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MANAGERIAL ECONOMICS – (22MBA26)
Module -1 Introduction
Managerial Economics: Meaning, Nature, Scope, & Significance, Uses of Managerial

Economics, Role and Responsibilities of Managerial Economist. Theory of the Firm: Firm
and Industry, Objectives of the firm, alternate objectives of firm.
Managerial theories: Baumol’s Model, Marris’s Hypothesis, Williamson’s Model.
Economics is a social science concerned with the production, distribution, and consumption of
goods and services.
Economics studies how individuals, businesses, governments, and nations make choices about
how to allocate resources. Economics focuses on the actions of human beings, based on
assumptions that humans act with rational behavior, seeking the most optimal level of benefit or
utility.
Economics can generally be broken down into macroeconomics, which concentrates on the
behavior of the economy as a whole (analyzes the decisions made by countries and
governments), and microeconomics, which focuses on individual people and businesses
( allocation of resources, and prices of goods and services, taxes, regulations and government
legislation.).
Managerial Economics: Meaning & Definition
• Branch of Economics: ‘Managerial Economics is the study of Economic Theories,

Principles and Concepts which is used in Managerial Decision Making.’
• ‘Managerial Economics is the Application of various Theories, Concepts and Principles

of Economics in the Business Decisions.’
• It also Includes ‘The Application of Mathematical and Statistical tools in Management

decisions.’
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Definition:
“Managerial economics is the study of allocation of resources available to a firm among the
activities of that unit” -Hynes.
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“The integration of economic theory and business practice for the purpose of facilitating decision
making and forward planning by management. – Spencer and Seligman.
Nature of Managerial Economics:
• Science as well as Art of decision making.
• It is essentially Micro in nature but Macro in analysis.
• It is mainly a Normative science but positive in analysis.
• It is concerned with the application of theories and principles of economics.
• It discusses Individual problems.
• It is dynamic in nature not a Static.
• It discusses the economic behavior of a firm.
• It concentrates on optimum utilization of resources.
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Scope of Managerial Economics:
Managerial economics is concerned with the application of economic concepts and analysis to
the problem of formulating rational managerial decisions. There are four groups of problem in
both decision making and forward planning.
 Resource allocation: Scarce resources have to be used with utmost efficiency to get
optimal results. These include production programming, problem of transportation, etc.
 Inventory and queuing problem: Inventory problems involve decisions about holding
of optimal levels of stocks of raw materials and finished goods over a period. These
decisions are taken by considering demand and supply conditions. Queuing problems
involve decisions about installation of additional machines or hiring of extra labour in
order to balance the business lost by not undertaking these activities.
 Pricing problems: Fixing prices for the products of the firm is an important part of the
decision making process. Pricing problems involve decisions regarding various methods
of pricing to be adopted.
 Investment problems: Forward planning involves investment problems. These are
problems of allocating scarce resources over time. For example, investing in new plants,
how much to invest, sources of funds, etc.
Study of managerial economics essentially involves the analysis of certain major subjects like:
 Demand analysis and methods of forecasting
 Cost analysis
 Pricing theory and policies
 Profit analysis with special reference to break-even point
 Capital budgeting for investment decisions
 The business firm and objectives
 Competition.
 Inflation and economic conditions.
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Significance of Managerial Economics:
 Business Planning: Managerial economics assists business organizations in formulating

plans and better decision making. It helps in analyzing the demand and forecasting future
business activities.
 Cost Control: Controlling the cost is another important role played by managerial
economics. It properly analyses and decides production activities and the cost associated
with them. Managerial economics ensure that all resources are efficiently utilized which
reduces the overall cost.
 Price Determination: Setting the right price is one of the key decisions to be taken by
every business organization. Managerial economics supplies all relevant data to managers
for deciding the right prices for products.
 Business Prediction: Managerial economics through the application of various economic
tools and theories helps managers in predicting various future uncertainties. Timely
detection of uncertainties helps in taking all possible steps to avoid them.
 Profit Planning and Control: Managerial economics enables in planning and managing
the profit of the business. It makes an accurate estimate of all cost and revenue which
helps in earning the desired profit.
 Inventory Management: Proper management of inventory is a must for ensuring the
continuity of business activities. It helps in analyzing the demand and accordingly,
production activities are performed. Managers can arrange and ensure that the proper
quantity of inventory is always available within the business organization.
 Manages Capital: Managerial economics helps in taking all decisions relating to the
firm’s capital. It properly analyses investment avenues before investing any amount into
it to ensure the profitability of an investment.
 Assist in Decision Making
 Optimization of Resources
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Uses of Managerial Economics
• Production Decisions
• Inventory Decisions
• Cost Decisions
• Marketing Decisions
• Investment Decisions
• Personnel Decisions
Roles and Responsibilities of Managerial Economist:
A managerial economist helps the management by using his analytical skills and highly
developed techniques in solving complex issues of successful decision-making and future
advanced planning and assists the business planning process of a firm.
• Demand estimation and forecasting
• Preparation of business/sales forecasts
• Analysis of the market survey to determine the nature and extent of competition.
• Analyzing the issues and problems of the firms.
• Carrying out cost-benefit analysis.
• Assisting the business planning process.
• Advising on pricing, investment and capital budgeting policies.
• Evaluation of capital budgets.
• Building micro and macroeconomics models of particular aspects of the firm.
• Directing economic research activity.
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Theory of the Firm:
The theory of the firm is the microeconomic concept founded in neoclassical economics that
states that a firm exists and makes decisions to maximize profits. The theory holds that the
overall nature of companies is to maximize profits meaning to create as much of a gap between
revenue and costs. The firm's goal is to determine pricing and demand within the market and
allocate resources to maximize net profits.
Theory of the firm is related to comprehending how firms come into being, what are their
objectives, how they behave and improve their performance and how they establish their
credentials and standing in society or an economy and so on.
The theory of the firm aims at answering the following questions:
• Existence – why do firms emerge and exist, why are not all transactions in the economy
mediated over the market?
• Which of their transactions are performed internally and which are negotiated in the
market?
• Organization – why are firms structured in such a specific way? What is the interplay of
formal and informal relationships?
• Heterogeneity of firm actions/performances – what drives different actions and

performances of firms?
Firm and Industry
A Firm is a commercial enterprise, a company that buys and sells goods and services to
consumers with the aim of making a profit. A business entity such as a corporation, limited
liability company, public limited company, sole proprietorship, or partnership that has goods or
services for sale is categorized as a firm.
An Industry is an economic activity concerned with the processing of raw materials and
manufacture of goods. It can also be said as a sector that produces goods or related services
within an economy.
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Objectives of the Firm
1. Profit maximization
2. Sales maximization
3. Utility maximization
4. Increase market share/market dominance
5. Social/environmental concerns
6. Profit satisficing
7. Co-operatives
1. Profit maximization: Considering any business that exists, they are usually concerned
with maximizing profit.
Higher profit means:
 Higher dividends for shareholders.
 More profit can be used to finance research and development. Higher profit
makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers.
2. Sales Maximization: Firms often seek to increase their market share, even if it means
less profit. This could occur for various reasons:
 Increased market share increases monopoly power and may enable the firm to
put up prices and make more profit in the long run.
 Managers prefer to work for bigger companies as it leads to greater prestige and
higher salaries.
 Increasing market share may force rivals out of business. E.g. the growth of
supermarkets has led to the demise of many local shops. Some firms may actually
engage in predatory pricing which involves making a loss to force a rival out of
business.
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3. Utility maximization: It means “that managers get satisfaction from using some of
the firm's potential profits for unnecessary spending on items from which they personally
benefit.” To pursue his goal of utility maximisation, the manager directs
the firm's resources many ways.
4. Increase Market Share/ Market Dominance: This is similar to sales maximization and
may involve mergers and takeovers. With this objective, the firm may be willing to make
lower levels of profit in order to increase in size and gain more market share. More
market share increases its monopoly power and ability to be a price setter.
5. Social Concern: A firm may incur extra expense to choose products which don’t harm
the environment or products not tested on animals. Alternatively, firms may be concerned
about local community / charitable concerns.
 Some firms may adopt social/environmental concerns as part of their
branding. This can ultimately help profitability as the brand becomes more
attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone –
even if it does little to improve sales/brand image.
6. Profit Satisficing: Profit satisficing is a situation where there is a separation of

ownership and control. As a result, the owners are likely to have different objectives to
the managers and workers.
7. Co-operatives: Co-operatives may have completely different objectives to a typical

business. A co-operative is run to maximize the welfare of all stakeholders – especially
workers. Any profit the co-operative makes will be shared amongst all members.
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Alternate Objectives of the Firm:
• Economic objectives:
• Maximize growth rate
• Desire for liquidity
• Non-economic objectives:
• Survival
• Retention of Customers
• Innovation
• Recognition
• Optimum Utilization of Resources
• Supplying desired goods at reasonable prices
• Social welfare
• Building up public confidence for the public
Managerial Theories of the Firm:
Managerial theories of the firm place emphasis on various incentive mechanisms in explaining
the behaviour of managers and the implications of this conduct for their companies and the wider
economy.
According to traditional theories, the firm is controlled by its owners and thus wishes to
maximise short run profits. The more contemporary managerial theories of the firm examine the
possibility that the firm is controlled not by its owners, but by its managers, and therefore does
not aim to maximise profits. Although profit plays an important role in these theories as well, it
is no longer seen as the sole or dominating goal of the firm. The other possible aims might be
sales revenue maximisation or growth.
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Managerial Theories of the Firm
• Baumol's Theory of Sales Revenue Maximisation
• Marris Growth Maximization Model
• Williamson’s Managerial Discretionary Theory
1. Baumol's Theory of Sales Revenue Maximisation:

Baumol’s Model: Baumol's theory of sales revenue maximization was created by American
economist William Jack Baumol. It's based on the theory that, once a company has reached an
acceptable level of profit for a good or service, the aim should shift away from increasing profit
to focus on increasing revenue from sales.
W.J.Baumol suggested Sales Revenue maximisation as an alternative goal to profit

maximisation. Managers only ensure acceptable level of profit, pursuing a goal which enhances
their own utility.
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Assumption of the Theory:
1. There is a single period time horizon of the firm.
2. The firm aims at maximizing its total sales revenue in the long run subject to a profit
constraint.
3. The firm’s minimum profit constraint is set competitively in terms of the current market
value of its shares.
4. The firm is oligopolistic whose cost curves are U-shaped and the demand curve is
downward sloping. Its total cost and revenue curves are also of the conventional type.
From the above graph considering Output in X axis and TR/TC/profit in Y axis, where TC is the
total cost curve, TR the total revenue curve, TP the total profit curve and MP the minimum profit
or profit constraint line. The firm maximizes its profits at OQ level of output corresponding to
the highest point В on the TP curve. But the aim of the firm is to maximize its sales rather than
profits. The sales maximization output is OK where the total revenue KL is the maximum at the
sales maximization output OK is higher than the profit maximization output OQ. But sales
maximization is subject to minimum profit constraint highest point of TR. This sales
maximization output OK is higher than the profit maximization output OQ. But sales
maximization is subject to minimum profit constraint. The output OK will not maximize sales as
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the minimum profits OM are not being covered by total profits KS hence total revenue gets
decrease from L to E showing the quantity level showing the quantity of output ‘OD’. By the
above Baumol justified that sales revenue has to be optimally increased.
Arguments in favour of Maximisation of Sales Goal:

Baumol’s argument to justify sales revenue importance.
1. If the sales of a firm are declining then the banks, creditors and the capital market are not
prepared to provide finance to the firm anymore.
2. Its own distributors and dealers might stop showing interest on the firm’s product in
future.
3. Consumers might not buy its product because of its unpopularity and there is a more
chance of competitors acquiring the consumers.
4. Firm reduces its managerial and other staff with fall in sales.
5. But if firm’s sales are large, there are economies of scale and the firm expands and earns
large profits.
6. Salaries of workers and management also depend to a large extent on more sales and the
firm gives them bonus and other facilities.
Conclusion: This theory states that the sales maximization is to increase the total revenue by
money where, Sales can increase up to the point of profit maximization where the marginal cost
equals marginal revenue. If sales are increased beyond this point money sales may increase at the
expense of profits. If sales are increased beyond this point money sales may increase at the
expense of profits.
2. Marris’s Growth Maximization Model:

Robin Marris in his book The Economic Theory of ‘Managerial’ Capitalism (1964) has
developed a dynamic balanced growth maximising theory of the firm. He concentrates on the
proposition that modern big firms are managed by managers and the shareholders are the owners
who decide about the management of the firms.
The managers aim at the maximisation of the growth rate of the firm and the shareholders aim at
the maximisation of their dividends and share prices. To establish a link between such a growth
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rate and the share prices of the firm, Marris develops a balanced growth model in which the
manager chooses a constant growth rate at which the firm’s sales, profits, assets, etc., grow.
“In Corporate firms, there is structural division of ownership and management which allows
managers to set goals which do not necessarily conform with those of the owners.
The shareholders are the owners. Their utility function includes variables such as
• Profits,
• Size of output,
• Size of capital,
• Market share and
• Public image.
The Managers have other ideas. Their utility functions are:
• Salaries,
• Job security,
• Power and status.
The Marris’s model is based on the following assumptions:

• The objective of the firm is to maximise its balanced growth rate.
• The Growth itself depends on two factors: First, the rate of growth of demand for the
firm’s product - GD; and second, the rate of growth of capital supply – GS.
• All major variables such as profits, sales and costs are assumed to increase at the same
rate.
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Conclusion:
• Thus the manager of a firm aims at maximising his utility, and his utility depends upon
the rate of growth of the firm. Though promoting the growth of the firm is the main aim
of the manager, yet he is also motivated by his job security. The manager’s job security
depends upon the satisfaction of shareholders who are concerned to keep the firm’s share
prices and dividends as high as possible.
• Thus the manager aims at maximising the rate of growth of the firm and the shareholders
(owners) aim at maximising their profits in the form of dividends and share prices. Marris
analyses the means by which the firm tries to achieve its growth-maximisation goal.
3. Williamson’s Managerial Discretionary Theory:

 Oliver E. Williamson found (1964) that profit maximization would not be the
objective of the managers of a company.
 This theory assumes that utility maximisation is a manager’s sole objective. However
it is only in a corporate form of business organisation that a self-interest seeking
manager maximise his/her own utility, since there exists a separation of ownership
and control.
 The managers can use their ‘discretion’ to frame and execute policies which would
maximise their own utilities rather than maximising the shareholders’ utilities.
 This is essentially the principal–agent problem. This could however threaten their job
security, if a minimum level of profit is not attained by the firm to distribute among
the shareholders.
Managerial utility function:

The managerial utility function includes variables such as salary, job security, power, status,
dominance, prestige and professional excellence of managers.
The basic assumptions of the model are:
• Imperfect competition in the markets.
• Divorce of ownership and management.
• A minimum profit constraint exists for the firms to be able to pay dividends to their
shareholders.
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Arguments:
• In the Williamson theory or model argues that managers have discretion in pursuing
policies which maximize their own utility rather than attempting the maximization of
profits which maximizes the utility of owner and shareholders.
• Profit acts as a constraint to this managerial behavior in that the financial market and the
shareholders require a minimum profit to be paid out in the form of dividends, otherwise
the job security of managers is endangered.
• In this theory Williamson considered the two important factors namely, staff
expenditures on emoluments (slack payments), and funds available for discretionary
investment give to managers a positive satisfaction (utility) because these expenditures
are a source of security and reflect the power, status, prestige and professional
achievement of managers.
• Being the head of a large staff is a symbol of power, status and prestige, as well as a
measure of professional success, because a progressive and increasing staff implies
successful expansion of the particular activity for which a manager is responsible within
a firm.
From the above graph, taking Discretion Profit in Y-axis and Staff Expenditure in X- axis, where
U1, U2, U3 shows the utility level of the managers with facilities provided by the firm. With the
different combination of factors the level of utility changes. Hence the profit of the firm relies on
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the ideal combination of factors such as Discretion Profit and Staff Expenditure.
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Criticism:
1. This model does not clarify the basis of the derivation of his feasibility curve. In particular, he
fails to indicate the constraint in the profit-staff relation, as shown by the shape of the feasibility
curve.
2. It lumps together staff and manager’s emoluments in the utility curve. This mixing up of non-
pecuniary and pecuniary benefits of the manager makes the utility function ambiguous.
3. This model does not deal with oligopolistic interdependence and of oligopolistic rivalry.
Question Bank:
1. Define managerial economics.
2. Explain the concepts of Micro and Macro economics.
3. Discuss the scope of managerial economics.
4. Explain the significance and uses of managerial economics.
5. Elaborate the roles and responsibilities of managerial economist.
6. Discuss the objectives of the firm.
7. Explain the Baumol’s sales revenue maximization model, with a suitable graph.
8. What are the assumptions of Marris’s model? Explain with graph.
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Module -2 Demand Analysis
Law of Demand, Exceptions to the Law of Demand, Elasticity of Demand –Classification

of Price, Income & Cross elasticity, Advertising and promotional elasticity of demand.
Uses of elasticity of demand for Managerial decision making, Measurement of elasticity of
demand. Law of supply, Elasticity of supply, Demand forecasting: Meaning &
Significance, Methods of demand forecasting.
Introduction:
The economy relies on the willingness of consumers to make purchases and the ability of
companies to supply them. When consumers make more purchases, inflation and interest rates
decrease. When consumers decrease their purchases or if producers are unable to supply,
inflation and interest rates increase. Consumer demand drives production and supports a thriving
economy. In this article, we provide the demand definition in economics, explore the different
types of demand and explain the factors that influence it.
Meaning of Demand:
Demand is an economic principle referring to a consumer's desire to purchase goods and
services and willingness to pay a price for a specific good or service.
Demand refers to the willingness and ability of consumers to purchase a given quantity of a
good or service at a given point in time or over a period in time. Demand is a consumer want or
a need supported by an ability to pay.
Types of demand:
• Joint demand
• Composite demand
• Short-run and long-run demand
• Price demand
• Income demand
• Competitive demand
• Direct and derived demand
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Factors that influence demand:

Demand is influenced by the activities of consumers and businesses. Businesses attempt to drive
demand through marketing efforts. Consumers drive demand through their tastes, income levels
and resistance to price increases.
 Expectations
 Income
 Price
 Availability of alternatives
 Complementary products
 Consumer preferences
 Market size
Demand Analysis:
Demand analysis is the process of understanding the customer demand for a product or service in
a target market. Companies use demand analysis techniques to determine if they can successfully
enter a market and generate expected profits to expand their business operations. It also gives a
better understanding of the high-demand markets for the company’s offerings, using which
businesses can determine the viability of investing in each of these markets.
Steps in market demand analysis:
 Market identification
 Business cycle
 Product Niche
 Evaluate competition
Law of Demand:
The Law of demand explains the functional relationship between price of a commodity and the
quantity demanded of the commodity. It is observed that the price and the demand are inversely
related which means that the two move in the opposite direction.
An increase in the price leads to a fall in quantity demanded and vice versa. This relationship can
be stated as “Other things being equal, the demand for a commodity varies inversely as the
price”.
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Demand Schedule:
It states that “As the price of any goods and services increases, the quantity demanded of that
good and services decreases as all other factors remains constant”. Even the vice versa is also
true.
Demand Curve
From the above graph, considering factor price in Y-axis and Quantity demanded in X-axis and
initial price of any goods and services be P3 and the corresponding quantity demanded be Q3. As
the price of any goods and services increases from P3 to P2 and P1, the corresponding quantity
demanded for any goods and services decreases from Q3 to Q2 and Q1 respectively. Hence the
law says that as the price gets increases the quantity demanded falls. Even considering the case
of vice versa also satisfies.
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Relationship between Price and Quantity demanded:

1. As the price increases, the quantity demanded decreases.
2. As the prices decreases, the quantity demanded increases.
Exceptions to the Law of Demand:

There are two exceptions to the Law of Demand where we consider that as a rare case. Giffen
and Veblen goods are exceptions to the Law of Demand. However, they are extreme cases and
can be quite difficult to prove. But economists generally agree that there are rare cases where the
Law of Demand is violated.
The demand curve slopes from left to right upward if despite the increase in price of the
commodity, people tend to buy more due to reasons like fear of shortages or it may be an
absolutely essential good. The law of demand does not apply in every case and situation. The
circumstances when the law of demand becomes ineffective are known as exceptions of the law.
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Some of these important exceptions are as under:

 Giffen Goods
 Conspicuous Consumption / Veblen Effect
 Conspicuous Necessities
 Ignorance
 Emergencies
 Future Changes In Prices
 Change In Fashion
 Demonstration Effect
 Snob Effect
 Seasonal Goods
 Giffen Goods: Some special varieties of inferior goods are termed as Giffen goods.
Cheaper varieties millets like bajra, cheaper vegetables like potato etc come under
this category.
 Conspicuous Consumption / Veblen Effect: This exception to the law of demand is
associated with the doctrine propounded by Thorsten Veblen. A few goods like
diamonds etc are purchased by the rich and wealthy sections of society. The prices of
these goods are so high that they are beyond the reach of the common man.
 Conspicuous Necessities: Certain things become the necessities of modern life. So we
have to purchase them despite their high price. The demand for T.V. sets, automobiles
and refrigerators etc. has not gone down in spite of the increase in their price.
 Ignorance: A consumer’s ignorance is another factor that at times induces him to
purchase more of the commodity at a higher price. This is especially true, when the
consumer believes that a high-priced and branded commodity is better in quality than a
low-priced one.
 Change in Fashion: A change in fashion and tastes affects the market for a
commodity. The law of demand becomes ineffective.
 Emergencies: During emergencies like war, famine etc, households behave in an
abnormal way. Households accentuate scarcities and induce further price rise by making
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increased purchases even at higher prices because of the apprehension that they may not
be available.
 Future Changes in Prices: Households also act as speculators. When the prices
are rising households tend to purchase large quantities of the commodity out of the
apprehension that prices may still go up.
 Demonstration Effect: It refers to a tendency of low income groups to imitate the
consumption pattern of high income groups. They will buy a commodity to imitate the
consumption of their neighbors even if they do not have the purchasing power.
 Snob Effect: Some buyers have a desire to own unusual or unique products to show
that they are different from others. In this situation even when the price rises the
demand for the commodity will be more.
 Seasonal Goods: Goods which are not used during the off-season (seasonal goods) will
also be subject to similar demand behaviour.
Elasticity of Demand:
The term elasticity means a proportionate (percentage) change in one variable relative to a
proportionate (percentage) change in another variable. The quantity demanded of a good is
affected by changes in the price of the good, changes in price of other goods, changes in income
and changes in other factors. Elasticity is a measure of just how much of the quantity demanded
will be affected due to a change in price or income.
Elasticity of Demand is a technical term used by economists to describe the degree of
responsiveness of the demand for a commodity due to a fall in its price. A fall in price leads to an
increase in quantity demanded and vice versa.
In other words, it is the percentage change in quantity demanded divided by the percentage
change in one of the variables on which demand depends.”
Classification of Elasticity of Demand:

1. Price Elasticity of Demand.
2. Income Elasticity of Demand.
3. Cross Elasticity of Demand.
4. Advertising and Promotional Elasticity of Demand
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1. Price Elasticity of Demand:

The response of the consumers to a change in the price of a commodity is measured by the price
elasticity of the commodity demand.
The responsiveness of changes in quantity demanded due to changes in price is referred to as
price elasticity of demand. The price elasticity of demand is measured by dividing the percentage
change in quantity demanded by the percentage change in price.
Percentage change in quantity demanded

=
Percentage change in price
Price Elasticity of Demand
Determinants of Price Elasticity of Demand:
• Availability of substitutes
• Nature of need
• Consumer habits
• Price range
• Number of users
• Possibility of consumption
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2. Income Elasticity of Demand:

It measures the responsiveness of demand after a change in income level of individuals. Income
elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a
change in real income of consumers who buy this good, keeping all other things constant.
“It is the ratio of percentage change in quantity demanded over the percentage change in income
level of individuals”.
Percentage change in quantity demanded

=
Percentage change in Income
Income Elasticity of Demand
In the given figure, quantity demanded and consumer’s income is measured along X-axis and Y-
axis respectively. The small rise in income from OY to OY1 has caused greater rise in the
quantity demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income
elasticity greater than unity.
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3. Cross Elasticity of Demand:
It measures the responsiveness of demand of one product, after a change in price level of other
product. “It is the ratio of percentage change in quantity demanded of any one product (X) over
the percentage change in price level of other product (Y)”.
The cross elasticity of demand for substitute goods and complimentary goods is always positive
because the demand for one good increases when the price for the substitute goods and
complimentary goods increases.
For example: if there is an increase in the price of tea by 10%. and the quantity demanded for
coffee increases by 2%, then the cross elasticity of demand = 2/10 = +0.2.
If two commodities are unrelated goods, the increase in the price of one good does not result in
any change in the demand for the other goods.
% increase in quantity demanded of product A
Cross Elasticity of Demand = --------------------------------------------------
% increase in price of product B
Cross Elasticity of Demand

In the above figure, quantity demanded for Coke and price of Pepsi are measured along X-axis
and Y-axis respectively. When the price of Pepsi increases from OP to OP1, quantity demanded
for coke rises from OQ to OQ1 and vice versa. Thus, the demand curve DD shows positive cross
elasticity of demand.
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4. Advertising and Promotional Elasticity of Demand:

In the modern competitive or partial competitive market economy, advertising has a great
significance. Under advertising, various visible or verbal activities are done by the firm for the
purpose of creating or increasing demand for its goods or services. Informative advertising is
very helpful for the consumer in making rational purchase decisions.
“It is a ratio of percentage change in quantity demanded of any goods and services over the
percentage change in expenses incurred for advertising and promotion”.
Following is the formula for advertising elasticity. EA = Percentage ΔQ/Percentage Δ A
% increase in quantity demanded

Cross Elasticity of Demand =
% increase in advertisement expenses
The extension of demand through advertising can be measured by advertising or promotional

elasticity of demand (EA) which measures the expected changes in demand as a result of change
in other promotional expenses. The demand for some goods is affected more by advertising.
• Advertising elasticity of demand (AED) measures the impact advertising expenditure has
in generating new sales for a company.
• Companies want a positive AED because this indicates their advertising efforts are
resulting in an increased demand for their goods and services.
• AED may not be the most accurate predictor of advertising's impact on sales because it
does not take into account other factors that affect demand, such as changes in consumer
tastes and spending habits.
• Consumer demand can also be impacted by the price of products and the availability of
lower-priced substitutes.
Criticism of Advertising Elasticity of Demand (AED)

Because a number of outside factors, such as the state of the economy and consumer tastes, may
also result in a change in the quantity of a good demanded, the advertising elasticity of demand is
not the most accurate predictor of advertising's effect on sales. For example, in a sector where all
competitors advertise at the same level, additional advertising may not have a direct effect on
sales.
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Uses of Elasticity of Demand for Managerial Decision Making:
• Determination of Price policy: Determination of Prices means to determine the cost of

goods sold and services rendered in the free market. A manufacturer has to consider the
elasticity of demand for the product.
• Price discrimination: it is an act of selling same products at different prices to different

section of customers or in different sub-markets. A monopolist adopts a price
discrimination policy only when the elasticity of demand of different consumers or sub-
markets is different. Consumers whose demand is inelastic can be charged a higher price
than those with more elastic demand.
• Public utility pricing: In case of public utilities which are run as monopoly undertakings
e.g. elasticity of water supply, railways, postal services, price discrimination is generally
practiced, charging higher prices from consumers or users with inelastic demand and
lower prices in case of elastic demand.
• Shifting of tax burden: It is possible for a business to shift a commodity tax in case of
inelastic demand to his customers. But if the demand is elastic, he will have to bear the
tax burden himself, otherwise demand for his goods will go down sharply.
• Pricing of Joint supply products: Certain goods, being products of the same process are
jointly supplied, e.g. wool and mutton. Here if the demand for wool is inelastic compared
to the demand for mutton, a higher price for wool can be charged with advantage.
• Super Markets: Super-markets are a combined set of shops run by a single organization
selling a wide range of goods. They are supposed to sell commodities at lower prices than
charged by shopkeepers in the bazaar. Hence, price policy adopted is to charge slightly
lower price for goods with elastic demand.
• Use of machines on employment: Workers often oppose use of machines out of fear of
unemployment. Machines need not always reduce demand for labor as this depends on
price elasticity of demand for the commodity produced. When machines reduce costs and
hence price of products, if the products demand is elastic, the demand will go up,
production will have to be increased and more workers may be employed for the product
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is inelastic, machines will lead to unemployment as lower prices will not increase the
demand.
• Factor pricing: The factors having price inelastic demand can obtain a higher price than
those with elastic demand. Workers producing products having inelastic demand can
easily get their wages raised.
• Taxation policy: Government can easily raise tax revenue by taxing commodities which
are price inelastic.
• International trade: (a) A country benefits from exports of products as have price
inelastic demand for a rise in price and elastic demand for a fall in price. (b) The demand
for imports should be inelastic for a fall in price and elastic for a rise in price. (c) While
deciding whether to devalue a country’s currency or not, price elasticity of demand for a
country’s exports would be an important factor to be taken into consideration. If the
demand is price elastic, it would lead to an increase in the country’s exports and
devaluation would fail to achieve its objective.
Measurement of Elasticity of Demand:

The price elasticity of demand is measured by its coefficient (Ep). This coefficient (Ep) measures
the percentage change in the quantity of a commodity demanded resulting from a given
percentage change in its price. If EP>1, demand is elastic. If EP< 1, demand is inelastic, and Ep=
1, demand is unitary elastic.
1. Perfectly Elastic Demand (If Ed = ∞)
2. Relatively Elastic Demand (If Ed > 1)
3. Unitary Elastic Demand (If Ed = 1)
4. Perfectly Inelastic Demand (If Ed = 0)
5. Relatively Inelastic Demand (If Ed is between 0 and 1 or < 1)
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1. Perfectly Elastic Demand (If Ep (Ped) = ∞): If Ep (Ped) = ∞ said to be perfectly elastic,
where the price remains constants but influences the demand to change. Hence the
demand curve will be horizontal in nature.
It is one in which a no or very small change in price will cause a large change in amount
demanded. A no or very small rise in price reduces the demand to zero. A small decrease
in price leads to a big expansion in demand.
2. Relatively Elastic Demand (If Ep (Ped) > 1): If Ep (Ped) > 1 said to be relatively elastic,
then demand responds more than proportionately to a change in price. The demand is said
to be relatively elastic when the change in demand is more than the change in price.
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3. Unitary Elastic Demand (If Ep (Ped) = 1): If Ep (Ped) = 1 said to be unitary elastic (i.e.
the % change in demand is exactly the same as the % change in price), then demand is
unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total
spending the same at each price level. In this type of demand a given percentage change
in price leads to exactly the same percentage change in amount demanded. As there is no
change in the demand and price it is called as unitary demand.
4. Perfectly Inelastic Demand (If Ep (Ped) = 0): If Ep (Ped) = 0 said to be demand is

perfectly inelastic, where demand does not change at all when the price changes. Hence
the demand curve will be vertical in nature. This is one which shows that whatever the
change in price may be the amount demanded remains same.
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5. Relatively Inelastic Demand (If Ep (Ped) is between 0 and 1): If Ep (Ped) is between 0
and 1 said to be relatively inelastic, (i.e. the % change in demand is smaller than the
percentage change in price), then demand is inelastic.
When the change in demand is less than the change in price, then the demand is said to be
inelastic.
Demand Forecasting:
All organizations operate in an atmosphere of uncertainty but decisions must be made today that
affect the future of the organization. There are various ways of making forecasts that rely on
logical methods of manipulating the data that have been generated by historical events. A
forecast is a prediction or estimation of a future situation, under given conditions.
Meaning: Demand Forecasting is the process in which historical sales data is used to develop an
estimate of an expected forecast of customer demand. To businesses, Demand Forecasting
provides an estimate of the amount of goods and services that its customers will purchase in the
future.
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Demand forecast will help the manager to take the following decisions effectively.
Significance of Demand Forecasting:

 Fulfilling objectives.
 Preparing the budget.
 Stabilizing employment and production.
 Expanding organizations.
 Taking Management Decisions.
 Evaluating Performance.
 Helping Government.
Methods of Demand Forecasting:

1. Qualitative or Survey method
a. Consumer survey
b. Collective opinion model
c. Sales force pooling
d. Delphi (experts opinion) method
2. Quantitative or Statistical method
a. Trend projection
b. Barometric
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c. Econometric
d. Moving average
1. Qualitative or Survey method:

The survey method or qualitative method is one of the most commonly used methods for
forecasting demand in the short term. In this, organizations conduct surveys to determine
demand directly from consumers.
Qualitative techniques are the ones which apply knowledge of the business, market, product and
customer to make a judgment call on the forecast. There are many qualitative techniques used in
forecasting. These techniques are primarily based on opinion, like the Delphi Method, Market
Research, Panel consensus etc.
a. Survey Method: Survey method is one of the most common and direct methods of
forecasting demand in the short term. The data considered to be as a primary data can be
collected by using the various techniques such as interviewing methods, by using
questionnaires and by observation.
Hence Survey method can be classified into 2 main types namely,
 Buyer Intentions. This method encompasses the future purchase plans of consumers and
their intentions. In this method, an organization conducts surveys with consumers to
determine the demand for their existing products and services and anticipate the future
demand accordingly.
 Seller Intentions. This method encompasses the future sells plans of seller and their
intentions. In this method, an organization conducts surveys with seller to determine their
approach for their existing products and services and anticipate the future demand
accordingly. It also helps in setting sales targets, which act as a basis for evaluating sales
performance. An organization make demand forecasts for different regions and fix sales
targets for each region accordingly.
b. Collective opinion model:In this method, sales representatives predict the estimated future
sales individually in their respective areas. The individual estimates are then aggregated to
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determine the total estimated future sales. The principle underlying this method is that
salesmen are closest to the consumers and they have the intimate feel of the market.
c. Sales force pooling: Under this method, the salesman are nearest persons to the customers
and are able to judge, their minds and market. They estimates changes in sales price, product,
designs, publicity programmes, expected changes in competition, purchasing power, income
distribution, employment and population. It makes use of collective wisdom of salesmen,
departmental heads and top executives.
d. Delphi (experts opinion) method: This technique is a group process where experts in the
field of marketing research make demand forecasting. The experts are interrogated through a
sequence of questionnaires in which responses to the first questionnaire are used to prepare
the second questionnaire. The information available to some experts is shared with all experts
for forecasting. This method is used for long term forecasting to estimate potential sales for
new products. This method presumes two conditions:-
1) The panelists must be rich in expertise, knowledge, and experience.
2) The conductors are objective in their job. This method saves time and other resources.
2. Quantitative or Statistical method:

The statistical methods are used when forecasting is to be done for a longer period of time. These
methods utilize the time series and cross-sectional data to estimate demand. these methods are
considered more superior as compared to other methods due to the following reasons:
1) The estimates are real.
2) There is a minimum subjectivity in these methods.
3) The cost involved is minimal.
Methods are scientific and based on the relationship between the dependent and independent
variables.
a. Trend Projection Method: It is the most classical method of business forecasting, which is
concerned with the movement of variables through time, this method requires a long time-
series data. The trend projection method is based on the assumption that the factors liable for
the past trends in the variables to be projected shall continue to play their role in the future in
the same manner and to the same extent as they did in the past while determining the
variable’s magnitude and direction.
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b. Barometric Method: It is a method of forecasting was developed to forecast the trend in the
overall economic activities. This method can nevertheless be used in forecasting the demand
prospects, not necessarily the actual quantity expected to be demanded. Often, the barometric
method of forecasting is used by the meteorologists in weather forecasting. The weather
conditions are forecasted on the basis of the movement of mercury in a barometer. Based on
this logic, economists use economic indicators as a barometer to forecast the overall trend in
the business activities.
c. Econometric Method: It is a Method that makes use of statistical tools and economic
theories in combination to estimate the economic variables and to forecast the intended
variables. The econometric model can either be a single-equation regression model or may
consist a system of simultaneous equations. In most commodities, the single-equation
regression model serves the purpose. But, however, in the case where the explanatory
economic variables are so interdependent or interrelated to each other that unless one is
defined the other variable cannot be determined, a single-equation regression model does not
serve the purpose. And, therefore in such situation, the system of simultaneous equations is
used to forecast the variable.
d. Moving Average (MA): Moving average or simple moving average is the simplest way to
forecast by calculating an average of last ‘n’ periods. The average value is considered to be
the forecasted value for the next period.
Question Bank:
1. Explain the term Demand.
2. What is Income elasticity of demand?
3. What is meant by Advertising Elasticity?
4. State “Law of Demand”. What are its exceptions?
5. Explain the different survey methods of demand forecasting.
6. Explain Cross – elasticity of demand. Explain its uses.
7. Explain the different methods of demand forecasting.
8. What is price elasticity of demand? Explain diagrammatically different types degrees of
price elasticity.
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Module – 3
Production Analysis & Cost Analysis
Production Analysis: Concepts, production function with one variable input - Law of Variable
Proportions. Production function with 2 variable inputs and Laws of returns to scale, Indifference
Curves, ISO-Quants & ISO-Cost line, Least cost combination factor, Economies of scale,
Diseconomies of scale. Technological progress and production function
Cost Analysis: Concepts, Types of cost, Cost curves, Cost – Output Relationship in the short run
and in the long run, LAC curve
Break Even Analysis: Meaning, Assumptions, Determination of BEA, Limitations, Uses of BEA in
Managerial decisions..
3.1 Introduction or Production Concepts:

Production can be defined as an organized activity of transforming physical inputs into output
which will satisfy the products needs of the society.
or
Production is an act of creating value that satisfies the wants of the individuals.
Production refers to the transformation of inputs or resources into outputs or goods and services.
Production is a process in which economic resources or inputs (composed of natural resources
like labour, land and capital equipment) are combined by entrepreneurs to create economic
goods and services (outputs or products).
Firms are required to take different but interrelated production decisions like:
1. Whether or not to actually produce or shut down?
2. How much to produce?
3. What input combination to use?
4. What type of technology to use?
Factors of Production:
Factors of production include resource inputs used to produce goods and services. Economist
categorizes input factors into four major categories such as land, labor, capital and organization.
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 Land: Land is heterogeneous in nature. The supply of land is fixed and it is a permanent
factor of production but it is productive only with the application of capital and labour.
 Labour: The supply of labour is inelastic in nature but it differs in productivity

and efficiency and it can be improved.
 Capital: is a man made factor and is mobile but the supply is elastic. Capital used in
production is of two types namely, physical capital and human capital.
 Entrepreneurship: the organization plans, supervises, organizes and controls the business
activity and also takes risks.
Production Analysis refers to analyzing the inputs or resources that are used to produce a firm’s
final product. It defines the relationships between the prices of the commodities and productive
factors on one hand and the quantities of these commodities and productive factors that are
produced on the other hand.
Production analysis basically is concerned with the analysis in which the resources such as land,
labor, and capital are employed to produce a firm’s final product. To produce these goods the
basic inputs are classified into two divisions:
Variable Inputs: Inputs those change or are variable in the short run or long run are variable
inputs.
Fixed Inputs: Inputs that remain constant in the short term are fixed inputs.
Production Function signifies the technical relationship between the physical inputs and
physical outputs of the firm for given production technology.
Q = f (a, b, c,.............z)
Where a,b,c.....z are various inputs such as land, labor ,capital etc.
Q is the level of the output for a firm.
If labor (L) and capital (K) are only the input factors, the production function reduces to −
Q = f(L, K)
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Production Function describes the technological relationship between inputs and outputs. It is a
tool that analysis the qualitative input – output relationship and also represents the technology of
a firm or the economy as a whole.
3.2 Short Run & Long Run of A Firm:

The distinction between the short run and the long run is based on the difference between fixed
and variable factors. A factor of production is treated as a fixed factor if it cannot easily be
varied over the time period under consideration. On the other hand, a variable factor is one which
can be varied over the time period under consideration.
The short run is defined to be that period of time when some of the firm’s inputs are fixed.
Since it is most difficult to change plant and equipment among all inputs, the short run is
generally accepted as the time interval over which the firm’s plant and equipment remain fixed.
The long run is that period over which all the firms’ inputs are variable. In other words, the firm
has the flexibility to adjust or change its environment. Production processes of firms generally
permit a variation in the proportion in which inputs are used. In the long run, input proportions
can be varied considerably.
3.3 Measure of Productivity or Production Schedule:
Production schedule refers to table showing the fixed inputs and variable inputs and the total
production, marginal and average production accordingly.
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From table,
Total Product is the total output resulting from the efforts of all the factors of production
combined together at any time.
Average Product is the total product per unit of the variable input.
Marginal Product is the change in the total product per unit change in the quantity of variable
factor.
3.4 Productions function with one variable input:
The production function shows the maximum output or total product (TP) that can be produced
by employing a combination of factors of production at a given time period. The average product
(AP) depicts the TP per unit of input used. The marginal product (MP) is the change in the total
product resulting from a unit change in a variable input. If we assume labour (L) as a variable
input, then
• TPL=f(L)
• APL=TP/L
• MPL=ΔTP/ΔL
3.5 Law of Variable Proportion or Law of Returns to factor:
States that “As the proportion of one factor in a combination of factors is increased, after certain
point first the marginal product and then the average product of that factor will diminish.”
Assumptions of Law of variable proportion:

1. Only one factor in combination of factors is variable and rest are constant
2. All units of variable factor are homogenous
3. Technology pf production remains constant
4. Firm considers to be in short run
5. Output products are measured in physical units.
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**Note: Above table is optional while writing in exams**
Three Stages of the Law:
1. First Stage: Increasing Returns
First stage starts from point ‘O’ and ends up to point F. At point F average product is maximum
and is equal to marginal product. In this stage, total product increases initially at increasing rate
up to point E. between ‘E’ and ‘F’ it increases at diminishing rate. Similarly marginal product
also increases initially and reaches its maximum at point ‘H’. Later on, it begins to diminish and
becomes equal to average product at point T. In this stage, marginal product exceeds average
product (MP > AP).
2. Second Stage: Constant returns

It begins from the point F. In this stage, total product increases at diminishing rate and is at its
maximum at point ‘G’ correspondingly marginal product diminishes rapidly and becomes ‘zero’
at point ‘C’. Average product is maximum at point ‘I’ and thereafter it begins to decrease. In this
stage, marginal product is less than average product (MP < AP).
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3. Third Stage: Diminishing Returns
This stage begins beyond point ‘G’. Here total product starts diminishing. Average product also
declines. Marginal product turns negative. Law of diminishing returns firmly manifests itself. In
this stage, no firm will produce anything. This happens because marginal product of the labour
becomes negative. The employer will suffer losses by employing more units of labourers.
However, of the three stages, a firm will like to produce up to any given point in the second stage
only.
**Note: Above table is optional while writing in exams and is for sole purpose of
understanding**
3.6 Production Function with two variable inputs:
Refers to the relationship between the output resulting in production by varying the two or more
inputs. There may be various technical possibilities of producing a given output by using
different factor combinations. Which particular factor combination will be actually selected by
the firm depends both on the technical possibilities of factor substitution as well as on the prices
of the factors of production.
Production Function with two Variable Inputs explains the production behavior of the firm with
all variable factors. We are restricting our analysis to two variable inputs because it simply
allows us the scope for graphical analysis.
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3.7 Law of Returns to Scale:
Stated as “The relationship between changes in the output and proportionate change in all factors
of production”
Assumptions of Law of returns to scale:
1. All inputs or factors of production are variable
2. Production technology remains constant
3. Product produce is measure in physical units
Scale of
Unit Total Returns Marginal Returns
Production
1 1 Labor + 2 4 4 (Stage I - Increasing Returns)

Acres of Land
2 2 Labor + 4 10 6
Acres of Land
3 3 Labor + 6 18 8
Acres of Land
4 4 Labor + 8 28 10 (Stage II - Constant Returns)

Acres of Land
5 5 Labor + 10 38 10
Acres of Land
6 6 Labor + 12 48 10
Acres of Land
7 7 Labor + 14 56 8 (Stage III - Decreasing Returns)

Acres of Land
8 8 Labor + 16 62 6
Acres of Land
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RS = Returns to scale curve

RP = Segment of stage 1: increasing returns to scale
PQ = segment of stage 2: constant returns to scale
QS = segment of stage 3: decreasing returns to scale
Stage 1: Increasing Returns to Scale
In figure, stage I represents increasing returns to scale. During this stage, the firm enjoys various
internal and external economies such as technical economies, managerial economies and
marketing economies. Economies simply mean advantages for the firm. Due to these economies,
the firm realizes increasing returns to scale. This stage is also explained saying increasing returns
in terms of “increased efficiency” of labor and capital in the improved organization with the
expanding scale of output and employment factor unit. It is referred to as the economy of
organization in the earlier stages of production.
Stage 2: Constant Returns to Scale

In figure, the stage II represents constant returns to scale. During this stage, the economies
accrued during the first stage start vanishing and diseconomies arise. Diseconomies refers to the
limiting factors for the firm’s expansion. Emergence of diseconomies is a natural process when a
firm expands beyond certain stage. In the stage II, the economies and diseconomies of scale are
Page46
exactly in balance over a particular range of output. When a firm is at constant returns to scale,
an increase in all inputs leads to a proportionate increase in output but to an extent.
Stage 3: Diminishing Returns to Scale
In figure, the stage III represents diminishing returns or decreasing returns. This situation arises
when a firm expands its operation even after the point of constant returns. Decreasing returns
mean that increase in the total output is not proportionate according to the increase in the input.
Because of this, the marginal output starts decreasing. Important factors that determine
diminishing returns are managerial inefficiency and technical constraints.
3.8 Iso-Quants:
Iso-Quant is a curve showing all possible combinations of inputs or factors of production

physically capable of producing a given level of output. Iso-quants are also called as Iso-
Products or Equal-product curves.
Isoquants are a geometric representation of the production function. The same level of output can
be produced by various combinations of factor inputs. The locus of all possible combinations is
called the ‘Isoquant’.
Below table and graph helps to understand the concept of isoquant
Page47
Assumptions of Isoquants:
1. There are only two factors of production
2. Factors of production is divisible into smaller units and can be used in proportions
3. Production technology remains constant
4. Different factors are used in most efficient way.
Properties of Iso-Quants:
Property 1: An isoquant curve slopes downward, or is negatively sloped. This means that the
same level of production only occurs when increasing units of input are offset with lesser units of
another input factor. This property falls in line with the principle of the Marginal Rate of
Technical Substitution (MRTS). As an example, the same level of output could be achieved by a
company when capital inputs increase, but labor inputs decrease.
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Property 2: An isoquant curve, because of the MRTS effect, is convex to its origin. This
indicates that factors of production may be substituted with one another. The increase in one
factor, however, must still be used in conjunction with the decrease of another input factor.
Property 3: Isoquant curves cannot be tangent or intersect one another. Curves that intersect
are incorrect and produce results that are invalid, as a common factor combination on each of the
curves will reveal the same level of output, which is not possible.
Property 4: Isoquant curves in the upper portions of the chart yield higher outputs. This is
because, at a higher curve, factors of production are more heavily employed. Either more capital
or more labor input factors result in a greater level of production.
Property 5: An isoquant curve should not touch the X or Y axis on the graph. If it does, the
rate of technical substitution is void, as it will indicate that one factor is responsible for
producing the given level of output without the involvement of any other input factors.
Property 6: Isoquant curves do not have to be parallel to one another; the rate of technical
substitution between factors may have variations.
Property 7: Isoquant curves are oval-shaped, allowing firms to determine the most efficient
factors of production.
**Graphs for the properties are given in class and refer them**
Types of Isoquant:
Isoquants are differentiated on the basis of substitutability of the factors of production and they
are as below
1. Linear Isoquant:
This type of isoquant are depicted by a straight line sloping downward from left to right, as
shown in Figure-(a). It indicated a perfect and unlimited substitutability between two factors
implying that the product may be produced even by using only capital or labour or by infinite
combinations of the two factors.
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2. Right angled Isoquant:
are L-shaped curve Figure-(b) and also known as Leontief isoquants. They assume a perfect
complementary nature between factors implying zero substitutability. Factors are jointly used in
a fixed proportion. It means that there is only one method of production to produce a commodity.
Hence, to increase output, both factors are to be increased holding the proportion constant.
3. Convex Isoquant:
In this the inputs can be substituted but not perfectly. The curve of this type is convex to origin
as we always consider for the isoquant curve.
3.9 Iso-Cost Curve:
Isocost line shows all combinations of inputs which cost the same total amount. The use of the
Isocost line pertains to cost-minimization in production, as opposed to utility-maximization. An
Isocost line shows the maximum amount which a firm is willing to expend on production.
Page50
For the two production inputs labor and capital, with fixed unit costs of the inputs, the equation
of the is cost line is
rK + wL=C
Where w represents the wage rate of labor,

r represents the rental rate of capital,
K is the amount of capital used,
L is the amount of labor used, and
C is the total cost of acquiring those quantities of the two inputs.
The cost-minimization problem of the firm is to choose an input bundle (K,L) feasible for the
output level that costs as little as possible. A cost-minimizing input bundle is a point on the
isoquant for the lowest possible isocost line.
3.10 Indifference Curve:
An indifference curve connects points on a graph representing different quantities of two goods,
points between which a consumer is indifferent. An indifference curve is a graph showing
combination of two goods that give the consumer equal satisfaction and utility. Each point on an
indifference curve indicates that a consumer is indifferent between the two and all points give
him the same utility.
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Graphically, the indifference curve is drawn as a downward sloping convex to the origin. The
graph shows a combination of two goods that the consumer consumes. The above diagram shows
the U indifference curve showing bundles of goods A and B. To the consumer, bundle A and B
are the same as both of them give him the equal satisfaction. In other words, point A gives as
much utility as point B to the individual. The consumer will be satisfied at any point along the
curve assuming that other things are constant.
3.11 Least Cost Combination Factor:
Producer’s equilibrium or optimization occurs when he earns maximum profit with optimal
combination of factors. A profit maximization firm faces two choices of optimal combination of
factors
1. To Maximize its output for a given cost
2. To minimize its cost for given output
Thus the least cost combination of factors refers to a firm producing the largest volume of output
from a given cost and producing a given level of output with the minimum cost when the factors
are combined in an optimum manner.
Assumptions made for to understand this concept are:
1. There are two factors, labour and capital.
2. All units of labour and capital are homogeneous.
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3. The prices of units of labour (w) and that of capital (r) are given and constant.
4. The cost outlay is given.
5. The firm produces a single product.
6. The price of the product is given and constant.
7. The firm aims at profit maximisation.
8. There is perfect competition in the factor market.
1. To maximize output for given cost:
The firm maximizes its profits by maximizing its output, given its cost outlays, and the prices of
the two factors. This analysis is based on the same assumptions, as given above.
From the fig, the firm can reach the optimal factor combination level of maximum output by
moving along the iso-cost line CL from either point E or F to point P. This movement involves
no extra cost because the firm remains on the same iso-cost line the firm is maximising its output
level of 200 units by employing the optimal combination of OM of capital and ON of labour,
given its cost outlay CL.
But it cannot be at points E or F on the iso-cost line CL, since both points give a smaller quantity
of output, being on the isoquant 100, than on the isoquant 200. The firm cannot attain a higher
level of output such as isoquant 300 because of the cost constraint.
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The firm is in equilibrium at point P where the isoquant curve 200 is tangent to the iso-cost line
CL Thus the equilibrium point has to be P with optimal factor combination OM + ON.
2. To minimize cost for given output:
Given these assumptions, the point of least-cost combination of factors for a given level of
output is where the isoquant curve is tangent to an iso-cost line. The iso-cost line GH is tangent
to the isoquant 200 at point M.
The firm employs the combination of ОС of capital and OL of labour to produce 200 units of
output at point M with the given cost-outlay GH. At this point, the firm is minimising its cost for
producing 200 units.
Any other combination on the isoquant 200, such as R or T, is on the higher iso-cost line KP
which shows higher cost of production. The iso-cost line EF shows lower cost but output 200
cannot be attained with it. Therefore, the firm will choose the minimum cost point M which is
the least-cost factor combination for producing 200 units of output.
M is thus the optimal combination for the firm. The point of tangency between the iso-cost line
and the isoquant is an important first order condition but not a necessary condition for the
producer’s equilibrium.
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3.12 Technological Progress and Production function:
As knowledge of new and more efficient methods of production become available, technology
changes. Furthermore new inventions may result in the increase of the efficiency of all methods
of production. At the same time some techniques may become inefficient and drop out from the
production function.
These changes in technology constitute technological progress. Graphically the effect of

innovation in processes is shown with an upward shift of the production function figure a, or a
downward movement of the production isoquant figure b. This shift shows that the same output
may be produced by less factor inputs, or more output may be obtained with the same inputs.
Figure-a Figure-b
Technical progress may also change the shape (as well as produce a shift) of the isoquant. Hicks
have distinguished three types of technical progress, depending on its effect on the rate of
substitution of the factors of production.
1. Capital-deepening technical progress:
Technical progress is capital-deepening (or capital-using) if, along a line on which the K/L ratio
is constant, the Marginal Rate of Substitution (MRS L K ) increases. This implies that technical
progress increases the marginal product of capital by more than the marginal product of labour.
The ratio of marginal products (which is the MRSL K) decreases in absolute value; but taking into
account that the slope of the isoquant is negative, this sort of technical progress increases the
MRSL K. The slope of the shifting isoquant becomes less steep along any given radius. The
capital-deepening technical progress is shown in figure
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Labour-deepening technical progress:
Technical progress is labour-deepening if, along a radius through the origin (with constant K/L
ratio), the MRSL, K increases. This implies that the technical progress increases the MP L faster
than the MPK. Thus the MRSL ,K, being the ratio of the marginal products [(∂X/∂L)]/[(∂X/∂K)],
increases in absolute value (but decreases if the minus sign is taken into account). The
downwards-shifting isoquant becomes steeper along any given radius through the origin. This is
shown in figure
Neutral-technical progress:
Technical progress is neutral if it increases the marginal product of both factors by the same
percentage, so that the MRSL K (along any radius) remains constant. The isoquant shifts
downwards parallel to itself. This is shown in figure
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3.13 Economies & Diseconomies of Scale:
Economies of scale are defined as the cost advantages that an organization can achieve by
expanding its production in the long run. In other words, these are the advantages of large scale
production of the organization. The cost advantages are achieved in the form of lower average
costs per unit.
It is a long term concept. Economies of scale are achieved when there is an increase in the sales
of an organization. Economies of scale are the cost advantages that enterprises obtain due to their
scale of operation, with cost per unit of output decreasing which causes scale increasing.
Figure illustrates that average cost falls as output increases, with the result that large firms may
enjoy lower costs that smaller competitors. This competitive cost advantage allows large firms to
have larger profit margins and have more options in pricing policy.
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Reason for Economies of Scale:
1. Managerial - managers are on a fixed salary
2. Marketing - advertising, endorsements promotional events do not directly depend on quantity

produced
3. Techinical - machinery, buildings etc are paid for as a fixed amount
4. Bulk buying - remember it is the cost per unit of buying in bulk not the total cost (Great
example is supermarkets and local shop)
5. Financial - similar in principle to buying in bulk but this time interest rates a more favorable.
The economies of scale are divided in to internal economies and external economies:
i. Internal Economies:
Refer to real economies which arise from the expansion of the plant size of the organization.
These economies arise from the growth of the organization itself.
Illustration of Internal Economies of Scale:
 Technical Economies of Scale

 Marketing Economies of Scale
 Financial Economies of Scale
 Managerial Economies of Scale
 Commercial Economies of Scale
ii. External economies:
Occur outside the organization. These economies occur within the industries which benefit
organizations. When an industry expands, organizations may benefit from better transportation
network, infrastructure, and other facilities. This helps in decreasing the cost of an organization.
Illustration of External Economies of Scale:
 Economies of Information
 Economies of Concentration
 Economies of Disintegration
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Diseconomies of scale are when the cost per unit of production (Average cost) increases because
the output (sales) increases.
Reasons for diseconomies of scale
1. Communication - becomes more complex
2. Coordination - between departments
3. X- Inefficiency - management costs increase (non-productive costs)
4. Principle agent problem - delegating to employees who are not as committed as the owner
3.13 Cost Analysis:
Cost Analysis refers to the measure of the cost – output relationship, i.e. the economists are
concerned with determining the cost incurred in hiring the inputs and how well these can be re-
arranged to increase the productivity (output) of the firm.
In other words, the cost analysis is concerned with determining money value of inputs (labor,
raw material), called as the overall cost of production which helps in deciding the optimum level
of production.
Cost refers to the money value that is incurred in acquiring the resources and producing the
product.
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Determinants of Cost:
 Level of output: The cost of production varies according to the quantum of output. If the
size of production is large then the cost of production will also be more.
 Price of input factors: A rise in the cost of input factors will increase the total cost of
production.
 Productivities of factors of production: When the productivity of the input factors is high
then the cost of production will fall.
 Size of plant: The cost of production will be low in large plants due to mass production
with mechanization.
 Output stability: The overall cost of production is low when the output is stable over a
period of time.
 Lot size: Larger the size of production per batch then the cost of production will come
down because the organizations enjoy economies of scale.
 Laws of returns: The cost of production will increase if the law of diminishing returns
applies in the firm.
 Levels of capacity utilization: Higher the capacity utilization, lower the cost of
production
 Time period: In the long run cost of production will be stable.
 Technology: When the organization follows advanced technology in their process then
the cost of production will be low.
 Experience: over a period of time the experience in production process will help the firm
to reduce cost of production.
 Supply chain and logistics: Better the logistics and supply chain, lower the cost of
production.
3.14 Types of Cost
Fixed Costs (FC): The costs which don’t vary with changing output. Fixed costs might include
the cost of building a factory, insurance and legal bills. Even if your output changes or you don’t
produce anything, your fixed costs stay the same.
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Variable Costs (VC): Costs which depend on the output produced. For example, if you produce
more cars, you have to use more raw materials such as metal. This is a variable cost.
Marginal Costs (MC): is the cost that incurred due to the production of an extra or additional
unit.
Opportunity Cost: Opportunity cost is the next best alternative foregone. “It is cost incurred
due to one’s own choice”, i.e the opportunity an individual loose by choosing other.
Incremental cost: Incremental cost is the total cost incurred due to an additional unit of product
being produced.
Explicit costs: these are costs that a firm directly pays for and can be seen on the accounting
sheet. Explicit costs can be variable or fixed and it is a clear amount.
Implicit costs: these are opportunity costs, which do not necessarily appear on its balance sheet
but affect the firm. For example the assets of the owner used for the purpose of business.
Sunk Cost: these are costs that have been incurred and cannot be recouped. Depreciation is
considered as one of the best example for sunk cost. Example if you spend money on advertising
to enter an industry, you can never claim these costs back.
Future Cost: It is a type of cost, where the cost incurred to estimate the future data or
forecasting of the organization. It is a type of cost which cannot be exceptional in nature.
Social Cost: This is the total cost to society. It will include the private costs plus also the
external cost (cost incurred by a third party). May also be referred to as ‘True costs’ where the
company spends on betterment of the society.
3.15 Cost Curves:
Total fixed costs: Given that total fixed costs (TFC) are constant as output increases, the curve is
a horizontal line on the cost graph.
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Total variable costs: The total variable cost (TVC) curve slopes up at an accelerating rate,
reflecting the law of diminishing marginal returns.
Total costs: The total cost (TC) curve is found by adding total fixed and total variable costs. Its
position reflects the amount of fixed costs, and its gradient reflects variable costs.
Total cost (TC) = Variable cost (VC) + fixed costs (FC)
3.16 Cost – Output Relationship in Short Run:
The below diagram shows Average Cost (AC), Average Fixed Cost (AFC), Average Variable
Cost (AVC) and Marginal Cost (MC) on OY-axis and units of output on OX-axis. AC, MC and
AVC are U-shaped curves. The U-shaped curves are on account of the operation of the laws of
return during short period. AFC curve shows a decreasing trend. MC curve passes through the
minimum points of AC and AVC curves.
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From the above graph;
1. Average Fixed Cost in Short Run: The average fixed cost is the total fixed cost divided by
the volume of output. There is an inverse relation between output and average fixed cost. With
the increase in output average fixed cost decreases and with the decrease in output the average
fixed cost will increase.
It is calculated from the following formula:
AFC = TFC/Q
 Q is volume of output
 AFC and TFC are average fixed cost and total fixed cost.
2. Average Variable Cost (AVC): The average variable cost is total variable cost divided by the
volume of output. Average variable cost falls with the increase in output, reaches at its minimum
and then starts rising. By the operation of law of increasing returns the AVC decreases, and by
the operation of constant returns leads to constancy in AVC and the law of diminishing returns
leads to increase in AVC. The shape of AVC is U-shaped because of the operation of the laws of
returns during short period.
The AVC is calculated by the formula given below:
AVC = TVC/Q
AVC and TVC are average variable cost and total variable cost while Q is the volume of output.
3. Average Total Cost (ATC): Average Total Cost (ATC) is the aggregate of AFC and AVC.
ATC can be calculated from total cost (TC) divided by the volume of output or by aggregating
AVC and AFC.
The ATC curve decreases with the increase in output and remains constant up to a point and
thereafter it increases with the increase in output. Its shape is U-shaped because of the operation
of the laws of return during short period.
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The following is the formula of calculating AC:
ATC = TC/Q or ATC = AFC + AVC
ATC and TC are average total cost and total cost while Q is the volume of output.
4. Marginal Cost (MC): It is an addition to total cost by producing an additional unit of output.
It can be calculated as the change in total cost divided by an additional unit change in the output.
Marginal Cost changes with the change in average variable cost (AVC) and it is independent of
average fixed cost (AFC). Initially, MC Falls, reaches the minimum and thereafter continuously
increases. MC is also U-shaped curve. MC curve cuts the ATC and AVC curves at their
minimum points.
MC = Change in ATC/ Change in Q
**Note: to understand the above concept**
(1) AFC declines continuously, approaching both axes asymptomatically (as shown by the de-
creasing distance between ATC and AVC) and is a rectangular hyperbola.
(2) AVC first declines, reaches a minimum at Q2and rises thereafter. When AVC is at its
minimum, MC equals AVC.
(3) ATC first declines, reaches a minimum at Q3, and rises thereafter. When ATC is at its
minimum, MC equals ATC.
(4) MC first declines, reaches a minimum at Q1, and rises thereafter. MC equals both AVC and
ATC when these curves are at their minimum values.
3.17 Cost – Output Relationship in Long Run:
Long period gives sufficient time to business managers to change even the scale of production.
All the factors of production are variable. All the costs are variable costs and there is no fixed
cost. The supply of goods can be adjusted to their demands because scale of production and
factors of production can be changed.
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Log Run Average Cost (LAC): In the long run, all the factors of production are variable and the
firm has a variety of choices to select the size of the plants and the factors of production to be
employed. Various short run average cost curves represent the various sizes of the plants
available to a firm. We can get the long run average cost curve with the help of all the short run
average cost curves. The long run average cost curve envelopes all the short run average cost
curves in it. It is also called an ‘Envelope Curve’ or ‘Planning Curve’.
From the above figure long run cost represented on OY-axis and output on OX-axis. SAC, SAC1,
SAC2, SAC3 and SAC4 are short run average cost curves which represent the different size of
plants. LAC has been drawn by combining all those points of least cost of producing the
corresponding output. The least per unit cost of production is OQ, OQ 1, OQ2, OQ3, OQ4, and
OQ5 respectively.
3.18 Break-Even Analysis: Break-even analysis seeks to investigate the interrelationships

among a firm’s sales revenue or total turnover, cost, and profits as they relate to alternate levels
of output. A profit-maximizing firm’s initial objective is to cover all costs, and thus to reach the
break-even point, and make net profit thereafter. This is explained with the example of an Break
Even Chart
The basic formula for break-even analysis is derived by dividing the total fixed costs of
production by the contribution per unit.
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Fixed Cost Fixed Cost
Break-even point in quantity (BEP) = or
Contribution per unit Selling price – Variable cost
Contribution per unit = Selling price per unit – Variable cost per unit
Break Even Chart: Break-Even charts, the concepts like total fixed cost, total variable cost, and
the total cost and total revenue are shown separately. The break even chart shows the extent of
profit or loss to the firm at different levels of activity.
In this diagram output is shown on the horizontal axis and costs and revenue on vertical axis.
Total revenue (TR) curve is shown as linear, as it is assumed that the price is constant,
irrespective of the output. This assumption is appropriate only if the firm is operating under
perfectly competitive conditions. Linearity of the total cost (TC) curve results from the
assumption of constant variable cost.
It should also be noted that the TR curve is drawn as a straight line through the origin (i.e., every
unit of the output contributes a constant amount to total revenue), while the TC curve is a straight
line originating from the vertical axis because total cost comprises constant / fixed cost plus
variable cost which rise linearly. In the figure, В is the break-even point at OQ level of output.
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Assumptions of Break Even Analysis:
(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.
(ii) The fixed costs remain constant over the volume under consideration.
(iii) It assumes constant rate of increase in variable cost.
(iv) The cost and revenue functions remain linear.
(v) The price of the product is assumed to be constant.
(vi) The volume of sales and volume of production are equal.
(vii) It assumes constant technology and no improvement in labour efficiency.
(viii) The price of the product is assumed to be constant.
Managerial Use of Break Even Analysis:
(i) Safety Margin: The break-even chart helps the management to know at a glance the profits
generated at the various levels of sales. The safety margin refers to the extent to which the firm
can afford a decline before it starts incurring losses.
The formula to determine the sales safety margin is:
Safety Margin= (Sales – BEP)/ Sales x 100
(ii) Target Profit: The break-even analysis can be utilised for the purpose of calculating the
volume of sales necessary to achieve a target profit.
(iii) Change in Price: The management is often faced with a problem of whether to reduce
prices or not. Before taking a decision on this question, the management will have to consider a
profit. A reduction in price leads to a reduction in the contribution margin.
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This means that the volume of sales will have to be increased even to maintain the previous level
of profit. The higher the reduction in the contribution margin, the higher is the increase in sales
needed to ensure the previous profit.
(iv) Change in Costs:
When costs undergo change, the selling price and the quantity produced and sold also undergo
changes.
Changes in cost can be in two ways:
(i) Change in variable cost, and

(ii) Change in fixed cost.
(i) Variable Cost Change: An increase in variable costs leads to a reduction in the contribution
margin. This reduction in the contribution margin will shift the break-even point downward.
Conversely, with the fall in the proportion of variable costs, contribution margins increase and
break-even point moves upwards.
(ii) Fixed Cost Change: An increase in fixed cost of a firm may be caused either due to a tax on
assets or due to an increase in remuneration of management, etc. It will increase the contribution
margin and thus push the break-even point upwards. Again to maintain the earlier level of
profits, a new level of sales volume or new price has to be found out.
(v) Decision on Choice of Technique of Production: The breakeven analysis is the most simple
and helpful in the case of decision on a choice of technique of production. For low levels of
output, some conventional methods may be most probable as they require minimum fixed cost.
For high levels of output, only automatic machines may be most profitable. By showing the cost
of different alternative techniques at different levels of output, the break-even analysis helps the
decision of the choice among these techniques.
(vi) Make or Buy Decision: Firms often have the option of making certain components or for
purchasing them from outside the concern. Break-even analysis can enable the firm to decide
whether to make or buy.
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(vii) Plant Expansion Decisions: The break-even analysis may be adopted to reveal the effect of
an actual or proposed change in operation condition. This may be illustrated by showing the
impact of a proposed plant on expansion on costs, volume and profits. Through the break-even
analysis, it would be possible to examine the various implications of this proposal.
(viii) Plant Shut Down Decisions: In the shut down decisions, a distinction should be made
between out of pocket and sunk costs. Out of pocket costs include all the variable costs plus the
fixe cost which do not vary with output. Sunk fixed costs are the expenditures previously made
but from which benefits still remain to be obtained e.g. depreciation.
(ix) Advertising and Promotion Mix Decisions: The break-even point concept helps the
management to know about the circumstances. It enables him not only to take appropriate
decision but by showing how these additional fixed cost would influence BEPs. The
advertisement pushes up the total cost curve by the amount of advertisement expenditure.
(x) Decision Regarding Addition or Deletion of Product Line: If a product has outlive utility
in the market immediately, the production must be abandoned by the management and examined
what would be its consequent effect on revenue and cost. Alternatively, the management may
like to add a product to its existing product line because it expects the product as a potential
profit spinner. The break-even analysis helps in such a decision.
Limitations of Break Even Analysis:
• Keeping important factors constant is a drawback.

• The projected future with constant factors will not give correct results.
• Assumption of cost-revenue –output relationship is only true for short run.
• The simple form of break-even chart makes no provision for taxes and corporate income.
• Matching cost with output imposes another limitation on break-even analysis.
• Due to much assumption BEA as become approximation rather than exact.
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QUESTION BANK:
1. Explain the laws of “Return to scale”.
2. What is opportunity cost? Give an example.
3. Write a note on law of variable proportion.
4. What is Economies of scale? Explain with graph.
5. What are different cost concepts?
6. Explain LAC curve with the help of graph.
7. What is Iso-quant curve? Briefly explain its properties along with graph.
8. Explain Iso-cost curve by graph representation.
9. Define cost? Mention its determinants.
10. What is contribution?
11. What is Break-Even Analysis? Explain its uses in managerial economics.
12. Explain with graph how to access profits and apply BEP for decision making using
linear revenue and cost functions.
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Module -4
Market Structure & Pricing Practices
Market Structure: Perfect Competition, Features, Determination of price under perfect

competition, Monopoly: Features, Pricing under monopoly, Price Discrimination. Monopolistic
Competition: Features, Pricing Under monopolistic competition, Product differentiation.
Oligopoly: Features, Kinked demand Curve, Cartels, Price leadership.
Descriptive Pricing Approaches: Full cost pricing, Product line pricing, Pricing Strategies:
Price Skimming, Penetration Pricing, Loss leader pricing, Peak Load pricing.
Market is a place where the various sellers and buyers sell and buy the products respectively. In
this module we will be discussing about various market structure.
4.1 Perfect Competition: Perfect market is a market condition with large buyers and sellers
dealing in homogenous commodity or identical product and in this market condition, all buyers
and sellers are aware of the price of the product that indicates the price of the product throughout
the market.
Perfect competition describes a market structure where competition is at its greatest possible
level. To make it more clear, a market which exhibits the following characteristics in its structure
is said to show perfect competition:
1. Large number of buyers and sellers
2. Homogenous product is produced by every firm
3. Free entry and exit of firms
Features of Perfect Competition:
1. Large number of sellers and buyers: In a perfectly competitive market, there are large
numbers of buyers and seller each demanding a small part of the total market demand and supply
of the product respectively. As a result, no single seller or buyer is in a position to influence the
market price determined by the forces of market demand and supply.
2. Homogeneous Product: In a perfectly competitive market, all the firms produce and supply
the identical products. It means that the products of all the firms are perfect substitutes of each
other. As a result of this, the price elasticity of demand for a firm’s product is infinite.
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3. Free entry and exit: In a perfectly competitive market, there are no restrictions on the entry
of new firms into market or on the exit of existing firms from the market.
4. Perfect knowledge: In a perfectly competitive market, the firms and the buyers possess
perfect information about the market. It implies that no buyer or firm is ignorant about the price
prevailing in the market.
5. Perfect mobility of factors of production: In a perfectly competitive market, the factors of

production are completely mobile leading to factor-price equalization throughout the market
6. Free and Perfect Competition among buyers and sellers: In a perfect market, there are no
checks either on the buyers or sellers. They are free to buy or to sell to any person. It means there
are no monopolies.
7. Absence of Price control: In a perfectly competitive market, each buyer is aware of product
and its price in the market likewise the seller is also aware of the pricing of the product in the
market. Thus no individual in the market can influence the market.
8. Absence of transport cost: In a perfectly competitive market, it is assumed that there are no
transport costs. If transport costs are incurred, prices should be different in different sectors of
the market.
9. One price of Commodity: As there are large sellers in the market, all the sellers sell the
product at same price. Every firm is a price taker. It takes the price as decided by the forces of
demand and supply. No firm can influence the price of the product.
10. Independent Relationship among buyers and sellers: In a perfectly competitive market, it
is considered to be no seller is related to buyer. Thus there is no chance for buyer to ask the
product for lesser price and buyer will not sell the products at lesser price.
Determination of Price in Perfect Competition:
In perfect competition, the price of a product is determined at a point at which the demand and
supply curve intersect each other. This point is known as equilibrium point as well as the price
is known as equilibrium price. In addition, at this point, the quantity demanded and supplied is
called equilibrium quantity.
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From the above figure when price is OP, the quantity demanded is OQ. On the other hand, when
price increases to OP1, the quantity demanded reduces to OQ1. Therefore, under perfect
competition, the demands curve (DD’) slopes downward
From the above figure the quantity supplied is OQ at price OP. When price increases to OP1, the
quantity supplied increases to OQ1. This is because the producers are able to earn large profits
by supplying products at higher price. Therefore, under perfect competition, the supply curves
(SS’) slopes upward.
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From the above figure, it can be seen that at price OP1, supply is more than the demand.
Therefore, prices will fall down to OP. Similarly, at price OP2, demand is more than the supply.
Similarly, in such a case, the prices will rise to OP. Thus, E is the equilibrium at which
equilibrium price is OP and equilibrium quantity is OQ.
The price at which demand and supply are equal is known as equilibrium price and the quantity
bought and sold at the equilibrium price is known as equilibrium output.
In the figure, equilibrium price is determined at the point E where both demand and supply are
equal. The upper limit of the price of a product is determined by the demand. The lower limit of
the price is determined by the production cost. The point E can be regarded as the position of
stable equilibrium.
Monopoly: A market structure characterized by a single seller, selling a unique product in the
market. In a monopoly market, the seller faces no competition, as he is the sole seller of goods
with no close substitute.
"Monopoly is a market situation in which there is a single seller. There are no close substitutes of
the commodity it produces, there are barriers to entry”. -Koutsoyiannis
Features:
1. One Seller and Large Number of Buyers: The monopolist’s firm is the only firm; it is an
industry. But the number of buyers is assumed to be large.
2. No Close Substitutes: There shall not be any close substitutes for the product sold by the
monopolist. The cross elasticity of demand between the product of the monopolist and others
must be negligible or zero.
3. Difficulty of Entry of New Firms: There are either natural or artificial restrictions on the
entry of firms into the industry, even when the firm is making abnormal profits.
4. Monopoly is also an Industry: Under monopoly there is only one firm which constitutes the
industry. Difference between firm and industry comes to an end.
5. Price Maker: Under monopoly, monopolist has full control over the supply of the
commodity. But due to large number of buyers, demand of any one buyer constitutes an
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infinitely small part of the total demand. Therefore, buyers have to pay the price fixed by the
monopolist.
6. Price discrimination: A company that is operating in a monopolistic market can change the
price and quantity of the product or service. Price discrimination occurs when the company sells
the same product to different buyers at different prices.
Considering that the market is elastic, the company will sell a higher quantity of the product if
the price is low and will sell a lesser quantity if the price is high.
7. No Competition: As there is only one firm in monopoly there are no competition in this type
of markets. Thus, this market is competition free.
8. Full Control over Price: As a single firm itself acts as the industry, the firm operating in this
market will always have an hedge of pricing the products at its will. Thus it controls the price
completely.
9. Full Control over Supply: In this market the products or services do not have close
substitutes and thus the producers have the control over the supply of their products.
Pricing or Price-Output Determination Under Monopoly:
A firm under monopoly faces a downward sloping demand curve or average revenue
curve. Further, in monopoly, since average revenue falls as more units of output are sold, the
marginal revenue is less than the average revenue. In other words, under monopoly the MR
curve lies below the AR curve.
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The Equilibrium level in monopoly is that level of output in which marginal revenue equals
marginal cost. The producer will continue producer as long as marginal revenue exceeds the
marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond
this point the producer will stop producing.
It can be seen from the diagram that untill OM output, marginal revenue is greater than marginal
cost, but beyond OM the marginal revenue is less than marginal cost. Therefore, the monopolist
will be in equilibrium at output OM where marginal revenue is equal to marginal cost and the
profits are the greatest. The corresponding price in the diagram is MP or OP’. It can be seen from
the diagram at output OM, while MP is the average revenue, ML is the average cost, therefore,
PL is the profit per unit.
Price Discrimination:
In monopoly, there is a single seller of a product called monopolist. The monopolist has control
over pricing, demand, and supply decisions, thus, sets prices in a way, so that maximum profit
can be earned. The monopolist often charges different prices from different consumers for the
same product. This practice of charging different prices for identical product is called price
discrimination.
According to Robinson, “Price discrimination is charging different prices for the same product or
same price for the differentiated product.”
Different price discrimination are as follows:
First-degree Price Discrimination: Refers to a price discrimination in which a monopolist

charges the maximum price that each buyer is willing to pay. This is also known as perfect price
discrimination as it involves maximum exploitation of consumers. In this, consumers fail to
enjoy any consumer surplus. First degree is practiced by lawyers and doctors.
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ii. Second-degree Price Discrimination: Refers to a price discrimination in which buyers are
divided into different groups and different prices are charged from these groups depending upon
what they are willing to pay. Railways and airlines practice this type of price discrimination.
iii. Third-degree Price Discrimination: Refers to a price discrimination in which the

monopolist divides the entire market into submarkets and different prices are charged in each
submarket. Therefore, third-degree price discrimination is also termed as market segmentation.
In this type of price discrimination, the monopolist is required to segment market in a manner, so
that products sold in one market cannot be resold in another market. Moreover, he/she should
identify the price elasticity of demand of different submarkets. The groups are divided according
to age, sex, and location. For instance, railways charge lower fares from senior citizens. Students
get discount in cinemas, museums, and historical monuments.
Monopolistic competition
Monopolistic competition is a form of market structure having large number of sellers and
buyers dealing in similar products or close substitute products where there are no entry or exit
barriers.
Features of Monopolistic Competition:
1. Large Number of Sellers:
There are large numbers of firms selling closely related, but not homogeneous products. Each
firm acts independently and has a limited share of the market. So, an individual firm has limited
control over the market price. Large number of firms leads to competition in the market.
2. Product Differentiation:
Each firm is in a position to exercise some degree of monopoly (in spite of large number of
sellers) through product differentiation. Product differentiation refers to differentiating the
products on the basis of brand, size, colour, shape, etc. The product of a firm is close, but not
perfect substitute of other firm.
Implication of ‘Product differentiation’ is that buyers of a product differentiate between the same
products produced by different firms. Therefore, they are also willing to pay different prices for
the same product produced by different firms. This gives some monopoly power to an individual
firm to influence market price of its product.
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3. Selling costs on Advertisements:
Under monopolistic competition, products are differentiated and these differences are made
known to the buyers through selling costs. Selling costs refer to the expenses incurred on
marketing, sales promotion and advertisement of the product. Such costs are incurred to persuade
the buyers to buy a particular brand of the product in preference to competitor’s brand. Due to
this reason, selling costs constitute a substantial part of the total cost under monopolistic
competition.
4. Freedom of Entry and Exit:
Under monopolistic competition, firms are free to enter into or exit from the industry at any time
they wish. It ensures that there are neither abnormal profits nor any abnormal losses to a firm in
the long run. However, it must be noted that entry under monopolistic competition is not as easy
and free as under perfect competition.
5. Lack of Perfect Knowledge:
Buyers and sellers do not have perfect knowledge about the market conditions. Selling costs
create artificial superiority in the minds of the consumers and it becomes very difficult for a
consumer to evaluate different products available in the market. As a result, a particular product
(although highly priced) is preferred by the consumers even if other less priced products are of
same quality.
6. Pricing Maker:
A firm under monopolistic competition is neither a price- taker nor a price-maker. However, by
producing a unique product or establishing a particular reputation, each firm has partial control
over the price. The extent of power to control price depends upon how strongly the buyers are
attached to his brand.
7. Non-Price Competition:
In addition to price competition, non-price competition also exists under monopolistic

competition. Non-Price Competition refers to competing with other firms by offering free gifts,
making favourable credit terms, etc., without changing prices of their own products.
Firms under monopolistic competition compete in a number of ways to attract customers. They
use both Price Competition (competing with other firms by reducing price of the product) and
Non-Price Competition to promote their sales.
8. Demand curve is downward sloping:

Under monopolistic competition, large number of firms selling closely related but differentiated
products makes the demand curve downward sloping. It implies that a firm can sell more output
only by reducing the price of its product.
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9. No Close Substitute products:
Products in this market do not have close substitutes to the competitors’ products.
Price-Determination under Monopolistic Market in Short Run:
During short period there may be three situations of the firms under monopolistic
competition as given below:
1. Profit Making Situation: AR>AC
Profit making situation will be when individual firm’s revenue is greater than its cost (AR>AC).
Profit making situation is also called abnormal or super profit situation as given in Diagram 1.
Price, costs and revenues are shown on OY-axis while output on OX-axis. The point of
equilibrium is E where marginal cost is equal to marginal revenue (MC=MR) of the firm. The
price is OP, output is OQ. The average profit (AR—AC) is TS and total profit is PLST.
2. Normal Profit: AR=AC
When the firm’s average revenue is equal to its average cost the situation is called normal profit.
In the diagram output is shown on OX-axis, price, costs and revenue are shown on OY-axis. The
point of equilibrium is E where firm’s marginal cost is equal to its marginal revenue (MC=MR).
Price is PQ and output is OQ. At P the average revenue is equal to average cost hence the firm is
earning normal profit only.
3. Loss Making Situation: AR<AC
Under monopolistic situation during short period a firm will earn loss when its cost is greater
than its revenue (AC>AR). It can be explained with the help of the Diagram 3.
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Price, cost and revenue are shown on OY-axis while output is shown on OY-axis respectively.
The point of equilibrium (MC=MR) is E. Price is OP and output is OQ. Average loss (AC- AR)
is ST and total loss is LPTS.
Price-Determination under Monopolistic Market in long Run:
In monopolistic competition, since the product is differentiated between firms, each firm does
not have a perfectly elastic demand for its products. In such a market, all firms determine the
price of their own products. Therefore, it faces a downward sloping demand curve.
Conditions for the Equilibrium of an individual firm
The conditions for price-output determination and equilibrium of an individual firm are as
follows:
1. MC = MR
2. The MC curve cuts the MR curve from below.
Price and Output Determination during Long Period:
Under monopolistic competition, firms have freedom to enter and exit the industry. In the long
run if firms are earning profit new firms are attracted and it will increase the output and
consequently prices will fall leading to conversion of profit making situation into normal profit
situation.
Contrary to it when firms are incurring losses during long period they will leave the industry. It
will reduce the volume of output, prices will increase and the loss making situation will be
converted into normal profit. Thus, the firms will earn normal profit only during long period. It
can be seen from Diagram 4.
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Price, costs and revenue are shown on OY-axis and output on OX-axis. Point of equilibrium
(MC=MR) is E. Price is PQ and output is OQ. At P point average cost is equal to average
revenue (AC=AR). Hence, the firm is earning normal profit only during long period.
Product Differentiation:
A firm may have convinced consumers that its product is significantly better than the product of
new entrants. The new firm may be forced to sell at lower price and reduce profit though the
existing product may not essentially be superior.
The real differentiation refers to the technical features like the product’s technical life and
performance, durability, cost of operation and maintenance, etc.
On the other hand, the non-technical differentiation may take the form of brand names,
trademark, packing, shape, size, etc. The non-technical differentiation adds a subjective appeal to
a product inducing buyers to increase its demand or pay more for it.
Price: Price can be used to differentiate a product in two ways. Companies can charge the lowest
price compared to competitors to attract cost-conscious buyers—the retailer Costco is an
example. However, companies can also charge high prices to imply quality and that a product is
a luxury or high-end item, such as a Bugatti sports car.
Performance and Reliability: Products can be differentiated based on their reliability and
durability. Some batteries, for example, are reputed to have a longer life than other batteries, and
consumers will buy them based on this factor.
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Location and Service: Local businesses can differentiate themselves from their larger national
competitors by emphasizing that they support the local community. A local restaurant, for
example, will hire locally and may source its food and ingredients from local farmers and
purveyors.
Quality: How does the quality, reliability, and ruggedness of your product compare to others on
the market?
Design: Have you done something different with your design? Is it minimalistic and sleek? Easy-
to-navigate?
Customization: Can you customize parts of the product that competitors
cannot? Similarly we can differentiate the products on basis of color, brand, size
etc.
Oligopoly:
Oligopoly market is a situation where in there are few number of sellers and large buyers dealing
in homogenous product or differentiated products and there are entry-exit barriers for new firm.
Features of Oligopoly:
1. Few firms: Under oligopoly, there are few large firms. The exact number of firms is not
defined. Each firm produces a significant portion of the total output. There exists severe
competition among different firms and each firm try to manipulate both prices and volume of
production to outsmart each other. For example, the market for automobiles in India is an
oligopolist structure as there are only few producers of automobiles.
2. Interdependence: Firms under oligopoly are interdependent. Interdependence means that

actions of one firm affect the actions of other firms. A firm considers the action and reaction of
the rival firms while determining its price and output levels. A change in output or price by one
firm evokes reaction from other firms operating in the market.
3. Nature of the Product: The firms under oligopoly may produce homogeneous or
differentiated product.
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If the firms produce a homogeneous product, like cement or steel, the industry is called a pure or
perfect oligopoly.
If the firms produce a differentiated product, like automobiles, the industry is called
differentiated or imperfect oligopoly.
4. Barriers to Entry of Firms: The main reason for few firms under oligopoly is the barriers,
which prevent entry of new firms into the industry. Patents, requirement of large capital, control
over crucial raw materials, etc, are some of the reasons, which prevent new firms from entering
into industry. Only those firms enter into the industry, which is able to cross these barriers. As a
result, firms can earn abnormal profits in the long run.
5. Non-Price Competition: Under oligopoly, firms are in a position to influence the prices.
However, they try to avoid price competition for the fear of price war. They follow the policy of
price rigidity. Price rigidity refers to a situation in which price tends to stay fixed irrespective of
changes in demand and supply conditions. Firms use other methods like advertising, better
services to customers, etc. to compete with each other.
If a firm tries to reduce the price, the rivals will also react by reducing their prices. However, if it
tries to raise the price, other firms might not do so. It will lead to loss of customers for the firm,
which intended to raise the price. So, firms prefer non- price competition instead of price
competition.
6. Lack of Uniformity: Another feature of oligopoly market is the lack of uniformity in the size
of firms. Firms differ considerably in size. Some may be small, others very large. Such a
situation is asymmetrical. This is very common in the American economy. A symmetrical
situation with firms of a uniform size is rare.
7. Existence of Price Rigidity: In oligopoly situation, each firm has to stick to its price. If any
firm tries to reduce its price, the rival firms will retaliate by a higher reduction in their prices.
This will lead to a situation of price war which benefits none. On the other hand, if any firm
increases its price with a view to increase its profits; the other rival firms will not follow the
same. Hence, no firm would like to reduce the price or to increase the price. The price rigidity
will take place.
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8. Advertising: As the firms follow non-price competition by keeping the prices close to rival
firms; to increase the sales and profit of the firm they have to involve themselves in marketing
and promotions of the product.
9. Selling Costs: Since firms try to avoid price competition and there is a huge interdependence
among firms, selling costs are highly important for competing against rival firms for a larger
market share.
Price Determination under Oligopoly:
Oligopoly can be either collusive or non-collusive. Collusive oligopoly is a market situation

wherein the firms cooperate with each other in determining price or output or both. A non-
collusive oligopoly refers to a market situation where the firms compete with each other rather
than cooperating.
1. Price Determination in Non-Collusive Oligopoly:
In this case, each firm follows an independent price and output policy on the basis of its
judgment about the reactions of his rivals. If the firms are producing homogeneous products,
price war may occur. Each firm has to fix the price at the competitive level. On the contrary, in
case of differentiated oligopoly, due to product differentiation, each firm has some monopoly
control over the market and therefore charge near monopoly price.
Usually, in Oligopolistic markets, there are many price rigidities. In 1939, Paul Sweezy used an
unconventional demand curve – the kinked demand curve to explain these rigidities.
Kinked-Demand Curve:
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MR= Marginal Revenue
MC= Marginal Cost
KPD= Deman Curve or Average Revenue
OR is output at price OP0
In the figure above, KPD is the is the kinked-demand curve and OP0 is the prevailing price in the
oligopoly market for the OR product of one seller. Starting from point P, corresponding to the
point OP1, any increase in price above it will considerably reduce his sales as his rivals will not
follow his price increase.
This is because the KP portion of the curve is elastic and the corresponding portion of the MR
curve (KA) is positive. Therefore, any price increase will not just reduce the total sales but also
his total revenue and profit. On the other hand, if the seller reduces the price of the product
below OPQ (or P), his rivals will also reduce their prices.
However, even if his sales increase, his profits would be less than before. This is because the PD
portion of the curve below P is less elastic and the corresponding part of the marginal revenue
curve below R is negative. Therefore, in both price-raising and price-reducing situations, the
seller is the loser. He will stick to the prevailing market price OP0 which remains rigid.
This asymmetrical behavioral pattern results in a kink in the demand curve and hence there is
price rigidity in oligopoly markets. The prices remain rigid at the kink (point P). In other words,
the price will remain sticky at OP0 and the output = OR at this price.
Due to the difference in the elasticities, the MR curve becomes discontinuous corresponding to
the point of change in elasticity of the demand curve. The kink represents this. At the output <
OR, the demand curve is KP and the corresponding MR curve is KA and MR>MC. For output >
OR, the demand curve is PD and the corresponding MR curve is BMR and MR<MC.
2. Price Determination in Collusive Oligopoly:
Sometimes, firms may try to remove uncertainty related to acting independently and enter into
price agreements with each other. This is collusion. Collusion is either formal or informal. It can
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take the form of cartel or price leadership.
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Price and Output under Perfect Collusion:
Under oligopoly, perfect collusion may be formed among different producers, sellers in two
ways, namely, centralised cartel and market sharing cartel, and price and output are determined
accordingly.
A cartel is an association of independent firms within the same industry which follow the
common policies relating to price, output, sale, profit maximization, and the distribution of
products.
(a) Centralised Cartel:
Under this type of collusion different firms of oligopoly market structure set up a centralised
cartel. These firms transfer their function relating to managerial decisions and other activities to
the centralised cartel to improve the volume of profit. Centralised cartel aims at maximisation of
profit of all the firms. The cartel fixes price of the product, volume of output and production
quota of individual firms.
In the diagram AR is the demand curve of industry and MR is the marginal revenue curve which
has been drawn on the basis of AR or demand curve. ∑MC is the total marginal cost curve of the
industry which is the aggregate marginal cost of two firms engaged in production in that
industry. Marginal revenue curve of industry is cut by the marginal cost curve of the industry at
point E where ∑MR is equal to ∑MC (∑MR=∑MC). It is the equilibrium of the industry. Price is
OP and output is OQ in the industry. Number of products to be produced by a firm is fixed on
the basis of MR, that is when MR of firm is equal to combined MR of market.
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(b) Market Sharing Cartel:
Another form of perfect collusion is the market sharing by the firms. This type of collusion can
be effective and successful when all the firms are producing homogeneous product and
production costs are similar. In order to explain this type of collusion we assume that there are
two firms producing on the uniform cost of production and are ready to share market on 50:50
basis.
There are two main methods of market-sharing:
(a) Non-price competition; and (b) Quota system.
(a) Non-Price Competition Cartel:
The non-price competition agreement among oligopolistic firms is a loose form of cartel. Under
this type of cartel, the low-cost firms press for a low price and the high-cost firms for a high
price. But ultimately, they agree upon a common price below which they will not sell. Such a
price must allow them some profits. The firms can compete with one another on a non-price
basis by varying the colour, design, shape packing etc. of their product and having their own
different advertising and other selling activities. Thus each firm shares the market on a non-
prices basis while selling the product at the agreed common price.
(b) Market Sharing by Quota Agreement:
The second method of market sharing is the quota agreement among firms. (All firms in an
oligopolistic industry enter into collusion for charging an agreed uniform price. But the main
agreement relates to the sharing of the market equally among member firms so that each firm
gets profits on its sales.
Price and Output under Imperfect Collusion: Price Leadership
Under oligopoly price and output can also be determined without any collusion among the firms.
The firms may decide to follow a firm in price and output determination in the long run. Such
sort of policy is called price leadership under oligopoly.
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Price leadership is based on informed collusion. Under price leadership, one firm is a large or
dominant firm and acts as the price leader who fixes the price for the products while the other
firms allow it.
In the diagram output is shown on OX-axis while price, cost, and revenue are shown on OY-axis.
DD is the market demand curve while DD 1 is the demand curve of the firm. AC 2 and MC2 are
average cost curve and marginal cost curve of the firm having high cost of production. Its point
of equilibrium is E2 where the price is OP2 and the output is OQ2.
The average cost curve (AC1) and marginal cost curve (MC1) are of a firm having least cost of
production. Its point of equilibrium is E1 where the price of the firm is OP1 and output is OQ1.
The marginal revenue curve (MR) of both the firms is equal to their MC 1 and MC2. The firm
producing OQ1 output with OP1 price is the low cost producing firm and it will be the price
leader in the market and the same price policy OP1 will be following by other firm.
There are several types of price leadership. The following are the principal types:
(a) Price leadership of a dominant firm, i.e., the firm which produces the bulk of the product
of the industry. It sets the price and rest of the firms simply accepts this price.
(b) Barometric price leadership, i.e., the price leadership of an old, experienced and the largest
firm assumes the role of a leader, but undertakes also to protect the interest of all firms instead of
promoting its own interests as in the case of price leadership of a dominant firm.
(c) Exploitative or Aggressive price leadership, i.e., one big firm built its supremacy in the
market by following aggressive price leadership. It compels other firms to follow it and accept
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the price fixed by it. In case the other firms show any independence, this firm threatens them and
coerces them to follow its leadership.
Descriptive Pricing Approaches:
Pricing is the art of converting the value of products or services into quantitative terms to
customers at a point of time.
Factors determining Pricing:
(i) Cost of Production: Cost of production is the main component of price. No company can sell
its product or services at less than the cost of production. Thus, before price fixation, it is
necessary to compile data relating to the cost of production and keep that in mind.
(ii) Demand for Product: Intensive study of demand for product and services in the market be
undertaken before price fixation. If demand is relatively more than supply, higher price can be
fixed.
(iii) Price of Competing Firms: It is necessary to take into consideration prices of the products
of the competing firms prior to fixing the price. In case of cut-throat competition it is desirable to
keep prices low.
(iv) Purchasing Power of Customers: What are the purchasing power of the customers and at
what price and how much they can purchase? It should also be taken into consideration.
(v) Government Regulation: If the price of the commodity and services is to be fixed as per the
regulation of the government, it should also be borne in mind.
(vi) Objective: Usually, at the time of price fixation a certain amount of profit is added to the
cost of production. If company’s objective is to earn higher profit it may add higher amount of it.
(vii) Marketing Method Used: Price is also influenced by the marketing method used by the
company, e.g., commission which is to be paid to the middlemen for sale of the goods is also
added to the price. Similarly, if the customers are to be provided “after sale service” facility, then
those expenses are also added to the price.
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Pricing Strategies are:
 Full cost pricing

 Product line pricing
 Price Skimming
 Penetration Pricing
 Loss leader pricing
 Peak Load pricing
1. Full cost pricing: Full cost pricing is a practice where the price of a product is calculated by a
firm based on its direct costs per unit of output plus a markup to cover overhead costs and
profits.
It is a price-setting method under which you add together the direct material cost, direct labor
cost, selling and administrative costs, and overhead costs for a product, and add to it a markup
percentage (to create a profit margin) in order to derive the price of the product. The pricing
formula is:
(Total production costs + Selling and administration costs + Markup)

-----------------------------------------------------------------------------------------
Number of units expected to sell
2. Product line pricing: Product line pricing involves the separation of goods and services into
cost categories in order to create various perceived quality levels in the minds of consumers. You
might also hear product line pricing referred to as price lining, but they refer to the same
practice.
3. Price Skimming: Price skimming is a product pricing strategy by which a firm charges the
highest initial price that customers will pay and then lowers it over time. As the demand of the
first customers is satisfied and competition enters the market, the firm lowers the price to attract
another, more price sensitive segment of the population. The skimming strategy gets its name
from "skimming" successive layers of cream, or customer segments, as prices are lowered over
time.
4. Penetration Pricing: Penetration pricing is a marketing strategy used by businesses to attract

customers to a new product or service by offering a lower price during its initial offering. The
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lower price helps a new product or service penetrate the market and attract customers away from
competitors. Market penetration pricing relies on the strategy of using low prices initially to
make a wide number of customers aware of a new product.
The goal of a price penetration strategy is to entice customers to try a new product and build
market share with the hope of keeping the new customers once prices rise back to normal levels.
5. Loss leader pricing: Loss leader pricing is an aggressive pricing strategy in which a store
sells selected goods below cost in order to attract customers who will, according to the loss
leader philosophy, make up for the losses on highlighted products with additional purchases of
profitable goods. Loss leader pricing is employed by retail businesses; a somewhat similar
strategy sometimes employed by manufacturers is known as penetration pricing.
6. Peak Load pricing: The Peak Load Pricing is the pricing strategy wherein the high price is
charged for the goods and services during times when their demand is at peak. In other words,
the high price charged during the high demand period is called as the peak load pricing.
This type of price discrimination is based on the efficiency, i.e. a firm discriminates based on
high usage, high-traffic, high demand times and low demand times. The consumer who
purchases the commodity during the high demand period has to pay more as compared to the one
who buys during low demand periods.
Question Bank:
1. Define perfect competition.

2. Define cartels.
3. What is monopoly? Discuss its characteristics.
4. What is price discrimination? Mention the degrees of price discrimination.
5. Mention the characteristics of of perfect competition.
6. Explain the concept of monopolistic completion. How prices are determined.
7. Elaborate the characteristics of oligopoly.
8. Define market structure. What are the different types of market structure?
9. Explain kinked demand curve along with graph and its assumptions.
10. How are prices determined under perfect competition? Explain with the help of
suitable graphs.
11. Discuss the various descriptive pricing strategies.
12. Enumerate the factors governing pricing decisions.
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Module -5
Indian Business environment
Nature, Scope, Structure of Indian Business Environment – Internal and External Environment.
Political and Legal Environment, Economic Environment, Socio – Cultural Environment, Global
Environment Basic Macro Economic Concepts: Open and Closed Economies, Primary, secondary
and Tertiary sectors and their contribution to the economy. SWOT Analysis for the Indian
economy. Measuring the Economy: Measuring GDP and GDP Growth rate, Components of GDP.
The term ‘business environment’ means the sum total of all individuals, institutions and
other forces that are outside the control of a business enterprise but that may affect its
performance. Thus, the economic, social, political, technological and other forces which operate
outside a business enterprise are part of its environment.
Business Environment refers to the “Sum total of conditions which surround man at a given
point in space and time. In the past, the environment of man consisted of only the physical
aspects of the planet Earth (air, water and land) and the biotic communities. But in due course of
time and advancement of society, man extended his environment through his social, economic
and political function.” In a globalised economy, the business environment plays an important
role in almost all business enterprises.
The important point is that these individuals, institutions and forces are likely to
influence the performance of a business enterprise although they happen to exist outside its
boundaries.
For example, changes in government’s economic policies, rapid technological

developments, political uncertainty, and changes in fashions and tastes of consumers and
increased competition in the market - all influence the working of a business enterprise in
important ways. Increase in taxes by government can make things expensive to buy.
Technological improvements may render existing products obsolete. Political uncertainty may
create fear in the minds of investors. Changes in fashions and tastes of consumers may shift
demand in the market from existing products to new ones. Increased competition in the market
may reduce profit margins of firms.
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Concept of BE:
• Business: Business may be defined as an organized effort by an individual or group of

individuals engaged in production and supply of goods and services for the profit.
• Environment: It is the system in which human beings live and they have to adjust
themselves according to it. It is a mixture of social, economic, legal and technological
factors. This environment imposes several constraints on the enterprises and has
considerable impact and influence on the scope and direction of its activities.
• Business environment refers to those aspects of the surroundings of business enterprises

which affects its operation and determine its effectiveness. It is a mixture of complex,
dynamic and uncontrollable external factors within which a business is to be operated.
• According to Arthur M. Weimer, “Business environment is the climate or set of

conditions: economic, social, political or institutional in which business operations are
conducted.”
• Indian business environment is characterized by the co-existence of both public and

private sector in respect of its participation in various economic activities in the country.
Accordingly, the various economic policies of the country can promote the development
of both the sectors in different spheres of activities.
Nature of BE:
The nature of Business Environment is simply and better explained by the following approaches:
 System Approach: In original, business is a system by which it produces goods and

services for the satisfaction of wants, by using several inputs, such as, raw material,
capital, labour etc. from the environment.
 Social Responsibility Approach: In this approach business should fulfill its
responsibility towards several categories of the society such as consumers, stockholders,
employees, government etc.
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 Creative Approach: As per this approach, business gives shape to the environment by
facing the challenges and availing the opportunities in time. The business brings about
changes in the society by giving attention to the needs of the people.
 Related to Economic Activities: The main objective of the business is to earn profits.
Hence, the business environment is related to the economic activities of the person
(entrepreneur) like trade, commerce, industries, and direct services etc.
 Dynamic Concept: The business environment is the dynamic concept. The components
of the environment are also subject to change according to the country timings,
circumstances, etc.
 Affects Various Factors: The business and its environment are interdependent and also
have natural effects. The entrepreneur or the owner of the business cannot overlook this
environment and its factors.
 Effect of Economic Systems: Economic systems also affect the business environment.
The business environment of any particular country is in consonance with capitalist,
communist, socialist, and mixed systems, etc. For example, the public sector and private
sectors, both developed in India, as the adoption of the mixed economy.
 Internal and External Environment:Every enterprising, institution has two types of
environment internal and external. The institution has control over its internal
environment, but it has no control over the external environment. Hence, the business
organization has to mould itself, according to the external environment.
Scope of BE:
 Identifies business opportunities and threats
 Helps in planning and policy formulation
 Provides useful resources
 Improves performance
 Helps in coping with rapid changes
 Enhances business image
 Assist in facing competition
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Importance of Business Environment:

There is a close and continuous interaction between the business and its environment. This
interaction helps in strengthening the business firm and using its resources more effectively. As
stated above, the business environment is multifaceted, complex, and dynamic in nature and has
a farreaching impact on the survival and growth of the business. To be more specific, proper
understanding of the social, political, legal and economic environment helps the business in the
following ways:
 Identifying Firm’s Strength and Weakness: Business environment helps to identify the
individual strengths and weaknesses in view of the technological and global developments
 Determining Opportunities and Threats: The interaction between the business and its
environment would identify opportunities for and threats to the business. It helps the business
enterprises for meeting the challenges successfully.
 Giving Direction for Growth: The interaction with the environment leads to opening up new
frontiers of growth for the business firms. It enables the business to identify the areas for growth
and expansion of their activities.
 Continuous Learning: Environmental analysis makes the task of managers easier in dealing
with business challenges. The managers are motivated to continuously update their knowledge,
understanding and skills to meet the predicted changes in realm of business.
 Image Building: Environmental understanding helps the business organisations in improving
their image by showing their sensitivity to the environment within which they are working.
 Meeting Competition: It helps the firms to analyse the competitors’ strategies and formulate
their own strategies accordingly.
Significance of Business Environment:

The significance of business environment is explained with the help of the following points:
 Help to understand internal Environment: It is very much important for business
enterprise to understand its internal environment, such as business policy, organisation
structure etc. In such case an effective management information system will help to
predict the business environmental changes.
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 Help to Understand Economic System: The different kinds of economic systems

influence the business in different ways. It is essential for a businessman and business
firm to know about the role of capitalists, socialist and mixed economy.
 Help to Understand Economic Policy: Economic policy has its own importance in
business environment and it has an important place in business. The business
environment helps to understand government policies such as, export-import policy, price
policy; monetary policy, foreign exchange policy, industrial policy etc. have much effect
on business.
 Help to Understand Market Conditions: It is necessary for an enterprise to have the
knowledge of market structure and changes taking place in it. The knowledge about
increase and decrease in demand, supply, monopolistic practices, government
participation in business etc., is necessary for an enterprise.
Structure of Indian Business Environment:
The structure of business environment can be divided into two broad dimensions:
1. Internal Environment
2. External Environment
• Micro Environment
• Macro Environment
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Internal Environment:
Internal environment is internal to the organization and it is controllable. In brief important
internal factors are as follows:
1. Culture and Value System: Organizational culture can be viewed as a system of shared
values and beliefs that shape a company' behavioral norms. A value is an enduring
preference for a mode of conduct or an end - state. The value system of founders has a
great and lasting impact on the value system of organization. Value system not only
influences the operations and behavior it also influences the choice of business.
2. Mission and Objectives: The business domain of the company. The mission and
objectives of the company guide priorities, direction, of development, business
philosophy, and business policy.
3. Management Structure and Nature: Structure is the way in which the tasks and sub
tasks are related. Structure is about the hierarchical relationship, span of management
relationship between different functional areas. Structure of top management, pattern of
shareholding etc.
4. Human Resource: It deals with factors like manpower planning, recruitment and
selection, and development, compensation, communication, and appraisal. Besides this
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internal environment includes corporate resources, production/operation of goods and

services, finance and accounting system and methods, marketing and distribution.
External Environment:
An external environment is composed of all the outside factors or influences that impact the
operation of business. The business must act or react to keep up its flow of operations.
The external environment can be broken down into two types:
 Micro Environment
 Macro Environment
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Micro environment: “The micro environment consists of the actors in the company’s immediate
environment that affects the performance of the company. These include the suppliers, marketing
intermediaries, competitors, consumers and the publics. ” - Philip Kotler.
1. Suppliers: Suppliers of the raw materials; other inputs and components to the company.
Importance of reliable sources of supply is always felt by the company. When there is un-
operating environment. Certainty of supply, companies maintain high inventory. As a
result, cost increases. Supply chain management is very essential to the efficiency of a
firm.
2. Customers: Monitoring customer sensitivity is very essential. Customer environment is
increasingly becoming global. Depending on a single customer is too risky. In choosing
the customer segments and company should consider relative profitability, dependability,
and stability of demand, growth prospects and the extent of competition.
3. Competitors: A firm’s competitors are “the other firms” and those who compete for the
discretionary income of the consumers. Eg: competition for a company TVs may come
from other TV manufacturers. Other competitors include two-wheelers, refrigerators,
cooking ranges, stereo sets, and so on. Consequent to the liberalization, the competitive
environment in India underwent sea-change. Many companies restructured their
strategies.
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4. Marketing intermediaries: Marketing intermediaries are the firms that aid the company
in promoting, selling and distributing goods to final consumers. Marketing intermediaries
are vital links between the company and the final consumers. A dislocation of the link
may cost the company very heavily. Eg: Hindustan Unilever faced major challenge when
it faced collective boycott in Kerala on the issue of trade margin.
5. Financiers: Individual and institutional lenders. Financing capabilities, their policies and
strategies, attitudes and activity to provide non-financial assistance are very important.
6. Publics: Publics are the groups, which have actual interest in the ability of an
organization to achieve its targets. Media publics, citizen action publics and local publics
are the examples. Growth of consumer’s publics (like NGOs)is an important development
affecting business. Co-operation between company and publics is established for mutual
benefit of the company and local community.
Macro environment:
It consists of external factors that the company itself doesn't control but is certainly affected by.
The factors that make up the macro-environment are economic factors, demographic forces,
technological factors, natural and physical forces, political and legal forces, and social and
cultural forces.
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1. Demographic: Size and growth rate of population, life expectancy age and sex
composition of population, work participation rate, distribution of population,
employment status, rural-urban distribution of population, education levels, religion,
caste, ethnicity and language are the demographic factors. These factors constitute
demographic environment. Business decisions are also influenced by these demographic
factors.
2. Political Environment: This includes the political system, the government policies and
attitude towards the business community and the unionism. All these aspects have a
bearing on the strategies adopted by the business firms. The stability of the government
also influences business and related activities to a great extent. It sends a signal of
strength, confidence to various interest groups and investors.
3. Legal Environment: This refers to set of laws, regulations, which influence the business
organizations and their operations. Every business organization has to obey, and work
within the framework of the law. The important legislations that concern the business
enterprises include: (i) Companies Act, 1956 (ii) Foreign Exchange Management Act,
1999 (iii) The Factories Act, 1948 (iv) Industrial Disputes Act, 1972 (v) Payment of
Gratuity Act, 1972 etc., Besides, the above legislations, the following are also form part
of the legal environment of business such as, Provisions of the Constitution and Judicial
Decisions.
4. Economic Environment: The survival and success of each and every business enterprise
depend fully on its economic environment. The main factors that affect the economic
environment are:
(a) Economic Conditions: The economic conditions of a nation refer to a set of
economic factors that have great influence on business organisations and their
operations. These include gross domestic product, per capita income, markets for
goods and services, availability of capital, foreign exchange reserve, growth of
foreign trade, strength of capital market etc. All these help in improving the pace
of economic growth.
(b) Economic Policies: All business activities and operations are directly influenced
by the economic policies framed by the government from time to time. Some of
the important economic policies are: (i) Industrial policy (ii) Fiscal policy (iii)
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Monetary policy (iv) Foreign investment policy (v) Export –Import policy (Exim
policy).
(c) Economic System: The world economy is primarily governed by three types of
economic systems, viz., (i) Capitalist economy; (ii) Socialist economy; and (iii)
Mixed economy. India has adopted the mixed economy system which implies co-
existence of public sector and private sector.
5. Socio-cultural Environment: Socio-culture variables like the beliefs, value system,
attitudes of people and their demographic composition have a major impact on their
personality and behavior style. The social environment of business includes social factors
like customs, traditions, values, beliefs, poverty, literacy, life expectancy rate etc. The
social structure and the values that a society cherishes have a considerable influence on
the functioning of business firms. For example, during festive seasons there is an increase
in the demand for new clothes, sweets, fruits, flower, etc.
6. Technological: Technology is understood as the application of scientific knowledge to
practical tasks. Technology reaches people through the business. Technology changes
fast. Businessmen should always be alert to the changed technology. They should adopt
the changed technology to the business processes. A business unit, which keeps pace with
technology up gradation, succeeds. Technological factors exercise considerable influence
on business.
7. Global Environment: The international environment consists of all factors that operate
at the transnational, cross-cultural level and across the border. The world is a global
village today and it is getting closer and closer as far as business is concerned. For the
sake of business, countries are burying their grievances and forging economic
relationships.
Basic Macro Economic Concepts:

Macroeconomics is a branch of economics that studies how an overall economy - the market or
other systems that operate on a large scale - behaves. Macroeconomics studies economy-wide
phenomena such as inflation, price levels, rate of economic growth, national income, gross
domestic product (GDP), and changes in unemployment.
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Macroeconomics deals with the performance, structure, and behavior of the entire economy, in
contrast to microeconomics, which is more focused on the choices made by individual actors in
the economy (like people, households, industries, etc.).
Open and Closed Economies:
Open economy: Market-economy mostly free from trade barriers and where exports and imports
form a large percentage of the GDP.
No economy is totally open or closed in terms of trade restrictions, and all governments have
varying degrees of control over movements of capital and labour. In an open economy, market
forces are allowed to determine production levels.
Degree of openness of an economy determines a government's freedom to pursue economic
policies of its choice, and the susceptibility of the country to international economic cycles.
In terms of the percentage of the GDP dependent on foreign trade, the UK is a more open
economy than the US.
Features of open economy:
 Import and export helps increase the GDP and thus there is economic growth.
 Open economies are able to get cheaper imports and can sell exports at higher prices.
 International trade in goods and services enables each country to concentrate on the
production of those goods in which it has a comparative cost advantage, and import those
in which it has a comparative cost disadvantage.
 An open economy is more flexible if it exports and imports in such a manner that when
there is a crisis they are able to withstand those pressures, in other words are not totally
dependent on other countries.
 Open economies provide an incentive for research and adoption of innovations.
 Open economies are interdependent. And this exposes them to certain unavoidable risks.
Disturbances like trade cycles, and fluctuations in income, prices and employment etc.,
originating in one economy, spread to other economies also, this depends on the size of
the economy, intensity of the initial disturbances and degree of integration or
interdependence.
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 Certain varieties of imports can expose a country to undue political, economic and
cultural risk. Examples are imports necessary for defence, health care, energy needs, food
needs, and the like.
 Large scale increase in international capital flows has resulted in problems like heavy
indebtedness of certain countries and their inability to repay their debts.
 International trade adds to the productive capacity of a country, but if its terms of trade
deteriorate so much that there is a net decline in its economic welfare then it is not
economic growth.
Closed economy: An economy in which no activity is conducted with outside economies. A

closed economy is self-sufficient, meaning that no imports are brought in and no exports are sent
out. The goal is to provide consumers with everything that they need from within the economy's
borders.
Closed economies are more likely to be less developed if they lack internal sources of some raw
materials, such as oil, gas and coal. Due to the prevalence of international trade, truly closed
economies are rare. Even governments that seek to limit the political or cultural influences of the
outside world are likely to trade with other economies on some scale.
Closed economy is characterized by protective tariffs, state-run or nationalized industries,
extensive government regulations and price controls, and similar policies indicative of a
government-controlled economy.
Features of a closed economy:

 A closed region is independent from other regions, so there is no fear of coercion or
interference.
 Transit costs may be a problem for an isolated region, but the absence of imports and
exports relieves all shipping costs.
 Nearly every country or region has regulations on items produced and sold. These ensure
that the product is safe or satisfies certain conditions. While regulating every item is
difficult, a region with a closed economy may find it slightly easier. This is because it
does not have to check imports, only internal items.
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 A closed economy must also be able to feed itself and so is highly dependent on
agricultural and other farming methods to be able to survive. If the country suffers from
any adverse conditions such as too much rain or not enough rain, this will have a direct
impact on the economy and people may starve.
 An economy on its path of development, like India, should focus more on producing for
the country on domestic level and restrict them from using imported goods.
Sectors of Indian Economy:

Economic activities result in the production of goods and services while sectors are the group of
economic activities classified on the basis of some criteria.
Economic activities are classified into groups using some important criterion. These groups are
known as sectors of an economy.
The Indian economy can be classified into various sectors on the basis of ownership, working
conditions of the workers and the nature of the activity being performed.
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1. Classification of economic activities on the basis of nature of activity

a. Primary Sector
b. Secondary sector
c. Tertiary sector
2. Classification of economic activities on the basis of conditions of work
a. Organised sector
b. Unorganised sector
3. Classification of economic activities on the basis of ownership of assets
a. Public sector (government’s control)
b. Private sector (controlled by individual or group of individuals)
a. Primary Sector of Indian Economy:Primary Sector is directly dependent on the

environment for manufacture and production. A primary sector is a sector whereby the
raw materials are extracted from the earth. Primary Sector includes those activities which
lead to the production of goods by exploitation of natural resources.
Examples of primary sector activities are agriculture, fishing, mining, animal husbandry etc.
Primary sector is also known as agriculture and related sector. It produces natural products like
cotton, milk, fruits, wheat, fish, rubber etc.
Primary sector are activities undertaken by directly using natural resources. Example -
Agriculture, Mining, Fishing, Forestry, Dairy etc. It is called primary sector because it forms the
base for all other products that we subsequently make. Since most of the natural products we get
are from agriculture, dairy, forestry, fishing it is also called Agriculture and related sector.
b. Secondary Sector:A secondary sector is a sector whereby the raw material that is
extracted from earth is converted to semi- finished goods or finished goods. Secondary
sector activities follow the primary activities, in which the natural products are changed
to manufacture different commodities. When the main activity involves manufacturing
then it is the secondary sector.
All industrial production where physical goods are produced come under the secondary sector
thus, the secondary sector is also called the industrial sector.
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• An agricultural product like cotton is woven into cotton fabric or sugar cane is processed
to produce sugar.
• Secondary Sector covers activities in which natural products are changed into other forms
through ways of manufacturing that we associate with industrial activity.
It covers activities in which natural products are changed into other forms through ways of
manufacturing that we associate with industrial activity. It is a next step after the primary,
where the product is not produced by nature but has to be made. Some process of
manufacturing is essential; it could be in a factory, a workshop or at home. Example: Using
cotton fiber from a plant, we spin yarn and weave cloth; using sugarcane as a raw material
we make sugar, we convert earth into bricks. Since this sector is associated with different
kinds of industries, it is also called industrial sector.
c. Tertiary Sector:Tertiary Sector activities help in the development of the primary and
secondary sectors. These activities, by themselves, do not produce a good but they are an
aid or a support for the production process. This sector is also known as the service
sector.
For example, goods that are produced in the primary or secondary sector would need to be
transported by trucks or trains and then sold in wholesale and retail shops also called the service
sector.
Examples of tertiary sector activities are banking, insurance, finance etc.
When the activity involves providing intangible goods like services then this is part of the
tertiary sector. Financial services, management consultancy, telephony and IT are good examples
of the service sector. Like the secondary sector, it also provides value addition to a product. This
sector is also known as the service sector.
Sectorial contribution to the economy:

• Primary Sector: It currently contributes 17% of Indian GDP at current prices.
This sector provides employment to around 53% of the Indian population. The best
example of the primary sector in India is agriculture, which accounts for the largest share.
• Secondary Sector: It contributes an estimated 29% of the Indian GDP (at current prices).
The Indian government has always placed high weightage on industrial development.
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This sector includes 'Mining & quarrying', Manufacturing (Registered & Unregistered),
Gas, Electricity, Construction, and Water supply. 16% of the employment is provided by
the industrial sector.
• Tertiary Sector: This sector is also known as the tertiary sector of the economy.
Currently, this sector the backbone of the Indian economy and contributing around 54.3%
of the Indian GDP. Services sector provides employment to approximately 23% of the
population.
SWOT Analysis for the Indian economy:
Strengths:
1. India has a great workforce
2. There is a high percentage of arable land
3. Notes on the diverse nature of the economy.
4. Availability of skilled labor
5. A stable economy is not affected by external changes
6. The extensive higher education policy is the third largest reservoir of engineers
7. High growth rate of the economy.
8. The IT and BPO sector, which provides valuable foreign exchange, is booming.
9. Abundance of natural resources.
Weakness:
1. The labor force involved in agriculture is very high, representing only 17% of GDP
2. A quarter of the population below the poverty line
3. High unemployment rate
4. Inequality in the current socio-economic conditions
5. Poor infrastructure
6. Low productivity
7. Massive population that leads to resource shortages
8. Low-level automation
9. Red topicism, bureaucracy
10. Low literacy rates
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11. Unequal distribution of wealth

12. The rural-urban division leads to disparities in living standards
Opportunities:
1. The scope of the entry of private companies in various sectors for business.
2. Foreign direct investment flows are likely to increase in many sectors.
3. It is possible to earn large currencies in the IT and ITES sector.
4. Invest in R&D and engineering design.
5. Infrastructure area
6. Large domestic market: an opportunity for the sale of multinationals
7. There are huge reserves of natural gas in India and there are huge opportunities for natural
gas fuels.
8. A vast forest area and diverse wildlife
9. Huge agricultural resources, fisheries, plantations, crops and livestock.
Threats:
1. Depression of the global economy
2. High fiscal deficit
3. Government intervention in some states is threatening
4. Volatility in crude oil prices worldwide
5. Increase in import invoice
6. Population explosion, the population growth rate is even higher
7. The monsoon depends a lot on the rain.
Measuring the Economy:

The economy of country will be measured based on the economic indicators, the three most used
economic indicators are inflation, gross domestic product (GDP), and labor market data.
Gross domestic product is the best way to measure economic growth. It takes into account the
country's entire economic output. It includes all goods and services that businesses in the country
produce for sale. It doesn't matter whether they are sold domestically or overseas.
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Gross domestic product (GDP):

Gross domestic product (GDP) is the total monetary or market value of all the finished goods and
services produced within a country's borders in a specific time period. As a broad measure of
overall domestic production, it functions as a comprehensive scorecard of a given country’s
economic health.
Features of GDP:
• Gross Domestic Product (GDP) is the monetary value of all finished goods and services
made within a country during a specific period.
• GDP provides an economic snapshot of a country, used to estimate the size of an
economy and growth rate.
• GDP can be calculated in three ways, using expenditures, production, or incomes. It can
be adjusted for inflation and population to provide deeper insights.
• Though it has limitations, GDP is a key tool to guide policymakers, investors, and
businesses in strategic decision making.
Components of GDP:
• Consumption (C)
• Investment (I)
• Government Spending's (G)
• Net Exports (X – M)
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1. Consumption: It is Household Final Consumption Expenditure.It Includes,

 Durable goods – cars, furniture, large appliances.
 Non-durable goods – clothing, food, fuel.
 Services – banking, health care, education.
2. Investment: Investment by Business or Households in Capital. It Includes,

 Construction of New Mine.
 Purchase of Machinery or Equipment for Factory.
 Purchase of software.
 Expenditure on New Houses.
 Buying Goods and Services.
3. Government Spending's: Total Government Expenditures on Final Goods and Services.

It Includes,
 Investment Expenditure by Government.
 Purchases of weapons for Military.
 Salaries of Public Servants.
4. Net Exports (X – M):

 Gross Exports (X) • All Goods and Services Produced for Overseas Consumption.
 Gross Imports (M) • Any Goods or Services Imported for Consumption.
Measuring GDP
There are several popular variations of GDP measurements which can be useful for different
purposes:
• Nominal GDP: GDP evaluated at current market prices, in either the local currency or in
U.S. dollars at currency market exchanges rates in order to compare countries' GDP in
purely financial terms.
• GDP, Purchasing Power Parity (PPP): GDP measured in "international dollars" using the
method of Purchasing Power Parity (PPP), which adjusts for differences in local prices
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and costs of living in order to make cross-country comparisons of real output, real
income, and living standards.
• Real GDP: Real GDP is an inflation-adjusted measure that reflects the quantity of
goods and services produced by an economy in a given year, with prices held constant
from year to year in order to separate out the impact of inflation or deflation from the
trend in output over time.
• GDP Growth Rate: The GDP growth rate compares one year (or quarter) of a country's
GDP to the previous year (or quarter) in order to measure how fast an economy is
growing. Usually expressed as a percent rate, this measure is popular for economic
policy makers because GDP growth is though to be closely connected to key policy
targets such as inflation and unemployment rates.
• GDP Per Capita: GDP per capita is a measurement of the GDP per person in a country's
population. It indicates the the amount of output or income per person in an economy can
indicate average productivity or average living standards. GDP per capita can be stated
in nominal, real (inflation adjusted), or PPP terms.
GDP = C + I + G + NX - where consumption (C) represents private-consumption expenditures

by households and nonprofit organizations, investment (I) refers to business expenditures by
businesses and home purchases by households, government spending (G) denotes expenditures
on goods and services by the government, and net exports (NX) represents a nation’s exports
minus its imports.
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Question Bank:
1. Define business environment.
2. Discuss the nature and scope of Indian business environment.
3. Briefly explain the structure of Indian business environment.
4. Write a note on open and closed economies with their features.
5. Mention the sectors of Indian Economy and their contribution towards economic
development.
6. Discuss the SWOT analysis for Indian Economy.
7. What is GDP?
8. Explain the components of GDP in detail.
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Module -6
Indian Industrial Policy
Industrial Policies and Structure: A critical look at Industrial Policies of India, New Industrial
Policy 1991; - Private Sector- Growth, Problems and Prospects, SMEs –Significance in Indian
economy-problems and prospects. Fiscal policy and Monetary Policy. Foreign Trade: Trends in
India’s Foreign Trade, Impact of WTO on India’s Foreign Trade.
Industrial Policies – Concept:

The industrial policy means the procedures, principles, policies rules and regulations which
control the industrial undertaking of the country and pattern of industrialization. It explains the
approach of Government in context to the development of industrial sector.
The industrial policy in the pre-reform period i.e. before1991 put greater emphasis on the state
intervention in the field of industrial development. These policies no doubt have resulted into the
creation of diversified industrial structure but caused a number of inefficiencies, distortions and
rigidities in the system. Thus during late 70’s and 80’s, Government initiated liberalization
measures in the industrial policy framework. The drastic liberalization measures were however,
carried out in 1991.
Objectives of Industrial Policies:

• To create a high-wage, high productivity
• High innovation
• High investment economy based on diversity of ownership and enterprise type with many
different industry sectors.
Industrial Policies in India:

• Industrial Policy Resolution of 1948
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• The New Industrial Policy of 1991
NEW INDUSTRIAL POLICY 1991:

In order to accelerate Industrial Development in India, and in accordance with the changing
circumstances, various industrial policies were declared in the years 1948, 1956, 1977, 1980 and
1985, but in spite of all efforts, the pace and as well as the level of Industrial Development in
India, could not reached according to its need. Therefore, in order to lift unnecessary restrictions
on Industries, under the licensing policy, and to increase their efficiency, development and
technological level, in order to make Indian goods usable in the competitive global market, on
24th July, 1991, in Lok-Sabha the Minister of States for industries, Mr. P. J. Kurian declared the
Industrial Policy, 1991.
Objectives of New Industrial Policy – 1991:

• To liberalise the economy
• To increase employment opportunities
• To encourage foreign assistance and co-partnership
• To make the Public Sector more competitive
• To increase the production and productivity, give encouragement to industries
• To liberate the economy from various government restrictions
• Industrial development of backward areas
• To give liberty to private sector to work independently
• To make development for modem competitive economy
• To give encouragement for expansion of production capacity
• To increase exports and liberalize (facilitate) imports.
Salient Features of New Industrial Policy – 1991:

• Liberalized Industrial Licensing Policy: Under this policy, with the exception of 18
industries, licensing system has been removed for all other industries. Some of those 18
industries, where the licensing system is still mandatory are; Army and Defense, Forest
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Conservation, Industries engaged in manufacturing goods which are harmful to the

Environment and industries, which are manufacturing luxury goods, for the affluent (very
rich) class, etc.
• Localisation Policy: Those industries which are situated in cities, where the population
is less than 1 million, industrial permission from the government, to start any industry is
not required. In cities having population of more than 1 million, with the exception of
electronics and other pollution free industries, all industrial units may be 25 kilo meters
away from the city’s boundary.
• Foreign Investment: Provision has been made to invest up to 51 percent by foreign
investors in the equity shares of Indian Companies. Earlier, this limit was limited up to
40% only. This will increase the flow of foreign capital into India and make possible
technical exchange from developed countries.
• Workers’ Participation in Management: Under this industrial policy, emphasis has
been laid on safeguarding the workers’ interest. Provision has been made for workers’
participation in management, in order to manage sick units, provision has been made
to form co-operative societies of workers, to run them.
• Role of Public Sector: Those public sector undertakings which are not doing well at
present, but in which there are enough chances of improvement, shall be re-constituted.
Public sector undertakings, which are facing constant financial crisis, shall be kept
under observation by ‘Board of Industrial and Financial Reconstruction’ or by any other
institution, which is fixed by the government.
• Change in the MRTP Act: In the industrial policy 1991, major changes have been made
in the Monopolistic and Restrictive Trade Practice Act. Companies having investment of
Rs. 100 crores, will not be required to take prior Government permission, for opening
new subdivisions, or to expand the present industry or for amalgamation of companies.
This industrial policy has also eliminated the investment limit, which was fixed by
MRTP Act.
• Creation of Productive Capacity: In order to increase the productive capacity of new
industries, all administrative controls have been removed. Industrialists will only have
to inform the government of opening of new units or increasing their production
capacity.
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• Foreign Technology: No prior permission from government will be required in

importing foreign technology, up to the limit of One Crore rupees. Indian companies,
will be free to negotiate their terms and conditions, with their foreign collaborators, in
matters of technology transfers (exchange of ‘technical know-how).
• Promotion of Industries in Rural Areas: In order to remove the regional imbalances,
under this industrial policy, various provisions have been made to encourage industries
in rural areas.
• Reservation of Small Scale Industries: This policy has stated that the government shall
keep giving assistance to small scale industries. The limit for small scale industries has
been reduced from Rs 3 Crores to Rs. 1 Crore, since 24 December, 1999.
Impact of Industrial Policy – 1991

 The all-round changes introduced in the industrial policy framework have given a new
direction to the future industrialization of the country.
 Industrial growth was 1.7 per cent in 1991-92 that has increased to 8.8 percent in 2021-
22.
 The industrial structure is much more balanced.
• The impact of industrial reforms is reflected in multiple increases in investment
envisaged, both domestic and foreign. This is due to encouraging response from the
private sector.
• There has been dramatic increase in FDI since 1991. The foreign investment as a
percentage of total GDP has increased from 0.5 percent in 1990-91.
• Investments in infrastructure sector such as power generation have surged from players
of various sizes in different states. The capital goods have grown at an accelerated pace,
over a high base attained in the previous years, which augurs well for the required
industrial capacity addition.
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Private Sector:
The private sector is the part of a country’s economy which consists of industries and
commercial companies that are not owned or controlled by the government.
The private sector is the part of the economy that is run by individuals and companies for profit
and is not state controlled. Therefore, it encompasses all for-profit businesses that are not owned
or operated by the government.
Types of Private Sector Businesses
The private sector is a very diverse sector and makes up a big part of economies. It is based on
many different individuals, partnerships, and groups. The entities that form the private sector
include:
• Sole proprietorships
• Partnerships
• Small and mid-sized businesses
• Large corporations and multinationals
• Professional and trade associations
• Trade unions
Growth of Private Sector:
• Private sector contributes about three-forth of the country’s national income. Moreover,
this sector also plays a vital role to increase gross domestic saving (CDS) and gross
domestic capital formation’(GDCF) within the economy.
• The private sector accounts for over 60 percent of GDP in countries, similar to dynamic
emerging markets in other regions.
• The share of private corporate sector’s profits to India’s GDP in 2018 amounted to about
2.2 percent. This was a slight increase compared to the previous year, indicating a
growing trend of private sector’s contribution to the country’s domestic output.
• About 80% of the total working forces are employed in either organized
or unorganized private sector units.
• The Indian economy grew at a rate of 6.8% during 2018 and is projected to grow at a rate
of 7% and 7.2% during 2019 and 2020, respectively. The private sector has played a huge
role in India’s development and is largely responsible for the phenomenal growth
registered by the country since the economy was opened up in 1991.
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Problems of Private Sectors:

• Regulatory Procedure and Related Delays
• Unnecessary Control
• Inadequate Diversification
• Reservation for the Small Sector
• Lack of Finance and Credit
• Low Ratio of Profit
• Lack of public confidence
• Lack of transparency in the operations
Prospects of Private Sector:

The private sector too has shown sufficient enthusiasm and has registered a fast rate of growth
by raising increasing funds in the capital market and setting up a series of joint ventures in other
countries.
• Openness in trading sector
• Industrial licensing has been abolished for all projects except for a short list of industries
related to security and strategic concerns, social reasons, hazardous chemicals and
overriding environmental concerns.
• Exception from licensing will apply to all substantial expansion of existing units.
• Approvals will be given for direct foreign investment upto 51 percent foreign equity in
high priority industries.
• Automatic permission will be given for foreign technology in high priority industries.
• No permission will be required from the MRTP commission for expansion, new
undertakings, mergers, amalgamations and take over’s and appointment of directors.
SME’s – Small and Medium Enterprises:

Small and medium enterprises (SMEs) are businesses that maintain revenues, assets or a number
of employees below a certain threshold. Small and medium-sized enterprises are businesses
whose personnel numbers fall below certain limits. Small and Medium Enterprises are
undertakings that are classified on the basis of the size of investment and they exist in both the
Manufacturing and Services Sectors of the economy.
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Characteristics of SME’s:
• Born out of individual initiatives and skills
• Greater operational flexibility
• Low cost of production
• High employment orientation
• Limited Investment
• Personal Character/Owner-Management
• Labour-Intensive
• UnorganisedLabour
• Local Area of Operations
• Reduction of regional imbalance
Significance of SME’s in Indian economy:

• Employment generation
• Increases Production
• Export contribution
• Innovation and development
• Utilizing resources optimally
• Developing entrepreneurial capacity
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• Increases GDP
• Feeder to large industries
• Opportunities for growth
• Encourage regional development
• Boost exports
SME’s Problems or Challenges:

• Absence of adequate credit from Banks.
• Limited Capital and Knowledge.
• Competition
• Non – Availability of proper Information Technology.
• Lower capacity of production.
• Lack of marketing strategy.
• Lack of infrastructure
• Identification of new markets.
• Challenge of getting skilled low cost labour.
• Follow-up with various government departments to resolve problem.
Prospects of SME’s:
• Business partnerships
• New business model
• Training and development
• Up gradation of materials, process and technology
• Diversified scope of business
• Exposure to foreign trade
• Less government intervention
• Economic benefits
Page122
Economic policies:
An economic policy statement is a declaration of a government’s political activities, plans and
intentions relating to a concrete cause or, at the assumption of office, an entire legislative
session. It is related to the government revenues and expenditures.
Fiscal policy:
Fiscal policy refers to the use of government spending and tax policies to influence economic
conditions, especially macroeconomic conditions, including aggregate demand for goods and
services, employment, inflation, and economic growth. In India, the Union finance minister
formulates the fiscal policy.
Tools of fiscal policy: There are two key tools of the fiscal policy:
• Taxation: Funds in the form of direct and indirect taxes, capital gains from investment,
etc, help the government function. Taxes affect the consumer’s income and changes in
consumption lead to changes in real gross domestic product (GDP).
Page123
• Government spending: It includes welfare programmes, government salaries, subsidies,

infrastructure, etc. Government spending has the power to raise or lower real GDP, hence
it is included as a fiscal policy tool.
Fiscal policy objectives:

Some of the key objectives of fiscal policy are;
• Economic stability
• Price stability
• Full employment
• Optimum allocation of resources
• Accelerating the rate of economic development
• Encouraging investment
• Capital formation and growth
Monetary Policy:
Monetary policy refers to the use of monetary instruments under the control of the central bank
to regulate magnitudes such as interest rates, money supply and availability of credit with a view
to achieving the ultimate objective of economic policy.
The central bank designs the monetary policy in keeping with the government’s economic
policy. Monetary policy is about expansion and contraction of money and the central bank is the
implementing body of the monetary policy. Given below is the study of money supply and our
central bank, i.e., the Reserve Bank of India (RBI).
Monetary policy refers to the policy of the central bank – i.e Reserve Bank of India – in matters
of interest rates, money supply and availability of credit. It is through the monetary
policy, RBI controls inflation in the country.
The various instruments of monetary policy include;
Variations in bank rates, other interest rates, selective credit controls, supply of currency,
variations in reserve requirements and open market operations.
Factors affecting Money Supply in India:

There are five sources which contribute to the aggregate monetary resources in the country:
 Net bank credit to the bank
Page124
 Bank credit to the commercial sector

 Net foreign exchange assets of the banking sector
 Government currency liabilities to the public
 Non-monetary liabilities of the banking sector.
Instruments of monetary policy (methods of credit control):

 Open Market Operations
 Bank Rate
 Direct Regulation of Interest Rates on Commercial Banks’ Deposits and Loans
 Cash Reserve Ratio (CRR)
 Statutory Liquidity Ratio (SLR)
 Direct Credit Allocation and Credit Rationing
 Selective Credit Controls (SCC)
 Credit Authorisation Scheme (CAS)
 Fixation of Inventory and Credit Norms
 Credit Planning
Fiscal policy v/s Monetary Policy:
Page125
Foreign Trade:
Foreign trade is exchange of capital, goods, and services across international borders or
territories. In most countries, it represents a significant share of gross domestic product (GDP).
While international trade has been present throughout much of history, its economic, social, and
political importance has been on the rise in recent centuries.
Foreign trade in India includes all imports and exports to and from India. At the level of Central
Government it is administered by the Ministry of Commerce and Industry. Foreign
trade accounted for 48.8% of India’s GDP in 2018.
Foreign trade plays a vital part in the economy of each country. Foreign trade helps a country to
utilize its natural resources and to export its surplus production, it contributes hugely to the GDP
of a country. We are going to discuss the importance of foreign trade in India and all of its
aspect.
Trends in India’s Foreign Trade:

• Huge Growth in the Value of Trade
• Higher Growth of Imports
• Inadequate Growth of Exports
• Mounting Trade Deficit: Deficit in the Balance of Trade
• Forced Dynamism
• Cooperation among Countries
• Liberalization of Cross-border Movements
• Transfer of Technology
• Growth in Emerging Markets
Impact of WTO on India’s Foreign Trade:

The foreign trade is having both positive and negative impact, such as;
• Boost to exports
• Technical assistance
• Sustainable development
• Promotion of competition
• Settlement of disputes
Page126
• Prominence to develop nations

• Increasing inequality
• Threat to service sector
• Rising is price
Question Bank:
1. State the objectives of Industrial policy.
2. Give in detail the features and implications of New Industrial policy 1991.
3. What is private sector? State the types of private sector in India.
4. Explain the problems and prospects of private sector.
5. Discuss the characteristics and significance of SME’s in the Indian economy.
6. Enumerate the problems or challenges of SME’s.
7. What is fiscal policy? Mention its components.
8. Differentiate monetary and fiscal policy.
9. What is foreign trade? Mention its benefits.
10. Identify the current trends in India’s foreign trade.
11. Explain impact of WTO on India’s foreign trade.
Prof. Devaraju N&Prof. Savanth S T, East West Institute of Technology,Bangalore. Page127
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MANAGERIAL ECONOMICS – (22MBA26)

Managerial Economics: Meaning, Nature, Scope, & Significance, Uses of Managerial

Managerial theories: Baumol’s Model, Marris’s Hypothesis, Williamson’s Model.

Managerial Economics: Meaning & Definition

• Branch of Economics: ‘Managerial Economics is the study of Economic Theories,

• ‘Managerial Economics is the Application of various Theories, Concepts and Principles

• It also Includes ‘The Application of Mathematical and Statistical tools in Management

Nature of Managerial Economics:

• Science as well as Art of decision making.

• It is essentially Micro in nature but Macro in analysis.

• It is mainly a Normative science but positive in analysis.

• It is concerned with the application of theories and principles of economics.

• It discusses Individual problems.

• It is dynamic in nature not a Static.

• It discusses the economic behavior of a firm.

• It concentrates on optimum utilization of resources.

Scope of Managerial Economics:

Significance of Managerial Economics:

 Business Planning: Managerial economics assists business organizations in formulating

Uses of Managerial Economics

Roles and Responsibilities of Managerial Economist:

• Analyzing the issues and problems of the firms.

• Carrying out cost-benefit analysis.

• Assisting the business planning process.

• Advising on pricing, investment and capital budgeting policies.

• Evaluation of capital budgets.

• Building micro and macroeconomics models of particular aspects of the firm.

• Directing economic research activity.

Theory of the Firm:

The theory of the firm aims at answering the following questions:

• Heterogeneity of firm actions/performances – what drives different actions and

Firm and Industry

Objectives of the Firm

4. Increase market share/market dominance

6. Profit Satisficing: Profit satisficing is a situation where there is a separation of

7. Co-operatives: Co-operatives may have completely different objectives to a typical

Alternate Objectives of the Firm:

• Maximize growth rate

• Desire for liquidity

• Optimum Utilization of Resources

• Supplying desired goods at reasonable prices

• Building up public confidence for the public

Managerial Theories of the Firm:

Managerial Theories of the Firm

• Baumol's Theory of Sales Revenue Maximisation

• Marris Growth Maximization Model

• Williamson’s Managerial Discretionary Theory

1. Baumol's Theory of Sales Revenue Maximisation:

W.J.Baumol suggested Sales Revenue maximisation as an alternative goal to profit

Assumption of the Theory:

1. There is a single period time horizon of the firm.

Arguments in favour of Maximisation of Sales Goal:

2. Marris’s Growth Maximization Model:

The Marris’s model is based on the following assumptions:

3. Williamson’s Managerial Discretionary Theory:

Managerial utility function:

Module -2 Demand Analysis

Law of Demand, Exceptions to the Law of Demand, Elasticity of Demand –Classification

Factors that influence demand:

Relationship between Price and Quantity demanded:

Note: Above table is optional while writing in exams