Fy B Com Business Economics I PDF

F.Y.B.Com. Dr.
Ranga Sai
Lecture Notes Vaze College, Mumbai
Business Economics Paper I

As per
Revised June 201

2010
Dr.Ranga Sai
Revised Business Economics I Syllabus for F.Y.B.Com from June 2008 onwards
University of Mumbai
Section I
Module I: Demand analysis

Utility: Cardinal and ordinal approaches
Indifference Curve Analysis
Properties of IC, Consumer Equilibrium, Price Effect, Derivation of demand curve
from PCC
Consumer surplus
Elasticity of demand, Income, cross, promotional. Case studies-
Demand forecasting: meaning significance and methods-case studies
Module II Theory of production

Production function-short run and long run- Law of variable proportions- Isoquant-
producers’ equilibrium- returns to scale-economies of scale- economies of scope- case
studies
Module III Cost of production

Concepts: social costs private costs, economic and accounting costs- fixed and
variable cost curves in short and long run costs- Learning curve- producers’ surplus-
case studies
Section II
Module IV Revenue Concepts
Average Revenue, Marginal Revenue, Total Revenue- Relationship between Average
Revenue and Marginal revenue and elasticity of demand
Objectives of firm: Profit, sales and Growth Maximization, Break even analysis
Module V Markets
Equilibrium under perfect competition in the long run, Monopoly, Equilibrium in the
long run, Monopolistic competition: features, Oligopoly: features, Globalization:
cartels and price leadership in oligopoly
Case studies
Module VI Pricing Methods

Marginal cost, Full Cost, Discriminatory, multi-product and transfer pricing
Capital Budgeting- Meaning and importance- Investment criteria: Payback period,
Net present value and internal rate of return methods
Available for free and private circulation

At www. rangasai.com and www. vazecollege.net
Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 2

Dr.Ranga Sai
CONTENT
Section I
Properties of IC
Consumer Equilibrium,
Income Effect
Price Effect
Derivation of demand curve from PCC
Consumer surplus
Elasticity of demand, Income, cross, promotional. Case studies-
Demand forecasting
Module II Theory of production
Production function
Law of variable proportions
Isoquant- producers’ equilibrium- returns to scale
Economies of scale
Economies of scope
Concept of costs
Behavior of short cost curves
Behavior of long run cost curves
Learning curve
Producers’ surplus
Case studies
Section II
Module IV: Revenue Concepts
Relationship between AR and MR
Objectives of firm
Break even analysis
Module V: Markets
Equilibrium under perfect competition
Long run,
Monopoly
Equilibrium in the long run,
Monopolistic competition
Oligopoly, Duopoly
Case studies
Module VI: Pricing Methods
Marginal cost,
Full Cost,
Price discrimination
Multi-product
Project Planning
Payback period,
Net present value
Internal rate of return

Dr.Ranga Sai
Dear Student friends…
During these days of commercialization it becomes very difficult to find

information on web which is relevant, authentic as well as free.
We believe that knowledge should be free and accessible to all those who
need.
With this intention the notes, which are originally intended for the
students of Vaze College, Mumbai, are made available to all, without any
restrictions.
These notes will be useful to all the F.Y.B.Com students of University of
Mumbai, who will be writing their Business Economics Paper I
examinations on or after March 2009. Distance Education students are
advised to refer the recommended syllabus.
This is neither a text book nor an original work of research. It is simple
reading material, complied to help the students readily understand the
subject and write the examinations. We no way intend to replace text
books or any reference material.
This is purely for academic purposes and do not have any commercial
value.
Feel free to use and share.
We solicit your opinions and suggestions on this endeavor.
Dr. Prof. Ranga Sai

rangasai@rangasai.com
June 2010

Dr.Ranga Sai

Utility analysis of consumer behavior given by Marshall is based on the
cardinal measure of utility. The theory is based on the basic assumption
that the utility can be measured.
Accordingly, the theory describes utility as the want satisfying capacity

of a good. Such utility is classified as time utility- a good changes form
time to time depending on the seasons; place utility- a good changes
utility form place to place; form utility- where the good changes utility
with changing form.
Use value is the value of a good in use. It depends on the want satisfying
capacity of the good.
Exchange value, on the other hand deals with what a good can get in
return in the market.
The value paradox states that use value and exchange value are inversely
proportional. With increasing use value of good its exchange value
decreases. e.g. water, air.
Similarly with increasing exchange value its use value decrease .e.g.
diamonds, gold
But a transaction can take place only when use value is equal to exchange
value. This conflict is called as value paradox.
Under the utility theory the consumer behavior is explained by the Law of
diminishing marginal utility. According to the law ‘with the increasing
use of a good its marginal utility decreases’.
The consumer maximizes his satisfaction by equating marginal utilities of

all the goods he consumes. This is called the law of equi-marginal
utilities.

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Consumption theory in economics contains two parts. Firstly, the theory

studies the consumer behavior and secondly, the theory will suggest the
consumer the way in which satisfaction van be maximized.
In utility analysis, the Law of Diminishing marginal utility studies
consumer behavior and the law of Equi-marginal utilities suggested a
method of maximizing consumer satisfaction.
Indifference curve analysis is a consumption theory given by Hicks and

RGD Allen. The theory is an improvement over Utility analysis. Utility
analysis had a major draw back that it measured utility in cardinal terms.
Indifference curve analysis measures utility in ordinal terms. Further, IC
analysis provides wider descriptions and details as compared to utility
analysis.
IC deals with various combinations of two goods which give the

consumer the same amount of satisfaction.
Indifference Schedule
X Y
1 12
2 10
3 7
4 3
All these combinations give the consumer same amount of satisfaction. In

this case the consumer will not be able to choose any combination as
better than other. The consumer will be indifferent between these
combinations. The curve drawn indifference schedule is called the IC.
Hicks use an IC to explain the consumer behavior.
ICs can be understood better with the help of its properties.

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Properties of Indifference curves
1. Indifference curves towards the axis represent lower satisfaction and

IC away from the axis represents higher satisfaction.
In the diagram IC 1 represents lower satisfaction and IC2 represents

higher satisfaction.
This is because on higher IC the consumption increases and on lower IC
consumption decreases.
It can be seen that for the same amount of Y the consumer gets +2 on IC2
and gets -2 on IC1. Higher the consumption higher the satisfaction and
lower the consumption lower the satisfaction
2. Indifference curves never touch the axis. By touching the axis the
indifference curve will represent only one good. In fact an IC should
necessarily represent two goods always.
3. Indifference curve is a down ward sloping curve. It slopes down

from left to right. A consumer has to sacrifice one goods to gain the

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other. This is essential to keep the level of satisfaction constant on an

IC.
4. On an indifference curve the marginal rate of substitution decreases.
The marginal rate of substitution, is the rate at which a substitutes one

commodity with the other.
By gaining one commodity the consumer shall sacrifice the other. This is
needed to keep the level of satisfaction constant on an IC.
the slope of an indifference curve, MRS = ∆y/∆x.
The marginal rate of substitution decreases on an IC. On the diagram it

can be seen that
On the upper half, the consumer sacrifices 4 Y for 1 X, that is the rate of
substitution is 4/1

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On the Lower half it can be seen that the rate of substitution is 1/ 4 i.e. the
consumer equates 1Y with 4 X.
This is because on the upper half the consumer has more of Y so he likes
more of X and lower half he has more of X so he likes more of Y.
In this process the rate of substitution decreases from 4/1 to 1/ 4.
On an IC the consumer expresses his utility behavior through decreasing

Marginal rate of substitution.
Comparing the IC analysis and the Utility analysis it can be seen that
the marginal rate of substitution is equal to the ratio of the marginal
utilities,
MRS = ∆Y = - MUx
∆X MUy
5. An indifference curve is convex to the origin. Only on a convex curve
the marginal rate of substitution decreases. Slope of an IC is found by
drawing a tangent. The slope of the tangent is the slope of IC at that
point.
On a concave curve the slope of IC increases that is MRS increases. So it

is not an IC. Similarly, a straight line has constant slope or constant MRS
hence not an IC.

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A curve convex to the origin has decreasing slope or decreasing MRS,

hence, an IC.
6. Indifference curves need not be parallel. Converging indifference

curves are accepted to be correct.
7. Indifference curves do not intersect. Indifference curves need not be

parallel. Converging indifference curves are accepted to be correct but
they shall not intersect. Intersection of Indifference curves is considered
to be illogical, inconsistent and irrational.
In the diagram it can be seen that
Combination A gives larger satisfaction, because it is on a

higher indifference curve IC1
And
Combination B gives smaller satisfaction, because it is on a
lower indifference curve IC2
But
Combination C gives same satisfaction, yet it is on two
indifference curves IC1 and IC2.
Two indifference curves can not give same satisfaction. This is illogical,
inconsistent and irrational.
Foundations of Assumptions of Indifference curves:
Indifference curve analysis is based on the following assumptions:

1. Transitivity: It is assumed that the combinations are continuous
to form a curve. The combinations between two tested sets are
given.

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2. Ordinality: The indifference curve analysis considers ordinal

measure of utility. That is utility is compared but not qualified.
2. Rationality: The consumer is rational. He always prefers higher
satisfaction to the lower and he knows all the combinations
giving him same satisfaction or different satisfactions.
3. Convexity: A convex indifference curve represents the consumer
behavior. The convex IC shows the utility behavior with out
actually measuring utility in cardinal terms.
4. Scale of preference: On a series of indifference curves the
consumer has a preference increases from low to high. The
consumer always prefers higher satisfaction to lower. This is
called the scale of preference.
Price Line
The price line represents the budget of the consumer. It is made up of the
money income of the consumer and the prices of two goods. The price
line deals with various combinations of two good that a consumer can
buy with in his limited income. This is only the possibility of buying and
does not represent the choice of the consumer. Given the price line, the
consumer can buy any combination on the line or combinations below the
line.
When the price of a good decreases the real income of the consumer
increases. Real income is what the consumer can buy with his money
income. With this, the price line will shift upwards on a single axis (shift
on X axis if the price of X decreases)

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Similarly, if the money income increases the price line will shift upwards
parallel on both axes.
Consumer equilibrium
The consumer equilibrium suggests the method in which he consumer can

maximize satisfaction with in the given limitations of money income and
prices.
The indifference curve analysis is an improvement over the utility

analysis. It is given by Hicks and RGD Allen. As an improvement IC
analysis uses ordinal measure of utility in place of cardinal measure.
Assumptions
Consumer equilibrium is based on the following assumptions:
1. The prices of two goods are given and constant.
2. The money income of the consumer remains constant
3. The tastes and preferences of the consumer remain same
4. The consumer is rational, i.e. the consumer prefers larger satisfaction
to smaller satisfactions.
5. The theory follows all the foundations of indifference curves, like
convexity, transitivity, ordinality and scale of preference.
The consumer equilibrium considers the indifference map and the price
line.
The indifference map represents the consumer behavior, tastes and
preferences of the consumer. On the other hand the price line represents
income and the prices of two goods.
The indifference curve is made up of combinations the consumer wants to

consume on the other hand the hand the price line denote the
combinations the consumer can buy. Consumer equilibrium determines

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such combinations which the consumer can buy, those which he likes and
finally gets maximum satisfaction.
The consumer equilibrium is derived by combing the indifference curves

and the price line.
In the diagram
IC3 is possible because the consumer can not reach this with
his limited income.
IC1 is possible because there are several combinations with
in the budget; price line
IC2 and the price line have one combination common. At the
point of tangency between the IC and price line i.e. E.
This is the consumer equilibrium. A combination which offers maximum
satisfaction and is also falls with in the price line.

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Conditions of Consumer Equilibrium

The consumer equilibrium is found at a place where Indifference Curve
(IC) and Price Line (PL) are tangential.
Slope of the price line = Slope of the Indifference curve

Or Slope of the price line = Marginal Rate of substitution
[Equilibrium condition]
In the diagram
E1 is not equilibrium because slope of IC > Slope of PL
E2 is not equilibrium because slope of IC < Slope of PL
At E Slope of IC= Slope of PL, hence equilibrium
There are two conditions of consumer equilibrium

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a. Necessary Condition: Tangency is a necessary condition.

It is case of optimizing satisfaction. In the diagram E2 is a
necessary condition. Yet it is not the equilibrium.
b. Sufficient condition: Tangency + convexity is sufficient

condition. Tangency represents mathematical
optimization and convexity denotes consumer behavior. In
the diagram E2 is necessary condition. It fulfills tangency as
well as convexity.
Such consumer equilibrium remains valid as long as the price and money
income remain unchanged.
Income Effect
Income effect shows the effect of changes in the money income of a
consumer on his consumption.
All other things remaining constant if the money income of the consumer
increases, the price line will shift upwards parallel. An upward shift of
price line indicates an increase in the income. With an increase in the
income the consumer will consume more. The IC will shift upwards on
the new price line. The increase in the consumption of a commodity is
called income effect.
When the money income increases the consumer shifts on to IC2. The
increase in consumption of X is called income effect. If we join the points
of equilibrium an income consumption curve can be drawn.
Income consumption curve shows changes in the consumption of a

commodity for changes in money income. The nature shape of the ICC
indicates the nature of commodity, whether normal good, inferior or
Giffen’s good.

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With increase in the money income if the consumption increases it is

called positive income effect and if consumption decreases with
increasing income it is called negative income effect.
The nature of income effect determines the shape of the Income

Consumption Curve.
ICC1: If the ICC slopes upwards to the right both X and Y are normal
goods with positive income effect.
ICC2: If the ICC slopes backwards, Y is inferior with negative income
effect and X is normal with positive income effect.
ICC3: If the ICC slopes forwards to the right, X is inferior with negative
income effect and Y is normal with positive income effect.
Assumptions
Income effect is based on the following assumptions:
1. The prices of two goods are given and constant.
2. The money income of the consumer is given and subject to changes.
4. The consumer is rational, i.e. the consumer prefers larger satisfaction
to smaller satisfactions.
5. The theory follows all the foundations of indifference curves, like
convexity, transitivity, ordinality and scale of preference.
Substitution Effect
When the price of commodity decreases the consumer substitutes a
costlier commodity with a cheaper commodity with out affecting the level
of satisfaction. This is called Substitution effect.

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In the diagram, the movement from Eq1 to E2 is called substitution

effect. The consumer consumes more of X by sacrificing Y. The
movement is on the same IC showing that the level of satisfaction
remains same.
The substitution effect is always positive for normal as well as inferior
goods. For Giffen’s goods substitution effect is positive but very weak.
Substitution effect together with income effect constitutes the price effect.
Price Effect
Price effect shows the effect of changes in the price of a good on
consumption.
All other things remaining constant if the price of a commodity increases,

the price line will shift upwards on that axis. An upward shift of price line
indicates an increase in the real income. With an increase in the real
income the consumer will consume more. The IC will shift upwards on
the new price line. The increase in the consumption of a commodity is
called price effect.
When the price decreases the consumer shifts on to IC2. The increase in
consumption of X is called price effect. If we join the points of
equilibrium a price consumption curve can be drawn.
Price consumption curve shows changes in the consumption of a

commodity for changes in price. The nature shape of the PCC indicates
the nature of commodity, whether normal good, inferior or Giffen’s good.
Assumptions
Price effect is based on the following assumptions:

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1. The prices of two goods are given and the price of one good
only changes.
2. The money income of the consumer is given and constant.
4. The consumer is rational, i.e. the consumer prefers larger
satisfaction to smaller satisfactions.
5. The theory follows all the foundations of indifference curves,
like convexity, transitivity, ordinality and scale of preference.
Composition of Price Effect

Price effect is made up of income effect and substitution effects. When
the price of a commodity decreases:
a. The real income increases and the consumer consume

more of a commodity. This is called income effect.
b. When a commodity becomes cheaper the consumer has a
natural tendency to substitute the costlier commodity with a
cheaper commodity. This is called as substitution effect.
Thus, Price Effect= Income Effect+ Substitution Effect

In the diagram
E1 is the consumer equilibrium

With a decrease in the price of X the price line shifts upwards and
the consumer will shift on to IC2 at equilibrium E2. The
movement from E1 to E2 is called Price effect
To separate income effect from price effect-
Shift the price line parallel from E2 downwards, so as to reach IC1
at E3.
A parallel downward shift indicates decrease in the income.
The price line shall be shifted to such level on IC1 that the
consumer comes back on to his original level if satisfaction.

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With a decrease in income effect the consumption is reduced to E3,

The consumption from E1 to E3 is substitution effect, found on the
same IC.
According to Hicks the price line should be shifted on to lower IC

such that the ‘consumer is neither better off nor worse off’
Nature of Price Effect

Positive price effect means with a decrease in the price the consumption
increases. This is same as the law of demand. The exception to the law of
demand is negative price effect.
The price effect is positive for normal goods and inferior goods. There
are some inferior goods where the price effect is negative. These goods
with negative price effect are called Giffen’s goods.
The price effect depends on the components - income and substitution

effects.
Income Effect Substitution Effect Price effect

Normal Goods +ve +ve +ve
Inferior goods -ve (weak) +ve (strong) +ve
Giffen’s Goods -ve (strong) +ve (weak) -ve

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For normal goods the price effect is positive because the components
income and substitution effects are positive.
Inferior Goods
In case of inferior goods in general, the price effect is positive.
The income effect is negative but very weak. The substitution effect is
positive and very strong. So finally, the price effect remains positive.
In the diagram:
The movement from E3 to E2 is negative income effect. This is
negative
The movement from E1 to E2 is positive substitution effect which
positive and strong.
So, finally, the movement from E1 to E2 is positive price effect.
Inferior goods in general follow the law of demand with positive price
effect.
Giffen’s Goods

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Giffen’s goods are those inferior goods where the income effect is
strongly negative and substitution effect is weak.
Giffen’s goods re inferior goods but all inferior goods are not Giffen’s
goods. Giffen’s goods are those inferior good which have a negative price
effect.
In the diagram:
The movement from E3 to E2 is negative income effect. This is
negative and strong
The movement from E1 to E2 is positive substitution effect which
positive but week.
So, finally, the movement from E1 to E2 is negative price effect.
Derivation of demand curve from Price Consumption Curve

For drawing the demand curve there is a need for a set of prices and
corresponding quantities. The Price Consumption curve shows different
price lines. Each price line represents one price of commodity X. The
corresponding quantities can be read fro the X axis at different
equilibriums.
The quantities from different equilibriums are drawn on the lower graph
with X axis marked quantity. The price at different quantities can be
plotted on the Y axis. By joining all the points the demand curve can be
drawn on
the lower panel.

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Elasticity of Demand
Elasticity of demand measures intensity of changes in the quantity of a

commodity for changes in the price, income or the price of a related
commodity. Accordingly, it is called price elastic, income elasticity or
cross price elasticity of demand.
Price Elasticity of demand

Price elasticity of demand measures proportionate changes in the quality
of a commodity for proportionate changes in the price.
Price elasticity relates quantity demanded and the price.
Price elasticity is measured as
The price elasticity has a negative value, because the price decreases for
an increase in the quantity demanded.
ep = 1, Unitary elastic, reference elasticity
ep > 1, Relatively elastic, luxury goods
ep < 1, Relatively inelastic, necessary goods
ep = ∞, Perfectly elastic, hypothetical
ep = 0, Perfectly inelastic, hypothetical

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The value of elasticity changes with changing responsiveness of quantity

changes for changes in the price. Larger the responsiveness greater will
be the elasticity. No change in the quantity the elasticity will be zero. For
highly sensitive quantity, the elasticity will be infinity.

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Income Elasticity of demand

of a commodity for proportionate changes in the income.
Income elasticity relates quantity demanded and the income.
With an increase in the income the consumer increases the consumption.

This happens in case of normal goods. Incase of inferior goods with
increase in the income the consumer degreases the consumption. This is
called negative income effect.

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For normal goods the value of income elasticity is positive for inferior
goods it is negative,
ey = 1, Unitary elastic, reference elasticity positive income effect

ey > 1, Relatively elastic, luxury goods positive income effect
ey < 1, Relatively inelastic, necessary goods positive income effect
ey < 0, Inferior goods negative income
effect
ey = 0, Perfectly inelastic, hypothetical
ey = ∞, Perfectly elastic, hypothetical
Cross Price Elasticity of Demand

of one commodity for proportionate changes in the price of a related
commodity.

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Cross Price elasticity relates quantity demanded of one commodity and

the price of a related commodity.
The value of cross price elasticity depends on the type of relationship

between the goods.
exy < 0, Complementary goods

When the price of X increases, the demand for x decreases, the consumer
decreases the demand for Y. Since, X and Y are complementary goods.
Complementary goods are those which give utility only in combinations.
These are called joint goods having joint demand. e.g. shoe and shoe lace,
pen and ink
exy > 0, Substitute goods

When the price of X increases, the demand for x decreases, the consumer
increases the demand for Y. Since, X and Y are substitutes.
Substitute gods are those goods which give similar utility. Since the
goods give similar utility the consumer can consume one in the place of
the other.
exy = 0, Unrelated goods

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If the price of X increase the demand for Y remains unchanged this is

because the goods are unrelated and independent in consumption and
utility.
Point Elasticity of Demand

According to Lucas all goods tend to be elastic at higher prices and
inelastic at lower prices. This principle can be shown geometrically on a
demand curve using point elasticity of demand method.
It is ratio of lower segment to the upper segment.
The elasticity increase as it moves upon the demand curve to the left.
The demand curve is extended on both sides so as to make a right angle

triangle.
Then the elasticity at point is measured as
E= Lower segment
Upper segment
Or BC
AB
So
e = 1, Unitary elastic, reference elasticity
e = 0, Perfectly inelastic, hypothetical
e > 1, Relatively elastic, luxury goods
e < 1, Relatively inelastic, necessary goods
e = ∞, Perfectly elastic, hypothetical
Promotional Elasticity of Demand
Promotional elasticity of demand measures proportionate changes in the

sales of a commodity for proportionate changes in the promotional
budget.
Price elasticity relates sales and the promotional budget.

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Promotional elasticity is a managerial tool of corporate decision making.

It enables the enterprise to decide whether a sales promotion budget is
desirable or not in terms of generating corporate incomes and sales.
An elastic promotional elasticity means that the sales are in larger

proportions than the promotional budget and desirable. If the promotional
elasticity is less than one that inelastic it means that the promotional
budget has failed in promoting proportionate sales, hence undesirable.
The promotional budget may have components like media, advertising,
sales promotions, free samples, gifts, promotional offers etc.
Consumer Surplus
Consumer surplus is the excess of Utility drawn over the price paid.
According to the law of demand the price decreases with increasing
quantity. This is because the utility decrease with in creasing
consumption as per the law of diminishing marginal utility.
A consumer pays the price according to the utility drawn on the last
commodity. This price is uniform for all the earlier units. In this process
the consumer derives surplus utility over the price paid on earlier units.
This surplus utility is called the Consumer Surplus.
Consumer surplus = Utility derived – price paid

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Consumer surplus is the excess of utility derived by consumer. The

producer surplus is the surplus of price charged by the producer over the
supply price. The supply curve shows that the price increases with
increasing quantity. The price is charged as per the last unit produced,
whereas the producer receives a surplus over the supply price. This is
called producers’ surplus. The producers’ surplus can be increased by
reducing consumer surplus. This is called consumer exploitation.
Assumptions
1. The concept believes in the law of diminishing marginal utility
2. The law of demand is considered for determining the price.
3. The price remains uniform.
4. The supply of goods is uniform.
5. The tastes of the consumer remain constant
6. There is perfect competition.
Limitations
The concept of consumer surplus has several limitations due to its rigid
assumptions.
1. The utility can not be measured
2. Consumer surplus can not be easily quantified.
3. Market imperfections deny consumer surplus to the consumer.

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4. Marketing techniques increase consumer surplus by showing greater

utility and then in crease price.
5. Consumer surplus encourages the government to levy tax.
Applications:
Consumer surplus is a very useful concept applied in marketing, product

design and pricing.
1. It helps in determining the price. Larger the consumer surplus,
greater the possibility of increasing the price.
2. The Government can determine tax based on consumer surplus.
3. Under monopoly, the producer charges different prices for the
same commodity depending on the consumer surplus. It helps
on price discrimination.
4. Necessities have larger consumer surplus than luxury goods.
5. Consumer surplus helps in demand forecasting.
Demand forecasting
Demand forecasting refers to future market situation. Demand forecasting

is an important technique of corporate decision making. It enables a firm
decide upon a commodity for production among several or helps in
understanding the future market of a given product.
Nature and significance of demand forecasting
1. Demand forecasting starts with defining the product or the

product mix. This will depend on the nature of firm and its
corporate image.
2. Once the product is decided the forecast will now describe the
buying objectives of the product. The buying objectives will
determine the target population for whom the product is being
produced.
3. The buying objectives will influence the product design, the cost
and ultimately, the price.
4. Depending on the product design, the inputs are drawn. The
factors need to be imported or domestically procured. The demand
forecast will provide the sources and the costs.
5. To define the market prospects the product is identified with the
product cycle. The product may belong to any of the states of
product cycle: interdiction, growth, competition, stagnation or

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decay. The stage to which the product belongs will determine the
selection of the product and forecast.
6. Specialized inputs and labour may require efforts in procuring
and training.
7. The production and delivery schedule is drawn depending on the
market. Seasonal good may have different delivery schedule as
compared with a regular good of consumption.
8. The price is decided and the cash flows are estimated. The sales,
revenue profits, costs and the rates of return are estimated for
period of three to five years.
9. The market is described with respect to risk of competition,
Government policy, future prospects. In case of any risk the
possible methods of overcoming risk will be indicated.
Such demand forecast will be useful for a firm in taking decisions.
Process of demand forecasting

The process of demand forecasting depends on the nature of product and
nature of firm. The process differs from firm to firm and product to
product.
1. The demand forecast has to first consider the corporate policy.

The product to be produced depends on the firm and the nature of
market image it carries.
2. There after the approach to demand forecast changes between an
existing firm and a new firm. An existing firm will have historical
data which can be used for future analysis, where as a new firm has
to generate relevant data from the market.
3. Depending on the product, firm and market the method of
demand forecasting will be selected. Thus a model is built with all
required parameters.
4. The tolerance limits are defined. These are the accuracy levels of
the forecast. The accuracy level will determine whether to accept
or reject the model.
5. The Model goes for sample testing in a limited region to see all
the needed information is got. The trial run will help in making
modifications to the model, if need be.
6. When the model is successful, the larger study is conduced and
the results are analyzed.
7. Finally, the forecast will provide projected cash flows for five
years to come. Notes, definitions are given together with risk and
methods to risk management. A detailed description on the market
trends and the prospects of the product to be marketed is appended.

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Methods of Demand forecasting

There are different types of demand forecast each meant for a specific
objective and has a specific data requirement and ha specific information
to offer.
The methods of demand forecasting can be classified into two groups:
A. Statistical or Quantitative methods of demand forecasting
B. Survey methods of demand forecasting
A. Quantitative OR Statistical methods of Demand forecasting

Quantitative methods of demand forecasting need a large data base for
analysis. It is more suited for older firms with historical data. Quantitative
methods provide accurate results but skills in analysis and interpretation
will it more effective.
Some of the quantitative methods are static and consider only limited
variables. The active forecasts use highly developed mathematical tools
of analysis and provide accurate and dependable results.
1. Linear equation
Linear equation is the simplest of quantitative methods of demand

forecasting applied on time series data. It assumes a constant rate of
change of sales and based on the change coefficient, the sales for any
future year is estimated.
Illustration
Given, initial sales (a) of 1500 tons and an annual increase (b) of 500
tons, the out put can be estimated for any future year, with the equation:
Sales, Y = a + bt,
Where a is the initial sales, b is the annual expected change and t is the
time period.
The projected sales after 5 years will be
Sales, Y = 1500 + ( 500 x 5 )

= 1500 + 2500
= 3,500
The linear equation is a static method of quantitative demand forecasting.
It assumes a constant rate of change. Though it is not the most accurate
method, it is commonly used as preliminary estimate.

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2. Trend line
Seasonality is a characteristic of time series data. It prevents the usage of
any liner method of demand fore casting. For this reason, the data needs
to be corrected for the seasonality before any method is applied.
The seasonality is time series data can be corrected in different ways. One
method is applying the statistical method of trend fitting or least squares
method.
A trend line is fitted in such a manner that the positive variations are
same as the negative variations. In other words the trend should be an
average of the seasonal changes. In other words the trend line should be
so fitted that the square of the deviations is least.

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3. Moving averages
The seasonality is time series data can be corrected by applying the

statistical method of moving averages. The date is studied to first find out
the period of seasonality. Then a moving average is calculated by taking
average of that period, sequentially, each year. Each year one earlier
observation is dropped and a later observation is included. This way, the
set of averages of the reference period is computed.
Normally, after applying the moving averages the trend becomes clear. If
the trend can not be found the moving averages is repeated with different
time period or on the same period again.
In the illustration a moving average of three years is applied and the trend
is brought out.
4. Regression equation
Regression equation deals with the relation between the quantity
demanded and the factors determining it. The process begins with the
demand function
Quantity demanded, Qd = f( P, Pc,T,A)
Once the demand function is identifies the nature of effect is describes

and the intensity of relation is qualified in terms of figures. Then the
regression equation is cast as an input output relation

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Quantity demanded, Qd = a – 0.8 P + 0.3 Pc + 0.2 T + 0.9 A + E
Where, P - is the price Pc - the price of the competitors, T - tax , A -

advertising, and E - stochastic variable, explaining the change not
explained by the existing variables
With this equation all the factors re brought out. The demand forecast can
be managed with the help of these parameters.
B. Survey methods of demand forecasting

The survey methods of demand forecasting provide descriptive analysis.
The method is suitable for consumer gods, for firms which are new.
Hence there is no need for historical data, the methods uses cross
sectional data.
There are several survey methods which collect information from those
whose decisions determine the market demand.
1. Consumer survey
The consumer survey collects information form the consumer directly on
the nature of product price payable, qualities and attributes, the position
of a given product with respect to other competing goods, customer
satisfaction and the utility.
The consumer opinions can be collected in questionnaire designed

specific to the purpose and the opinions can be solicited in three different
ways.
a) By mail: Collecting information from consumers through post

is most economical and the methods can provide large
information. This method gives enough time for the
respondent. But the method may consume more time and
information can be, at times, spurious.
b) By telephone: Telephonic interviews help in getting candid
opinions. This method gives quick results and it is very
economical. However the method may be confined to those
consumers having telephone facility.
c) By personal interviews: Interviews are by far the best method
of collecting consumer opinion. The method can provide more
information than the study expect. However, the method can
be very expensive and time consuming

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2. Expert opinion study

This is also called the Delphi methods. The method depends on the
opinion of experts in determining the nature of demand forecast. In case
of certain good, the consumer opinions may not be important. The
consumer may depend on the experts for advice. Medicines, sport
equipment, text books, health drinks belong to this category.
3. End use study

The method collects opinions of the user sector in estimating the demand
for a given product. The method is suitable for industrial products/
intermediate goods; those goods which become input for some other firm
to become consumer goods.
For such goods the demand for the end product will determine the
demand for the intermediate goods.
E.g. steel, cotton, cement etc.
4. Simulated market / Consumer clinics

Simulated market is a model market which represents the actual market.
In a simulated (artificial) market the consumers are let in predetermined
amounts of money. The consumers buy goods with this money. The
choice of the consumers provides valuable and most dependable
information for the study. This method is most dependable, accurate and
quick in giving information
5. Export potential study

Export potential studies generally apply linear models with large
descriptive notes on the cultural pattern of consumption and
Government/local practices. These are statistical models as well as
opinion studies.
Active and Passive forecasts

Quantitative methods provide accurate results but skills in analysis and
interpretation will it more effective.
Some of the quantitative methods are static and consider only limited
variables. The active forecasts use highly developed mathematical tools
of analysis and provide accurate and dependable results.
Static fore casts are simple mathematical models which are mostly used
for the ease. They provide quick estimates for preliminary studies.
Active forecasts are non linear models which are advanced models using
more variables. They provide dependable estimates.

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In the diagram it can be seen that a and b are active forecasts for similar
static forecast. As non linear forecasts they can show larger variation in
rate of change. A static model is a linear relation which can give only an
average growth.
Features of an ideal demand forecast
An ideal demand forecast should fulfill the following characteristics:

1. Accuracy: A demand forecast shall be accurate. Te accuracy is
given by the tolerance limit. The percentage of tolerance will
determine the accuracy.
2. Comprehensive: A comprehensive demand forecast will provide
details on the product, product mix and a detailed study f the market.
The risks and the prospects for growth shall be also made clear.
3. Economical: The cost of conducting survey shall be low so that
the demand fore cast will be in the reach of even the smaller firms.
4. Time: The demand forecast shall take as little time as possible so
that the data and analysis remain relevant to the market and the
policies of the Government.
5. Flexibility: The demand forecast shall be flexible enough to
accommodate small changes and also adjust itself to the need of
future demand forecasts.
6. Durability: A demand forecast shall be durable. A good model of
demand forecast should be useful for a long time to come. Any
changes should be adapted as per the need in future.

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Module II: Theory of production

Production function
A production function provides the relationship between out put and

various factors of production. A production function is a functional
relation between the inputs and out put.
The production function can be classified as per time period. There can
be short run production function and the long run production function.
Between time periods the nature of factors can change.
In the long run all factors change; when all factors change there can be
large changes in the out put can be brought, the technology can change,
the cost structure may be totally renewed. So, the expression of long run
production function will be
Quantity of out put,

Q = f ( Labour, raw material, power, land, buildings, machinery /
T)
Where T, is technology; an embedded (associated) factor of production. It

is the qualitative description of capital,
In the short run certain factors are fixed certain other variable. Fixed
factors remain fixed even with changing out put. On the other hand
variable factors change with changes in the out put. So the expression of
production function will have fixed and variable factors.

Q, = f ( labour, raw material, power/ F , T)
Where F represents the fixed factors which remain unchanged in the short
run and T is the level of technology given and constant.
The short run production function will always carry the expression fixed
and variable, separately.
Law of variable proportions
The law of variable proportions studies the relationship between one

variable factor and the out put. It studies the behavior of out put for
changing variable factor. It deals with a short run production function

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with one variable factors with all other factors are given and kept
constant.
Q, = f ( labour / F , T)
Where F represents the fixed factors which remain unchanged in the short
run and T is the level of technology given and constant.
According to the law of variable proportions, ‘all other factors remaining

constant, if the usage of one variable factor increases, the out put will
increase rapidly, then slowly and finally decreases’.
Total Average Marginal Production Stages of production

Labour Product Product Product Elasticity
Units TP AP MP
1 5 5 0 Increasing
2 8 4 3 Ep>1 returns
3 15 5 7 I Stage
4 24 6 9
5 30 6 6
6 30 5 0 Ep<1 Diminishing returns
II Stage
7 28 4 -2 Ep<0 Negative returns
III Stage
I Stage: Stage of increasing returns

During the first stage the out put increase rapidly because
a. The variable factors become more and more productive, initially.
b. The fixed factors become more productive.
c. The elasticity of production is more than 1 ( Ep>1)
During the first stage AP, MP and TP are increasing. MP reaches a
maximum called as the point of inflexion. From this point onwards there
will be a change in the level of factor productivity.
At the end of the stage, AP=MP and TP continues to increase.
II Stage: Stage of diminishing returns

During the second stage the out put increase slowly because
a. The factor substitution becomes limited
b. Other factors become less and less productive
c. The elasticity of production is more less 1 ( Ep<1)
During the second stage AP decreases but it is slower than MP. Further,
MP<AP, MP decreases and TP is increasing, but slowly. At the end of the
stage MP=0

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III Stage: Stage of negative returns

During the third stage the out put decreases because
a. There will overcrowding of one variable factor
b. Fixed factors also become less productive.
c. The elasticity of production is less than o ( Ep<0)
During the third stage, AP, MP and TP are all decreasing.
Assumptions:
1. All factors re given and remain constant and only labour changes
2. The level of technology remains same.
3. There is perfect competition in product and factor markets.
4. Variable factors are of similar productivity.
Isoquants
An isoquant is made up of various combinations of two factors which
give rise to a fixed amount of out put.
Isoquant deals with a production function with two variable factors.
Output = f (K,L / F ,T)

where K - Capital, L – labour, F – fixed factors, kept constant in the short
run and T – the technology given.

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Each Isoquant deal with a specific level of out put. Isoquants away from
the origin represent higher out put and isoquants towards the axis
represent lower out put.
The Isoquant depends on the level of factor substitutability. Factors of

production are not perfect substitutes. The ridge lines give the limits of
factor substitutability. The area between the ridge lines is called the
economic zone. This is the area where there is factor substitutability. The
analysis is confined to this area alone. The area out side the ridgelines can
not be used for any study, because the factor substitutability ends.
The slope of the Isoquant represents the Marginal rate of technical

substitution (MRTS). It is the ratio of change in K for changes in L.
The Marginal rate of technical substitution is the manner one factor is

substituted by the other factor so as to give a fixed output through out the
isoquant. Such slope of isoquant depends on the nature of factors and
intensity of production.

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Producers' equilibrium (Least cost combination)
Producers’ equilibrium deals with a least cost combination of producing a

specific level of out put the producer would like to produce.
A producer will be a t a state of equilibrium when he produces a desired
level of out put at a cost which is least. This can be done by using
isoquants. By choosing isoquant we consider a production function with
two variable factors all other factors and technology remaining constant.

Where K - Capital, L – labour, F – fixed factors, kept constant in the short
Firstly the producer will determine the level of out put to be produced;
the isoquant is selected. The producers' equilibrium is found at a place
where the slope of the isoquant is same as the factor price ratio line.
Mathematically, the slope of the isoquant is equal to the slope of the price
ratio line. Or the slope of the price ratio line is same as the Marginal rate
of Technical Substitution.
The producers' equilibrium finds the least cost combination. Least cost
combination is the combination of two factors which will produce a given
level of out put at least cost.
There are different least cost combinations for different levels of out put.

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Assumptions
1. Producers’ equilibrium considers a production function with two
variable factors.
2. The level of technology remains same
3. All other factors are given and constant
4. There is perfect competition in factor and product markets.
The prices of two factors are given and remain unchanged.
Least cost combinations are found at different levels of out put by

following the condition of producers’ equilibrium. When all the points of
equilibriums or the least cost combinations at different levels of out put
are joined, the production path or the scale line can be derived.
The shape and position of the scale line will indicate the type of
technology or the intensity of factor usage. If the production path is
towards the capital axis it is capital intensive, if it is toward the labour
axis the technology is labour intensive.

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Laws of Returns to Scale
The laws of returns to scale deals with the long run production function.
In the long run all factors change; when all factors change there can be
large changes in the out put can be brought, the technology can change,
the cost structure may be totally renewed. So, the expression of long run
production function will be

Q = f ( Labour, raw material, power, land, buildings, machinery /
T)
Where T, is technology; an embedded (associated) factor of production. It

is the qualitative description of capital,
According to the laws of returns to scale -

In the long run when the scale of production increase,
a. The out put may increase in larger proportions than the inputs
used called Increasing returns to scale
OR
b. The out put may increase in the same proportions as the inputs
used called Constant returns to scale
OR
c. The out put may increase in lesser proportions than the in puts
used called Diminishing returns to scale.
The laws of returns to scale can be explained with the help of isoquants.
By choosing isoquant we consider a production function with two
variable factors all other factors and technology remaining constant.

Where K - Capital, L – labour, F – fixed factors, kept constant in the short
1. Increasing returns to Scale

According to Increasing returns to scale
In the long run when the scale of production increase, the out put may
increase in larger proportions than the inputs used called increasing
returns to scale

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Increasing returns to Scale
- The gap between E1, E2, E3,

and E4 decreases
- Economies of scale
- Decreasing costs
The out put responds positively because; it operates on economies of

scale. In the long run the firm derives certain advantages called
economies of scale. These economies of scale can come from within
called internal economies or come from out side the firm called external
economies.
Due to economies of scale the costs keep on decreasing. This is called
decreasing costs.
In the diagram it can be seen that the gap between the isoquants keep on
decreasing thus showing that lesser and lesser factors are needed for
producing additional output.
2. Constant returns to scale

In the long run when the scale of production increase, the out put may
increase in the same proportions as the inputs used called Constant
returns to scale
Constant returns to Scale
- The gap between E1, E2, E3,

and E4 remains constant
- Neutral Economies of scale
- Constant costs

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In case of constant returns to scale the out put increases in the same
proportions as the inputs. The firm is a said to be operating on neutral
economies. The firms neither get nor loose any advantages due to large
scale production.
In the diagram it can be seen that the gap between the isoquants remain
constant thus showing that same ratio of factors are needed for producing
additional output. The per unit costs remain constant. This is case of
constant costs
3. Diminishing returns to scale.
In the long run when the scale of production increase, the out put
may increase in lesser proportions than the in puts used called
Diminishing returns to scale.
Diminishing returns to
Scale
- The gap between E1, E2,
E3, and E4 increases
- Diseconomies of scale
- Increasing costs
The out put responds discouragingly, because; it operates on

diseconomies of scale. In the long run the firm may face certain
disadvantages called diseconomies of scale. These diseconomies of scale
can come from within called internal diseconomies or come from out side
the firm called external diseconomies.
Due to diseconomies of scale the costs keep on increasing. This is called
increasing costs.
In the diagram it can be seen that the gap between the isoquants keep on
increasing thus showing that more and more factors are needed for
producing additional output.

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Assumptions:
1. It is case of long run production function
2. The scale of production increases
3. Technology remains same
4. There is a perfect completion in factor and product markets.
5. Each isoquant represents a fixed increment of output.
Economics of Scale
In the long run all factors becomes viable and the firm can increases its
scale of production. When the firm increases the scale of production it
gets certain advantages. These advantages are called economies of scale.
A. Internal economies of scale

These are the advantages the firm gets from the factors within the firm.
These factors are endogenous to the production function.
1. Managerial economies: In the long run the firm will have better
managerial talent in organizing factors for better productivity.
2. Technical economies: The firms will have improved
technology in the long run and the firm will progressively
reduce costs.
3. Economies of by product: The firm will be able to develop
waste into marketable by product in the long run. This will
add to the revenues of the firm.
4. Economies of supervision: Better supervision will improve the
factor productivity in the long run.
5. Economies of cost: With improved supply chain and labour
productivity the costs will reduce in the long run.
6. Economies of integration: In case of forward integration the
firm will undertake an additional process of production and
add value o the out put. The revenue will increase
Similarly, backward integration will enable a firm produce
such factors which were earlier bought form the factor
markets. This again reduces the cost and adds to the profit
margins.
7. Risk bearing economies: Firms will greatly increase capacity to
take risk with new products and technologies in the long run.
This is due to established market and strong finances.
8. Economics of specialization: The firm may develop certain
specialization in the long run depending on the production
function and acceptance in the market. This may create niche
and better price.

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B. External economies of scale

These are the advantages the firm gets from the factors out side the firm.
These factors are exogenous to the production function.
1. Economies of marketing: The firms will be able to market with
ease due to establishment of brand and dealership network
2. Economies of finance: The firms will have better financial
position in the long run due to accumulated profits. The firm will
also have better institutional axis for raising more finance easily.
3. Economies of environment: In the long run the firm becomes
more environmentally friendly with larger investment on
pollution control and resource conservation
Economies of Scope
Economies of scope deals with the advantage a firm receives by

producing a product mix of two goods instead of two firms producing
them separately.
When a single firm produces two products it gets advantages arising out
of production function, managerial and technological reasons.
In the diagram, the linear curve denotes the combinations of two

products the firms can produce separately. If the firm produces together
the production possibility is found on the concave curve. The advantage
of producing together is marked as extra.
The rate of advantage can be measured as

C(a) + C(b) – C (a+b)
C(a+b)
Where, C(a) – cost of product a , C(b) – cost of product b, C(a+b) – cost
of products a and b.

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This is different from the economies of scale a firm enjoys in the long
run. This advantage of scope can be derived by a firm even in the short
run. This is the advantage of having multiple product mix instead of a
single product.
There are several concepts of cost developed, each suitable for a different
purpose. There are financial cost and social costs, accounting cost and
economic costs, short run and long run costs and the opportunity cost.
1. Accounting cost and economic costs: Accounting costs consider

documentation of expenditure for purpose of future analysis. It is
the analysis in retrospection. The analysis deals with spent money.
As against this, the economic cost study the nature of costs, their
behavior and methods of optimizing cists for minimizing cost of
production and maximizing profits.
2. Financial cost and social costs: Financial costs are private costs, the
costs paid by a firm to procure factors for creating out put. The
major consideration is optimizing usage of factors for cost
reduction and maximizing profits.
On the other hand the social cost deal with the burden of
production on the society, environment, and resource conservation.
Most of the social costs can not be quantified. But these cots are
very important in terms of social objectives and justice.
3. Financial costs and physical costs: Financial costs are economic costs
mentioned in uniform value terms. Since all the factors are
mentioned in uniform terms, it is easy to apply any quantitative or
statistical method for regulating their usage and optimizing for
profits.
Physical costs on the other hand are factors mentioned in dissimilar
units. Since they are dissimilar in expression and quantitative, it is
not easy to apply techniques of quantitative analysis. Yet physical
costs are important for production planning and procurement of
factors.
4. Opportunity Cost: Opportunity cost is the cost of a factor in its
alternative use. This is the minimum which needs to be paid to
bring a factor in use. Any payment less than this will make the
factor leave the production function and join an alternative use.
The concept of opportunity cost is useful in determining the factor
price. The factor price needs to be equal to or greater than the
opportunity cost. Larger the opportunity cost higher will be the
factor price.
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Short run Cost curves

In the short run certain factors are fixed certain other variable.
Accordingly, certain costs are fixed and certain costs variable.
In the shot run there are three costs - total fixed cost, total variable cost
and total cost. In addition there are four per unit costs- average fixed cost,
average variable cost, average cost and the marginal cost.
Illustration: for a given TFC of 100 and TVC over 8 units, the costs will
be
Out TFC TVC TC AFC AVC AC MC

put
1 1000 100 1100 1000 100 1100 -
2 “ 180 1180 500 90 590 80
3 “ 240 1240 333 80 413 60
4 : 340 1340 250 85 335 100
5 “ 480 1480 200 96 296 140
6 “ 680 1680 166 113 179 200
7 “ 980 1980 142 140 282 300
8 “ 1480 2480 125 185 310 500
1. Total Fixed cost

The fixed cost remains constant in the short run at level of out put. The
fixed cost curve is a horizontal curve parallel to x axis. At zero level of
out put the total cost is equal to total fixed cost.
2. Total variable cost

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The total variable cost increases with increasing cost. The shape of the
variable cost curve is drawn form the law of variable proportions. This
it has three segments. At zero level of out put the variable cost is zero.
3. Total cost
Total cost = Total fixed cost + Total variable cost
The total cost is the sum of total fixed cost and total variable cost. At
zero level of out put the total cost is equal to total fixed cost. The
shape and size of total cost is similar to total variable; cost but it starts
form total fixed cost.
4. Average Fixed cost

Average Fixed Cost = Total fixed cost
Out put
Average fixed cost curve is a downward sloping curve. It keeps on
decreasing, but never touches the axis. It is asymptotic to x axis.
Geometrically, on this curve the product of coordinates always a
constant.
5. Average Variable Cost
Average Variable Cost = Total Variable Cost
output
Average variable cost is a broad U shaped curve; the shape of the
curve is drawn from the behavior of variable facto and the law of
variable proportions.
6. Average Cost
Average Cost = Total cost
Out put
Or Average Cost = Average Fixed cost + Average Variable
Cost

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Average cost curve is a U shaped curve; the shape is derived by the

combination AC and AVC. AC curve lies above AVC. Average cost is
minimum when AC = MC
7. Marginal cost
Marginal cost = TC (n-1) - TC n
Marginal cost curve is a J shaped curve. It passes through the minimum
point of AC. When AC=MC, Marginal cost is minimum. The shape is
derived from the behavior of marginal product in the law of variable
proportions.
The short run Average Cost Curve is a U shaped Curve

The U shape of the average cost curve is made up of three segments;
down ward part, change in the trend and upward trend:
a. Initially, AVC and AFC are both decreasing so the resultant

AC also decreases
b. There after, AFC continues to decrease but AVC increases.
There is a change it the trend. The decreasing curve now
changes trend towards increase.
c. Finally, the increasing AVC is stronger than decreasing AFC
and AC now continues to increase.
The Ac curve takes a U shape.
Further, Average Cost = Average Fixed cost + Average Variable Cost

So, the gap between AVC and AC is equal to AFC.
Long run costs

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The long run cost curves are derived from the short run cost curves. The
long run AC is derived from the short run AC. In the long run when the
scale of production increases, the AC curves shift down wards showing
decreasing costs. This is due to economies of scale. This is case of
decreasing costs
In the long run, when the scale of production increases, the AC curves
may shift horizontally to the right. This is due to neutral economies of
scale. This is case of constant costs.
In the long run when the scale of production increases, the AC curves
shift upwards showing increasing costs. This is due to diseconomies of
scale. This is case of decreasing costs

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The long run AC is made up of these three segments. Thus the LAC is
flatter than the SACs. The LAC is also called the envelope curve. For this
reason “The long run average cost curve is flatter than the
short run average cost curve.”
Long run Marginal cost curve passes through the minimum point of LAC.
Following are the long run factors responsible for flatter long run average
cost curve:
1. Population
Though population changes even in the short run. The effect of
population can be seen only in the ling run, by way of changes in
the pattern of demand and labor force.
2. Technology
Technology helps in the ling run in reducing costs and making
production function efficient.

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3. Alternative sources of raw material and energy

Alternative and cheaper sources of raw material and energy
change the production function and help in expanding out put and
making it economical.
4. Expanding markets
Expanding markets provide purpose for the industry to produce
and distribute. In the long run, mass consumption in the economy
increases.
Producers’ surplus
The producer surplus is the surplus of price charged by the producer over
the supply price. The supply curve shows that the price increases with
increasing quantity. The price is charged as per the last unit produced,
whereas the producer receives a surplus over the supply price. This is
called producers’ surplus.
Producers’ surplus is the area above the producers supply curve and
below the market price.
The producers’ surplus depends on the elasticity of factor availability,
factor prices, the demand for the goods and the Government regulation on
the price.
Large producers’ surplus will shift the burden of tax on to the seller.
Large consumer surplus will put he burden of tax on the consumer.
The producers’ surplus can be increased by reducing consumer surplus.
This is called consumer exploitation.
Assumptions
1. The quantity of supply increases with price
2. There is perfect competition in factor and product markets

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3. The is perfect knowledge on price quantity demanded and

supply
Learning curve
Learning curve refers to progressive decrease in the cost of production
over a period of time, as experienced by firms.
Learning curve shows the relationship between the cost of production and
time.
The costs tend to decrease with passing time because:
1. Repetitive production of a commodity leads to
specialization
2. The usage of raw martial becomes more efficient
3. Wastages in production can be reduced due to
specialization.
4. Supply chain improves and inputs will help better
productivity.
Learning curve is different from economies of scale. Economies of scale

are found in the long run where as learning curve can be experienced
even in the short run due to specialization
In the diagram there is a change in the incremental costs between a and

b. At b the incremental costs have become lesser than at a. This is the
learning curve.
Case study

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Section II
Module IV: Revenue concepts
Total revenue (TR): This is the revenue got by the firm by selling certain
amount of out put.
Average Revenue (AR): This is the average proceeds per unit. This is
same as the price. For this reason, the demand curve is same as the
average revenue curve.
Marginal Revenue (MR): This is the additional revenue got by affirm by

selling an additional unit.
Revenue relationships under perfect competition

The price under perfect competition is determined by the industry. A
single firm is too insignificant to determine the price. Larger number of
firms together determines the price. Under perfect competition the
number of firms is so large that no single firm can, alone, influence the
price.
A firm can produce only an insignificant part of the total out put. This is
the reason why a firm continues to get the same price at any level of out
put. It means that the fir has a demand curve with infinite elasticity.
Quality Price TR AR MR
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10

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Under perfect completion the firm is a price taker and it has to determine
that level of out put which will give maximum profits. The firm has also
AR=MR in revenue relationships.
Revenue relationships under imperfect competition
A monopolist faces a downward sloping demand curve: Under monopoly,

there is no distinction between firm and industry. The demand is direct on
to the firm. Incase of perfect competition, the industry faces down ward
sloping demand curve and the firm gets the perfectly elastic demand
curve. In case of monopoly the firm directly faced the downward facing
demand curve.
It means that the firm can sell more only by reducing price. With this
difference, the relation ship between AR and MR also changes
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
Relationship between AR and MR

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AR and MR are downward sloping curves. MR curve lies below AR

curve. MR curve cuts the plane below AR curve into two halves.
Geometrically, it has a property:
A perpendicular drawn on Y axis will show
ab = bc.
Relationship between Elasticity of demand and Revenues

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Where e – is the point elasticity of Demand, AR is average revenue and

MR is Marginal Revenue.
Objectives of Firm
The firm may have several objectives ranging from, economic, short run,
long run material and non material in nature. All objectives are important.
However the firm may decide its own priorities in objectives. Certain
firms may have material objectives significant certain other firms may
have normative objectives significant. Some objectives are uniformly
significant for all firms.
Following are some of the important objectives of a firm.
a. Economic objectives
Economic objectives are material objectives which may be short as well
as long run. Economic objectives are normally considered by all firms.
These economic objectives can be classified as follows:
1. Profit maximization:
Each firm tries to maximize profits. This is a universal objective for

firms. The firms aim at maximizing the difference between total revenue
and total cost.

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The firm will produce such out put which will give maximum
profit. The gap between TR and TC can be maximized by
drawing two tangents, one on each with same slope.
The slope of TC is MC and slope of TR is MR. By equating

slopes; MC is equated with MR.
So, MC=MR emerges as equilibrium condition for optimizing out
put for a firm.
Firms may aim at maximizing rate of profit or profit. The rate of

profit is maximized by pricing so that there is larger gross profit
margin. On the other hand maximizing profit may be attained by
maximizing out put.
2. Workers welfare
Workers welfare helps in maintaining harmonious
relationships and also maintaining high levels of productivity
and loyalty.
3. Consumer satisfaction
Consumer satisfaction helps in maintaining brand image,
market share, prevents defection of consumers to another
brand.
4. Investors benefit
In case of joint stock companies, the firm will aim at
increasing the net asset value of the company. Accordingly,
it will have a investor friendly policy in dividends and
bonus.
5. Specialization
Specializing in certain product or service will be useful in
establishing brand image, market share and growth.
6. Creating brand equity
Every firm aims at creating a brand and as large consumer
following as possible. This is in the long run interest of the
firm.
b. Long run objectives

1. Survival
The basic objective of firm is to survive in the long run. In
the long run the competition may increase, in such a market
the basic principle is to survive.
2. Market leadership

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The firm wills always aim at being the market leader. This is
a material objective as well as normative objective. In most
cases profit depends on this objective.
3. Increasing market share
The firms will initially aim at increasing market share. This
is the objective before aspiring for market leadership.
4. Growth: forward and backward integration
The firm may go for forward integration thus adopting an
additional process of production or take up backward
integration whereby, produce locally such component which
was earlier brought form the factor market.
c. Non material objective

1. Social responsibility
The forms may assume social responsibility as an important
factor. It is give back from the society from where the firm
makes a living.
2. Environmental protection
The firm may work in the direction of protecting the
environment. This is dome by being eco-friendly and having
less pollution.
3. Resource conservation
The resource conservation may help in reducing costs but it
also helps in reducing social costs. The society benefits form
resource conservation
4. Creating social infrastructure
The firm may create social infrastructure by constructing
educational institutions, hospitals, townships, and
aforestation.
Module V: Markets
Perfect Competition
Perfect competition refers to a competition between large umber of

buyers and sellers dealing in homogenous product at uniform price.
Features of perfect competition
1. Large number of buyers and sellers

The number of buyers and sellers should be so larger that no firm can
determine the supply or no single buyer can determine demand and no
singe person can determine the price.
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2. Homogenous product
The product is homogenous, so that no form has a reason to charge a
different price.
3. Free entry and exit of firms:
When there is free entry and exit of firms, the firms keep joining the
production as long as there are profits. With new firms joining the super
normal profits, get distributed among more and more firms.
At the same time when the profits decrease the less efficient firms leave
the industry. So in the long run, efficient firms which can operate at
normal profits only exist. In the long run the perfect competition has only
firm which operate on normal profits.
4. Perfect knowledge
The buyers and sellers have perfect knowledge of \demand, supply and
price.
5. Free mobility of factors of production
Free mobility of factors ensures that the cost of factors is same across all
the regions. Equal factor prices give all the firms same opportunity to
make profits and survive. So, efficiency of firms will determine the
profitability of firms.
6. No transport cost
The transport cost should be insignificant as compared wt the cost of
production. This is possible only when the firms cater to local markets.
7. No advertising
The firms need not advertise, because each firm will have infinite market
at the given price. Advertising will add to cost and reduce profits
8. Uniform price
Uniform price ensures that the consumers have choice between firms and
the firms have no reason to charge different price due to homogenous
product.
9. No Government restrictions
There are no government interventions by way of taxes or mobility of
goods.
Price determination under perfect competition (Industry)

The price under perfect competition is determined by the industry. Perfect
competition is a market condition where the buyers and sellers are
equally important in the determination of price. It is an ideal situation
whether both the buyers and the sellers are equally represented.

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Under perfect competition the price is determined by the firms and

buyers, no single firm or buyer can influence the price. The buyers are
represented by demand curve and the firms are represented by supply
curve.
The demand curve indicates

The choice and tastes of the consumers
The utility of the good
The utility behavior of the consumer
The capacity and willing of the consumer to pay the
price
Similarly, the supply curve indicates
The willing ness of the firm, to sell goods at different
price
The cost conditions
Nature of factor markets
Supply and demand curve together determine the equilibrium price. The
equilibrium price is the one which is acceptable to both buyers and
sellers. This is determined by the large number of buyers and spellers.
Price Quantity Quantity Supplied Market

demanded
10 600 1000 D<S Surplus
9 700 900 D<S Surplus
8 800 800 D=S Equilibrium

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7 900 700 D>S Scarcity

6 1000 600 D<S Scarcity
At P1 D<S, Goods are not being sold, price is high
At P2 D<S, there is scarcity, the firms do not accept low price
At P3 D=S, the price is acceptable to both sellers and buyers
This is the equilibrium price. The price remains unchanged as long as the
demand and supply remain constant.
Nature of perfect competition:
Demand and supply are both responsible in the determination of

equilibrium.
According to classical economics, the equilibrium is a natural process;
the demand and supply get equated automatically.
Perfect competition encourages efficiency of firms. It leads to efficient
allocation of resources.
Perfect competition is an assumption for all the theories of economics.
The equilibrium quantity and price remain unchanged as long as the
demand and supply remain constant.
Out put determination under perfect competition by a firm
Perfect competition is a market condition where the buyers and sellers are
equally important in the determination of price. It is an ideal situation
whether both the buyers and the sellers are equally represented.
The price under perfect competition is determined by the industry. A

single firm is too insignificant to determine the price. Larger number of
firms together determines the price. Under perfect competition the
number of firms is so large that no single firm can, alone, influence the
price.
A firm can produce only an insignificant part of the total out put. This is
the reason why a firm continues to get the same price at any level of out
put. It means that the fir has a demand curve with infinite elasticity.
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10

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Under perfect completion the firm is a price taker and it has to determine
that level of out put which will give maximum profits. The firm has also
AR=MR in revenue relationships.
Given, these condition the firm will optimize its out put at a point where
MC=MR,
Conditions of out put determination:

While maximizing out put the firm shall follow two conditions
I Order condition: MC=MR
II Order Condition: MC cuts MR from below.
At a point where MC=MR the difference between TC and TR will be
maximum.
The gap between TR and TC can be maximized by drawing two tangents,

one on each with same slope.
The slope of TC is MC and slope of TR is MR. By equating slopes; MC

is equated with MR.
So, MC=MR emerges as equilibrium condition for optimizing out put for
a firm.

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Nature of firm
A firm can make profits or incur losses depending on the price and costs.
A firm can earn profits; normal profits and super normal profits or incur
losses; maximum bearable loss and shut down condition. Each on of this
will determine the nature of firm. This is true in case of any firm, whether
perfect competition or imperfect competition.
Normal profit:
A firm is said to be making normal profit when AR = AC. The price (AR)
covers the costs. The cost includes the managers’ remuneration. However
there is no surplus above managers’ remuneration. If the entrepreneur
him self is the manager, he will receive normal profit as his share of
remuneration
Normal profit is also called ‘no profit no loss’ condition or break even
point in managerial economics.

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Super Normal profit:

A firm is said to be making supernormal profits if AR > AC. The price
charged by the firm covers all the costs and also generates a surplus over
the expenditure. In this case the firm receives the managers’ remuneration
(normal profits) and also a surplus over it. Hence it is called super normal
profits.
Losses
A firm is said to be making losses if, AR < AC. In case of loss there is a
need for further analysis. The firm needs to decide whether to stay in
production or shut down. In such a case Average variable cost (AVC) is
considered.
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Maximum bearable loss:

If AR = AVC the firm is said to be at maximum bearable loss.
The price received covers the AVC and the fixed cost is not covered. So
even if the firm closes down, in the short run the fixed cost remains as
loss. This is a case where, the loss remains same (fixed cost) whether the
firm stays in production or shuts down. This is called the maximum
bearable loss.
Shut down Condition

If AR < AVC, the firm needs to close down.
The price received fails to cover fixed cost as well as a part of variable
cost. So if the firm closes down the loss is equal to fixed cost. If the firm
continues to produce the loss will be fixed cost and a part of variable cost.
So, the firm can reduce losses by closing down. This is called Shut down
condition.

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Long run equilibrium under perfect competition
In the long run the following factors operate:
The supply becomes more elastic: With time, supply becomes more and
more elastic. So the price tends to decrease. The AR=MR received by the
firm also decrease. However, at the same time the average cost curve also
becomes flatter, showing decline in costs. Flatter AVC means more out
put being produced at lesser cost.
There is free entry and exit of firms: When there is free entry and exit of
firms, the firms keep joining the production as long as there are profits.
With new firms joining the super normal profits, get distributed among
more and more firms.
At the same time when the profits decrease the less efficient firms leave
the industry. So in the long run, efficient firms which can operate at
normal profits only exist. In the long run the perfect competition has only
firm which operate on normal profits.
The long run average cost curve becomes flatter than short run cost curve
Following are the long run factors responsible for changes in average cost
curve in the long run:
1. Population
Though population changes even in the short run. The effect of
population can be seen only in the ling run, by way of changes in
the pattern of demand and labor force.
2. Technology
Technology helps in the ling run in reducing costs and making
production function efficient.
3. Alternative sources of raw material and energy

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Alternative and cheaper sources of raw material and energy

change the production function and help in expanding out put and
making it economical.
4. Expanding markets
Expanding markets provide purpose for the industry to produce
and distribute. In the long run, mass consumption in the economy
increases.
Hence in the long run the equilibrium of the firm is arrived at a point
where:
LAC = MR (long run) = LMC = AR(long run)
Where
MR (long run) =MC represents determination of optimum out put,
LAC = LMC indicate the firm operating at optimum level, and
LAC = AR (long run) means the firm is operating on normal
profits
Monopoly
Monopoly refers to an imperfect market situation where a single seller

sells the product in different markets at uniform or discriminating prices.
Monopoly is identified with single firm large number of buyers and the
monopolist as the price maker.
Following are the features of monopoly market.

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Features of Monopoly
1. Single seller: The monopoly market has a single firm. There is no

distinction between firm and industry. Since a single firm supplies to the
large number of buyers, the firm tends to be large and specializing in its
production
2. Large number of buyers: There is a large market even under monopoly.
However there may be differences in the elasticity of demand in each
segmented market.
3. Product: The product may be homogenous or even differentiated
depending on the nature of market and division of submarkets.
4. Monopoly power: The entry into monopoly market for other firms is
restricted. This is due to the monopoly power the firm has. The monopoly
power is got by the firm due to following factors.
a. Legal restriction: The law may prevent other firms from
entering. E.g. Government monopolies on entry
b. Exclusive ownership of technology of production: If the
technology of production is known only to a single
firm the monopoly power remains un effected.
c. Exclusive ownership of raw material: Access to raw
material is held by a single firm, the monopoly
power remains intact
d. Registered trade marks and brands: I case of registered
trade marks; firms can not duplicate and compete in a
market. It remains as monopoly.
e. Personal monopolies: Personal monopolies have
individual branding. They can not be duplicated. The
personal monopolies continue
5. Price discrimination: With price discrimination a monopolist sells the
same product at different prices in different markets at the same time. The
objective of price discrimination is profit maximization.
6. A monopolist faces a downward sloping demand curve: Under
monopoly, there is no distinction between firm and industry. The demand
is direct on to the firm. Incase of perfect competition, the industry faces
down ward sloping demand curve and the firm gets the perfectly elastic
demand curve. In case of monopoly the firm directly faced the downward
facing demand curve.
It means that the firm can sell more only by reducing price. With this
difference, the relation ship between AR and MR also changes

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Relationship between Average revenue and Marginal revenue

under monopoly
A monopolist faces a downward sloping demand curve, so he can sell

more only by reducing the price. This will change the AR and MR
relationship. Since it is an imperfect market, AR is not equal to MR. It
can be seen that AR is greater than MR. Further, AR and MR are related
through elasticity of demand.
Q Price TR AR MR
1 10 10 10 -
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
Geometrically, AR curve cuts the plain below AR into two halves. So any
perpendicular drawn on Y axis will show the property, ab = bc
Equilibrium under simple monopoly
Under monopoly, the demand curve is downward sloping, so the AR and

MR curves also slope down wards and look different. However the
optimizing condition for out put remains same as in case of perfect
competition.

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At a point where MC = MR the firm finds its equilibrium out put. When
MC = MR the difference between TC and TR will be maximum.
The output is found on the x axis. The price determination is done by AR
curve. This is the demand curve which will tell the maximum price that
can be charged for this level of out put.
In case of simple monopoly, there will be only one product and single
price. In case of differentiated monopoly
Nature of firm
A firm can make profits or incur losses depending on the price and costs.
A firm can earn profits; normal profits and super normal profits or incur
losses; maximum bearable loss and shut down condition. Each on of this
will determine the nature of firm. This is true in case of any firm, whether
perfect competition or imperfect competition.
Normal profit:
A firm is said to be making normal profit when AR = AC. The price (AR)
covers the costs. The cost includes the managers’ remuneration. However
there is no surplus above managers’ remuneration. If the entrepreneur
him self is the manager, he will receive normal profit as his share of
remuneration
Normal profit is also called ‘no profit no loss’ condition or break even
point in managerial economics.

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Super Normal profit:

A firm is said to be making supernormal profits if AR > AC. The price
charged by the firm covers all the costs and also generates a surplus over
the expenditure. In this case the firm receives the managers’ remuneration
(normal profits) and also a surplus over it. Hence it is called super normal
profits.
Losses
A firm is said to be making losses if, AR < AC. In case of loss there is a
need for further analysis. The firm needs to decide whether to stay in
production or shut down. In such a case Average variable cost (AVC) is
considered.
Maximum bearable loss:

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Shut down Condition

If AR < AVC, the firm needs to close down.
The price received fails to cover fixed cost as well as a part of variable
cost. So if the firm closes down the loss is equal to fixed cost. If the firm
continues to produce the loss will be fixed cost and a part of variable cost.
So, the firm can reduce losses by closing down. This is called Shut down
condition.
Long run equilibrium under monopoly
In the long run the monopolist will find his equilibrium at a point where
MR (Long run) = MC (Long run)

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In the long run the AC curve becomes flatter an the firm will be able to
produce more out put at lesser cost.
At the equilibrium the monopolist can

Determine price P1 by restricting the out put at Q1. In this case the
monopolist will have super normal profits.
OR
Determine price P2 price with larger output Q2 and optimize the cost by
producing at minimum AC in the long run. In this case the monopolist
will have normal profits.
Monopolistic Competition
Monopolistic competition is a case of imperfect competition where

limited number of firms, compete with differentiated product at dissimilar
prices.
Following are the features of monopolistic competition:
1. Large number of buyers: The number of buyers is large. It is a large

market where firms compete.

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2. Limited number of firms: The number of firms remains limited due to

intense competition. The entry is not restricted by law, but competition
discourages new firms.
3. The prices need not be uniform. Each firm produces goods as per their
own market, so the product quality, utility differ. In such a case the prices
also differ.
4. Product differentiation
Product differentiation means the same product being projected different,
by modifying with additional utility, quality or term of sale.
The product differentiation is done in flowing ways:
a. By an additional quality: the firm may show a different quality
of the product which may not exist in the market. The quality
should be such that the utility of the product gets enhanced.
b. Additional quality: The product can be designed with an
additional utility. Products with different utilities have elastic
and larger demand. This is one method of improving the appeal
of the product. It is seen that dual utilities have improved the
quality of the product like the two-in-one products.
c. By different term of sale: the fir may offer a different terms of
sale. It may be by way of guarantees, after sale service, quizzes,
contests, prices, Etc.
The objective of price differentiation is to claim monopoly power in an

imperfect market. This is done by creating unique selling proposition.
Product differentiation means differences in cost. With differences in cost

the price also changes. Firms sell at different prices. The competition
between firms with different prices is called non-price competition. The
firms justify the price by either different image/ brand equity or by
different qualities/utility of the product.
Non-price competition benefits the firms. The consumer is made to pay

higher pries which are falsely justified through advertising.
5. Selling cost
Selling cost is the cost of generating demand. Under monopolistic

competition, the firms engage in non price competition. The firms
charging different prices justify their prices by advertising, publicity,
field campaign and similar promotional activities.

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Selling cot helps in generating demand, brand image and justifying the
price. Selling cost does not give utility. Selling cost is a burden on the
consumer.
Production cost on the other hand generates utility. The production cost
decreases with increasing out put in, proportion. This is due to economies
of scale. Whereas, the selling cost increases in larger proportions to
increasing out put. This is because, advertising becomes more and more
expensive, with increasing out put.
Selling cost makes demand elastic and shifts demand curve u wards.
In the diagram it can be seen that, selling cot has increased the average
cost. Yet, the demand curve has shifted upwards and also became elastic.
This is the advantage the firm receives by spending selling cost.
Wastages in Monopolistic competition
A comparison between perfectly competitive firm and that of imperfect

competition shows that there are wastages and exploitation under,
imperfect competition.
1. The price monopolistic competition is higher than the
competitive price. The AR being high at the equilibrium out put
the firm charges higher price.
2. The out put under imperfect competition is lesser than the
competitive output. By restricting the out put the firm can charge
higher price.
3. Imperfect competition leads to less than optimum size of out put:
The monopoly firm restricts the out put so that it can realize
higher price. In the process it produces less than optimum size of
out put. The firm will be producing at higher cost, but the price

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charged, will be much higher granting larger profits to the

monopoly firm.
4. Imperfect competition will lead to unfair competition.

Monopolistic competition has wasteful advertising. Advertising
leads to increases in cost and dos not yield any utility to the
consumer.
5. Non price competition leads to price exploitation of consumers.
Under non price competition the firms sell goods at different
price and justify higher price by advertising. In case of perfect
competition the prices are low and uniform.
Oligopoly
Oligopoly is an imperfect market condition identified with limited
number of firms with high interdependence competing with differentiated
or uniform product at uniform prices.
Following are the features of oligopoly market
1. Limited number of firms:
The number of firms is limited due to intense competition. The
industry remains as a small group of firms.
2. Large number of buyers

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The number of buyers will be very large. There will be huge

market for which the firms compete.
3. High degree of interdependence between firms

The firms will have high degree of interdependence in terms of
price and product design. The firms almost share the same
demand curve. However, the demand is made elastic or remains
inelastic depending on the nature of advertising.
No firm can deviate and change the product description. Any

change made by the firm will lead to the consumer shifting to
other competing firms. The demand remains very flimsy for a
firm. The demand is maintained carefully by maintaining the
same price, similar product details and advertising.
4. Rigid and uniform prices

The price will remain uniform and rigid. When the price is
accepted by the firms and the buyers, it continues for a long time.
A consumer will not pay a higher price because he can continue
to get the same price from other firms.
A firm will not reduce the price because the consumer is willing
to pay the given price. On the other hand reduction in the price
may be treated as a loss of quality. This is called as price illusion.
5. Advertising
Advertising is an essential part of oligopoly market. Advertising
is essential for registering the product with the consumer.
Advertising allows the product to have the required exposure to
the consumer so that the consumer can include the product in his
options.
Further, advertising make the demand elastic. By making the

demand elastic, the firm will be able to sell more goods at the
given price.
6. Types of oligopoly
There are different types of oligopoly each based in a different
marketing practices followed to manage competition.
a. Pure and differentiated oligopoly

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Pure oligopoly deals with goods are homogenous whereas

differentiated oligopoly may have apparent product
differentiation. The market offers flexibility the firms to change
the nature of the product keeping the base utility same. In ace of
pure oligopoly it is easy to maintain price uniformity. With
product differentiation, the price tends to change because of cost
variations. Even in theses conditions the firms need to maintain
the uniform prices. For this reasons the firma can only adopt
apparent product differentiation without changing the cost
structure.
b. Complete and partial oligopoly

Complete oligopoly refers to market where all the firms are
equally placed in terms of competition, price and market share.
Whereas in case of partial oligopoly, there can be one large firm
emerging as the leader. The leader will have the advantage of
giving a lead price to the product which other firma will follow.
The leadership firm will have the privilege of designing the
product, price and the nature of competition.
Pure oligopoly may at times change to partial oligopoly by

frequent mergers. Firms merge among themselves to form a large
firm so that a leadership role can be achieved.
c. Collusive and Non collusive oligopoly

Non collusive oligopoly refers to a market where the forms
operate independently, however with interdependence. In case of
collusive oligopoly, the firms may collide, enter into agreements
to lessen competition and share the market to exploit the
consumers.
7. Cartels
Cartels are a case of collusive oligopoly. Firms in market with
intense competition form arrangements to avoid competition by
making agreements so that all firms tend to benefit at the cot of
the consumer. Cartels are harmful business organization formed
to enhance exploitation and increase profits.
There can be different types of cartels depending on agreements.

a. In a cartel, the firms with high price may insist that its
price prevail, so that all firms can maximize profits.
b. At the same time the firm with lesser price may insist on its
price to be followed so that larger out put can be sold.

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These are price cartels. In both these cases competition is

avoided and market becomes lucid.
c. The firms may divide the market geographically and
restrict mutual entry in respective territory. In this case the
market has one monopoly firm selling the product.
d. The firms may have system of marketing royalties as
consideration for sharing territory for attaining monopoly
power. A firm operating in market as an exclusive
monopolist may have to pay market royalty to other firms
restricting entry.
The cartels can be operating at international levels, where the regions

are shared on the basis of trading currencies or countries. The counter
may form commodity agreements, bilateral agreements, and
multilateral agreements for a specific time. All these agreements
where the firms or the counties get captive markets belong to cartels.
Duopoly
Duopoly is a model of oligopoly market with two firms designed to study
the interdependence of firms for pricing.
Following are the feature of a model duopoly market:
1. Two firms:
The number of firms is limited to two. This is for the purpose of
studying the details of interdependence. Hence it is a model of
oligopoly.
2. Large number of buyers

The number of buyers will be very large. There will be huge market
for which the firms compete.
3. High degree of interdependence between firms

The two firms will have high degree of interdependence in terms of
price and product design. Two firms almost share the same demand
curve. However, the demand is made elastic or remains inelastic
depending on the nature of advertising.
Single firm can deviate and change the product description. Any
change made by the firm will lead to the consumer shifting to other
competing firm. The demand remains very flimsy for a firm. The
demand is maintained carefully by maintaining the same price,
similar product details and advertising.

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4. Rigid and uniform prices

The price will remain uniform and rigid. When the price is accepted
by both the firms and the buyers, it continues for a long time. A
consumer will not pay a higher price because he can continue to get
the same price from other firm. A firm will not reduce the price
because the consumer is willing to pay the given price. On the other
hand reduction in the price may be treated as a loss of quality. This is
called as price illusion.
5. Advertising
Advertising is an essential part of oligopoly market. Advertising is
essential for registering the product with the consumer. Advertising
allows the product to have the required exposure to the consumer so
that the consumer can include the product in his options.
Further, advertising make the demand elastic. By making the

demand elastic, the firm will be able to sell more goods at the given
price.
6. Kinky demand curve

The demand curve for the duopoly market is med up of the
individual demand curves of two forms. These are the demand
curves made by the firms by the independent advertising campaigns
and publicity.

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Yet the firms will have demand curves with different elasticities. The
demand curve for the market is made up of these tow demand curves.
The inelastic segment of the demand curve at lower price s and the elastic
segment of demand curve ay higher prices form the segmented demand
curve in duopoly.
It is learn in point elasticity of demand that all goods tend to be elastic at

higher prices and inelastic at lower prices.
The firms will be operating on the segmented demand curve which forms
a kink at P. P is the point which is common on both the demand curves.
This is the price which can be followed on both the firms.
P is the uniform and rigid price followed by firms under duopoly.
Case Studies
Illustrative case study I (Objectives of firm)
Tata group of Companies are regular in paying their taxes to the

Government. They have a clean track record of tax remissions over years.
In compliance with the environmental laws the company is serious and
has ISO 14000 certification. In general Hr management and productivity
is good with least attrition harmonious relations.
Customer care and customer relations are held high the company
documents reveal. However, the company has been making profits with
good dividend record and net worth.
Illustrative Case Study II (perfect competition)
Goldmine Inc. launched its new range of gold jewelry in Indian market.
In a market which is governed by seasonal demand and fluctuating gold
prices, Goldmine inc. had two product ranges. The ethnic designs which
were priced 12 percent more than the trendy designs.
Goldmine Inc joined the manufacturers’ guild to advertise for gold
jewelry and contributed 3 percent of its cost of production for common
product promotion.
Liberal gold import policy helped Goldmine keep its products in
competitive range.
Illustrative Case study III (Monopolistic Competition)

Dr.Ranga Sai
Venus Soaps and detergents entered the Indian market recently with its
new brand of toilet soap ‘Rainbow’. The soap had multiple layers, each
with a different color and fragrance. It claimed that the soap will provide
a variety of fragrances to alleviate the consumer from boredom.
The soap contained a small 10 mm plastic toy in it, which could be
revealed after continuous usage. The consumers are advised to collect
these toys and exchange for a larger 18” rose wood replica.
Three such rosewood replicas would entail the consumer for a cruise in a
luxury liner for ten days.
Being a new entrant in the market Venus soaps provided an
advertising/promotional budget of Rs 12 crores which is 18 percent of
market price of the product.
The price of the soap was priced at Rs. 18. The price is ten rupees more
than the average price of soap in the market.
Illustrative Case Study IV (Oligopoly- Collusive- cartel)
Swiss Spring Aqua bottles mineral water in India. The company found
that the product could not afford a lavish promotional budget due to
slender profit margins. However the company proposed a moderate
advertising budget of Rs 3.5 crores which could help register its product
with consumers.
Swiss Spring Aqua knew it no longer afford the advertising budget on a

regular basis, so it negotiated with a leading Indian company Aqua-pura
and bought territory right of Western India for a royalty of Rs 1.5 crores,
which is much less than it’s advertising budget.
Swiss Spring Aqua could sell the product at 10 percent higher price. With
a 40 percent market share now Swiss Spring Aqua could sustain price and
other companies hiked their price by ten percent.
Illustrative case study V (Monopoly)
Dr Anant Malhotra, a neurologist, treats Parkinson’s disease with

guarantee. He developed his own sonic pulsar for stimulating neural
activity. Two months basic treatment costs Rs 2,25,000. To visiting
patients from other countries the fees amount to $ 45,000.
Dr Malhotra has a nursing home where poorer patients are offered out
patient treatment for a fee of Rs.15, 000. Dr Malhotra runs Anant Ashram
at Neral where older patients are houses and treated free. He visits the
Ashram twice each week.

Dr.Ranga Sai
Break even Analysis
Break even out refers to the level of output where TR = TC. This is the
minimum out put the firm need to produce its costs. Any output there
after will grant profit to the firm. Usage of break even point for corporate
decision making is called Break even analysis.
At break even point total cost is equal to total revenue. After break even
point the profitability begins. The out put less than break even out put
shows losses.
Every firm aims at break even level of output in the beginning. The break
even level is a no profit no loss condition. In other words it is case of
normal profits. The costs cover only the manager’s remuneration and
there is no surplus over that. It is similar to the condition AR = AC.
At break even point there are no profits, so TR = TC

Dr.Ranga Sai
Where,
TR is total revenue
TC is total cost
P is price
AVC is average variable cost
TFC is total fixed cost
Q is out put
Break even analysis is based on the following assumptions

1. The cost and revenue functions are linear functions. This is for the
sake of simplicity.
2. The firm can estimate the cost and revenues in advance.
3. Price remains uniform at all levels of out put.
4. The costs are made up of fixed and variable costs.
Angle of Incidence
The angle of incidence is the angle made by the TR and TC functions at

the break even point. In break even analysis the angle of incidence is very
important in selecting a project among various competing projects.
The angle of incidence decides the nature of break even point.
If the angle of incidence is larger the break even out put will be smaller.
In other words, if the angel of incidence is smaller the break even out put
will be larger.
While comparing competing projects on the basis of break even points, a
project with larger angle of incidence will be selected. Because a firm
will always wishes to keep the Break even out put small so that, it can
operate on profits hat sooner.

Dr.Ranga Sai
Application of Break even analysis
A firm will firstly, attain the break even out put so that it can be out of
losses and start making profits.
However, the firm needs to allot revenues for different purposes

depending on the earnings of profit or revenue.
Firstly, the firm will slot revenue for depreciation on assets. Depreciation
is a nominal expenditure. It is that part of fixed assets that is consumed
during the year and that part of fixed cost that can be charged to the out
put. Depreciation is the first priority after attaining break even out put.
When a firm makes profits it has to pay taxes. The firm now provides for
taxes after deducting depreciation.
Thereafter, marketing overheads can be deducted. These marketing

overheads are for more than one year. So if the revenue permits the firm
may provide for durable marketing overheads.
Finally, the revenue in excess of all these provisions yield profits that can
be distributed among owners or retained as reserves and surplus.

Dr.Ranga Sai
Limitations
1. Break-even analysis is only a supply side analysis, as it

tells you nothing about what sales are actually likely to be
for the product at these various prices.
2. It assumes that the price remains uniform at levels of out
put
3. It assumes that fixed costs are constant
4. It assumes average variable costs are constant per unit of
output,
5. It assumes that the quantity of goods produced is equal to
the quantity of goods sold
6. In multi-product companies, it assumes that the relative
proportions of each product sold and produced are constant

Dr.Ranga Sai
Module VI: Pricing Methods
Marginal Cost Pricing
The Conventional pricing is followed when MC = MR, the price is

determined by AR curve. The conventional pricing is described by the
theory of firm and pricing. Independent of markets and competition the
pot put is determined by equating MC and MR. This as an optimizing
output will help in determining the price as per the AR (demand) curve.
Marginal Cost pricing: when AR=MC, the price is equated with Marginal
Cost. The Marginal cost pricing is more advantageous than conventional
pricing because, the out put tends to be larger than the conventional
method. Further, the price tends to be smaller.
This is the method followed by the Government in most administered

pricing methods.
Administered pricing refers to the pricing adopted by the government in

determining the price of a product independent of market and profitability
considerations.
The resources are put to efficient use when the price equated with MC.
The price is lower and the out put is higher.
Thus way the government can encourage the consumption of a product
and also utilize the production capacity fully, thus achieving efficient

Dr.Ranga Sai
allocation of resources. The Government follows this method for pricing

petroleum prices.
Under administered pricing the Government can also follow Average cost
pricing: when AR=AC, the price is equated with Average Cost. This is a
pricing where the firm will be operating at normal profits. In this case the
out put is highest and the price is lowest. The government follows this
method for pricing products like fertilizers. The consumption of fertilizers
is desirable in the national interests in increasing the output of agriculture.
Full Cost Pricing
The corporate pricing practices are mostly based on the cost sheet
approach, where the price includes all the costs chargeable to the product.
The considerations of average and marginal costs are no more valid. The
cost sheet approach to pricing includes relevant inputs of production and
overheads.
Out line of cost sheet:

Direct labour + direct material+ direct expenses = Prime cost
Prime cost + Production over heads = Works cost
Works cost + administration overheads = Cost of
production
Cost of production + selling and distribution over heads = Cost of sales
Full cost pricing considers all relevant costs and over heads. The costs
include all the variable costs and part of fixed cots. The fixed cost is
represented in different ways
As per the standard accounting procedures, the fixed cost is represented

as depreciation. It is that part of the fixed capital that is consumed during
that year on out put. The amount charged on the out put pit depends on
the life span of the asset and cost of replacement.
Alternatively, the fixed cost can be represented as the interest on fixed

capital for that year.
In both the cases the fixed capital is represented in the cost of production.
To this cost the firm will add a profit mark up. The price so determined is
called as the price of the product as per full cost pricing or profit mark-up
method.

Dr.Ranga Sai
Price = Mc + Lc+ FC+ π

q
Where,
Mc is the cost of material
Lc is the labour cost
FC is the fixed cost apportioned to the out put
q
π is the profit mark-up
Full cost pricing a popular method of pricing method. This is because of
its several advantages
1. Represents all costs
As against the conventional pricing methods, full cost pricing is
realistic
2. Fixed costs
Fixed costs are correctly represented. The costs which can be
assigned to the out put are correctly drawn.
3. Realistic representation of creation of utility
The cost represents the actual inputs going into production
representing their scarcities and productivities.
4. Easy for firms to adopt
Since it is simple and provides great scope for analysis of cost of
production it is commonly adopted by firms.
5. Flexible
The system is very flexible. Simple cost sheet method enables the
firm to apply the system across time and products.
6. Extendable to multi commodity or multi location pricing
A firm producing multiple goods or producing from various
locations can use the method easily. The system can be
integrated in multi- product pricing and branch accounting.
Profit mark-up
Profit mark-up is the rate of return expected by the firm on its sales. It is
the gross profit margin. Determination of Profit mark-up is matter of
great care and risk. Firms determine the Profit mark-up depending on
several factors.
The profit mark-up depends on several factors
1. Corporate policy
The policy of the firm will determine the level of profit mark-up
2. Nature of product

Dr.Ranga Sai
The product can be consumer good, further, consumer durable,

luxury good, perishable or similar. Profit mark-up changes in
each case.
3. Nature of market and competition
Market and competition have great bearing on the Profit mark-up.
Highly competitive markets will have lower Profit mark-ups.
4. Pricing strategy
Having a certain degree of Profit mark-up can be matter of
corporate strategy. It is an internal matter for a firm.
5. Industry standard
Every industry has its own standard of Profit mark-up. May it be
hospitality, automobile, housing or consumer goods; each has its
own degrees of Profit mark-up.
6. Product life cycle
The product life cycle decides the degree of Profit mark-up.
Whether the product is at introduction, growth, competition,
stagnant or decay will all have a Profit mark-up of their own.
7. Cost of capital
The cost of capital has a direct bearing on the levels of Profit
mark-up expected. There is a direct relation between these.
7. Expected rate of return or profitability
Each firm will have its own expected rate pf return on
investment. The Profit mark-up will depend on that.
Strategic pricing
Corporate pricing policies consider several practices which may include
corporate policy and corporate ambitions more than simple cost and profit
margin. Strategic pricing considers market, product, corporate
policy/image and ambitions of the firm. Accordingly, the pricing strategy
may follow a set of procedures.
Strategic pricing has the following objectives:

a. Increasing the market share competition
Strategic pricing helps in increasing the competition, market
share, independent of profit or profitability.
b. Incasing the volume of sales
Profit may increase on volume of sales in certain pricing
policies.
c. Managing competition
Strategic pricing is most suited for managing competition. In
case of new firms or new launch of a product, the company

Dr.Ranga Sai
needs to establish its image. Proper pricing policy helps in

forming an image.
d. Managing the market
The pricing policy changes with changes in the trends in the
market. The market is made up of consumer choices,
government policies, other firms and technology.
e. Corporate policy
The policy of the firm decides the kind of pricing it needs to
adopt at a given point of time. This may change from time
to time.
f. Product launch
When a new product is launched the strategic policy enables
the firm decide among various alternatives of pricing.
g. Growth strategy
Pricing strategy can aim at the growth of the company. The
growth in turn defines strategy in corporate policy.
The pricing strategies are of different types
1. Penetration pricing policy

2. Skimming price policy
3. Flexible price policy
4. Follow-the-leader price policy
These are different pricing strategies each having its own advantage the
firm will adopt such pricing strategy that suits its corporate policy.
Penetration price policy

The penetration price policy aims at capturing the market by keeping the
price as low as possible. The basic objective of penetration price policy is
to increase sales and market share, irrespective of profit or profitability.
Penetration price aims at margins on volumes. Low rates of profits but

higher profits due to volume of sales. Further, it helps in increasing
market share of company. This is one of the major objectives of any firm.
A firm launching the product for the first time may follow penetration
price.
With penetration price policy the rim will be able to register the product
with the consumer. It is like an introductory offer.

Dr.Ranga Sai
Skimming price policy

In case of skimming price policy, the firm will determine a higher price.
The objective will be to target the product at a specific consumer group
that can pay a higher price.
Such higher price is always justified with the help of advertising and
media support. The skimming price is also called as the niche pricing.
The firm only targets a small portion of the market and the product will
be accordingly designed. The skimming price carries a product image for
the higher income groups.
Flexible price policy

In case of flexible pricing policy, the firm may follow one system and
switch over to the other. The firm may launch the product with
penetration price and thereafter increase the price.
The firm may keep changing the price as per season, competition or costs
of production. However the efficiency of this pricing depends on the
acceptability at the market,
Follow-the-leader price policy

In certain markets one firm is larger than the others. The firm will have a
larger share and it leads the market. This is similar to partial oligopoly.
In such case other firms have no choice but to follow the leader.
Firms in general will follow the price adopted by the leader or determine
such price that will be acceptable in the market. However, the leadership
price continues to be the shadow price; a bench mark price for other firms
to take cue from.
All pricing strategies have their own advantages and justifications. It

depends on the firm to choose the right kind of pricing strategy that suits
the corporate need.
Discriminative Pricing
Price discrimination means the firm selling the same product in different
markets at the same time at different prices. The objective of price
discrimination is profit maximization.
Price discrimination is generally followed by a monopolist.
Price discrimination is not always possible. There are certain conditions

to be fulfilled for practice of price discrimination.
Dr.Ranga Sai
Price discrimination is possible only under the following conditions

1. Legal sanction
The practice of price discrimination shall be accepted by the
law. In absence of legal sanction price discrimination will be
called cheating.
2. Geographically distant markets
The markets with different pieces shall be geographically
far. The markets should be far enough to prevent resale of
goods.
3. No possibility of resale
Resale should be prohibited. In case of resale the monopoly
profits will be drained out by those reselling the goods.
4. No storage possible
Resale is not possible only I those goods whether storage is
not possible.
5. Apparent product differentiation
The firm shall follow apparent product differentiation. In
such cases the buyers will find justification for paying a
different price.
6. Let go attitude of the consumer
The consumers should have a let go attitude. In case of
consumer resistance, price discrimination is not possible.
7. Difference in elasticities of demand
Difference in elasticities is an essential condition for price discrimination.

There will be as many sub markets as the differences in elasticities.
In an elastic market, the firm can not charge higher price. Any increase in
price will greatly decrease quantity demanded. So the price tends to be
low. In an inelastic market, the quantity is not sensitive to price, so the
firm will charge a higher price.
The inelastic market: Market A has higher price and lower out put.

Dr.Ranga Sai
The elastic market; Market B has lower price and higher out put
Equilibrium with price discrimination
Firstly, the market is divided into sub markets depending on the elasticity
of demand. Each market will have a different elasticity of demand.
Suppose the firm can divide the markets into two sub markets: market A -
an inelastic market and Market B - an elastic market.
1. Out put determination

MC = Σ MR
2. Out put distribution
Σ MR = MRa = MRb
3. Price determination
The prices are determined as per ARs.
Though the markets are different, the place of production is centralized.

The firm will produce at a single place. Depending on the component
markets, the aggregate market is constructed.
The firm will determine the equilibrium out put; this is the out put which
will be distributed among different markets. The firm will consider the
aggregate MR i.e. Σ MR for determining the equilibrium.

MC = Σ MR
This is the optimum out put determined at the aggregate market.

Dr.Ranga Sai

Σ MR = MRa = MRb
The out put is distributed in different markets by equating Marginal

revenues. The equilibrium level of MR is passed over to different
markets, this way the equilibrium is created in sub markets. The
equilibrium level of MR will indicate the out put in different markets.
The prices are determined in different markets as per the Average
revenues (demand) in different markets.
It can be seen that the

The inelastic market: Market A has higher price and lower out put.
The elastic market: Market B has lower price and higher out put
Dumping
Dumping is a special case of price discrimination where the firm is a
monopolist in the home market and faces competition in the foreign
market.
In the home market the firm faces a downward sloping (demand) AR
curve whereas in the foreign market the AR curve is perfectly elastic with
AR=MR=Price relation.
The firm firstly, determines the out put to be produced for the local as
well as the foreign markets. There after, the out put needs to be
distributed among home and foreign markets. Finally, the price is
determined.

Dr.Ranga Sai

MC = MR ( maximum possible MR)
MRh = MRf
The prices are determined as per AR in the home market
and at the existing price at the foreign market.
The out put is determined by equating MC=MR. This is the profit

maximizing out put. The out put is distributed by equating MRs in
different markets. i.e. MRf = MRh
At this point the out put is allotted for home market and he price is
determined as per the downward sloping demand curve. The remaining
out put is sold in the foreign market at the price prevailing as per
AR=MR=Price.
It can be seen that the firm sells a small out put in the home market at
high price and a large out put in the foreign market at low price. This is
called dumping.
Multi product pricing

When a firm has more than one product the pricing method will be
interdependent. The firm will have different AR curves for different
products. The demand is generated by nature of product and the consumer
acceptance.
So firstly, the firm will determine the equilibrium level of out put, by
equating MC and Marginal revenue.
MC = MR
There after the firm will equate equilibrium level of Marginal Revenues
of different products. This is done by equating Marginal revenues of
different products at equilibrium level.
MRa = MRb = MRc = MRd = MR….
This way, the out put of different products is determined as per the
markets for these different products.
Finally, the prices are determined as per the Average Revenues. The
respective demand curves will determine respective prices. It is assumes
that the MC is common for all the products and the demand is different
for different markets and products.
Dr.Ranga Sai
Capital budgeting
Capital budgeting (or investment appraisal) is the planning process used

to determine whether a firm's long term investments such as new
machinery, replacement machinery, new plants, new products, and
research and development projects are worth.
The non recurring expenditure can be evaluated by methods of project

evaluation. In fact all projects are desirable but due to scarcity of
resources all projects can not be implemented. The projects need to be
prioritized depending on their worth. For this purpose, project evaluation
or capital budgeting becomes essential.

Dr.Ranga Sai
Basic Steps of Capital Budgeting

1. Estimate the cash flows
Every project generates cash in flows and cash out
flows. The difference between these in and out flows
refer to the net flows.
2. Assess the risk in of the cash flows.
The cash flows need to be regular. This is a matter of
liquidity of the project. The project needs to be
evaluated for its risk in yielding cash in flows
3. Determine the appropriate discount rate
Discount rate is used to reduce the value of future
returns to present value. The rat can be based on the
cost of capital or the expected rate of return or
profitability.
4. Estimates
Find the PV of the expected cash flows. This is done by
calculating the annuities. These are annual returns.
These returns need to be discounted as per the waiting
time involved. The discounts shall be so designed that
they increase with increasing waiting time.
5. Evaluation
Accept the project if Internal Rate of Return satisfies
expected Internal Rate of Return or the Present Value is
lowest or the pay back period is low
Payback period
Pay back period is the time period during which the sum of the net cash
flows equals the investment. Payback period refers to the time required
for the project to return back the investment. Every project generates cash
in flows and cash out flows. The difference between these in and out
flows refer to the net flows.
A project which has a low pay back period is selected. It is method based
on the liquidity of the project.
Project A Project B Project C

I Year 30,000 40,000 30,000
II Year 35,000 40,000 30,000
III Year 35,000 20,000 30,000
IV Year 30,000 30,000 30,000

Dr.Ranga Sai
Among three projects Project C is rejected firstly, because the payback

period is larger than three years. For Projects A and B the pay back
period is three years.
Among Projects A and B, the project which offers larger returns in lesser
time is Project B. It gives back 80% of the investment in two years. So,
Project B is selected against A. In turn Project A gives only 65% of the
investment.
So pay back period considers recovering investment in lesser time,

further, the project should return most past of the investment in lesser and
lesser time. Hence pay back period totally depends on the liquidity of the
project.
The draw back of payback period is that it neglects profitability. However
this method is most popular means project evaluation only because of its
simplicity.
Net Present Value

Net present value refers to the present value of future returns. NPV as
method of project evaluation means that the sum of the future returns
shall be equal to the present value of the project.
Every income yielding asset has three properties:

a. The assets yields returns over its life time, different each
year
b. The asset has a fixed life span during which it gives returns
c. A price is payable for the asset before it yields returns.
These are important issues in making investment decisions.
Net present value refers to the present value of future returns. The present
value of any future returns is always low. To arrive at the present value
the future value needs to be discounted. The discounts should be such that
they should increase with increasing time,
The sum of such discounted future returns is called as the net present
value. In this case the rate of discount is determined by the firm. So larger
the discount rate, lower will be the net present value.
The present value of the project cash flows of the future,

Dr.Ranga Sai
Where Q1, Q2, Qn are expected returns over n years,

are discounts over n years.
is discounted annual return
Internal Rate of Return

The internal rate of return (IRR) is a popular method in capital budgeting.
The IRR is a discount rate that makes the present value of estimated cash
flows equal to the initial investment.
Every income yielding asset has three properties:

a. The assets yields returns over its life time, different each
year
b. The asset has a fixed life span during which it gives returns
c. A price is payable for the asset before it yields returns.
These are important issues in making investment decisions.
The cost of the project,
Where Q1, Q2, Qn are expected returns over n years
are discounts over n years.
is discounted annual return
And r is the internal rate of return

The Internal rate of return method will result in the same decision as the
Net present value method. The decision rule of taking the project with the
highest internal rate of return, this may be same as the project with a
lower Net present value.

Dr.Ranga Sai
Internal rate of return is commonly used in the evaluation of projects by

banks for financing. The banks have bench mark internal rate of returns
for each kind of enterprise. If the project fulfills the minimum required
internal rate of return, the project is financed.
In case of own funds the enterprise may have the cost of funds as the
bench mark for accepting or rejecting the project.
(21202)5-5-2010

Dr.Ranga Sai
Other books in this series
Business Economics Paper II B.Com Second Year

Business Economics Paper III B.Com Third Year
Introduction to Economics B.M.M. First Year

Micro Economics B.A. First Year
Micro Economics First Year B.Com Accounting and Finance I Semester
First Year B.Com Banking and Insurance I Semester
Macro Economics First Year B.Com Banking and Insurance II Semester
Second Year BCom Accounting and Finance IIISemester
Based on University of Mumbai curriculum
Available for free and private circulation

At www. rangasai.com and www. vazecollege.net

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F.Y.B.Com. Dr.

Business Economics Paper I

Revised June 201

Module I: Demand analysis

Module II Theory of production

Module III Cost of production

Module VI Pricing Methods

Available for free and private circulation

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 2

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 3

Dear Student friends…

During these days of commercialization it becomes very difficult to find

Dr. Prof. Ranga Sai

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 4

Module I: Demand analysis

Accordingly, the theory describes utility as the want satisfying capacity

The consumer maximizes his satisfaction by equating marginal utilities of

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 5

Indifference Curve Analysis

Consumption theory in economics contains two parts. Firstly, the theory

Indifference curve analysis is a consumption theory given by Hicks and

IC deals with various combinations of two goods which give the

All these combinations give the consumer same amount of satisfaction. In

ICs can be understood better with the help of its properties.

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 6

Properties of Indifference curves

1. Indifference curves towards the axis represent lower satisfaction and

In the diagram IC 1 represents lower satisfaction and IC2 represents

3. Indifference curve is a down ward sloping curve. It slopes down

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 7

other. This is essential to keep the level of satisfaction constant on an

4. On an indifference curve the marginal rate of substitution decreases.

The marginal rate of substitution, is the rate at which a substitutes one

the slope of an indifference curve, MRS = ∆y/∆x.

The marginal rate of substitution decreases on an IC. On the diagram it

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 8

On an IC the consumer expresses his utility behavior through decreasing

On a concave curve the slope of IC increases that is MRS increases. So it

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 9

A curve convex to the origin has decreasing slope or decreasing MRS,

6. Indifference curves need not be parallel. Converging indifference

7. Indifference curves do not intersect. Indifference curves need not be

In the diagram it can be seen that

Combination A gives larger satisfaction, because it is on a

Foundations of Assumptions of Indifference curves:

Indifference curve analysis is based on the following assumptions:

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 10

2. Ordinality: The indifference curve analysis considers ordinal

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 11

The consumer equilibrium suggests the method in which he consumer can

The indifference curve analysis is an improvement over the utility

The indifference curve is made up of combinations the consumer wants to

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 12

The consumer equilibrium is derived by combing the indifference curves

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 13

Conditions of Consumer Equilibrium

Slope of the price line = Slope of the Indifference curve

There are two conditions of consumer equilibrium

Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 14

a. Necessary Condition: Tangency is a necessary condition.

b. Sufficient condition: Tangency + convexity is sufficient

Income consumption curve shows changes in the consumption of a

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