure incurred by a firm on the factors of production
required for the production of a commodity.
• TC = TFC + TVC

Total Cost Schedule

Relationship between TC, TFC and TVC

1. TFC curve is a horizontal straight line parallel to X-axis as it remains
constant at all levels of output.
2. TC and TVC curves are inversely S-shaped because they rise initially
at a decreasing rate then at a constant rate and finally at an increasing
rate. The reason behind their shape is the Law of variable proportions.
3. At zero output, TC is equal to TFC because there is no variable cost
at zero level of output. So, TC and TFC curves start from the same
point, which is above the origin.

Cost and
Production Analysis 53
 Managerial Economics 4. The vertical distance between TFC curve and TC curve is equal to
TVC. As TVC rises with increase in the output, the distance between
TFC and TC curves also goes on increasing.
NOTES 5. TC and TVC curves are parallel to each other and the vertical distance
between them remains the same at all levels of output because the gap
between them represents TFC, which remains constant at all levels of
output.

Average Costs
• The per unit explain the relationship between cost and output in a more
realistic manner. From total fixed cost (TFC), TVC and TC, we can obtain
per unit costs. The 3 kinds of ‘per unit costs’ are:
1. Average Fixed Cost (AFC)
2. Average Variable Cost (AVC)
3. Average total Cost (AC)

Average Fixed Cost

• AFC refers to the per unit fixed cost of production. It is calculated by
dividing TFC by total output.
• AFC = TFC/Q

Cost and
54 Production Analysis
 Managerial Economics

NOTES

AFC
• AFC declines with rise in output. Since, TFC is constant, AFC falls with
increase in the output. It happens because the same amount of fixed cost
is divided by increasing output. AFC curve is a rectangular hyperbola.
• AFC does not touch any of the axes –AFC is a rectangular hyperbola. It
gets nearer and nearer to axes, but never touches them. AFC curve can
never touch the X-ais as TFC can never be Zero. AFC curve can never
touch the Y-axis because at zero level of output, TFC is a positive value
and any positive value divided by zero will be an infinite value.

AVC
• Average variable cost refers to the per unit variable cost of production. It
is calculated by dividing TVC by total output.
• AVC = TVC/q

Cost and
Production Analysis 55
 Managerial Economics

NOTES

AVC
• AVC initially falls with increase in output and after reaching its minimum
level, AVC starts rising.
• AVC is U-shaped curve.
• The 3 phases of AVC curve that is decreasing, constant and increasing
phases correspond to the three phases of Law of Variable proportions.

ATC or AC
• Average cost refers to the per unit total cost of production. It is calculated
by dividing TC by total output. AC =TC/q
• AC is also defined as the sum of AVC and AFC that is
• AC = AFC +AVC
• AC = ATC

Average Cost

Cost and
56 Production Analysis
AC Managerial Economics
• AC is a U shaped curve. It means AC initially falls (1st Phase), and after
reaching its minimum point (2nd phase), it starts rising (3rd Phase).
1st Phase –When both AFC and AVC fall till the level of 2 units of output, NOTES
AC also falls.
2nd Phase –At 3rd unit of output, AFC continues to fall but AVC remains
const. So, AC falls till it reaches its min point.
3rd Phase –After 4 units of output, rise in AVC is more than fall in AFC
and therefore AC starts rising.

AC, AVC and AFC

• Ac Curve will always lie above the AVC curve because Ac, at all levels
of output includes both AVC and AFC.
• AVC reaches its minimum point at a level of output lower than that of
AC because when AVC is at its minimum point, AC is still falling because
of falling AFC.
• As the output increases the gap between Ac and AVC curves decreases,
but they never intersect each other. It happens because the vertical
distance between them is AFC, which can never be zero.

4.5 PRODUCTION AND PRODUCTION FUNCTION

Production and Production function

Production refers to the transformation of physical inputs into physical
outputs. Production refers to the output of goods and services produced by
businesses within a market.
Cost and
Production Analysis 57
 Managerial Economics Production function
The production function identifies the maximum quantities of a particular
good or service that can be produced per time period with various combinations
NOTES of resources, for a given level of technology. Mathematically, the production
function can be represented as follows:
Q = f(L,K,N etc) wherein Q = quantity of output per unit of time;
L,K,N represents the various factors like land, capital and labour etc which
are used in the production of output.

4.6 LAW OF VARIABLE PROPORTIONS

Law of Variable Proportions

The law of variable proportion also known as the Law of diminishing
returns. According to Prof. Benham, “As the proportion of one factor in a
combination of factors is increased, after a point, first the marginal and then the
average product of that factor will diminish”.

Assumptions of the Law

Variable factor is only one and all other factors to be kept constant.
• The units of variable factors are homogenous.
• The techniques used for production shall be constant.
• The law of variable proportion is applicable for short period.
• The possibilities for varying the proportion of factor inputs are available.
The law of diminishing returns occurs because factors of production such
as labour and capital inputs are not perfect substitutes for each other. This means
that resources used in producing one type of product are not necessarily as
efficient (or productive) when switched to the production of another good or
service. For example, workers employed in producing glass for use in the
construction industry may not be as efficient if they have to be re-employed in
producing cement or kitchen units. Likewise many items of capital equipment
are specific to one type of production. They would be much less efficient in
generating output if they were to be switched to other uses.
There is normally an inverse relationship between the productivity of the
factors of production and the unit costs of production for a business. When
productivity is low, the unit costs of supplying a good or service will be higher.
It follows that if a business can achieve higher levels of efficiency among its
workforce, there may well be a benefit from lower costs and higher profits.
We can understand the law of variable proportion with the help of an
Cost and example here:
58 Production Analysis
 Managerial Economics

NOTES

Total Product or Output (TP)

Total product is the output derived from all factor units, both fixed and
variable employed by the producer. TP is summative of marginal product.
Average Product or Output (AP)- Average product is calculated by dividing
the TP with number of variable factors employed.
Marginal Product is the output derived from the employment of an
additional unit of variable factor unit.
Relationship between TP, MP and AP
Total Product keeps on increasing as long as MP is positive. It is highest
when MP is zero and TP declines when MP becomes negative.
MP increases in the beginning attains the maximum and then starts
diminishing.
AP behaves like MP and in the beginning MP will be higher than AP but
towards end AP will be higher than MP.
• As more of a variable resource is combined with a given amount of a
fixed resource, marginal product eventually declines
• This is the most important feature of production in the short run →
dictates the shape of the production function and the cost curves

Cost and
Production Analysis 59
 Managerial Economics Stages of Law of Variable Proportions

NOTES

4.7 ISO-QUANTS AND ISO-COST LINES

Iso-quants and Iso-costs

Iso-quants means the same level of production (output) is there with the
different combinations of factor inputs (Labor, capital). Iso means equal and
quants means quantity and thus also known as equal product curve.
In the words of K.J. Cohen and R.M Cyert, “ An iso-product curve is a curve
along which the maximum achievable production is constant”. Iso-product curve
Cost and helps in finding of combination of two factors, which yields maximum output at
60 Production Analysis the minimum cost.
 Iso-quant Map – As shown in fig. , as the quantity of one factor is reduced, Managerial Economics
the quantity of other factor has to be increased in order to have the same total
product. Iso-quant map depicts the different amount of outputs by different iso-
quants. NOTES

Marginal Rate of Technical Substitution (MRTS)

MRTS is defined as the rate at which the factors can be substituted for
another without affecting any change in the quantity of output. Let us understand
it with the help of table given below:

As shown in the table for A2 combination, factor A (15-10) is equal to Factor

B (1-2) or in other words factor A is reduced by 5 with an increase in 1 for factor
B. Therefore, the MRTS is 5:1. We also can see that as as the factor B increases
the factor A is reducing that is law of diminishing marginal rate of technical
substitution is applicable.
Cost and
Production Analysis 61
 Managerial Economics

NOTES

Properties of Iso-quants
1. Iso-quant is convex to the origin.
2. Iso-quant curve shall never touch either the X or Y axis.
3. Iso-quant curve slope downward from left to right.
4. Two Iso-product curves shall never intersect each other.
5. The iso-quants shall be parallel to each other.

Iso-cost line
Iso-cost line or curve is basically the combination of two factor inputs of
firm which can be purchased at given price with a given outlay. Iso-cost line has
an important role to determine the combination of factors, the firm will opt for
production with intent to minimise cost. Moreover, the iso-cost line depends on
two things first, the prices of factors of production and secondly the total outlay
that the firm has to incur on the factors.
This can further be explained with the help of given example and diagram.

Cost and
62 Production Analysis
Least cost Combination of Inputs (Producers Equilibrium) Managerial Economics
Producer’s equilibrium helps in minimizing cost for a given level of output
or maximising output with a given amount of investment expenditure. We can
understand producers equilibrium with the help of iso-quant curve and Iso-cost NOTES
line. Iso-cost curve is basically the combination of two factor inputs so that a
given output can be produced. Iso-cost curve represents the total outlay of
producer and the prices of factors of production. Producer is interested to
maximise the profits that is reducing the production cost and maximising the
output. Thus, the producer selects the least cost combination of the factor inputs.
The equilibrium is the point where the maximum output with minimum cost is
possible. The position of equilibrium is at the point where Iso-quant curve is
tangential to Iso-cost line. Therefore, the point at which the Iso-quant is tangent
to the ISo-cost line represents the minimum factor combination for producing a
given level of output. At this point, Marginal rate of technical substitution
(MRTS) between the two points is equal to the ratio between the prices of
the inputs.

Fig -
Long Run Production Function (Change in all factor inputs in the same
proportion)

Laws of Returns to Scale

The returns to scale implies when all the factors are variable for change in
output. An increase in scale implies that all factor inputs are increased in the same
proportion. In returns to scale, all inputs are increased in the same proportion. In
returns to scale, all factor inputs are increased or decreased to exactly the same
proportion so that the scale of production has the same proportion among the
factors.

Different phases of Returns to scale

Economist has questioned the behaviour pattern of output when all factor
Cost and
inputs are increased in the same proportion. The economists are of the view that Production Analysis 63
 Managerial Economics factor inputs cannot be increased in the same proportion and the proportion
between the factor inputs cannot be uniform. Let us try to understand the returns
to scale with the help of tabular and diagram.
NOTES

It can be seen from the table that the (stage I) land and labor units are
increasing in the same proportion that is land by 1 unit and labor by 2 units. The
proportionate increase in output is more when 4 units of land and 8 units of labor
are used. Thereafter, the output increase is constant (stage II) that is 5 units of
land and 10 units of labor as well as 6 units of land and 12 units of labor. Finally,
in the third stage when 6 units of land and 12 units of labor are used the increase
in output is less than proportionate.

Diagrammatic representation
We can see in the diagram that the marginal curve slope upwards from A to
B, that is the stage I and is known as the increasing returns to scale. The curve is
horizontal in stage II from B to C also known as the constant returns to scale.
Finally, in stage III from C to D, the marginal curve is downward sloping and is
Cost and
64 Production Analysis known as diminishing returns to scale.
Increasing returns to scale Managerial Economics
The increase in the output is more than proportionate when the producer
increases the quantity of all factors in a given proportion. For eg when the
quantities of all inputs are increased by 10% and the output increases by 15% NOTES
which implies that increasing rate of return is operating.

Constant returns to scale

The increase in the output is in the same proportionate when the producer
increases the quantity of all factors in a given proportion. For e.g. when the
quantities of all inputs are increased by 10% and the output increases by 10%
which implies that constant returns to scale is operating.

Diminishing returns to scale

The increase in the output is less than proportionate when the producer
increases the quantity of all factors in a given proportion. For e.g. when the
quantities of all inputs are increased by 10% and the output increases by 5%
which implies that diminishing returns to scale is operating.

4.8 ECONOMIES AND DISECONOMIES OF SCALE

Economies of scale imply that the firm is producing with large scale
production. Let us take the example of global giants like Walmart, Nestle,
Kellog’s dealing with different markets and producing at large scale to reduce
the cost of production. In fact, with the increase in the production by a firm the
average cost gets reduced which ultimately leads to the development and growth
of a firm. Further, as stated by Prof Marshall the economies could be studied
under two categories that is the internal economies and the external economies.

4.8.1 Internal Economies

Internal economies basically depends on the size of firm and varies from
firm to firm. Internal economies could be either due to specialisation or increased
division of labor. Moreover, internal economies arise due to increase in the output
and is not possible without increase in output. The characteristics of internal
economies are as follows:
1. Internal economies are firm specific.
2. Internal economies are dependent on the size of a firm.
3. Internal economies are the end result of increase in the scale of
production.
4. Internal economies are within the firms and arise due to improvements
in the internal factors.
Cost and
Production Analysis 65
 Managerial Economics 4.8.2 Types of Internal economies
A. Marketing economies
As firm increases its size, it is possible for a firm to buy the raw-
NOTES
material at economical prices as it buys in large quantities and
regularly. The other marketing expenses are also spread across the
overall cost due to large scale production. For eg. The promotional
expenses like advertising, selling expenses, marketing research,
transportation cost also gets proportional allocation due to economies.

B. Specialisation and division of labor

Due to increase in the size of firm, the firm is able to specialise on the
basis of labor specialisation and division of labor is also possible. Mass
production is possible when the scale of production is high. Thus, the
efficiency here increases and this results in more productivity as well
as labor cost per unit of output also decreases.

C. Technical economies
Technical economies arise due to increase in scale of production and
using advanced technologies thus improving upon the processes,
reducing wastages and efficiency in the system. This scale of
producing at a large volume also reduces the average cost, however
the fixed cost of installing the plants and technologies, computer etc
may be high but the average cost gets reduced due to large scale
production. Thus, it is possible to use modern techniques when the
scale of production is large and avail the cost benefits.

D. Financial economies
The firm may have to procure huge funds owing to the size of business
and large scale production. This permits the firm to mobilise the funds
from the financial institutions at a reasonable rate of interest.

E. Labor economies
The firm can employ the highly skilled labor to get the benefit of skill
sets required by the firm. This is possible due to large scale production
by a firm and spreading the cost of labor. The firm can also provide
training to the existing manpower to enhance their skill sets required
by a firm.

F. Risk and Survival economies

The firm producing at a large scale could be result of
merger/acquisition or leader in the market. It is possible for such firms
to have more cushions for risk since the large size firms have better
Cost and knowledge in terms of environmental issues and can address the risk
66 Production Analysis
 factors in a proper manner. Moreover, the large size firms deal in Managerial Economics
variety of products to diversify the risk and increase their survival in
the market.
NOTES
4.8.3 Types of Internal Dis-economies
Diseconomies occur when a firm continues to expand beyond optimum
capacity, and thus the economics of scale will disappear.
A. Inefficiency at Management level
With the increase in the scale of production and the size of business
there are possibilities of ineffective coordination, decision making in
time and wisely, lack of managerial skills as well as delay in the
process. Thus, at times when the management is over loaded with too
many activities than the delegation takes place. This delegation of
work to the lower or middle level may disrupt the processes and
problems in terms of marketing, sales, production etc may take place
leading to diseconomies of scale. Therefore, the optimum level should
be followed to achieve the desirable results.

B. Technical diseconomies
There is an optimum level to manufacture or produce or to use
advanced techniques/technologies. However, in case of over use of
advanced resources beyond the optimum level the problems arise
which is said to be the technical diseconomies. This is due to high cost
of maintenance or accidents taking in the process. Moreover, lack of
technical experts to handle these issues could be another resistance to
work.

C. Financial diseconomies
There are various schemes in which concessions are provided by the
Government and financial institutions to the small firms. But at the
same time there are different restrictions and norms for the firms
procuring large funds and also manufacturing in bulk quantities.

4.8.4 Types of External Economies

A. Economies of Concentration
The concept is also known as ‘Localisation of Industry’ that is when
most of the large number of firms producing the same commodity is
concentrated in a particular area. These firms are able to get the benefit
of cheap labor, raw-material availability, transportation and other
marketing and financial services at a reasonable rate which ultimately
leads to the reduction in cost of operation of a firm.

Cost and
Production Analysis 67
 Managerial Economics B. Economies of disintegration
This type of economies arise when the units are split into different
units for proper administration and operation of the firm. For. E.g. in
NOTES carpet exports sector the industry has been split into small small units
of looms and the task pertaining to documentation and logistics is
taken by some other firms. This division of work/task of big firms
enhances the efficiency in the working and cutting down of the cost.

C. Economies of Information
With the increase in the number of firms across a particular area it
becomes possible to exchange ideas and information easily. This
sharing of information could be through workshops, seminars and
training. Moreover, publication in journal, magazines and emails etc
could further enhance the flow of information. Thus, this wide spread
of information through various channels helps in strengthening the
resources of firm and economizing the expenditure of firm.

4.8.5 External diseconomies

When the firms are concentrated in one particular area than the problem of
environmental issues, pollution, congestion and scarcity of labor may arise which
leads to diseconomies of scale. Therefore, the firms can get the benefit of large
scale up to a specific level and beyond that the diseconomies of scale takes place.

4.9 SUMMARY

Cost analysis explains the various amounts of costs incurred to produce a

particular quantity in monetary firms. Cost concepts are used in economics to
take informed decision. Cost analysis is important for taking various decisions
including the pricing, production and output. Various types of costs like
opportunity cost, Fixed and variable cost, direct and indirect cost, explicit and
implicit costs are used to take business decisions. In economics production refers
to the conversion of inputs into outputs for final consumption. Production
functions are of two types that is short run and long run. In the short run, we can
change any one of the variable and other inputs are constant. The law of
diminishing returns exhibits that how there will be variations in the quantity of
output with the change in one variable whereas the other input factors are kept
constant. The change in output can be explained wen there is change in only two
factor inputs and other factors are constant through iso-quants and iso-cost
curves. Whereas in the long-run production function, the laws of returns to scale
explains changes in output with the change in all factor inputs in the same
proportion. Therefore, it is of essence for an managerial economist to have the
Cost and knowledge of both cost and production functions to maximise the output with
68 Production Analysis minimum cost.
 Managerial Economics

4.10 EXERCISE
NOTES
Q.1 What do you understand by production function. Briefly explain short
run and long run production function.
Q.2 Explain the law of variable proportion with the help of suitable
diagram.
Q.3 Explain the different types of cost used in cost analysis?
Q.4 Write short note on Iso-quants and Iso-cost curves.
Q.5 Calculate TFC and TVC

Cost and
Production Analysis 69
 Managerial Economics

NOTES

Q.6 Calculate TC, if TFC at 0 level of output is 60.

Q.7 Find out the Missing Values?
Q.8 Calculate TFC,TVC,ATC,AFC and AVC

*****

Cost and
70 Production Analysis
 Managerial Economics

Unit – 5 NOTES
Market Structure

STRUCTURE
5.1. Objectives
5.2. Meaning and Concept of Market Structure
5.3. Perfect Competition
5.4. Monopoly Competition
5.5. Monopolistic Competition
5.6. Oligopoly
5.7. Price discrimination
5.8. Summary
5.9. Exercise

5.1. OBJECTIVES

After studying this chapter, students shall be able to

• Understand the features of different markets that is perfect competition,
monopolistic, monopoly and oligopoly markets.
• Explain the price and output determination for various markets.
• Understand the Game theory for decision making.

5.2 MEANING AND CONCEPT OF MARKET STRUCTURE

Market structure means the characteristics of market that influence the

behavior of sellers and buyers for trade. The structure of market can easily be
understood through following questions given below:
i. Number of buyers and sellers in the market
ii. Type of product that is standardized product or differentiated product.
iii. Easy entry and exit from the market or barriers to entry and exit.
Market Structure 71
 Managerial Economics Markets can be classified under four types namely
1. Perfect Competition
2. Monopolistic Competition
NOTES
3. Monopoly
4. Oligopoly

More in detail, the key ingredients of any market structure consist of

• Number of firms in the market/industry
• Extent of barriers to entry
• Nature of product
• Degree of control over price
Moreover, the Knowledge about market structure shall enable to answer the
following questions:
i. How much profit a firm will make (normal or supernormal)
ii. How much quantity it will produce at its profit-maximization point
(i.e. whether it will be a large level of output or a small one relative to
the market)
iii. Whether or not a higher level of output would increase the cost or
productive efficiency of the firm or allocative efficiency for society
(see the summary on monopoly for details)
iv. Are the prices set too high, too low, or just right?

5.3 PERFECT COMPETITION

Concept of Perfect Competitions

Perfect competition is a market where there are large number of buyers and
sellers, standardized product and free entry and exit.

Features of Perfect Competition

1. Large number of buyers and rulers. The first condition for a perfect
competition is that the large number of buyers and sellers exist in the
market. Therefore, an individual buyer and seller have no effect on
the demand and supply. Because an individual buyer’s demand is
insignificant in the demand market. It is so negligible that an individual
buyer’s demand maker no difference and no effect on the total demand
market. Similarly an individual firm’s supply is so insignificant in the
total supply of the market that if ever any change occurs in individual
firms supply. Then also it has no effect upon the total market supply.
72 Market Structure
 Even if such a firm closes down, then also the market supply remains Managerial Economics
unchanged.
2. Free entry and exit. The other important feature for perfect competition
is free entry and free exit of every firm. There is free entry and exit of NOTES
the firm. So every firm has full freedom of entry as well as exit from
the market.
3. Homogeneous product – The product is identical in the perfect
competition that is homogeneous product. Perfect competition
signifies that the firms have identical products and are perfect
substitutes of each other.
4. Absence of transportation costs – One of the important characteristic
of perfect competition is no transport costs for movement of either the
product or factors. Then if transport cost occurs then the production
costs of firms producing at two diff rent places will differ and thus,
the prices will not remain same of different products. If prices differ
then the condition of perfect competition will not exist, so this
assumption of free transport facilities is very important for perfect
competition. (Raw material can be moved easily)
5. Perfect mobility of factors of production. The factors of production
should be perfectly mobile then only a firm can adjust its supply to the
demand market.
6. Perfect knowledge of the market. Here, buyers and the sellers should
have a perfect knowledge of the market. As, there is a perfect
knowledge of the market to buyer as well as seller. It maintains
uniform Price throughout the market. So, seller will not accept the
lower price than already existing in market will the buyer pay higher
price than the market price. So, thus every seller has a knowledge of
price that buyer pay higher price that buyer will offer and every seller
will accept. Seller – full knowledge of competition. Buyer – full
knowledge of product.
7. No government interference - It is assumed that the government does
not interfere in economic activities of the people. Prices are determined
according to demand and supply conditions of the market.
As studied earlier there are conditions be fulfilled for a perfect competition.
In them
i. Large number of buyers and sellers.
ii. Homogeneous product.
iii. Perfect knowledge of market.
These are the three basic conditions of perfect competition.
Whenever these conditions do not exist the market becomes imperfect. So
for “Imperfect Competition” then the market and the competition is not perfect. Market Structure 73
 Managerial Economics Thus, when there conditions are not complete then the competition is not at
all perfect competition and this type of situation can be named as are of ‘imperfect
competition’
NOTES This “Imperfect competition” can further be classified as monopolistic
competition. So, in all there are 3 types of imperfect competition.

Profit maximization under perfect competition in the short run

The short run is the period where at least one factor of production is fixed.
In perfect competition, it also means that no new firms can enter the market.
Equilibrium analysis can help us answer questions about the market-clearing
price and quantity; where the profits are maximized and how much are these
profits; how individual firms make their short run supply decisions and how these
translate into the long-run industry supply curve.
In the short run, a perfectly competitive firm can settle at equilibrium where
it is making super normal profits, normal profits, loss, or where it decides to shut
down.
In the short run, the firm’s supply curve is identical to the positive part of
MC. The short run industry supply curve is simply the horizontal summation of
the supply curves of individual firms.
The demand (or AR) curve for the industry is downward sloping but for any
individual perfectly competitive firm, is horizontal. Thus, the firm can sell as
much at the given market price. For this reason, the AR and MR curves align
under perfect competition.
Determination of Price and Output
1) TR and TC Approach
2) MR and MC Approach

74 Market Structure
 Managerial Economics

NOTES

Fig- 1 TR and TC (Perfect competition)

Profit = TR –TC (Maximum vertical distance between TR and TC in the
diagram is at point B and therefore profit is maximum.
At point A and point C, TR =TC or we can say that no profit no loss. (BEP
that is break even point).

Market Structure 75
 Managerial Economics Profit determination using MR and MC approach
1) Firm is price taker in the perfect competition since the price is decided
by demand and supply forces of Industry.
NOTES

Fig-2 (Price determination by Industry –Perfect competition)

Case -1 Perfect Competition in short run (AR3) Price (P1) (Supernormal profit)
Condition – MR = MC and MC cuts MR from below (at point E)
At point E, output is OQ
As we can see in Fig.3 that AR3(P1) > E (MR =MC) =Profit
Revenue (OP1) X Quantity 4 - Cost (OP2 *EQ) = P1P2K1E (Profit)

Fig-3 Short run competition (Perfect Competition)

Case -2 Perfect Competition in short run (AR2) Price (P2) (Normal profit)
Condition – MR = MC and MC cuts MR from below (at point E)
76 Market Structure
 At point E, output is OQ Managerial Economics
As we can see in Fig.3 that at at point E, AR2(P2) =Cost or OP2 = EQ
Revenue (OP2) X OQ = OP2EQ
NOTES
Cost (OP2 *EQ) = OP2EQ (Normal Profit)

Case -3 Perfect Competition in short run (AR1) Price (P1) (Normal profit)
Condition – MR = MC and MC cuts MR from below (at point E)
At point E, output is OQ
As we can see in Fig.3 that at at point E, AR1(P1) < Cost or OP3 < EQ
Revenue (OP3) X OQ = OP3K2Q
Cost (OP3 *EQ) = OP3EQ -Loss
OP3K2Q < OP3EQ Loss
Also for shut down point, AVC (Average variable cost is to be considered)
and the P should be higher than AVC to continue. In case AVC is higher than AR
then it is shut down point.

Profit maximization under perfect competition in the long run

In the long run, all the factors of production are variable. In the long run,
any firm can enter or leave the industry. If there are supernormal profits in the
short run, more firms will be attracted to the market and the increase in supply
will push prices down to eliminate supernormal profit possibilities in the long
run. By contrast, if firms are making losses in the short run, they will leave the
industry in the long run causing supply to fall, prices to rise and normal
profitability to be restored. In the long run, therefore, perfectly competitive firms
can only earn normal profits.

Fig 4 -Perfect Competition in the long run

Market Structure 77
 Managerial Economics As we can see in fig-2 that AR =MR=MC=AC and hence this is the situation
of normal profit. Thus, in long run entry of firms is more initially when there are
profits and firms exit in case there are losses. As a result finally the situation is
NOTES as shown in fig-2 that is normal profit.

5.4 MONOPOLY COMPETITION

Monopoly competition –Monopoly (Mono means single) arises when there

is only seller in the market and therefore the only producer has control on the
supply of that specific commodity. Also, in monopoly firm is the Industry (one
seller). Monopoly is the other form of market that is just opposite of perfect
competition.

5.4.1 Features of Monopoly Competition

1. Single seller
2. No close substitutes.
3. No difference in firm and industry
4. No competition
5. Price maker
6. Downward sloping demand c…
7. Fixes either price of output

5.4.2 Types of Monopoly

1) Pure and also monopoly
It is an extreme case of monopoly. It is a situation in which there is
only are who does not face any competition or there no close
substitutes for his product.

2) Limited or imperfect monopoly

If refers to a situation in which the mainly one seller but he faces some
competition from other producer.

3) Simple Monopoly
It refers to a situation in which a uniform price is changed all the
buyers for a product.

4) Discriminating (different) monopoly

In this type different prices are charged from different buyers for a
product in different markets.
78 Market Structure
 5) Private monopoly (individual) Managerial Economics
It refers to a monopoly firm owned and controlled by private individual
private institutions.
NOTES
6) Public or social monopoly (govt.)
When the firm is operated and controlled or the entire supply is made
by the government it is called public monopoly. The main aim of
monopoly is public welfare. All nationalized industries are example
of public monopoly. (Railway)

7) Legal monopoly
When the legal nights are obtained by a firm for trade mark, copy right
etc. so that the firms may not imitate them it is called legal monopoly.

8) Natural monopoly
When a single firm enjoys control over the supply of mineral resources
or saw material, there is said to be natural monopoly.

9) Technological monopoly
When a big firm uses highly efficient and developed technology to
produce a product there is said to be technological monopoly

10) Bi-lateral monopoly

When there is only one buyer and a seller in the market, there is said
to be bi-lateral monopoly

Monopoly –Case -1 Conditions for equilibrium

Fig. 5 Monopoly
Market Structure 79
 Managerial Economics As we can see in Fig.5 that MR =MC at point E and the AC is more than
AR (Price). Thus, the firm incurs loss if average cost is higher than average price.
Also, we can find the revenue and cost by multiplying the output with price for
NOTES both AR (P1) and cost.

Monopoly –Case -2 Conditions for equilibrium

As we can see in Fig.6 that MR =MC and the ATC is less than AR (D).
Thus, the firm incurs profit. Also, we can find the revenue and cost by
multiplying the output with price and cost respectively.
At equilibrium the output is 100, price is 24 and cost is 20.

Fig-6 Monopoly
As we can see in fig.6 total revenue is 24 *100 =2400
Total Cost = 20 *100 =2000
Profit = 400 i.e (100 * (24-20)

5.5 MONOPOLISTIC COMPETITION

Monopolistic competition
Monopolistic competition is the market where large number of sellers are
available with differentiated products, which are close but not perfect substitutes
of each other.

5.5.1 Features of Monopolistic Competition

1. Free entry and exit of firms
The firms can enter as well as exit from the business due to the reason
that the products are differentiated.

80 Market Structure
 2. Similar products Managerial Economics
The firm produces commodities which are similar but not identical to
each other.
NOTES
3. Competition and monopoly behavior
The firm has acquired some monopoly power due to its differentiation
of product from the others. However, the competition between the
similar products exist in the business.

4. Non-price competition
The firms have competition based on product and its attributes and not
the price competition.

5. Product differentiation
One of the important feature of monopolistic competition is the
differentiation of product.

6. Demand curve
Product differentiation under monopolistic competition enables the
firm towards more elastic demand curve. This means that with a slight
reduction in the price of product the demand increases in large
proportion.

Price-output equilibrium
• Short run equilibrium –Short run is a period where there is shortage
of time to make changes in the resources like production process.
Equilibrium point e where MR = MC and MC cuts from below

Market Structure 81
 Managerial Economics • The monopolistically competitive firm produces the level of output at
which marginal revenue equals marginal cost (point e) and charges the
price indicated by point b on the downward-sloping demand curve. In
NOTES panel (a), the firm produces q units, sells them at price p, and earns a
short-run economic profit equal to (p – c) multiplied by q, shown by
the blue rectangle.

Equilibrium point e where MR = MC and MC cuts from below

At point c we find that ATC (AC) > AR (P) and therefore the firm
incurs loss.
• In panel (b), the average total cost exceeds the price at the output where
marginal revenue equals marginal cost. Thus, the firm suffers a short-
run loss equal to (c – p) multiplied by q, shown by the pink rectangle.

Price output determination in the long run

Fig-Long run equilibrium

82 Market Structure
 As shown in fig – at point E (Equilibrium), MR = MC and MC cuts MR Managerial Economics
from below
At P (10) AR =AC = Price
NOTES
Thus, we find that in monopolistic competition in the long run the firm can
only earn normal profits.

5.6 OLIGOPOLY COMPETITION

Oligopoly - (Sellers >> few) (Buyers >> large)

The word oligopoly is derived from two Greek word oligoi meaning a few
and word pollein which means to sell. An oligopoly is a market situation in which
there are a few sellers and a large member of buyers. There firms produce and
sell homogenous or different products which close substitutes of each other. e.g.
Firms producing TV sets, automobiles etc. There is a high degree of competition
as them. They are highly interdependent for the price and output. A price set by
one firm is followed by other firms.
Large amount of money is spent on advertising and sales promotion.
Oligopolist firms spent large amount of money on research and development
of firm and on packing, design etc.
Advertisement is done to convince the customers that our product is superior
than there competitive advertisement is done.
It does not have only one producer as in monopoly.
Nor does it have a very large number of sellers like monopolistic
competition. (Perfect) This is a type of market which contains few limited or
small numbers of producer (This is the basic feature of oligopoly)
E.g. There is a great competitive advertising for consumer products like
tooth paste hair oil cream etc.
Product differentiation is possible in oligopoly e.g. Scooter, cars, TV, etc.
these types of consumer durable goods in India are produced in Oligopoly market
and there products are definitely differentiated.
Every firm is free to fix price of its product but this freedom is closely
dependent by mutual interdependence of firms. This is also a special feature of
oligopoly.

Price war
A firm can’t attract customers of rival firms to itself by lowering the price
of its product but the rival firms when loses its customer will again lower down
the prices of its product this will result into competitive price cutting which is
known as price war. Ultimately all the firms in the industry will suffer losses..
Market Structure 83
 Managerial Economics Duopoly (2 sellers) (perfectly substitute – Product
Two firms: As the name itself indicates duopoly is a market category where
there are only two sellers or the producers the market.
NOTES
Interdependence between sellers: As there are only two sellers the decision
of one seller’s price and output affect the decisions of other firm. Due can say
that duopoly represents an extreme case of interdependence of between the two
firms as a result; both the firms have to watch the reactions of each other’s firms.
The production of both the firms is perfectly identical to each other or in other
words they are perfect substitutes to each other and this feature makes
interdependence.
Duopoly situation is full of uncertainty. It is matter of price, output, cut
throat competition acting according to the game theory where both taking steps
as if they playing a game or chess.

Game Theory
Game theory examines oligopolistic behavior as a series of strategic moves
and countermoves among rival firms. It analyzes the behavior of decision-
makers, or players, whose choices affect one another. Provides a general approach
that allows us to focus on each player’s incentives to cooperate or not.
Pay off Matrix - Payoff matrix is a table listing the rewards or penalties that
each can expect based on the strategy that each pursues. Each prisoner pursues
one of two strategies, confessing or clamming up. The numbers in the matrix
indicate the prison sentence in years for each based on the corresponding
strategies. The prisoner’s dilemma applies to a broad range of economic
phenomena such as pricing policy and advertising strategy.
Table -1- Pay-off Matrix

5.7 PRICE DISCRIMINATION

When different prices are charged for the same product to different buyers
then it is termed as price discrimination.

84 Market Structure
Types of Price discrimination Managerial Economics
1. Age Discrimination
Railway Tickets Charges are charged less to Senior Citizens and
NOTES
Children.

2. Time Discrimination
Movie Ticket Charges are charged less for morning and matinee
shows.

3. Personal Discrimination
A Monopolist charges different prices to different buyers. E.g. Fees
charged by Surgeon, Lawyer, Teacher may differ to different clients.

4. Use Discrimination
Different prices are charged depending upon its use for same service.
For E.g. Electricity charged to Industrialists, Agriculturalist and
Household at different rates.

5.8. SUMMARY

Market structure describes the number of sellers and buyers, nature of

commodity, free entry and exit of firms etc. Perfect competition is a market where
there are large number of buyers and sellers, standardized product and free entry
and exit. Monopoly arises when there is only seller in the market and therefore
the only producer has control on the supply of that specific commodity. Also, in
monopoly firm is the Industry (one seller). Monopoly is the other form of market
that is just opposite of perfect competition. Oligopoly means few sellers and the
products can be homogenous (steel industry) as well as differentiated.

5.9. EXERCISE

1. Explain the Meaning and Concept of Market Structure

2. Explain the features of Perfect Competition
3. Explain the features of Monopolistic Competition
4. Explain the features of Monopoly Competition
5. Explain the features of Oligopoly Competition
6. Explain Price discrimination
7. Explain with graph price and output determination of Perfect Market,
Monopoly and Monopolistic Competition

*****
Market Structure 85
 Managerial Economics

NOTES
Unit – 6 National Income

STRUCTURE
6.1. Objectives
6.2. Meaning and Concept of National Income
6.3. Methods of Measurement of National Income
6.4. Inflation and its types
6.5. Theories of Profit
6.6. Fiscal Policy and its impact on decision making
6.7. Summary
6.8. Exercise

6.1 OBJECTIVES

After studying this chapter, students shall be able to

• Understand the concept of national income and the methods for
measuring the national income.
• Explain the inflation and its types.
• Understand the fiscal policy and its impact on decision making.

6.2 MEANING AND CONCEPT OF NATIONAL INCOME

National Income is the final outcome of the economic activities performed

within a country. National income is one of the basic aggregate measures in
Macroeconomics, which provides a comprehensive objective measure of welfare
of the people. National income is the market value of final goods and services
produced in an economy over a specific time period (usually a year).
Macroeconomics deals with a number of large totals or aggregates, which
are used to conceptualize and measure key components of the economy. The most
fundamental of these is the total output of goods and services, conventionally
referred to as the national income.

86 National Income
 It is impractical to try to measure output or income in real, physical terms, Managerial Economics
simply because it is impossible to sum apples and oranges or any of the millions
of goods and services which are produced and received as income in a modern
economy. Instead, physical quantities must be converted to a common measure NOTES
and the measure used for this purpose is the national unit of account, the dollar,
INR, or other currency.
The value of total output or income in an economy during some accounting
period, usually a year or quarter of a year, is a significant statistic. It is generally
used as an indicator of the economy’s performance. Because a larger output or
income is equated with a rise in the economic well-being of a country’s
population, a higher output or income is considered desirable and a lower one
undesirable. The economy’s overall performance is tracked by the changing value
of the total output or income statistic.

The Circular Flow

A modern economy can be simply modeled in the aggregate by thinking of
it as comprising two key sectors, households which consume produced goods
and services and which supply labour and other productive services to firms,
which use the labour and other productive services supplied by households to
produce the goods and services the households consume. Households supply the
services of productive factors (land, labour, capital, etc.) and the firms convert
these inputs into produced goods and services which return to the households.
Owners of firms are, of course, also part of the household sector where they
function in their other capacity as consumers of goods and services.
The real flows of productive services and produced outputs have
corresponding flows of money payments associated with them. Firms pay out
wages and salaries in return for labour services, rents to owners of land and other
natural resource inputs, and interest and profits to suppliers of capital and
entrepreneurial inputs. Householders consequently have money income with
which to pay for the produced goods and services that flow to them from firms.
Thus, there are money flows corresponding to the real flows, but they move, of
course, in the opposite direction.
Because the flows of payments for produced goods and services and
payments for factor inputs are continuous, aggregate income/output in this simple
model could be measured at any point, metering the flow anywhere in the circuit.
If measured in terms of spending on produced goods and services, it would be
natural to call this a measure of total spending or total expenditure. If measured
in terms of outlays made for the services of productive factor inputs, it would be
total income (from the point of view of the owners of those factor inputs).
Obviously the two totals would have to be the same.

National Income 87
 Managerial Economics Circular Flow of Income

NOTES

This is a greatly simplified model. One thing missing is the possibility of

saving. If households do not spend all their income on produced goods and
services, but hold some of it back as savings, every time income flows into the
household sector the flow of payments made to producers will diminish. This is
a "leakage" of income/spending from the system and the volume of the flow
would diminish—the level of national income would fall. But if there are savings,
there could also be new investment. If businesses borrowed income saved by
households and used it to finance the building of new plant or for other business
purposes, it would be injected back into the income stream (in the form of
payments to workers and other factor owners who supplied the necessary real
inputs needed to produce the new capital). Banks and other financial
intermediaries serve as the nexus through which savings are converted into
investment spending and returned to the income stream.
In the simple economy above we can write the identity of output produced
and output sold as
Y ≡ C+I………………………………………(i)
That is all output produced is either consumed or invested. The
corresponding identity for the disposition of personal income is that the income
is allocated on C (Consumption) and part is saved (S). This implies that
Y ≡ C+S………………………………..……(ii)
It also flows that from (i) and (ii) C+I ≡ Y ≡ C + S. ………(iii)
Subtracting C from both sides gives I ≡ Y - C ≡ S which shows that saving
is also income less consumption and also investment is identically equal to
88 National Income saving.
 If another complication, government, is added to the simple model, another Managerial Economics
potential for a leakage of income from the system is introduced. Governments
impose taxes (T) on households (and firms) and this results in a diversion of
income from the private sector to government. This is another leakage and it too NOTES
has a corresponding potential for injecting such income back into the stream, this
time in the form of government spending on produced goods and services.
Taxation reduces disposable income. Disposable income is given by Yd ≡ Y-T
and also Yd ≡ C+S. Thus C+S ≡ Yd ≡ Y-T
Finally, most real world economies are not closed. Instead they are "open"
to the rest of the world, with leakages from domestic income/expenditure flows
in the form of payments made for goods and services produced abroad ( imports,
M or Z) and injections of income back into the domestic flows as a result of sales
of goods by domestic firms to consumers abroad (exports, X). As already seen,
there can also be important flows of savings and investment between one country
and the rest of the world.

Circular Flow of Income

From the diagram Y = C + I + G + (X-M) = C + S + T

The important ideas to understand at this point are that national income or
expenditure can be thought of as a continuous flow which can be measured in
different ways ( Product ≡ income ≡ expenditure on the product) and that this
simple process is complicated by the possibilities of leakages and injections
National Income 89
 Managerial Economics arising from private saving and investing; government taxation and spending;
and foreign trade and capital movements.

NOTES THE NATIONAL ACCOUNTS

All the economies today measure the volume of aggregate income, usually
defined as Gross Domestic Product, in much the same way.

Gross Domestic Product (GDP)

GDP refers to the total monetary value of all goods and services produced
within the geographic boundaries of a nation during a given year. The word
“domestic” implies that only the income produced in that country is accounted
for. The income that arises from investments and possessions owned abroad is
thus not included in the GDP estimates. It is calculated simply by valuing the
outputs of all “final” goods and services at “market” prices ( i.e. actual prices at
which they are bought and sold) and then adding the total. N.B. The market value
of all intermediate products- those used to produce the final output is excluded
from the calculation of GDP since the values of intermediate goods are already
implicitly included in the market prices of the final goods. “Gross” implies not
all output was available for private/public consumption and investment, part went
to replace or maintain worn out capital equipment. To calculate the GDP, all the
goods and services produced and rendered in a final form during the period
concerned are multiplied by their prices and then added together to yield the total
market value of the GDP. The prices used for this purpose will be the market
prices paid for the various goods and services during the year. Final goods and
services are distinguished from intermediate goods and services are distinguished
from intermediate goods and services are on the basis that they are bought by
consumers for final use.
The GDP therefore concerns the production of new products taking place
during a specified period. For example the resale of any second hand article (e.g.
car, machine ) would not form part of the GDP. Nor do activities on the stock
market affect the GDP in any way.
If the allowance for depreciation is subtracted from the GDP we arrive at
Net Domestic Product (NDP). If on the other hand the allowance for depreciation
is subtracted from GNP we arrive at NNP.

Nominal and Real GDP

Two measures of GDP are given: nominal GDP (also called current dollar
GDP) and real (constant dollar) GDP. Nominal GDP measures the value of output
at the prices prevailing at the time of production, while real GDP measures the
output produced in any one period at the prices of some base year. The growth
rate of the economy is usually taken to be the rate at which real GDP is increasing.
Whatever their minor differences, all national accounting conventions
follow the basic pattern identified in the preceding discussion of the circular flow
90 National Income of income and expenditure. There are always at least two main calculations, one
which sums total expenditures on goods and services produced, the other of total Managerial Economics
income received as a result of producing those same goods and services. Because
both are measures of the same thing they must, by definition, yield the same total.
In national accounting in ex-post sense expenditure on production is always NOTES
equal to production and income. Product ≡ Income ≡ Expenditure on the product
Why these measures if the total must be the same? One reason is that the
estimates provide a check on one another with respect to accuracy. Another is
that the measures break down into different components, some of which are more
useful for certain purposes than others.

GROSS NATIONAL PRODUCT (GNP)

This is the most important and widely used measure of national income. It
is the most comprehensive measure of a nation’s productive activities. It is
defined as the value of all final goods and services produced during a specific
period, usually one year (Dwivedi, 1996). In other words it refers to that part of
the GDP that is actually produced and earned by or transferred to resident
nationals of that country. Earnings of foreigners which arise out of their domestic
economic activities are thus excluded. To derive the GNP from GDP subtract
from GDP:
(i) Profits, interest and other income from domestic investment which
accrues to non- residents.
(ii) Wages accruing to guest workers, foreign sportsmen etc.
And add
(i) Profits, etc. accruing from abroad to permanent residents.
(ii) Wages and salaries earned by permanent residents outside Zimbabwe.
For Zimbabweans working abroad their income is included in the GNP of
Zimbabwe. Where there is substantial foreign participation in the economy and
a large part of total domestic income is earned and repatriated by foreigners and
foreign companies as in many LDCs, GDP will be much larger than GNP. As a
result statistics of GDP growth may give a false impression of the economic
performance of a particular developing nation. GNP is therefore a more
appropriate measure of national income.

NET NATIONAL PRODUCT (NET NATIONAL PRODUCT)

Net National Product = Gross National Product– Depreciation. Net National
Product (NNP) is calculated by deducting from GNP the depreciation of existing
capital stock over the course of the period. The production of GNP causes wear
and tear to the existing capital stock, for example, machines wear out as they are
used. Depreciation is important because it shows which proportion of the total
output should actually be saved in order to maintain the economy’s production
capacity at the same level. It is a more accurate measure of national product but
in real life GNP is mostly used because net investment (Gross Investment – National Income 91
 Managerial Economics Depreciation) is difficult to measure especially as rate of depreciation is not
known (straight line, declining or reducing balance?) or may be quite inaccurate.
Depreciation estimates may also not be quickly available.
NOTES

6.3 METHODS OF MEASURING NATIONAL INCOME

Methods of Calculating GDP

There are three methods or approaches for measuring total output, namely:
1) Expenditure
2) Income method
3) Value Added or Output approach

A. The Expenditure Approach

Expenditure approach-involves only counting the value of those transactions
where a commodity reaches its final destination. The market for consumer goods
is by implication the market where final goods and services are sold.
Measuring total output by the expenditure method can be explained through
C+I+G+(X-M):
(a) Expenditures by consumers on goods and services (abbreviated simply
to the letter C);
(b) Expenditures by businesses on capital goods (total investment
spending, I);
(c) Expenditure by government on goods and services, G); and
(d) Net exports (the total value of exports minus the total value of imports,
X-M). Because all spending done in the country falls into one or other
of these four categories, we can say that total expenditure is the sum
of C+I+G+(X-M). We now examine each of these four main
components of total spending.

Consumption (C)
Consumption spending is the total of all outlays made by households on
final goods and services. In all countries it is by far the largest component of total
spending. It covers spending on an enormous range of items, including durable
goods like television sets and cars, non-durable goods like food and clothing,
and personal services such as legal advice, hairdressing, and dental care. But it
usually excludes spending on houses, which is customarily (and arbitrarily)
treated as investment expenditure. C also excludes purchases of second-hand
goods that were produced in some earlier accounting period so as not to double
count the value of such output.
92 National Income
Government Expenditure on Goods and Services (G) Managerial Economics
All governments payments to factors of production in return for factor
services rendered are counted as part of the GDP. Much of the spending done by
governments in the developed countries today takes the form of simple transfers NOTES
of income from taxpayers to those eligible for the wide range of income
supplements available to assist the elderly, the sick and the unemployed, or as
payments of interest to holders of the public debt. Such transfer payments do not
represent spending on current production and consequently, are excluded in
national income determination. What is counted is government spending on
goods and services, many of which are bought by the government on behalf of
the public and which are ultimately "consumed" by households: education, health
care services, national defence, roads, water and sewage systems, postal services.
There are two complications concerning government expenditures
• Because so many of these goods and services are provided "free" or in
other ways that bypass markets, it is difficult to determine their value in
the same way that the value of the other items entering into C would be
determined. Consequently, national income accountants value
government spending on the basis of what the government pays for the
goods and services it requires.
• Government expenditure on goods and services is that such spending is
often done on things like highways which are themselves capable of
being used to assist in the production of other goods. Logically, such
spending should be thought of as investment spending and included in
the next category to be discussed. Some countries produce their accounts
in such a form that government spending can be separated into two
categories, current spending on goods and services, and investment
spending.

Investment (I)
Investment is the production of goods that are not for immediate
consumption. The goods are called investment goods (inventories and capital
goods including residential housing) The total investment in an economy is called
Gross Investment.
Total or gross investment Expenditure may be divided into two main
categories:
Expenditure on capital goods—purchases of plant and equipment either to
replace existing capacity that is wearing out or to increase capacity. This is often
called fixed capital formation.
Expenditure on inventories. Many businesses find it convenient or necessary
to hold certain supplies of goods on hand, in which case investment in inventories
may be considered voluntary. But business conditions are uncertain and so firms
may also find themselves holding stocks because they miscalculated demand. In
either case, firms are considered to be investing when they accumulate
National Income 93
 Managerial Economics inventories. On the other hand, if their inventories decrease they are
"disinvesting." Inventory investment is highly volatile, changing greatly in
amount and composition from year to year.
NOTES Gross investment, then, is the total amount of (usually private) spending
during the accounting period on capital goods (defined as structures, machinery
and equipment, and inventories). Because capital by its nature consists of things
that are used in the production of other goods and services, it is inevitable that it
will wear out or "depreciate." The amount necessary for replacement is called
Depreciation or capital consumption allowance. Gross Investment – Depreciation
= Net Investment. Unless it is continually renewed, the stock of capital in the
economy will gradually be depleted. Handling depreciation is one of the more
difficult parts of national income accounting.

Net Exports (X-M)

The External Sector Exports (X) represents an addition to domestic
expenditure and must be added to it in order to arrive at an indication of aggregate
demand or aggregate expenditure. Imports (M or Z) are a subtraction from
domestic expenditure. An increase in imports (Z or M) lowers aggregate demand
and hence employment whereas a rise in exports (X) has the opposite effect.
A significant part of total spending in most countries goes toward the
purchase of goods produced abroad rather than domestically. As noted in
discussing the circular flow, such outlays represent spending which leaks from
the domestic economy to the rest of the world and is consequently treated as a
negative entry in measures of total domestic spending. But it is offset to a greater
or lesser degree by the spending of non-residents on goods produced and exported
to international markets. It is often convenient, therefore, to take domestic
spending on imports and foreign spending on exports as a combined value,
usually called net exports, a value which may be positive or negative in any
accounting period depending on which component, exports or imports, is larger.
Summing these four expenditure components, C+I+G+(X-M), gives a
single figure, the total amount of spending done in the economy during the
accounting period. It should be possible to arrive at exactly the same figure by
summing all income received in the economy during the accounting period.
(GDP = Y = C+I+G+(X-M),

B. Measuring Total Output by the Income Method

Factor Income method or Income approach- this involves calculation of
GDP by adding up all incomes deriving from the production process. In other
words, all payments made in respect of the 4 factors of production (labour,
capital, land and entrepreneurship) over the year will together represent the value
of the GDP. This implies that the total of all wages and salaries, interest, rent and
profits is conceptually equal to the GDP as calculated according to the production
method. In principle output expressed in monetary terms must be equal to the
94 National Income total monetary income deriving from it. [i.e. value of final goods and services =
Total income] Value of output is equal to the total value of expenditure, Managerial Economics
consequently the latter must also be equal to total income.
As seen in discussing the circular flow, what the firms producing the
national output see as costs of production, owners of productive factors see as NOTES
income. Factor costs and factor incomes are consequently the same thing viewed
from different perspectives.
GDP = wages + rents + interest + non-income charges
Quantitatively, by far the most important and certainly the simplest factor
costs to measure are the payments made by employers for labour services. These
payments are usually reported in the official statistics under a heading such as
"Wages, salaries, and supplementary labour income," with the latter term
referring to employee benefits such as pensions, workers’ compensation benefits,
and employer contributions to unemployment insurance funds or other worker
social security schemes. Summing all these items yields the total amount received
during the accounting period by the owners of productive factors. But if this
figure for factor costs or income is compared with the total arrived at by the
expenditure method, it falls considerably short of the amount expected.
Indirect taxes and subsidies result in a discrepancy between the market price
and the factor cost of goods and services.
Scenario I. The market price of most goods and services includes indirect
taxes, such as general sales tax, value- added tax and excise taxes with the result
that the market price is greater than the price the seller of the good or service
receives.
Scenario 2. Subsidies paid to producers to keep the market price of certain
goods and services lower than it would otherwise be, result in the producers’
income being greater than the market price.
To calculate the GDP at factor cost, i.e. the amount received by the factors
of production that produced the goods and services concerned, we therefore have
to deduct indirect taxes from the GDP at market prices and add back subsidies.
Thus: factor cost ≡ market price – indirect taxes + subsidies. This point becomes
important when we relate GDP to the incomes received by the factors of
production.

C. Output Approach or the Value Added Method

Value Added or production approach or output approach. This involves
counting, in each transaction, only the value added (i.e. the addition to the value
of the output)
A third method is available for estimating the total output of the economy
and it is called the "value added method" because it simply sums the net value
of the output produced by all the firms in the economy. GDP is the value of final
goods and services produced. The insistence on final goods is simply to make
sure that we do not double count. This approach measures GDP in terms of values
National Income 95
 Managerial Economics added by each of the sectors of the economy. This is conceptually simple, but in
practice complex because of the need to avoid double counting. There are many
interactions among firms in a modern economy. Many produce goods that are
NOTES sold not to final users as consumer goods, but to other firms. Consider a firm
producing power supply devices for computers. It buys components from
suppliers, assembles them, and sells the finished product to another firm which
incorporates it into a computer. If the value of the power supplies was measured
when they were produced and again as part of the price of the finished computer,
total output would obviously be exaggerated. Dealing with this requires that the
value of each firm’s output be reduced by the amount of all payments made by
that firm to obtain inputs. This involves considerable work, but the resulting data
are often very useful because they yield a breakdown of national output on an
industry-by-industry basis. In formula terms:
Value Added = output of firm - output purchased from other firms.
If we follow the course of this process, we will see that the sum of values
added at each stage of process is equal to the final value of the item sold. Value
added is also the basis for the Value added Tax (VAT). A number of LDCs (Less
Developed Countries) have introduced the value-added tax. The appeals of the
value-added tax are simplicity, uniformity, and the generation of substantial
revenues.
A problem associated with the value added approach is valuation of
inventories of goods produced but unsold. Unsold inventories are valued at
market prices yet profits (or losses) have not been realised; prices may fall or
rise; goods may not be sold. This means that a rise in market prices causes a rise
in value of the existing inventories. To avoid this distortion a correction is made
to eliminate changes in the value of inventories due to price changes; that is stock
appreciation should be deducted from the value.

6.4. INFLATION AND ITS TYPES

Inflation is basically the increase in the price levels and is generally

monetary. There could be different reasons for increase in inflation but is
primarily caused by increase in supply of money. Broadly, we can say that there
are 2 types of inflation.

A) Demand Pull Inflation

It takes place mainly because there is more money in hand and so more is
the purchasing power of the people. So the factors are responsible for rise in
money supply are known as factors of Demand Pull Inflation. Some of the factors
related to demand pull inflation are as follows:
(1) increase in money supply.
96 National Income
 (2) Rise in private expenditure. Managerial Economics
(3) Repayment of loan.
(4) Reduction in Taxes.
NOTES
(5) Rise in Exports.
(6) Rise in Employment.
(7) Rise in credit creation of commercial banks

B) Cost Push Inflation

When the supply cannot match the increase in demand & supply then price
rise. This known as Cost Push Inflation. Thus, in the case, prices may increase
to excess of demand over supply or due to cost production. Thus, when increased
cost pushes up price level, then it is known as cost push inflation.
t is caused due to following factors
a) High wage rates.
b) High Taxation.
c) Rise in Price of import.
d) Rise in administration prices.
e) Rise in Transport Cost.
f) Limited Resources.
g) Natural calamities.

Some other types of inflation are

1. Creeping Inflation
A very slow rise in price is called as creeping inflation. e.g.: Just like
a creeping child. In this stage rise in price annually is less than 3% in
creeping stage.

2. Walking Inflation
When there is moderate rise in price is known as walking inflation. It
is in the range of 3% to 9% p.a. This stage is an alarm to the
government to be alert.

3. Running Inflation
When prices rise at the rate of speed of 10% to 20% It is called as
running inflation.

4. Galloping Inflation
When prices rise just like horses gallop then it is called as Galloping
Inflation. The price rises at multiplying rates i.e. 20% to 100% p.a. or
100% to 200% p.a. National Income 97
 Managerial Economics 5. Hyper Inflation
The Hyper Inflation situation is uncontrolled prices rise over 1000%
p.a. This situation results in total collapse of the monetary system. But
NOTES this type is rarely found in real life.

(1) Effects on Distribution of Income

Inflation raises results to increase in equalities. Rich becomes richer
and poor becomes poorer. Thus, we can say that, business person’s
gains and fixed income earners suffer.
(2) Effects on various types of persons
a) Salaried Person
The white collared people e.g. – Professors have to suffer loss
during inflation because rising prices and low salaries do not
match each other.

b) Fixed Income Group People

All such people who are having fixed income e.g. Pensioners,
landlords etc. lose because they get fixed income but there is rise
in price and thus, value of money falls.

c) Businessman
All types of businessmen gets profits during inflation due to
raising prices. Real Estate Agents earn maximum profits during
inflation. Because, prices of land & property rise faster than
general price level.

d) Creditors
Creditors are losing during inflation because value of money falls
and thus, they receive less in terms of goods & services.

e) Debtors
Debtors gain during inflation because when they repay money
back, they pay less in terms of goods and services.
98 National Income
 f) Farmers Managerial Economics
Farmers who are the owners of land gain but landless agricultural
workers are all at loss because their wages do not rise as compare
rising prices. NOTES
(3) Effects on Production
(a) Total production level gets discouraged.
(b) Black marketing increases.
(c) Fall in savings.
(d) Creation of essential goods.
A continuous rise in prices creates a sell market and thus, as a result,
producers produce and sell sub-standard commodities to get profits
(bad / inferior quality goods).

(4) General Effects

1) Rise in frustration.
2) Rise in unrest of mind.
3) Rise in insecurity
4) Honesty, hard work, sincerity have no place

6.5. THEORIES OF PROFIT

Profit Theory
Risk bearing and uncertainty theory of profit
According to Hawley, since entrepreneur undertakes risk in his business,
thus he is entitled to receive award of profit. So, higher the risk, higher will be
the profit. This theory neglects all other factors which are related to profits.

Uncertainty theory of profit

This theory is improved version of Hawley’s theory. It is stated by
prof.knight. As per him, entrepreneur bears uncertainty in life and so he should
get a reward as profit. There are 2 types of risks - Insurable and non-insurable
risks. Insurable risks can be compensated by getting money from insurance
company. Example, loss against fire, theft. But, non-insurable risks cannot be
compensated by insurance company.

Dynamic theory of profit

This theory is related to the dynamic changes in an economy. The producer
who is able to make dynamic changes in his production as per the dynamic
changes in an economy will enjoy profit. Examples of dynamic changes -Change
National Income 99
 Managerial Economics in demand, Change in fashion, Change in government policies, Change in taste
and preferences etc

NOTES Innovation theory of profit

This theory is proposed by Schumpeter. As per him, there is a direct
relationship between innovation and profit. Thus ,the producer who makes
innovations and inventions and discoveries in his production will enjoy profit.
Innovations can be related to
1 product innovation
2 market innovation
3 modern technology

6.6 FISCAL POLICY AND ITS IMPACT ON MANAGERIAL

DECISION MAKING

Chief Instruments of Economic Policy

The two important subdivisions of economic policy are the monetary policy
and the fiscal policy. These two policies are applied as mutually complementary
policies to serve as instruments of government’s economic policy which is
applied to achieve certain social goals. Often the two overlap, because it is almost
impossible to envisage any major fiscal or monetary measure which does not
affect the other.
o. Fiscal Policy
This is the policy of government with regard to level of government
spending and tax structure. Government expenditure includes transfer
payments, government current expenditures and budgetary balance
(extent of borrowing). Taxation (i) provides the funds to finance
expenditure. (ii) Can also be used for income redistribution. Taxes are
subdivided into direct and indirect.

o Direct taxes
These are levied directly on persons / corporates and include income
tax, corporate tax, poll tax and inheritance taxes, import duties. Typical
uses for this instrument are a reduction in income inequalities, regulate
aggregate demand, protection of domestic producers, reduce poverty,
and provision of infrastructure and to adjust balance between aggregate
demand and supply. Import duties are important sources of revenue in
many African countries. Countries impose import tariffs for some or
all of the following reasons: (a) Revenue, protection to local producers,
(b) discriminate between essential and non-essential goods and (c)
B.O.P purposes.
100 National Income
 o (ii) Indirect tax is levied on a thing and is paid by an individual by Managerial Economics
virtue of association with that thing, e.g. local rates on property, sales
taxes and excise duties. Tax structure can be regressive proportional
or progressive. Tax incentives may be given - investment allowances, NOTES
tax holidays, accelerated depreciation allowances, duty-free imports;
no-tax concessions may be given by government for e.g. provision of
roads, water and power. In some African countries rural taxation- was
used e.g. Cameroon, Mali and Sudan.

Problems of Fiscal Administration

(a) Tax evasion
(b) Shortage of trained and experienced staff.
(c) Corruption.
(d) Attitudes towards payment of taxes.
(e) Poor co-ordination of budgets with development plans.

BUSINESS CYCLE
Business Cycles (or trade cycle)
A business cycle is the more or less regular pattern of expansion (recovery)
and contraction (recession) in economic activity around a growth trend
(Dornbusch et al, 1998). Business cycles can also be described as the periodic
booms and slumps in economic activities. The ups and downs in the economy
are reflected by the fluctuations in aggregate economic magnitudes, such as,
production, investment, employment, prices, wages, bank credits etc.

Trade Cycles or business cycles- simplified diagram

The upward and downward movements in these magnitudes show different

phases of a business cycle (Dwivedi, 1996). Basically there are only two phases
in a cycle, namely prosperity (boom) and depression (recession). Considering
the intermediate stages between prosperity and depression, the various phases of
trade cycle may be enumerated as follows:
National Income 101
 Managerial Economics 1) Expansion
2) Peak
3) Recession;
NOTES
4) Trough
5) Recovery and expansion

Expansion or prosperity (or boom)

This boom is characterised by increase in output, employment, investment,
aggregate demand, sales, profits, bank credits, wholesale and retail prices per
capita output and a rise in standard of living. The growth rate eventually slows
down and reaches the peak. However:
• A boom increases spending on imports, causing balance of payments
problems.
• Once high levels of employment have been reached, output cannot be
increased any further and the boom causes inflation.

Peak
• This is characterized by slacking in the expansion rate, the highest level
of prosperity, and downward slide in the economic activities from
the peak.

Recession
The phase begins when the downward slide in the growth rate becomes
rapid and steady. Output, employment, prices, etc. register a rapid decline, though
the realised growth rate may still remain above the steady growth line. So long
as growth rate exceeds or equals the expected steady growth rate, the economy
enjoys the period of prosperity, high and low. When the growth rate goes below
102 National Income
the steady growth rate, it marks the beginning of depression in the economy. Managerial Economics
Total output, employment, prices, bank advances etc. decline during the
subsequent periods. In other words there is a slump in the economy. [A slump
reduces spending on imports, thus improving the balance of payments. Reduced
NOTES
total spending lowers inflationary pressure.] The span of depression spreads over
the period growth rate stays below the secular growth rate (or zero growth rate)
in a stagnated economy.

Trough
This is the phase during which the downtrend in the economy slows down
and eventually stops and the economic activities once again register an upward
movement. Trough is the period of most severe strain on the economy.

Recovery
When the economy registers a continuous and rapid upward trend in output,
employment, etc, it enters the phase of recovery though the growth rate. When
it exceeds this rate, the economy once again enters the phase of expansion and
prosperity. If economic fluctuations are not controlled by the government, the
business cycles continue to recur as stated above.

6.7. SUMMARY

National Income is the income of all the people in the country. There are
three methods to calculate the national income: Income method, expenditure
method and value added method. The GDP comprises of C+G+I+(X-M) and it
is important to pay attention to the consumption and investment. That is as the
consumption increases the GDP will increase and similarly with the increase in
investment also the GDP tends to increase. Inflation is rise in General Price Level
and there are two types- Demand pull and Cost push Inflation. In India, CPI
(Consumer Price Index) is used to measure the level of inflation. There are three
theories of profit- Risk Bearing, Uncertainty and Innovation Theory. Fiscal Policy
is related to Budget of Government and the Govt has made sufficient efforts to
reduce the fiscal deficit by increasing the revenue and reducing the expenditure.

6.8. EXERCISE

1. Explain the Meaning and Concept of National Income

2. Describe the Methods of Measurement of National Income
3. What is Inflation and its types? Explain its effects or consequences
4. Explain the theories of profit with suitable example.
5. Explain Fiscal Policy and its impact on decision making
6. What do you mean by Trade Cycles? Explain its four phases
***** National Income 103
 Managerial Economics

CASELET-ECONOMICS-1
NOTES

Mr Anil is working as a store manager in one of the reputed retail giants in

Delhi that is Big Bazar. He keeps on understanding the changing patterns of
consumers and retailers based on certain principles. He describes one of the
interesting situation of the store. The company happen to reduce the price of one
of the branded air conditioner and the observations were interesting. Mr Anil
reported that with the reduction in price of air- conditioner by 10% the increase
in quantity demanded was more than 20%. Mr Anil happen to meet an economist
and tried to understand the effect of change on the goods.
The economist has further provided a tabular format to describe the concept
of elasticity of demand. The accompanying table lists the cross-price elasticities
of demand for several goods, where the percent quantity change is measured for
the first good of the pair, and the percent price change is measured for the
second good.

Assuming that you have sound knowledge of economics, answer the

following questions.
1. What type of products are being discussed when Mr Anil says that
Price reduces by 10% and quantity demanded increases by 20%.
2. Explain the sign of each of the cross-price elasticities. What does it
imply about the relationship between the two goods in question?
3. Use the information in the table to calculate how a 5% increase in the
price of Pepsi affects the quantity of Coke demanded

104 National Income

CASELET-ECONOMICS-2 Managerial Economics

The Story of Raju – Fond of Soft Drinks

This is a story of Raju, (poor guy) residing in Mumbai who use to sell vada
pao. The Poor guy could earn his livelihood through his small unregistered NOTES
business. He understood the customer sentiments through their behaviour and
personal feedback over a period of two years. But, he was happy by selling about
hundred vada pao a day and total revenue use to be around six hundred with a
profit of about 150 per day. One fine day he came across two young college
students asking him to provide 10 vada pao’s when it was all over and he was
set to leave at 6.30 PM. Mr Raju replied very politely, that all the Vada pao’s are
sold out and therefore can’t offer more for today. The college students insisted
him to prepare by taking some time and they offered to pay twice the actual price
of vada pao. But, raju still said better you get it from the corner shop in the right
Mr Shyam. One of the college student Bikram offered him Pepsi and said “Are
Bana de bhai…Raju ka Vada Pao ka Baat hee kuch aur Hay”. Raju was looking
at them and sipped the Pepsi…he liked it very much and said ..I will provide you
the Vada pao at the original price of Rs 6 only but I need one more Pepsi (“Where
can I get It” –he asked the college students). Bikram said don’t worry for Pepsi
and prepare the vada pao’s. Raju was very happy after this deal when he was
treated in a friendly manner by Bikram and Ankit.
Raju liked the taste of Pepsi and became habitual of it. Now, everyday after
selling all the vada pao’s, he use to visit a departmental store named varun baker’s
and buy one for a price of Rs 35. However, after about a month he has to pay Rs
40/ for the same Pepsi. He inquired the reasons for increase in price of Pepsi
from Mr Varun Baker’s.
Mr Varun replied by showing the trend of Pepsi based on supply given by
Manufacturer:
Table 1 (Supply of Pepsi)

Having understood the trend he calculated that in April, revenue was 9000
and in July it use to be 20,000. He realised that it is important to increase the
price if he want to increase the supply. He decided that from July onwards he
will increase the price by Rs 1 every month and increase the supply of Vada pao’s
by 25%.

Table -2 (Projected Supply of Vada pao)

National Income 105
 Managerial Economics Since, he was having good location as well as taste and therefore could sell
all the Vada pao’s for Rs 7 in July and for Rs 8 in Aug. However, he realised that
in Sept he was not able to attract the customers. Customers after having come to
NOTES know that the price per vada pao is Rs 9 started moving to shyam vada pao where
still the vada pao was sold at Rs 6 per unit. Moreover, shyam has been working
to improve the taste of Vada pao which was now equally acceptable. However,
in Aug’16 his(Shyam) daily sell was 200 vada pao’s with an earning of Rs 2 per
unit. Mr Shyam use to buy the raw material directly from the wholesale market
to reduce the cost of vada pao. By the end of Sept’16, Mr Shyam increased the
Price to Rs 7 per unit and increased the supply to 250. Mr Raju is still consuming
the pepsi and in September he was surprised to note that the price of Pepsi is
now Rs 35 per unit. He went to Mr Varun Baker’s to understand as to why the
price of pepsi has been reduced.

Part-I Questions
1. What are the determinants for Supply of good.
2. What are your views for the business strategy of Mr Raju. Critically
analyse it.
3. What are your views for the business strategy of Mr Shyam. Critically
analyse it.
4. What should Mr Raju do to attract the customers. If you are Varun
baker’s, what could be the possible reasons for decrease in Price of
Pepsi as inquired by Mr Raju.

*****

106 National Income