Business Economics 0070682151, 9780070682153

Table of contents :
Cover
Contents
1. Economics: An Introduction
Introduction
Economics: Meaning and Definitions
Nature and Scope of Economics
Basic Economic Problems
Positive and Normative Economics
Micro and Macro Economics
Key Terms and Concepts
Chapter Summary
Questions
2. Business Economics: Definition, Nature, Scope and Concepts
Introduction
Definitions
Nature of Business Economics
Scope of Business Economics
Role of Business Economists
Some Important Concepts
Efficiency
Time Element
Key Terms and Concepts
Chapter Summary
Questions
3. Demand: Meaning and Determinants
Introduction
Demand
Law of Demand
Key Terms and Concepts
Chapter Summary
Questions
4. Elasticity of Demand
Introduction
Elasticity of Demand
Elasticity of Demand: Measurement
Factors Determining Elasticity of Demand
Importance of Elasticity
Key Terms and Concepts
Chapter Summary
Questions
5. Demand Forecasting
Introduction
Objectives of Demand Forecasting
Methods of Demand Forecasting
Selecting Best Forecasting Method (or) Qualities of Best Forecasting
Key Terms and Concepts
Chapter Summary
Questions
6. Supply: Law, Determinants and Market Equilibrium
Introduction
Supply: Meaning and Definition
Law of Supply
Elasticity of Supply: Meaning
Determinants of Supply
Market Equilibrium or Price Determination
Key Terms and Concepts
Chapter Summary
Questions
7. Theory of Consumer Behaviour: Demand, Diminishing
Marginal Utility and Equi-Marginal Utility Introduction
Utility
Law of Diminishing Marginal Utility
Law of Equi-Marginal Utility
Cardinal and Ordinal Utility Theories and Theories of Risk and Uncertainty
Key Terms and Concepts
Chapter Summary
Questions
8. Theory of Consumer Behaviour: Indifference Curve Approach
Introduction
Indifference Curve Approach
Equilibrium Conditions
Key Terms and Concepts
Chapter Summary
Questions
9. Laws of Production
Introduction
Production
Short Run and Long Run
Total, Average and Marginal Products
Producer’s Equilibrium
Key Terms and Concepts
Chapter Summary
Questions
10. Cost and Break-Even Analysis
Introduction
Cost
Short Run Cost and Long Run Cost
Economies of Scale
Diseconomies of Scale
Break-Even Analysis
Key Terms and Concepts
Chapter Summary
Questions
11. Market Structure
Introduction
Market Structure
Perfect Competition
Monopoly
Monopolistic Competition
Duopoly
Oligopoly
Key Terms and Concepts
Chapter Summary
Questions
12. Pricing Techniques
Introduction
Price Discrimination
Cost Plus or Mark-Up Pricing
Peak-Load Pricing
Transfer Pricing
Skimming Price
Penetration Price
Key Terms and Concepts
Chapter Summary
Questions
13. Managerial Theories of Firm
Introduction
Classical Theory of Profit Maximisation
Transaction Cost Theory of a Firm
Baumol’s Theory of Sales Maximisation
Williamson’s Managerial Utility Function
Marris Growth Maximisation Model
Cyert and March Behavioural Theory of a Firm
Key Terms and Concepts
Chapter Summary
Questions
Madras University
(Semester Examination) Business Economics, April 2007
(Semester Examination) Managerial Economics, April 2007
(Semester Examination) Business Economics, April 2007
(Semester Examination) Business Economics, Nov 2006
(Semester Examination) Business Economics, Nov 2005
(Semester Examination) Business Economics, Nov 2005
(Semester Examination) Managerial Economics, Nov 2005
(Semester Examination) Managerial Economics, Nov 2004
(Semester Examination) Managerial Economics, April 2002
(Non-Semester Examination) B.B.A. Business Economics, May 1999
(Non-Semester Examination) B.B.A. Business Economics, May 1999

Citation preview

Business Economics

About the Authors Dr K Jothi Sivagnanam is Professor in Economics, University of Madras, and has been engaged in teaching, research and extension activities for the last 23 years. He has also served in the State Planning Commission, Government of Tamil Nadu for a brief term. He is the chairman of the Review Committee of the text book on Indian Economy for students of Tamil Nadu Higher Secondary Education. His areas of interest are mostly teaching and public economics. He has published nearly 35 articles in national and international journals and three books. He is a member of the Academic Council and the Board of Studies of various universities and colleges. Dr R Srinivasan, Reader in Econometrics, University of Madras, has nearly 21 years of teaching experience in various colleges and universities in Tamil Nadu. He has published more than 40 articles in national and international journals and business news papers. He has written a few chapters in the economics books published by NCERT, New Delhi and Government of Tamil Nadu. Srinivasan has served in the Government of Tamil Nadu as an economist in the Tax Reforms Committee (2002–03) and as full time member in the State Planning Commission (2006-08). Currently he is a parttime member of the State Planning Commission and is a member in the Academic Council and Board of Studies of various universities and colleges in Tamil Nadu.

Business Economics

K. Jothi Sivagnanam Professor in Economics University of Madras R. Srinivasan Reader in Econometrics University of Madras

Tata McGraw Hill Education Private Limited NEW DELHI McGraw-Hill Offices New Delhi New York St Louis San Francisco Auckland Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal San Juan Santiago Singapore Sydney Tokyo Toronto

Tata McGraw-Hill Published by the Tata McGraw Hill Education Private Limited, 7 West Patel Nagar, New Delhi 110 008. Business Economics Copyright © 2010 by Tata McGraw Hill Education Private Limited. No part of this publication may be reproduced or distributed in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise or stored in a database or retrieval system without the prior written permission of the publishers. The program listings (if any) may be entered, stored and executed in a computer system, but they may not be reproduced for publication. This edition can be exported from India only by the publishers, Tata McGraw Hill Education Private Limited. ISBN (13): 978-0-07-068215-3 ISBN (10): 0-07-068215-1 Managing Director: Ajay Shukla Head—Higher Education Publishing and Marketing: Vibha Mahajan Publishing Manager—B&E/HSSL: Tapas K Maji Assistant Sponsoring Editor—B&E/HSSL: Hemant K Jha Development Editor: Shalini Negi Assistant Manager (Editorial Services): Anubha Srivastava Senior Copy Editor: Sneha Kumari Senior Production Manager: Manohar Lal Production Executive: Atul Gupta Product Manager: Vijay S Jagannathan Senior Product Specialist: Daisy Sachdeva General Manager—Production: Rajender P Ghansela Assistant General Manager—Production: B L Dogra Information contained in this work has been obtained by Tata McGraw-Hill, from sources believed to be reliable. However, neither Tata McGraw-Hill nor its authors guarantee the accuracy or completeness of any information published herein, and neither Tata McGrawHill nor its authors shall be responsible for any errors, omissions, or damages arising out of use of this information. This work is published with the understanding that Tata McGraw-Hill and its authors are supplying information but are not attempting to render engineering or other professional services. If such services are required, the assistance of an appropriate professional should be sought. Typeset at Bharati Composers, D-6/159, Sector-VI, Rohini, Delhi 110 085, and printed at Adarsh Printers, C-50-51, Mohan Park, Naveen Shahdara, Delhi-110 032 Cover Design: Kapil Gupta Cover Printer: SDR Printers RADXRRAZRZXBB The McGraw-Hill Companies

To Chandru Sana Jeyanth

Preface

This book provides an introduction to the basic concepts and content of Business Economics. The primary target for this book is the B. Com. (Second Year) students of the University of Madras. Though the book is designed based on the revised B. Com. syllabus (semester pattern) of the University of Madras, it could also be used by students of all other undergraduate courses (BA, BBA, BE) who study either Business Economics or Managerial Economics as one of the papers. The book is an undergraduate level textbook, in a lucid style without sacrificing comprehension. Hence, for those who have not taken a basic university course in economics, this book could be used as a beginner’s text. The focus of this book is on explaining the basic concepts and tools of standard microeconomics and their application in the process of business and management decision making. The authors are thankful to Dr V Loganathan, Emeritus Professor of Economics, Sir Thyagraya College, Chennai for his helpful comments and suggestions he has given during the course of writing the book. The authors also thank Dr A Joseph Durai, Reader in Economics, Presidency College, Chennai for his support and encouragement. The authors wish to thank Mr M Palaniappan, Mr Ahamad, Mr M Murugan and Mr Babu for their assistance. The authors wish to place on record their deep appreciation of the publishers of the book for their excellent cooperation and good team work. We are very grateful to G Mark Pani Jino, Vibha Mahajan, Tapas Kumar Maji, Hemant Kumar Jha, Shalini Negi, Anubha Srivastava, Sneha Kumari, Manohar Lal, Atul Gupta and Bhaskar Bokolia for their collective effort and support. The authors, along with the publishers, acknowledge the following reviewers for their invaluable feedback without which this book would have not come out in its present shape: K Jayaraman, RKM Vivekananda College, Chennai Vincent S Jayakumar, RKM Vivekananda College, Chennai A Rohini Priya, SDNB Vaishnav College for Women, Chennai The authors crave the indulgence of the readers for the errors that might have crept in inadvertently. Suggestions for improvement are welcome. K Jothi Sivagnanam R Srinivasan

Contents

Preface 1. Economics: An Introduction Introduction 2 Economics: Meaning and Definitions 2 Nature and Scope of Economics 9 Basic Economic Problems 10 Positive and Normative Economics 12 Micro and Macro Economics 13 Key Terms and Concepts 15 Chapter Summary 15 Questions 15

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2. Business Economics: Definition, Nature, Scope and Concepts Introduction 18 Definitions 18 Nature of Business Economics 20 Scope of Business Economics 20 Role of Business Economists 21 Some Important Concepts 23 Efficiency 28 Time Element 30 Key Terms and Concepts 33 Chapter Summary 33 Questions 34

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3. Demand: Meaning and Determinants Introduction 36 Demand 36 Law of Demand 40 Key Terms and Concepts 45 Chapter Summary 46 Questions 46

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x Contents 4. Elasticity of Demand Introduction 49 Elasticity of Demand 50 Elasticity of Demand: Measurement 56 Factors Determining Elasticity of Demand Importance of Elasticity 59 Key Terms and Concepts 60 Chapter Summary 60 Questions 60

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5. Demand Forecasting Introduction 63 Objectives of Demand Forecasting 63 Methods of Demand Forecasting 64 Selecting Best Forecasting Method (or) Qualities of Best Forecasting 74 Key Terms and Concepts 76 Chapter Summary 76 Questions 77

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6. Supply: Law, Determinants and Market Equilibrium Introduction 80 Supply: Meaning and Definition 80 Law of Supply 80 Elasticity of Supply: Meaning 83 Determinants of Supply 86 Market Equilibrium or Price Determination 87 Key Terms and Concepts 89 Chapter Summary 89 Questions 90

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7. Theory of Consumer Behaviour: Demand, Diminishing Marginal Utility and Equi-Marginal Utility Introduction 92 Utility 92 Law of Diminishing Marginal Utility 94 Law of Equi-Marginal Utility 97 Cardinal and Ordinal Utility Theories and Theories of Risk and Uncertainty 101 Key Terms and Concepts 102 Chapter Summary 102 Questions 102

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Contents

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8. Theory of Consumer Behaviour: Indifference Curve Approach Introduction 105 Indifference Curve Approach 105 Equilibrium Conditions 112 Key Terms and Concepts 116 Chapter Summary 116 Questions 117

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9. Laws of Production Introduction 120 Production 120 Short Run and Long Run 122 Total, Average and Marginal Products 123 Producer’s Equilibrium 127 Key Terms and Concepts 131 Chapter Summary 131 Questions 132

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10. Cost and Break-Even Analysis Introduction 135 Cost 135 Short Run Cost and Long Run Cost Economies of Scale 145 Diseconomies of Scale 146 Break-Even Analysis 147 Key Terms and Concepts 150 Chapter Summary 150 Questions 150 11. Market Structure Introduction 153 Market Structure 153 Perfect Competition 155 Monopoly 162 Monopolistic Competition 166 Duopoly 169 Oligopoly 169 Key Terms and Concepts 170 Chapter Summary 170 Questions 170

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135

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xii Contents 12. Pricing Techniques Introduction 173 Price Discrimination 173 Cost Plus or Mark-Up Pricing 176 Peak-Load Pricing 177 Transfer Pricing 178 Skimming Price 179 Penetration Price 180 Key Terms and Concepts 181 Chapter Summary 181 Questions 182

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13. Managerial Theories of Firm Introduction 184 Classical Theory of Profit Maximisation 184 Transaction Cost Theory of a Firm 185 Baumol’s Theory of Sales Maximisation 185 Williamson’s Managerial Utility Function 186 Marris Growth Maximisation Model 187 Cyert and March Behavioural Theory of a Firm Key Terms and Concepts 189 Chapter Summary 189 Questions 190

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Madras University (Semester Examination) Business Economics, April 2007 191 (Semester Examination) Managerial Economics, April 2007 192 (Semester Examination) Business Economics, April 2007 193 (Semester Examination) Business Economics, Nov 2006 194 (Semester Examination) Business Economics, Nov 2005 195 (Semester Examination) Business Economics, Nov 2005 196 (Semester Examination) Managerial Economics, Nov 2005 197 (Semester Examination) Managerial Economics, Nov 2004 198 (Semester Examination) Managerial Economics, April 2002 199 (Non-Semester Examination) B.B.A. Business Economics, May 1999 200 (Non-Semester Examination) B.B.A. Business Economics, May 1999 201

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Chapter

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Economics: An Introduction ‘The Age of Chivalry is gone; that of sophisters; economists, and calculators has succeeded.’ —Edmund Burke

Learning Objectives The aim of this chapter is to introduce the subject of economics and explain its meaning, definition, nature and significance. At the end, the students will be able to understand the subject alongwith significance and the basic problems and concepts associated with it. The specific objectives are: • To understand the meaning and various definitions of economics • To learn the nature, scope and the basic problems of economics • To distinguish between positive and normative economics and micro and macro economics

2 Business Economics INTRODUCTION To understand business economics, it is first necessary to know what economics is about. Some minimum knowledge of the subject is necessary even for common people to function effectively as citizens in any economy. Such minimum knowledge includes understanding of leading development challenges like poverty, unemployment, inflation, the way economies and markets work, the benefits and costs of various policy options and the necessity to allocate scarce resources among competing uses. There are hidden economic patterns of human behaviour that we encounter in our daily lives. Many of the problems are economic in nature. We make tradeoffs when resources have alternative uses. We take decisions in such a way as to get more out of our limited resources (optimisation). Thus, optimization is not the exclusive domain of economic activities. It is also possible in everyday situations of our life, games, human relations, and even in human emotions like love, and so on. In recent decades, economics increasingly studies many non-monetary fields, such as politics, law, psychology, history, religion, marriage and family life and happiness. And economic principles not only help us to ‘get more’ at individual levels, they do more so in societies at local, provincial, national and global levels. Incentive is the central aspect of economic approach and thinking. An incentive is anything that encourages or motivates human behaviour in a particular way rather than otherwise. Incentive may be just mundane reward like money or bonus (monetary), or a smile or a note of recognition that encourages efficiency at work. What does economic theory precisely do for business? Standard economics, more particularly micro economics, provides excellent conceptual basis and tools to understand the market and its players such as consumers, producers, dealers and labourers. Economics helps us to understand the various aspects of business, viz., production and distribution of commodities. Business students need to learn about economic activity in order to understand the outcome of such activity. This will help them to take better decisions in business and management. Hence, this chapter introduces the basics of economics as a starting point followed by an exposition of business economics, i.e. how the economic principles and tools are used in the process of business and managerial decision making.

ECONOMICS: MEANING AND DEFINITIONS Economics: Meaning Economics is the science that deals with production, distribution and consumption of goods and services in a society. From a technical perspective, economics studies the process by which limited resources are allocated to satisfy infinite human wants, that is, how different societies allocate scarce resources optimally to satisfy the wants and needs of their members.

Economics: An Introduction

3

Economics mainly deals with making choices about production, distribution and consumption of goods and services (commodities) to satisfy present and future needs of the society. Economics also deals with money—how it is created, and how its supply is regulated. Definitions of Economics So far we have given a general idea about economics and its central concern. The following definitions give an appropriate description of economics. The subject matter of economics has been ever expanding and more rapidly in recent times. Hence, it is a bit difficult to precisely define what economics is in the context of its continued expansion of scope that covers even information, crime, sports and games, environment, human happiness, posterity, etc. That is why one economist (Jacob Vainer) said ‘Economics is what economist do’. On Definitions Definitions should be our tools and not masters. There is no right or wrong about definitions, but there are customary usages. Problems arise when, as is often the case, different definitions are customary in different branches of our subject. Confusion can then occur when various people are unknowingly using different definitions of the same term and, therefore, talking past each other. —Richard G. Lipsey, An Introduction to Positive Economics. Further, there is fear that defining economics may limit its scope. Modern economists also do not use the definitions because the boundaries of the subject have expanded greatly since Adam Smith. However, for a beginner and for a functional purpose we need some exposition to famous definitions. Economists have given many important definitions of economics. Adam Smith, Alfred Marshall, Lionel Robbins and Samuelson are the leading economists who gave the most important definitions of economics. They have focused on different aspects of the subject as listed below. Adam Smith (1776) : Wealth Alfred Marshall (1890) : Welfare Lionel Robbins (1935) : Scarcity and Choice Paul Samuelson (1948) : Growth Wealth Definition of Adam Smith Adam Smith (1723-90) was one of the prominent classical economists. He considered wealth as the subject matter of economics. He considered economics as the Science of Wealth. Adam Smith, being the earliest classical economist, is considered as the father of economics. He was the first economist who separated economics from philosophy

4 Business Economics and gave an independent status of discipline to it. He arranged all economic ideas systematically. He published his famous book An Enquiry into the Nature and Causes of Wealth of Nations in the year 1776. Adam Smith has not made any deliberate attempt to define economics because it was viewed in his period as a part of philosophy. In fact, economics has emerged as a separate discipline only in the 1880s and thereafter. However, as the title of Adam Smith’s book (An Enquiry into the Nature and Causes of Wealth of Nations) itself provides his viewpoint of economics in a nutshell, it is considered as his definition. According to Adam Smith, economics is the science of wealth that deals with the acquisition, accumulation and utilisation of wealth of nations. If his definition is viewed as the reflection of his own contemporary conditions, his maiden effort is no doubt a great accomplishment. He viewed society as a whole. According to him wealth is not the society’s capital stock at a given time but the society’s income flow during a year. Economic development, the leading theme of his book, deals with the long term forces that govern the growth of wealth of nations. Though it may be uncharitable, it is also necessary, for students’ sake, to view his definition with an absolute perspective (i.e., against the modern standards). In ordinary usage, wealth means money. But, in economics, the concept of wealth refers to scarce goods, which satisfy human wants. There are many goods which satisfy human wants. But all of them are not wealth because they may be available in abundance or they may not have money value. Air, for instance, is the basic necessity of human existence but that is not wealth because it is available in abundance and hence has no money value. Thus, Adam Smith definition emphasises the problems of wealth creation. As his definition gives prominence to wealth it is called as wealth definition. Criticism

The wealth definition of Adam Smith has been criticised on certain counts. Most of these criticisms are unsympathetic because they place the Adam Smith’s thought out of context of his time. Too Materialistic: Smith‘s conception of economics laid over emphasis on national wealth. The exclusive stress on wealth as the ultimate end of humanity has attracted criticisms. This made others to describe economics as the science of bread and butter (or mamnomism). Social scientists like Mather Arnold, John Ruskin and Carlyle called it a ‘dismal science’ and the ‘science of darkness’. Restricts the Scope of Economics: Another drawback of this definition is that it restricts the scope of economics. The over emphasis on wealth made people think that this is all about making money. Hence, it is also called as the ‘sciences of getting rich’. By overemphasising on wealth, this definition narrowed the scope of economic enquiry. Neglect of Welfare: Wealth is not an end itself. It is just a means to achieve some end. The end is welfare, not the welfare of a few but society’s welfare, or collective welfare. Thus, any society should aim to maximum social welfare (end) by means of available wealth. That is, welfare is primary and wealth is secondary.

Economics: An Introduction

5

But wealth definition, by its exclusive stress on ‘material wealth’, neglected social welfare which is the ultimate development objective of any modern society. However, many of the criticisms against Smith are unsympathetic and unfair given the historical settings of his time. Welfare Definition of Alfred Marshall Alfred Marshall (1842-1924) was a leading neo-classical economist. He shifted the emphasis from ‘wealth’ to ‘welfare’ in his definition of economics. Alfred Marshall published one of the most influential books in economics, Principles of Economics, in the year 1890. In it, he defines economics in terms of human welfare rather than material wealth. Marshall defined economics as follows: ‘Economics is the study of mankind in the ordinary business of life; it examines that part of a social action which is most closely connected with all attainment and use of the material requisites of well being. Thus, it is on one side a study of wealth, and on the other, the more important side, a part of the study of man’. The following are the most important aspects of Marshall’s ‘welfare’ definition. Emphasis on Welfare: Marshall’s definition has shifted the focus of economics discipline from ‘wealth to welfare’. Marshall agrees that economics studies on one side about wealth and on the other about material well being of man. That is, he does not accept Smith’s view that economics is only about wealth. Focus on Man: In Marshall’s definition, the primary focus is on man. Economics studies mankind in ordinary business of life. According to him, study of man is the most important aspect of economics. Thus, the subject matter of economics deals with man’s efforts in gathering wealth to satisfy his wants. Scope of the Subject: Marshall defined economics as a subject, not a method. He was the first one to give a clear scope to the subject matter of economics. Individual and social actions have several aspects, like social, political and economic. But he has separated economic aspects from non-economic ones. According to him, the subject examines only the individual and social actions that are closely connected with wealth, gathering and wealth-using activities to attain material well being. Criticism

Marshall’s welfare definition, though a refinement over the wealth definition of Adam Smith, could not escape from criticism. Lionel Robbins, spearheading the attack, declared that the wealth definition misrepresents the science of economics. The following are some of the criticisms against Marshall’s welfare definition. Faulty Divide: The wealth definition classified human behaviour into economic activity and non-economic activity. Marshall considered only those activities which promote material welfare as economic activity. This has failed to cover the whole field of economics that includes almost all activities, including that of services, teaching, law, etc. If there is scarcity of a thing or any activity in relation to its demand, it becomes the subject matter of economics in modern days.

6 Business Economics That way, even the availability of pure air in our cities is taken up for study in economics. Highly Narrow: Marshall’s idea that only material means promote economic welfare is highly narrow. Amartya Sen’s Capability Approach has helped to construct human development index with many non-material dimensions of human well-being including literacy, health, freedom, empowerment, etc. Vague Conceptualisation of ‘Welfare’: In Marshall’s definition, the concept of welfare is not defined clearly. It is difficult to quantify human welfare; it is basically a subjective phenomenon that varies from one individual to another. But Marshall assumed that money was a unit to measure welfare. Money, whose value is flexible, cannot be taken as a measuring rod for welfare. And recent researches show that money is not the principal determinant of human happiness. Not Analytical: According to the latter neo-classical economists, Marshall’s definition is classificatory in nature and is not based on sound analytical reasoning. Robbins criticised Marshall’s consideration of only the so called ‘economic activities’, i.e., those human activities that promote material welfare alone; many other activities have been left out as ‘non-economic’. Robbins rejects such classification and analytically argues that any activity becomes ‘economic’ if it is undertaken under conditions of scarcity. In war ravaged regions like Sri Lanka, people value peace more than anything under the sun. Deep inside a desert, water has more value than diamond. Marshall viewed economics as a topic or as questions but not as a method. He also viewed the society as a whole unlike the latter neo-classical economists who viewed it as a simple collection of individuals. His definition is not being used today by economists because the boundaries of economics have rapidly expanded since the days of Marshall. Economists study more than exchange and production, though exchange remains at the heart of economics. However, the greatness of Marshall’s contribution needs to be seen in a relative perspective of his time. Greatness of Marshall Judged by the existing standards of present day theory, Marshall’s Principles is an unsatisfactory book. Nevertheless, if a man’s contribution is to be judged on the basis of his solution of old problems as well as posing of new problems to the subsequent generations, Marshall’s Principles must be considered as one of the most durable and viable books in the history of economics. It is the only 19th century treatise on economic theory that still sells in hundreds every year. —Mark Blaug, Economic Theory in Retrospect Scarcity Definition of Lionel Robbins Lionel Robbins’ (1898 – 1984) ‘scarcity’ definition is the most popular and used even today. He was the first one to emphasise the scientific nature of economics. His definition of economics, in effect, makes possible an extension of economics

Economics: An Introduction

7

beyond the traditional questions the discipline used to deal with. Though the basic question remains the same (scarce means and unlimited wants), Robbins viewed economics more as a method (how choices are being made) rather than as a topic or questions. And unlike his predecessors he emphasised that economics studies individuals rather the society as a whole. He has defined economics in his book ‘An Essay on the Nature and Significances of Economic Science’ in 1932. ‘Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses’. The following are the fundamental aspects of Robbins’ scarcity definition. 1. Economics deals with ‘human behaviour as a relationship between ends and scarce means’. The object is to get more (optimum) satisfaction out of limited resources. 2. Human wants (or ends) are various and unlimited. 3. Means are scarce (or limited). 4. Scarce resources (like time, money and factors of production) can be subjected to alternative uses. Water can be used for drinking through public provision or it can be used to fill a private swimming pool in a five star hotel. But, economics does not pass any judgement about the ends. 5. As scarcity is the central aspect of Robbins’ definition, it is also known as scarcity definition of economics; and scarcity requires choice. Wants differ in terms of importance or urgency. This particular aspect obviously leads us to the problem of choice. Suppose, if all our wants are of equal importance, then it is difficult to choose. 6. According to Robbins, economics deals with an aspect of human behaviour under the influence of scarcity, and is not about certain kinds of behaviour as believed by Marshall. 7. Economics is a science and does not analyse value judgments. The scarcity of a thing in relation to its demand is the subject matter of economics. According to Robbins, an economic problem will arise only when there is scarcity. The problem arises when wants exceed one’s means with alternative uses and /or wants, though limited, have different importance. For example, a student who wishes to score high marks needs to work extra hours during the day. As there are only 24 hours in a day, he has to forego his time for entertainment. In other words, he has to make a choice between the entertainment and his academic scores. Thus, choice between alternatives is the basic principle underlying all economic activity. In Robbins’ words, ‘To plan is to act with a purpose, to choose, and choice is the essence of economic activity’. It may also to be noted that problems may also arise during times of abundance. For example, air is abundantly available in nature and is free. But, as it is polluted by high levels of carbon emission during peak hour traffic in cities, the government

8 Business Economics has chosen to regulate the emission by strictly enforcing emission standards in automobiles. Though this has addressed the issue to some extent, the challenge to protect the abundantly available free air remains. Merits

1. Robbins’scarcity definition is more analytical than those of his predecessors. 2. His definition covers almost all activities which come under the realm of economics. 3. Robbins’ definition makes economics a scientific study. 4. It emphasises scarcity and choice which are two important aspects of life under all economic, political and business activities. 5. Ethical aspects of economic problems are not taken into account in discussions. In other words, the moral aspects of life are not considered. Criticism

Missing Human Touch: Robbins’ definition is known for its logical rigor but it has no human touch. He has defined economics as a science, without any link between economics and human welfare. Many economists have established that economics is a social science and its aim should be promotion of human welfare rather than attaining any scientific stature. Limits the Scope of Economics: Robbins’ definition is being criticised for limiting the subject matter of economics merely to resource allocation and price determination; the scope of economics is much wider. For instance, he has totally left out the most important macro economic questions concerned with growth, employment, inflation and business cycles. Growth Definition of Paul Samuelson Paul A. Samuelson’s (1915-2009) definition of economics is known as the ‘growth’ definition. His definition is relatively more comprehensive than that of his predecessors. While the earlier definitions by Smith, Marshall and Robbins emphasised wealth, welfare and scarcity, respectively, Samuelson combined all these aspects together in his definition, and went on to add one more dimension to his definition, namely, time element and growth. According to Samuelson, ‘Economics is a social science concerned chiefly with the way society chooses to employ its resources, which have alternative uses, to produce goods and services for present and future consumption’. According to Samuelson, economics is a social science and it is mainly concerned with the way how society employs its scarce resources for alternative uses to produce commodities and distribute them among people. This is nothing but a brief summary view of his predecessors. But, he goes a step further and discusses ‘present and future’ consumption of commodities by ‘various people or groups’.

Economics: An Introduction

9

Some more Definitions of Economics David Ricardo: Economics studies how the produce of the earth is distributed. George Bernhard Shaw: Economy is the art of making the most of life. Ludwig von Mises: Economics is the logic of rational action. Robert Solow: Economics becomes the study of the consequences of greed, rationality and equilibrium. John M. Keynes: The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessors to draw correct conclusions. Duesenberry’s: Economics is all about how people make choices. Sociology is about why there isn’t any choice to be made. Jacob Viner: Economics is what economists do. Thus, the merit of Samuelson’s definition is that it has accommodated the dynamic changes in the ‘means’ as well as the ‘ends’ over time. Time element is an important dimension of economic analysis which Samuelson rightly recognised. This is the precise reason why it is called ‘growth’ definition. Another interesting point of his definition is that a society may or may not make use of money; but his definition is applicable equally to both. That is, his definition is applicable not only to a modern economy with money but also to a primitive economy without money. The issues of choice and optimisation of resources are present in a barter economy where money is absent. As noted earlier, Samuelson’s definition incorporates the views of his predecessors and hence all those criticisms leveled against the earlier definitions are equally valid for his definition.

NATURE AND SCOPE OF ECONOMICS Economics plays the most significant role in modern times. In recent decades, as the movements of finance capital, and commodities between countries have increased phenomenally, and people are also connected globally (to some extent), the study of economics has gained more significance. Economic decisions being made by individuals, governments and business firms, and such decisions have deeper and wider implications for the wellbeing of individuals, societies, countries and the world at large. In the present era, people face two formidable challenges, namely, development and poverty—we produce millions of goods and services and some people use most of them while the rest have to go without them. While we have been able to accelerate our growth at a faster pace, the benefits have failed to reach the majority of people.

10 Business Economics Why does almost two-thirds of the world population go to sleep with an empty stomach, in spite of the fact that the world GDP has increased manifold? What are the causes for such grim scenario and how can we mitigate human suffering of such colossal magnitude? These questions obviously take us to the realm of economics. The basic structure of an economy needs to be understood thoroughly to assess and analyse poverty as well as the nature of our growth process. The roots of many such challenges can be traced to the quality of economic decisions made at different levels. Thus, economic issues are the major concern of individuals, society, governments, politics and business. Nature of Economics As human beings, we need many goods and services. We like to consume goods including basic necessities like food, clothes, house, water and luxuries like diamonds, cars and huge bungalows. We also need services like education, health and social security, etc. All these goods and services are together called commodities; millions of commodities are produced and distributed all over the world. Millions of decisions are being made in the production and distribution of all such commodities. Commodities satisfy human wants and give pleasure or utility to individuals. Acquiring the material means (resources) to satisfy all our wants has always been a challenge in almost all societies. Economic resources, namely land, labour, capital and entrepreneurship, are used in producing commodities; these resources are called as factors of production. Since these resources have limited availability in every society, the capability of a society to produce the required commodities is also limited. This gives rise to the problem of making relevant choices and economics is the study of the process by which scarce resources are allocated to satisfy society’s wants.

BASIC ECONOMIC PROBLEMS Each society, whether capitalist, socialist or a mixed economy like ours, must address three basic and independent problems of economic organisation: 1. What to produce and in what quantities? (the what question) Missiles or hospitals; if so, in what numbers? Is it more hospitals and less weapons, or vice versa? 2. How shall goods be produced and how to use society’s scarce resources? (the how question) Energy consumption by depleting scarce petrol or by generating more energy from costlier renewable source? 3. For whom shall the goods be produced? ( for whom or distribution question) Whether distribution should be based on purchasing power or needs or some combination of both.

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These three are the basic economic problems and they are interdependent. These are common to all economies. Every society attempts to make its own choice which depends on its specific economic system. There are three main alternative economic system namely capitalism, socialism and mixed economic system. Whatever may be the economic system, the society must make the correct choice regarding the above three basic economic problems from the various alternatives available. Two more questions about these problems are: 1. Why are choices being made? 2. How do we make our choice? The reason for making choices is scarcity. Choices are made because the resources (land, labour, capital and time) required to produce all commodities that a society needs are limited or scarce. Every society attempts to answer these issues based on the specific choice of its development perspectives. The nature of a particular choice in a particular society depends on its specific economic system like capitalism, socialism, and mixed economy like India. But the common thread in all systems is that every choice involves a cost, namely, opportunity cost. The cost of any choice is the alternative option(s) that a society foregoes. A brief note on these vital concepts of economics may be of immense help. Infinite Wants The starting point of all economic activity in the world is the existence of human wants. There are many commodities that people like to consume. We want basic goods like food, clothes, and shelter, and luxuries like big bungalows, luxury cars, diamond jewellery, swimming pool, etc. We also like to have services like education, information, health, reservation, etc. Goods and services together constitute commodities. Consumption of commodities satisfies a range of human desires. Hence, the list of commodities we want to consume is very long and may even be beyond our imagination. We call them infinite or unlimited wants. Obtaining resources (means) to satisfy our wants has been a perpetual problem. Finite Resources If we have unlimited income and/or wealth most of the wants listed above can be fulfilled. But, in reality, most people do not have sufficient resources to purchase all the commodities they want. A family of four, with a monthly salary of, say, Rs. 20,000, can meet only most of its basic needs, and not the luxuries. Similarly, a rural agricultural labourer’s family with four members and a daily wage of Rs. 100, that too only during agricultural season may not be able to meet even its basic needs. If both these families have enough resources like the very rich people, most of their wants will be fulfilled. But, in the real world, the income of the people is finite or limited while the wants are infinite or unlimited. Thus, the means to satisfy our wants are limited.

12 Business Economics Scarcity and Choice Scarcity means that the available finite resource is not enough to satisfy the infinite human wants. Both time and money at our disposal are limited. The factors of production, namely, land, labour and capital are also limited. Also, modern economies have grown faster in recent years and have increased our resources manifold. But our wants have also grown in greater proportion. When we satisfy some wants, new wants appear. Thus, all our wants cannot be satisfied due to the limited means at our disposal. Thus, scarcity limits our ability to satisfy our wants. And it makes choice inevitable, which wants need be chosen and which may be dropped. Making a choice is precisely an economic problem. Economics studies choice-making under conditions of scarcity. Thus, economics studies the process by which scarce resources are allocated for competing ends.

POSITIVE AND NORMATIVE ECONOMICS Positive economics is about ‘what is’ and normative economics is about ‘what ought to be’. The distinction between positive economics and normative economics will be useful for both economic theories, analysis of economic problems and economic policy designs. Positive Economics Positive economics explains what actually happens in the real world. It does so without the involvement of any personal opinion on the economic aspects being explained. Positive economics simply deals with the ‘causes and effects’ of economic phenomena. Thus, positive economics describes the economic phenomena in a natural fashion. It simply answers the question ‘what is’ without giving any opinion about the desirability or otherwise of the particular economic phenomenon. For instance, 1. What is the level of rural poverty in Tamil Nadu? 2. Why TNEB charges different unit prices for different consumers (households, business activities, cinema theatres etc.,)? The answers to these questions will be positive statements because they will be mere answers to above questions. 1. In Tamil Nadu, 22.2 per cent (76.50 lakh) rural people live below the poverty line. 2. TNEB adopts discriminated pricing policy and accordingly it charges different prices for different types of utility/ consumption. These answers simply describe for the facts without making any moral or value judgement about the desirability, or otherwise, of either the level of rural poverty or the discriminated pricing policy of the Electricity Board. Thus, positive economics is concerned with the question ‘what is’.

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Normative Economics Normative economics is concerned about the valuation of economic phenomena involving value judgment, opinion or judgement about the desirability or undesirability of a situation of the economic phenomena. Normative economics answers the question ‘what ought to be’ or how an economic problem should be solved. For instance, should Special Economic Zones (SEZ) be allowed by displacing people from such zones? Your answer may be ‘yes’ or ‘no’. But both the answers, i.e. the acceptance or the rejection of SEZ, are normative judgements because your answer expresses your judgement (good or bad) about the people’s displacement, to facilitate economic development that may not be beneficial to them. Lionel Robbins was the one who emphasised the distinction between positive economics and normative economics. Subsequently Milton Friedman said, ‘While positive economics ‘describes’ what actually happens, normative economics ‘prescribes’ what ought to be’. A physician who diagnoses the problem of the patient prescribes the medicine too. If he refuses to do so, the situation is pathetic. Similar will be the situation if positive an economist refuses to prescribe saying that it is the job of the policy makers or the elected representatives. The one who has diagnosed the problem is the right person to prescribe the solution and is more competent to do so without bothering the scientific stature of the subject.

MICRO AND MACRO ECONOMICS Economics is studied under various subdivisions. The Journal of Economic Literature has made a comprehensive and detailed classification and has standardised it by giving specific codes to 19 major divisions, and each division has many more branches. The two major subdivisions are micro economics and macro economics. Micro Economics Micro economics, as the name implies, is about the parts of the economy rather than the whole economy. It deals with the behaviour of individual economic actors (or agents) in a market economy such as consumers, producers and governments. For instance, it studies how a consumer (or household) allocates his income among expenditure on various commodities. Similarly, it is concerned with the firm’s profit maximising level of production of a commodity. Micro economics provides various ‘theories of consumer behaviour’ that explain the behaviour of the consumer under different market structures. Similarly, a firm’s behaviour is explained by ‘theories of market structure’. The behaviour of the consumer will aim for maximisation of utility and the firms will aim for maximisation of profit. Microeconomics also examines the interactions of these actors in various market structures, like perfect competition, monopoly and imperfect competition.

14 Business Economics The scope of micro economics includes the determination of commodity prices, factor prices, partial equilibrium analysis, general equilibrium analysis and theories of welfare economics. In other words, micro economics explains the allocation of scarce resources for different uses and distribution of commodities among people. Macro Economics Macro economics analyses the behaviour of the economy as a whole in totality. It is the study of economic aggregates. It explains the broad macro variables of the economy and their interactions. Thus, macro economics examines the aggregates, such as total national income, its growth, total (un)employment, inflation or the general price level in an economy. It is not concerned with individual units and their problems. According to Boulding, ‘Macro economics deals with not individual quantities as such, but with the aggregates of these quantities, not with individual incomes but with national income, or not with individual prices but with the price level, not with individual outputs but with the national output’. The scope of macro economics includes almost all current problems of an economy. It includes theory of employment and income, theory of general price level, theory of economic growth and macro theories of income distribution. Macro economics also deals with growth cycles in the long run, capital accumulation, capital output ratio, technological change, foreign investments and trade. The general objectives of macro economic policies include attainment of full employment, sustained economic growth, stable price levels, and balanced external sector. It is to be noted that the boundaries of micro-macro divisions are getting blurred in modern times due to overlapping of issues. For instance, when the international crude price races to beyond $140 per barrel, coupled with the falling supply in recent times, it is purely a micro economic problem; but it affects the entire macro economic framework of the world, that too with greater repercussion on the developing countries like India. Hence, it is difficult to maintain such water tight division because of the deepening integration of the world economies and growing complexity of the economic issues. However, it is still necessary to introduce such distinction at the introductory level. Micro and Macro Economics One of the most valuable results of the criticisms of traditional monetarists and new- classicists is that macro economists have been forced to examine in great detail the micro underpinnings of assumed macro economic relations. —Richard G. Lipsey, An Introduction to Positive Economics

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Key Terms and Concepts Scarcity Basic Economic Problems Economic Growth Choice Unlimited Wants Economic Thoughts Scarce Resources Welfare

Wealth Economic Resources Factors of Production Positive Economics Normative Economics Micro Economics Macro Economics Finite Resources

Chapter Summary This chapter explains the meaning, nature and scope of economics, positive and normative economics and micro and macro economics. • Economics is the science of choice as well as a way of thinking. • Economic principles and methods have wider applications, ranging from economy to human emotions. They help to ‘get more’, given the constraints. • Economists have defined economics in terms of wealth, welfare, scarcity and choice. • The basic problems of any economy are production and distribution. • Positive economics deals with ‘what is’ and normative economics deals with ‘what ought to be’. • Micro economics is about the parts of the economy and macro economics is about the whole economy. But in the real world both are interrelated.

Questions A. Very Short Answer Questions 1. Elucidate Adam Smith’s definition of wealth. 2. List the demerits of Adam Smith’s definition. 3. Explain Marshall’s welfare definition of economics. 4. What are the criticisms of welfare definition of economics? 5. Discuss Robbins’ scarcity definition of economics.

16 Business Economics 6. What is growth definition of economics? 7. Compare wealth definition with welfare definition. 8. What are the main ideas of Robbins’ definition? 9. Compare Marshall’s definition with Robbins’ definition. B. Short Answer Questions 1. Define economics. 2. Explain welfare definition of economics. 3. What is Marshall’s definition of economics? 4. Explain Robbin’s scarcity definition. 5. What is growth definition of economics? 6. What is the subject matter of economics? 7. Distinguish between positive and normative economics. 8. Distinguish between micro and macro economics. 9. Explain the nature of economics. 10. Make a critical appraisal of Lionel Robinson’s definition of economics? C. Long Answer Questions 1. Make critical examination of Marshall’s welfare definition of economics. 2. Explain the scarcity definition of economics? 3. Economics is the science of choice. Discuss. 4. Explain the nature and scope of economics? 5. Briefly examine the shift in economic thought in defining economics since Adam Smith. 6. Examine the role of economics and its significance in modern times. 7. Distinguish the following: (a) Positive and normative economics (b) Micro and macro economics 8. What are the basic problems faced by an economy?

Chapter

2

Business Economics: Definition, Nature, Scope and Concepts If you catch too many fish, the best place to store them is in another person’s stomach. —A proverb

Learning Objectives The main objective of this chapter is to discuss the meaning, scope and concepts of business economics. At the end, the students would be able to understand what is business economics and how economic principles and methods are applied in the business decision-making process. The • To • To • To • To

specific objectives are: explain the meaning, definition and scope of business economics know the role of business economists understand some important concepts in economics understand the role of time elements in business economics

18 Business Economics INTRODUCTION Business economics is the application of economic principles and methods to business management practices. It deals with the business organisation and decision making process of the firm. It helps firms in business administration; decision making and business planning. Decision making involves the process of choosing the best (optimum) choice(s) or course of action(s) from the many alternatives available to the decision makers of the firm. Forward planning involves the establishment of future plans. Profit is the ultimate aim of almost all business firms. Hence, forward planning and decision making will generally be targeted towards the maximisation of the firm’s profit. Some argue that business economics is essentially about the firms and it deals mainly with the factors which help to influence the firm’s decisions regarding the process of production and distribution of commodities to satisfy human wants and needs. The focus is shifted to objectives of the firms other than profit, like sales, size of firms market share, competition, etc. Whatsoever may be the short term objective of a firm, the ultimate one could be nothing but profit. Given such a goal, the nature of most business problems is basically economic, i.e. getting more from the given resources, and the nature of competition. The productive resources of the firms are limited in general. Acquiring more such productive resources, transforming them into goods and services and selling them for maximum profit involve innumerable plans, decisions and strategies; and the bottom-line of all such issues is getting more from them. The limited resources have to be used efficiently in such a way as to attain the ultimate objective of the firm, viz., maximum profit. This is possible only by making the best (optimum) choice in using the scarce resources of the firms and by making best decisions about the various aspects of business during the course of business management. The firm with several alternatives has to analyse all possible options and decide the most efficient course of action by using the given resources to attain maximum profit. Here comes the relevance of economics. The economic theories and methods help business manager to make efficient choices that give optimum results in business problems using techniques such as profit maximisation, demand forecasting, optimum price determination, cost minimisation, revenue forecasting and revenue maximisation.

DEFINITIONS As discussed earlier, attempting to define any subject matter concisely and adequately is a bit difficult venture with an associated risk of limiting the boundaries of the subject. Like economics, it is also difficult to have the most accurate definition of business economics which is concise as well as comprehensive. Many scholars have attempted to define business or managerial economics by empahsising its various aspects. However, the focus of this section is to summarise them to know what business economics is all about rather than deliberating about the accuracy or otherwise of any one definition.

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Business economics deals with the application of economic principles and methods for business and managerial decision making of firms. The following are some of the attempts to define business or managerial economics. ‘Managerial economics deals with the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by the management’. —Spencer and Sigelman ‘Managerial economics is concerned with the application of economic principles and methodologies to the decision making process within the firm or organisation under conditions of uncertainty. It seeks to establish rules and principles to facilitate the attainment of the desired economic goals of the management. These economic goals relate to costs, revenues and profits and are important within both the business and the non business institutions’. —Prof. Evans J. Douglas ‘The purpose of managerial economics is to show how economic analysis can be used in formulating business policies’. —Joel Dean ‘Managerial economics is concerned with application of economic concepts and economic analyses to the problems of formulating material managerial decisions’. —E. Mansfield ‘Managerial economics deals with the application of economic theory and methodology to decision making problems faced by public, private and not for profit institutions. Managerial economics extracts from economic theory (particularly micro economics) those concepts and techniques that enable the decision maker to allocate efficiently the resources of the organisation’. —McGuigan and Moyer The various definitions listed above are almost same in form and content with minor shift here and there. These definitions clearly show that economic principles are useful in decision making, forward planning and to arrive at rational business and managerial solutions towards efficient outcomes. The essence of these definitions can be summarised as follows. Business economics may be viewed as the study of economic principles and methods which are relevant or useful for business and managerial decision making of firms.

20 Business Economics NATURE OF BUSINESS ECONOMICS In business economics, economic principles are applied to problem solving at the level of the firm. The problems, of course, relate to choices and application of resources in the process of production and consumption of commodities which are basically economic in nature. Business economics bridges economic theory and economics in practice. It also uses quantitative techniques, such as correlation, regression, calculus, game theory and linear programming. The bottom-line that runs through most of business economics is the attempt to optimise business decisions, given the firm’s objectives and given the resource constraints (including time) imposed by the society. Decision makers of firms are confronted with many issues of decision, having to choose from among a number of possible alternatives. They must choose a specific course of action by which the firm’s given resources must efficiently be used for achieving the ultimate goal, profit. This is, thus, essentially a problem of choice. Had there been no alternatives available, there would have been no decision making exercise at all. Managerial economics helps in analysing alternatives and selecting the one which would achieve the optimal result, within the limited resources and other constraints. It helps to identify alternative means of achieving given objectives and then to select the alternative that accomplishes the objectives efficiently. For instance, let there are two possible strategies identified, say X and Y, to meet the growing demand for the product, and X represents an internal expansion of capacity and Y the purchase of surplus owned by the competitor. Suppose the objective of the firm is to maximise its profits. The decision rule may be followed, viz., if profits from strategy X are greater than those from Y, then X be chosen, and if the profits from strategy Y are greater than those from X, then Y be chosen. Economic theory assists a manager in choosing an appropriate objective function and creating decision rules. Further, there are many forces and institutions that affect the business outcomes in the real world. They include government structure, policies, climate, socio-and political issues, NGOs, media, international agreements and trade blocks, etc. However, economic forces are the most critical among them. Business economics also studies mostly such forces, both at the micro and macro level, that affect the business firms and their profit. Thus, business economics is broadly an approach to decision making about business problems using economics.

SCOPE OF BUSINESS ECONOMICS The following are some of the key issues that constitute the subject matter of business economics, at least at the undergraduate level. They are discussed at length in the remaining chapters. Fundamentals of Business Economics • Basic concepts and principles of economics

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• Opportunity cost and production possibility curve • Scarcity and efficiency The Consumer Markets • • • • • • • • • •

Demand and supply analysis Demand function Demand schedule and demand curve Determinants of demand Demand forecasting Supply function Supply schedule and supply curve Equilibrium of supply and demand curve Price elasticity of demand Elasticity and revenue

The Business Organisation • Prediction of consumer behaviour • Determinants of demand curve, like price, income, taste, prices of other brands, etc. • How and when consumers react to market signals like price • Consumer preferences, and business organisation • Determinants of firms behaviour • Input cost, output and profit relations • Price determination in different market structures • Pricing and sales strategies of firms

ROLE OF BUSINESS ECONOMISTS Business economics has emerged as a profession only after the Great Depression of 1930s, when economists took key positions in governments. After the Second World War, firms began recruiting increasingly business economists. Since then, the need for business economists has grown rapidly. Now their role is vital in investment, manufacturing, mining, banking, insurance, transport, communication, trade and various other business enterprises. They are also playing many vital role in government departments, public sector enterprises, trade organisations and public policy making. Understanding the nature of professionals such as doctors, engineers, lawyers, teachers and auditors is relatively easies than that of an economist. The role and responsibilities of an economist, in general, and a business economist, in particular, are a bit difficult to define. The role of a business economist is vast, complex and challenging because of the sophisticated nature of the profession. Economic science is not as exact as the physical sciences. The nature, structure

22 Business Economics and functional dynamics of each economy vary based on it’s society and polity and their interdependence with the global economy at large. Hence, the role played by business economists also differs from one firm to another, both within and in different countries. However, the following are some general roles of business economists. Collection and Management of Information Business decision, any decision for that matter, needs to be made on the basis of accurate, detailed and relevant information. As most information is external, the firm may neither be aware of nor able to monitor the information. Hence, the collection of all such relevant information about the general business environment, the actions of the rivals, technological developments, macro economic environment, inside activities, etc., is the first responsibility of a business economist. Business Analysis The focus of business economics is mainly on the application of micro economic analysis to decision making. Macro economics is also relevant to analyse the general environment of the business. Hence, a business economist should first be well versed in the theory and practice of micro as well as macro economics along with decision making skills in various branches of a business. The public policy changes at the national and international levels and the business cycles can have significant impact on the firm’s business prospects. A business economist can analyse and interpret all such national and global developments, particularly their impact on sales, prices, costs, competition and other such matters of relevance to the firm. Business economists are also capable of observing and analysing what goes on internally in the enterprise. Business Forecasting Forecasting future business prospects is one of the principal roles of a business economist. The business economist provides the baseline macro economic forecasts that have crucial bearing on the estimates of sales, revenue, profit and annual budget estimates. As most future business prospects depend on the performance of the economy as whole and its various sectors, such forecasts help firms to make accurate and reliable targets or decisions on inputs, output, revenue, etc. Business Performance Monitoring The business economist also plays a key role in the performance evaluation of business firms. In close relation with forecasting, the performance appraisal of a firm within the given macro scenario is important for strategic business planning. For instance, a firm may deviate in either way from the targets already fixed. The reasons for such divergence need to be thoroughly analysed. Such analysis can help to identify the causes of both good as well as bad performance. These

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understandings can help to correct past mistakes and to focus on the secrets of success formulas. Strategic Business Planning The business economists can make potential contributions to the strategic business planning process. They can develop more effective planning system for the highly competitive and complex global business environment. The role of the business economist grows exponentially when the firm progresses through advanced stages of strategic planning. The business economist provides vast array of analysis in areas of industry, economy, competition, regulation, trade and public policies. He also helps to devise organisational structure and management systems required to implement the plans successfully.

SOME IMPORTANT CONCEPTS Before proceeding to discuss the economic principles that are relevant for decision making and business planning, a brief review of some basic concepts will be in order. Further, some concepts used both in economics and in business need clarification. For instance, most of the information about the cost of production is supplied by accountants to business decision makers. Some of these concepts may differ from the conceptualisation of the economist. Hence, these concepts need to be defined clearly for any effective application. The following are some of such concepts. Opportunity Cost As discussed in Chapter I, economics is the science of making choice. Choices are being made because our resource endowments are not sufficient (scarce) to produce all the commodities we need and want. That is, choice emanates from scarcity. Moreover, every choice that is being made out of scarcity involves cost. For example, at an individual level you must have chosen among alternatives, like, • Whether to watch the latest movie or study an extra hour for the forthcoming semester examination?. • Whether to pursue post graduation for two years or take up the job with monthly salary of Rs.20,000? • Whether to invest Rs.10,00,000 to start a business or place it in term deposit for ten years? For every alternative chosen, the next best alternative must be given up. The cost of one commodity or choice or decision measured in terms of what must be given up is called ‘opportunity cost’. For example, if you choose to watch the latest movie you sacrifice an extra hour of preparation for the forthcoming semester examination. The cost incurred in the choice of watching movie is the loss of the next best alterative, that is,

24 Business Economics the outcome of an extra hour preparation. Thus, by watching a movie, you have foregone the opportunity of scoring better marks in that semester. Likewise, the opportunity cost of giving up the job with salary Rs. 20,000 per month in order to pursue post graduation is Rs. 4,80,000 (the amount of salary that would have been earned during the study period). The opportunity cost of the decision to start a business is the interest for the term deposit of Rs. 10,00,000 for ten years. Thus, the opportunity cost is expressed in terms of the next best alterative foregone. In other words, the best alterative scarified when a choice or decision is made is the opportunity cost of that decision or choice. Choices are mostly made based on opportunity cost. The concept of opportunity cost is useful for valuing different choices and evaluating the actual cost of decision making. Business and management decisions need to be made by confronting different alterative possible scenarios. In such context, the concept of opportunity cost is highly useful. It is to be noted that choices are made due to scarcity. If there is no scarcity, there would be no need to choose. Similarity as choice must be made from available alternatives; it involves comparison of cost and benefit. Production Possibility Curve The opportunity cost can also be demonstrated graphically with help of Production Possibility Curve (PPC). A society has to make choices regarding the three basic economic problems discussed in Chapter I. For instance, the society has to choose the commodities to be produced along with their respective quantities with the limited resources is a simple way to represent the nature of the society’s choice the production possibility curve. The production possibility curve shows different combinations of two goods that can be produced with a given amount of resource. It differentiates between the outcomes that are possible to produce and those which cannot be produced subject to the available resources. As can be seen from Table 2.1, if an economy produces only ballistic missiles, the output will be twelve ballistic missiles. But, if the economy reduces its ballistic missile production to eleven, it can also construct six public hospitals. Thus, the opportunity cost of constructing six public hospitals is just one ballistic missile. In other words, the opportunity cost of one ballistic missile is six public hospitals. The other combinations in Table 2.1 can also be shown as similar trade-offs between missiles and hospitals. All the combinations are presented graphically by PPC in Figure 2.1. Point A in Figure 2.1 corresponds to the first combination in Table 2.1, point B to the second combination, and so on. Thus, PPC is the locus of all such possible combinations. There is no ‘ideal’ point on the curve. Any point inside the curve means that resources are not being utilised efficiently. Similarly, points outside the curve suggest that they are not attainable with the current level of resources. Figure 2.1 shows the PPC for an economy with a limited amount of productive resources.

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The given amount of resources can either be used to produce good X or good Y or combination of both. The PPC shows the maximum amount of ballistic missiles and public hospitals that can be produced with the limited amount of available resources. Table 2.1

Production Possibility Schedule

Production Possibilities

Good X Ballistic Missiles

Good Y Public Hospitals

A

12

0

B C D E F

11 10 8 6 0

6 8 10 11 12

In the Figure 2.1, A and F are the possibilities where the economy either produces only good X or only good Y. But the production possibility curve as a whole is the locus of all combinations of good X and good Y. Points B, C, D and E are such that the economy can produce both commodities in varying combination. Possibility B shows eleven units of good X and six units of good Y, Possibility D shows eight units of good X and ten units of good Y, and so on. The extreme cases A Hospitals and F show the maximum feasible amount F E of production, if resources are entirely 12 used to any one of the commodities. D 10 The specific choice between more C public health and less weapons, or vice versa, depends on the given social and democratic value system of a society B and its citizens. For instance, a society may attach more importance to its public A health care and the country may be forced 0 8 12 Missiles by popular democratic pressure to ban continental ballistic missiles and choose Fig. 2.1 Production Possibility Curve choice A, i.e., no missiles but only public hospitals. Accounting Profit and Economic Profit The meaning of profit in economics is different from its meaning in business economics. In general, the term ‘profit’ (P) means the amount by which revenue (R) exceeds all the costs (C) of doing business. This profit is nothing but ‘accounting profit’, the difference between revenue and cost. Profit (P) = R – C

26 Business Economics But, in economics, the concept of profit has different meaning. Though the basic identity, i.e., P = R – C, is the same, the scope of the term ‘cost’ is wider in economics. In economics, cost includes both explicit cost and implicit cost. In business accounting, costs are structured according to their causes. Most of them are only the explicit costs incurred on production and selling activities of the firms. Such explicit costs include input costs, such as salary, cost of raw material, taxes, interest and depreciation. Depreciation is an annual charge arrived at by accountants to determine the cost of replacing plants and machineries bought earlier. This charge, to cover the full cost, will be split annually for the entire productive life span of those assets. But, economic principle focuses on the efficient allocation of resources among the alternative uses of inputs at a given point of time. Hence, economists focus on opportunity cost which is implicit in nature. For instance, the Britannia Industries Ltd. sold its entire plant located in Padi, Chennai for a very high price to Infosys, the software giant and moved its production facilities to an alternative location where the land cost was very low. The opportunity cost of Britannia’s decision to sell its land in Chennai metro is the sale price he got over and above the land cost of his new location. Opportunity cost, a return that could have been earned if the inputs were employed elsewhere, is also called implicit cost. It is the compensation for not having used the inputs in alternative opportunities. To compute total cost, opportunity cost needs to be added along with explicit cost. Accounting profit is the difference between total revenue and all explicit cost whereas economic profit is the difference between total revenue and total economic cost that includes explicit cost and implicit cost (or opportunity cost). Hence, it is obvious that economic profit will be lesser than the accounting profit as we add implicit and opportunity cost together. The following identities can help further. Accounting Profit = Total Revenue – Explicit Cost Economic Profit = Total Revenue – Explicit Cost + Opportunity Cost Or Economic Profit = Total Revenue – Total Economic Cost Where Total Economic Cost = (Explicit cost + Opportunity Cost) Thus, to compute economic profit, implicit cost has to be added with explicit cost. Some authors define opportunity cost only with reference to the capital or in the sense of taking risk. This is erroneous and it should be noted that all factor inputs, including land and labour, have opportunity cost. To obtain the services of, say, land or labour, a firm needs to pay at least as much for them as in their next best alternative use. Hence, it is not just capital or investment alone. All the factor inputs have opportunity cost as long as they have better alternative uses. Marginal and Incremental Concepts Marginal and incremental concepts are well established concepts in economics and they have critical relevance for sound business decision making.

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27

Marginal Analysis Marginal analysis deals with a type of decision making in economics. It refers to the effect of incremental change in production or consumption of a good. Marginal cost and marginal benefits are the two most important concepts in economics without which ‘nothing matters in economic decision making’. A marginal change is a proportionally very small change (positive or negative) to the total quantity of some variable. Marginalism is the analysis of such changes in terms of their relationship with the economic variables. Here ‘small’ refers to a least amount of change in activity level in relation to the total level of activity. Marginal cost (MC) is the additional cost incurred in producing one more unit of a product. Marginal utility is the additional benefit derived from marginal change in an activity. Similarly, marginal revenue (MR) is the additional change in total revenue (TR) resulted from selling one additional unit of output. DTC MC = _____ DQ Change in total cost MC = __________________ Change in output Similarly, DTR MR = _____ DQ Change in total revenue MR = _____________________ Change in output Marginal changes can also be quantified by differentiating total magnitudes. For instance, MR can be expressed as a derivative of the TR with respect to output. TR = R(Q); where

Q = Quantity produced d(TR) MR = ______ dQ

Similarly, MC is the derivative of the TC with respect to quantity of output produced. Hence,

d(TC) MC = ______ dQ

Thus, marginal changes measure the rate of change in total magnitudes for a given unit change in some select variable. Marginal changes can also be shown graphically. Incremental change is the change in some variables due to a specific decision or change in business activity.

28 Business Economics For instance, a firm decides to increase its production by 20 per cent, and may want to know the total effect of this increase on other variables like cost, revenue and profit. An increase in production may bring in changes in variables with varying intensities. An increase in production may increase variable cost (discussed later) proportionately but it may bring down the average fixed cost. These two together influence the change in total cost. For the given illustration, incremental cost is the change in total cost associated with 20 per cent change in production. In simple words, incremental cost is the additional cost of producing a given increment of production. Similarly, incremental profit is the change (increase or fall) in total profit associated with the new decision of the firm. The change could also be in the quality of product, production technology or use of resources, or in any activity of the business. Thus, the concept of incremental change is used to measure the effects of alternative decisions on cost, revenue and profit. Knowledge about such incremental changes, their effects and better alternative courses of action are vital for the decision makers. Haynes has listed four criteria to choose a profitable decision from the options available to a firm: 1. It increases revenue more than costs 2. It decreases some costs more than it decreases others 3. It increases some revenue more than it decreases others 4. It reduces costs more than revenue Thus, a change in business activity will be profitable only when the ultimate difference between incremental revenue and incremental costs is positive. Incremental cost analysis is useful only when it is used with incremental revenue and decisions are based on the ultimate effect, viz, incremental profit. Thus, the contribution of any decision is equal to the incremental revenue minus the incremental cost involved; and the decision will be made only if it results in a positive contribution to profits. Marginal changes are incremental changes, but they are an extreme case of incremental changes, with unit-by-unit changes. Marginal change is a limiting case of incremental change, where the increment is a single additional unit in addition to the existing total. But, that is not the case in incremental change. The concept of incremental change is closely related to marginal change with some difference. An increment may be any amount of change to the total and it need not be a least or small change; whereas marginal change is the least addition to the total. In other words, least incremental changes are the marginal changes. But both concepts are used to measure and analyse the functional relationship between different variables to make a decision.

EFFICIENCY Efficiency simply means the absence of waste. It is concerned with the relationship between resource inputs (cost of inputs, viz., land, labour, capital, etc.) and outputs

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29

whereby efficiency is increased by a gain in units of output per unit of input. This is possible either by holding the output constant and reducing the inputs or holding the input constant and increasing the output to the extent possible. Beyond such physical relation, efficiency analysis helps mainly to determine the net balance between positive and negative effects of any economic act or event. The notion of efficiency also refers to cost-benefit analysis. It is important to understand that efficiency is not an absolute but a relative term. It is always refered in relation to some criterion. And the criterion for economic efficiency is value. Any change that increases value is an efficient change. Similarly, any change that reduces value is inefficient. The concept of efficiency is used both at the micro and the macro level of social and economic analysis. In micro economics, a firm is considered to be efficient if it attains the maximum profit possible, given the shortest time and limited resources and other constraints. Similarly, a consumer is considered to be efficient if he attains the greatest utility by consuming the best mix of commodities bought at the least price. In macro economics, an economy is considered to be efficient when all its resources are used to produce the maximum possible amount of output mix with the given technology. The ultimate concern of economists is the efficiency with which society’s resources are allocated for different uses. At the society’s level, efficiency measures whether society’s resources are used towards maximum collective welfare of its citizens or not. Application of the criterion of economic efficiency means that society makes choices which maximise the public and private goods produced from the given resources allocated to them. Inefficiency arises when resources could be reallocated in such a way that would produce more of all or some goods with the same amount of resources. Similar situations in business organisation are innumerable, and the concept of efficiency can be used to maximise the outcomes, given the limited resources. One of Paul Haynes’ brief but interesting note on efficiency is as follows: ‘To economists, efficiency is a relationship between ends and means. When we call a situation inefficient, we are claiming that we could achieve the desired ends with less means, or that the means employed could produce more of the ends desired. Less and more in this context necessarily refers to less and more value. Thus, economic efficiency is measured not by the relationship between physical quantities of ends and means, but by the relationship between the value of the ends and the value of the means’. Every concept of efficiency has to employ some measure of value. Economists normally use monetary measure. Monetary measure of value is broad, useful and more appropriate. Such measure facilitates comparison of different evaluations made by different people.

30 Business Economics There are positive and normative reasons for the economists’ interest in economic efficiency. People as well as business firms mostly search for values. This is the positive reason. The search for value can be seen in the pursuit of utility maximisation (by consumers) and profit maximisation (by firms). And, this is the driving force of most market economies. The normative reason is the basis to arrive at appropriate policy recommendations for many economic problems. The criterion of economic efficiency is often used to evaluate the effectiveness of different policies or situations. For instance, if an economist wishes to ask whether the recent hike in the petroleum price mostly affects the poor masses or the rest, he needs a criterion to find an appropriate answer. The value maximised in the notion of economic efficiency is the reflection of goals, like maximum utility or profit, to be pursued respectively by the people and the business firms. The concept of efficiency as well as inefficiency can be explained with the help of PPC, as discussed earlier. An economy is efficient when it uses all its given resources to produce maximum amount of commodities. This is attained on any point on the PPC, as discussed earlier. Any combination away from the PPC indicates either inefficient use of Hospitals resources or impossible situations with available resources. O In Figure 2.2, the points below D the PPC, for instance I, indicate the production of lesser amount I of missiles or hospitals than those by the points like D on PPC, with the given resources and technology. As more production by combinations on PPC means more 0 Missiles value, the points below PPC are inefficient. Similarly, the points Fig. 2.2 Efficient and Inefficient Choices in PPC above PPC, like O are unattainable, given the society’s resources and technology. Hence, all the points on PPC are efficient because they maximise output for all the resources available to the society.

TIME ELEMENT Time element plays an important role both in economics as well as in business decision making. Short Run and Long Run Economists divide time periods into short run and long run. For instance, the flexibility of a firm in adjusting its production to meet the change in demand depends on the nature of its inputs. There are two types of inputs, namely, fixed inputs

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31

and variable inputs. The fixed input is one whose quantity cannot be adjusted in a limited time period. Heavy machinery, buildings and capital equipments are such fixed inputs and they may need more time for installation or replacement. However, variable inputs, like labour, raw material and electricity, can be changed quickly to change the supply. Thus, short period for a firm is the time period during which at least one of the inputs is fixed input and long period is the time period during which all the inputs are variable inputs. However, specific duration of short period and long period will vary from firm to firm. Time in Business In business decisions making, a firm has to pay its dues over a span of time, i.e., weekly, monthly or annually, or any time in the future. It may also have to pay a series of amounts over a span of time in the future. As the value of money is not constant over time and keeps changing according to the levels of inflation in the economy, it is necessary to evaluate the change in value of money and cash flows over time. That is, time value of money needs to be quantified and incorporated in business decision making. This is more important, particularly, when the cash flows are spread over many years in the future. The perception of time also affects a wide range of business decisions regarding money, investment, capital and valuation of companies. The concept of discounting deals with time value of money. Time value of money assumes that a fixed amount of money available today is more valuable than the same amount in the future. People value spending now more than future spending due to three reasons: • There is an inherent risk and uncertainty involved in any future event. Hence, present spending is preferred. • Future spending involves sacrifice of current spending. This opportunity cost could be avoided by spending now. • Effect of inflation reduces the value or purchasing power of money in the future. For instance, Rs.1,000 buys ten units of good X today. However, buying the same ten units of good X after a year may require more than Rs. 1,000. This means that the value of money or purchasing power has declined after one year due to inflation. Time Value of Money and Discounting All perceptions of time discussed above lead to reduction in the value of money in the future in comparison with its present value. The concept of ‘discounting’ helps to measure the current costs and benefits in relation to those occurring in the future. Discount rate is the rate at which the value of money changes from one year to the next. In the above illustration, if the discount rate is 0.09 per cent, then Rs.1,000, an year from now, is worth only Rs.910 or 91 per cent today. This concept is useful to quantify the time value of money at different points in the future which, in turn, can help business decisions. The concept of time discounting in economic evaluation is used to discount not only future costs,

32 Business Economics but also future benefits. This concept can also be extended to time valuation of all economic resources, like investment, capital and valuation of stocks and companies. There are algebraic methods to calculate time value of money, capital and value of companies. Present value is today’s value of the sum of money to be received in the future. Present value results when the opportunity cost of having to wait for future consumption is added to amount to be received in the future. Thus, present value denotes the ‘discounting’ of a sum of money to be received in the future. It can also be computed by inversing the compound interest as shown in the following equation.

[

1 Present Value = FVn ______n (1 + i)

]

Where

n = the number of years until payment is received i = the opportunity rate or discount rate PV = present value of the future sum of money FVn = future value of the investment at the end of n years PVIFi, n = present value interest factor Compound interest means interest that itself earns interest. For instance, if interest on fixed deposit is added to the principal at the end of year one, the principal sum for the second year is greater by the amount of interest. The total return depends on the number of years or the number of times interest is compounded. Illustration 2.1 Find (1) the future value of Rs.5 invested after 2 years at 11 per cent per annum rate of interest, and (2) the present value of Rs.5 to be received in 2 years at 11 per cent per annum rate of interest. Solution 1. The future value of any amount of money is equivalent to the original sum multiplied by its compound interest. FVn = PV (1 + i) n Where

n = number of years the interest is compounded i = annual interest rate or discount rate = Rs.5 (1 + .11)2 = Rs.5 (1.2321) = Rs.6.1605 Suppose the compounded period is less than one year, i.e., it is monthly, quarterly or half yearly, the formula for future value is

[

1 Future Value = PVn 1 + __ m

mn

]

where m = the number of times interest is compounded during a year. For quarterly compounding ‘m’ is 4.

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33

2. The present value of any amount of money is equivalent to the future value multiplied by its reverse compound interest. The reverse compound interest is nothing but the discounting rate.

[

1 Present Value = FVn ______ (1 + i) n

]

[

1 = Rs.5 ________2 (1 + .11)

[

1 = Rs.5 ______ 1.2321

]

]

= Rs.5 [.81162243] The discount rate is .81162243 Hence, Present Value = Rs. 4.058

Key Terms and Concepts Opportunity Cost Production Possibility Curve Accounting Profit Economic Profit Short Run Long Run Marginal Cost Present Value Marginal Analysis Time Value of Money

Business Forecasting Future Value Efficiency Inefficiency Time Element Total Revenue Marginal Revenue Discount Rate Incremental Change Discounting Rate

Chapter Summary This chapter has explained the meaning, nature and scope of business economics. It has also introduced basic concepts of business economics. • Business economics is the application of economic principles and methods to business decision making in firms. • Business economists play many important role in the firms.

34 Business Economics • Important concepts like opportunity cost, production possibility curve, accounting profit and economic profit, marginal and incremental concepts, efficiency and time element have wider applications in business economics.

Questions A. Very Short Answer Questions 1. What is business economics? 2. State some basic concepts of business economics. 3. Explain accounting profit. 4. What is economic profit? 5. Define the term ‘Production Possibility Curve.’ 6. Define opportunity cost. 7. Explain the concepts of time and discounting. 8. Briefly explain the scope of business economics. 9. Define the concept of marginal change. 10. What are the roles of a business economist? 11. Define the concept of efficiency. B. Short Answer Questions 1. Define business economics and explain its meaning. 2. Explain the nature of business economics. 3. Explain the scope of business economics. 4. Give the role of a business economist. 5. Distinguish between marginal and incremental change. 6. Distinguish between economic and accounting profit. 7. Explain the concept of time and discounting principle. 8. Explain the concept of efficiency with the help of production possibility curve. C. Long Answer Questions 1. Discuss the nature and scope of business economics. 2. Explain the role and responsibilities of a business economist in a business firm. 3. Explain the time value of money and the principle of discounting. 4. Explain opportunity cost and production possibility curve.

Chapter

3

Demand: Meaning and Determinants ‘One difference between a liberal and a pickpocket is that if you demand your money back from a pickpocket, he won’t question your motives’. —Anonymous

Learning Objectives The objective of this chapter is to explain the meaning, determinants and the law of demand. At the end, the students would be able to understand the basic concepts of the theory of demand and its important role in business decisions. The • To • To • To • To

specific objectives are: introduce the concept of demand understand the determinants of demand and the related concepts know the law of demand and its significance understand individual demand and market demand

36 Business Economics INTRODUCTION Demand and supply are the most basic tools of economic analysis. Both micro economics and macro economics use them as fundamental tools of analysis. The tools of demand as well as supply can be used to show how prices and quantities are determined in a market economy. Diverse economic issues, such as growth, inflation, unemployment, trade, public finance, etc., are analysed by economists with the help of these tools. Demand is one of the most important building blocks of economics. The concept of demand plays a greater role in business economics. The profitability or success of a firm depends on its ability to minimise its cost. More important than cost is sales. That is, the demand or willingness of consumers to buy a product is the most important determinant of a firm’s profitability. Price of a product is one of the determinants of consumer’s demand for a particular product. The other factors that influence demand are, such as income and taste of the consumers, style, reliability, durability, packaging and brand image, availability of close substitutes, competitor’s sales strategies, etc. Thus, understanding the behaviour of consumers is the most significant requirement for appropriate pricing and framing best sales strategies. Demand analysis is an attempt by economists to explain the behaviour of consumers in a market economy. Given the pivotal role of demand as a significant determinant of a firm’s profitability, ascertaining the determinants of demand and estimates of expected future demand will be of great help for business decision makers. Short run business decisions with regard to cost, revenue, production and profits will be based on the estimation of current demand. Similarly, long run decisions regarding diversification, expansion, forward planning, etc., will require estimation of future demand. The estimation of demand and demand forecasting need to be explained within a larger framework of the theory of consumer behaviour developed by economists.

DEMAND Meaning Demand has a well defined meaning in economics. In ordinary usage, when people say petrol demand, or kerosene demand, they refer to a mere desire to buy a commodity which is also not demand. In economics, demand for a commodity refers to the willingness to buy it backed by the ability to pay. In technical terms, demand is a schedule which shows the various amounts of a product that the consumers are willing and able to purchase at each price. Thus, demand refers to a demand curve that traces different quantities of a product demanded at different prices. Hence, the series of price-quantity combinations (or demand curve) are in the minds of the consumer when he/she enters the market.

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37

Demand also implies that consumers can pay for the concerned product, and that they are also willing to pay the required money. For instance, many may dream of owning an Audi A4, a luxury car with rain sensing intelligent wipers, but only a few hundreds in India can convert their desires into demand. This is because consumers’ choices are subject to one major constraint, viz., their income, which is limited in relation to their desires. The scarcity of income also makes the consumer’s choices for different commodities interdependent. That is, people adjust their purchase of several commodities within their limited income. Quantity Demanded and Demand It is important to distinguish between quantity demanded and demand. As they have different meanings, they need to be used appropriately. Demand in economics means actions of the consumers. A consumer’s decision regarding how much of a commodity to be demanded depends on the price of that commodity, the consumer’s income, taste and preferences, price of other commodities available, and so on. While quantity demanded depends on a single factor price, demand depends on all factors, other than price. Quantity demanded is the number of units of a commodity that a consumer is willing and able to buy in a given period under a given set of conditions. The main condition that must be specified would include the price of the commodity, consumer’s income, taste and all other factors that affect demand. The quantity demanded—the quantity of the commodity that a consumer wishes and can purchase—depends on changes in all other factors, such as consumer’s income, taste, price of other commodities, and so on. Among the factors that affect demand, price of a commodity plays a key role in individual markets. Hence, the relationship between price and quantity demanded is first analysed by using the device of ceteris paribus (Latin phrase for keeping other things constant). The distinction between price change that affects the quantity of a commodity demanded and changes in all other factors, which change the demand or pricequantity relationship, as a whole is very important. A change in the quantity demanded is represented by a movement on the demand curve and change in demand is represented by a shift in the demand curve (discussed below). Determinants of Demand As shown above, demand in economics refers to a relationship between price and the number of units of a commodity that people would want to and can buy. And demand also depends on many other factors. If it is so, then what are the ultimate determinants of demand? The answer is that all of them influence demand but with varying degrees of impact. Demand function is the simple construct that can be used to explain all the determinants of demand with their varying relative significance. For instance, what are the factors that could influence the demand for a single good, Bajaj Pulsar motorbike (X). The following are some of the factors that affect its demand:

38 Business Economics • Price of the commodity X • Consumer’s income • Consumer’s tastes and preferences • Prices of other brands’ bikes in the market • Consumer’s wealth • Expectations about future prices • Level of advertisement All these factors (even many more) can be incorporated in the demand function as: Dx = f (Px, Y, T, Py, W, S, A, … ) where Dx = demand for commodity X Px = price of commodity X Y = consumer’s income T = consumer’s tastes and preferences Py = prices of other brands like Honda or Suzuki W = wealth of consumer S = future expectations or speculation A = level of advertisement The focus of economics is mainly on the relationship between the price of a product and how much consumers are willing and able to buy. Still, it is important to examine all determinants of demand for a commodity. Price of Commodity Price is one of the most important determinants of demand and the relationship is explained through law of demand (explained below). Economists have identified some exceptions to the law of demand; but they are rare cases and not applicable to all commodities in general. Hence, price is the most significant factor that determines the demand for a commodity. Income of Consumer The income of the consumer is the next significant determinant of demand for a commodity. There is the positive (direct) relationship between a consumer’s income and the demand for the commodity. Whatsoever may be the price or other factors, when income of an individual rises, his demand for the commodity will certainly expand. Similarly, when income falls, the demand for the commodity will contract. However, inferior goods are exception to such direct relationship between income and demand. Tastes and Preferences of Consumers Demand for a commodity also depends on the tastes, preferences and latest fashion. Whenever tastes and preferences of the consumer change, his demand also changes. For example, demand for cut pieces has come down and demand for

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39

ready made garments has gone up due to change in fashion as well as consumer’s preference. Price of Other Brands Some commodities can be substituted for other commodities. For example, the so called energy drinks, like Horlicks, Boost, Bournvita, are substitutes for each other. If the price of one brand falls in relation to others, there will be increase in demand for that particular brand and fall in the demand for others. Thus, the prices of substitutes and demand for a commodity have an indirect relationship or they move in opposite directions. Consumer’s Wealth Wealth of the consumer or income distribution in the society determine the consumption pattern, and hence the demand for different commodities. The consumption pattern of wealthy people is different from that of poor or middle income families. The former may demand more luxuries than the latter. Hence, distribution of rich and poor in a society will determine the demand for different goods. Level of Advertisement Advertisement is yet another factor that determines the demand for commodities. Advertisement can influence consumer’s decision to a considerable extent. Most of the cosmetic and beverage industries basically depend on advertisement to sell their products. Hence, the level of advertisement expenditure has a direct relation with demand. Future Expectations An expectation of future price change is another factor that determines the demand for a product. If consumers believe that the price of petrol will be hiked next day, they may rush to petrol stations and buy larger quantities than they normally do. Other Factors In the above demand function for a particular product only some known variables have been listed. These variables may have different degrees influence on the demand for the product. However, there may also be many unknown variables that have lesser influence on demand. But the demand analysis has listed the most significant variables that determine demand, such as: • Government policy changes • Number of consumers in the market for a product • Size of population of a country • Climate and weather conditions • State of business or business cycle (boom or recession) • Consumer innovativeness and new technologies • Socio-cultural values

40 Business Economics LAW OF DEMAND As noted earlier, for most goods, price of the product is the most significant factor in determining how much people are willing and able to buy. The law of demand defines the nature of relationship between price and quantity demanded. According to the law of demand, there is an inverse relationship between the price and quantity demanded of a commodity over a period of time, keeping other things constant. This fundamental law indicates that as the price of a good decreases, the quantity of the good demanded by the consumer increases (rises) and when the price increases, the quantity of the good demanded decreases (falls), if other things are constant at the given time. Demand Function The demand function simply specifies the functional relationship between quantity demanded of a good and all the variables that determine demand. Equations are the shortest way and the more useful way to represent the law of demand. For example, if demand for commodity x is ‘qx’, the following equation states that the quantity demanded of good x. The dependent variable is the function of its determinants or independent variables, like price ‘Px’ and others. That is,

qx = f(Px, Y, Py, S, A, …,)

Here, ‘Px’ is the independent variable that causes change in ‘qx’. The slash over all other factors (Y, T, Py, W, S) in the equation indicates that they are constant for the given period. The equation shows the functional relationship between the dependent variable, ‘quantity demanded’ of a good, and the independent variables, all determinants of demand, including the price of the good. Alfred Marshall defined the law of demand as: ‘The greater the amount sold, the smaller must be the price at which it is offered, in order that it may find purchasers; or, in other words, the amount demanded increases with a fall in price and diminishes with rise in price’. Thus, the law of demand states that the quantity demanded varies inversely with price, keeping other things constant. Assumptions of Law of Demand The following assumptions are made under the clause ceteris paribus. 1. Consumer’s income remains same 2. Consumer’s tastes and preferences remain same 3. Prices of other goods remain same 4. Prices of substitutes for the goods remain same

Demand: Meaning and Determinants

41

5. No change in consumer’s wealth 6. No speculation about future price 7. All factors which can influence demand remain same Demand Schedule The demand for a product can also be shown in terms of schedule and curve. These make it relatively easier to understand the determinants of consumer choice. As price is the main factor influencing demand, demand schedule shows various quantities demanded (willing and able to pay) by consumers at different prices. Table 3.1

Demand Schedule

Price of Good X

Quantity Demanded (in units)

Points in the Graph

60 50 40 30 20

5 7 10 15 20

a b c d e

The prices are arbitrarily chosen prices. The demand schedule shows the various quantities demanded of a good at different prices. Thus, the schedule explains the series of combinations of price and quantity of a commodity an individual consumer is expected to demand. The above schedule shows various quantities demanded by consumer at five different prices. It is clear from the schedule that when the price falls from Rs.60 to Rs.50, the quantity demanded expands from 5 to 7. Demand Curve Law of demand can also be explained with the help of demand curve. Demand curve is a simple construct to explain the relationship between price and quantity demanded. It is a graph depicting the relationship between the price of a commodity and Price D the quantity of it that consumers are willing a and able to buy at the given price. Demand 60 b curve is drawn on the assumption that all 50 c other determinants of demand listed earlier 40 d are held constant. 30 e In Figure 3.1, demand curve is drawn to the 20 data presented in the demand schedule. The 10 demand curve usually slopes downwards from D¢ left to right reflecting an inverse relationship 0 5 7 10 15 20 between the price and quantity demanded. Quantity demanded And the downward slope also reflects the ‘law of demand,’ that is, keeping other things conFig. 3.1 Demand Curve stant, the quantity demanded of good X will

42 Business Economics rise (expand) with every fall in its price and the quantity demanded of good X will fall (contract) with every rise in its price.’ Any point on the demand curve indicates a particular price-quantity relation. For instance, point ‘c’ indicates that that when price of good X is Rs. 40, the quantity demanded by the consumer is 10 units. Likewise, joining all the five points viz. a, b, c, d, and e gives the entire demand curve which shows the complete functional relationship between price and quantity demanded. The law of demand was initially based on the law of diminishing marginal utility. Both laws assumed that utility, a psychological phenomenon, is absolutely quantifiable, that is, utility is cardinal. But economists have challenged the assumption of cardinal utility. Subsequent approaches argued that though utility can not be measured in absolute units, it is possible to order or rank. Thus, a consumer can compare the utility derived from one commodity, say X, against another, say Y. It is possible to say X gives more satisfaction than Y. Theory of indifference curve analysis is one such early attempt to place the law of demand on the empirical and realistic basis. This approach is based on the measurement of utility in ordinal or relative terms. Why the demand curve slopes downwards? Earlier, cardinal utility was the basis of demand analysis. The demand curve slopes downwards mainly due to the law of diminishing marginal utility. According to the law of diminishing marginal utility, an additional unit of a commodity gives lesser satisfaction. The consumer will always try to equate the price of the commodity with the marginal utility he derives from it. That is, the consumer will try to attain the following (equilibrium) condition at every point on the demand curve. MUx = Px As every additional unit, as per the law of diminishing marginal utility, gives lesser utility in comparison with the previous units, the consumer is prepared to pay only a lesser price when he moves down the marginal utility curve, as shown in Figure 3.2A. Therefore, the consumer will buy only when his equilibrium condition is fulfilled. As shown in Figure 3.2A and 3.2B, the demand curve slopes downwards because the marginal utility curve also slopes downwards and the consumer is at equilibrium at points where MU1 = P1, MU2 = P2, MU3 = P3, and so on. Market Demand The demand curve discussed above is with reference to an individual consumer. The market demand expresses the quantity demanded of a good in the market as a whole, i.e., the quantity of a good demanded by all consumers. The success of a firm basically depends on its sales which, in turn, depend mainly on setting the right price for a product keeping all consumers in the market. To know the crucial question of what is the best price for a particular product, the firm needs to know the total demand of all consumers, or simply the market demand.

Demand: Meaning and Determinants P

MU

MU1

P1

MU2

P2

MU3

P3 X1 X2 X3 Quantity demanded

X1 X2 X3 Quantity demanded

(a)

Fig. 3.2

43

(b)

(a) Diminishing Marginal Utility Curve, (b) Demand Curve

Table 3.2

Market Demand Schedule

Price per Unit of Good X

Quantity of Good X Demanded by Consumer A

Consumer B

Market (A+B)

6 8 10 12 14 16 18

2 6 12 18 24 30 35

8 14 22 30 38 46 53

20 18 16 14 12 10 8

Market demand represents the aggregation of individual demands for a firm’s product. A market demand curve is simply a summation of all individual demands at various prices. The market demand may be represented by a demand schedule. The demand schedule can be obtained by summing up all individual demand schedules, as shown in Table 3.2. It is assumed that there are only two consumers in the market. To obtain the market demand (A + B), the quantities demanded by A and B are added at each price. The market demand curve is the horizontal summation of individual demand curves, as shown in Figure 3.3. Market Demand Function The functional relationship between the quantity demanded of a good in the market as whole and its determinants can be symbolically expressed as follows. Qx = f(Px, P1, P2, P3, …. Pn, Y, A)

44 Business Economics Price

Price

Quantity demanded (A)

Fig. 3.3

Price

Market Demand

Quantity demanded (B)

Quantity demanded (A + B)

Market Demand Curve

where, Qx is the quantity demanded of a good at a given time (or depended variable) that functionally depends on its determinants (or independent variables) viz, Px = price of good X P1, P2, P3, …. = prices of n other goods Y = aggregate income all consumers A = advertisement expenditure This equation is slightly different from the demand equation of an individual consumer. It is to be noted that prices charged by all competing brands are included. With this equation, it is possible to estimate accurately what quantity of the good would be demanded in the entire market at a given point of time. For this, the numerical values of all independent variables need to be collected and used for the estimation of their respective co-efficients that indicate the relative significance of a each independent variable in determining the market demand. These estimates are of great use for decision making about the best price for the product. Movement along the Demand Curve and Shift in Demand Curve The relationship between the demand curve and demand function can be explained, respectively, by movement along the demand curve and shift in the demand curve. A change in the quantity demanded is represented by a movement along the demand curve (up or down, accordingly) keeping other factors constant. On the other hand, a change in other factors or demand is indicated by a shift in the entire demand curve. As discussed earlier, a demand curve shows the relationship between quantity demanded of a good and price of that good by holding all other determinants of demand constant.

D

P1

a b

P2

D X1

X2

Q

Fig. 3.4 Change in Demand

Demand: Meaning and Determinants

45

Given this, any change in price of the good results in changes in the quantity demanded of a good. This change will be taking place on any points along the demand curve. Figure 3.4 shows that if the price of good X is at P1, then demand would be Q1. If, however, the price is reduced to P2, then demand would move to Q2. As the line DD consists of all such combinations of price and quantity demanded, any change in price will result in movements along the demand curve. So far, it was assumed that other determinants would be held constant. What would happen if any D1 of those variables in the demand function change? For example, if income of the consumer increases, D he may buy more units at each price. This is because the quantity demanded of a good and consumer’s income are positively related. Hence, when income increases, the entire demand curve would shift to the right indicating that more of the good would be D1 D bought at higher income. X1 X2 Q In Figure 3.5, the entire demand curve shifts upwards to the right, from DD to D1D1. It is to be Fig. 3.5 Shift in Demand noted that more goods are demanded at all prices. Similarly, a fall in income would push the entire demand curve downwards and inwards towards the origin. Demand at each price declines as a result of the fall in consumer’s income. Hence, similar changes in other determinants in the demand of a good, like price of substitutes, and so on, would shift the entire demand curve. Such shifts may be either upward or inward, and it all depends on the nature of the relationship between that particular determinant and quantity demanded of good.

Key Terms and Concepts Law of Demand Market Demand Demand Curve Demand Function Downward Slope Change in Demand

Individual Demand Demand Schedule Quantity Demanded Determinants of Demand Diminishing Marginal Utility Shift in Demand

46 Business Economics

Chapter Summary This chapter has introduced the concept of demand and explained the behaviour of the consumer in a market economy. Along with the law of demand many related concepts, viz., demand schedule, demand curve and demand function have been explained. • Quantity demanded of a good depends on many factors, like price, income, price of substitutes, taste, etc. • Among them, price of the good is the most dominant determinant of demand function. • According to law of demand, the price and quantity demanded of a good are inversely related, keeping other things constant. • Change in demand is due to change in price of the good, whereas shift in demand curve is due to change in other determinants of demand. • Market demand is the horizontal summation of individual demand curves.

Questions A. Very Short Answer Questions 1. Explain the meaning of demand. 2. Give any two features of demand. 3. Give any two determinants of demand. 4. What is the law of demand? 5. State any two assumptions of the law of demand. 6. What is demand schedule? 7. What is demand curve? 8. What is market demand schedule? 9. Explain market demand curve. 10. Why demand curve slopes downwards? 11. What is shift in demand? 12. What is demand function? B. Short Answer Questions 1. Explain the factors influencing demand. 2. Distinguish between individual demand and market demand. 3. Explain the law of demand. 4. State the main assumptions of the law of demand.

Demand: Meaning and Determinants

47

5. Give a market demand schedule and curve with an illustration. 6. Why does the demand curve slope downward? 7. Discuss the importance of the law of demand. 8. Distinguish between change in demand and shift in demand. C. Long Answer Questions 1. What is law of demand? Explain with diagrammatic illustration and formulae. 2. Explain the demand function and the determinants of demand. 3. Briefly explain the law of demand. Why does demand curve slope downwards? 4. Distinguish between: (a) Individual demand and market demand curve (b) Demand and quantity demanded (c) Movement along the demand curve and shift in demand curve

Chapter

4

Elasticity of Demand ‘The demand for certainty is one which is natural to man, but is nevertheless an intelleetual vice’. —Bertrand Russell

Learning Objectives This chapter introduces the concept of price elasticity of demand. At the end, the students would be able to understand the concepts of elasticity of demand, types of elasticity, determinants of elasticity and its role in business decision making. The specific objectives are: • To explain the meaning and types of elasticity of demand • To discuss the ranges of elasticity along the demand curve • To understand the different methods of measuring elasticity • To know the determinants of elasticity of demand • To learn the importance of elasticity in economic analysis

Elasticity of Demand

49

INTRODUCTION As per the law of demand, the quantity demanded of a good that a consumer would buy increases when the price of the good falls and it would decrease with a price rise. Thus, the law of demand gives only the direction of change in price and quantity demanded of a good; it does not show the degree of responsiveness, that is, the rate at which the quantity demanded of a good changes for a marginal change in price or any other determinant of demand. For instance, you can see the different degrees of responsiveness in the quantity demanded for two commodities, viz., rice and carrot, as a result of a uniform change in their respective prices (Figure 4.1 and Figure 4.2). Price D R

Price

DC P

P

DC DR Q

Fig. 4.1

Q¢

Quality

Price Elasticity of Rice

Q

Fig. 4.2

Q¢

Q ¢¢ Quantity

Price Elasticity of Carrot

The difference in the rate of change in demand for the same amount of change in price is due to different price elasticities of demand for these two goods. That is, for the same amount of change in price from P to P’ change in the quantity demanded is higher for carrot than for rice. Such differences in the sensitivity of quantity demanded to changes in price of a good can precisely be measured by the concept of elasticity. It has wider application in tax policies of the government and pricing policies of the firms. Business decision makers need to know how consumers would react to a change in price. The concept of elasticity is useful not only for revenue purpose but also for planning and efficient use of resources. Knowledge of the demand curve and related elasticities are very useful for business decisions regarding changing prices as well as quantum of production. A company may change the price of its good as an experiment and may want to know the precise impact of such price changes on demand and revenue. Alfred Marshal introduced the concept of elasticity. The clear formulation of the concept of elasticity was another significant contribution of Alfred Marshall to demand

50 Business Economics theory. Marshall’s discussion of elasticity was not limited to demand but extended to supply. It has also been extended into cross-price and income elasticities.

ELASTICITY OF DEMAND Meaning Elasticity, in general, means the sensitivity or responsiveness of one variable to any change in another related variable. Price elasticity of demand is a measure of responsiveness of the quantity demanded to changes in price. It is expressed as the ratio of the percentage change in quantity demanded to the percentage change in price. This ratio captures the extent to which quantity demanded would respond to a change in price. Thus, price elasticity of demand, or supply elasticity of demand, is equivalent to the absolute value of the percentage change in quantity demanded divided by the percentage change in price of the same commodity. Types of Elasticity of Demand The concept of elasticity of demand can be classified with respect to a change in its determinants, like own price, prices of substitutes or complementary commodities and income of the consumer. Accordingly, there are three types of elasticity of demand; • Price elasticity of demand • Income elasticity of demand • Cross elasticity of demand Price Elasticity of Demand Price elasticity of demand (PED) is the degree of responsiveness of quantity demanded to a change in price. It can be defined as the percentage change in quantity demanded in response to a 1 per cent change in price. Percentage Change in Quantity Demanded Price Elasticity of Demand = ___________________________________ Percentage Change in Price % DQ Or Price Elasticity of Demand = ______ % DP Symbolically, DQ/Q = ______ DP/P DQ P = ___ × __ DP Q Where P = Price, Q = Quantity and D = Change Range of Elasticity Along a Linear Demand Curve Elasticity changes over at cutting point along the demand curve. This is so even when the slope of the demand curve is linear. That is, the values of elasticity can differ significantly even along a straight line demand curve.

Elasticity of Demand

51

Price Ae=a

e=>1 e= 1

P

B e= 1 Relatively Elastic

(c)

(d)

P

P

D

D¢

Q PED = a Perfectly elastic (e)

Fig. 4.4

Ranges of Price Elasticity of Demand

Percentage Change in Quantity Demanded Income Elasticity of Demand = ___________________________________ Percentage Change in Consumer’s Income Symbolically, DQ/Q = ______ DY/Y

Elasticity of Demand

53

DQ Y = ___ × __ DY Q Where P = Price, Y = Income and D = Change Cross-elasticity of Demand Prices of related goods will also affect the demand for a particular good. For instance, the change in the price of desktop computers will affect the demand for its substitute – the laptop; the change in the price of petrol will affect the demand for its complimentary commodity – the car. The cross-elasticity of demand measures the rate of change in the demand of one good to changes in price of another related good. Thus, it is the responsiveness of demand for one good x (say Desktop PCs) to the change in the price of another good y (say Laptop PCs). Percentage Change in Quantity Demanded of X Cross-elasticity of Demand = ________________________________________ Percentage Change in Price of Substitute Good Y Symbolically, DQx/Q = _______ DPy/Py DQx Py = ____ × ___ DPy Qx Where Px = Price of good x, Py = Price of Substitute, Q = Quantity and D = Change Price, Revenue and Elasticity of Demand It is important for a business firm to know not only the magnitude of the quantity change as result of a price change, but also its impact on total revenue and marginal revenue. Revenue: Total, Marginal and Average The total revenue of a firm is the total earnings from the sale of its product. If the price change for all consumers is same, then total revenue is price multiplied by quantity sold. Total Revenue (TR) = Price (P) × Quantity (Q) TR = P × Q In Figure 4.5, TR is bell-shaped. It increases along with sales up to Q1, and then starts declining. Marginal revenue is the addition to total revenue from selling the last unit of output. It represents nothing but the rate of change of total revenue. As shown in the figure, MR lies below the demand curve. The demand curve is also the

54 Business Economics average revenue (AR) curve. Average revenue is simply total revenue (TR) divided by quantity sold (Q). Average revenue will be identical to price. That is, the price of the product is the average revenue earned per unit of sales. Total Revenue Average Revenue (AR) = ____________ Total Output TR AR = ___ Qy TR Py ◊Q AR = ___ = _____ = P Qy Qy MRnn = TRnn – TRn–1n The relationship between price, revenue and elasticity of demand is the prime concern for pricing analysis of a firm. Normally, when the price is very high, sales will be low because only a few will buy at high price; and, as a result, revenue will also be low. On the other extreme, if price is zero, sales may be massive but without any revenue. That is, when price is raised from zero onwards, total revenue will start increasing. But the total revenue increase will continue only up to a peak, and after reaching that peak, it will start declining. The reverse will continue until the total revenue reaches zero level. Price, MR e=a A

e = >1

P1 = 9

e=1 e = 1), change in marginal revenue will be positive. (c) When price elasticity of demand is less than one (PED < 1), change in marginal revenue will be negative. For instance, case (c) can be illustrated with Figure 4.5. As per Figure 4.5, the firm cannot sell more than 18 units at the rate of Rs.9 per unit. To increase sales more than 18 units, price must be brought down. For instance, to sell the 19th unit, price must drop to Rs.8 and the total revenue will fall from Rs.162 to Rs.152 (19 × Rs.8 = 152). The marginal revenue has declined to the extent of Rs.10 by the sale of an extra unit. This is because of the inelastic demand for the product. Similarly, if the firm increases its price to Rs.12, sales will come down from 18 to 12 units but total revenue will be Rs.144. As demand is elastic in this region (see Figure 4.5), marginal revenue will be increasing. The lower segment of the marginal revenue curve is increasing corresponding to the elastic segment of the demand curve. Whereas, after the peak, the marginal revenue is decreasing as it falls in the inelastic region. Thus, the above discussion, shows that firms can always maximise profit by charging prices where demand is either unitary elastic or elastic. Table 4.2 gives a summary view of the relationship between elasticity, marginal revenue and total revenue. Table 4.2 Price Elasticity of Demand and Revenue Effect on Total Revenue Elasticity Values Unitary (PED = 1) Elastic (PED > 1) Inelastic (PED < 1)

Marginal Revenue

For Fall in Price

For Rise in Price

0 Positive Negative

0 Increase Decrease

0 Decrease Increase

Given this scenario, firms need to make sensible decisions about price to be charged to maximise revenue. Price elasticity of demand will be useful not only to mark the revenue maximising price but also to make forecasts.

56 Business Economics ELASTICITY OF DEMAND: MEASUREMENT The slope of the demand curve, as shown in Figures 4.1 and 4.2, provides a rough measure of differing elasticities for the two demand curves; but it cannot provide an accurate picture. Price elasticity of demand has been defined as the ratio of the percentage change in quantity demanded to the percentage change in price. Hence, such percentage changes need to be calculated to arrive at an accurate measure of elasticity. There are different methods for making such calculations of price elasticity of demand, as listed below. (1) Percentage method (2) Arc Elasticity method (3) Point method or slope method Percentage Method Under this method, elasticity is measured as the relative change in demand divided by relative change in price, or, percentage change in demand divided by percentage change in price. For instance, in Figure 4.6, if the price of milk falls from Rs.8 to Rs.6, the quantity demanded changes from 40 litres to 50 litres, the PED can be computed with the following formula. %Dq PED = _____ %Dp In terms of percentage, the price fall from Rs.8 to Rs.6 is 25% and rise in demand from 20 litres to 30 litres is 50%. p 12

D

10

A

8

B 6

4

2

D¢ 0 10

Fig. 4.6

Measure of Elasticity

20

30

40

50

60

q

Elasticity of Demand

As

57

%Dq PED = _____ %Dp 25 = ___ = 0.5 50

This means that for every one unit fall in price, there is a 0.5 unit increase in demand. It is important to note that price elasticity of demand is a pure number and does not depend on the units in which price and quantity demanded are measured. In the above illustration, unit of price is measured in rupee and quantity in litres. The percentage method, however, is an approximate one, and is not accurate enough to measure the elasticities in non-linear demand curves. Arc Elasticity Method If the demand curve is a non-linear curve, percentage change cannot be applied DQ DQ because the ratio ___ will not be a constant. The ratio ___ will continuously vary DP DP over the gradient of a non-linear demand curve. In such cases, the alternative measures of price elasticity of demand, namely arc elasticity and point elasticity, are used. Arc elasticity is a measure of average elasticity. The segment of a demand curve between two points is called as ‘arc’. Arc elasticity measures the average elasticity between two points on a demand curve. Instead of using only the initial value (as in the case of percentage method), the arc elasticity method uses the average of both the initial and final values of an arc. That is, arc elasticity examines an average relationship over a range in the demand curve. The formula to measure price elasticity of demand by arc method is DQ _________ × 100 (Q + Q1)\2 _______________ Arc Elasticity = DP _________ × 100 (P + P1)/2 The alternative formula is DQ ___ Q1 Arc Elasticity = ____ DP ___ P1 DQ P + P1 Or = ___ × ______ DP Q + Q1

Price

A a

p p¢

b p≤

B q

Fig. 4.7

q¢

q≤

Quantity

Arc Elasticity of Demand

Point Method or Slope Method Point method is a relatively better method to measure price elasticity of demand. This method is particularly useful when the demand curve is not a straight line. By this

58 Business Economics method, the price elasticity of demand can be measured at a single point, that is, at a single price – quantity combination on a given demand curve. This method uses differentiation to find the effect of an infinitesimally small (marginal) price change on quantity demanded. The formula to measure price elasticity of demand by point method is: dQ ___ Q dQ P PED = ____ = ___ × __ dP ___ dP Q P dQ where ___ represents the differentiation of Q (quantity demanded) with respect to P dP dQ (price). Differentiation ___ finds the slope of the demand curve at a point. dP That is, point elasticity of demand (e) is P e = slope of the demand curve × __ Q

FACTORS DETERMINING ELASTICITY OF DEMAND The elasticity of demand depends on the shape of the demand curve; Some of the important factors are affecting price elasticity of demand listed below. 1. 2. 3. 4. 5. 6.

Availability of substitution commodities Income effect Time element Nature of the commodity Number of uses for the commodity Consumer’s taste

Availability of Substitution Commodities The substitution effect (discussed elaborately in subsequent chapters) depends on the availability of substitute commodities. If there are close substitutes available, demand for a commodity will be more elastic. Otherwise, the reverse will be the case. Income Effect The income effect of a fall in the price of a commodity depends on the proportion of income spent on that particular commodity. The higher the income spent on a given commodity, the more elastic the demand, keeping other things constant. Time Element Time element is another important factor that determines the value of elasticity. Demand tends to be more elastic in the long run. This is because consumers may

Elasticity of Demand

59

normally take time to adjust their consumption behaviour. Similarly, the demand is inelastic in the short run because it is difficult for consumers to cut down their consumption suddenly. Nature of a Commodity The specific nature of a commodity is yet another important determinant of its price elasticity. The degree of substitutability of a good will vary from one consumer to another. It depends on the particular nature of the need that is being satisfied by the good. A sophisticated camera is a ‘necessity’ for a professional photographer; but it may be a ‘luxury’ for a common man. Number of Uses for a Commodity If the number of uses for a commodity are several, then, the demand will obviously be more elastic. And the demand will be less elastic if the product has only a few uses. Consumer’s Taste Consumer’s tastes will change continuously; and such changes in tastes towards a particular commodity will obviously affect the elasticity of demand.

IMPORTANCE OF ELASTICITY The concept of elasticity of demand is widely used in the decision making of both private business firms and government. The importance of the tool emanates from its wider application in such diverse areas. The following are some such areas where the concept of elasticity is being applied. Business decision making: The concept of elasticity is of great importance in the various decision making processes of the business firm. It enables planning and efficient use of resources. It helps in determining prices as well as quantum of production. A company may also ascertain the impact of price changes on demand and revenue. Price Discrimination: In a monopolistic market condition, the seller can charge different prices form different consumers in order to eliminating consumer surplus. Such discrimination can be easily effected with the help of the elasticity of demand. Taxation: Elasticity of demand is also highly useful in the taxation policy of the government. It helps the finance minister to fix a particular rate of tax on a commodity based on its demand and elasticity. Wage Fixation: Elasticity of demand can also be applied in the price determination of factor market. For instance, wages are normally fixed on the basis of elasticity of demand for labour. International Trade: Governments fix the terms of foreign trade like tariff, terms of trade etc. by using the concept of elasticity. The concept of elasticity is also used in determining the rate of exchange

60 Business Economics

Key Terms and Concepts Elasticity of Demand Price Elasticity Cross-elasticity Point Method Range of Elasticity Slope Method

Price Discrimination Income Elasticity Percentage Method Arc Method Income Effect Consumer’s Surplus

Chapter Summary Elasticity of demand is an important tool in economics as well as in business. This chapter has introduced the concept of elasticity of demand and its various types, methods of measurement, determinants and importance. • Elasticity is a measure of responsiveness in quantity demanded due to changes in the determinants of demand. • The three types of elasticity are price elasticity, income elasticity and cross-elasticity of demand. • The range of elasticity varies over the demand curve from zero to infinity. • The relationship between price, revenue and elasticity is important for business decisions. • The three methods to measure price elasticity of demand are percentage method, point method and arc method. • Consumer’s income, prices of substitutes, taste and time element are some of the major determinants of elasticity. • The concept of elasticity is important for business decision making in many ways.

Questions A. Very Short Answer Questions 1. What is price elasticity of demand? 2. Briefly state different types of elasticity. 3. Give any two determinants of price elasticity of demand. 4. Define perfectly inelastic demand. 5. Define cross-elasticity of demand.

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61

6. What is unitary elasticity? 7. What is income elasticity of demand? 8. State different methods of measuring elasticity of demand. 9. Explain point method of measuring elasticity. 10. State the percentage method of measuring elasticity of demand. B. Short Answer Questions 1. Explain the various types of elasticity of demand. 2. Explain the ranges of elasticity along the demand curve. 3. Explain the various factors influencing elasticity. 4. Distinguish between point and arc methods of measuring elasticity. 5. Explain the relation between price, revenue and elasticity. 6. Explain the various methods of measuring elasticity of demand. 7. Distinguish between percentage and point methods of measuring elasticity. 8. Explain the importance of the concept of elasticity. C. Long Answer Questions 1. Define price elasticity of demand and explain its various values with suitable illustrations. 2. Explain the following: 1. Price elasticity of demand and its types 2. Income elasticity of demand and its types 3. Cross-elasticity of demand and its types 3. Explain the concept of elasticity and different methods of its measurement. 4. Define price elasticity and explain the determinants of price elasticity. 5. Explain the relationship between elasticity, price, total revenue and marginal revenue. 6. Explain the factors determining elasticity and its application in decision making in business and government sectors.

Chapter

5

Demand Forecasting An economic forecaster is like a cross-eyed javelin thrower; they don’t win many accuracy contests, but they keep the crowd’s attention — Anonymous

Learning Objectives This chapter aims to discuss the role and use of demand forecasting in predicting consumer behaviour. At the end, the students would be able to understand the concepts, objectives, and various methods of demand forecasting. The specific objectives are: • To introduce the concept of demand forecasting • To discuss the short-term and long-term objectives of demand forecasting • To understand the various methods of forecasting demand • To learn the trend and regression method with illustrations • To understand the qualities of best forecasting methods

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63

INTRODUCTION The two preceding chapters have discussed several useful concepts in demand analysis; and it was assumed that the demand function for a product was known. However, in practice, the actual demand function needs to be estimated by using actual data on demand and its key determinants, like price, income, taste, etc. Such estimation of demand function or demand forecasting is the subject matter of this chapter. Demand forecasting is necessary to make use of the demand relationship in business decision making. The firm must know what will be the demand for its product at various time periods, say today, tomorrow, or a month or a year later. Such information is essential for the firm to adjust either price, or production, or both in such a way as to achieve its ultimate goal of profit maximisation. However, it is not so easy to forecast demand on the basis of the current data. But, once the demand function is estimated, the firm can acquire substantial benefits. It can provide accurate insights into the key factors that determine sales. This, in turn, can help the firm to make good decisions. Further, the knowledge of demand function and the key determinants of future demand will also help firms in planning production capacity and in the choice of goods to be produced. Further, forecasting demand is also equally essential for public sector in various areas. For instance, the Planning Commission of India may want to estimate the demand for final housing, primary schools, energy, etc., for the next Five Year Plan.

OBJECTIVES OF DEMAND FORECASTING The estimation of demand function and demand forecasting have several objectives. The objectives of demand forecasting may be classified into short-term and longterm objectives. Short-Term Objectives Raw material management: Demand forecasting will be useful to attain efficiency in raw material use and management. Owing to demand estimate, only the required quantity of raw material would need to be stocked. This also reduces inventory cost. Short-Term Capital Efficiency: Demand forecasting helps to manage shortterm capital efficiently. The working capital requirement for daily expenses can be arranged as per the specific requirements of demand forecasting. Regulation of Sales: Fixing accurate sales target and incentive level for sales as per demand forecast is yet another useful objective. Selling activities and selling expenses can also be regulated as per the demand forecast. Price Policy: Reliable sales forecast will be useful to prepare relevant pricing polices. If the demand is high as per the forecast, prices can be increased marginally; similarly, when the forecast shows lower demand, a higher price may dip the sales further. Hence, demand forecast can help to formulate relevant price policies to maximise profit.

64 Business Economics Planning: Given accurate demand forecasting, appropriate production plan and policies can be formulated in tune with the demand forecast. Such planning can help to avert either over-production or under-production. Objectives of Demand Forecasting (Long-Term) 1. Demand forecasting is essential for the firm to ascertain future demand in the long run. Such long run forecast will be of use to plan for the expansion of the existing plants, new plants or new product launches. 2. Demand forecasting for the long run will be useful to plan for labour requirements. According to the long-term manpower needs, relevant training programme may be launched to acquire skilled and trained labour force. 3. Assessment of long-term demand forecast enables the firm to plan, mobilise and manage adequate capital and financing. 4. Long-term demand forecast can help firms to identify profitable avenues of investments on the lines of economic growth cycles.

METHODS OF DEMAND FORECASTING There are different methods to estimate and forecast demand function. The following are the three important methods. Each has some merits as well as demerits. 1. Consumer survey or interview 2. Market experimentation 3. Statistical methods a. Trend projection b. Regression analysis Among these three methods, the first two are direct methods, and are used widely by specialised market research agencies or firms. The statistical method is an indirect one but is one of the best and is more accurate. It is the single most important method used in business economics. The two main statistical methods are trend projection and regression analysis. Consumer Survey Consumer survey, or market survey, is the direct method. Firms can obtain information about their product by directly asking actual or potential consumers through survey or interview. The consumer may simply be asked about the quantity they would buy at various prices, or their future buying intentions. They may also be asked about their reaction to new products to be launched, or to changes in established products. All these information can be used to determine the relationship between demand for the firm’s product and its determinants, like price, income, taste, etc. Interview or survey can provide quick but excellent information about the prevailing market conditions which may be used to estimate the demand relationship.

Demand Forecasting

65

The consumer survey can be detailed, or can be quick on-the-street interviews. Market research agencies widely use pre-tested questionnaires and interviews on behalf of firms. The results are then aggregated to estimate the demand function, using which the firms can make more accurate decisions. One of the major advantages of the consumer survey is that it is very useful when the existing information is limited. It gives latest information about the current market conditions and much useful and supplementary information, like the effect of advertisement, product characteristics, consumer awareness about relative products, their prices, etc. It is simple and can provide quick information. Though the consumer survey technique is simple, quick and useful, its quantity is limited. The validity of the result is doubtful. The reliability of the result depends on how accountably the survey is conducted; it is subject to sample bias. For instance, the respondents may not be actual consumers. Market Experimentation Market experiment is yet another direct method of demand forecasting. In this method, the consumer behaviour is examined in a controlled environment, or in a segmented market, instead of examining it in a whole market. The demand for the product at various prices is explored in a relatively small geographical area (like select cities or shops), or with reference to a specific consumer group. This is also called test marketing. Test marketing is quite useful for exploring consumer relation to different prices or other determinants of demand for the given product. In this method, the actual spending behaviour of the consumers is observed instead of asking them about their behaviour. This method can also be used for investigating other important aspects, such as regional variations in sales, advertisements, consumer behaviour, etc. It can also identify problems, if any, in any city or region. Like the consumer survey method, this direct market method also has some serious drawbacks. First, the regions or cities are normally heterogeneous and may not be comparable. The response obtained in one city may not be similar to that of another city. As the sample is very limited, the results are doubtful. It is costly and more risky. Controlled variations in the price or product may adversely affect sales prospects. This method can be used only for a short period. This method is not useful for identifying long-term trend. Statistical Methods Statistical method is an indirect method of demand forecasting but it is the most effective one. While the above two methods may provide data about demand, they may not be able to draw accurate inferences about the demand function. Estimation of demand function requires detailed information about both the dependent variable (quantity demanded) and independent variables (price, income, price of substitutes, taste, etc).

66 Business Economics The most effective means of estimating the demand function relationship are the statistical methods, particularly by regression analysis. The cost of demand estimation is also relatively low by regression technique. This method has also gained wider popularity because of the easy availability of fast computers loaded with powerful statistical software packages like SPSS, SAS, Strata, etc. The demand function can also be estimated using the trend analysis. Trends can be estimated by various methods including the regression technique. Trend Method Trend method is based on the assumption that past demand patterns can be used to predict future demand. Economic performance, in general, follows some pattern and the past pattern can be used to predict future trend. In the trend method, or time series analysis, past information recorded over time is used to draw a graph or a line of best fit. This line is called trend line, and it can then be extended to forecast the future trend. Time series simply means observations recorded over a period of time. The observations are normally related to profits, sales, revenues, costs and related variables of a firm. Time series analysis is used to understand, interpret and estimate many types of variations in economic variables over time. Time series has four components, namely 1. Secular trend (T) 2. Seasonal variations (S) 3. Cyclical variations (C) 4. Irregular variations (I) All above variations are used for forecasting the future cause of events. This chapter is confined to the discussion of only the trend, which can be completed with the following methods. 1. Free-hand method 2. Semi-average method 3. Moving average method 4. Method of least square Free-Hand Method

Free-hand method is the simplest method of measuring trend. Time and the concerned variables are plotted, respectively, on the X-axis and Y-axis of a graph. Then the plotted points are joined together by a free-hand smooth curve to draw a trend line. It is the easiest method to fit a trend line. It can also be done with the help of MS-Excel in personal computer. Though it is the easiest method, the accuracy of the line is limited. And there is some subjectivity involved in drawing the trend line by the free-hand method. Figure 5.1 shows the trend line of sales over a period of ten years drawn by freehand method.

Demand Forecasting

67

45 40 35

Sales

30 25 20 15 10 5 0 1

2

3

5

4

6

7

8

9

10

Time Period

Fig. 5.1

Trend Line by Free-Hand Method

Semi-Average Method

This is another simple way of measuring trend. The given data would be divided into two equal parts. For instance, in case of ten years data on sales, from 1998 to 2007, the two equal parts will be First five years (1998-2002), and Second five years (2003-2007) In case of odd number of years, say 11, the middle year will be omitted. The average sales for the two segments will be calculated and plotted against the mid-point of each part as shown in Table 5.1. Then these two points would be plotted on a graph. The required trend line is drawn by joining the two plotted points. Illustration 5.1: The sales figures of a firm over the last ten years are given below. Fit a trend line by the method of semi-average method. Year

Sales in 00000 units

1998 1999 2000

290 408 525

2001 2002

643 584

2003 2004

707 704

2005 2006

766 807

2007

856

Sum of sales in five years (1998-2002) = 2450/5 = 490

Sum of sales in five years (2003-2007) = 3840/5 = 768

Solution: Semi-average of the first half is 490. It is plotted against the middle year of that half, i.e., year 2000. Similarly, the semi-average of 768 is plotted against year 2005. The trend line is arrived at by connecting these two points in a graph.

68 Business Economics Moving Average Method

This is yet another simple method of fitting trend line. The moving averages are simply the consecutive arithmetic means of successive data of a series. The moving averages help to smoothen time series observations. The moving averages can be calculated for three years, five years, or months, weeks or even days. The following illustration will explain the procedure. The data used in Illustration 5.1 can be used to compute three yearly and four yearly moving averages. Three yearly moving averages of a time series are defined as follows: Year

Sales in, 00,000 Units

3 Yearly Moving Total

3 Yearly Moving Average

1998 1999 2000 2001 2002 2003 2004 2005 2006

290 408 525 643 584 707 704 766 807

1223 1576 1752 1934 1995 2177 2277 2429

407.66 525.33 584 644.33 665 725.66 759 809.66

2007

856

-

-

If the consecutive observation are a, b, c, d…………………, then a+b+c MA1 = ________ 3 b+c+d ________ MA2 = 3 c________ +d+e MA3 = 3 In the case of four yearly moving averages, or any even number of years, like 6 or 8, the moving total does not correspond to the middle year. Hence, another moving total, called as centered moving total is calculated to plot the averages against the particular mid-year. The computed values have to be plotted against each mid-point of the three years to draw the trend line in a graph. For instance, 407.66 should be plotted against the year 1999, 525.33 against 2000, and so on. Method of Least Square

The method of least square is a widely used technique to select a single line of best fit for any time series trend. The trend in demand or sales can formally be estimated for projection using the method of least square. The basic aim of the method of least square is to algebraically fit a trend line whose equation is of the form of the three yearly averages Y=a+bX

69

Demand Forecasting

Where,

Y = dependent variable (effect) X = independent variable (cause) b = slope a = constant or intercept On a priori basis, X and Y are related, and in the above case Y depends on X. That is, the dependent variable Y responds to changes in the independent variable X. And b, the slope of the line, means the change in the dependent variable Y due to unit change in independent variable X. To find the trend line with least deviation of the actual data from its average values, slope b and constant a need to be computed from the given pair of observations X and Y. The constant a and slope b can be computed by solving the following two normal equations. Straight Line Y = a + bX Normal equations SY = na + bS X SXY = aSX + bSX2 The following illustration can help to understand the method further. Illustration 5.2: The sales figures of a firm over a period of seven years are given below. (1) Fit a trend line by the method of least square (2) Based on the trend, project the probable sales for the year 2010. Year

2001

2002

2003

2004

2005

2006

2007

5

6

6

7

9

7

10

Sales in million units

Solution:

The equation for the straight line to be fitted is Y = a + bX

Where, Y = sales, X = Years, b = slope, a = constant The normal equations are SY = na + bSX

...(1)

2

SXY = aSX + bSX

...(2)

To solve the two normal equations the following are needed to be computed from the given data. SY, SX, SXY, SX2 and n Year

Sales (million units)

Year 2004

=Y

=X

X2

XY

YC = 7.14 + .71X

Trend Line

2001 2002 2003

5 6 6

–3 –2 –1

9 4 1

–15 –12 –6

5 5.71 6.42

2004 2005

7 9

0 1

0 1

0 9

7.14 7.91 Table Contd.

70 Business Economics Table Contd.

2006 2007

7 10

2 3

4 9

14 30

SY = 50

SX = 0

SX 2 = 28

SXY = 20

8.62 9.33

By substituting the numerical values in equations (1) and (2), we get

That is,

and

35 = 7a + b(0)

...(3)

20 = a(0) + 28b

...(4)

35 = 7a 35 a = ___ = 7.14 7 20 = 28b 20 b = ___ = .714 28

The computed straight line trend is YC = 7.14 + .71 X The trend values YC for each year are computed by substituting their respective X values in the above equation. For instance, the trend value for the year 2001 is Y2001 = 7.14 + .71 (–3) = 7.14 + .71 (–3) = 7.14 – 2.14 = 5 Similarly, Y2002 = 7.14 + .71 (–2) = 5.71 The trend values for all years are shown in the last column and it may be noted that YC changes each year at the rate of .71 which is the com- Sales puted co-efficient of X. Thus, 10 sales increase every year by 9 .71 million units. 8 In Figure 5.2, year is mea7 sured on X axis and sales figY = 7.14 | .71X ures are measured on Y axis. 6 The dots are the actual pairs of 5 values. If all YC values are plot4 ted in the graph it will form a perfect straight line trend. 3 Based on this trend, the 2001 2002 2003 2004 2005 2006 2007 probable sale for the year 2010 Year can be computed. The value of Fig. 5.2 Trend Line fit by Method of Least Squares X for the 2010 will be 6. By substituting this in YC, we get

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71

YC = 7.14 + .71 X Y2010 = 7.14 + .71

...(6)

= 11.42. That is, if the same current trend continues, sales of the firm in the year 2010 will be 11.42 million units. Regression Method Regression method assumes a causal relationship between the independent variable and the dependent variables. In demand function, while changes in quantity demanded is the dependent variable, the determinants of demand, viz., price, income, taste, etc., are independent variables. The independent variables are the ‘cause for any effect’ in the dependent variable. When the relationship is between one independent variable and one dependent variable, it is called simple regression; whereas the relationship between one dependent variable and many independent variables is called multiple regressions. Regression analysis involves a number of stages as listed below: 1. Model Specification 2. Data Collection 3. Specifying regression equation 4. Estimation and interpretation Specification of Variable or Model Specification: The first step to carry out regression analysis is to specify the range of variables which may affect demand for the given product. It is also necessary to specify the specific form of the relationship, like linear or non-linear. The demand function provides an a priori basis for this. That is, the relationship between quantity demanded and its determinants is already known. Such known or theoretically established relation is called deterministic relationship. Where the relation is unknown or the specification of the form of function is uncertain, it is called as statistical relationship. In the case of statistical relationship, the regression co-efficient may be computed with alternative assumptions regarding the form of the function. The particular specification that explains the maximum variation is chosen. In the case of demand function, the relationship is deterministic (or a priori). The own price of a good is expected to be the main determinant of quantity demanded for most products. Q = f(p) ...(5.1) If the firm wants to know the effect of the price of a substitute good the function becomes Q = f(p, y) ...(5.2) Where ‘Q’ represents sales, ‘p’ represents price and ‘y’ represents income of the consumer. The question of whether there are any substitute goods, or past prices of

72 Business Economics the own good, or consumer’s taste affecting sales could be considered for inclusion. Similarly, any other factors which affect sales could also be identified. But, given the limitations of economic theory, non-availability of data on some variables and difficulties of quantification, it is impossible to identify and include all relevant variables on the right side of equation 5.2. To account for the omitted variables in the model, a residual (or error) term needs to be added. Hence, the linear demand function will be Q = f(p, y, u) ...(5.3) where ‘u’ is the error term Data Co1llection: After identifying all the relevant variables affecting sales, the data needs to be collected for analysis. The range of information regarding price, advertisement and rival products can be obtained by observing retail sales. Some of them may also be available in public domains. Data on consumer’s income, taste, demographic changes, taxes, etc., can be collected from government sources like CSO NCAER, Census, etc. Estimation of Regression: Ordinary least square method is a widely used technique to estimate both linear and non-linear forms of regression equation. In simple regression, two variables are used. The variation in the dependent variable is explained by the independent variables, by examining the tendency of the former to respond to the movements of the later. This tendency of the dependent variable to vary must be consistent and systematic for a regression model to have meaning. Regression analysis aims to determine the exact and precise form of such tendency. In the OLS method, ‘least square’ means estimating the ‘line that minimises the sum of squares of the differences between the observed values of the dependent variable and the fitted values from the line. The following illustration will explain the relationship between two variables. Illustration 5.3: Find the regression equation for the following data keeping X as the independent variable and Y as the dependent variable. X Y

Solution:

8 2

10 4

10 6

14 8

13 10

13 12

16 14

The regression line of Y on X is Y = a + bX

...(1)

The most simple formula given by Wonnacoat (1977) to calculate the least squares slope or regression co-efficient b is __ __ S(X – X) S(Y – Y) _______________ b= __ S(X – X)2 __

__

The deviations S(X – X) and S (Y – Y) can be abbreviated further as follows. __

S(X – X) = x __

S(Y – Y) = y

Demand Forecasting

73

Sxy b = ____2 Sx The computed value of b can be substituted in the regression line to find the value of the constant a. Now

__

X

Y

x = S(X – X)

__

y = S(Y – Y)

x2

xy

8

2

–4

–6

16

24

10 10 14

4 6 8

–2 –2 2

–4 –2 0

4 4 4

8 4 0

13 13 16

10 12 14

1 1 4

2 4 6

1 1 16

2 4 24

SX = 84

SY= 56

Sx = 0

Sy = 0

SX 2 = 44

SXY = 66

__

84 SX ___ X = ___ n = 7 = 12 __

56 SY ___ Y = ___ n = 7 =8 Sxy b = ____2 Sx 66 b = ___ = 1.5 44 The value of constant a can be calculated by substituting the value of b in another simple formula __ __ a = Y – bX a = 8 – 1.5(12) a = 8 – 18 = – 10 Substituting these values of a and b in equation (1), we get the estimated trend line YC = –10 + 1.5 X Or

YC = 1.5 X –10

Multiple Regression In the above illustration, there is only one independent variable that causes changes in the dependent variable. But the real world is not so simple. An economic variable may change due to many factors. The variables that are possible to identify and are amenable for quantification need to be included as independent variables in the regression equation. This will give more accurate estimation and prediction. For instance, the demand function given below (discussed in Chapter 3) depends on factors like own price, prices of substitutes, income, taste, climate, tax policy, etc.

74 Business Economics Dx = f(Px, Y, T, Py, W, S, A, ....) where Dx = demand for commodity X Px = price of commodity X Y = consumer’s income T = consumer’s tastes and preferences Py = prices of other brands like Honda or Suzuki W = wealth of consumer S = future expectations or speculation A = level of advertisement Here, quantity demanded has to be estimated and predicted by using multiple regression analysis. The variables affecting quantity demanded (dependent variable) will be included as independent variables.

SELECTING BEST FORECASTING METHOD (OR) QUALITIES OF BEST FORECASTING As there are many methods to forecast demand with different levels of strength and weaknesses, firms need to select the most appropriate technique to meet their specific requirement. To select the appropriate method of forecasting, managers must ascertain the time and resources involved and the level of accuracy needed. The following are some of the criteria for selecting the most suitable forecasting method. 1. Data availability 2. Availability and simplicity 3. Accuracy 4. Reliability 5. Flexibility 6. Durability 7. Time and cost 8. Role of judgement Data Availability: Availability of adequate past data is the basic requirement to make any reasonable forecast about the future. Different methods require different types of data, like time series, cross-section and panel data. Further, the sources may either be primary or secondary. Therefore, the selection of a particular forecasting technique depends on the availability of required data for the method. Accuracy: Level of accuracy is one of the important factors to select the relevant method of forecasting. Accuracy normally depends on precision with which the independent variable can be predicted. As accuracy of different methods of forecasting varies considerably; the manager has to choose the method according to the required level of accuracy. Time and Cost: Some forecasting methods may be effective in the short run while others may be effective only in the long run. For instance, survey method may be

Demand Forecasting

75

quick and trend projection involves a longer time horizon. Similarly, cost of using different methods also varies. Hence, a firm should also consider the time and cost involved while selecting a particular method of forecasting. Availability and Simplicity: The data required for forecasting should be simple and readily available for use. Certain secondary sources of data, like census, is prepared once in ten years. But the National Council of Applied Economic Research (NCEAR) surveys on consumer spending are available annually. There are also monthly and weekly statistics, like inflation data. The firm should choose a simple method that uses immediately available sources of data. Reliability: Reliability of the results is yet another important criterion in choosing a specific method of forecasting. Time and resources involved may be considered but not at the cost of reliability of the predictions. Hence, reliability of the chosen method’s forecasting capability should be ascertained. Flexibility: Economic and business conditions are always dynamic. The moment the required data is collected, many new and sudden developments may take place. A new policy may be announced, or new entry in the industry may take place bearing significant effect on sales. Hence, the model should be flexible enough to include such new variables or conditions. Durability: Though the model needs to be flexible, the results should be durable. For instance, the functional relationship of a demand function should be stable and the forecast should be valid for a reasonable time-span. Role of Judgement: The role of judgement is the last important factor in choosing a particular method of forecasting. For instance, application of all the above criteria may pose challenges because no single method may satisfy all of them. Under such conditions, the manager should judge effectively to make the best trade-off to choose a method to suit the resources and requirement.

Formulae Trend Line by the Method of Least Squares Straight Line Y = a + bX Normal equations SY = na + bSX

...(1) 2

SXY = a SX + bSX Where, Y - dependent variable (effect) X - independent variable (cause) b - slope a - constant or intercept

...(2)

Regression Line of Y on X The regression line of Y on X is Y = a + bX ...(1) The most simple formula to calculate the least squares slope or regression coefficient ‘b’ is

76 Business Economics __

__

S(X – X) S(X – Y) b = _______________ __ S(X – X)2 Sxy = ____2 Sx The value of constant a can be calculated by substituting the value of b in another simple formula __ __ a = Y – bX Or

Key Terms and Concepts Demand Forecasting Long-term Objectives Consumer Survey Statistical Methods Free Hand Method Moving Average Method Regression Method Multiple Regression

Objectives of Forecasting Short-Term Objectives Market Experiments Trend Semi-Average Method Method of Least Square Model Specification Qualities of Best Forecasting

Chapter Summary Demand forecasting is of the most practical use in economics as well as in business. This chapter has introduced the concept of demand forecasting and its objectives in the short and long run. The various methods of demand forecasting with suitable illustrations and their relative strengths and weaknesses have been explained. The factors to be considered in selecting the best method of forecasting have also been discussed. • Demand forecasting plays a critical role in business decision making. • It provides an accurate insight about the key determinants of sales and future demand; it also helps firms for planning production capacity and the choice of goods to be produced. • There are many specific objectives in the short-term as well as long-term for demand forecasting. • There are mainly three methods to forecast demand, viz., consumer survey or interview, market experimentation and statistical methods. • Trend projection and regression analysis are the main techniques of statistical method.

Demand Forecasting

77

• Each method has some strengths and weaknesses and choosing the right method depends on many factors like data availability, accuracy of results, time and cost involved.

Questions A. Very Short Answer Questions 1. What is demand forecasting? 2. What are the objectives of demand forecasting? 3. What is trend? 4. What is survey method of demand forecasting? 5. What is market experimentation? 6. Explain statistical method of demand forecasting. 7. What is regression method? 8. What is method of least squares? 9. State the qualities of good demand forecasting. B. Short Answer Questions 1. What is demand forecasting? Explain its objectives. 2. Discuss the various methods of demand forecasting. 3. Explain the method of least squares to forecast demand. 4. Discuss the various objectives of demand forecasting. 5. Describe the best qualities of good demand forecasting. 6. Compute the trend by the method of three yearly moving average from the given data. Year

2000

Sales in, 000 units 110

2001

2002

2003

2004

2005

2006

2007 2008

30

120

140

150

145

155

160

157

C. Long Answer Questions 1. Explain the various methods of demand forecasting. 2. Explain the various factors to be considered to select an appropriate method of forecasting. 3. Explain the following: (a) Free-hand method of trend (b) Moving average method (c) Regression method (d) Least square method 4. Compute the trend line from the given data by the method of least squares.

78 Business Economics Year Sales in, 000 units

2001

2002

2003

2004

2005

2006

15

16

16

19

18

22

2007 2008 23

25

5. Find the regression line of y = a + bx from the following data. x

6

5

9

8

2

6

y

7

8

6

5

4

6

Chapter

6

Supply: Law, Determinants and Market Equilibrium ‘One difference between a liberal and a pickpocket is that if you demand your money back from a pickpocket, he won’t question your motives’. —Anonymous

Learning Objectives This chapter aims to introduce the concept of supply and market equilibrium. It describes how demand and supply determine market price. At the end, the students would be able to understand, the law of supply, its determinants, and how market attains equilibrium. The specific objectives are: • To introduce the concept of supply • To discuss the law of supply, supply curve and supply function • To understand the elasticity of supply and its types • To introduce the concept of backward bending supply curve of labour • To examine the various determinants of supply • To understand how demand and supply interact with each other to determine the equilibrium price and quantity of a commodity in a market

80 Business Economics INTRODUCTION Along with demand, economic theory deals also with the concept of supply. Supply and demand together determine the market clearing or equilibrium price and quantity. Supply means the quantum of goods offered for sale at alternative prices during a specific period of time. Business firms supply commodities in output markets and demand factors of production in input markets. The concept of supply deals with the behaviour of firms in the output market. Firms engage in business mainly for profit. A firm can make profit when revenue exceeds costs. Given this scenario, supply decision of a firm normally depends on profit levels. That is, supply is likely to react to changes in revenue and cost of production. The revenue of the firm mainly depends on the price of the product and the number of units sold. Cost depends mainly on the input prices and technology. As input prices and technology may remain same in the short run, profit depends on revenue maximisation, which, in turn, depends on price and sales. The law of supply explains the relationship between supply and price of the product, given the input prices, technology and other determinants of supply.

SUPPLY: MEANING AND DEFINITION Quantity supplied is the amount of a good that a firm would be willing and able to offer for sale at a given price during a particular time period; other things that affect supply, like prices of inputs, resources, technology, etc., are assumed to be constant. Some definitions of supply are given in the Box. Definitions of Supply Anotol Murad: Supply refers to the quantity of a commodity offered for sale at a given price, in a given market, at a given time. McConnel: Supply may be defined as a schedule which shows the various amounts of a product which a particular seller is willing and able to produce and make available for sale in the market at each specific price in a set of possible prices during a given period.

LAW OF SUPPLY Law of supply establishes a direct relationship between quantity of a good supplied and its price. That is, law of supply can be summed up as: other things remaining the same, an increase in market price would lead to an increase in quantity supplied and a decrease in market price would lead to a decrease in quantity supplied. According to this law, price is the major determinant of supply. Generally the marginal cost of production increases with increase in outout, hence, the rising price acts as an incentive for firms to supply more.

Supply: Law, Determinants and Market Equilibrium

81

Supply Schedule The law of supply can be illustrated with the help of supply schedule, supply curve and supply function. Supply schedule shows how much of a good would be sold at different prices. Table 6.1 shows the various quantities of a good supplied at different prices. Table 6.1

Supply Schedule Price (Rs. per Kg) 7

Quantity Supplied (1000 kg per Week) 10

9 12 16 20

20 30 45 45

That is, supply Schedule 6.1 simply lists different amounts of the good that the seller would put up for sale at the alternative prices. For instance, as shown in Schedule 6.1, the firm sells 10 units (10,000 kg) when the price is Rs.7 per kg. If the price rises to Rs.9 per kg, it offers 20 units. The firm continues to increase its offer quantity as price rises. But when the price rises from Rs.16 to Rs.20, quantity supplied no longer increases. This is because the firm’s ability to respond to an increase in price is limited by its total capacity for production in the short run. Hence, in the above illustration, the firm’s maximum capacity is 45 units (45,000 kg) at which the supply stays constant. Supply Curve The positive relationship between the quantity of a good supplied and its price can be graphically presented through a supply curve. Supply curve slopes upward indicating the direct relationship between price and supply. The supply curve may be linear or non-linear. When the supply Price S Supply Curve schedule is plotted on a two dimen20 sional graph, with price of the good 15 measured on the Y-axis and the quantity supplied on the X-axis, the 10 outcome is a linear supply curve. The upward sloping supply curve 5 implies that as price rises, the quantity supplied tends to increase. That 0 10 20 30 40 50 is, the producer would supply more Quantity supplied when the price is higher. Note that the positive slope of the supply Fig. 6.1 Needs to be redrawn to measurement curve becomes vertically steeper after reaching its full capacity of 45,000 kg.

82 Business Economics The supply curve may, alternatively, represent the minimum price that the firm would want to charge for supplying each quantity. Supply Function The question of how much of a product will be supplied will depend on many factors. The price of a good is one of the most important factors. Other than price, the cost of production, the technology used, prices of related products, etc., are some of the determinants of the quantity supplied. The supply function captures the relationship between the quantity supplied and the determinants of quantity supplied. Qs = f(Px, C, T, I, Py) Where Px T I Py

= = = =

Price of the good Technological know-how, Input prices, Prices of other substitute. P

P

S¢

S

S S ¢¢

P¢ P S¢ S O

Q Q¢ (a) Change in supply

Q

S ¢¢ Q ¢¢ Q¢ Q (b) Shift in supply

Q

Fig. 6.2

Change and Shift in Supply Just like demand, price is the major determinant of supply and the other determinants are related to the conditions of supply. While the price determines slope of the supply curve, other determinants cause the shift in the supply curve. As shown in Figure 6.2 (a), higher the price, more would be the supply of good, and lower the price, lower would be the supply. But both these changes in supply in response to price changes take place on the supply curve. Thus, any price changes from P to P,¢ or from P¢ to P, bring movement on the supply curve. However, change in condition of supply or change in the other determinants of supply may shift the entire supply curve. For instance, during summer, the ice-cream supply may increase at the existing price itself, whereas, during winter, it may fall

Supply: Law, Determinants and Market Equilibrium

83

again. These changes in the condition of supply may shift the supply curve either to the right (summer) or to the left (winter) as shown in Figure 6.2 (b). Market Supply Curve Like demand, the ‘market supply schedule’ is the supply schedule of all firms in a given industry. The market supply schedule S simply shows the quantity supplied of a particular product that sellers are prepared to sell at P ¢¢ different prices in the market in a given period of time. The market supply function presents P this relationship between quantity supplied and its price and other determinants. P¢ The relationship between quantity supplied and its price need to be plotted on the graph to obtain the supply curve. Thus, market supply Total quantity supplied curve represents the total quantity supplied at each price, keeping other things constant. The Fig. 6.3 Market Supply Curve market supply curve can be arrived at in the same way as the market demand curve. The market supply curve can be arrived at by a horizontal summation of individual supply curve of all firms in the industry. Figure 6.3 shows one such market supply curve.

ELASTICITY OF SUPPLY: MEANING Elasticity of supply measures the response of a good supplied to a change in the price of that good. While the law of supply explains the direction of change in supply to a price change, elasticity of supply explains the rate of change in supply in response to a price change. Elasticity of supply can be defined as the ratio between percentage change in quantity supplied to percentage change in price of the good. That is,

Percentage change in quantity supplied Elasticity of supply = ________________________________ percentage change in price

Figure 6.4 shows the varying responses in quantity supplied for a uniform price change. There are two supply curves S and S¢ with different elasticity. For a price change from P to P¢, supply extends from Q to Q¢ with S. But for the same price change from P to P¢, supply extends from Q to Q¢¢ with S¢. At price P, therefore, S¢ is said to be more elastic than S. Backward Bending Supply Curve Elasticity of supply, in general, is likely to be positive in output markets as higher price encourages more supply from firms. However, some interesting problems arise in the input market, more particularly in the labour market. Consider the case of a labour supply curve, which shows the quantity of labour supplied at different wage rates.

84 Business Economics P Wage

S

c

S¢ P¢ P

b

W*

a

Q Q¢ Fig. 6.4

Q ¢¢

Elasticity of Supply

Units of labour

Q Fig. 6.5

Backward Bending Supply Curve

Figure 6.5 shows the labour supply curve which is backward bending. The shape of the labour supply curve explains the response of the households to changes in wage rate. When there is an increase in wage level, the households get more income. But they may not increase the supply of labour in response to a hike in wage beyond certain level because they also value leisure. Since there are only 24 hours in a day, the individuals face a trade-off between wages (or goods and services that can be bought by the wage) on one hand, and leisure on the other. The individuals therefore attempt to maximise their total utility by distributing their 24 hours between labour and leisure. Initially, when the wage rate increases from the lowest level to higher level, the individuals increase the supply of their labour to get more income. Hence, below W¢, the supply curve is upward sloping. But, when the wage rate increases beyond W¢, the supply of labour starts declining. This is because when wage rate is sufficiently high to buy the required goods and services, the individual prefers more leisure to work. Types of Elasticity of Supply There are three main types of elasticity of supply which are of economic significance. They are: 1. Perfectly Elastic Supply 2. Perfectly Inelastic Supply 3. Unitary Elastic Supply Perfectly Elastic Supply In the case of perfectly elastic supply, the co-efficient of elasticity will be infinite (a). It indicates that when a single firm demands a very small proportion of, say, labour, it can obtain an infinite amount of supply. Figure 6.6 (a) shows that at a given price of

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P, the supply curve is horizontal, which means availability of infinite labour supply. This is the case of perfect competition in factor market where production takes place at constant cost. P

P S

P

S

O

Q

O

Elasticity of supply = 0

(a)

Fig. 6.6

Q

Q

Elasticity of supply = a

(c)

(a) Perfectly Elastic Supply (b) Perfectly Inelastic Supply

Perfectly Inelastic Supply

In the case of perfectly inelastic supply, the supply of a good is fixed for any change in price. The co-efficient of elasticity is equal to zero indicating no change in supply for any change in price. Figure 6.6 (b) illustrates the perfectly inelastic supply curve as a vertical line. As quantity Q is fixed, no change will take place. Perfectly inelastic supply is possible in the case of rare artifacts, paintings or coins which are limited in supply forever. Also, Unitary Elastic Supply

In the case of unitary elastic supply, the supply of a good changes in the same proportion as the given price change. The co-efficient of elasticity of supply is 1. Figure 6.7 shows the unitary elastic supply curve that passes through the origin. The unitary elastic supply curve has limited significance in economics as compared to the unitary elastic demand curve because the former describes a condition where supply changes are always in equal proportion to a given price change. And this may be a rare situation.

P S

P

P¢

Q

Q¢

Q

Elasticity = 1

Fig. 6.7

Unitary Elasticity of Supply

86 Business Economics DETERMINANTS OF SUPPLY As discussed in the supply function, quantity supplied depends on many factors, including price. The following are some determinants of supply. Own Price:

As shown earlier, price is the most significant factor affecting the quantity supplied by a firm. As profit is the difference between revenue and cost, higher price will yield higher revenue as well as profit. Hence, it is obvious that firms would be willing to supply more at higher price. Technological Knowledge: An improvement in production techniques is an other factor that determines the level of supply. If the improved technique reduces cost of production, supply curve will shift to the right indicating higher supply. Input Prices:

A change in input costs affects the supply curve of a firm. When the cost of inputs rises, supply tends to fall, and vice versa. An increase in the input price would increase the cost of the product. As a result, only lesser amount of goods can be supplied at the old price. A fall in input costs would have an opposite effect. Invisible Hand ‘Every individual is continually exerting himself to find out the most advantageous employment for whatever capital [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society. . . . He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention.’ —Adam Smith, The Wealth of Nations (1776)

Prices of Substitutes:

Changes in the prices of the other goods, particularly substitutes, also affect supply. If the price of a substitute commodity increases, it may attract more resources for its production. Such shift in production will obviously reduce the supply of the original product. Expectations: If the price of a particular product is expected to rise, stocks will be retained for future sale. That is supply, will fall when there is an expectation for price increase. Similarly, if the price is expected to fall, stocks will be depleted fast. Taxes and Subsidies: Government policies of taxation and subsidies affect supply. A tax that the government imposes on the sale of a good would result in fall in the quantity supplied for sale at the old price. That is, tax increases the price and moves the supply curve to the left. A subsidy, on the other hand, cuts the cost and moves the supply curve to the right indicating higher supply at the old price. Entry of New Firms: Entry of new firms also affects the supply of existing firms; when a new firm enters the market and captures a considerable market share, it proportionately reduces the share of other firms. But this is possible only in the long run.

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Non-Economic Factors:

Supply can be influenced by many non-economic factors both in the short run as well as in the long run. For instance, the possible depletion of non-renewable energy sources or invention of new raw materials may affect the supply of some goods. Natural disasters, war, changing political climate, etc., are some of the other non-economic factors.

MARKET EQUILIBRIUM OR PRICE DETERMINATION Demand and supply are the two most important concepts used to explain the market mechanism or the behaviour of the market economy. We have discussed how price determines both demand and supply. In the market equilibrium framework, demand and supply together determine market price. In a free market economy, demand and supply alone are expected to determine price and quantity, both in the goods market and the factor market. The discussion on demand has highlighted that the demand curve shows the quantities of the commodity consumers would buy at various prices. Similarly, supply curve shows the quantities that firms would be willing to sell at various prices. But there is only one price at which the buyer and the seller transact. That price is called the equilibrium price or the market clearing price. Equilibrium simply means a balance or a state of rest with no tendency to change. In a free market economy, economic activities are mostly organised through the system of market. Buyers and sellers pursue their respective objectives by interacting in the market. While buyers’ preferences are governed by the utility maximising behaviour, sellers’ preferences are governed by the profit maximising behaviour. Utility maximisation is possible by a price cut whereas profit maximisation is possible by a price hike. Equilibrium price or market clearing price is determined by the interaction of these two opposing interests. As demand and supply curves have the same axes, viz., price and quantity, both can be combined Price in a single diagram (Figure 6.8). The demand curve exhibits the consumer’s S D S>D preference, that is, more will be bought Excess Supply at lower price. The supply curve, on P¢ the contrary, shows that less will be supplied at lower price. Given these P* E D=S diverging preferences, the two curves have diametrically opposed slopes, and they also intersect with each other at P ¢¢ price P* and quantity Q*. The point of D>S intersection, E is called an equilibrium Excess Demand point where demand is equal to supply (D = S), and P* is the market clearing price and Q* is the equilibrium Q* Quantity Demanded quantity. Fig. 6.8

Equilibrium Price

88 Business Economics Given the opposing interest, thus, the consumers are willing to buy Q* quantity at the price of P*, and the seller is also willing to sell the same quantity at the price of P*. As quantity demanded by buyers is equivalent to quantity supplied by the sellers at P*, the equilibrium price is called as market clearing price. Equilibrium refers to state of rest or balance, and even if there is a deviation, the original equilibrium would be restored by the market forces, i.e., by the interaction of supply and demand. Deviation from equilibrium price exhibit either excess demand or excess supply. Excess Demand or Shortage in Supply Excess demand occurs when some buyers are unable to fulfill their demand, or there is shortage of goods. When goods are in short supply, consumers compete to buy the goods by bidding higher prices. Auctions are the typical case where prices are raised by consumers. When every buyer tries to bid a higher price to buy the desired quantity of goods, such competition raises the price until it reaches the equilibrium level. This upward tendency in price is shown by an upward arrow mark in the Figure 6.8. Excess Supply or Shortage in Demand Similarly, when there is excess supply, the sellers may find it difficult to sell their stocks at the current market price. Hence, they may offer special discounts, and when every seller does so the competition pushes the price downwards until it reaches the equilibrium price where supply and demand are equal. For instance, during season, the plantain prices will go down. Clearance sales at discounted prices are also the case of excess supply. Such downward tendency in the price due to excess supply is shown by a downward arrow in Figure 6.8. Thus, price acts as a signal to consumers and firms to restore equilibrium by adjusting the demand or supply. Demand–Supply Applications The tools of demand and supply determine price and quantity in a free market economy. Price, in a competitive market, is expected to equalise the demand and supply to bring equilibrium price and quantity. This is also called as price system. There are many applications in our day-to-day life where this price system functions. The price of vegetables shoots up if there are floods in Karnataka or a strike by truckers. This is the case of price increase due to shortage in supply. The price of vegetables also shoots up during festival season. This is the case of price increase due to excess demand. Sometimes, when market determined price is beyond the access of poor people, the state intervenes to protect them through rationing (or public distribution system). The functioning of the price system can be seen by students on the website of the National Stock Exchange of India (www.nse-india.com). During trading hours, one can witness how buy orders and sell orders change in seconds and determine the price of each share.

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Static and Dynamic Equilibrium In economics, economic equilibrium normally means equilibrium in a market where the price of a certain commodity has attained a point where the amount supplied of the product equals the quantity demanded. Thus, the supply and demand balance is an economic equilibrium. The equilibrium in the market discussed above is static. However, economic equilibrium in reality is dynamic in nature. For instance, the equilibrium price of a share is a case of dynamic equilibrium as it changes continuously. As economic conditions are ever changing and reality is always dynamic, the static equilibrium discussed above may not persist. But the concept of equilibrium needs to be considered as an ideal to be pursued forever. Partial and General Equilibrium What has been discussed above is just partial equilibrium with reference to one good or one sector. But equilibrium may be multi-sectoral where all sectors of an economy are examined. Such equilibrium is called as general equilibrium.

Key Terms and Concepts Equilibrium Static Equilibrium Partial Equilibrium Determinants of Supply Supply Curve Supply Function Excess Demand Change in Supply Quantity Supplied Price Determination

Law of Supply Dynamic Equilibrium General Equilibrium Elasticity of Supply Excess Supply Supply Schedule Market Mechanism or Price System Shift in Supply Market Supply Curve Backward Bending Supply Curve

Chapter Summary Like demand supply is an another dimension of a market economy. Demand and supply together determine the equilibrium price in a typical market economy. Business firms should know how the market system functions. This chapter has introduced the concept of supply, its elasticity and determinants, and how it establishes equilibrium price along with demand. • Quantity supplied by a firm mainly depends on price. • The other determinants are cost of inputs, technology, prices of close substitutes, etc.

90 Business Economics • Change in supply is due to change in the price of the good; whereas shift in supply is due to change in the other determinants of supply, or supply conditions. • Equilibrium price for a product, or for a factor, is determined by the interaction of supply and demand in a market economy. • Any deviation from equilibrium will either result in excess supply or excess demand. In both conditions, the market forces (demand and supply) will interact to re-establish the balance.

Questions A. Very Short Answer Questions 1. What is supply? 2. Briefly state the law of supply. 3. Define elasticity of supply. 4. Define supply function. 5. Define market supply. 6. Define backward bending supply curve for labour. 7. What are the different types of elasticity of supply? 8. Define market equilibrium. B. Short Answer Questions 1. Explain the law of supply. 2. Briefly explain the different types of elasticity of supply? 3. Explain the concepts of supply function, supply schedule and supply curve with illustrations. 4. Explain market supply. 5. Distinguish between change in supply and shift in supply. 6. What is backward bending supply curve for labour? 7. Explain price determination in a market economy. 8. What are the major determinants of supply? C. Long Answer Questions 1. Explain the law of supply and its determinants. 2. Explain the different types of elasticity of supply. 3. Explain backward bending supply curve for labour. 4. Explain how equilibrium price is determined in a market economy. 5. Discuss the various determinants of supply. 6. Briefly discuss the following concepts. • Supply function • Excess demand • Excess supply • Market equilibrium • Change and shift in supply

Chapter

7

Theory of Consumer Behaviour: Demand, Diminishing Marginal Utility and Equi-Marginal Utility ‘The laws of economics are to be compared with the laws of the tide, rather than with the simple and exact laws of gravitation’. —Alfred Marshal

Learning Objectives This chapter aims to introduce the most fundamental concepts in economics, viz., utility, demand and the cardinal utility theories. The cardinal utility theories (law of demand and law of diminishing marginal utility) assume that utility is quantifiable and explain the behaviour of the consumer. The specific objectives are: • To introduce the concept of utility, demand, marginal utility and total utility • To explain the law of diminishing marginal utility • To explain the law of equi-marginal utility • To understand the concepts of cardinal utility and ordinal utility

92 Business Economics INTRODUCTION The law of demand explains the relationship between price and quantity demanded. The downward sloping demand curve indicates the manner in which price influences consumer’s choice. A consumer buys more at lower prices. Why does consumer buy more when price falls? Or, what is the rationale behind such behaviour of the consumer? Or, simply, why does the demand curve slope downwards? Or, how do people make choices? To answer all these questions, one should understand the economist’s construction of the simple theory of consumer choice. The rationale behind consumer’s choice is explained first by the marginal utility theory. The basic assumption of these theories is that consumers will allocate their income between different goods with an ultimate aim of maximising their utility.

UTILITY Utility simply means satisfaction gained from the consumption of a product. The term utility in economics means that a good has the power to satisfy a want. The satisfaction that a consumer derives from consuming a good is called ‘utility’. Utility, being a psychological phenomenon, is not amenable to management. Utility cannot be measured objectively as it is purely subjective in nature, like love, beauty, etc. Utility is also a relative concept. For instance, an alcoholic may get utility from alcohol whereas a teetotaller person may not get the same utility. Paradox of Value The issue of relative price determination of goods leads to the ‘paradox of value’. This can be explained with two goods, water and diamond. Water is a necessity, but its price is low in comparison with diamond, a luxury. Water, being a necessity, gives more utility than diamond, which has no such usage, yet water is cheaper and diamond is costlier. So the price of a commodity does not reflect its use value. This paradox is explained in terms of relative scarcity, supply and demand. It is not luxury or necessity that determine value but supply and demand. Supply and demand determine the relative value, and hence its price. Water, though a necessity, is available in plenty in relation to demand. But, the supply of diamond in relation to the demand is very less. Utility is also value neutral between good and bad. Drinking alcohol may damage the individual’s health. But alcohol has utility as it is wanted (or needed) by that particular individual. And utility, being a psychological feeling, cannot be explained or demonstrated to others. It can only be felt by the consumer of the given product. Measurement of Utility Utility, being a subjective concept, is different from one individual to another. Even the same individual may get different levels of satisfaction from the same product at

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different times. For instance, the first cup of coffee in the morning may give more satisfaction than at noon. Hence, it is very difficult to quantify utility. Economists like Hicks and Samuelson argued that utility cannot be measured. However, their predecessor, Alfred Marshall, argued that utility can be measured indirectly. To get one more unit of a good, how much the consumer is willing to sacrifice needs to be found. The price of their product is the extent of sacrifice the consumer would be willing to make to attain the satisfaction or utility of the good. Hence, price is an indirect way of measuring utility. If the utility is higher the consumer may be willing to pay a higher price, and vice versa. Therefore, price acts as a measure of utility. Marginal Utility and Total Utility The aim of all consumers is maximisation of total utility. But they make their decisions only on the basis of marginal utility. Thus, consumers decide their consumption at the margin in order to maximise their total utility. Marginal Utility Each addition to a given quantity is called marginal change. Utility represents ‘value’ or satisfaction. Marginal utility represents the change in utility from consuming an additional unit of the product. It is defined as the addition to total utility due to consumption of an extra unit of the product. Thus, marginal utility is the change in total utility gained or lost from the consuming or little more of a product. Total Utility Total utility represents the summation of utility gained from consuming some amount of a product. It can be defined as the sum of utilities gained from the each unit of a good consumed. For instance, if five units of a good are consumed, total utility is the sum of the satisfaction derived from consuming in each of the five units of the good. Given the income, the objective of the consumer is to obtain the greatest possible level of total utility. The assumption of ‘consumer’s aims to maximise their total utility’ is the basic formulation of neo-classical economics. However, the most important idea to be noted is that the utility maximising consumer makes decisions considering only marginal utility and not total utility. Table 7.1

Utility Schedule

Goods Consumed

Total Utility Unit

Marginal Utility Unit

1

9

10

2 3 4

14 17 18

8 5 2

5 6

18 16

0 –2

94 Business Economics In economics, decisions are mostly made at the margin. Table 7.1 shows the various levels of marginal and total utility from consuming different quantities of a good. It clearly shows that total utility rises till the consumption of the fourth unit, becomes zero for the next, and starts falling from the sixth unit. Figure 7.1 depicts the above schedule in the form of a graph showing the total utility curve and the marginal utility curve. Total and marginal utility can be represented symbolically as: TUn = U1 + U2 + ... Un –1, Un U1 = Utility from first unit U2 = Utility from second unit Un = Utility from nth unit MUn = TUn – TUn–1 Where

MUn = Marginal utility of nth unit TUn = Total utility from nth unit TUn–1 = Total utility from n–1th unit

LAW OF DIMINISHING MARGINAL UTILITY Law of diminishing marginal utility is one TU of the early as well as simple theories of consumer behaviour. It simply states that ‘as additional units of a good are consumed, each additional (or marginal) unit gives less and less utility’. Hence, marginal utility added to total utility will be diminishing. Alfred Marshall’s definition of the law is as follows: ‘The additional benefit, which a person derives from a given increase of his stock of a thing, diminishes with every increase in the stock he already has.’ Thus, the law states that as the consumer increases consumption of a given good at a point of time, the marginal utility gained goes on diminishing. For instance, consumption of a cup of coffee gives 10 units of satisfaction. If two cups are consumed at a point of time, the marginal utility will not be 20 units but

TU Curve

Quantity of goods consumed

Q

MU

MU Curve

Quantity of goods consumed

Fig. 7.1

Q

Total and Marginal Utility Curves

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less, say, 18 units. Similarly, 3 cups give 23 units and 4 cups give 25 units of satisfaction. Thus, marginal utility decreases as more and more cups of coffee are consumed. If the consumer gains 18 units of satisfaction from two cups of coffee, utility gained from the first cup is 10 and the second is 8. Any further increase in consumption of the same product will eventually reduce the satisfaction gained from each additional unit. In Table 7.1, note that consumption of one cup gives 10 units of satisfaction. Two cups give 18 units of satisfaction. The satisfaction derived from the second cup can be computed simply by deducting the 10 units of satisfaction from the first cup. Likewise, the marginal utility from every additional unit can be arrived at. Why the marginal utility should decline with increase in total consumption? Any want is fully satisfied. For example, you are thirsty, and you could endlessly drink water. Off course, the first sip of water should give you high level of satisfaction, but thereafter, for every additional sip the level of satisfaction should decline and at some points of time you will stop drinking further, that is, at that time, the marginal utility of the last sip should be zero. Hence, the marginal utility from highest level in the first sip, should have declined to zero marginal utility in the last sip. This is the rationale for diminishing marginal utility. Marginal Utility and Demand Curve As noted earlier, consumers aim to maximise their total utility but make decisions at the ‘margin’, or by considering the marginal utility. Consumers allocate their given income among different commodities in such a way as to maximise their total utility. But, with regard to one commodity, they decide on the basis of marginal utility. Maximisation of total utility occurs at a point when the consumer cannot increase total utility by any reallocation of his spending. Such equilibrium takes place when the following condition is fulfilled. MU1/P1 = MU2/P2 = ..... MUn/Pn In case of a single good, consumer try to maximise utility by equating his ‘Marginal Utility’ to the price of that good. For instance, in Figure 7.2, when MU of the first unit is very high, at ten, the consumer is willing to pay a higher price, P. But when the second cup gives lesser utility of eight units, the consumer prefers to give a lesser price, P1, and so on. Thus, over the downward slope of the MU curve, the consumer is willing to pay prices according to the level of the MU i.e., when MU is high, he is prepared to pay a higher price, and when it is less he wants to pay a lesser price. This is the reason why the demand curve is sloping downwards. Assumptions The law of diminishing marginal utility is based on certain basic assumptions which are as follows: Homogeneous Goods The units of the goods being consumed must have some similar standards. They should be identical or homogeneous, like cups of coffee, or pairs of shoes, or glasses of drink, from the utility point of view.

96 Business Economics MU of X

Price of X

MU ¢

P¢ P ¢¢

MU ¢¢

P ¢¢¢

MU ¢¢¢ X¢ Fig. 7.2

X¢¢

X¢¢¢

MU

Quantity of X

X¢

X¢¢

X¢¢¢ Quantity of X

Marginal Utility and Price

Static Condition The law is operational only under a static condition, that is, all units of the good are consumed at a given time. There is no time interval between the successive units of consumption. This static condition is the most important basis of the law. Rationality The consumer is assumed to be rational. This is the basic assumption of neo-classical economics as a whole. According to this assumption, a consumer will try to maximise his total utility. He will do so by satisfying his wants in the order of preference and by allocating his limited income for the consumption of different commodities. Constant Taste The taste, habits, customs and preferences of the consumer are assumed to remain constant in the short run. Any change in any one of them may affect the operationalisation of the law. Cardinal Utility The law assumes that utility is cardinal, that is, utility can be measured in numerical units. A hypothetical measuring scale, utils, is being used to quantify the level of utility. Exceptions to the Law of Diminishing Marginal Utility The law of diminishing marginal utility may not be universally applicable. There are exceptions to this law. Some such exceptional cases where the law would not hold good are given: Liquor: Marginal utility may not diminish in the case of alcohol. A drunkard, though drinking continuously, may not have diminishing marginal utility.

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Money:

It is also noticed that diminishing marginal utility does not apply to money. The human greed drives people to earn more and more money, and they do not see any diminishing marginal utility. Hobbies: Some types of hobbies, viz., collection of stamps and coins (specially old stamps and coins) offer more satisfaction to a person instead of diminishing satisfaction with increasing collection. Importance of the Law of Diminishing Marginal Utility Some points highlighting the importance of the law are given below: 1. The law of diminishing marginal utility provides the basic framework for the cardinal utility theory of consumer behaviour. 2. The law of diminishing marginal utility provides the foundation for the theory of taxation. 3. Based on this law, business firms can change the design, packing and style of their goods. Limitations of the Law of Diminishing Marginal Utility The law of diminishing marginal utility, though important in many respects, suffers from many limitations. Some of them are given below: 1. The assumption of cardinal utility is unrealistic, and it has been severely criticised by the proponents of ordinal utility theories. 2. There are many exceptions to this law, like drunkards and drug addicts, collectors of rare coins and artefacts, etc. This law would not operate in such cases. 3. Consumers would consume many goods as against the assumption of single good consumption. 4. The assumption of constant utility of money is another unrealistic assumption. 5. Consumers are not always rational. Their choices are sometimes governed by emotions or, demonstration effects.

LAW OF EQUI-MARGINAL UTILITY While the law of diminishing marginal utility explains the behaviour of the consumer with reference to one good, the law of equi-marginal utility explains the consumer behaviour when he consumes two or more commodities. This law is also known as the principle of proportionality between prices and marginal utility or the law of substitution or the law of maximum satisfaction. Consumers do not normally make choices with reference to one single good, they choose from among many goods at a time. They also substitute one good for another. As wants are unlimited, the limited income of the consumer needs to be allocated optimally among many goods. The law of equi-marginal utility explains how consumers distribute their limited income among various commodities to attain maximum possible satisfaction.

98 Business Economics Assumptions The law of equi-marginal utility is based on the following assumptions. 1. Utility of a commodity is cardinal, i.e., quantifiable or measurable. 2. The consumer is rational and always prefers more to less. 3. Marginal utility of money is assumed to be constant. 4. The price of the commodity and income of the consumer are fixed. 5. It is operative only in the case of two or more goods. Definition and Meaning Alfred Marshall, who advanced this law, defined it as follows: ‘If a person has a thing which can be put to several uses, he will distribute it among these uses in such a way that it has the same marginal utility in all’. According to the law of equi-marginal utility, the limited income of the consumer is spent on more than one good in such a way that the marginal utility derived from the spending on each good is equal. In other words, consumer income will be spent on buying many goods in such a way that the marginal utility derived from each rupee spent on all the goods will be equal. This way, the consumer will be aiming to get the maximum utility from his given income. Consumer’s Equilibrium Assume that the consumer wants to spend his given income on two goods, namely, A and B. As the consumer is assumed to be rational, his aim is getting more satisfaction from his limited income. Towards that, he is expected to allocate his limited income to buy goods A and B in such a way that he maximises his total utility or satisfaction. The point of equilibrium is the one where he gets maximum utility from his total expenditure incurred on the two goods, A and B. In other words, the consumer will be in equilibrium at the point where the satisfaction gained from the last rupee spent on both goods (A and B) is equal. In terms of an equation, the consumer will be in equilibrium at a point where the ratio of marginal utility derived from good A to price of A is equal to the similar ratio for good B. Thus, MUA MUB MUM = _____ = _____ PA PB Where, MUA = Marginal utility of good A MUB = Marginal utility of good B PA = Price of good A PB = Price of good B MUM = Marginal utility of money

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Table 7.2 Marginal Utilities of Two Goods Units

MUx (Units)

MUy (Units)

1 2 3 4

10 8 6 4

12 9 6 3

5 6

2 0

0 –3

7

–2

–6

MUA MUB The marginal utilities of money expenditure are the ratios _____ and _____. These PA PB two ratios refer to the marginal utility of each rupee spent on the each good. The law of equi-marginal utility can also be presented with the help of the following tables and curve. If the price of good A is Rs.2 and B is Rs.3, the marginal utility of money expenditure on goods A and B can be calculated by dividing the marginal utilities by their respective prices. Table 7.3

Marginal Utility of Money Expenditure

Units

MUA ____ in Utils PA

MUB ____ in Utils PB

1 2 3 4 5 6 7

5 4 3 2 1 0 –1

4 3 2 1 0 –1 –2

Table 7.3 shows the marginal utility derived from each rupee spent, respectively, on good A and good B. They are declining due to the operation of diminishing marginal utility. The marginal utility derived from each rupee spent on good A becomes negative after the sixth unit. In the case of good B, the marginal utility turns out to be negative after the fifth unit itself. According to the law of equi-marginal utility, the consumer would buy either two units of A and one unit of B, or three units of A and two units of B, or five units of A and four units of B. The pair of consumer choice depends on his level of income. But, whatever may be the income, the consumer would allocate his income in such MUA MUB a way that the ratios _____ and _____ are equal. He would continue to buy upto five PA PB units of A and four units of B because, after this the respective marginal utilities would become zero. And the consumer would not choose either two units of A and B

100 Business Economics

Marginal utility of Money Expanditure (Units per rupee)

or three units of A and B because, in such cases, the marginal utilities are not equal. Thus, the important point to be noted is that the consumer would equate marginal utility of each rupee spent on the two goods. Figure 7.3 illustrates the law of equi-marginal utility with the help of equi-marginal utility curves. Curves AA and BB are the marginal utility curves of good A and good B. Both curves have been drawn by plotting the marginal utility of money spent MUA MUB on the two goods. Thus, the values of the two ratios _____ and _____ are plotted on PA PB the Y-axis and the quantity of the two goods are measured on the X-axis. Both the curves slope downwards indicating the operation of the law of diminishing marginal utility.

A B

MU of B P of B MU of money

E

O Fig. 7.3

MU of A P of A

b

a

B

A Quantity

Equi-Marginal Utility Curves

Having assumed marginal utility of money as constant, the expenditure level measured on the Y-axis depends on the income of the consumer. Suppose if the income is at OE, a horizontal line drawn from point OE will intersect AA and BB. A vertical line from the point of intersections will fix the quantity of good A at point Oa and quantity of good B at point Ob on the quantity axis. At these levels the marginal utility of money spent on both the goods are equal. Thus, the consumer has distributed his income between two goods with the help of the downward sloping marginal utility curves in such a way that the marginal utility of each rupee spent on the two goods is MUA MUB equal. Hence, this is the equilibrium point where MUM = _____ = _____. PA PB Any change in income may bring a shift on the Y-axis but the above equality will hold intact at each level because of the two parallel downward sloping marginal utility curves. Limitations of Law of Equi-Marginal Utility The following are some of the limitations of the law of equi-marginal utility.

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1. The assumption of cardinal utility is unrealistic. 2. Indivisibility of many goods poses serious difficulty in applying this law. 3. Money is like any other good and its marginal utility is not constant. 4. Utilities of various goods are interdependent; but the law assumes that they are independent.

CARDINAL AND ORDINAL UTILITY THEORIES AND THEORIES OF RISK AND UNCERTAINTY The theories of consumer behaviour can be divided under three major categories: 1. Cardinal utility theories 2. Ordinal utility theories 3. Theories of risk and uncertainty Cardinal Utility Theory The Cardinal Utility theories assume that utility is quantifiable. Utility can be measured by hypothetical measure, namely ‘utils’. Many economists, like Alfred Marshall, Carl Menger and J. Benthem, have made use of this assumption to build their theories. Law of Diminishing Marginal Utility, Law of Equi-Marginal Utility and Law of Demand have been constructed with this assumption as the basis. Ordinal Utility Theory The ordinal utility theories argue that utility is a psychological phenomenon, like happiness, satisfaction or feelings. Most of them are highly subjective in nature and they may vary from one individual to the other. Hence, they cannot be quantified in precise numerical terms. However, they may be ranked or ordered like beauty or other qualitative variables. Thus, utility can be ordered in relative terms like ‘less than’ or ‘greater than’. Economists like J.R. Hicks, Paul Samuelson and R.G.D Allen have contributed a great deal in the formulation of ordinal utility theories. Indifference Curve Analysis and Revealed Preference Axiom are some of the major ordinal theories of consumer behaviour. Theories of Risk and Uncertainty Both the cardinal and ordinal theories of consumer behaviour assume certainty in conditions. More particularly, they assume that the choices of consumers and their outcomes are certain. For instance, the consumer pays a certain price for a good because he is certain about the outcome or utility he would gain from the good. But, in real life, there are many situations with uncertain outcomes or elements of risk. How a consumer will make choices when the outcomes are uncertain or involves risks? Economists like John von Neumann, Oskar Morgenstern, Friedman and Saveage have developed theories that explain the behaviour of the consumer under risk and uncertain conditions.

102 Business Economics

Key Terms and Concepts Utility Marginal Utility Total Utility Equi–Marginal Utility Homogeneous Goods Risk and Uncertainty Utility Maximisation

Cardinal Utility Ordinal Utility Diminishing Marginal Utility Consumer Behaviour Consumer’s Equilibrium Money Expenditure Rationality

Chapter Summary The behaviour of the consumer in the market has been explained in this chapter. For this purpose, we analysed • The relationship between total utility and marginal utility • The demand curve is derived from marginal utility curve • Consumer maximises his utility at the point of equilibrium • Importance of Diminishing Marginal Utility in the real world • Equi-Marginal Utility explains the consumer behaviour with regard to two goods.

Questions A. Very Short Answer Questions 1. What is utility? 2. What is marginal utility? 3. Differentiate between marginal and total utility. 4. What is meant by consumer’s equilibrium? 5. What is meant by cardinal utility? B. Short Answer Questions 1. Distinguish between the concept of marginal utility and total utility. 2. Explain the derivation of demand curve from diminishing marginal utility curve. 3. State the assumptions of the law of diminishing marginal utility. 4. State the importance of the law of diminishing marginal utility. 5. Explain the law of diminishing marginal utility.

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6. What are the exceptions to the law of diminishing marginal utility? 7. What are the limitations of law of diminishing marginal utility? 8. State the assumptions of the law of equi–marginal utility. C. Long-Answer Questions 1. Explain the meaning and importance of the law of diminishing marginal utility. 2. Explain the behaviour of the consumer through the law of diminishing marginal utility. 3. Explain consumer’s equilibrium in the law of equi–marginal utility. 4. Discuss the important cardinal utility theories of consumer behaviour.

Chapter

8

Theory of Consumer Behaviour: Indifference Curve Approach ‘Contentment is natural wealth; luxury is artificial poverty’. —Socrates

Learning Objectives This chapter aims to introduce an important approach for consumer behaviour that is, ordinal utility theory, viz., indifference curve approach. The indifference curve approach argues that utility, being a psychological phenomenon, cannot be measured in numerical units; but it is possible for a consumer to rank or order commodities based on the level of utility derived from each one. The specific objectives are: • To introduce the concept of ordinal utility • To explain the behaviour of the consumer by indifference curve approach • To explain the concepts of price effect, income effect, and substitution effect through indifference curve approach • To derive demand curve using indifference curve analysis

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INTRODUCTION Business firms produce commodities to make profit. They produce with the expectation that the consumers would buy their products. Thus, it is necessary to understand the preferences of the consumers, or their behaviour. Such understanding can also help firms to modify their products in order to meet the expectations or changing consumer tastes. Some multi-national corporations (MNC) have the practice of modifying their products continuously and introducing different brands mainly to discourage competition or new entry. Consumers are assumed to behave in a rational manner. Like profit maximising firms, consumers aim to maximise their satisfaction or utility at minimum cost. The theory of consumer behaviour, discussed in the earlier chapter, is based on the assumption of cardinal utility. The cardinal utility theory also treats that utility is susceptible to cardinal measurement. The Marshalian approach has been criticised for its restrictive and unrealistic assumption of measuring utility by hypothetical cardinal units. Economists have challenged its scientific validity. In 1934, J.R. Hicks and R.G.D. Allen argued that the law of demand could be derived based on the principle of rational choice without the assumption of cardinal utility. They developed the indifference curve approach as an alternative to explain the behaviour of the consumer. But Johnson and Slutsky had independently developed the same approach as early as in 1913 and 1915.

INDIFFERENCE CURVE APPROACH Indifference curve approach is based on the ordinal measurement of utility. This approach begins with the premise that each consumer is able to consistently rank his preferences for various commodities based on the level of utility he/she derives from each commodity. Hence, this approach is also called ‘preference approach’. It also helps to analyse the effects of price and income changes on the preference of the consumer. Indifference Curve: Meaning Indifference curve represents consumer’s choice set and preferences. ‘Indifference’ simply means ‘no difference’. An indifference curve is the locus of points, each representing a combination of some amount of good X and some amount of good Y, that yield the same amount of satisfaction to the consumer. Definition Indifference curve is the locus of points representing parts of quantities between which the individual is indifferent, and so it is termed as an indifference curve’ —J.K. Hicks

106 Business Economics Assume there are two goods fruits and vegetables. A consumer has to choose between three combination A (3 fruits + 1 vegetable), B (2 fruits + 2 vegetables) and C (1 fruit + 4 vegetables). All these three combinations give the same level of satisfaction. Obviously, the consumer will be indifferent between three combinations. Why these combinations should give the same level of satisfaction? Suppose combination A gives a particular level of satisfaction. When the consumer moves from combination A to combination B. He/She losses 1 fruit but gain 1 vegetable, thus the loss in fruit is compensated by the gain in vegetables. Therefore the satisfaction from A should be equal to satisfaction from B and the consumer is indifferent between A and B. Similarly as the consumer moves from B to C, he/she losses 1 fruit but gains 2 vegetables. Once again, the loss in fruit is compensated by Fruits (Y ) gain in vegetables, therefore the consumer is indifferent between B and C. The indifference curve A (IC) in Figure 8.1 represents a level of utility that a consumer can obtain from buying various combinations of X and Y on the B indifference curve. The points A, B and C represent three differC ent combinations of good X and IC good Y. But all the three combinations provide the same level O Fish (X ) of satisfaction to the consumer. Hence, the consumer is indifferFig. 8.1 Indifference Curve ent between any combinations on the indifference curve. Assumptions of Indifference Curve Approach The indifference curve approach is based on the following assumptions. Rationality: The consumer is assumed to be rational. This is a general assumption being followed in most of neo-classical economics. It means that a consumer always wants to maximise his satisfaction. In simple terms, ‘more is better’ for any consumer because ‘more’ is expected to make him better-off. Ordinal Utility: Utility is assumed to be amenable only for ordinal ranking. Utility cannot be quantified in numerical units as assumed by the cardinal utility theory. But the levels of satisfaction can be ranked in order of consumer preferences. Diminishing Marginal Rate of Substitution (DMRSXY): It is assumed that the marginal rate at which the consumer is willing to substitute one good for another will be diminishing in such a way as to keep the same total utility on the indifference curve. This is mainly due to the law of diminishing marginal utility (detailed explanation is given below).

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Transitivity: The indifference curve approach also assumes that consumers are capable of choosing among the various combinations of goods. While choosing, their choice is assumed to be transitive, that is, if the consumer prefers A over B, and B over C, then he must prefer A over C. Consistency: Consumer’s choice is also assumed to be consistent. If a consumer prefers A to B, then he should not prefer B to A, that is, the consumer will always be consistent in his choice.

Diminishing Marginal Rate of Substitution (DMRSXY) Diminishing marginal rate of substitution (DMRSXY) between two goods (X and Y) is the fundamental assumption of the indifference curve approach. According to this assumption, the rate at which one good is substituted for another will be diminishing so that the total utility from the two goods remains the same on all combinations of the indifference curve. The convex shape of the indifference curve is due to the operation of DMRSXY. The DMRSXY emanates from the law of diminishing marginal utility. The concept of DMRSXY can be illustrated with help of a diagram. In Figure 8.2, a comparison of two segments a-a¢ and b-b¢ can help to the understand the law of diminishing marginal utility and DMRSXY. Moving from point a to a¢, the consumer is prepared to sacrifice a larger amount of good Y (i.e. Y-Y’) to gain a small amount of good X (i.e. X-X¢). But at the lower segment of the same indifference curve, the rate of trade-off between X and Y gets reversed. Moving from point b to b¢, the consumer is willing to trade-off only a smaller amount of Y (i.e., Y¢¢-Y¢¢¢ ) to gain a substantial amount of X (i.e., X¢¢-X¢¢¢ ). Good Y

a

Y Y¢

a¢

b

Y≤

b¢

Y¢≤ O

Fig. 8.2

IC X X¢

X≤

X¢≤

Good X

Diminishing Marginal Rate of Substitution Between X and Y

108 Business Economics Such changing trade-off is due to the law of diminishing marginal utility. Between the segment a-a¢ the marginal utility of good Y must be very low because the consumer is already consuming a large amount of good Y. But the marginal utility of good X in this segment (a-a¢) is very high because the consumer is consuming a small amount of good X. The consumer, by moving from a to a¢, however, continues to gain the same level of total utility because the utility lost by giving up more of Y is compensated by the gain of same utility from a smaller quantity of X. Because of such differing marginal utility, the consumer is willing to give up more of Y for smaller quantity of X in the segment a-a¢. On the contrary, in the segment b-b’ in the indifference curve, the consumer is willing to sacrifice only a small amount of good Y to gain a larger amount of good X. This is because the consumption of good Y has come down, as a result, its marginal utility has increased; whereas the increased consumption of good X has reduced its marginal utility. Therefore, the consumer has reduced the rate at which good Y would be given up for good X. The marginal rate of substitution between good X and good Y is equivalent to the ratio of the marginal utilities of the two goods. MUX Thus, MRSXY = _____ MUY The ratio is also the slope of the indifference curve at a given point. Hence, MUX Slope of Indifference Curve = MRSXY = _____ MUY The slope or the ratio would fall while moving downward from left to right on the indifference curve that is MRSxy diminishes. Such falling rate of substitution is called the Diminishing Marginal Rate of Substitution (DMRSXY). Properties of the Indifference Curve Based on the assumptions discussed above, the following properties can be attributed to the indifference curve. Negative Slope Indifference curve always has a negative or downward slope. Negative slope means as Y declines X increases. Any other shape like flat or upward slope would not satisfy the assumption of rationality. We have already seen, if the consumer should get the same level of satisfaction, then decline in Y should be compensated by increase in X. Thus, the indifference curve has to be necessarily downward slopping. Hicks on Negative Slope ‘So long as each commodity has a positive marginal utility, the indifference curve must slope downward to the right’ —J.R. Hicks

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Indifference Curves are Convex to the Origin Each indifference curve must be convex to the origin. Convexity of the indifference curve implies the diminishing MRSXY operates. We have already explained why there is diminishing MRSXY. Higher Indifference Curve Means Greater Utility Higher indifference curves yield higher levels of satisfaction. For every point on the X-Y quadrant, an indifference curve can be drawn. This way an indifference map can be constructed; and, within that map, higher indifference curves indicate higher levels of satisfaction because they consist of larger quantity of at least one or both the goods. Larger quantities of goods on a higher indifference curve yield greater satisfaction than lesser quantities on lower indifference curves (See Figure 8.4). Indifference Curves Never Intersect Indifference curves never intersect with each other and they cannot be tangent to one another. This is an important property of indifference curves. Violations of this property will go against the definition of the Good Y indifference curve itself. Suppose, in Figure 8.3, IC1 is greater than IC2 points b and a are in c IC1 giving greater satisfaction than b points on IC2. Similarly, points C and a are on IC2 giving lesser satisfaction a than points on IC1. Now it is paradoxical for point a to give two different levIC1 els of satisfaction, hence indifference curves cannot intersect each other. IC2 O

Good X

Indifference Map An indifference curve is drawn by joining various combinations of goods X and Y that provide the same level of satisfaction. Similar indifference curves with varying levels of satisfaction can be drawn within the same quadrant. Such indifference curves are called indifference map. Figure 8.4 shows a typical indifference map. For each point in the X-Y quadrant, an indifference curve can be drawn. Hence, within two indifference curves, say IC1 and IC2, innumerable indifference curves can be drawn. Thus, an indifference map consists of infinite number of indifference

Fig. 8.3

Indifference Curve won’t intersect

Good Y

IC4 IC3 IC2 IC1 O

Fig. 8.4

Good X

Indifference Map

110 Business Economics curves. The basic question, however, is, the given such vast number of indifference curves, which one would the consumer choose? The concept of budget line would be used to understand this issue. Budget Line or Price Line Let us assume the concept of budget line simply defines the set of possible choices available to the consumer, given the price of the good and the income of the consumer. Suppose, if the given money Good Y income ‘M’ has to be spent on M /Py two goods, viz., X and Y, then the A budget line may take the form as in Figure 8.5. The budget line A indicates that, given the prices of good X and good Y, the maximum amount the consumer can buy. OA is the maximum quantity of good Y M /Px that can be purchased if all income is spent on good Y. Similarly, if all O B Good X income is spent on X, OB is the maximum quantity of good X the Fig. 8.5 Budget Line or Price Line consumer can buy. The consumer is able to buy any combinations on or within the budget line. A consumer can buy any combination of X and Y that lie between these two points, A and B, on the budget line. He can substitute good X for good Y, or vice versa. Any point on the budget line exhausts the given income of the consumer. Combinations above the budget line are not reachable because such combinations cost the consumer more than the given. Similarly, the combinations below the budget line are available to the consumer but he may not prefer them because he cannot spend all his income. As a rational consumer, he is expected to buy more of good X as well as good Y within his income. Any point on the budge line exhausts the given income of the consumer. The Budget line can be defined, as a locus of all points that show different combinations of X and Y that have a total expenditure equal to the given income (or) the budget line shows different combinations of X and Y, spending all the given income, at the given prices of X and Y. AB = Y = Px X + Py Y Where, Y = income of the consumer, AB is the budget line Px = Price of good X Py = Price of good Y X, Y = quantities of good X and Y respectively. The budget line is determined by the fixed income (M) and known prices, Px and Py. Maximum quantity of a commodity that can be bought can be arrived at by dividing the income by the respective prices. The intercepts of the budget line on the Y and X axes also indicate the maximum of each good that can be bought.

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M Maximum quantity of X = ___ = B PX M Maximum quantity of Y = ___ = A PY The slope of the budget line is the price ratio the two goods. PX Slope of budget line = ___ PY Any changes in the parameters, namely, income or price of goods, can change the budget line. For instance, an increase in the income of the consumer can shifts the entire budget line. In Figure 8.6 the shifts are parallel indicating that given the increase in income, the consumer can buy more quantities of both X and Y. Similarly, a fall in income brings a downward shift in the budget line. Good Y

Good Y

A≤

A

A¢ A

B

B B¢ B≤ Good X

Fig. 8.6

Change in Income

Fig. 8.7

B¢ Good X

Change in Price

Changes in the price of good(s) can also shift the budget line. For instance, assume that there is a cut in the price of good X. This will shift the budget line as shown in Figure 8.7. The budget line shifts along X-axis, because lower price of X, the consumer can buy more of X. Consumer’s Equilibrium or Choice of Consumer The consumer choice can be explained with the help of the indifference map and the budget line. A indifference curve indicates the indifference of a consumer between different combinations of X and Y that give the same level of satisfaction. The indifference map represents the availability of similar curves in large numbers. But, as the income and the prices of the goods are fixed, the budget line shows the choices available to the consumer. The consumer choice is the challenge of choosing the most preferred combinations of X and Y that give maximum satisfaction within the given income. As discussed earlier, the combinations above the budget line are not reachable due to limited income. The combinations on and within the budget line are available to

112 Business Economics the consumer. But a rational consumer will choose, the highest indifference curve that can be achieved within the budget constraint. Thus, he attains equilibrium wherever he maximises his satisfaction. As point E provides the highest level of satisfaction, the consumer chooses this combination. At point E, IC2 is tangent to the budget line. It is the highest indifference curve available to the consumer, and is the maximum satisfaction level the consumer can reach with his income. Hence, E is called equilibrium point and X* and Y* are the equilibrium quantities of goods X and Y. Good Y M /Py

B

A

Y*

E

IC3

C D

IC2 IC1 X*

Fig. 8.8

M /Px

Good X

Consumer’s Equilibrium

EQUILIBRIUM CONDITIONS The following two conditions should be satisfied for consumer’s equilibrium: 1. The slope of the indifference curve must be equal to the slope of the budget line. The slope of the Indifference Curve is the marginal rate of substitution between X and Y (MRSxy). The slope of the budget line is the ratio of the price of X and Y (i.e., Px /Py). Hence, Slope of Indifference Curve = Slope of Budget Line i.e.,

MUX PX MRSXY = _____ = ___ MUY PY

At the point of tangency, there is no scope to reach any other higher indifference curve. 2. The second condition requires that, at the point of tangency, indifference curve must be convex to the origin. If it has other shapes, equilibrium cannot be attained and it may lead to corner solutions. Consider the implications of concave indifference curve as shown in Figure 8.9. Among

Theory of Consumer Behaviour: Indifference Curve Approach

the two points A and C, a rational consumer will end up buying only one good at point A. Hence, the condition of convexity must be met to attain consumer equilibrium in indifference curve approach. Income Effect, Price Effect and Substitution Effect

113

Good Y

A

C

Any changes in the price of the good or the income of the consumer will change O B Good X the equilibrium conditions. This can be understood through the following: Fig. 8.9 Corner Solution of Concave 1. Income Effect Indifference Curve 2. Price Effect and 3. Substitution Effect Indifference curve approach helps to understand these three effects and their relations in a better way than the cardinal theory. Income Effect Keeping all other things, including the prices of goods constant, any changes in the income of the consumer would shift the budget line. Such shift would be parallel to the original budget line because change in income (increase or decrease) would equally affect the consumption of both goods measured on X- and Y-axes. Figure 8.10 shows the parallel shift in budget line due to increase Good Y in income. Budget line AB moves A¢≤ upwards to A’B’ due to an increase A≤ in consumer’s income. The equilibrium point also moves upward to a A¢ ICC higher indifference curve. Further A increase in income will shift the budget line upwards. The equilibrium is also shifted from the initial level to a new point of tangency in A¢¢B¢¢, A¢¢¢B¢¢¢ and so on. Connecting all those points of equilibrium, we O get the income consumption curve B B ¢ B ≤ B ¢≤ (ICC), which shows when income Good X increases, demand for any one or Fig. 8.10 Income Consumption Curve (ICC) both the commodities will increase.

114 Business Economics Price Effect Price effect simply means the change in consumer demand due to changes in price. For instance, if price increases, the consequent fall in quantity demanded is the price effect. Such continuous changes can be used to construct the price consumption curve. In Figure 8.11, a fall in the price of good X shifts the budget line from AB to AB¢, indicating increased purchasing power. Thus, the budget line moves only on the X axis indicating that the consumer would buy more good X due to fall in price. Good Y A

PCC

O

B

B¢

B≤ Good X

Fig. 8.11 Price Consumption Curve (PCC)

The points of tangency between new budget line takes place with a higher indifference curve. Any further in price of good X will shift the budget line to AB¢¢ and a new equilibrium takes place at a higher indifference curve. The line joining the points of tangency between each budget line and each indifference curve form the price consumption curve (PCC). It may be noted that if the price of good Y falls, more of good Y would be bought and the budget line would move along the Y axis. Substitution Effect Price effect is the combination of two effects, viz., income and substitution effects. Any fall in price of a good would encourage the consumer not only to buy more of that good, but also to substitute for the goods whose price remains unchanged. Thus, consumers have a tendency to replace costly goods with more of cheaper goods. Such substitution is the optimising behaviour of the consumer. The cardinal utility theory treats the consumer’s decision to buy a commodity is based on its price and never considered the substitution effect. Price effect has two components, namely, income and substitution effects. The cardinal utility theory could not split these two components of price effect. Instead, all changes in the quantity demanded were attributed to price. But the indifference curve approach can split the income and substitution effects separately.

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Derivation of Demand Curve through Indifference Curve Indifference curve can also derive the law of demand without any of the restrictive assumptions of the cardinal utility theory. Figure 8.12 shows that the budget line moves from AB to AB¢ and AB¢¢ due to fall price of good X from P to P¢ and P¢¢. The equilibrium point also shifts from (a) to (b), and then to (c), that at higher indifference curves. The movement of the equilibrium point is towards the right indicating that more of good X is bought as price falls. In the lower segment of the figure, the price is measured on the Y-axis along with the quantity of good X on the X-axis. It clearly shows that the quantity of good X is bought more when the price falls. When price is P, quantity X is bought. When price is P¢¢, quantity bought increases to X¢¢. If all parallel equilibrium points on the lower segment, a¢, b¢ and c¢, are connected, it forms the downward sloping demand curve, indicating the inverse relation between price and quantity demanded. Note that the indifference curve could establish the demand curve without any restrictive assumption of the cardinal utility theory.

Good Y

A

IC IC¢

IC≤

a

b

PCC c

B X

X¢

B¢ X≤

B≤ Good X

Price of X

a¢

P

b¢

P¢

c¢

P≤

Demand curve X

X¢

X≤

Good X

Fig. 8.12 Derivation of Demand Curve Through Indifference Curve

116 Business Economics Importance of Indifference Curve Approach The indifference curve approach is a significant advancement in the field of consumer behaviour analysis, and is useful for many practical applications in welfare economics and policy making. The following are some of its applications. 1. Indifference curve approach is less stringent in its assumptions than the cardinal utility theory. 2. It provides a sound basis to measure consumer’s surplus 3. It establishes a better criterion to classify substitutes and complimentary goods 4. It helps to decompose price effect into income and substitution effects 5. It is useful in designing various government policies Limitations of Indifference Curve Approach The indifference curve approach is considered to be superior to cardinal utility approach in explaining consumer behaviour. But it also has some limitations. Some are listed below: 1. The assumption about the existence of convex indifference curve is weak 2. All consumers are not as rational as this approach assumes 3. This approach retains the assumption of constant utility of money 4. Consumer’s ability to order and choose among such vast alternatives is doubtful 5. Consumers can commit mistake in choosing their options 6. Consumer choice may change due to other factors, like emotions, advertisements, etc.

Key Terms and Concepts Indifference Curve Indifference Map Diminishing Marginal Utility Budget or Price Line Marginal Rate of Substitutions (MRS) Price Effect Slope of Indifference Curve Diminishing MRS Income Effect Properties of Indifference Curve Substitution Effect Consumer’s Equilibrium

Chapter Summary Consumer behaviour is explained through indifference curve approach without many the unrealistic assumptions of cardinal utility theory. Indifference curve is simple in its assumptions and is able to derive the demand curve.

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• Indifference curve approach assumes utility can be measured by ordinal ranks. • Indifference curve is convex to the origin and has downward slope. The curves do not intersect with each other. • The marginal rate of substitution between two goods diminishes due to operation of the law of diminishing marginal utility. • Within a given income and prices, a consumer reaches equilibrium when the slope of the budget line is tangent to the highest indifference curve. • Indifference curve analysis can be used to derive the demand curve without assuming utility as cardinal.

Questions A. Very Short Answer Questions 1. Define indifference curve. 2. What is cardinal measurement of utility? 3. State any two assumptions of the indifference curve. 4. State consumer’s equilibrium condition with indifference curve. 5. What is marginal rate of substitution (MRS)? 6. What do you mean by ordinal utility? 7. Explain diminishing marginal rate of substitution. 8. What is meant by rational consumer? 9. Why does indifference curve slope from left to right? 10. What is indifference map? 11. What is price line? B. Short Answer Questions 1. What are the properties of an indifference curve? 2. State the assumptions of indifference curve. 3. Explain the concept of indifference map and budget line. 4. Explain the diminishing marginal rate of substitution between two goods in the indifference curve analysis. 5. Explain consumer’s equilibrium in indifference curve analysis. 6. Explain the concepts of price, income and substitution effects. C. Long Answer Questions 1. Explain the assumptions and properties of indifference curve analysis. 2. Explain the equilibrium of consumer with the indifference curve approach. 3. Explain the following concepts using diagrams:

118 Business Economics (a) Marginal rate of substitution (MRS) (b) Indifference map (c) Shift in budget line 4. Explain the price effect, income effect and substitution effect in the indifference curve approach with the help of graphical illustrations.

Chapter

9

Laws of Production ‘Until the laws of thermodynamics are repealed, I shall continue to relate outputs to inputs, i.e., to believe in production function’. —Paul A. Samuelson

Learning Objectives This chapter aims to introduce the basic concepts of the theory of production. It explains two of the most important laws of production, viz., law of variable proportion and law of returns to scale. It also explain the equilibrium of the consumer. The specific objectives are: • To introduce the concept of production, both in short and long run • To explain the law of variable proportion • To explain the law of returns to scale • To explain producer’s equilibrium

120 Business Economics INTRODUCTION A market system has two participants, buyers and sellers. The theory of consumer behaviour discussed earlier has explained consumer choice and decisions behind demand and supply curves. Firms need to consider consumer preferences in order to increase revenue, and profit. Firms should also consider their own activities and environment. Thus, behaviour of a firm explains the supply side of the market and a major determinant of a firm’s profit, as well as of the overall efficiency of the market economy. A firm purchases inputs from the factor market, converts them into output through the process of production and sells them in the goods market. Thus, a business firm demands factor inputs in factor markets and supplies outputs (like cellphones, motorbikes, ice-cream, etc.) in output markets. Production function is useful to specify the technical relationship between inputs and outputs. This chapter discusses the economic aspects of the production process, the central economic issue of production is how a firm should use its inputs to produce goods at the least cost.

PRODUCTION In economics, production means the process of combining factor inputs and transforming them into outputs. The factor inputs are land, labour, capital, organisation and natural endowments. They are also called factors of production. The outputs are those goods and services which provide utilities or have exchange value. Thus, production is the process of creation of commodities which have utilities or exchange value. Business firms engage in production with the ultimate aim of earning maximum profit. For instance, a firm decides about quantity of output to be produced, technology to be applied, quantum of probable sale, etc. All such production decisions of the firm depend on its cost and revenue. And the difference between cost of production and revenue from sales determines profit. Importance of Production Production, consumption and distribution are the three major divisions of economics. Among them, production is the basis for the other two divisions. There are several reasons for this. 1. Production creates value by applying labour on land and capital. 2. According to the neo-classical economists, production also helps to improve welfare because more commodities mean more utility, and hence more welfare. 3. By utilising factor inputs production generates employment and income which keep the economy on the development track.

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4. The theory of production forms the basis to understand the relation between cost and output. 5. Ownership pattern of factors of production also helps to understand the macro theories of distribution. Production Function Production function simply relates factor inputs to outputs. The functional relationship between factor inputs and outputs is called production function. Production function expresses quantities of total output as a function of quantities of inputs. This relation between factor inputs and outputs depends on the available technology. Given the nature of the available technology, the production function denotes the relationship between maximum attainable output and a given amount of inputs. Thus, production function is the relationship between technically efficient combination of factor inputs and outputs. ‘Production function is the name given to the relationship between the rate of input of the productive services and the rate of output of the products. It is the economists’ summary of technical knowledge’ —G. J. Stigler Production function can be expressed in equation form as follows. Q = f (L, N, K, O) Where, Q = quantity of output L = land N = labour K = capital O = organisation However, the general form of production function is Q = f (N, K). All the three variables (Q, N, and K) are flow variables. N and K can be combined in many ways. Each way represents a particular production method. Production function consists of all such technically possible combinations, but all of them need not be efficient. However, it is possible to identify the efficient input combination that provides the maximum amount of possible output. That is, an efficient input combination is the one that produces the maximum output from a given amount of inputs. Production function helps to identify such efficient input–output combinations. Cobb Douglas production functions is one of the widely used production functions in economics. It can be written as follows. Q = A La Cb where, constants (or parameters) a and b indicate the relative distributive share of inputs L and C in total output Q and A is a positive constant defining the scale of production.

122 Business Economics Importance of Production Function Production function has several uses. some of the most important uses are listed below. 1. It helps to determine the level of production of a firm, an industry or an entire economy. 2. It identifies the maximum output that can be attained with a given amount of inputs. 3. It identifies the minimum inputs with which a given amount of output can be attained. 4. Production function provides innumerable possibilities for substituting one input for another, and helps to identify the input combination with least cost. 5. It helps to solve the managerial problem of technical efficiency. Production Decision To understand the laws of production, it is necessary to discuss some of the basic issues of production decisions. The input-output decision of a firm includes the following three issues: 1. How much to produce? 2. How to produce? 3. How much input to be used? These issues need to be decided in such a way as to either to minimise the cost of production of a given output or attain technical efficiency in employing the inputs to maximise output. Technical efficiency refers to the effectiveness with which a specified input combination is used to produce the maximum possible output. Technical efficiency is also known as X-efficiency.

SHORT RUN AND LONG RUN Time element plays a significant role in all the above decisions. For instance, the decision to expand a firm’s output twice or thrice may need significant time to mobilise capital for building new plants, to buying machinery and to recruiting additional workforce. Any small increment in output within the existing plant capacity may not require such a long time. Such differences in time period between major expansion and marginal increase in output is mainly due to the nature of the input change involved. In other words, the ability of a firm to change its production depends on the nature of the relevant inputs. There are two types of factor inputs, fixed and variable. A variable input is one in which the firm can change as and when required. A fixed input is the one which the firm cannot change within a given time period. For instance the exhaust tower in a Ariyalure cement factory is a fixed input which cannot be changed immediately, whereas the main raw material, gypsum, can be adjusted to meet any small increase in production. This provides the basis for the two time periods for decision making, namely short run and long run.

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Short Run In the short run period, it is difficult for any firm to change all its inputs. There may be one or two inputs whose quantity determines the capacity of the entire plant. Such factors are called fixed factors and they remain fixed. Any change in such inputs needs adequate time. Hence, a short run period is one during which at least one of the firm’s inputs remain fixed. Limited flexibility in production can be attained by altering only the variable inputs. Long Run In the long run, all factor inputs will change. Any major expansion, like doubling the inputs or manifold increase in output, requires expansion of all inputs. This requires along period of time. Hence, a long run period is the one during which all the inputs undergo changes and there are no fixed inputs. Period of short run changes from firm to firm. A day may be a short run for a tea shop, but even one year may be a short run for a can manufacturer. Therefore, short run cannot be defined in terms of years, or months, or days. Therefore, short run and long run periods can only be defined by the time taken to change all inputs.

TOTAL, AVERAGE AND MARGINAL PRODUCTS Total products A firm has many options. It can increase its output by increasing one variable input or all the inputs (variable as well as fixed). Suppose, only one input is variable, the quantities of all other inputs remain fixed. Then the output depends on that single variable input. L Symbolically, Q = f (L, K) TP Q = f (L, K) Thus, output from the PF depends on the level of one single input, L, keeping other input (K) fixed. This relationship between the output and one variable input, keeping the other inputs fixed, is referred to as the total product of the variable input. It is also known as total return from the variable input. O Q This can be plotted in the form of a graph. The total product curve in Figure 9.1 shows the Fig. 9.1 Total Product Curve relationship between output (Q) and variable input (L), keeping the other input (c) as fixed. Total product curve depicts how many units of good X can be produced with different quantities of labour (L). TP increases up to certain level and then it starts diminishing. Average Product Average product refers to the quantity of output per unit of available input. It can be arrived simply by dividing total product by the units of variable input.

124 Business Economics Thus, Total Product Average Product of Labour = ________________ Quantity of Labour TP APL = ___ L Where, APL = average product of labour TP = total product L = corresponding quantity of labour Marginal Product Marginal product of an input is the output gained from per unit change in input, keeping other inputs as constant. When capital is assumed to be constant in the short run, marginal product of labour is the change in output divided by change in quantity of labour. Output

d

MP

AP

Labour

Fig. 9.2

Marginal Product and Average Product Curves

Change in Output Marginal Product of Labour = _______________ Change in Labour DQ MPL = ___ DL Where,

Q = Output, L = Input, = Change. Marginal product increases at the initial level and after reaching the maximum of 3 units it starts declining (Table 9.1). Plotting these figures would form the reverse ‘U’ shaped marginal cost curve as in Figure 9.2. The reasons are explained below. Laws of Production

The laws of production mainly deal with two types of input-output relations or production functions. Accordingly, there are two fundamental laws of production, 1. Law of Variable Proportion (Short Run Analysis) 2. Law of Return to Scale (Long Run Analysis)

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125

The production function is first used to study the implications on output due to one variable input, while all other inputs are held constant. This type of input-output relation is dealt within the law of variable proportion. This is mostly a short-term concern. The production function then deals with the implication on output as a result of change in all inputs. This is the long-term concern and forms the subject matter of law of return to scale. Law of Variable Proportion (Short Run Analysis) To understand the law of variable proportion it is first necessary to state the law of diminishing marginal productivity. The law of diminishing marginal productivity states that, keeping at least one input fixed, if we increase the variable input by equal quantities, then its marginal product would eventually diminish. Thus, increasing the variable input would diminish its marginal product. Table 9.1 Total Product, Marginal Product and Average Product Labour (units) (1)

Total Product (TP) (2)

Marginal Product (MP) (3)

Average Product (AP) (4)

0 1 2 3 4 5 6

0 1 3 6 8 9 7

0 1 2 3 2 1 –2

0 1 1.5 2 2 1.8 1.1

The law of variable proportion is closely related to the law of diminishing marginal productivity. The law of variable proportion is also known as the law of variable factor proportion. The law of variable proportion states that when equal units of a variable input are increased, a point is reached beyond which any addition of variable input would lead to diminishing rate of return and marginal product would decline. Diminishing returns refer to reduction in output with every additional unit of input. Figure 9.2 shows how marginal product of an input initially rises with its employment level until it reaches a maximum at point ‘d’ and starts declining. ‘Diminishing marginal productivity of labour, when it is used in connection with a fixed amount of capital, is a universal phenomenon. This fact shows itself in any economy, primitive or social’ —Clark, 1899 The inverse ‘U’ of the marginal product curve in Figure 9.2 can also be found in Table 9.1. The marginal product in column (3) starts increasing from the first unit up to the third unit, and then it starts declining.

126 Business Economics The reasons for such shape and movement of the marginal product are: 1. Increasing variable inputs use fixed inputs intensively during the initial phase 2. Factor proportion reaches an optimal point 3. Variable input, for instance, labour, gains efficiency when production increases 4. Beyond such optimum level (point d in Figure 9.2,), inputs combination becomes unfavourable as variable inputs gets crowded. Law of Returns to Scale (Long Run Analysis) The law of variable proportion has examined the implications of change in variable input (s) when at least one input is fixed. As at least one input is fixed, this is mostly a short run phenomenon. However, as discussed earlier, all inputs are variable in the long run. The law of returns to scale examines what happens to output when all inputs are changed simultaneously. Thus, the law of returns to scale deals with the proportionate increase in all inputs and their effect on output; whereas the law of variable proportion describes what happens when at least one input remains unchanged. Whereas other inputs are changed. If all inputs vary in same proportion, what would be the effect on output? Law of returns to scale discusses the following three possible effects on output when all inputs are changed in same percentage. 1. Constant returns to scale 2. Increasing returns to scale 3. Decreasing returns to scale Constant Returns to Scale: If all inputs vary in the same proportion, output

may also change in exactly the same proportion. That is, if inputs are doubled, output would also increase by two-fold. Such proportional increase in output due to change in input is called constant returns to scale. Increasing Returns to Scale: If a proportionate increase in all the inputs leads to an increase in output by more than that proportion, it is called increasing returns to scale. That is, if the inputs are doubled, output would increase by more than two-fold. Decreasing Returns to Scale: If a proportionate increase in all inputs leads to

an increase in output by less than that proportion, it is called decreasing returns to scale. That is, if the inputs are doubled, output would increase by less than two-fold. Returns to Scale and Economies of Scale Returns to scale and economies of scale are closely related terms but with different meaning with respect to production analysis. Both simply describe what happens when the scale of production increases. Returns to scale indicates changes in output due to proportional rate of change in all inputs. Economies of scale refers to the cost advantage for a firm as a result of

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127

expansion. When scale of production is expanded, per unit cost would get reduced. Such cost advantage occurs in the long run. It is further discussed in Chapter 10.

PRODUCER’S EQUILIBRIUM Production function is a highly useful tool in choosing the optimum combination of factors of production to produce the given output. Such optimum combination of factor inputs is also called point of producer’s equilibrium. Producer’s equilibrium can be explained with the help of tools, namely, isoquant curves and isocost line. Isoquant curve is similar to indifference curve and isocost line is similar to budget line. Before discussing these tools, it is necessary to list the assumptions under which producer’s equilibrium can be attained. Assumptions: 1. Profit maximisation is the ultimate goal of firms 2. The producer is assumed to be rational 3. The prices of the factor inputs are given 4. The price of the output is also fixed Isoquant: Meaning An Isoquant or equal product curve represents producer’s choice set and preferences. It is used as a tool to describe the production function. An Isoquant is the locus of points, each representing a combination of some amount of input L (labour) and some amount of input K (Capital), that can produce an equal amount of the product. As all the points of the two input combinations produce the same amount of output, the producer is indifferent in his choice among them. Hence, Isoquant is also called product indifference curve. Table 9.2 shows various combinations of labour and capital that can be used to produce 100 units of good X. Table 9.2

Equal Production with Two Inputs

Combinations

Capital (K) (Units)

Labour (L) (Units)

Output (Good X) (Units)

A

1

5

100

B C D

1.5 2 3

3 2 1.5

100 100 100

E

5

1

100

For instance, combination A shows that 1 unit of capital and 5 units of labour can be combined to produce 100 units of output X. Similarly, the same amount of X can be produced with Combination, C i.e., 2 units of capital and 2 units of labour, or combination E, i.e., 5 units of capital and 1 unit of labour.

128 Business Economics The locus of points of all possible combinations of capital and labour that can be used to produce 100 units of good X is called the equal product curve of 100 units of X. Thus, an isoquant (Fig. 9.3) represents a level of production that the producer can obtain from using various combinations of L and C on the indifference curve. The points A, B, C, D and E represents five different combinations of the two inputs. As all the five combinations provide the same level of output, the producer is indifferent between the combinations on the isoquant curve.

Labour

Q = 100 O Fig. 9.3

Capital

Isoquant or Equal Product Curve

Properties of Isoquant Isoquant has following properties which are analogous to those of the indifference curve. Negative Slope: Isoquant always has a negative or downward slope. Isoquant is downward sloping from left to right, because as one input is increased the other input should be increased to keep the quantum of output constant. Isoquants are convex to the origin: Each isoquant curve must be convex to the origin. Hence, he would substitute one for the other. The slope of the isoquant, i.e., MRTSLK, indicates the rate at which one input is substituted for the other. As MRTSLK is diminishing, isoquant is convex to the origin. Higher Isoquant Means Higher Output: Higher isoquant yields higher level of output. It is because higher isoquant consists of larger quantity of at least one or both inputs. And larger quantities of inputs obviously yield higher production. Isoquants will Never Intersect: Isoquants will never intersect each other and

they cannot be tangent to one another. This is similar to the property that indifference curves can never cut each other. If two isoquants cut each other, then it would give a parodoxical situation of one combination of inputs producing two different levels of output. Slope of Isoquant The slope of the isoquant is equal to the ratio of the marginal productivity of the two inputs. This ratio is equal to the marginal rate of technical substitution between the two inputs. That is, the marginal rate of technical substitution MRTSCL between labour (L) and capital (K) is the slope of their isoquant. Symbolically, MPK Slope of Isoquant = _____ = MRTSKL MPL

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129

Isoquant Map An isoquant is drawn by joining various combinations of inputs L and K that yield equal production. Similar isoquants with varying levels of production can be drawn within the same quadrant. For instance, isoquant Q1 represents units of output, isoquant Q2 will produce 200 units and isoquant Q3 represents 300 units. Isoquants with varying levels of production within a quadrant is called isoquant map. Figure 9.4 shows an isoquant map. Isoquant Q1 represents production of 100 units of output by employing any input combination on Q1. Similarly, Q2 can produce 200 units, Q3 can produce 300 units, and so on. Thus, an isoquant map consists of infinite number of isoquants. The basic question, however, is which isoquant the producer would choose, for which, the concept of isocost line needs to be introduced. Labour

Q4 = 400 Q3 = 300 Q2 = 200 Q1 = 100 Capital

Fig. 9.4

Isoquant Map

Isocost or Budget line Let us assume that the total outlay of a firm is fixed, and that the prices of two factors namely labour and capital are fixed in the market. The isocost line represents all equally costly input combinations for a producer. Isocost line shows all the combinations of capital and labour for a given total cost. The isocost line can be defined as TO = L (w) + C (r) Where, w = wage rate and r = rate of interest. The slope of the isocost line is the ratio of the input prices. Symbolically, Wage Rate Slope of Isocost line = ___________ Interest Rate r = __ w

130 Business Economics Labour Labour

A¢ A

A

TC w

TC r B

B¢

Capital

Fig. 9.5 Isocost Map

B Capital Fig. 9.6

Isocost Line or Budget Line

Just like the isoquant map, there are infinite number of the isocost lines, or the isocost map (Figure 9.5), for various levels of total cost. The higher isocost line indicates higher cost and the lower one indicates lower cost of inputs. The higher isocost line includes more units of inputs than the lower one. But for a given budget and input prices, there can be only one budget line, as shown in Figure 9.6. Under such condition, maximisation of output is the only option left for the producer. Producer’s Equilibrium The producer is in equilibrium when he maximises his profits. Profit is the difference between cost of production and revenue earned from the sales of the production. Thus, profit can be defined as P=R–C The producer’s ultimate aim is maximisation of P, which is possible in two ways. One is maximisation of revenue and the other is minimisation of cost. Revenue depends on the price of the good, which is assumed to be constant. As input prices are also fixed in the short run, the producer can maximise profit (P) only by producing maximum possible output of a given total cost. Thus, producer’s equilibrium is attained at a point where outputs maximise for a given cost of outlay. To identify such equilibrium point, the isoquant map and isocost lines need to be superimposed upon each other. The equilibrium point can be defined at the maximum output that can be produced for the given budget line. The highest possible isoquant tangent to the budget line at point E determines the equilibrium point where slope of isocost line is also equal to slope of isoquant at point E. r Slope of the Isocost Line = __ w MPK Slope of Isoquant = _____ = MRTSKL MPL

Laws of Production

MPK r At point E, _____ = MRTSKL = __ w MPL In Figure 9.7, profit maximising output at equilibrium point is 200 units on ‘q’ for the given cost outlay. And L*, and C* constitute optimum input combination to produce the maximum output of 200 units. Let us take any other combination on the isocost line, say B, it produces 100 units of output, hence E is preferable to any other point on the isocost line.

131

Labour

A

K w B E

L*

q = 100 K*

q = 200 K r B Capital

Fig. 9.7 Isocost Line or Budget Line

Key Terms and Concepts Production Total Production Variable Proportion Isoquant Marginal Productivity Output Short Run Constant Returns to scale Isoquant Map

Production Function Returns to Scale Average Product Isocost Line Factor inputs DMRTSLK Long Run Increasing Returns to scale MRTSLK

Chapter Summary The laws of production, the short run and the long run, are explained. Producer’s equilibrium is discussed with the tools of isoquant and isocost line. • Production is the process of converting inputs into outputs. • Production function relates output to inputs and summarises the process of converting inputs into output. • The law of variable proportion examines the effect of a change in variable input(s) on output when at least one input is fixed. It is a short run analysis. • Law of returns to scale examines what happens to output when all inputs are changed simultaneously in the long run.

132 Business Economics • Producer’s equilibrium occurs when maximum output is attained with the least cost of input combination, within a given budget.

Questions A. Very Short Answer Questions 1. What is production? 2. Define production function. 3. What is meant by short run? 4. What do you mean by long run? 5. Define marginal product. 6. What do you mean by average product? 7. What is meant by fixed input? 8. What is meant by variable input? 9. Define Isoquant line. 10. What are the conditions for producer’s equilibrium? 11. What is the law of variable proportion? B. Short Answer Questions 1. Distinguish between short run and long run periods. 2. Distinguish between fixed and variable inputs. 3. What is the importance of production? 4. What is production function. Explain its importance. 5. Explain the concept of total, average and marginal products. 6. Distinguish between law of variable proportion and laws of returns. 7. What are the reasons for the shape of the marginal product curve? 8. Explain the conditions of producer’s equilibrium. C. Long Answer Questions 1. Explain the meaning and significance of production and production function. 2. Explain the shape and movements of marginal product curve, average product curve and total product curve. 3. Explain producer’s equilibrium with the help of isoquant and isocost line. 4. Distinguish between law of variable proportion and laws of returns. 5. Explain various returns to scale of production. 6. Explain the law of variable proportion.

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133

7. Explain the relationship between total product curve and marginal product curve in short run. 8. Explain the following (a) Decreasing return to scale (b) Slope of isoquant curve (c) Diminishing marginal rate of technical substitution

Chapter

10

Cost and Break-Even Analysis ‘Economies are supposed to serve human ends, not the other way round. We forget at our peril that markets make a good servant, a bad master and a worse religion’. —Amory Lovins

Learning Objectives This chapter aims to introduce the concepts of cost, revenue and profit. The theories of cost are discussed in terms of short run and long run periods. The shape and movement of the long run cost curve is explained with different returns to scale due to economies and diseconomies of scale. The relation between cost, revenue and profit is discussed in terms of break-even analysis. The specific objectives are: • • • •

To introduce the various concepts of cost To discuss the theories of cost in the short run and the long run To understand the relation between short run and long run cost curves To discuss the sources of various economies and diseconomies of scale • To understand the concept of break-even and its merits and demerits

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135

INTRODUCTION The production function, discussed earlier, describes the physical relationship between input and output. The theory of cost expresses a similar relationship in terms of monetary terms; that is, the relation between output and cost of corresponding inputs. Production function is also used to identify the most efficient input combinations to produce any amount of output. But there are other issues to be decided upon by a business firm. Given the different techniques of production, say, labour intensive and capital intensive techniques, which one should the firm choose? In other words, it is a challenge to choose the optimum input combination. The optimum input combination purely depends on the cost of inputs because profit, the ultimate goal of firms, depends on cost incurred and the revenue earned.

COST Cost: Meaning Cost of production, or cost, refers to the expenses incurred in the production of any amount of a good. The money spent is mostly payment for services of factor inputs employed for production. Thus, cost of production depends on the quantity of output, the relevant inputs combination and the cost of inputs. Cost, in economics, basically refers to opportunity cost. It is used to discuss the efficient allocation of society’s resources. A business firm also needs to address the issue of allocating its limited resources for the best possible uses. There are also other cost concepts, like opportunity cost and explicit and implicit costs. They have already been discussed in Chapter 2. Cost Function The cost function is the functional relationship between output and cost, given a technology and prices of inputs. Symbolically, cost function can be written as C = f(Q) where C = Cost Q = Quantity of output

SHORT RUN COST AND LONG RUN COST The cost function or the functional relationship between cost and output can be discussed by two fundamental concepts, viz., short run cost and long run cost. The distinction between short run cost and long run cost is similar to the one described in production analysis. Long Run Cost In the long run, all factor inputs are variable. Nothing remains constant because increasing production in the long run requires expansion of plant capacity or creation

136 Business Economics of a new or additional plant. As all factors undergo changes, firms have complete flexibility in expanding the level of production. Short Run Costs: Variable Cost and Fixed Cost The short run is the period during which at least one factor input is held constant. It is the operating period during which the firms have limited flexibility in changing the level of output. For example, if plant size is fixed, the firms cannot change the output level beyond the existing plant capacity. The change in the variable inputs is also limited as the factory does not have huge production facility in terms of machinery. Thus, the change in output is due to change in variable inputs. Hence a distinction can be made between variable cost and fixed cost. The distinction between variable cost and fixed cost is fundamental, and they are used with reference to only short run production. The variable cost and fixed cost together constitute total cost in short run. Total Variable Costs The variable cost ‘varies’ with production within the limits imposed by the fixed plant capacity. The following are some variable costs: • Cost of raw materials • Cost on wages and salaries of temporary labour • Cost of depreciation on machines, buildings and such other capital goods • Cost of running any fixed capital, like fuel, electricity, maintenance, etc. Total Fixed Cost Fixed costs are also called overhead. A firm has to spend for land, some machinery of permanent nature, an effluent treatment plant, etc. All such expenses have to be incurred irrespective of the output level, and they are called total fixed cost. The fixed costs do not change with changes in output; they are independent of output. As these costs must be incurred by a firm in the short run even if there is no production, they are called as fixed cost. The following are some fixed costs: • Cost of salaries to regular staff • Cost of land, buildings, machinery, and capital of fixed nature • Cost incurred on insurance premium • Cost incurred for any other purpose of permanent nature Total Cost The total cost (TC) refers the total cost of production at any level of production. The total cost is summation of total variable cost (TVC) and total fixed cost (TFC).

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137

Table 10.1 Total Fixed Cost, Total Variable Cost and Total Cost (In Rupees) Quantity (units) (1)

TFC (2)

TVC (3)

TC = TFC + TVC (4)

0 1 2

20 20 20

0 18 24

20 38 44

3 4 5

20 20 20

29 36 48

49 56 68

6 7

20 20

68 98

88 118

Thus, the sum of total fixed cost and total variable cost is the total cost. i.e., Where,

TC = TFC + TVC TVC = Total variable cost TFC = Total fixed cost TC = Total cost

Table 10.1 and Figure 10.1 show total variable cost, total fixed cost and total cost curves and their relationship. Column (2) in the Table shows 20 as the TFC of a firm over the entire range of output. Note that the total fixed cost curve is a flat line in Figure 10.1. It starts at zero units on the X-axis reflecting the fact that it has to be incurred even in the absence of production. Cost

Cost

Cost

TC TVC

TVC

TFC O

TFC O

Output

O Output

Output

TFC + TVC = TC Fig. 10.1 Total Cost, Total Variable Cost and Total Fixed Cost

The total variable cost, however, changes with the number of units produced. Higher the output, larger will be the total variable cost. But the rate of change in total variable cost varies over the levels of production. The production cost will increase slowly during the initial level of production. Thus, cost will increase at a decreasing rate at the early levels of production. When production is increased further, the total variable cost will continue to increase but at a ‘increasing rate’.

138 Business Economics Total cost curve has the same shape as of total variable cost. It is because the TVC is higher by an amount of TFC since it is added to TFC. Thus, as shown in Figure 10.1, total cost is simply the vertical summation of total fixed cost and total variable cost. Average Fixed Cost Average cost is the per unit output cost. It can be arrived at by simply dividing total cost by the quantity of output. The average fixed cost (AFC) is total fixed cost divided by the quantity of output. Thus, AFC simply is the fixed cost per unit of output. It would obviously decline as output increases because a fixed amount is being shared (or divided) by the increasing output. TFC Thus, AFC = ____ Q Where

Table 10.2

AFC = Average fixed cost TFC = Total fixed cost Q = Quantity of output Average Fixed Cost, Average Variable Cost and Average Cost (In Rupees)

(1)

(2)

TFC AFC = ____ Q (3)

0 1 2 3 4 5 6 7

20 20 20 20 20 20 20 20

20 20 10 6.6 5 4 3.3 2.8

Quantity (Units)

TFC

(4)

TVC AVC = ____ Q (5)

0 18 24 29 36 48 68 98

0 18 12 9.6 9 9.6 11.3 14

TVC

TC

SAC = AFC + AVC

(6)

(7)

20 38 44 49 56 68 88 118

20 38 22 16.2 14 13.6 14.6 16.8

In Table 10.2, the total fixed cost of 20 is being divided by increasing amount of output. As a result, average fixed cost declines steadily with increasing output. The graphical presentation in Figure 10.2 shows that average fixed cost curve is a rectangular hyperbola. Under rectangular hyperbola, any combinations of cost and output will have same area or magnitude. Note that AFC for the combination ‘a’ is 20 (a2 = 1 × 20); and for the combination ‘b’ is also 20 (b2 = 4 × 5). Average Variable Cost Average variable cost (AVC) is obtained by dividing total variable cost by the quantity of output. It is the variable cost per unit of corresponding output. TVC AVC = ____ Q

Cost and Break-Even Analysis Cost

139

Cost

20

a AFC =

a

TFC Quantity of output

2

TFC

20

b 4

O

O Output

b 1 2

AFC

2

3

4

5

6

7

Output

Fig. 10.2 Total Fixed Cost and Average Fixed Cost

Where,

AVC = Average variable cost TVC = Total variable cost Q = Quantity of output

In Table 10.2, AVC is computed by dividing TVC by output. The short run average variable cost is zero when output is zero. For the first unit produced, the AVC is 18, and it starts declining and reaches 9. After reaching the lowest cost 9 for the 4th unit, AVC starts increasing and reaches 14 for the 7th unit. Thus, AVC declines initially due to increased productivity of the variable Cost factors and reaches minimum when the input (fixed and variable) combination SAVC become optimum (or the plant reaches its optimum capacity). Beyond this it starts ‘declining’. Plotting this entire trend in a graph will yield a ‘U’ shaped AVC curve, as in Figure 10.3. As output increases, AVC will fall till production reaches efficient capacity output due to the operation of increasO ing returns. But beyond the efficient Output capacity output, the AVC will rise due Fig. 10.3 Short Rum Average Variable Cost to the operation of diminishing returns. Curve Average Total Cost Average total cost is also known as average cost. It is the average cost per unit of output produced. Adding average total fixed cost to average total variable cost will give average total cost (ATC). It can also be arrived by dividing total cost by the quantity of the corresponding output.

140 Business Economics Thus, or, Where

ATC = AFC + AVC TC ATC = ___ Q AC = Average cost TC = Total cost Q = Quantity of output

Marginal Cost Marginal cost, in the short run, is the cost of producing the last unit of output. It can be computed by dividing the change in total cost by change in output. Thus, it is the addition to total cost as a result of one more unit of output. DTC Thus, SMC = ____ DQ Where SMC = Short run marginal cost TC = Total cost Q = Quantity of output D = Change Marginal cost essentially reflects changes in total variable cost. Note that as fixed cost is assumed to be constant in the short run, and any change in output is reflected only in variable cost. That is, the change in total cost caused by change in output must be due to change in variable cost. Thus, any increase in output in the short run would reflect only in variable cost. It is clearly shown in Table 10.3. MC is simply the increment in TVC for each unit of output. And marginal cost is the change in total variable cost due to the production of the last unit of output. MC can also be computed in a simple way: MCn = TCn – TCn – 1 Where,

MCn = Marginal cost TCn = Total cost of producing n units TCn–1 = Total cost of producing n–1 units

Marginal cost is also ‘U’ shaped (Figure 10.4). It is the mirror image of marginal product curve discussed in the previous chapter. The ‘U’ shape is due the operation of the law of variable proportion. Table 10.3

Marginal Cost

(In Rupees)

Quantity (units)

TVC

TC

DTC MC = ____ DQ

(1)

(2)

(3)

(4)

0 1

0 18

20 38

18

2

24

44

6

Cost and Break-Even Analysis 3 4

29 36

49 56

5 7

5 6

48 68

68 88

12 20

7

98

118

30

141

As marginal product of variable input rises initially, marginal cost declines. The reasons behind the law of variable proportion, viz., optimum factor proportion, intense use of fixed factors and Cost improving efficiency of variable input, equally hold good for the ‘U’ SAC shaped MC curve. Due to the above SMC factors, increasing factor returns, set in during the initial level of production, and marginal cost starts falling. The marginal cost curve starts rising due to the operation of diminishing return. The reasons are that the factor proportion changes to unfavourable O Output Q* level and the production process gets crowded with more variable inputs Fig. 10.4 Short Run Marginal Cost and Average when production is increased beyond Cost Curves a certain level. Relationship between Marginal Cost and Average Cost Marginal cost curve intersects average cost curve at its lowest point. When MC is below AC, AC falls towards MC. After the intersection, MC is above AC, and, from this point, AC starts increasing away from MC (Figure 10.4) Short Run Cost Curves Figure 10.5 gives a summary view of all short run cost curves. Alfred Marshal focused mostly on the ‘U’ shaped marginal cost curve. The shape and movement of average variable cost and average cost curves, and even total cost curves, are solely determined by the shape and movement of marginal cost curve, which in, turn, is due to the operation of increasing and diminishing returns to variable factors. From Figure 10.5, we can conclude: • Cost of production would be lowest at the point of intersection of the MC and AC.

Cost

AC

MC

AVC

AFC O

Fig. 10.5 Short Run Cost Curves

Output

142 Business Economics • The shut down point of production is determined by the AVC. • AFC starts from a height and slides gently and monotonically as production increases Long Run Average Cost Curve (LAC) If a firm wants to expand its output to meet its growing demand, it needs to expand its production capacity by altering all its inputs, like land, plant, machinery, wages, etc. Thus, in contrast to the short run (where at least one input remain fixed), in the longrun all inputs are variable. In the long run, as there are no fixed factors, we have no distinction between fixed and variable costs. Hence, the focus would be on marginal and average costs. The long run average cost (LAC) is TC Total Cost LAC = ___ = _________ Q Output The long run marginal cost (LMC) is the cost of producing an extra unit of output. The long run marginal cost is LMC = TCn – TCn – 1 Where, TCn – Total production cost of nth unit of output TCn – 1 – Total production cost of n –1th unit of output Relationship between LAC and SAC LAC is derived from the envelope of an infinite of number of short run average cost curves (SAC), as shown in Figure 10.6. Each SAC represents a particular plant size. This means that the firm has a series of plants of different sizes to choose from, in order to expand production. This is the reason why the LAC is also called ‘planning curve’. Cost

LAC SAC7

SAC1 LMC SAC6 SAC2 SAC5 SAC3 SAC4 LAC*

b

Q*

Output

Fig. 10.6 Long Run Average Cost Curve

Each SAC is ‘U’ shaped, and by joining the outer points (like a, b, c and d in Figure 10.7), the long run average cost curve is derived. This is the reason why the

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Cost

LAC SMC d¢

a

SAC≤

SAC

d

LMC SMC¢

SMC≤ c

SAC¢

b

Q

Q¢

Q ≤ Output

Fig. 10.7 SAC and LAC

LAC is also called as ‘envelope curve’. Each SAC touches the LAC only at a single point of tangency. How the firm chooses its plant size or moves over the LAC can be illustrated with the selection of three potential plant sizes represented by SAC, SAC’ and SAC’’ (Figure 10.7). These three SACs represent small, medium and large plant sizes. For instance, if the firm wants to produce OQ output it will be on SAC at point a, it has to accept the excess capacity. If the firm wants to increase its output level gradually to meet the demand it need not move on the same SAC to reach the lowest cost at point d; instead, the firm can shift to the falling segment of another SAC (tangent to LAC at d) which lies below the lowest point of the previous SAC. This way, the firm can keep moving on the LAC. The continuum of SACs provides smooth LAC. But the optimum plant size, or the lowest long run average cost, is attained at point b where LMC cuts LAC at its lowest point. At point b in Figure 10.7, even SMC cuts SAC at its lowest. LAC, LMC, SAC and SMC are all equal at this point. A firm may not prefer to move beyond this point because then the cost would rise. Hence, the ‘U’ shaped LAC could also be reduced to only ‘L’ shape. The shape and movement of the long run marginal cost curve (LMC) is similar to that of the average cost curve. LMC cuts LAC at the lowest point. Both are same for the first unit of output; then LMC lies below LAC as long as LAC falls. But, when LAC starts rising, after the intersection at point b, it lies below LMC. Why LAC is ‘U’ Shaped? The shape and movement of the long run average cost (LAC) curve is determined by the scale of production and the corresponding returns to scale due to various economies of scale of production. As discussed in the earlier chapter, there are three possible returns to scale on cost when scale of production is increased. Each one is due to economies or diseconomies of scale.

144 Business Economics 1. Increasing returns to scale (or Economies of scale) 2. Constant returns to scale (or Constant cost) 3. Decreasing returns to scale (or Diseconomies of scale) Increasing Returns to Scale (or Economies of Scale): If expansion of a firm’s scale of production reduces the production cost, as shown in Figure 10.8 (a), it is called increasing returns to scale The reduction of cost or increasing returns is due to economies of scale (discussed below in detail). Constant Returns to Scale (or Constant Cost): When cost of production remains constant for expansion in the scale of production, as shown in Figure 10.8 (b), the it is called constant returns to scale. That is, to increase output thrice, inputs need to be increased thrice. There is no reduction in cost or economies of scale does not take place. Decreasing Returns to Scale (Diseconomies of Scale): If an expansion in the scale of production increases the cost of production (due to the requirement of more than proportionate input), it is called decreasing returns to scale; and the shape of the AC curve would decline, as shown in Figure 10.8. (c). Increasing cost is due to diseconomies of scale. Cost

Cost

Cost

LAC

LAC O (a)

Output

LAC O (b)

Output

O (c)

Output

Fig. 10.8 (a) Economies of Scale or Increasing Returns (b) Constant Cost or Constant Returns (c) Diseconomies of Scale or Decreasing Returns

Cost

LAC

Output

Fig. 10.9 Long Run Average Cost Curve (LAC)

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The three segments of Figure 10.8 together constitute the ‘U’ shaped long run average cost curve. If there is a constant return to scale between increasing returns to scale and decreasing returns to scale then the LAC would be saucer shape with a flat base, as in Figure 10.9. It depicts the functional relationship between output and average cost of production in the long run. To produce a given level of output, LAC indicates the lowest average cost among infinite plant sizes.

ECONOMIES OF SCALE Economies of scale mean the cost advantage of large scale production. They occur mostly in the long run when increasingly larger plants yield lower cost of production. Thus, it is related to the size of the plant. Economies of scale arise when a business firm expands its scale of production, the unit cost of production decreases. If the unit cost increases while expanding the scale of production, it is called diseconomies of scale. If cost remains same for plant expansion, there are no economies of scale. These three possibilities determine the shape of the long run cost curves. At the initial level of production, the firm has increasing returns due to economies of scale and the average cost falls. The operation of diseconomies causes decreasing returns to scale and it increases the average cost. Constant return operates when cost remains same. Types of Economies of Scale Economies of scale can be classified under two broad categories, viz., internal economies of scale and external economies of scale. Internal Economies of Scale Internal economies of scale involve cost reduction within the firm. They are exclusive to a particular firm. For instance, a firm may develop a new technology with patent to cut costs. This is an internal advantage enjoyed only by the concerned firm. The following are some of the sources of internal economies. • Labour economies • Technical economies • Managerial economies • Marketing economies • Financial economies • Risk bearing economies Labour Economies: Division of labour is a major source of cost reduction. Large scale production needs division of labour. It improves the skills, professional capabilities and specialisation of work force. This saves time, improves productivity and cuts costs. Technical Economies: The sources of technical economies are indivisibilities and specialisation of the machinery. Very large scale production requires heavy machinery and sophisticated equipments which are indivisible and need huge investment. But, in the long run, they become more profitable at appropriate scale of production.

146 Business Economics Managerial Economies:

The main source of managerial economies is specialisation and division of labour. It can be achieved by delegating the decision making to right persons and ensuring supervision. The departments can be divided in terms of broad areas, like production, sales, finance, accounting, material, research, etc. This helps in supervision and in fixing responsibility to each department. Marketing Economies: Marketing economies are associated with selling products and buying raw materials and inputs. A large firm can enjoy economies in expenditure on advertisement, selling and product promotion activities. Increasing production leads to lower unit cost on all such expenditures. Similarly, as the size of procurement is large, the firm gets a better bargaining power to reduce its input prices. Financial Economies: A large firm has the advantage of mobilising required finance relatively at a cost than that of a smaller firm. A large firm can easily raise share capital and loans from public, issue debentures and borrow from banks at lower interest rate. In the globalised era, it can raise resources even from abroad at lower interest rate. Risk Bearing Economies: A large firm can spread its risks through appropriate diversification of production and marketing. For instance, in the current phase of recession, many CEOs have announced cost cutting strategies in order to absorb the losses incurred on sales. They may also shift risk from one product to another as they have many products with different brand names. Such maneuvering is possible only for a large firm.

External Economies of Scale External economies are those which occur externally. They are enjoyed by all firms. When costs are reduced by external factors, like improved infrastructure, they are called external economies. They may occur from the following sources: Economies of Concentration:

A large number of firms are concentrated in special export zones or industrial estates. The benefits of various infrastructures in such areas accrue to all firms to reduce their cost of production. Economies of Information: Firms of a particular industry could share common portals of information, like own journal, web sites, news bulletins, or an information centre to provide and share basic information, like raw materials, technology development, etc. Such information sharing would help to reduce the average unit cost of production. Economies of Disintegration: Each big industrial production can be sub-divided into several processes. Growth of subsidiary and ancillary industries in and around industrial estates would help large firms to cut their unit cost of production by disintegrating the production process.

DISECONOMIES OF SCALE The diseconomies of scale mean increase in average cost when a firm expands its scale of production. Firms continue their production until they reach the lowest point in the long run average cost curve. When the scale of production continues to grow

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and expand beyond this optimum level, the firm faces decreasing returns or diseconomies of scale due to increasing unit cost. The sources of diseconomies of scale are many. Some one listed below. 1. It is difficult to manage the firm when it grows beyond certain optimum level. 2. Controlling top level managers and supervision of the large work force are difficult. 3. Bureaucratic inefficiency, poor coordination and wastages increase the cost of production. 4. The input combination is optimum at the lowest point of LAC, moving further leads to suboptimal outcomes. 5. Division of labour slips from the point of efficiency to overcrowding. 6. A very large firm faces strong trade union bargaining for just pay, bonus and improved working conditions. But it should be noted that business firms may stop expanding their scale of production at their lowest point of LAC. As profit is the ultimate goal, firms may not move beyond such optimum level. This is one of the reasons why the shape of LAC is also considered to be ‘L’ instead of ‘U’. Thus, firms may continue with constant returns to scale after completing the phase of increasing returns.

BREAK-EVEN ANALYSIS The relationship between cost, revenue and profit is most important for a firm to exercise its options in deciding optimum output levels. The ultimate objective of a firm is maximisation of total profit. This depends on the total revenue earned through sales (demand side) and total cost of production (supply side). Thus, total profit is equal to total revenue minus total cost (P = TR-TC). Break-even analysis is a useful method to analyse the relationship between cost, revenue and profit. It aims to determine the level of output at which a firm attains the break-even point. Meaning of Break-Even Point Break-even point simply means a no-profit-no-loss situation. The firm breaks it even at an output level where total revenue equals total cost. Thus, Break-even point TR = TC. Cost, Revenue and Profit The relationship between cost, revenue and profit may lead to three possibilities: (1) The firm earns profit when revenue exceeds cost (2) The firm suffers loss when cost exceeds revenue (3) The firm breaks even when revenue equals cost It should also be noted that when the firm is breaking even, it earns normal rate of return which is already factored in the total cost. As discussed earlier, total cost comprises of fixed cost and variable cost. The total cost function may be linear or non-linear. The total cost function is linear when

148 Business Economics variable cost remains same over a period; otherwise it is non-linear. Total revenue is the amount of money a firm receives by the sale of its output in the market. Profit (P) is total revenue minus total cost. Profit = Total Revenue – Total Cost P = TR-TC = (P × Q) – TC Symbolically, break-even point or no-profit-no-loss level is Break-even Point = TR = TC P × Q = TFC + TVC P × Q = TFC + AVC × Q Q (P – AVC) = TFC TFC Q = _______ P – AVC Illustration: If total fixed cost (TFC) is Rs.1000, price is Rs.60 and average variable cost (AVC) is Rs.10 per unit, what is the break-even level of output? Solution:

TFC Break-Even = ________ P – AVC 1000 = _______ 60 – 10 1000 = _____ 50 = 20 units

Profit

Fixed cost Variable cost

Cost, revenue and profit

Graphical Representation: To maximise profit, the difference between TR and TC needs to be maximised. Towards this, the firm must find the price and quantity that maximise the difference between TR and TC. Figure 10.10 shows the break-even point through linear cost (TC) and revenue functions (TR). The TR is passing through the origin indicating that the price is constant in the perfectly competitive market. And TR the total cost curve starts from the level of fixed cost and increases as variable cost increase for Profit different levels of output. The firm is breaking Break-even point even at the level of output Q* where the TR is TC equal to TC. To the left of Q* the firm faces losses and to the right of Q* it has profit, as TR exceeds total cost. At the point of breakeven, TR is exactly equal to TC. At the initial Loss level of production, the loss (shaded area in Figure 10.10) is greater. It can be minimised O only by increasing production. Similarly, from Output Q* the break-even point, profit can be maximised Fig. 10.10 Break-Even Point by increasing production.

Cost and Break-Even Analysis

Importance of Break-Even Analysis

TR and TC

TC a

B¢ TR

Max P

B

O

Q

a¢

Q*

Q ¢ Output

Q*

Q ¢ Output Total profit

Total profit

Figure 10.11 exhibits break-even points through non-linear functions. The total cost function is non-linear reflecting the law of variable proportion. The firm maximises its profit at only one output level, Q*, where the vertical distance between total cost and total revenue is maximum. Below and above the output level Q* the firm earns profit, but it is lesser than at the Q* level. At output levels below Q and above Q¢, the firm suffers losses because, in both cases, TC is more than TR. Hence, points B and B¢ are called break-even points because the firm makes neither profit nor loss at B and B¢.

149

O

Q

Break-even analysis has many applicaFig. 10.11 Break-Even Points tions and plays a significant role in business decision making. Some of them are: 1. Break-even analysis helps to make decisions about the optimum level of price and output. 2. It helps to adjust the level of output to maximise profit, or at least to minimise loss. 3. It helps to plan for the purchase of raw materials and other inputs in adequate quantity at appropriate time. 4. It also helps to choose the appropriate technology. 5. It is useful in planning cost cutting strategies in advance. 6. It also helps to plan and adjust selling expenditure. Limitations of Break-Even Analysis Though break-even analysis is important for various decision making processes, it suffers from many limitations. Some are listed below. 1. Price and output decisions depend on many other determinants, like competition, business cycles, etc. Hence, break-even analysis may go wrong. 2. Break-even analysis is static in nature. The real business environment is more dynamic and profits depend on various other factors in addition to cost and revenue. 3. Application of break-even analysis is difficult when a firm engages in the production of different products. 4. Estimation of cost function is difficult in the long run. 5. Splitting total cost into fixed and variable components is also difficult.

150 Business Economics

Key Terms and Concepts Cost Short Run Cost Fixed Cost Average Cost Total Cost Diseconomies of Scale ‘U’ Shaped Cost Curve Envelope Curve Break-Even Point Internal Economies Diseconomies

Cost Function Long Run Cost Variable Cost Marginal Cost Economies of Scale Constant Cost ‘L’ Shaped Cost Curve Planning Curve Maximum Profit External Economies

Chapter Summary The concepts of cost and cost function are discussed in the short run and in the long run. The shape of the long run cost curve and its relation with the short run cost are explained. The various economies of scale accruing to the firm in the long run are also explained. Finally, the concept of break-even point is discussed. • Cost function relates cost to output and provides various options to decide the profit maximising output level. • Cost is determined mainly by the level of output and input prices along with other determinants. • Short run is the period where at least one input is fixed, and in the long run all inputs are variable. • The long run average cost is ‘U’ shaped due to economies and diseconomies of scale at various levels of output. • Break-even is attained when revenue from the sale of a product equals the cost of producing that output.

Questions A. Very Short Answer Questions 1. Define cost function. 2. Define short run cost. 3. Define long run cost.

Cost and Break-Even Analysis

4. 5. 6. 7. 8. 9. 10.

151

What are fixed and variable costs? What is marginal cost? What is average cost? What is planning curve? What is break-even point? What is an envelope curve? Distinguish between short run and long run.

B. Short Answer Questions 1. What is the relationship between marginal cost and average cost? 2. Explain the shape of the long run average cost curve. 3. Explain the short run cost curves. 4. Explain SAC and LAC and their relationship. 5. Explain various costs incurred by the firm. 6. Explain the break-even point. 7. Explain the various economies of scale. 8. Why is the long run average cost curve ‘U’ shaped? C. Long Answer Questions 1. Explain the various cost curves in the short run. 2. What is the relationship between fixed and variable costs? 3. Explain the shape and movements of the long run average cost curve. 4. Explain the SAC and LAC and their relationship. 5. Explain total, average and marginal cost curves in the short run. 6. Explain the break-even point with a suitable diagram. 7. Explain the sources of economies and diseconomies of scale. 8. Explain the reason for the ‘U’ shape of LAC. .

Chapter

11

Market Structure ‘The market came with the dawn of civilization and it is not an invention of capitalism. If it leads to improving the well-being of the people there is no contradiction with socialism.’ —Mikhail Gorbachev

Learning Objectives This chapter aims to discuss the price and output determination by firms under different market structures. Market structure deals with the behaviour of firms in making decisions regarding supply and price. Different markets have various degrees of control and competition. At the end, the students would be able to understand the concepts, objectives and equilibrium conditions of firms under different market structures. The specific objectives are: • To introduce the concept and classification of market • To understand the price and output decisions of firm under different market structures • To understand the different degrees of competition among firms and their relative control over the market • To learn about the behaviour of firms in a market economy

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INTRODUCTION The theory of market structure, is central to both economics and business. The market consists of buyers and sellers. It has already been discussed in Chapter 6 how the buyers and sellers together determine price in a simple market framework. The behaviour of these two needs to be understood further to understand how price of a good is determined. Understanding the market mechanism would also help in understanding whether society’s resources would be allocated efficiently and income would be distributed equally. The theory of consumer behaviour has already been discussed in detail in previous chapters. Similarly, behaviour of the producer (or firm) in determining supply needs detailed understanding to know about the market system. How firms behave in response to demand, competition and other market conditions.

MARKET STRUCTURE The term ‘market’, in ordinary language, refers to a particular place or locality where goods are sold and purchased. The term ‘market’ in economics connotes a different meaning. The existence of contract between the sellers and buyers for purchase of a commodity, at an agreed price, means an existence of the market. The buyers and sellers may be present in a small locality, or may spread over a region, or a town, or a country. The essential feature of a market is communication between sellers and buyers, which may be direct or indirect, through exchange of letters, telegrams, telephone, e-mail, short message services (sms), etc. This exchange of communication results in transaction of commodities at an agreed price. Definition of Market The market consists of buyers and sellers. The following definitions provide the various aspects of market. Cournot: ‘Economists understand by the term ‘market’, not any particular market place in which things are bought and sold but the whole of any region in which buyers and sellers are in such free intercourse with one another that the price of the some goods tends to equality easily and quickly.’ Ely: ‘Market means the general field within which the force determining the price of a particular product operates.’ Benham: ‘Market is any area over which buyers and sellers are in close touch with one another, either directly or through dealers, that the price obtainable in one part of the market affects the prices paid in other parts.’ Stonier and Hague: ‘Any organisation whereby buyers and sellers of a good are kept in close touch with each other …. ‘There is no need for a market to be in a single building…. The only essential for a market is that all buyers and sellers should be in constant touch with each other, either because they are in the same building or because they are able to talk to each other by telephone at a moment’s notice.’ Thus, it is evident that market means the sellers for a product come in contact with each other in order to buy or sell the commodity for an agreed price.

154 Business Economics Components or Essentials of a Market The essentials for a market are listed below. 1. A commodity should be offered for sale 2. Existence of buyers and sellers 3. A place which may be a region, a country or the entire world 4. Contact between buyers and sellers which results in fixation of price for the commodity Meaning of Market Structure Market structure refers to the manner in which markets are organised or structured. They are structured on the basis of the number of firms, their relative strength, the degree of competition and collusion among them, the extent of product differentiation and the ease of the firm’s entry into, and exit from, the market. Classification of Market Structure Markets may be classified into different types on the basis of area, time and nature of transactions, volume of business, status of sellers, regulation and competition. Among the various classifications, the most important one is based on competition. This is based on three crucial elements. They are the number of firms producing a commodity, the nature of the product produced by the firms, that is, whether it is homogenous or differentiated, and the restrictions or easiness with which the new firms enter the industry. Classification on the Basis of Area The markets, based on area, are classified into local, regional, national and international markets. If the commodity is sold only in a particular area, it is called local market. If the commodity is sold in a region, for example, in a few states in India it is known as regional market. If the commodity is sold throughout the country then it is said to have national market. If a commodity is sold outside the country, then it is known as international market. According to the nature of the commodity, taste and preferences of the buyers, availability of storage, method of business, political stability and portability of the commodity, it becomes saleable in local, or regional, national or international markets. Classification on the Basis of Time Marshall classifies market on the basis of time into very short period or market period, short period and long period. Very short period market refers to the market in which commodities are fixed in supply in the given time period. In this time period supply is fixed and changes in demand bring changes in price. Short period is the period in which changes in supply can be made to a limited extent in response to changes in demand. In short period, variable factors are increased or decreased in order to increase or reduce supply in response to changes in demand. In this period, it is impossible to increase fixed factors. Long period is the period in which all fac-

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tors, i.e., fixed factors and variable factors, can be varied for bringing about changes in supply in response to changes in demand. Classification on the Basis of Transactions Markets are classified as spot market and futures market on the basis of transactions. When goods are transacted on the spot, the market is called spot market. When people enter into agreements to buy or sell goods at a future date, then it is called futures market. Classification on the Basis of Volume of Business When goods are transacted in large quantities the market is known as wholesale market. In retail market, the volume of transactions of a particular commodity is less. Wholesale market is a link between the producer and the retailer, whereas retail market creates a link between the wholesaler and the consumer. Classification on the Basis of Regulation Markets are classified into regulated and unregulated market. In the regulated market the Government regulates sale and purchase of certain commodities. The market forces are not allowed to operate freely. In an unregulated market sale and purchase of goods are left to the operation of market forces. Classification on the Basis of Competition Markets are classified into perfect competition and imperfect competition. Market conditions vary between industries. The degree of competition faced by firms in an industry varies from industry to industry. The Market Structure Continuum The market structure continuum shown in the box gives an overview of the four basic market structures. The right extreme of the line indicates total market is controlled by a firm, whereas the left extreme indicates zero level market control by the firms. While moving from left to right, the firms gradually dilute the competition and gain higher degrees of market control. Market control depends on the number of sellers and the degree of competition. On the left, with infinite number of sellers and no market control, is the perfect competition. At the other extreme, with no competitor and a firm exercises complete control over the market, is monopoly. In between these two extremes, there are different market structures–for instance, imperfect competition refers to a market with many firms, but each enjoying some amount of monopoly power and at the same time facing competition from other firms. An oligopoly market is one, where there are a few firms, which may be either in collusion or in fierce competition with each other.

PERFECT COMPETITION Perfect competition is an extreme form of market structure. The market forces of demand and supply work freely. The operations of demand and supply determine

156 Business Economics The Market Structure Continuum

Perfect competition

Monopolistic competition

- Very large number - Relatively large number of sellers of sellers and and buyers buyers - Differentiated - Homogeneous products products - Firms are price takers - Free entry and exit - Easy entry and exit - Competition is total

Oligopoly

- A few large sellers - Differentiated or homogeneous products - Interdependence - Collusion - Entry barriers - Mutual control over price

Monopoly

- Single seller - Price maker - No substitutes - Control over market - Blocked entry - No competition

the allocation for resources among different commodities and distribution of income among factors. Perfect competition is a non-existent situation. According to Leftwich, the study of perfect competition ‘furnishes us with a simple and logical starting point for economic analysis’. It is a kind of market structure where there is no rivalry among firms since all the firms producing identical products will be able to sell the quantity produced by them at the prevailing market price. Assumptions The perfect competitive market can also be characterised by its own assumptions. They are: Large Number of Buyers and Sellers: The existence of large number of buyers and sellers in the market is an essential feature of perfect competition. The buyers and sellers are numerous and, hence, each buyer buys so little and each seller sells so little that none of them is in a position to influence the price in the market. The price of the product in the market is influenced by market demand and market supply. The firm is a ‘price taker’. Once the price is determined by the market forces of demand and supply each firm has to adjust its output according to the market price. Homogeneous Product: The products sold by the firms are identical in all respects. The technical characteristic and services provided by the firms are identical, and hence the products produced by competitive firms are considered perfect substitutes by consumers. Due to homogeneity of the products of the competitors, the sellers cannot charge price slightly more than the ruling market price. If a higher price is charged by the firm, it would lose all its customers. Absence of Regulations: There are no restrictions on the demand, supply and prices of goods and factors of production in the market. There are no restrictions or regulations on the supply of goods and factors, either by the government or by any cartel system among producers. There is no rationing of the product by the government. Free Entry and Exit: The firms in perfect competition have the freedom to enter or exit the industry. If the firms earn abnormal profits, new firms would enter the

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industry. The excess profit would be taken away due to entry of new firms. Similarly, if firms incur losses then they will leave the industry. Perfect Knowledge of Market Conditions: The buyers have knowledge about the product, hence, there is no need for the firms to advertise their products. Similarly, the sellers have knowledge of the market conditions. This implies that both the buyers and the sellers have full knowledge of the price at which the market demand and market supply are equal. Absence of information regarding market conditions inhibits the functioning of competition. Perfect Mobility of Factors of Production: The factors of production can freely move between industries. There is no monopoly in supply of raw materials. There is no labour union which prevents free functioning of market forces. Non-Existence of Transport Costs: The existence of a single price for the product is an essential condition in perfect competition. If there is transport cost, there can not be a uniform price. Perfect competition assumes that firms are present so close to each other and to that there are no transport costs. Distinction between Pure Competition and Perfect Competition The term ‘pure competition’ was first used by E.H. Chamberlin. The existence of a large number of buyers and sellers, existence of homogenous product, absence of artificial restrictions, and condition of free entry and free exit for firms are enough for competition to be termed pure competition. These conditions ensure absence of monopoly conditions in the market. Hence, all firms are price takers. Pure competition is a part and parcel of prefect competition. In addition to the above four conditions of pure competition, the other three conditions, namely, perfect knowledge on the part of buyers and sellers, perfect mobility of factors of production and non-existence of transport costs, should be present for the market to be classified as perfect competition. To summarise, it could be stated that there should be a single uniform price in the market and the price should be determined by the market forces of demand and supply, i.e., the combined action of all the buyers and sellers in the market determine the price. Firm and Industry These two concepts need `to be defined. A firm is a business organisation for transforming factors of production into outputs or commodities. A firm produces a product. For instance, Tata Steel produces steel. The concept of industry includes all the firms producing a particular product. For instance, all steel makers in India, like SAIL, Tata Steel, JSW, etc., constitute ‘steel industry’. Thus, a large number of firms producing similar products are included under the concept of industry. In perfect competition, the industry (all sellers), or market supply along with market demand (all buyers) determine the market price, as shown in Figure 11.1. The firm is called price taker because any individual firm has to sell only at the market determined price.

158 Business Economics D

S

D = MR = AR

P*

O

O Quantity in billions The Market

Quantity in hundreds The Firm

Fig. 11.1 Market Determined Price for The Firm in Perfect Competition

Short Run Equilibrium of a Firm To determine the equilibrium point or the profit maximising level of output, a firm must know its cost and revenue. We have already discussed various concepts of costs. The relevant concepts of revenue are marginal revenue and average revenue. Marginal revenue (MR) of a firm is the change in total revenue due to the sale of an extra unit of the good. Thus, it is the addition to total revenue from selling an additional unit of the good. The marginal revenue curve in perfect competition is just the horizontal price line, because price of the good is an addition to total revenue by selling an extra unit. Average revenue is the per unit revenue. It is arrived by dividing total revenue by the units of goods sold. TR PxQ Hence, AR = ___ = ____ Q Q AR = P That is, price is the average revenue earned per unit of sales and, therefore, it is also the demand curve for the product. Thus, the demand curve that a firm faces under perfect competition is the horizontal line where P = MR = AR. A firm could earn maximum profit (P) by maximising the difference between its total revenue (TR) and total cost of production (TC). Thus, P = TR-TC in perfect competition. The price is determined by the market forces (demand and supply), as shown in Figure: 11.1. In other words, price is determined by the industry and the firm is a price taker. The perfectly competitive firm, being a price taker, can maximise profit only by minimising the cost. Given this, a firm could be in equilibrium in the short run under the following conditions: Equilibrium Conditions: A firm can earn maximum profit when its cost of producing an extra unit is equal to the revenue earned from the sale of that unit. Thus, firm can earn maximum profit when, 1. MR = MC 2. The MC curve cuts the MR curve from below

Laws of Production

159

Price & Cost

CR Slope of MC > Slope of MR The first condition means market price L should be able to cover the marginal cost of producing the output. The second condition can A B be explained with Fig. 11.2. In Figure 11.2, the P MR MC = MR at two points A and B. Till the production reaches Q1, the MC is above MR, thereafter for every unit the firm must be incurring M loss and only at Q1 unit, it attains break-even. O Therefore, it has accumulated loss represented Q2 Q1 by the area PAL. As production increases from Q1 to Q2, for every unit MC is less than MR, so Fig. 11.2 Equilibrium of a firm the firms accounted profit from Q1 to Q2 is the shaded area AMB. Therefore, the firm attain maximum profit only at OQ2 level of output, and at Q2, the MC = MR and MC curve cuts MR curve from below. Any increase in production beyond Q2 will increases loss for the firm. Hence, “MC curve cuts MR curve from below” is an essential second condition for equilibrium of a firm. Figure 11.3 shows the three different cases of a firm, with abnormal profit, loss and normal profit (or break-even). Figure 11.3 (a) shows the profit maximising output of X which is determined by drawing a vertical line from point E, where MC is equal to MR. At this point, MC also cuts MR from below.

SMC

SAC SMC SAC E

P G

AR = MR G¢

L P

SMC SATC

L¢

E*

P E AR = MR P¢

AR = MR SAVC

S

AFC X Output

X≤

Output

Profit = Shaded area

Loss = Shaded area

(a)

(b)

X¢ X*

Output

Break point = E * Shut down point = S (c)

Fig. 11.3 (a) Short Run Profit (b) Short Run Loss (c) Short Run Equilibrium

Figure 11.3 (b) shows the short run loss of the firm. The profit maximising output of X is determined by drawing a vertical line from point E, where MC is equal to MR. At this point, MC also cuts MR from below. But, note that the firm is incurring a loss because the short run average cost (SAC) is above the short run average revenue, or price of the good. The extent of loss per unit is equal to AC – AR. The area LPEL’ is quantum of loss to the firm.

160 Business Economics Thus, even if MC equals MR, the short run profit or loss depends on whether the average revenue earned, or the price of the good, is more than the average cost. Note that in Figure 11.3 (a), AR or price P is greater than SAC and the difference between them determines the quantum of profit. Shut Down Point: If price falls further in Figure 11.3 (b), the loss would increase as the distance between SAC and AR gets widened. But how long can a firm continue its production with loss? The firm would continue its production as long it can meet the average variable cost from the price, or AR. Thus, if price falls below AVC, the firm would shut down production in order to minimise its loss. Point S in Figure 11.3 (c) shows the point where the firm would close down its operation to be better-off. Break-Even: Normal profit or break-even is attained when the short run average total cost is equal to price or short run average revenue. Thus, when price and SAC are equal, the firm attains break-even. Point E* is also the short run equilibrium with normal profit. The equilibrium output level of the firm is X* where price is equal to SATC. Hence, firm can get normal profit. At normal profit of the perfectly competitive firm, SAC = SMC = MR = AR = P. Supply Curve of the Firm Supply curve of the firm refers to the direct (or positive) relationship between the price and the output level of the firm. The supply curve shows how much output the firm would supply. The firm would supply when the market price increases, and would cut its supply when the market price declines. The point of intersection of firm demand curve with its MC curve determines the supply level of the firm. Figure 11.4 exhibits the derivation of supply curve of the firm. This indicates that quantity supplied by the firm increases when price increases. When price is P1 the firm would supply X1, and it would increase its supply to X3 when market price increases to P3. P

P

MC

P3

P3 Satc

P2

Savc

P1

O

S

X1 X2 X3

X

P2 P1

O

X1 X2 X3

X

Fig. 11.4 Firm’s Supply Curve

Supply curve of the industry is derived by horizontal summation of the supply curves of all the firms in the market. Suppose there are only two firms in the market. The derivation of industry’s supply curve is shown in Figure 11.5. Given the market price, firms A and B produce 1,000 and 2,000 units, respectively. As a result,

Laws of Production Firm A

Industry

Firm B

S1

S = S1 + S 2 Industry supply curve

S2

P*

P*

O 1000

Q

161

P*

O

2000

Q

O (1000 + 2000) 3000

Q

Fig. 11.5 Industry’s Supply curve

market supply is 3,000 units, which is the total product of all firms (A and B) in the industry. Long Run Equilibrium of a Firm and Industry

D

S

Price & cost

Price & cost

A competitive firm can earn abnormal profit or loss in short run, as shown in Figure 11.2 (a) and (b). But, it is impossible in the long run due to free entry and exit in the market. If a firm earns abnormal profit in the short run, it would attract new entry till the entry pushes the price (demand curve of each firm) downwards such that excess profit disappears. Likewise, if a firm incurs loss, it would also disappear in the long run, as a result of exit of loss-making firms. Hence, every firm can just equate its AR to AC and make only normal profit. Equilibrium situation of the firm and industry is shown in the Figure 11.6.

SMC

LMC SAC

P*

LAC

P = MR = D

X*

Output

X*

Output

Fig. 11.6 Long Rum Equilibrium of Firm in Perfect Competition

In the long run, there is no fixed cost because all costs are variable. As a result, long run total cost is also equal to long run variable cost. Hence, the equilibrium condition for the firm is P = LMC = LAC. Given this condition, the firm would adjust its plant size in such a way as to reach the lowest point of LAC with the above condition.

162 Business Economics Thus, the firm would be in equilibrium at the level of output at X*, where its short run marginal cost is also equal to its long run marginal cost, and the short run average cost is also equal to its long run average cost. Thus, the long run equilibrium of the firm under perfect competition exists at the output level, where SMC = LMC = SAC = LAC = P = MR The industry’s demand and supply curve determines the market price P*. Given this, the firms can earn profit only by cutting their cost of production. Any change in demand and supply would change the price and move the demand curve of each firm, resulting in loss or profit. And consequent entry or exit are expected to bring back the equilibrium where each firm is expected to earn just normal profit. Competition: Thus, such market mechanism in perfect competition is expected to achieve least cost of production, lowest price possible for the goods sold and optimal allocation of society’s resources. Share market, vegetable markets and markets for perishables are some of the markets where perfect competition can be witnessed.

MONOPOLY Monopoly is an extreme market structure where a single producer controls the entire supply of a unique commodity which has no substitutes. Monopoly is present only when there are strong barriers which prevent the entry of other firms into the industry. In monopoly, firm and industry are one and the same. The barriers which prevent new firms from entering the industry may be economic, institutional or artificial. Having total control over the market, the single firm is the ‘price maker’ for the industry. Whether monopoly is a boon or bane is a controversial issue. Normally, it depends on whether monopoly is in the private or public sector? For instance, Indian Railways, being a public sector monopoly, aims to facilitate economic growth and serve people. Meaning of Monopoly The term monopoly has two syllables—mono and poly. Mono means single and poly means seller. Hence, monopoly implies the presence of a single seller for a commodity which has no close substitutes, and there are barriers to entry and absence of competition in the market. This situation is called pure, or absolute, or perfect monopoly. This type of pure or perfect monopoly is usually not present in the economy. In reality, only imperfect monopoly is present. An imperfect monopoly is a situation wherein there is only a single seller for a product for which there are no close substitutes. In other words, it implies that substitutes are available but they are not close substitutes. Imperfect monopolist is not as strong as a perfect monopolist. Hence, in an imperfect monopoly, the cross elasticity of demand between the monopolist product and that of the distant competitor is small and above zero. According to Joel Dean, ‘A product of lasting distinctiveness’ is termed as monopolised product. Its distinctiveness lasts for several years.

Laws of Production

163

Assumptions of Monopoly The monopoly model is based on some basic assumptions. They are: 1. There is a single producer/seller for the product 2. There are no close substitutes for the product 3. The presence of barriers prevents new firms from entering the industry 4. The monopolist uses his monopoly power to maximise his revenue Basic Causes for Monopoly Monopolies emerge due to several reasons. The following are some of them. 1. Government Permission: Monopoly may be protected from competition by public policies. By restricting entry into an industry, the government can create a monopoly for reasons like public utility or national security. 2. Ownership of Resource: Monopoly may emerge due to ownership of raw material and production techniques in the hand of a single producer. 3. Economies of Scale: If a firm has downward sloping average cost curve, it poses monopoly power. When it increases its output, cost of production decreases. 4. Natural Monopoly: In the case of power, telephone and railways, the sheer size of investment creates natural monopolies, due to huge capital cost and long gestation period. 5. Pricing Policy: Sometimes artificial barriers are created by an existing firm at the market, by imposing price limit, to prevent other firms from entering into the market. 6. Patterns: If an individual or a firm owns a copyright or pattern for a product or a superior technology, it would create a monopoly. Demand and Revenue Curves The monopoly firm, being a single seller in the industry, faces normal downward sloping demand curve. Thus, the firm’s demand curve is also the industry’s demand curve. In contrast, the price line or demand curve of a firm in perfect competition is flat because the firm is the price taker. But the monopolist is a price maker in the market. The demand curve is also the average revenue curve (AR), which is equal to price and demand. The relationship between price and AR is explained in Table 11.1. Table 11.1

Price and Revenue of a Monopolist

Output (Q) 1 2

Price (P) 5 4

TR 5 8

AR 5 4

MR 5 3

3 4

3 2

9 8

3 2

1 –1

5

1

5

1

–3

164 Business Economics We know,

TR = P × Q TR AR = ___ Q DTR MR = ____ DQ

Due to the downward sloping demand curve, price and output are inversely related. At higher price, output would be lower. But when price decreases more output can be sold. The total revenue (TR) is determined by the price and quantity of output. Both AR and MR are sloping downwards. But the slope of MR is twice that of AR curve. However, both curves start at the same point. AR and MR are graphically depicted in Figure 11.7. P D e=a

e>1 e=1

e