MANAGERIAL ECONOMICS

(Important Questions and suggested model answers)

1. Define Managerial Economics.

Managerial economics is a specialized discipline of management studies

which deals with application of economic theory and techniques to business
management. Managerial economics is evolved by establishing links on
integration between economic theory and decision sciences (tools and
methods of analysis) along with business management in theory and
practice---for optimal solution to business/managerial decision problems.
This means, managerial economics pertains to the overlapping area of
economics along with the tools of decision sciences such as mathematical
economics, statistics and econometrics as applied to business management
problems.

“Managerial economics is a science which studies the economic aspects

of behaviour of the firm as an enterprise, and helps to allocate scarce
resources to their alternative uses in such a manner as to optimize the
firm’s ultimate objective, as an organization and a social institution,
under conditions of the imperfect knowledge, risk and uncertainty. It
provides principles, method, and techniques of analysis of economic
behaviour and at the same time prescribes ways and means to optimize
economic efficiency.”

2. Discuss the nature and scope of Managerial Economics. What are the
other related disciplines?

Nature and Scope of Managerial Economics:

All managerial decisions are basically economic in nature. The decisions are
either directly related to Economics or have economic implications; they
might not be based simply on economic calculations, and might involve
several non-economic, social, political, legal and technological
considerations as well. Managerial economics helps not only to analyse the
economic content and implications of the managerial decisions but also to
integrate several other aspects leading to sound decisions.

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Managerial economics incorporates elements of both micro and
macroeconomics dealing with managerial problems in arriving at optimal
decisions. It uses analytical tools of mathematical economics and
econometrics with two main approaches to economic methodology
involving ‘descriptive’ as well as ‘prescriptive’ models.

Managerial economics differs from traditional economics in one important

respect that it is directly concerned in dealing with real people in real
business situations. Managerial economics is concerned more about
behaviour on the practical side.

Managerial economics deals with a thorough analysis of key elements

involved in the business decision making.

Most managerial decisions are made under conditions of varying degrees of

uncertainty about the future. To reduce this element of uncertainty, it is
essential to have homework of research/investigation on the problem solving
before action is undertaken.

Knowledge of managerial economics is a boon to the manager/businessman/

entrepreneur. Modern businessman never believes in luck. He bangs on
skilful management and appropriate timely economic decision making. This
art is facilitated by the science of managerial economics.

Other related disciplines:

Managerial economics is closely related to and draws heavily upon several

areas in economics such as Theory of the Firm, Microeconomics,
Macroeconomics, Industrial Economics, and so on. Managerial economics is
basically micro in nature in that it deals with the firm’s behaviour in three
basic areas viz. Utility analysis, Theory of the Firm and Factor pricing.
Managerial Economics draws a few aspects from Macroeconomics such as
national income, technology forecasting, which are relevant to sales/demand
forecasting. While Industrial Economics analyses the economic problems of
the industry as a whole, Managerial Economics deals with the economic
aspects of managerial decision making at a micro level irrespective of the
sphere of activity.

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Macro Economics is not only related to but is also an integral part of the
functional areas of management such as production, finance, accounting,
marketing, operations research and personnel. To illustrate, Capital
budgeting might be taught in finance and accounting as well as in
Economics. While Economics would analyse the firm’s investment
decisions and economic viability of projects, finance would study their
financial viability. E.g. The Garland Project linking Himalyan rivers to the
southern plateau was considered feasible from the technical point of view,
but it was thought to be financially not feasible as it involved investment
beyond India’s capacity.

Distinguish between Micro and Macro Economics.

Broadly speaking, microeconomic analysis is individualistic, whereas

macroeconomic analysis is aggregative. Microeconomics deals with the part
(individual) units while macroeconomics deals with the whole (all units
taken together) of the economy.

1. Difference in nature: Microeconomics is the study of the behaviour of the

individual units. Macroeconomics is the study of the behaviour of the
economy as a whole.

2. Difference in methodology: Microeconomics is individualistic; whereas

macroeconomics is aggregative in its approach.

3. Difference in economic variables: Microeconomics is concerned with the

behaviour of microvariables or microquantities.. Macroeconomics is
concerned with the behaviour of macrovariables and macroquantities. In
short, microeconomics deals with the individual incomes and output,
whereas macroeconomics deals with the national income and national
output.

4. Difference in field of interest: Microeconomics primarily deals with the

problems of pricing and income distribution. Macroeconomics pertains to
the problems of the size of national income, economic growth and general
price level.

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5. Difference in outlook and scope: The concept of ‘industry’ in
microeconomics is an aggregate concept but it refers to all firms producing
homogenous goods taken together. Macroeconomics uses aggregates which
relate to the entire economy or to a large sector of the economy. Aggregate
demand covers all market demands.

6. Demarcation in areas of study: Theories of value and economic welfare

are major areas in microeconomics. Theories of Income and employment are
core topics in macroeconomics.

Is Managerial Economics a Positive or Normative Science? Discuss.

Positive Economics explains the economic phenomenon as “What is,

what was and what it will be. Normative Economics prescribes what it
ought to be”. Positive sciences simply describe, while normative sciences
simply prescribe.

According to Prof. Robbins, economics is a positive science. Science is,

after all, a search for truth and therefore, economics should study the truth as
it is and not as it ought to be. This is because when we say that this ought to
be like this, we presume that our point of view is correct. In a study of a
problem at a given point of time, not only economic considerations but also
many other considerations such as ethical, political etc. must be considered.
A policy decision is taken after weighing the relative importance of all these
factors. There are bound to be differences in respect of policy prescription
and it is better to keep away from areas which are controversial and study
the facts as they are.

According to economists like Marshall and Pigou, the ultimate object of the
study of any science is to contribute to human welfare. Thus economics
should be a normative science. It should be able to suggest policy measure to
the politicians. It should be able to prescribe guidelines for the conduct of
economic activities. Not only economists should build up the economic
theory but also at the same time they should provide policy measures.

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We must strike a balance between these two extreme views. As Keynes put
it, “The main function of economics is not to provide a body of settled
conclusions immediately applicable to policy. It provides a method or a
technique of thinking, which enables its possessor to draw correct
conclusions.”

Managerial economics is a blending of pure or positive science with applied

or normative science. It is positive when it is confined to statements about
causes and effects and to functional relations of economic variables. It is
normative when it involves norms and standards, mixing them with cause-
effect analysis.

One cannot disregard the normative functions of managerial economics,

though the discipline may be treated primarily as a positive science.
Normative approach in managerial economics has ethical considerations and
involves value judgments based on philosophical, cultural and religious
positions of the community.

The value judgments and normative aspect and counselling in managerial

economic studies can never be dispensed with altogether.

We may thus conclude, that Managerial Economics is both a Positive and

Normative Science.

Briefly discuss the three fundamental concepts of Managerial

Economics.

Managerial Economics is confined to the following three major fields:

(1) Pricing (2) Distribution (3) Welfare.

Chart:

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Pricing: Microeconomics assumes the toal quantity of resources available in
an economic society as given and seeks to explain how these shall be
allocated to the production of particular goods for the satisfaction of chosen
wants. In a free market economy, the allocatioin of resources is based on the
relative prices and profitability of different goods. To explain the allocation
of resources, microeconomics seeks to explain the pricing phenomenon.

Price theory explains how the price of a particular commodity is determined

in the commodity market. For in depth analysis of price determination it
contains:

• Theory of demand of the analysis of consumer behaviour.

• Theory of production and cost or the analysis of producer behaviour.
• Theory of product [pricing or price determination under different
market structures.

Distribution: The theory of distributioin basically deals with factor pricing.

It seeks to explain how rewards of the individual factors of production such
as land, labour, capital and enterprise are determined for their productive
contribution. In other words, it is concerned with rent, wages, interest,
profits, as the respective rewards of land, labour, capital and enterprise
respectively.

Since demand and supply of each of these factors are different, there are
separate theories to these. Thus the field of distribution includes, general
theory of distribution and theories of rent, wages, interest and profits.

Welfare: The theory of economic welfare explains how an individual

consumer maximizes his satisfaction when production efficiency is achieved
by allocation of resources in such a way as to maximize output from a
limited set of input.

Along with individual economic welfare, welfare economics is also

concerned with social welfare, which is based on overall economic
efficiency of the system. When maximum individual wants are satisfied at
the best possible optimum level by a production pattern through efficient
allocation of resources, overall economic efficiency or ‘Pareto optimality’
condition is reached. Such a situation can raise the standard of living of the
population and maximize social welfare.

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What are the important uses and limitation of microeconomics?
Importance and Uses:
1. It explains price determination and the allocation of resources.
2. It has direct relevance in business decision-making.
3. It serves as a guide for business’ production planning.
4. It serves as a basis for prediction.
5. It teaches the art of economizing.
6. It is useful in determination of economic policies of the Government.
7. It serves as the basis for welfare economics.
8. It explains the phenomena of International Trade.

Limitations:
1. Most of the micro-economic theories are abstract.
2. Most of the microeconomic theories are static – based on ceteris paribus,
i.e. “other things being equal”.
3. Microeconomics unrealistically assumes ‘laissez-faire’ policy and pure
capitalism.
4. Microeconomics studies only parts and not the whole of the economic
system. It cannot explain the functioning of the economy at large.
5. By assuming independence of wants and production in the system,
microeconomics has failed to consider their ‘dependent effect’ on economic
welfare.
6. Microeconomics misleads when one tries to generalize from the
individual behaviour.
7. Microeconomics in dealing with macroeconomic system unrealistically
assumes full employment.

How does Managerial Economists help the Manager in decision making

and forward planning?
Managerial Economists act as operations researchers and systems analysts in
the management services department of large business firms usually in the
private sector. Their job lies in designing the course of operations to
maintain and improve the ‘systems’ of the firm in terms of productivity,
market share, load factor percentage and so on and prepare reports for
helping the decision makers to cope with current as well as anticipated
future problems. In modern business, managers constantly face the major
problem of choice among alternative ways of producing goods and allied
business decisions. Managerial economists assist them in making a rational
choice.

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A Managerial economist is an economic adviser to a firm or businessman. A
firm or entrepreneur, in the course of its/his business operations, has to take
a number of decisions which are vital to the survival and growth of the
business. Such decisions may pertain to the nature of the product to be
produced, the quantity, quality, cost, price and its distribution, planning and
diversification of business, renewal of worn out equipments and machinery,
modernization, etc. The Managerial economist helps the businessman or the
manager in arriving at correct decisions.

In short, the business economist while helping in the decision making

process, measures a number of micro and macro variables by applying
intelligently certain quantitative and qualitative techniques to the
practical aspects and problems encountered by a business firm in its
business activity. Forecasting is a fundamental activity of the Managerial
economist. Indeed a business economist is greatly helpful to the
management by virtue of his studies of economic analysis. He is an
effective model builder. He deals with the business problems in a sharp
manner with a deep probing.
A Managerial economist in a business firm may carry on a wide range of
duties, such as:
• Demand estimation and forecasting.
• Preparation of business forecasts; to provide forecasts of changes
in costs and business conditions based on market research and
policy analysis.
• Analysis of the market survey to determine the nature and extent of
competition.
• Analysing the issues and problems of the concerned industry.
• Assisting the business planning process of the firm.
• Discovering new and possible fields of business endeavour and its
cost-benefit analysis as well as feasibility studies.
• Advising on pricing, investment and capital budgeting policies.
• Evaluation of capital budgets.
• Building micro and macro economic models of particular aspects
of the firm’s activities that are useful in solving specific business
problems. Most models may be prediction oriented.
• Directing economic research activity.
• Briefing the management on current domestic and global economic
issues and challenges.

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 DEMAND

What is Demand?

A demand is the effective desire or want for a commodity, which is backed

up by the ability (i.e. money or purchasing power) and willingness to pay for
it. The demand for a product refers to the amount of it which will be bought
per unit of time at a particular price. The demand can be expressed as actual
and potential.
Consumer demand has two levels: a) Individual Demand and b) Market
Demand.
Market demand is the sum total of individual demand. Prices are determined
on the basis of market demand. Market demand serves as a guidepost to
producers in adjusting their supplies in a market economy.

Factors influencing individual demands are :

• Price of the products.

• Income of the buyer.
• Tastes, Habits and Preferences.
• Relative prices of other goods.
• Relative prices of substitute and complementary products.
• Consumer’s expectations about future price of the commodity.
• Advertisement effect.

Factors influencing Market Demand:

• Price of the product.
• Distribution of Income and Wealth.
• Community’s common habits and scale of preferences.
• General standards of living and spending habits of the people.
• Number of buyers in the market and the growth of population.
• Age structure and sex ratio of the population.
• Future expecations.
• Level of taxation and Tax structure.
• Inventions and Innovations.
• Fashions
• Climate and weather conditions.
• Customs

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• Advertisement and Sales propaganda.

Demand Function:

At any point in time, the quantity demanded of a given product (goods or

services) depends upon a number of key variables or determinants. A
demand function in mathematical terms expresses the functional
relationship between the demand for the product and its various
determining variables.

Dx – Quantity demanded = f(Px) – function of price.

Here all other determining variables are assumed to be constant, keeping

only price as variable.

If the demand function is to be stated taking into account all variables,

without assuming them as constant, demand function is

Dx = f (Px, + Ps + Pc + Yd +T, A, N, u)

Dx = Demand for X. Px = Price of X, Ps = Price of Substitute of X, Pc =

Price of Complementary Goods, Yd = Disposable Income, T = Taste of
the buyer or preference, A = Advertising effect, N = Number of buyers
u = Unknown other determinants.

Demand function is not the quantity demanded at a given price, but

quantity demanded at each level of price.

a = signifies initial demand irrespective of price (constant parameter).

b = functional relationship between P – Price and D – Demand (constant
parameter)
Linear demand function is expressed as D = a – bP.
b has minus (-) sign to denote a negative function. Demand is decreasing
function of price.
b is the slope ( vertical length ÷ horizontal length) of the demand curve,
and suggests that it is downward sloping.

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 Dx = 20 – 2Px (Dx is Quantity demanded of X, Px Price of X)

Dx = 20 – 2Px
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4 What is law of demand? What are its exceptions? Why does a Demand
Curve slope downward?

3 Law of Demand: Ceteris paribus, the higher the price of a commodity, the
smaller is the quantity demanded and lower the price, larger the quantity
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demanded. Other things remaining unchanged, the demand varies inversely
to changes in price. Dx = f(Px). The demand curve is downward sloping
indicating an inverse relationship between price and demand.
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The price is measured on the Y – axis and Demand on the X- axis. When the
price falls, demand increases. The downward slope of demand curve implies
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that the consumer tends to buy more when the price falls. Thus the demand
curve is shown as downward sloping.

What are the assumptions underlying law of demand?

Assumptions underlying the law of demand:

 No change in Consumer’s income.

 No change in consumer’s preferences.
 No change in the Fashion.
 No change in the Price of Related Goods.
 No expectation of Future price changes of shortages.
 No change in size, age composition, sex ratio of the population.
 No change in the range of goods available to the consumers.
 No change in the distribution of income and wealth of the community.
 No change in government policy.
 No change in weather conditions.

Exceptions to the Law of Demand:

Sometimes it may be observed, that with a fall in price, demand also falls
and with a rise in price, demand also rises. This is apparently contrary to the

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law of demand. The demand curve in such cases will be typically unusual
and will be upward sloping.

There are few such exceptional cases:-

 Giffen Goods: In the case of certain Giffen goods, when price falls,
quite often less quantity will be purchased because of the negative
income effect and people’s increasing preference for a superior
commodity with rise in their real income. E.g. staple foods such as
cheap potatoes, cheap bread, pucca rice, vegetable ghee, etc. as
against good potatoes, cake, basmati rice and pure ghee.
 Articles of Snob appeal (Veblen effect) : Sometimes, certain
commodities are demanded just because they happen to be expensive
or prestige goods and have a ‘snob appeal’. They satisfy the
aristocratic desire to preserve the exclusiveness for unique goods.
These goods are purchased by few rich people who use them as status
symbol. When prices of articles like diamonds rise, their demand
rises. Rolls Royce car is another example.
 Speculation: When people are convinced that the price of a particular
commodity will rise further, they will not contract their demand; on
the contrary they may purchase more for profiteering. In the stock
exchange, people tend to buy more and more when prices are rising
and unload heavily when prices start falling.
 Consumer’s phychological bias or illusion: When the consumer is
wrongly biased against the quality of a commodity with reduction in
the price such as in the case of a stock clearance sale and does not buy
at reduced prices, thinking that these goods on ‘sale’ are of inferior
quality.

Reasons for change (increase or decrease) in demand:

 Change in income.
 Changes in taste, habits and preference.
 Change in fashions and customs
 Change in distributioin of wealth.
 Change in substitutes.
 Change in demand of position of complementary goods.
 Change in population.
 Advertisement and publicity persuasion.

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  Change in the value of money.
 Change in the level of taxation.
 Expectation of future changes in price.

Explain Veblen effect and draw up the market demand curve for veblen
effect product. ((2/2004)

Thorstein Veblen argued that the affluent class in the society has a tendency
to demonstrate their superiority of ‘high class’
By spending on frivolous goods and services – super luxury items such as
diamonds, fivestar hotels, palatial buildings, business or executive class of
air travel. Though the market demand for such a commodity tends to rise
when its price falls, the individual demand of the snobbish buyer will fall.
When a prestige good loses its snob value, its market demand from the
snobbish buyers will decrease with fall in its price; and the demand may be
added up from the new common buyers.

In certain branded goods such as ‘Ray Ban’ or ‘Levis’ products i.e.

exclusive or designer products, there exists an inherent paradox. Initially
these goods are meant to serve the Veblen effect. At high prices, there is
limited but good demand from the richer sections. But when these goods are
produced in larger quantity, their prices fall. It will carry mass appeal to
upper middle class. So the demand will expand initially. Further increase in
output will lead to further price reduction. But at this price, the product loses
its exclusivity or snob effect and the richer sections exclusive demand will
fall. The product will now be purchased on account of its functional utility
and will be competing in the market with other similar goods.

The demand curve DD has changing slopes at a and b points. At price P1,
the demand is Q1. When the price is lowered to P2, demand is Q2. A further
reduction of price to P3, leads to a fall in demand as the brand loses
exclusivity appeal. After that the product demand is determined just by its
functional utility.

How is an indifference curve technique an improvement over

Marshallian utility analysis?

The indifference curve approach is considered superior to the Marshallian

utility analysis of consumer demand in the following respects:

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It is more realistic. Marshall assumes cardinal measurement of utility,
which is unrealistic. The indifference curve technique makes an ordinal
comparison of utility and the level of satisfaction.

It uses the concept of scale of preferences with lesser assumptions than

the Marshallian concept of utility. The scale of preference is laid down on
the basis of a consumer’s tastes and likings, independent of his income.
Unlike Marshall, the Hicksian scale of preference needs no information as to
how much satisfaction is gained but it aims only at knowing whether a
consumer’s satisfaction level is greater than, less than or equal to, between
the various combinations of two goods.

It dispenses with the assumption of constant marginal utility of money.

Marshallian analysis assumes that to the consumer the marginal utility of
money remains constant. In the indifference curve analysis, such
assumption is not needed.

It is wider in scope: Marshallian demand theory deals with a single

commodity taken exclusively. Hick’s ordinal approach, considers at least
two goods in combination. Thus, the complementarity and substitutability
aspects of goods are being explicitly considered in Hicksian analysis.

It uses concept of Marginal Rate of Substitution which is scientific and

measurable: The utility approach is based on the law of diminishing
marginal utility. On the other hand, the indifference curve approach rests on
the principle of diminishing marginal rate of substitution. The concept of
marginal rate of substitution is superior to that of marginal utility because it
considers two goods together and also because it is a ratio expressed in
physical units of two goods and as such, it is practically measurable. The
replacement of the law of MU by MRS, is a positive change in a more
scientific manner.

It expresses the conditions of consumer equilibrium in a better way: In

Marshallian analysis, the consumer equilibrium condition is MUx = MUy .
Since utility cannot be measured numerically, this condition is
impracticable. Px Py
In Hicksian analysis, the equilibrium condition is expressed as MRSxy = Px/
Py which is measurable.

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It is more comprehensive as it recognizes the fact that equilibrium in
purchasing one commodity depends on the price of other goods and their
stocks as well.

It analyses the price effect in a better way: The Marshallian demand curve
has no means to separate the price effect into income and substitution
effects. In the indifference curve analysis, the price consumption curve
enables us to have the bifurcation of price effect into income and
substitution effects.
It examines the Phenomenon of Giffen Paradox. Marshall views the Giffen
Paradox as an exception to the law of demand, whereas the case of Giffen
goods is incorporated in the price consumption curve to examine the
consumer’s typical behaviour caused by negative income effect. Thus the
unsolved riddle about Giffen goods in the utility analysis is solved by the
indifference curve analysis. It represents the law of demand in a broader and
more precise way.

What are the shortcomings of the indifference curve approach?

It does not provide any positive change in the utility analysis.

It retains the Marshallian assumption of diminishing marginal utility:
It unrealisitically assumes perfect knowledge of utility with the
consumer.
It is weak in structure.
It has limited scope.
It is introspective.
It is not applicable to indivisible goods.
It assumes transitivity condition.

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ELASTICITY OF DEMAND

Demand usually varies with price. The extent of variation of demand is not
uniform. Sometimes the demand is greatly responsive to price changes,
while at other times, it may be less responsive. Elasticity is the extent of
responsiveness to variation. Two factors are relevant for measuring the
elasticity of demand – a) demand b) the detriment of demand. A ratio is
made of the two variables for measuring the elasticity coefficient.

Elasticity of demand = % change in quantity demanded

% change in detriment of demand

Unless specified, elasticity of demand means price elasticity of demand.

Logically, however, the concept of elasticity should measure the
responsiveness of demand to changes in variables concerned with demand
function. Thus there can be many kinds of elasticities of demand. Most
important are

Price elasticity of demand

Income elasticity of demand
Cross elasticity of demand

Marshallian classification of Price elasticity:

1. Unit elasticity of demand (e = 1)

2. Elastic demand - elasticity greater than unity. (e > 1)
3. Inelastic demand – elasticity is less than unity (e<1)

Explain with graphs how modern economists have classified price

elasticity of demand. What are the managerial uses of price elasticity of
demand?

Price elasticity of demand:

Ratio Method:
The extent of responsiveness of demand for a commodity to a given change
in price, other demand determinants remaining constant, is termed as the
price elasticity of demand. It is the ratio of relative change in demand
variables to price variables.

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Coeff.of price elasticity e = % change in quantity demanded OR
% change in price

proportionate change in quantity demanded =

ΔQ ÷ ΔP = ΔQ x P
proportionate change in price.
Q P ΔP Q

Q = Original demand, ∆Q = change in demand

P = Original Price, ∆P = change in price

The above method is also known as percentage method, when the ratio is
expressed as a percentage.

e = %∆Q
%∆P
Revenue Method:

Marshall suggested that the easiest way of ascertaining whether or not the
demand is elastic, is to examine the change in total outlay of the consumer
or total revenue of the seller corresponding to change in price of the product.

Total Revenue (or Total outlay) = Price x Quantity purchased (or sold)

According to this method, if the total revenue remains unchanged with a

change in the price, the demand is unit elastic, as demand changes in the
same proportion as price.

With a fall in price, if the total revenue rises, or with a rise in price, the total
revenue falls, the elasticity is more than unity.

With a rise in price, the total revenue also rises and with a fall in price, total
revenue also falls, the demand is less than unity.

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Point elasticity method or Geometric Method:

The simplest way of explaining the point method is to consider a straight

line demand curve. Extend the demand curve to meet the two axes. When a
point is plotted on the demand curve, it divides the line segment into lower
and upper segments.

Point elasticity is measured by the ratio of the lower segment of the demand
curve below the given point to the upper segment above the given point.

Point elasticity = Lower Segment below the given point

Upper segment above the given point.

This measure is called ‘point elasticity’ measurement because it effectively

measures elasticity of demand at a point on the demand curve assuming
infinitesimally small changes in price and quantity variables.

Arc elasticity method:

To calculate price elasticity over some portion of the demand curve rather
than at a point, the concept of arc elasticity of demand is used.

Arc elasticity is measured on a range on the demand curve between two

points. The formula for arc elasticity is
∆Q P1 + P2 where, P1 is the original price, p2 = new price
earc = -----x ---------- Q1 original quantity demanded
∆P Q1 + Q2 Q2 new demand
∆ P = P2 – P1,
∆ Q = Q2 – Q1

For practical decision making, it is better to use arc elasticity measure when
price changes more than 5%.
For all theoretical purposes, point elasticity rather than arc elasticity is
commonly used.

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What are the factors influencing elasticity of demand?

1. Nature of the commodity – according to the nature of satisfaction the

goods give. Luxury goods are price elastic.

2. Availability of close substitutes – demand will be elastic.

3. Number of uses the commodity can be put to – Single use goods will
have less elastic demand but demand becomes elastic if it can be put to
several uses.

4. Consumer’s income – demand from low income group will be elastic

while from very rich persons, relatively inelastic.

5. Height of price and range of price change – highly priced goods,

demand less elastic with small change in price. But with large changes,
demand will be elastic.

6. Proportion of expenditure
7. Durability of the commodity.
8. Influence of habit and custom
9. Complementary goods. Goods which are jointly demanded are less
elastic.
10.Time – less elastic during short periods generally.
11. Recurrence of demand.
12. Possibility of postponement.

Income Elasticity of Demand:

Income elasticity of demand is defined as the ratio of percentage or

proportional change in the quantity demanded to the percentage or
proportional change in income.

Income elasticity = % change in quantity demanded = em = %∆ Q

% change in income. % ∆M

OR ∆ Q x M or ∆ Q . M
Q ∆M ∆ M Q

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Cross elasticity of demand:

The cross elasticity of demand refers to the degree of responsiveness of

demand for a commodity to a given change in the price of some related
commodity.
The cross elasticity of demand between two goods is measured by dividing
the proportionate change in the quantity demanded of X by the proportionate
change in the price of Y.

Cross elasticity of demand : Proportionate or percentage change in

demand for X
Proportionate or percentage change in the
price of Y.

Ec or e xy = ∆Qx x ∆Py = ∆Qx x Px

Qx Py ∆Py Qx

Advertising or Promotional elasticity of demand :

eA = Percentage or proportionate change in sales

Percentage or proportionate change in ad.expenditure.

Arc Advertising elasticity : ∆Q x A1 + A2

∆A Q1 + Q2

What is demand forecasting?

Demand forecasting is not a speculative exercise into the unknown. It is

essentially a reasonable judgment of future probabilities of the market events
based on scientific background. Demand forecasting is an estimate of the
future demand. It cannot be hundred per cent precise. But, it gives a
reliable approximation regarding the possible outcome, with a reasonable
accuracy. It is based on the statistical data about past behaviour and
empirical relationships of the demand determinants. It is based on
mathematical laws of probability.

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What are the criteria of a good forecasting method?

Criteria of a good forecasting method:

Joel Dean lays down the following criteria of a good forecasting method:

Accuracy: Forecast should be accurate as far as possible. Its accuracy must

be judged by examining the past forecasts in the light of the present
situation.

Plausibility: It implies management’s understanding of the method used for

forecasting. It is essential for a correct interpretation of the results.

Simplicity:A simpler method is always more comprehensive than the

complicated one.

Economy: It should involve lesser costs as far as possible. Its costs must be
compared against the benefits of forecasts.

Quickness: It should yield quick results. A time consuming method may

delay the decision making process.

Flexibility: Not only the forecast is to be maintained up to date, there should

be possibility of changes to be incorporated in the relationships entailed in
forecast procedure, time to time.

Explain the survey methods of demand forecasting.

Market Survey or Opinion Poll:

A market survey is also called an opinion survey or opinion poll. While

conducting an opinion poll, the respondents should be chosen correctly after
ascertaining whose opinion is valuable in the matter. For example, in order
to estimate the demand for newly designed electric meters, the opinion of the
engineers in the purchase and service departments of electric companies is
important and not that of the ultimate consumers who have no say in the
matter.

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1. Representative sample: For conducting a survey, a sample population is
selected from the total population. It can then be classified into different
groups, each with its own character. A percentage of each group can be
surveyed in order to get varying opinions. The sample population has to be
as representative of the total population as possible. The degree of the
accuracy of the survey would depend upon the representative character of
the sample population.
2. A case: A student was asked to find out the image of a big cotton textile
mill as her project. The project report including the survey had to be
completed within 60 days without any financial commitment on the part of
the company under study. A study, under such constraints, would naturally
have its own limitations. The student chose the method of stratified
sampling, confined to a big city, the headquarters of the company. The
population was broadly classified into: (i) employees sub-grouped into
different strata, taking a few samples from each. (ii) all wholesalers (iii) a
few retailers in the city, selected on the basis of their share in sales (iv)
customers visiting retail outlets responded to the questionnaire (v) different
strata of general population, which at one time or the other purchased the
products of the mill – regrouped according to age, income, education and
status, selecting a few samples from each group. Within these constraints a
sample of 200 persons was collected. The results were quite encouraging.

Discuss the popular time series analysis techniques used for demand
forecasting.
Time series analysis:
Time series analysis helps to identify: (1) a long-run movement of the
variable; (2) seasonal fluctuations which are oscillatory but confined to one
year; (3) cyclical movements which are oscillatory and periodic.
The values of the movements are repeated between peaks and troughs.

A time series is dis-aggregated into four components or elements (i) Trend

(T) (ii) Seasonal component (S) (iii) Cycle (C) and (iv) an irregular or
random component. The first three are systematic while the last one is
unsystematic. The residue after eliminating the systematic components falls
in random component.These components can be written in two forms
additive or multiplicative – T+S+C+R OR TSCR. In the additive form it is
assumed that there is no interaction among the different components
whereas in the multiplicative form there is interaction. The multiplicative
form can be written in the additive form by taking the log as “ log y = log T
+ log S + log C + log R.”

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A common method of decomposition is to calculate the trend and eliminate
it from the original series by dividing throughout as TSCR/T; in the same
way other elements can be separated out. In the additive form an element is
removed by subtracting it from the series.

Much depends on the purpose. For example, if the growth rate of a variable,
say agricultural production, is to be estimated, calculating the trend equation
directly may not give the correct results, as agriculture is subject to both
seasonal and cyclical fluctuations. Thus, both the fluctuations are to be
removed first in order to attain better accuracy.

The decomposition of time series analysis has certain implicit assumptions:

1) the order of removal should be trend, seasonal, and cyclical. If the order is
changed, changed values will result.
2) effects are independent of each other; and
3) the trend is linear and the cycle is regular.

Criticism of the Method: These assumptions have been questioned.

Separation of trend and cycle may be dubious as both may be the result of
the same set of factors. Irregular variations may outweigh the others and the
phenomenon of the business cycle may not be very relevant in a planned
economy. The decomposition of the time series is an artificial attempt
imposed by the analyst. As a descriptive device this may be adequate, but as
an explanatory device for isolating different facts, th scheme is seriously
deficient. It is because, the deterministic hypothesis underlying the
systematic part is open to doubt from the point of view of behaviour of
economic agents. Because of these shortcomings, in recent years, the
emphasis in the study of time series has shifted to analysis of probabilistic
processes.

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 MONOPOLISTIC COMPETITION

Q. Monopolistic Competition is a blend of perfect competition and

monopoly. Discuss.
How is price-output determined under monopolistic competition?

Monopolistic competition as the name suggests entails the attributes of both

monopoly and competition.
Following are the main features:

Large number of sellers:

There are fairly large number of sellers. They sell closely related but not
identical products. The large number of firms in the same line of production
leads to competition. Competition is keen but impure because there is no
homogeneity of products offered. There are less chances of collusion
between them to eliminate competition and rig prices, as the number is quite
large.

The quantity supplied by an individual firm is relatively small compared to

the total market shared by all the firms. Thus there is very limited degree of
control over the market price by any firm.

In determining pricing and output policy, each firm can afford to ignore
reaction by rivals. The number of firms being large enough, the impact of
such an action by an individual firm, is insignificant.

Product Differentiation:

The firm’s independence under monopolistic competition, is attributed to the

degree of product differentiation it adopts. It is essentially competition with
differentiated products. The most distinguishing factor of monopolistic
competition is that the products are all branded and identified. There is no
homogeneity of products though they may be similar. Through such product
differentiation, each seller acquires certain degree of monopoly power.

Large number of buyers:

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There are numerous buyers. But buyers have preference for specific brands.
Buyers are literally patrons of a particular seller. Buying here is by choice
not by chance.

Free entry:

Entry and exit of buyers is freely possible. There are no barriers. There is
unrestricted entry of new firms into the group till it reaches complete
equilibrium. This makes the competition stiff because of close substitutes
but with different brand names produced by new entrants. This market
situation is more similar to perfect competition than monopoly. Owing to
unrestricted entry of new firms, abnormal profits are usually competed away
in the long run. Firms will seek to realize pure economic profits once again
by advertising and innovatioin in products and processes resorting to non-
price competition – competition in product variation as well as increase in
advertising expenditure.

Selling costs:

Advertising and other forms of sales promotion are an integral part of

monopolistic competition. These outlays are termed as selling costs. This
kind of heavy expenditure on sales promotion is because products are
identified and differentiated by their brand names unlike in perfect
competition, where products are homogenous without brand name, needing
no advertisement at all and firms experiencing perfectly elastic demand
curves.

Selling efforts are required to effect a shift in demand in order to capture a

better share of the market. Increase in demand is achieved through
advertisement and sales promotional efforts i.e. by increase in selling costs.
Success in achieving this increase, depends on how effective is the product
differentiation and preference achieved through advertisement.

Two dimensional competition:

There are two aspects in monopolisitic competition: (1) There cannot be too
much variation in price and the product has to be competitively prices.
Hence price competition. (2) There is non-price competition in terms of
product differentiation and spending on selling costs in order to capture a
bigger share of the market.

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The Group:

The firms involved in monopolistic competition are termed as “group” and

not “industry”. A group is a cluster of firms producing very related but
differentiated products. Monopolistic competition is characterized by
product differentiation. Firms produce similar but not identical goods. We
cannot conceive of an industry – such as automobile or bicycle industry in
an analytical sense – in the monopolistic competition. On account of product
differentiation, products of each firm, is identifiable and each firm is an
industry in itself, just like a monopoly form.

In reality, major companies control a large number of products over a wide

spectrum of the industrial economy. There are a variety of product groups
such as , Automobiles, Textiles, Footwear, Soaps and Detergents, Foods
and Beverages, Drugs and Chemicals, Cosmetics, Confectionery, Paper,
Electronics, Computers, Cement, Metals and Metal Products, Construction
etc.

Q. “A firm under monopolistic competition is a price maker”. Explain

how price is determined under monopolistic competition.

“A firm under monopolistic competition is a price maker. Unlike perfect

competition, there is pricing problem. The firm has to determine a suitable
price for its product which yields maximum total profit. Assuminga given
variety of products and constant selling outlays, when price is the only
variable factory, shortrun analysis of price adjustment, is similar to pure
monopoly. The market share of an individual firm in the total market of all
the firms in the group, is insignificant to cause any serious effect on the
market share of others by any downward price revision by the firm to
increase the market share. In the long run, however, a major difference is
noticeable in the equilibrium process, due to entry of new firms competing
away the abnormal profits. This causes change in demand conditions and
other factors associated with the process of group equilibrium.

Price determinatioin in the shortrun:

In the short run, the firm can adopt an independent price policy with least
consideration for the varieties produced and the prices charged by other

26
producers. The firm being rational in determining the price, will seek to
maximize the total profits.

There is a definite demand schedule as the quality of the product is given.

The product is differentiated. So the demand curve or sales curve is
downward sloping. The demand curve of a firm in monopolistic competition
is more elastic than in pure monopoly.

The degree of elasticity depends on the number of firms in the group and the
extent of product differentiation. If the number of firms is large, the demand
will be highly elastic, while it will be less elastic if the number is small.

In order to maximize its total profits in the short run, the firm produces that
level of output at which marginal cost is equal to marginal revenue (MC =
MR). Equilibrium output is determined at the point of intersection of MR
and MC.

Figure:

We have assumed the case of a firm with hypothetical cost and revenue data
in a monopolistically competitive market. For simplicity sake, it is assumed
that demand and cost conditions are identical for all the firms in the group.
These are bold assumptions made by Chamberlin. No doubt these
assumptions very much simplify the model but they are not altogether
unrealistic. In the case of retail shops such as provision stores and chemist
shops, standardized products will tend to have more or less identical demand
and cost conditions, as their product differentiation is confined to only
locational differences.

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Equilibrium point E is determined where SMC = SMR, OP price, OQ
output, ‫ ٱ‬PABC profit.

Price determination in the Long-run:

When firms earn super-normal profits in the short-run, some new firms will
be attracted to enter the business, as the group is open. On account of rivals’
entry, the share of the firm in the toal market will be reduced due to
competition from an increasing number of close substitutes. Gradually, in
the long run, the firm will earn only normal profits.

Monopolistic competition implies severe competition between a large

number of firms producing close substitute products. Hence this market
situation is more similar to perfect competition than monopoly. Owing to the
unrestricted entry of new firms, monopoly profits are usually competed
away in the long run. Consequently, firms will resort to non-price
competition i.e. competition in product variation as well as by increasing
their advertising expenditure (selling costs).

OLIGOPOLY

Oligopoly is a market situation comprising only a few firms in a given line

of production. The price and output polisy of oligopolistic firms are
interdependent. The oligopoly model fits well into such industries as
automobile, manufacure of electrical appliances etc. in our country. In an
Oligopolistic market, the firms may be producing either homogenous
products or product differentiation in a given line of production.

The following are the distinguishing features of an oligopolistic market:-

• Few Sellers : Homogeneous or differentiated products supplied by a

few firms.
• Interdependence: Firms have a high degree of dependence in their
business policies, price and output fixation.
• High cross elasticities: Firms under oligopoly have high degree of
cross elasticities and are always in fear of retaliation by rivals. Firms
consider the possible action and reaction of its competitors while
making changes in price or output.

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 • Each firm tries to attract customers towards its product by incurring
excessive advertisement expenditure. It is only under oligopoly that
advertising comes fully into its own.
• Constant struggle: Competition in Oligopoly consists of constant
struggle of rivals against rivals and is unique.
• Lack of uniformity: There is lack of uniformity in the size of different
oligopolies.
• Lack of certainty: In oligopolistic competition firms hae two
conflicting motives – 1) to remain independent in decision making
and 2) to maximize profits despite being interdependent. To pursue
these ends, they act and react to the price-output variation of one
another in an unending atmosphere of uncertainty.
• Price rigidity: Each firm sticks to its own price due to constant fear of
retaliation from rivals in case of reduction in price. The firm rather
resorts to non-price competition by advertising heavily.
• Kinked Demand Curve: According to Paul Sweezy, firms in an
oligopolistic market, have a kinky demand curve for their products.

KINKED DEMAND HYPOTHESIS OF AN OLIGOPOLY

MARKET:

The kinked Demand Curve or the Average Revenue Curve of an Oligopoly

Firm, has two segments : 1) the relatively elastic segment and (2) relatively
inelastic segment.

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 OUTPUT

Corresponding To the given price OP, there is a kink at point K on the

demand curve DD. DK is the elastic segment, while KD is the inelastic
segment of the curve. Kink implies an abrupt change in the slope of the
demand curve.Demand curve is flatter before the kink and steeper after the
kink.

The kink indicates the indeterminateness of the course or demand for the
product of the seller concerned. He thinks it worthwhile to follow the
prevailing price and not to make any change. In this case, raising of price,
would contract sales considerably as demand tends to be more elastic to
change in price. Lower of price, on the otherhand, will lead to retaliation
from rivals owing to close interdependence of price-output movement in the
oligopolistic market. Hence, seller will not expect much rise in sales because
of price reduction.

An important point involved in kinked demand curve is that it accounts for

the kinked average revenue curve to the oligopoly firm. The kinked average
revenue curve in turn, implies a discontinuous marginal revenue curve MA –
BR. Thus, the kinky marginal revenue curve explains the phenomenon of
price rigidity in the theory of oligopoly prices.

In an oligopolistic market, once a general price level is reached, whether by

collusion or by price leadership or through some formal agreement, it tends
to remain unchanged over a long period of time. The price rigidity is on
account of price interdependence indicated by the kinked demand curve.
Discontinuity of the oligopoly firm’s marginal revenue curve at the point of
equilibrium price, the price output combinatioin at the kink tends to remain
unchanged even though marginal cost may change. The firm’s marginal cost
curve can fluctuate between MC1 and MC2 within the range of the gap in
the MR curve without disturbing the equilibrium price and output position of

30
the firm. The price remains the same at the level of OP, and output OQ,
despite change in the margin costs.

PERFECT COMPETION

What are the features of perfect competition? Explain.

What are ISOquants? What are their properties? What is the difference
between ISOquant curve and Indifference curve?

‘ISO’ means ‘equal’. ‘quant’ stands for ‘quantity’. The equal product curve
is called Iso-quant or ‘production iso-quant’. It represents all the
combinations of two factor inputs which produce a given quantity of
product. It signifies a definite measurable quantity of output. Each Iso-quant
curve stands for a specific quantity of output. A number of curves can be
drawn for different specific quantities of output. All these curves together
form the Iso-quant map.

Iso-quant measures a quantum of production resulting from alternative

combinatioin of two variable inputs.

Difference between Iso-quant curve and Indifference curve

1. Indifference curve refers to two commodities. Iso-quant curve relates to

combination of two factors of production.
2. Indifference curve indicates level of satisfaction. Is-quant curve indicates
quantity of output.
3. No numerical measurement of satisfaction is possible. So it cannot be
labelled.
Iso-quant curve can be easily labeled as physical units out output are
measurable.

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4. The extent of difference of satisfaction is not quantifiable in the
Indifference map. But in Iso-quant map, we can measure the exact difference
between quantitites represented by one curve and another.

Properties of Iso-quants:

Isoquants have a negative slope. In order to maintain one level of output,

when the amount of one factor is increased, that of the other is decreased. At
each point on the iso-quant curve, we get a combination of two factors,
which give the same level of output.

Isoquants are convex to the origin. The slope of the isoquant measures the
marginal rate of technical substitution of one factor input (say labour) for the
other factor inpur (say capital). MRTS measures the rate of reduction in one
factor for an additional unit of another factor in combination for producing
the same quantity of output. The convexity of the isoquant curve suggests
that MRTS is diminishing, meaning, when quantity of one factor is
increased, the less of another factor will be given up, keeping the output
constant.

Iso-quants do not intersect. Each Isoquant represents a specific quantum of

output. If two Isoquants intersect each other, it would lead to a logical
contradiction as Isoquant representing a smaller quantity cannot be on a line
representing a larger quantity.

Isoquants do not intercept either X or Y axis. If an Isoquant touches any

axis, it means that any one factor can be taken as zero. Since it is not
possible to produce a product with a single factor, Isoquants do not meet
either axis.

Iso-quant is an oval shape curve. If relatively small amount of one factor is

combined with relatively large amount of another factor, marginal
productivity tends to be negative resulting in decline in total output. In such
cases, the end portion of the curves are regarded as uneconomical and the
curves are oval shaped.

Tangents of Iso-quants in an Iso-quant map represent the loci of

equilibrium when different quantities of output are produced by the
firm at minimum costs under the situation of two variable factor-inputs
with their fixed price ratio.

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Solved Problem in Isoquants: Refer to Problems.

33