UNIT - I

INTRODUCTION TO MANAGERIAL
ECONOMICS, DEMAND AND
DEMAND FORECASTING
 NATURE OF MANAGERIAL ECONOMICS

1. Close to Micro Economics

2. Operates against the backdrop of micro economics
3. Normative statements
4. Prescriptive actions (Goal oriented)
5. Applied in nature (models are built for real life
complex business)
6. Offers scope to evaluate each alternative (interms of
its cost and revenues)
7. Interdisciplinary
8. Assumptions and Limitations
 LINKAGES WITH OTHER DISCIPLINES

• Operations research – linear programming,

queing, transportation, sorting and sequencing
• Mathematics – algebra, calculus, exponentials
• Statistics - correlation and regression
• Accountancy
• Psychology
• Organisational behaviour
SCOPE OF MANAGERIAL ECONOMICS

VARIOUS MANAGERIAL
CONCEPTS DECISION ARES
AND
TECHNIQUES Applied to OPTIMAL
OF •DEMAND DECISIONS
MANAGERIAL •INPUT AND OUTPUT DECISIONS SOLUTION
ECONOMICS •PRICE OUTPUT DECISIONS
•PROFIT RELATED DECISIONS
•INVESTMENT DECISIONS
•ECONOMIC FORECASTING AND FORWARD
PLANNING
 DEMAND ANALYSIS
A product or service is said to have demand
only if it satisfies 3 conditions –
1. Desire to buy
2. Willingness to pay
3. Purchasing power
 DEFINITION

According to Stoner & Hague defines Demand

as “ Demand backed up by enough money to
pay for the goods demanded”.

It means that the demand is effective, if it is

backed up by the purchasing power and also
there must be willingness to buy a commodity.
 NATURE AND TYPES OF DEMAND

1. CONSUMER GOODS Vs PRODUCER GOODS

2. AUTONOMOUS Vs DERIVED DEMAND
3. DURABLE Vs PERISHABLE GOODS
4. FIRM DEMAND Vs INDUSTRY DEMAND
5. SHORT RUN Vs LONG RUN DEMAND
6. NEW DEMAND Vs REPLACEMENT
DEMAND
7. TOTAL MARKET Vs SEGMENT MARKET
DEMAND
 DETERMINANTS OF DEMAND
The demand for a particular product depends upon several factors.
1. Price of the product
2. Income levels
3. Consumer tastes and preferences
4. Expectations
5. Price of related goods
6. Common habits and scale of preference
7. Standard of living and spending habits of people
8. Number of buyers in the market and the growth of population
9. Age structure and gender ratio of the population
10. Level of taxation and tax structure
11. Inventions and innovations
12. Fashions
13. Climatic or weather conditions
14. Customs
15. Advertisement and sales propaganda
 DEMAND FUNCTION
Demand function describes a relationship between the
demand for a commodity and its various demand
determinants.

It describes how much quantity of goods is bought at

alternative prices of good, related goods, income levels and
various other variables which affecting demand.

Thus, demand function explain the relation of quantity

demanded for a commodity depends upon certain factors,
which influence the demand for a product.

The above factors can be built up into a demand function.

 DEMAND FUNCTION
Mathematically, the demand function for a product can be
expressed as follows:

Qd = f{Px, I, T, A, Pr, Ef,…O}

Qd = Quantity demanded
F = functional relationship of
Px = Price of commodity
I = Income of a consumer
A = Advertisement
Pr = Price of related goods
Ef = Expectations about of future
O = Any other factor capable of affecting the demand
 LAW OF DEMAND
The general tendency of consumer’s behavior in demanding a
commodity in relation to the changes in its price is described
by the law of demand.

The law of demand expresses the nature of functional

relationship between two variables that is price and quantity
demanded.

It states the demand varies inversely to a change in price. The

nature of this inverse relationship was stressed by the law of
demand.

The quantity demanded for a product depends on its price,

other things remaining the same. This law is based on ceteris
paribus concept.
 ASSUMPTIONS OF LAW

The main assumptions of law of demand:

• There is No change in the income of the
consumer.
• No change in taste and preferences of the
consumer.
• No change in the price of related goods.
• No change in advertisement cost.
• No change in expectations of future price
• No change in climatic conditions etc.
 Explanation of Law
Prof Marshall explained law of demand as “the amount demanded
increases with a fall in price and diminishes with a rise in price when other
things remaining the same”. It means the demand for a commodity extends
as the price falls and contracts as the price rises. The demand varies
inversely with the price, other things remaining unchanged.
Mathematically, the demand function for a product A expressed as follows:

Dx=f(Px)
Where Dx = Demand for commodity X
F = Functional relationship
Px = Price of commodity X

Marshall explained law of demand by taking one variable that is price,

keeping other factors constant. Once there is a change in other demand
determinants, the law does not hold good. Such an assumption forms the
limitation of the law of demand.
 DEMAND SCHEDULE
Demand schedule states the relation between the two variables
price and quantity demanded. In other words, demand
schedule is a list of quantity demanded at various prices in a
given period of time.
Price of goods Quantity Demanded
(in Rs) (in Units)

5 100
4 200
3 300
2 400
1 500
 GRAPHICAL REPRESENTATION
By taking the above data from demand schedule, we can plot a
graph. Quantity demanded is shown on X axis and price on Y
axis. We can obtain the demand curve DD by joining all the
points a,b,c,d and e, which represents various quantity
demanded at various prices. The DD is the demand curve
slopes downwards from left to right.
 EXCEPTIONS / LIMITATIONS
There are certain exceptions to this law. In other
words, the law does not hold well in the following
cases.
1. Giffen's paradox
2. Veblen effect
3. Speculation effect
4. Shortage of necessities
5. Ignorance of price
6. Consumer psychological bias or illusion
7. Impulse buying
 ELASTICITY OF DEMAND

The elasticity of demand is defined as the percentage

change in quantity demanded caused by one percent
change in the demand determinant, keeping all other
factors constant.
In other words it is the rate of responsiveness in the
demand of a commodity for a given change in price
or any other determinants of demand.
It means the extent of change in quantity demanded
because of a given change in other determining
factors.
Factors affecting elasticity of
demand
1. Nature of product
1. Necessaries - Inelastic
2. Comforts - Elastic
3. Luxuries - Elastic
2. Time frame
1. More time - Elastic
2. Less time - Inelastic
3. Degree postponement
1. Not postpone - Inelastic
2. Postpone - Elastic
 Factors affecting elasticity of demand

4. Number of alternative uses

1. More alternatives – Elastic
2. No Alternative uses - Inelastic
5. Tastes and preferences of consumer
1. Addicted – Inelastic
2. Not addicted – elastic
6. Availability of close substitutes
1. Close substitutes - Elastic
2. No close substitutes - Inelastic
7. In case of complementary goods – Elastic
 Factors affecting elasticity of demand
8. Level of prices
1. Cheaper(salt) - Inelastic
2. Expensive (diamonds) price rise- demand increase –Inelastic
price falls demand increases - elastic
9. Availability of subsidies
1. Providing subsidies (LPG) - Inelastic
2. Not providing subsidies - elastic
10. Expectation of prices – rise or decrease – Inelastic
11. Durability of the product
1. Durable goods - Elastic
2. Perishable goods - Inelastic
12. Government policy
1. Liberal – Elastic
2. Strict - Inelastic
 MEASUREMENT OF ELASTICITY OF
DEMAND
The elasticity of Demand is measured in the
following ways:
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Relatively elastic demand
4. Relatively inelastic demand
5. Unitary elasticity of demand
 1. PERFECTLY ELASTIC DEMAND
• When any quantity can be sold at a given price and when there is no
need to reduce price, the demand is said to be perfectly elastic.
• The quantity demanded increases from even though there is no
change in price and price is fixed at OP.
• DD is the demand curve which is horizontal to X axis. Therefore
elasticity of demand is infinity(Ed= ∞).
 2. PERFECTLY INELASTIC DEMAND
• when a significant degree of change in price leads to little or no change in
quantity demanded, then elasticity is said to be perfectly inelastic.
• In other words, there is no change in the quantity demanded even though
there is a big change (increase or decrease) in price. though there is a fall in
the price from OP2 to OP3, the quantity demanded remains unchanged.
• DD is the demand curve which is a vertical straight line parallel to Y
axis. Elasticity of demand Ed is equal to zero(Ed=0)
 3. Relatively Elastic Demand
• When the change in price brings more change in demand, the
demand is said to be relative elastic demand.
• The extent of increase in the quantity demanded is greater than
the extent of fall in the price here the demand curve is flat in
shape and the elasticity of demand Ed is said to be greater than one
(Ed>1)
 4. RELATIVELY INELASTIC DEMAND
The demand is said to be inelastic when the change in
demand is less than the change in price.
In other words, The extent of increase in quantity
demanded is lesser than the extent of fall in price. The
demand curve is in steep and the elasticity of demand
is less than one(Ed<1).
 5. Unitary Elastic Demand
The elasticity of demand is said to be unitary, when
the change in demand is equal to change in price. The
extent of increase in the quantity demanded is equal
to the extent of fall in the price. Here the demand
curve is in rectangular hyperbola and elasticity of
demand is said to be equal to one(Ed=1)
 TYPES OF ELASTICITY OF DEMAND

The following are the four types of elasticity of

demand-
• Price elasticity of demand
• Income elasticity of demand
• Cross elasticity of demand
• Advertising elasticity of demand
 1. PRICE ELASTICITY OF DEMAND

Price elasticity of demand tells us that the

quantity demanded of a commodity in
response to given change in price.
Price elasticity is always negative which
indicates that the customer tends to buy more
with every fall in the price.
The relationship between price and demand is
inverse.
 TYPES OF PRICE ELASTICITY OF
DEMAND
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Relatively elastic demand
4. Relatively inelastic demand
5. Unitary elasticity of demand
 1. Price elasticity of demand

Edp =

(Or)

Q1 = Quantity demanded before price changes

Q2 = Quantity demanded after price changes
P1 = Price before change
P2 = Price after change
 2. INCOME ELASTICITY OF DEMAND

• Income elasticity of demand refers to the degree of

responsiveness of quantities demanded to a given
change in income.
• Income elasticity is normally positive which
indicates that the consumer tends to buy more and
more with every increase in income.
• The income elasticity of demand can be measured by
the following formulae:
 2. INCOME ELASTICITY OF DEMAND

EdY =

(or)

=
TYPES OF INCOME ELASTICITY OF DEMAND

1. Highly Income Elastic (YEd > 1)

2. Unitary Income Elastic (YEd = 1)
3. Less Income Elastic (Yed < 1)
4. Zero Income Elastic (Yed = 0)
5. Negative Income Elastic (Yed < 1)
 3. CROSS ELASTICITY OF DEMAND

• The proportionate change in the quantity demanded

of a particular commodity in response to a change in
price of another related commodity.

• Thus, the price of one commodity say z, is the

independent variable whereas the quantity of another
commodity say X, is the dependent variable.

• The cross elasticity of demand can be measured by

the following formulae:
 3. CROSS ELASTICITY OF DEMAND

Cross Elasticity of Demand(Edc) =

(Or)

Where Q1 = Quantity demanded before change

Q2 = Quantity demanded after change
P2Y = Price after change in case of product Z
P1Y = Price before change
 3. Types CROSS ELASTICITY OF DEMAND

1. Positive cross elasticity if two goods are

Substitutes
2. Negative cross elasticity, If two goods are
complementary
 4. ADVERTISEMENT ELASTICITY OF DEMAND

• It refers to increase in sales revenue because of

change in the advertising expenditure.

• In other words, there is a direct relationship between

the amount of money spent on advertising and its
impact on sales.

• Advertising elasticity is always positive.

 4. ADVERTISEMENT ELASTICITY OF DEMAND

Advertising Elasticity of Demand(EdA) =

(OR)

Where Q1= Quantity demanded before change

Q2= Quantity demanded after change
A1= Amount spent on advertisement before change
A2= Amount spent on advertisement after change

•
 4. ADVERTISEMENT ELASTICITY OF DEMAND

• The advertising elasticity is said to be high when even

a small percentage change in the advertising
expenditure results in a large percentage of change in
the level of quantity demanded or sales.

• It is said to be low when a small percentage change in

the advertising expenditure results in small
percentage of change in the level of quantity
demanded or sales.
 Problems ON PRICE ELASTICITY OF DEMAND
1. Determine Price Elasticity of Demand given that the
quantity demanded for product M is 1000 units at a
price of Rs 100. The price declines to Rs 90 and the
quantity demanded increases to 1500 units.

2. Determine Price Elasticity of Demand given that the

quantity demanded for product M is 1000 units at a
price of Rs 100. The price declines to Rs 70 and the
quantity demanded increases to 1100 units.

3. Determine Price Elasticity of Demand given that the

quantity demanded for product M is 1000 units at a
price of Rs 100. The price declines to Rs 50 and the
quantity demanded increases to 1500 units.
 Problems ON INCOME ELASTICITY OF DEMAND

1. Determine Income Elasticity of Demand given

that the quantity demanded for product M is
1000 units at a price of Rs 100. The price
declines to Rs 80 and the quantity demanded
increases to 700 units.
 DEMAND FORECASTING
• Forecasting helps to assess the demand for products and
services and to plan production accordingly.
• Where the supply is not in accordance with the demand, it
results in the development of black market or excessive
prices.
• When there is a lot of competition, the entrepreneur has to
estimate demand for his products or services so that he
can plan his material inputs such as manpower, finances,
advertising and other overheads.
• In India, the services of National Council of Applied
Economics Research(NCAER) estimates the probable
demand for both industrial and consumer goods at the
national and the regional levels. These estimates help the
entrepreneurs to plan their production.
 FACTORS GOVERNING DEMAND FORECASTING
There are several factors which govern the forecasting process. These are:
1. Functional nature of demand
1. Market Demand
2. Individual Demand
2. Types of forecasts
1. Short run
2. Long run
3. Forecasting level
1. Firm level
2. Industry level
3. National level
4. Global level
4. Degree of orientation
1. General forecast
2. Segment wise forecast
 FACTORS GOVERNING DEMAND FORECASTING

5. Established or new products

When forecasting demand for a new products, it is very difficult so these things
are necessary:
• Find out the demand for a related existing product.
• The new product can be analyzed as a substitute for some existing product.
• Assess the growth and demand of established products.
• Assess the demand through a sampled or total survey of consumers
intentions over the new product features and price.
• Offer the product for sale in a limited market and test the results.
• Contact the dealers to know the customers reaction to the new product.
• It is not necessary that all the above alternatives should be tried
independently. More than one alternative can be pursued simultaneously.
FACTORS GOVERNING DEMAND FORECASTING
6. Nature of goods
• Consumer goods
• Producer goods
• Durable goods
• Perishable goods
7. Degree of competition
• Single traders
• Few traders
8. Other factors
• Political developments
• Changing fashion
• Customer preferences
• Changes in technology
• Changes in price level or inflation
• And so on.
 DEMAND FORECASTING

DEMAND
FORECASTING

QUALITATIVE QUANTITATIVE OTHER

METHODS METHODS METHODS
 DEMAND FORECASTING

QUALITATIVE
METHODS

SURVEY OPINION POLL

METHOD METHOD

EXECUTIVES SALES FORCE

CENSUS SAMPLE
OPINION OPINION
METHOD METHOD
METHOGS METHOD
 DEMAND FORECASTING

QUANTITATIVE METHODS

TREND PROJECTION METHODS STATISTICAL METHODS BAROMETRIC METHOD

FITTING
TREND MOVING LEAST LAGGING COINCIDENT
TIME SERIES EXPONENTIAL LEADING
LINE BY AVERAGES SQUARE REGRESSION CORRELATION INDICATOR INDICATOR
ANALYSIS SMOOTHING INDICATOR
OBSERVATIO METHOD METHOD
NS

CYCLICAL SEASONAL ERATIC

TREND
TREND TREND TREND
 TREND PROJECTION
1. TREND LINE/GRAPHICAL METHOD
– This is the simplest technique to determine the
trend
– All values of equal output or sale for different
years are plotted on a graph and a smooth free
hand curve is drawn passing through as many
points as possible.
– The directions of this free hand curve – upward
or downward shows the trend
Prob: sales of a firm for 5 years are given below
and have to forecast sale for next year.

Year Sales (cr)

2011 40
2012 50
2013 44
2014 60
2015 54
2016 62
 LEAST SQUARE METHOD
• Certain statistical formulae are used here to find the trend line
which best fits the available data.
• When the trend in sales over time is given by straight line, the
equation of this line is of the linear form:
Y=a+bX
To find value a and b
 YEAR(N) SALES(Y) X XY
000
2011-12 28 1 28 1
2012-13 38 2 76 4
2013-14 46 3 138 9
2014-15 40 4 160 16
2015-16 56 5 280 25
N=5 ΣY=208 ΣX=15 ΣXY=682 Σ = 55
 MOVING AVERAGE METHOD

• This method considers that the average of past

events determine the future events.
• This method provides consistent results if the past
events are consistent.
• Under this method the average keeps on moving
depending upon the number of years selected.
• Selection of number of years are decisive factor in
this method.
• Moving averages get updated as new information
flows in.
 DEMAND FORECASTING

OTHER
METHODS

EXPERTS
TEST CONTROLLED JUDGEMENTAL
OPINION
MARKETING EXPERIMENTS APPROACH
METHOD
 Production function

Production function refers to functional

relationship between the quantity of good
produced and factors of production.
Qo= (L,L1,C,O,T)
Where L = Land
L1 = Labour
C = Capital
O = Organiser
 LAND

1. LAND IS FREE GIFT OF NATURE

2. LAND IS LIMITED IN AREA
3. LAND IS PERMANENT
4. LAND LACKS MOBILITY
5. LAND IS OF INFINITE VARIETY
 LABOUR
LABOUR IS INSEPARABLE FROM LABOURER.
LABOURER SELLS HIS SERVICES NOT HIMSELF
LABOUR IS MORE PERISHABLE THAN OTHER
COMMODITY
LABOUR HAS BARGAINING POWER
LABOUR IS LESS MOBILE
LABOUR IS HUMAN BEING BUT NOT MACHINE
 LAW OF VARIABLE PROPORTION
PRODUCTION FUNCTION WITH ONE VARIABLE INPUT
LAW OF DIMINISHING RETURNS

This law was developed by Alfred Marshall.

The law states that when increasing number of
units of one variable factor is applied as a
fixed factor, the total output first increases at
increasing rate, then at a diminishing rate and
eventually decreases.
Hence, this law is known as diminishing
returns.
 ASSUMPTION OF LAW

• All other input factors are kept constant only

one factor is changing i.e labour.
• This law operates only in the short run.
Explanation of law
 STAGE 1
Stage of Increasing Returns: In this stage,
total product increases at an increasing rate.
Both average product and marginal product
also increases, but marginal product reaches to
its maximum point and starts diminishing. The
stage I ends where the average product reaches
its highest point S, where MP=AP. In this
stage TP>MP>AP.
 STAGE 2
Stage of Diminishing Returns: In this stage,
total product continues to increase but at a
diminishing rate until it reaches its maximum
point H where the second stage ends. In this
stage both the marginal product and average
product diminishing but are positive.
At the end of the second stage, i.e., at point M
marginal product of labour is zero which
corresponds to the maximum point H of the total
product curve TP. Under this stage TP>AP>MP.
 STAGE 3
Stage of Negative Returns: In stage 3, total
product and marginal product declines and
therefore the TP curve slopes downward. As a
result, marginal product of labour is negative
and the MP curve falls below the X-axis.
GRAPHICAL REPRESENTATION
 SIGNIFICANCE OF LAW
• Law of diminishing returns helps mangers to determine the
optimum labor required to produce maximum output.

• If an organization falls in stage I of production, it implies that

its capital is underutilized. Therefore, the organization needs to
increase the number of workers.
• In case, the organization is in stage III; it implies that the
organization needs to reduce number of workers. However,
stage I and stage III are irrelevant for managers for setting
the targets of output.

• Only stage II is used for this purpose because this stage

provides information about the number of workers that need to
be employed for reaching the maximum level of production.
 PRODUCTION FUNCTION WITH TWO VARIABLE
INPUTS / ISOQUANT/ISO PRODUCT

• The term Iso-quant or Iso-product is composed of two words,

Iso = equal, quant = quantity or product or output. Thus it
means equal quantity or equal product.

• Different factors are needed to produce a good. These factors

may be substituted for one another. A given quantity of output
may be produced with different combinations of factors.

• Thus, an Iso-product or Iso-quant curve is that curve which

shows the different combinations of two factors yielding the
same total product.
 ASSUMPTIONS OF LAW

1. Two Factors of Production: Only two factors are used

to produce a commodity.
2. Constant Technique: Technique of production is
constant or is known before hand.
3. Possibility of Technical Substitution: The substitution
between the two factors is technically possible. That
is, production function is of ‘variable proportion’ type
rather than fixed proportion.
4. Efficient Combinations: Under the given technique,
factors of production can be used with maximum
efficiency.
 ISO-PRODUCT SCHEDULE

Let us suppose that there are two factor

inputs—labour and capital. An Iso-product
schedule shows the different combination of
these two inputs that yield the same level of
output. It shows that the five combinations of
labour units and units of capital yield the same
level of output, i.e., 200 meters of cloth. Thus,
200 meter cloth can be produced by
combining.
 ISO-PRODUCT SCHEDULE:

COMBINATION UNITS OF UNITS OF OUTPUT MRTS

LABOUR CAPITAL
A 1 15 200 -
B 2 11 200 4:1
C 3 8 200 3:1
D 4 6 200 2:1
E 5 5 200 1:1

(a) 1 units of labour and 15 units of capital

(b) 2 units of labour and 11 units of capital
(c) 3 units of labour and 8 units of capital
(d) 4 units of labour and 6 units of capital
(e) 5 units of labour and 5 units of capital
 ISO-PRODUCT CURVE
From the above schedule iso-product curve can be drawn with the help of a
diagram. An. equal product curve represents all those combinations of two
inputs which are capable of producing the same level of output. It shows the
various combinations of labour and capital which give the same amount of
output. A, B, C, D and E.
 PROPERTIES OF ISO-PRODUCT CURVES:

1. Downward sloping:
2. Convex to the Origin
3. Two Iso-Product Curves Never Cut Each
Other
4. Higher Iso-Product Curves Represent Higher
Level of Output
5. No Isoquant can Touch Either Axis
 ISOQUANT CURVES

• An Iso-product map shows a set of iso-product curves. They

are just like contour lines which show the different levels of
output. A higher iso-product curve represents a higher level of
output. we have family iso-product curves, each representing
a particular level of output.
• An iso-product curve, on the other hand, represents a
particular level of output. The level of output being a physical
magnitude is measurable. We can therefore know the distance
between two equal product curves. While indifference curves
are labeled as IQ1, IQ2, IQ3, etc., the iso-product curves are
labeled by the units of output they represent -100 meters, 200
meters, 300 meters of cloth and so on.
 ISOCOST

• An isocost line is a graph showing various possible

combinations of inputs (labor and capital) that can be
purchased for an estimated total cost. Any combination of
inputs on an isocost line provides the same total cost for the
output. It is an important tool for determining what
combination of factor-inputs the firm will choose for
production process.
• On the isocost line, a firm can select from a variety of input
combinations that result in the same total cost. However,
firms make decisions on a combination of inputs depending
on their area of operation. If a firm is located in an area with
low labor costs, it may choose to build a labor-
intensive production facility to reduce production cost.
• Suppose a producer has Rs. One lakh and he wants to
spend his entire outlay on two factors – labor and
capital. Further suppose that the price of Labor is Rs.
2000 per unit and the price of capital is Rs 4000 per
unit. If the firm spends its whole outlay of Rs 1 lakh on
labor only, he can buy 50 units of labor. And, if the firm
spends its entire outlay on capital only, then he can buy
25 units of capital.
• A firm can purchase only such combinations of factor-
inputs which satisfy the given equation. For example, a
producer can purchase combinations like:
• ‘10 units labor + 20 units capital’ – 10X2000 + 20X4000 = 1,00,000
• ‘20 units labor + 15 units capital’ – 20X2000 + 15X4000= 1,00,000
• ‘ 30 units labor + 10 units capital’ – 30X2000 + 10X4000 =1,00,000
• ‘40 units labor + 5 units capital’ - 40X2000 + 5X4000 = 1,00,000
 GRAPHICAL REPRESENTATION

• In the given diagram, x-axis represents units of labor

and y-axis represents units of capital. Therefore, OF
in the figure represents 50 units of labor and OA
represents 25 units of capital.
• If we join points A and F, we get isocost line for Rs.
ONE LAKH. On this Isocost line the producer have
various combinations i.e B,C,D,E, at any combination
the producer is going to incur the same cost that is
one lakh.
 LAW OF RETURNS TO SCALE

In the long run all factors of production are variable.

No factor is fixed. Accordingly, the scale of
production can be changed by changing the quantity
of all factors of production. “The Term returns to
scale refers to the changes in output as all factors
change by the same proportion.”

Returns to scale are of the following three types:

1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Decreasing Returns to scale
 LAW OF INCREASING RETURNS TO SCALE

• This law states that the volume of output keeps on

increasing with every increase in the inputs. Where a
given increase in inputs leads to a more than
proportionate increase in the output, the law of
increasing returns to scale is said to operate.
• It means if all inputs are doubled, output will also
increase at the faster rate than double. Hence, it is
said to be increasing returns to scale. This increase is
due to many reasons like division of labour,
technology etc.
 DECREASING RETURNS TO SCALE

• Where the proportionate increase in the inputs

does not lead to equivalent increase in output, the
law of decreasing returns to scale operates. Where
if all the factors of production are increased in a given
proportion, output increases in a smaller proportion.
• It means, if inputs are doubled, output will be less
than doubled. If 20 percent increase in labor and
capital is followed by 10 percent increase in output,
then it is an instance of diminishing returns to scale.
 CONSTANT RETURNS TO SCALE

• Constant returns to scale refers to the

production situation in which output increases
exactly in the same proportion in which
factors of production are increased. In simple
terms, if factors of production are doubled
output will also be doubled.
 Different stages of returns
to scale
CAPITAL LABOUR % OF OUTPUT % OF LAWS
( IN UNITS) ( IN UNITS) INCREASE IN ( IN UNITS) INCREASE APPLICABLE
BOTH THE IN
INPUTS OUTPUT
1 3 - 50
2 6 100% 120 140 LAW OF
INCREASING
RETURNS TO
SCALE
4 12 100% 240 100 LAW OF
CONSTANT
RETURNS TO
SCALE
8 24 100% 360 50 LAW OF
DECREASING
RETURNS TO
SCALE
 Least cost combination of inputs

• The producers always want to produce the product at a

lesser cost to attain higher profits. The producer uses
isocost and isoquants to determine optimum input
usage that minimizes cost of production. Where the
slope of isoquant touches the isocost line, there lies the
lowest cost of production,
• Thus, the least cost input combination is that
combination where the slope of the isoquant is equal to
the slope of the isocost. Thus, the least cost
combination depends upon both isoquants as well as
isocost.
LEAST COST COMBINATION OF INPUTS
 COST
COST refers to expenditure incurred to
produce a particular product or service. All
costs involve a sacrifice of some kind or other
to acquire some benefit. For example, if I want
to eat food, I should be prepared to sacrifice
money.
 Types of cost
The following are the possible variations in the
concept of cost:
1. Long Run Vs Short Run Costs – time factor
2. Fixed Cost Vs Variable Costs – degree of
variability
3. Semi Fixed or Semi Variable Costs
4. Marginal Cost
5. Controllable Cost Vs un controllable costs –
degree of controllability
6. Opportunity Cost Vs Outlay Costs – Nature of
sacrifice
7. Incremental Cost Vs Sunk cost – increase in the
level of activity
8. Explicit cost Vs Implicit Cost – involvement of cash
flow
9. Out of pocket cost Vs Book Cost
10. Replacement Cost Vs Historical Cost - timing of
valuation
11. Past Cost Vs Future costs - degree of anticipation
12. Urgent Cost Vs Postponable Costs – degree of
urgency
13. Escapable Cost Vs Unavoidable Costs - degree of
compulsion
COST OUTPUT RELATIONSHIP IN SHORT RUN

The cost of production depends upon several factors such

as volume of production, prices and productivitiy of the
inputs such as land, labour, capital, organization and
technology.

The cost output relationship differs in short run and long

run. In short run, the costs are classified into fixed and
variable cost.

Short run is governed by certain restrictions in terms of

fixed cost. Whereas in long run all cost are variable and
studies the effect of varying the size of plants upon its
cost.
COST OUTPUT RELATIONSHIP IN SHORT RUN
• The above table represents the behavior of costs in the short
run. It is cleared from the above table that the fixed cost is
fixed even the output is increasing. Fixed cost is fixed at Rs.
60 which may include rent of factory building, interest on
capital, salaries of permanently employed staff, insurance
etc. The above table shows that fixed cost is same at all
levels of output but the average fixed cost, i.e., the fixed
cost per unit, falls continuously as the output increases.

• The cost on the variable factors (TVC) is changing

according to the production. If output increases variable
cost increases, if output decreases variable cost decreases.
The rate of increase or decrease is not constant. If there is
no production of output than there is no variable cost.
GRAPHICAL REPRESENTATION
COST-OUTPUT RELATIONSHIP IN THE LONG-RUN

Long run is a period, during which all inputs are

variable including the one, which are fixed in the
short-run. In the long run a firm can change its output
according to its demand. Over a long period, the size
of the plant can be changed, unwanted buildings can
be sold staff can be increased or reduced. The long
run enables the firms to expand and scale of their
operation by bringing or purchasing larger quantities
of all the inputs. Thus in the long run all factors
become variable.
 COST-OUTPUT RELATIONSHIP IN THE LONG-RUN

he long-run cost-output relationship is shown graphically with the help

of "LCA' curve.
1. Fixed Expenses Rs 40,000
Selling Price Per Unit Rs 10
Variable Cost Per Unit Rs 2
Calculate Break Even Point units and value?
2. Sales RS 40,000, fixed expenses 10,000 and
variable costs are direct labour 6,000, direct
material 10,000 and other variable expenses
4,000.
3. From the following data, findout the number
of units to be sold to earn a profit of 1,20,000
per year.
Selling price per unit RS40
Variable cost per unit RS 25
Fixed cost 1,80,000
Ans: 20,000 units
4. ABC wishes to know its BEP AND MARGIN OF
SAFETY during july to december from the
following information
Particulars January to June July to December
Sales 2,00,000 2,50,000
Net profit 20,000 30,000

PV Ratio = change in profit X 100

change in sales
Sales = fixed cost + profit
p/v ratio
(Pv ratio = 20%, fixed costs 20,000, bep 1,00,000
Mos 1,50,000)
 UNIT 3
MARKET STRUCTURES
&
MACRO ECONOMIC
CONCEPTS
 MARKETS
Market is defined as “a place or point at which buyers and
sellers negotiate their exchange of well defined products or
services”.

All the goods or services needs to be sold to the consumer for

a price, markets facilitates this process.

Market structure refers to the characteristics of a market that

influence the behaviour and performance of firms –
1. The degree of seller concentration
2. The degree of buyers concentration
3. The degree of product differentiation
4. The conditions of entry into the market
Based on degree of competition, the markets
can be divided into perfect markets and
imperfect markets.

Perfect Competition is said to exist when

certain conditions are fulfilled.
 FEATURES OF PERFECT MARKETS
A market structure in which all firms in an industry are price takers and in
which there is a freedom of entry and exit from the industry.

The market which satisfies perfect competition conditions known as perfect

market.
1. Large number of buyers and sellers
2. Homogeneous products or services
3. Freedom to enter and exit
4. Each firm is a price taker
5. Perfect information available to the buyers and sellers
6. Perfect mobility of factors of production
7. NO transportation cost
8. No govt intervention
 PRICE OUTPUT RELATIONSHIP IN PERFECT
COMPETITION UNDER SHORT RUN

In the short run, an individual firm under

perfect competition may either earn
• Super Normal Profits
• Normal Profits
• Incur losses
depending on the positions of the short run
cost curves.
 TO ATTAIN EQUILIBIRUM

In perfect competition the firm has to satisfy

two conditions to attain equilibrium-
• MC=MR
• MC curve should cut the MR curve from the
below
IN CASE OF SUPERNORMAL PROFITS
IN CASE OF NORMAL PROFITS
INCASE OF LOSSES
 PRICE OUTPUT RELATIONSHIP IN PERFECT
COMPETITION UNDER LONG RUN
In the long run perfectly competitive firms
earn only normal profits. This is due to the
unrestricted entry to new firms and exit of old
firms from the industry in the long run. There
are two extreme possibilities in long run:
1. When existing firms enjoy super normal
profits in short run or
2. When the existing firms are getting losses in
short run
PRICE OUTPUT RELATIONSHIP IN PERFECT
COMPETITION UNDER LONG RUN
 IMPERFECT COMPETITION

This concept was developed by Mrs.

Robinson. Imperfect market got the following
features-
• Large number of firms
• Product differentiation/product discrimination
• Free entry and exit
• Imperfect knowledge about market situations
 MONOPOLY
• Mono means single poly means seller, there is only one seller
in monopoly market. An extreme version of imperfect market
is monopoly. A single seller controls entire industry. The firm
and industry is one and the same in pure monopoly market
example RBI is the sole supplier of currency notes in India.
• Another context is where the firm is supplying half of the total
market may have a greater market power and the rest of the
market is shared by number of small firms.
• Monopoly refers to a position where a single firm is in a
position to control either supply or price of a particular product
or service. It cannot control or determine both price and supply
as it cannot control demand. If it decides on the price, it can
determine the quantity supplied at the given price or if the
quantity is decided, the price can be determined.
 FEATURES OF MONOPOLY

1. One Seller and Large Number of Buyers

2. No Close Substitutes
3. Difficulty of Entry of New Firms
4. Monopoly is also an Industry
5. Price Maker:
PRICE OUTPUT DETERMINATION IN
MONOPOLY UNDER SHORT RUN

INCASE OF SUPER NORMAL PROFITS

INCASE OF NORMAL PROFITS
INCASE OF LOSS
PRICE OUTPUT DETERMINATION IN
MONOPOLY UNDER LONG RUN
 Features of oligopoly
• Few firms(small number of big firms)-
• Interdependence
• Non price competition
• Barriers to entry of firms
• Role of selling costs
• Group behaviour – formation of cartels
• Nature of the product
• Indeterminate demand curve
 MONOPOLISTIC COMPETITION

Monopolistic competition is said to exist when

there are many firms and each one produces
such goods and services that are close
substitutes to each other.
They are similar but not identical.
There are no restrictions on the entry, many
firms who feel they can offer a relatively better
product or service, enter the market.
 FEATURES OF MONOPOLISTIC
COMPETITION

1. Large Number of Buyers and Sellers

2. Free Entry and Exit of Firms
3. Product Differentiation
4. A Selling Cost
5. Lack of Perfect Knowledge
6. Less Mobility
7. More Elastic Demand
8. Price maker