Module 1(One)

Business Economies
Business economics is a field of applied economics that studies
the financial, organizational, market-related, and environmental issues
faced by corporations. Business economics assesses certain factors
impacting corporations—business organization, management, expansion,
and strategy—using economic theory and quantitative methods. Research
topics in the field of business economics might include how and why
corporations expand, the impact of entrepreneurs, interactions
among corporations, and the role of governments in regulation.

• Business economics is a field of applied economics that studies

the financial, organizational, market-related, and
environmental issues faced by corporations.
• Business economics encompasses subjects such as the concept of
scarcity, product factors, distribution, and consumption.

Understanding Business Economics

In the broadest sense, economics refers to the study of the components and
functions of a particular marketplace or economy—such as supply and
demand—and the impact of the concept of scarcity. Within economics,
production factors, distribution methods, and consumption are important
subjects of study. Business economics focuses on the elements and factors
within business operations and how they relate to the economy as a whole.
The field of business economics addresses economic
principles, strategies, standard business practices, the acquisition of
necessary capital, profit generation, the efficiency of production, and overall
management strategy. Business economics also includes the study of
external economic factors and their influence on business decisions such as
a change in industry regulation or a sudden price shift in raw materials.

Concept of Economic: -
Economic is a social science. Its basic function is to study how people,
individual, household, firm and nation maximize their gain from limited
resources and opportunities
Maximizing behaviour/ optimizing behaviour is selecting the best out of
available option with the objectives of maximising gains from gives
resources.
1. Households; -
How household allocates their income (limited resources) between
various goods and services they consume so that they are able to
maximize their total satisfaction.
 2. Producers: -
Firms decides on the commodity to produce, the productive
technology, location of the firm, price of the product etc.
3. Nation; - How nation allocate their resources and materials between
competing needs of the society so that economic welfare of the
society can be maximized.
Economic is thus, a social science which studies human behaviour in
relation to optimizing allocation of available resources to achieve given
ends.
Economic is a study of the choice making behaviour of people
1. Economic world is very complex
2. Economic decision has to be taken under the condition of
a) Imperfect knowledge
b) Risk and uncertainty.
Micro and Macro Economies
Another useful distinction is that economic theories make is between Micro
economies and Macro- Economics. Micro- economies deal with the theory of
the firm, and the behaviour and problems of individuals and of Micro-
organization. Macroeconomics is concerned with the behaviour of the
economic as a whole, and the theories about its operation. Thus, the study
of the level and determination of national income, employment and prices
and the analysis of aggregates consumption and balance of payment
belongs to Macro- economics.

It should be obvious that the roots of managerial economics springs from

micro economic theory. Price theory, demand concept and theories of
market structure, to take a few examples, are element of micro- economic
which managerial economic draw upon. The dependence of the latter of
micro economic theory is very much like the dependence of medicine on
biological sciences and of engineering or technology on physic. It is
important to note that managerial economics has and applied bias and an
interest in applying economic theory in order to solve real life problems of
enterprise. Mere teaching of micro-economic theory will not therefore, be a
substitute for the teaching of managerial economic. However, an elementary
course in micro-economic theory is useful pre- requisite for all student on
managerial economics.
 Aggregative or macro-economic theory on the other hand, has relevance
for managerial economics. But one part of this subject to which managerial
economics could contribute is national income forecasting. The latter is an
important aid to business condition analysis which in turn could be a
valuable input for forecasting the demand for specific product groups.
Assumptions and estimates of demand are essential data for most of the
allocation decisions managerial economics is concerned with.

Fundamental Concepts that aid Decision Making.

1.Incremental Principle: -
The incremental concept is probably the most important concept in
economics and is certainly the most frequently used in Managerial
Economics. Incremental concept is closely related to the marginal cost and
marginal revenues of economic theory.
The two major concepts in this analysis are incremental cost and
incremental revenue. Incremental cost denotes change in total cost,
whereas incremental revenue means change in total revenue resulting from
a decision of the firm.
The incremental principle may be stated as follows:
A decision is clearly a profitable one if
(i) It increases revenue more than costs.
(ii) It decreases some cost to a greater extent than it increases others.
(iii) It increases some revenues more than it decreases others.
(iv) It reduces costs more than revenues.
2. The Opportunity Cost Concept:
_____________________________________________
Both micro and macroeconomics make abundant use of the fundamental
concept of opportunity cost. In Managerial Economics, the opportunity cost
concept is useful in decision involving a choice between different alternative
courses of action.
The concept of opportunity cost implies three things:
1. The calculation of opportunity cost involves the measurement of
sacrifices.
2. Sacrifices may be monetary or real.
3. The opportunity cost is termed as the cost of sacrificed alternatives.

Opportunity cost refers to expected income foregoes from the second-best

use of the resources involved in the present decision.
Suppose a firm has Rs. 100 million at disposal and there are only three
alternatives uses
1. Expand the size of the firm
2. Set up a new production unit in another locality
3. To buy shares from another firm
The expected annual income return (income) from an alternative are as
follows:
1. Rs. 20 million
2. Rs. 18 million
3. Rs. 16 million
Rational Decision-making would suggest invest the money in alternative 1.
this implies that the manager would have to sacrifices the Annual Return of
Rs. 18 million expected from alternative 2.
The difference between actual earning and opportunity cost is called
Economic gain or Economic profit.
The concept of opportunity cost assumes a great significance where
Economic gain is neither insignificant nor very large.

3.Discounting Principle; -
This concept is an extension of the concept of time perspective. Since future
is unknown and incalculable, there is lot of risk and uncertainty in future.
The mathematical technique for adjusting for the time value of money and
computing present value is called ‘discounting’.
The following example would make this point clear. Suppose, you are
offered a choice of Rs. 1,000 today or Rs. 1,000 next year. Naturally, you
will select Rs. 1,000 today. That is true because future is uncertain. Let us
assume you can earn 10 per cent interest during a year.
The concept of discounting is found most useful in managerial economics in
decision problems pertaining to investment planning or capital budgeting.
The formula of computing the present value is given below:
V = A/1+i
where:
V = Present value
A = Amount invested Rs. 100
i = Rate of interest 5 per cent
V = 100/1+.05 = 100/1.05 =Rs. 95.24

4.Concept of Time Perspective:

The time perspective concept states that the decision maker must give due
consideration both to the short run and long run effects of his decisions. He
must give due emphasis to the various time periods. It was Marshall who
introduced time element in economic theory.
The economic concepts of the long run and the short run have become part
of everyday language. Managerial economists are also concerned with the
short run and long run effects of decisions on revenues as well as costs. The
main problem in decision making is to establish the right balance between
long run and short run.
In the short period, the firm can change its output without changing its size.
In the long period, the firm can change its output by changing its size. In the
short period, the output of the industry is fixed because the firms cannot
change their size of operation and they can vary only variable factors. In the
long period, the output of the industry is likely to be more because the firms
have enough time to increase their sizes and also use both variable and
fixed factors.
In the short period, the average cost of a firm may be either more or less
than its average revenue. In the long period, the average cost of the firm will
be equal to its average revenue. A decision may be made on the basis of
short run considerations, but may as time elapses have long run
repercussions which make it more or less profitable than it at first appeared.
Concept of Inflation; -
Inflation is the decline of purchasing power of a given currency over time. A
quantitative estimate of the rate at which the decline in purchasing power
occurs can be reflected in the increase of an average price level of a basket
of selected goods and services in an economy over some period of time.

1) Types of inflation; -
Inflation is sometimes classified into three types: Demand-Pull
inflation, Cost-Push inflation, and Built-In inflation.

Most commonly used inflation indexes are the Consumer Price Index
(CPI) and the Wholesale Price Index (WPI).

2) Impact of Inflation: -
Rising prices, known as inflation, impact the cost of living, the cost of
doing business, borrowing money, mortgages, corporate, and
government bond yields, and every other facet of the
economy. Inflation can be both beneficial to economic recovery and,
in some cases, negative.
6. The Equi-marginal Concept: -
State that consumer choose combination of various goods in order to
achieve to maximum total utility. The principle states that an input should be
allocated so that value added by the last unit is the same in all cases. This
generalisation is popularly called the Equi-marginal. In other word consumer
will allocate spending their income across goods of services so that the
marginal utility per rupee of expenditure on each good. Purchase will be
equal to all other goods purchased.
It explains the way in which each consumer will spend portion of their
income across a variety of different goods in such a way to maximise their
overall satisfaction.
for example, if the value of the marginal product of labour in activity A is Rs.
50 while that in activity В is Rs. 70 then it is possible and profitable to shift
labour from activity A to activity B. The optimum is reached when the values
of the marginal product is equal to all activities. This can be expressed
symbolically as follows:
VMPLA = VMPLB = VMPLC = VMPLD = VMPLE
Where VMP = Value of Marginal Product.
L = Labour
ABCDE = Activities i.e., the value of the marginal product of labour employed
in A is equal to the value of the marginal product of the labour employed in
В and so on. The equi-marginal principle is an extremely practical notion.
 Module – 2 (two)
Demand is one of the crucial requirements for the existence of any business enterprise.
A firm is interested in its own profit and/or sales both of which dependent partially upon
the demand for its product. Demand is a desire for a commodity backed by the ability
and willingness to pay for it. Unless a person has adequate purchasing power or
resources and the preparedness to spend his resources, his desire for a commodity
would not be considered as his demand.
E.g., If a man wants to buy a car but he doesn’t have sufficient money to pay for it, his
wants is not demand.
If a rich person wants to buy a car but he is not wiling to pay, his desire too is not his
demand for a car.

MEANING OF DEMAND
Demand for a commodity implies:
a) Desire to acquire it
b) Willingness to pay for it, and
c) Ability to pay for it
The term demand for commodity always has a reference to a price, a period of time and
a place. Furthermore, it should be noted that a commodity is defined with reference to its
particular quality, if a quality changes it can be deemed as another commodity.

TYPES OF DEMAND
Categorization of Demand:
a) Demand for consumer’s goods and producer goods
b) Demand for perishable and durable goods
c) Derived and Autonomous demand
d) Firm and industry demand.
e) Demands by total market and by market segments.

a). Demand for consumer’s goods and producer goods: Consumer goods are goods used
for final consumption, e.g., Food items, readymade clothes, house. Producers goods are
used for production of other goods, consumer’s or producers’ E.g., machines, tools, raw
materials. Demand of consumers also terms as direct demand; these goods are directly
for final consumption. Demand for producers’ goods is derived demand, these goods are
demanded for final consumption but for the production of others goods.
b). Perishable and Durable demand:
Both consumers and producers’ goods are further divided into perishable (non-durable)
and Durable goods. Perishable goods are those which can be consumed only once over a
period of time. While durable goods are those which can be used more than once over a
period of time. In other word, Perishable goods are themselves consumed while only the
services of durable goods are consumed. E.g., Sweet, bread and milk are perishable
consumers’ goods.
Derived and Autonomous demand:
When the demand for the product is tied to the purchase of some parents conduct, its
demand is call Derived. For example, the demand for cement is a derived demand, for its
needs not for its own sake but for satisfying the demand for building. Autonomous
demand in other hands, is not derived. It is hard to find a product today whose demand
is wholly independent of all others demand. However, the degree of this independence
varies widely from products to products. Thus, the distinction between derived and
autonomous demand is more of degree than of kind.
Company and Industry demand.
Company demand denotes the demand for the product of a particular company while
industry demand means the demand for the product of a particular industry. For
example, demand for steel produced by Tata Iron and Steel Company (TISCO) while
demand for steels produced by all companies in India is industry for steels in India.
In perfect competition, company demand is completely divorced from industry demand. A
company can sell as much as it wishes to at the ruling price and can sell nothing at the
price even slightly higher than the ruling price. The price is determined at the point where
industry demand and industry supply are in equilibrium. Such markets do not exist but
market for agriculture products can be taken to approximate them. In monopolistic
competition, where there are many sellers with differential products, the industry
demand curve has little meaning. For, products of rival firms are advertised like different
products and so we have only company demand for each brand of a commodity. Like that
in monopoly. It differs from that of the monopolist in that the company demand under the
monopolistic competition may be affected by the number of rivals, their products and
prices, while that of monopolist is independent of such factors. Such market structures
are found for products and services like toothpaste, soaps, gasoline, tea, laundries, and
textiles.

Demand by Total Market and by Market Segments

Another important demand distinction is between total market demand and market
segments demand. The former refers to the total demand for a product whereas the
latter signifies demand arising from different segments of the market. A company or
industry may be interested not only in the totally different segments of the market, for
example from different regions different uses for its products, different distribution
channels, different customer sizes, and also for its different sub-products. Each of this
segment may defer significantly with respect to delivered prices, net profit margins,
competition season patterns, and cyclical sensitivity. When these different are great,
demand analysis should be confined to the individual market segments. A knowledge of
these segments’ demands help a unit in manipulating its total demand.

DETERMINANT OF DEMAND
Goods and services are demanded by consumer. Although the users of any good are its
consumer, demand analysis usually deals with the demand for consumers’ goods. A
consumers’ demand for a commodity or service depends on several factors:
 a) Consumers’ income: - Consumer income is the money that a consumer earns from
either work or investment, such as dividends distributed by companies to its
shareholders and the gain realized on the sale of an asset, such as a house.
When you combine these income sources, it's often referred to as
aggregate income.
b) Price of the commodity or service: - As the demand for goods and services increases,
the price of goods and services rises, and commodities are what's used to
produce those goods and services. Because commodities prices often rise with
inflation, this asset class can often serve as a hedge against the decreased
buying power of the currency.
c) Price of related goods or service: - Complements are goods that are consumed
together. Substitutes are goods where you can consume one in place of the other.
The prices of complementary or substitute goods also shift the demand curve.
d) Consumer taste and preferences: - Consumer preferences are defined as the
subjective (individual) tastes, as measured by utility, of various bundles of goods.
They permit the consumer to rank these bundles of goods according to the levels
of utility they give the consumer. ... Ability to purchase goods does not determine
a consumer's likes or dislikes.
e) Population and its distribution: - Demand for a product depends positively upon the
number of the consumers. Which varies directly with the size of population.
Furthermore, the spread of consumers over region, and urban-rural areas, and
their composition in term of children and adult, male and female, rich and poor,
etc.
f) Consumers’ expectation: - Consumer expectations refer to the economic outlook
of households. Expectations will have a significant bearing on current economic
activity. If people expect an improvement in the economic outlook, they will be
more willing to borrow and buy goods.

Consumer Equilibrium
Consumer’s equilibrium is a situation when he spends his given income on the
purchase of one or more commodities in such a way that he gets maximum
satisfaction and has no urge to change this level of consumption, given the prices of
commodities. When consumers make choices about the quantity of goods and
services to consume, it is presumed that their objective is to maximize total utility. In
maximizing total utility, the consumer faces a number of constraints, the most
important of which are the consumer's income and the prices of the goods and
services that the consumer wishes to consume. The consumer's effort to maximize
total utility, subject to these constraints, is referred to as the consumer's
problem. The solution to the consumer's problem, which entails decisions about how
much the consumer will consume of a number of goods and services, is referred to
as consumer equilibrium. The concept of consumer equilibrium state that,
Consumers derive utility from each commodity they consume. This utility is
dependent on the price of a product. The point at which the marginal utility (MU) of a
product equals its price (P) is where consumer satisfaction maximises. It is expressed
as MU = P. If the marginal utility of a product is higher than the price a consumer
would continue to purchase additional units and vice versa until MU equals the fixed
price level.
Determination of consumer equilibrium. Consider the simple case of a consumer who
cares about consuming only two goods: good 1 and good 2. This consumer knows the
prices of goods 1 and 2 and has a fixed income or budget that can be used to purchase
quantities of goods 1 and 2. The consumer will purchase quantities of goods 1 and 2 so
as to completely exhaust the budget for such purchases. The actual quantities
purchased of each good are determined by the condition for consumer equilibrium,
which is

This condition states that the marginal utility per dollar spent on good 1 must equal the
marginal utility per dollar spent on good 2. If, for example, the marginal utility per dollar
spent on good 1 were higher than the marginal utility per dollar spent on good 2, then it
would make sense for the consumer to purchase more of good 1 rather than purchasing
any more of good 2. After purchasing more and more of good 1, the marginal utility of
good 1 will eventually fall due to the law of diminishing marginal utility, so that the
marginal utility per dollar spent on good 1 will eventually equal that of good 2. Of course,
the amount purchased of goods 1 and 2 cannot be limitless and will depend not only on
the marginal utilities per dollar spent, but also on the consumer's budget.

The condition for consumer equilibrium can be extended to the more realistic case where
the consumer must choose how much to consume of many different goods. When there
are N > 2 goods to choose from, the consumer equilibrium condition is to equate all of
the marginal utilities per dollar spent, subject to the constraint that the consumer's
purchases do not exceed her budget.

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
one of the first steps in market demand is to identify the target market for the company’s
products or services. Surveys or customer feedbacks can be leveraged to determine the
current customer satisfaction levels. Any comments indicating dissatisfaction can be
taken into consideration for planning improvements that will eventually enhance
customer satisfaction.
Business cycle
After identifying the potential markets, the next step is to assess the stage of the
business cycle that each market is undergoing. A business cycle ideally comprises of
three stages: emerging, plateau and declining. Markets that are in the emerging stage
show higher consumer demand and low supply of current products or services. The
plateau stage depicts the break-even level of the market, where the supply of goods
meets the current market demand. A declining stage indicates lagging consumer
demand for the company’s goods or services.
Evaluate competition
A crucial factor of demand analysis is determining the number of competitors in the
market and their current market share. Markets in the emerging stage of the business
cycle tend to have fewer competitors. This translates to a higher profit margin for your
company.

Types of demand

As a business, you need to understand the different types of demand to be able to best
anticipate how much product you need. Demand characteristics provide a picture of how
well the industry is thriving and offers ideas as to where new service can be introduced.
The following list details seven types of demand in economics:

1. Joint demand
2. Composite demand
3. Short-run and long-run demand
4. Price demand
5. Income demand
6. Competitive demand
7. Direct and derived demand

1. Joint demand

Joint demand is the demand for complementary products and services. These can be
products that are accessories for others or that people commonly purchase together. For
example, cereal and milk or peanut butter and jelly. The two are linked but demand for
one is not necessarily dependent on the demand for the other.

2. Composite demand

Composite demand happens when there are multiple uses for a single product. For
example, corn can be used as animal feed, ethanol and food in its whole form. The rise in
demand for any of these products leads to a shortage in supply for the others. This
shortage can lead to a rise in price.

3. Short-run and long-run demand

Short-run demand refers to how people will immediately react to price changes while
elements are fixed. For example, if the demand for a product drastically decreases and a
manufacturer has high overhead costs, they have no choice but to absorb the profits lost.
Over time, or in the long run, companies have a chance to adjust to the new situation by
decreasing labor or increasing price and supplies.
4. Price demand

Price demand relates to the amount a consumer is willing to spend on a product at a

given price. Businesses use this information to determine at what price point a new
product should enter the market. Consumers will buy items based on their perception of
that product's value. Price elasticity refers to how the demand will change with
fluctuations in price.

5. Income demand

As consumers make more income, quantity demand increases. This means people will
buy more overall when they earn more income. Tastes and expectations also change with
an increase in income, reducing the size of one market and increasing the size of
another. Consumers will often buy a product or service because it is what they can afford
but may deem lower quality. The demand for those lower-quality products will decrease
as income increases.

6. Competitive demand

Competitive demand occurs when there are alternative services or products a customer
can choose from. From a business's perspective, they can use fluctuations in the price of
their competitors to determine how their own will sell. An example of this is between
name-brand and store-brand medicine. If a consumer prefers a name brand but it is out
of stock or the price increases significantly, the store brand will see a rise in sales.

7. Direct and derived demand

Direct demand is the demand for a final good. Food, clothing and cell phones are an
example of this. Also called autonomous demand, it's independent of the demand for
other products.

Derived demand is the demand for a product that comes from the usage of others. For
example, the demand for pencils will result in the demand for wood, graphite, paint and
eraser materials. In this example, the demand for wood is dependent on the demand for
its uses. Derived demand is similar to joint demand because of its connection to other
products. It is different from joint demand because it is dependent on the final product to
generate a need. Without the need for those end products, there is no demand for the
intermediate product.

LAW OF DEMAND AND ITS EXPECTATION

The law of demand explains the behaviour of consumers; either a single

consumer/household or all the consumers collectively. The law of demand states that
other things remaining the same (ceteris paribus), the quantity demanded of a
commodity is inversely related to its price. In other words, as price falls, the consumers
buy more. Or, the demand for a commodity falls when its price rises. Thus:

(1). The concept of demand generally refers to the quantity demanded at a given time,
which may be a point of time, a day or a week.
(2) The law of demand is based on the assumption that within the given time frame,
there would be no change in the quality of the goods in question. To put it differently,
among the various determinants of demand, the price of the commodity is only variable.

(3) The term ceteris paribus associated with the law of demand implies that taste and
preference, income, the prices of related goods and social status, all remains constant
over the period in which the impact of price variation on the quantity demanded is being
analysed.

(4) The law of demand is a partial analysis of the relationship between demand and
price, in the sense that it relates to the demand for only one commodity, say X, at a time
or over a period of time

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 Law of Demand states that the quantity demanded for a good or service rises as the price
falls, ceteris paribus (or with all other things being equal). Therefore, the Law of Demand is an
inverse relationship between price and quantity demanded.

PRICE ELASTICITY; -
Price elasticity of demand measures the degree of responsiveness of quantity demanded of a
commodity, say, X (Dx) to a change in the price of that commodity (Px). It can be computed by the
following formula.

EDx’ Px = Percentage change in Dx

Percentage change in Px
Price elasticities with five different magnitudes deserve our intention; -
1) Unity Elasticity
2) More than unity elasticity
3) Less than unity elasticity
4) Zero elasticity and
5) Infinite elasticity.
When a change in price leads to a more than proportionate change in demand, price elasticity is
greater than one. The said elasticity is unity if the changes in these two variables are
proportionate and it is less than one if the change in demand is less than proportionate to
change in the price. Price elasticity is zero when a change in price cause no change in quantity
demanded and it is infinity when no reduction in price is needed to it course an increase in
demand.
The price elasticity of demand is governed by several factors. The important are the nature of
commodity, and the availability of substitute for highly elastic. The larger the substitute a
commodity has, the larger is its price elasticity of demand.
Knowledge of price elasticity of demand for a commodity is very useful for its producers and
others dealing in them. Furthermore, the knowledge of price elasticity of demand would enable
the firm to estimate the likely demand for its product at different price.

INCOME ELASTICITY OF DEMAND

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.

• Income elasticity of demand is an economic measure of how responsive the quantity

demand for a good or service is to a change in income.
 • The formula for calculating income elasticity of demand is the percent change in quantity
demanded divided by the percent change in income.
• Businesses use the measure to help predict the impact of a business cycle on sales.
Income elasticity of demand (eD x’ I) measures the responsiveness of demand for a
commodity says, X(Dx) to a change in consumers’ income (I). It can be computed from
the following formula:
(eD x’ I) = Percentage change in Dx
Percentage change in I

For superior goods, income elasticity is positive, and for inferior goods, it is negative. Positive
income elasticity can be of three kinds:
1) More than unity (one) elasticity.
2) Unity elasticity and
3) less than unity elasticity.
The income elasticity is positive and more than unity when a change in income leads to a direct
and more proportionate change in quantity demanded. The income elasticity is positive and unity
when a change in income results into a direct and proportionate change in quantity demanded.
The income elasticity is negative when an increase in income leads to a decrease in quantity in
demanded. For example, a person may change from Bidis to cigarettes due to an increase in his
income. Income elasticity, in general, is higher for durable goods than for non- durable goods.
Knowledge of income elasticity of demand for various commodities is useful in determining the
effects of changes in business activity on various industries.

Types of Income Elasticity of Demand:

There are five types of income elasticity of demand:

1. High: A rise in income comes with bigger increases in the quantity demanded.
2. Unitary: The rise in income is proportionate to the increase in the quantity demanded.
3. Low: A jump in income is less than proportionate than the increase in the quantity
demanded.
4. Zero: The quantity bought/demanded is the same even if income changes
5. Negative: An increase in income comes with a decrease in the quantity demanded.

CROSS ELASTICITY OF DEMAND

Cross elasticity of demand describes the responsiveness of demand for good X to change in the
price of good Y. It can be computed from the following formula.

ED X’ PY = Percentage change in Dx
Percentage change in Py

When the goods are substitutes, the cross elasticity of demand is positive. This means that when
the price of tea goes down, people will consume less of coffee, for they will consume more tea,
and tea and coffee are substitute goods. If the two goods are complements, the cross elasticity of
demand will be negative. If the price of tea goes down, the quantity of sugar demanded will go
up, for tea and sugar are complementary goods. While the sign of cross elasticity indicates
whether the two goods are substitute or complements. The greater the cross elasticity, the more
related the two goods are. If the two goods have goods have no relationship, the cross
relationship between them will be zero.
The cross elasticity of demand is an economic concept that measures the responsiveness in the
quantity demanded of one good when the price for another good changes. Also called cross-price
elasticity of demand, this measurement is calculated by taking the percentage change in the
quantity demanded of one good and dividing it by the percentage change in the price of the other
good.
 • The cross elasticity of demand is an economic concept that measures the
responsiveness in the quantity demanded of one good when the price for another good
changes.
• The cross elasticity of demand for substitute goods is always positive because the
demand for one good increase when the price for the substitute good increases.
• Alternatively, the cross elasticity of demand for complementary goods is negative.

The concept of cross elasticity of demand is useful in measuring the interdependence of demand
for a commodity and the prices of its related commodities. Its is acknowledge thus helps a firm to
estimate the likely effect on its sales of pricing decision of its competitor and helpers.

Advertising Elasticity of Demand (AED): -

Advertising elasticity of demand (AED) is a measure of a market's sensitivity to increases
or decreases in advertising saturation. Advertising elasticity is a measure of an
advertising campaign's effectiveness in generating new sales. It is calculated by dividing
the percentage change in the quantity demanded by the percentage change in
advertising expenditures. A positive advertising elasticity indicates that an increase in
advertising leads to a rise in demand for the advertised good or services.

• 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.

ELASTICITY AND ITS APPLICATION

By definition, elasticity is ‘a measure of the responsiveness of quantity demanded or
quantity supplied to one of its determinants’ ;(Mankiw & Taylor, (2011:94)

• Elasticity allows economists to analyse supply and demand with greater precision.
• Elasticity measures how changes in market conditions can lead to a response in
buyers and sellers, i.e., how much trade is affected by changes in market
conditions.
• Price elasticity of demand: ‘a measure of how much the quantity demanded of a
good respond to a change in the price of that good, computed as the percentage
change in quantity demanded divided by the percentage change in price.

The Elasticity of Demand:

• This is how demand responds to changes in determinants.

• We are all familiar with the term ‘I’ll wait to buy it until it goes on sale’ ~ The law of
demand illustrates the concept that a fall in the price of a good increases the
quantity that is demanded, and as the definition states, the price elasticity of
demand measures how much a change in the price of a good affects the quantity
that is demanded.
• Goods can be placed in two categories; they are either ‘elastic’ or ‘inelastic’.
 • Elastic goods are goods in which demand will vary significantly if the price
changes - for example if the price goes down then the demand will go up. The
level of income of a person, the price of the good in relation to the market price of
other similar products and the availability of perfect or close substitutes are a few
things that greatly influence goods which are elastic.
• Inelastic goods are goods that do not have a perfect (if any) substitute. Therefore,
if there is a vary in the price of the good (either up – due to an increase in tax per
say or down) there will be no real vary in the demand for the product. Inelastic
goods are goods such as lifesaving medicines, tobacco and petrol – there are no
real substitutes for these goods and they are needed, so the demand for these
goods will not change despite an increase or decrease in the price. For this
reason, these goods are often taxed very heavily by the government.

Demand Forecasting

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 foreseeable future.
Types of demand forecasting
Demand Forecasting can be broadly classified based on the level of detailing, time span
considered and the scope of market considered.

Outlined below are the major types of Demand Forecasting:

• Passive Demand Forecasting: Passive Demand Forecasting is carried out for

stable businesses with very conservative growth plans. Simple extrapolations of
historical data are carried out with minimal assumptions. This is a rare type of
forecasting limited to small and local businesses.
• Active Demand Forecasting: Active Demand Forecasting is carried out for scaling
and diversifying businesses with aggressive growth plans in terms of marketing
activities, product portfolio expansion and consideration of competitor activities
and external economic environment.
• Short-term Demand Forecasting: Short-term Demand Forecasting is carried out
for a shorter-term period of 3 months to 12 months. In the short term, the
seasonal pattern of demand and the effect of tactical decisions on the customer
demand are taken into consideration.
• Medium to long-term Demand Forecasting: Medium to long-term Demand
Forecasting is typically carried out for more than 12 months to 24 months in
advance (36-48 months in certain businesses). Long-term Forecasting drives the
business strategy planning, sales and marketing planning, financial planning,
capacity planning, capital expenditure, etc.
 • External macro level Demand Forecasting: This type of Forecasting deals with the
broader market movements which depend on the macroeconomic environment.
External Forecasting is carried out for evaluating the strategic objectives of a
business-like product portfolio expansion, entering new customer segments,
technological disruptions, a paradigm shift in consumer behavior and risk
mitigation strategies.
• Internal business level Demand Forecasting: As the name suggests, this type of
Forecasting deals with internal operations of the business such as product
category, sales division, financial division, and manufacturing group. This includes
annual sales forecast, estimation of COGS, net profit margin, cash flow, etc.

STATISTICAL AND NON-STATISTICAL METHOD

Demand Forecasting is a systematic and scientific estimation of future demand for a
product. Simply, estimating the sales proceeds or demand for a product in the future is
called as demand forecasting.

There are several methods of demand forecasting applied in terms of; the purpose of
forecasting, data required, data availability and the time frame within which the demand
is to be forecasted. Each method varies from one another and hence the forecaster must
select that method which best suits the requirement.

Statistical Methods: The statistical methods are often used when the forecasting of
demand is to be done for a longer period. The statistical methods utilize the time-series
(historical) and cross-sectional data to estimate the long-term demand for a product. The
statistical methods are used more often and are considered superior than the other
techniques of demand forecasting due to the following reasons:

• There is a minimum element of subjectivity in the statistical methods.

• The estimation method is scientific and depends on the relationship between the
dependent and independent variables.
• The estimates are more reliable
• Also, the cost involved in the estimation of demand is the minimum.
The statistical methods include:
1) Trend Projection Methods
2) Barometric Methods
3) Econometric Methods
These are the different kinds of methods available for demand forecasting. A forecaster
must select the method which best satisfies the purpose of demand forecasting.

Non- statistical method

Broadly speaking, there are two approaches to demand forecasting- one is to obtain
information about the likely purchase behavior of the buyer through collecting expert’s opinion
or by conducting interviews with consumers, the other is to use past experience as a guide
through a set of statistical techniques. Both these methods rely on varying degrees of
judgment. The first method is usually found suitable for short-term forecasting, the latter
for long-term forecasting. There are specific techniques which fall under each of these
broad methods.

Simple Survey Method:

For forecasting the demand for existing product, such survey methods are often
employed. In this set of methods, we may undertake the following exercise.
1) Experts Opinion Poll: In this method, the experts on the particular product whose
demand is under study is requested to give their „opinion‟ or „feel‟ about the product.
These experts, dealing in the same
or similar product, are able to predict the likely sales of a given product in future periods
under different conditions based on their experience. If the number of such experts is
large and their experience-based reactions are different, then an average-simple or
weighted is found to lead to unique forecasts. Sometimes this method is also called the
„hunch method‟ but it replaces analysis by opinions and it can thus, turn out to be highly
subjective in nature.
2) Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method. Here
is an attempt to arrive at a consensus in an uncertain area by questioning a group of
experts repeatedly until the responses appear to converge along a single line. The
participants are supplied with responses to previous questions (including seasonings
from others in the group by a coordinator or a leader or operator of some sort). Such
feedback may result in an expert revising his earlier opinion. This may lead to a
narrowing down of the divergent views (of the experts) expressed earlier. The Delphi
Techniques,
followed by the Greeks earlier, thus generates “reasoned opinion” in place of
“unstructured opinion”; but
this is still a poor proxy for market behavior of economic variables.
3) Consumers Survey- Complete Enumeration Method: Under this, the forecaster
undertakes a complete survey of all consumers whose demand he intends to forecast,
once this information is collected, the sales forecasts are obtained by simply adding the
probable demands of all consumers. The principal merit of this method is that the
forecaster does not introduce any bias or value judgment of his own. He simply records
the data and aggregates. But it is a very tedious and cumbersome process; it is not
feasible where a large number of consumers are involved. Moreover, if the data are
wrongly recorded, this method will be totally useless.
4) Consumer Survey-Sample Survey Method: Under this method, the forecaster selects a
few consuming units out of the relevant population and then collects data on their
probable demands for the product during the forecast period. The total demand of
sample units is finally blown up to generate the total demand forecast. Compared to the
former survey, this method is less tedious and less costly, and subject to less data error;
but the choice of sample is very critical. If the sample is properly chosen, then it will yield
dependable results; otherwise, there may be sampling error. (The sampling error can
decrease with every increase in sample size).

Consumer equilibrium under Cardinal utility:

The Cardinal approach to Consumer Equilibrium posits that the consumer reaches his
equilibrium when he derives the maximum satisfaction for given resources (money) and other
conditions. A consumer is said to be highly satisfied when he allocates his expenditure in such a
way that the last unit of money spent on each commodity yields the same level of utility. The
concept of how consumer reaches his equilibrium can be further comprehended through the one-
commodity model and multiple commodity model. In one commodity model, the consumer
equilibrium is determined when he consumes a single commodity while in the multiple
commodity model, the consumer equilibrium is determined when he consumes two or more
commodities.

1. Consumer’s Equilibrium – One Commodity Model: Suppose a consumer with a given

number of resources (money) consumes a single commodity, say X. For a consumer, both his
income and commodity X will have respective utilities and he can either retain his income in the
form of asset or can exchange it for the commodity X. If the marginal utility of commodity X (MUx)
is greater than the marginal utility of money (Mum), then a utility-maximizing consumer will
exchange his money income for a commodity. Based on the assumption, the marginal utility of a
commodity is said to be declining with each successive unit and whereas the marginal utility of
money remains constant, therefore the consumer will spend his money income on commodity X
as long as MUx > Px (Mum). The Px is the price of the commodity and Mum is equal to one. Thus, the

consumer reaches his equilibrium when,

2. Consumer’s Equilibrium – Multiple Commodity Model: The single commodity model is

based on the unrealistic assumption that the consumer consumes a single commodity. It is
assumed that the consumer has a limited money income and that the utility derived from
multiple commodities are subject to diminishing returns. Also, several commodities yield different
levels of marginal utility, such as some yield higher MU while others yield less MU as compared to
the others. Thus, the rational and utility-maximizing consumer will select commodities on the
basis of their utilities. This means the consumer will first buy those commodities which yield the
highest utility, then the second highest and so on.
The consumer will allocate his expenditure in accordance with the MU of the commodities. He will
continue to switch his expenditure from one commodity to another until he reaches a stage
where last penny spent on each commodity yields the same utility. This is called as the Law of
Equi-Marginal Utility.

Hence, the theory of consumption is based on the notion that consumer aims at maximising his
utility for the amount of money spend on the goods and services. And the consumer reaches his
equilibrium when he derives the maximum satisfaction from his consumption

Cardinal Utility
The Cardinal Utility approach is propounded by neo-classical economists, who believe that utility
is measurable, and the customer can express his satisfaction in cardinal or quantitative
numbers, such as 1,2,3, and so on.
The consumption theory seeks to find out the answers to the following questions:

a) How does a consumer decide on the optimum quantity of a commodity that

he/she wishes to consume?
b) How consumers allocate their disposable incomes between several commodities
of consumption, such that utility is maximized?
The cardinal utility approach used in analysing the consumer behavior depends on the following
assumptions to find answers to the above-stated questions:

1. Rationality: It is assumed that the consumers are rational, and they satisfy their wants in
the order of their preference. This means they will purchase those commodities first
which yields the highest utility and then the second highest and so on.
 2. Limited Resources (Money): The consumer has limited money to spend on the purchase
of goods and services and thus this makes the consumer buy those commodities first
which is a necessity.
3. Maximize Satisfaction: Every consumer aims at maximizing his/her satisfaction for the
amount of money he/she spends on the goods and services.
4. Utility is cardinally Measurable: It is assumed that the utility is measurable, and the utility
derived from one unit of the commodity is equal to the amount of money, which a
consumer is ready to pay for it.
5. Diminishing Marginal Utility: This means, with the increased consumption of a
commodity, the utility derived from each successive unit goes on diminishing. This law
holds true for the theory of consumer behavior.
6. Marginal Utility of Money is Constant: It is assumed that the marginal utility of money
remains constant irrespective of the level of a consumer’s income.
7. Utility is Additive: The cardinalists believe that not only the utility is measurable but also
the utility derived from the consumption of different commodities are added up to realize
the total utility.
Thus, the cardinal utility approach is used as a basis for explaining the consumer behavior where
every individual aims at maximizing his/her utility or satisfaction for the amount of money he
spends on the consumption of goods and services.

Total Utility: - The Total Utility refers to the sum of utility that an individual derives from the
consumption of all the units of a given commodity at a point or over a period of time. In other
words, the total satisfaction derived from the consumption of various units of goods and services
is called total utility. Every unit of a commodity has its marginal utility (a utility derived from the
consumption of an additional unit), and the total utility is the summation of all these individual
marginal utilities.

Law of Diminishing Marginal Utility

The law of Diminishing Marginal Utility posits that with the more and more consumption of the
units of the commodity the utility derived from each successive unit goes on diminishing,
provided the consumption of other commodities remain constant. The concept of the law of
diminishing marginal utility can be understood through a real-life example. Suppose you are
thirsty, and as you drink the first glass of water, keeping the consumption of all other
commodities constant, you get the maximum satisfaction, and with each successive glass of
water, the additional benefit (utility) diminishes.

The law of diminishing marginal utility can be illustrated through the table given below. Suppose
there is a commodity X, whose utility can be measured in the quantitative terms. Thus, the law of
diminishing marginal utility holds universally, for both the durable and non-durable goods. In
certain conditions, such as accumulation of money, a hobby of collecting old coins, stamps,
visiting cards, etc. the marginal utility might initially increase, but eventually, it starts declining.

Assumptions of Law of Diminishing Marginal Utility

The law is said to hold true under certain conditions, and these conditions are referred to as the
assumptions of the law of diminishing marginal utility. These are:
 1. It is assumed that the unit of the consumer good is a standard one, i.e., the rational
quantity of the commodity is consumed. Such as, a cup of tea, a pair of shoes, bottle of
cold drink, glass of water, etc.
2. It is assumed that the utility is measurable, and the satisfaction of the consumers can be
expressed in the quantitative terms.
3. The consumer’s tastes and preferences remain same during the period of the
consumption.
4. There must be continuity in the consumption. If a break is necessary, then the time
interval between the consumption of two units should be appropriately short.
5. It is assumed that the quality of the commodity remains uniform during the period of
consumption.
6. All the commodities consumed by the consumer are said to be independent of each
other, such as the marginal utility of one commodity has no relation with the marginal
utility of another commodity.
7. It is assumed that the income of the consumer and the price of goods and
services remains unchanged during the period of consumption.
8. The marginal utility of money remains constant for the consumer.
9. The mental condition of the consumer should remain normal during the consumption
period. For example, if a person drinks any alcoholic drink, then he will derive more
pleasure with each additional glass of drink, this is because of a change in his mental
status due to intoxication.
The conditions of diminishing marginal utility hold universally. But, however, in certain conditions
such as accumulation of money, hobbies of collecting stamps, old coins, songs, etc. the marginal
utility might initially increase, but eventually it decreases.

Indifferent curve analysis:

An indifference curve, with respect to two commodities, is a graph showing those
combinations of the two commodities that leave the consumer equally well off or equally
satisfied—hence indifferent—in having any combination on the curve.

Indifference curves are heuristic devices used in contemporary microeconomics to

demonstrate consumer preference and the limitations of a budget. Economists have
adopted the principles of indifference curves in the study of welfare economics.

• An indifference curve shows a combination of two goods that give a consumer

equal satisfaction and utility thereby making the consumer indifferent.
• Along the curve the consumer has an equal preference for the combinations of
goods shown—i.e., is indifferent about any combination of goods on the curve.
• Typically, indifference curves are shown convex to the origin, and no two
indifference curves ever intersect.

Indifference curves operate under many assumptions, for example, typically each
indifference curve is convex to the origin, and no two indifference curves ever intersect.
Consumers are always assumed to be more satisfied when achieving bundles of goods
on indifference curves that are farther from the origin.
As income increases, an individual will typically shift their consumption level because
they can afford more commodities, with the result that they will end up on an
indifference curve that is farther from the origin—hence better off.

Many core principles of microeconomics appear in indifference curve analysis, including

individual choice, marginal utility theory, income, substitution effects, and the subjective
theory of value. Indifference curve analysis emphasizes marginal rates of
substitution (MRS) and opportunity costs. All other economic variables and possible
complications are treated as stable or ignored unless placed on the indifference graph.

Most economic textbooks build upon indifference curves to introduce the optimal choice
of goods for any consumer based on that consumer's income. Classic analysis suggests
that the optimal consumption bundle takes place at the point where a consumer's
indifference curve is tangent with their budget constraint.

The slope of the indifference curve is known as the MRS. The MRS is the rate at which
the consumer is willing to give up one good for another. If the consumer values apples,
for example, the consumer will be slower to give them up for oranges, and the slope will
reflect this rate of substitution.
MODULE 3
SUPPLY & PRODUCTION
# LAW OF SUPPLY AND FACTORS AFFECTING SUPPLY
i) Supply : It refers to the quantity schedule of quantifies of good or service
during in a specific period of time that will be offered for sale at various
prices.

Factors affecting supply.

1. Product Price(Px)
2. Prices of related Product(Py)
3. Cost and Technology(C and I)
4. Objectives of the firm(O)
5. Future Expections(F)
6. Weather conditions and other Short Term Factors(W)
7. Number of sellers (N)
8. Taxation Policy(T)

ii) Law of Supply

• Derives the relationship between price of the commodity and quantity

Supplied.
• According to this Law :
Indifference curve are negatively sloped by consuming more of X the
individual would have to consume less of Y is the order to remain as the
same indifference curve (at the level of same satisfaction).

# PRODUCTION
James Bates and J.R. Parkinson is the organized activity of transforming resources
into finished products in the form of goods and services; and the objectives of
production is to satisfy demand of such transformed Resources.
i) Factors of Productions

1. Land
2. Labour
3. Capital
4. Entrepreneur

ii) Production Function

States the Relationship between Input and output i.e. the amount of output that
can be produced with gives quantities of input under a given state of technical
knowledge.

Output – Volume of goods or Services

Input – Factors of Production.

iii) Law of Production:

The Laws of Production can be studied in three ways –

1. Law of variable proportions (One variable Input)

2. Optimum Contribution of Input (Isoquant Analysis)
3. Return to Scale Analysis.

iv) Law of variable Proportions

(Production function with one variable Input)

Or (Return to Factors)

The law of variable proportions states that as the quantity of one factor is
increased, keeping the other factors fixed, the marginal product of that factor will
eventually decline. This means that up to the use of a certain amount of variable
factor, marginal product of the factor may increase and after a certain stage it
starts diminishing. When the variable factor becomes relatively abundant, the
marginal product may become negative.
# THREE STAGES OF THE LAW OF VARIABLE PROPORTIONS:
These stages are illustrated in the following figure where labour is measured on
the X-axis and output on the Y-axis.

Stage 1.Law of Increasing Returns:

In this stage, total product increases at an increasing rate up to a point. This is

because the efficiency of the fixed factors increases as additional units of the
variable factors are added to it. In the figure, from the origin to the point F, slope
of the total product curve TP is increasing i.e. the curve TP is concave upwards up
to the point F, which means that the marginal product MP of labour rises. The
point F where the total product stops increasing at an increasing rate and starts
increasing at a diminishing rate is called the point of inflection. Corresponding
vertically to this point of inflection marginal product of labour is maximum, after
which it diminishes. This stage is called the stage of increasing returns because
the average product of the variable factor increases throughout this stage. This
stage ends at the point where the average product curve reaches its highest
point.

Reason:

1. Under-utilization of fixed Factors.

2. Indivisibility Factors
3. Specialization and division of Labour.
Stage 2. Law of Diminishing Returns:

In this stage, total product continues to increase but at a diminishing rate until it
reaches its maximum point H where the second stage ends. In this stage both the
marginal product and average product of labour are diminishing but are positive.
This is because the fixed factor becomes inadequate relative to the quantity of
the variable factor. At the end of the second stage, i.e., at point M marginal
product of labour is zero which corresponds to the maximum point H of the total
product curve TP. This stage is important because the firm will seek to produce in
this range.

Reason:

1. Certain Factors remains same.

2. Certain factors become source.
3. Lack of perfect substitution of production Factors.
4. Achievements of optimum capacity.

Stage 3. Law of Negative Returns:

In stage 3, total product declines and therefore the TP curve slopes downward. As
a result, marginal product of labour is negative and the MP curve falls below the
X-axis. In this stage the variable factor (labour) is too much relative to the fixed
factor.

Reason:

1. Reduction is variable Factors.

2. Moving beyond optimum level.

# LAW OF RETURNS TO SCALE

Returns to scale refer to the relationship between changes in output and
proportional changes in all factors of production.

Assumptions:

1. All inputs can vary except the enterprise.

2. There is no technology change during production.
3. There is perfect competition.
4. The output product is measured in quantitative.

Types:

Increasing Return to Scale: The output increasing rate faster than the
increasing rate of input Factors.

Constant Return to Scale: When the increase is total output exactly equals to
increase in inputs then the situation is termed as Constant Return to Scale.

Diminishing Return to scale: Such situation indicates arrival of saturation stage

which does not permit further increases in capacity of a plant. The output
increases rate is much less than the increase rate of input factors of
production.

# ISOQUANTS
- The term Isoquant has been derived from the Greek word ISO _ Equal and
Latin word Quantus – Quantity.
- Is locus of Points representing various combinations of two inputs-capital
and labour- Yielding same output.

Assumptions:

1. There are only two Inputs, Capitals (K) and Labour(L) to produce a
commodity(X).
2. The two Inputs – L and K – can subtitle each other but at a diminishing rate.
3. The technology of Production gives.

Properties of Isoquant Curve:

a. Isoquants have negative slope – Implies substitutability between Inputs. It

means that one of the inputs is reduced, the other input has to be
Increased that the total output remains unaffected.
b. Isoquants are curves to origin Implies of only the substitution between
Inputs but also diminishing Marginal Rate of Technical Substitution (MRTS).
MRTS is the rate at which a marginal cost of Labour can substitute as
marginal unit of capital without affecting output.(moving downward on the
isoquants)
−∆𝐾𝐾
MRTS = = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
∆𝐿𝐿
 Rate is indicated by Slope of Isoquants.
Reasons of MRTS Decreases:
1. No factor is a perfect substitute for another.
2. Inputs are subject to diminishing marginal Returns.
c. Upper Isoquants represents higher level of output between any two
Isoquants, the upper one represents a higher level of output than lower
one. The reason is an upper Isoquants implies a larger Input combination
which in general produces a larger output. Therefore, Upper Isoquants
indicates a higher level of output.
d. Isoquants cannot Intersect or be target to each other. The intersection of
Isoquants means that are equal which is wrong because it violates the Law
of Production.

# ISOCLINES
Isocline is an important concept relating to isoquants and production function.
An isocline shows the movement from one isoquant to another in an isoquant
map. An isocline is a locus of points on various successive isoquants at which
marginal rate of technical substitution (MRTS) between two factors is the
same, that is, constant at a particular value.

Isoclines and Production Path:

It is important to note that an isocline which is the locus of points on
successive isoquants at which MRTS is the same is drawn independently of the
prices of factors of production. The shape of isoclines depends on the physical
characteristics of the production function. Therefore, the concept of isocline is
different from the concept of expansion path along which also MRTS remains
the same, but with the given prices of factors. But expansion path represents
the optimum or least-cost combination of factors, given the prices of factors of
production. Hence, unlike an isocline, the expansion path shows the actual
choice of factor combinations by a rational producer and this choice of factor
combination depends on the prices of factors of production.
# COLLUSIVE OLIGOPOLY
- Competing Firms are termed as collude when they make some sort of
agreement about output and pricing.
- The oligopolists agreement between two firms is generally kept secret.
Agreement is not legal in most of countries.

Conditions for successful collusion:

1. Number of firms small.

2. Threat of entry potential rivals.
3. Stable demand condition.
4. Less fear of Anti-trust Laws.

Two types of collusion:

a. Perfect or Cartels collusion

b. Imperfect or Price Leadership collusion

(a)Cartels or Perfect Competition:

Market price is drives down to production cost level when rival oligopolists
enter into competition over price with each other. Therefore, there is strong
incentives for oligopolists collusion, this leads to rise in price and restriction in
output.

Opposite of competition is collusion – It states that the firms cooperate with

each other so as to take joint actions that keep their bargaining positions
stronger against customer. There are cartel arrangement primarily is the
perfect competition.

CARTEL

It is basically as explicit agreement that is carried out among independent

firms on various subjects such as output, prices, market shares, etc.

Two types:

1. Centralize cartels.
2. Market sharing cartels.
Centralized Cartels

The output and price decisions for the whole industry along with every
member firm are taken by Central Cartel Board in order to gain maximum joint
profits under the centralized cartel system.

1. The output quota of each member firm is fixed by CC

2. There is a distribution of total profits among the firms as per prior
Agreement.

Market sharing Cartel

It can be defined by following two methods:

1. Market sharing by Non-Price Cartel – Firms do agree to sell goods at

uniform price that is already agreed by all. But there is a freedom to
member firms to produce and sell quantity at which they can achieve
maximum profit. Also, there is a freedom to change the product design and
other methods to promote sake.
2. Market sharing by Quota – The oligopolistic firms do agree about the
output quota produced by them as well as sell this quantity as uniform
price.

(b) Imperfect collusion/ Price leadership

There are few or more than two sellers in an oligopolistic situation who are
capable to exercise monopolistic influence, existence of price leadership in
such market situation.

# Producer’s Equilibrium:
Equilibrium refers to a state of rest when no change is required. A firm
(producer) is said to be in equilibrium when it has no inclination to expand or
to contract its output. This state either reflects maximum profits or minimum
losses.
There are two methods for determination of Producer’s Equilibrium:
1. Total Revenue and Total Cost Approach (TR-TC Approach)

2. Marginal Revenue and Marginal Cost Approach (MR-MC Approach)

Conditions to attain equilibrium level under two different situations:

(i) When Price remains Constant (It happens under Perfect Competition). In
this situation, firm has to accept the same price as determined by the industry.
It means, any quantity of a commodity can be sold at that particular price.

(ii) When Price Falls with rise in output (It happens under Imperfect
Competition). In this situation, firm follows its own pricing policy. However, it
can increase sales only by reducing the price.

# ECONOMIES OF SCALE
Economies of scale are cost advantages reaped by companies when
production becomes efficient. Companies can achieve economies of scale by
increasing production and lowering costs. This happens because costs are
spread over a larger number of goods. Costs can be both fixed and variable.

The size of the business generally matters when it comes to economies of

scale. The larger the business, the more the cost savings.

Economies of scale can be both internal and external. Internal economies of

scale are based on management decisions, while external ones have to do with
outside factors.

Internal Versus External Economies of Scale:

As mentioned above, there are two different types of economies of scale.

Internal economies are borne from within the company. External ones are
based on external factors.
Internal economies of scale happen when a company cuts costs internally, so
they're unique to that particular firm. This may be the result of the sheer size
of a company or because of decisions from the firm's management. Larger
companies may be able to achieve internal economies of scale—lowering their
costs and raising their production levels—because they can buy resources in
bulk, have a patent or special technology, or because they can access more
capital.

External economies of scale, on the other hand, are achieved because of

external factors, or factors that affect an entire industry. That means no one
company controls costs on its own. These occur when there is a highly-skilled
labor pool, subsidies and/or tax reductions, and partnerships and joint
ventures—anything that can cut down on costs to many companies in a
specific industry.

# ECONOMIES OF SCOPE
An economy of scope means that the production of one good reduces the cost
of producing another related good. Economies of scope occur when producing
a wider variety of goods or services in tandem is more cost effective for a firm
than producing less of a variety, or producing each good independently. In
such a case, the long-run average and marginal cost of a company,
organization, or economy decreases due to the production of complementary
goods and services.

While economies of scope are characterized by efficiencies formed by

variety, economies of scale are instead characterized by volume. The latter
refers to a reduction in marginal cost by producing additional units. Economies
of scale, for instance, helped drive corporate growth in the 20th century
through assembly line production.

# THEORY OF COST

There are many forces behind the process of price determination for a good. One
such force is supply, which is directly determined by the costs of the company.
Theory of Cost explores the cost concepts, costs in the long and short run and
economies of scale.

Cost Concepts
Cost analysis is all about the study of the behavior of cost with respect to various
production criteria like the scale of operations, prices of the factors of
production, size of output, etc. It is all about the financial aspects of production.
In order to understand the cost function well, in this article, we will look at
various cost concepts.

Accounting and Economic Costs

When a firm starts producing goods, it has to pay the price for the factors
employed for the production. These factors include wages to workers employed,
prices for the raw materials, fuel and power used, rent for the building he hires,
and interest on the money borrowed for doing business, etc.

Accounting Costs are these costs which are included in the cost of production.
Hence, accounting costs take care of all payments and charges that the firm
makes to suppliers of different productive factors.

Direct or Traceable Costs and Indirect or Non-Traceable Costs

Direct costs – costs which are easily identifiable and traceable to a particular
product, operation or plant. For example, manufacturing costs are direct costs
since they can be related to a product line or territory or customer class, etc.
Ensure that you know the purpose of the cost calculation before determining if a
cost is direct or indirect.

Indirect costs – costs which are not easily identifiable or traceable to specific
goods, services, operations, etc. These costs bear some functional relationship to
production and may vary with the output. For example, costs related to electric
power and the common costs incurred for the general operation of the business
benefitting all products.

Fixed and Variable Costs

Fixed costs or Constant costs are not a function of the output. That is, they do
not vary with the output up to a certain extent. They require a fixed expenditure
of funds regardless of the output.

For example, rent, property taxes, interest on loans, etc. However, note that
fixed costs can vary with the size of the plant and are usually a function of
capacity. Therefore, we can conclude that fixed costs do not vary with the output
volume within a capacity level. Variable costs are cost concepts which are a
function of the output in the production period. Variable costs vary directly with
the output. Some examples of variable costs are the cost of raw materials, wages,
etc.

Classification of Costs

1) Classification by Nature

This is the analytical classification of costs. Let us divide as per their

natures. So basically there are three broad categories as per this
classification, namely Labor Cost, Materials Cost and Expenses. These
heads make it easier to classify the costs in a cost sheet. They help
ascertain the total cost and determine the cost of the work-in-
progress.

1. Material Costs: Material costs are the costs of any materials we use in the
production of goods. We divide these costs further. For example, let’s
divide material costs into raw material costs, spare parts, costs of packaging
material etc.
2. Labor Costs: Labor costs consists of the salary and wages paid to permanent
and temporary employees in the pursuit of the manufacturing of the goods
3. Expenses: All other expenses associated with making and selling the goods
or services.

2) Classification by Functions

This is the functional classification of costs. So the classification follows

the pattern of basic managerial activities of the organization.

The grouping of costs is according to the broad divisions of functions

such as production, administration, selling etc.

• Production Costs: All costs concerned with actual manufacturing or

construction of the goods
• Commercial Costs: Total costs of the operation of an enterprise other than
the manufacturing costs. It includes the admin costs, selling and
distribution costs etc.

3) Classification by Traceability

This aspect one of the most important classification of costs, into

direct costs and indirect costs. This classification is based on the
degree of traceability to the final product of the firm.

• Direct Costs: So these are the costs which are easily identified with a specific
cost unit or cost centers. Some of the most basic examples are the
materials used in the manufacturing of a product or the labor involved with
the production process.
• Indirect Costs: These costs are incurred for many purposes, i.e. between
many cost centers or units. So we cannot easily identify them to one
particular cost center. Take for example the rent of the building or the
salary of the manager. We will not be able to accurately determine how to
ascertain such costs to a particular cost unit.

4) Classification by Normality

This classification determines the costs as normal costs and abnormal

costs. The norms of normal costs are the costs that usually occur at a
given level of output, under the same set of conditions in which this
level of output happens.

• Normal Costs: This is a part of the cost of production and a part of the
costing profit and loss. These are the costs that the firm incurs at the
normal level of output in standard conditions.
• Abnormal Costs: These costs are not normally incurred at a given level of
output in conditions in which normal levels of output occur. These costs are
charged to the profit and loss account; they are not a part of the cost of
production.
# COST DETERMINANTS

The cost of production of goods and services depends on various input factors
used by the organization and it differs from firm to firm. The major cost
determinants are:
1.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.

2. Price of input factors: A rise in the cost of input factors will increase the total
cost of production.

3. Productivities of factors of production: When the productivity of the input

factors is high then the cost of production will fall.

4. Size of plant: The cost of production will be low in large plants due to mass
production with mechanization.

5. Output stability: The overall cost of production is low when the output is
stable over a period of time.

6. Lot size: Larger the size of production per batch then the cost of production
will come down because the organizations enjoy economies of scale.

7. Laws of returns: The cost of production will increase if the law of diminishing
returns applies in the firm.

8. Levels of capacity utilization: Higher the capacity utilization, lower the cost
of production

9.Time period: In the long run cost of production will be stable.

10. Technology: When the organization follows advanced technology in their

process then the cost of production will be low.

11. Experience: over a period of time the experience in production process will
help the firm to reduce cost of production.

12. Process of range of products: Higher the range of products produced,

lower the cost of production.
13. Supply chain and logistics: Better the logistics and supply chain, lower the
cost of production.

14. Government incentives: If the government provides incentives on input

factors then the cost of production will be low.

# SHORT RUN AND LONG RUN AVERAGE COSTS CURVES

As in the short run, costs in the long run depend on the firm’s level of output,
the costs of factors, and the quantities of factors needed for each level of
output. The chief difference between long- and short-run costs is there are no
fixed factors in the long run. There are thus no fixed costs. All costs are
variable, so we do not distinguish between total variable cost and total cost in
the long run: total cost is total variable cost.

The long-run average cost (LRAC) curve shows the firm’s lowest cost per unit at
each level of output, assuming that all factors of production are variable.
The LRAC curve assumes that the firm has chosen the optimal factor mix, as
described in the previous section, for producing any level of output. The costs
it shows are therefore the lowest costs possible for each level of output. It is
important to note, however, that this does not mean that the minimum points
of each short-run ATC curves lie on the LRAC curve. This critical point is
explained in the next paragraph and expanded upon even further in the next
section.
# REVENUE CURVE

Is the income generated from the sale of goods and services in a market?

Average Revenue (AR) = price per unit = total revenue / output

The AR curve is the same as the demand curve

Marginal Revenue (MR) = the change in revenue from selling one extra unit of
output

Total Revenue (TR) = Price per unit x quantity

The table below shows the demand for a product where there is a downward
sloping demand curve.

The demand curve and total revenue

Average and marginal revenue

The
revenue maximizing output and price
 Module 4: Market Structure

A market consists of all the actual and potential buyers and sellers of a particular product.

Market structure refers to the competitive environment in which the buyers and sellers of the
product operate.

Classification of Markets

Four types of market structure are usually identified. These types of market structure or
organisation are defined in terms of the number and size of the buyers and sellers of the product,
the type of products bought and sold (i.e., standardized or homogeneous as contrasted with
differentiated), the degree of mobility of resources (i.e., the ease with which firms and input owners
can enter or exit the market), and the degree of knowledge that economic agents (i.e., firms,
suppliers of inputs and consumers) have of prices and costs, and demand and supply condition.

These market characteristics are used to defined the four types of market structures.

1. Perfect competition is the form of market organisation in which (a) there are many buyers
and sellers of a product, each too small to affect the price of the product; (b) the product is
homogeneous; (c) there is perfect mobility of resources; and (d) economic agents have
perfect knowledge of market conditions.
2. Monopoly is the form market organisation in which a single firm sells a product for which
there are no close substitutes. Entry into the industry is very difficult or impossible.
3. Monopolistic competition refers to the case where there are many sellers of a differentiated
product and entry into or exit from the industry is rather easy in the long run.
4. Oligopoly is the case where there are few sellers of a homogeneous or differentiated
product. Although entry into the industry is possible, it is not easy.

Monopoly, monopolistic competition and oligopoly are often referred to as imperfect competition to
distinguish them from perfect competition.
Markets based on Competition
Perfect Competition

Under perfect competition, the market price and quantity of a product are determined exclusively
by the forces of market demand and market supply of the product, and examine how the firm
determines its best level of output in the short run and in the long run at the given market price.

Features of a Perfect Competition

 There are a great number of buyers and sellers of the product, and each seller and buyer are
too small in relation to the market to be able to affect the price of the product by his or her
own actions.
 The product of each competitive firm is homogeneous, identical, or perfectly standardized.
 There is perfect mobility of resources.
 Consumers, resource owners and firms in the market have perfect knowledge as to present
and future prices, costs and economic opportunities in general.

Perfect competition has never really existed. Perhaps the closest we might come today to a perfectly
competitive market is the stock market. Another case where we may have come close to satisfying
the first three assumptions of perfect competition is in the market for such agriculture commodities
as wheat and rice. The natural gas industry and the oil refining industries also approach perfect
competition.

Monopoly

Monopoly is the form of market organisation in which a single firm sells a product for which there
are no close substitutes. As opposed to a perfectly competitive firm, a monopolist can earn profits in
the long run because entry into the industry is essentially blocked. There are four basic reasons that
can give rise to monopoly;

 First, the firm may control the entire supply of raw materials required to produce the
product.
 Second, the firm may own a patent or copyright that precludes other firms from using a
particular production process or producing the same product.
 Third, in some industries, economies of scale may operate over a sufficiently large range of
outputs as to leave only one firm supplying the entire market.
 Fourth, a monopoly may be established by a government franchise. In this case, the firm is
set up as the sole producer and distributor of a product or service but is subjected to
governmental regulations.

Monopolistic Competition

Monopolistic competition is the form of market organisation in which there are many sellers of a
heterogeneous or differentiated product, and entry into and exit from the industry are rather easy in
the long run. As the name implies, monopolistic competition is a blend of competition and
monopoly. The competitive element results from the fact that in a monopolistic competitive market,
there are many sellers of the differentiated product, each too small to affect others. The monopoly
element arises from product differentiation (i.e., from the fact that the product sold by each seller is
somewhat different from the product sold by any other seller). The resulting monopoly is severely
limited, however, by the availability of many close substitutes.

Monopolistic competition is most common in the retail and service sectors of our economy.
Clothing, cotton textiles and food processing are the industries that come close to monopolistic
competition at the national level.

Oligopoly

Oligopoly is the form of market organisation in which there are few sellers of a homogeneous or
differentiated product. If there are only two sellers, we have a duopoly. If the product is
homogeneous, we have a pure oligopoly. If the product is differentiated, we have differentiated
oligopoly.

Oligopoly is the most prevalent form of market organisation in the manufacturing as well as service
sectors of industrial nations, including India. Some of the oligopolistic industries in India are
automobiles, primary aluminium, steel, electrical equipment, glass, cigarettes, mobile phones, civil
aviation and cement. The distinguishing characteristic of oligopoly is the interdependence or rivalry
among firms in the industry.

The sources of oligopoly are generally the same as for monopoly, i.e.,

 Economies of scale may operate over a sufficiently large range of outputs as to leave only a
few firms supplying the entire market.
 Huge capital investments and specialized inputs are usually required to enter an oligopolistic
industry and this acts as important natural barrier to entry.
 A few firms may own a patent for the exclusive right to produce a commodity or to use a
particular production process.
 Established firms may have a loyal following of customers based on product quality and
service (brands) that new firms would find very difficult to match.
 A few firms may own or control the entire supply of a raw material required in the
production of the product.
 The government may give a franchise to only a few firms to operate in the market.

Competition in the Global Economy

Domestic firms in most industries face a great deal of competition from abroad. Most India made
goods today compete with similar goods from abroad and in turn, compete with foreign made goods
in foreign markets. Steel, textiles, wines, automobiles, television sets, aircraft, etc. are but a few of
the domestic products that compete with foreign products for consumers’ rupees in the Indian
economy today. International competition affects the price and the quality of commodities sold by
domestic firms.
Theory of Firm

A firm is an entity that draws various types of factors of production in different amounts from the
economy and converts them into desirable outputs through a process with the help of suitable
technology.

Theory of 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.

Various theories of Firm

Transaction Cost theory

When external transaction costs are higher than the internal transaction costs, the company will
grow. If the external transaction costs are lower than the internal transaction costs, the company
will be downsized by outsourcing. The transaction cost approach to the theory of firm was created
by Ronald Coase (1937). Coase describes in his article “the Problem of Social cost” the transaction
costs he is concerned with; In order to carry out a market transaction it is necessary to discover who
it is that one wishes to deal with, to conduct negotiations leading up to a bargain, to draw up the
contract, to undertake the inspection needed to make sure that the terms of the contract are being
observed, and so on.

More succinctly transaction costs are:

• Search and information costs
• Bargaining and decision costs
• Policing and enforcement costs

Coase observes that market price governs the relationships between firms but within a firm,
decisions are made on a basis different from maximizing profit subject market prices. Within the
firm, decisions are made on through entrepreneurial coordination.

He notes that government measures relating to the market (sales taxes, rationing, price controls)
tend to increase the size of firms, since firms internally would not be subjected to such transaction
costs. Thus, Coase defines the firm as “the system of relationships which comes into existence when
the direction of resources is dependent on the entrepreneur”

Coase concludes that the size of the firm is reliant on the costs of using the price mechanism and on
the costs of using the price mechanism and on the cost of organization of other entrepreneurs.
These two factors collectively determine how many products a firm produces and how much of each
product they produce.

Managerial and Behavioural Theories

Managerial theories of the firm, as developed by William Baumol (1959 and 1962), Robin Marris
(1964) and Oliver E. Williamson (1966), suggest that managers would seek to maximize their own
utility and consider the implications of this for firm behaviour in contrast to the profit maximizing
case. Baumol suggested that managers’ interest is best served by maximizing sales after achieving a
minimum level of profit which satisfies shareholders. More recently, this has developed into
‘principal-agent’ analysis which models a widely applicable case where a principal (a shareholder or
firm) cannot infer how an agent (manager or supplier) is behaving.

PROFIT MAXIMISATION
The profit maximization theory states that firms (companies or corporations) will establish factories
where they see the potential to achieve the highest total profit. The company will select a location
based upon comparative advantage (where the product can be produced the cheapest). The theory
draws from the characteristics of the location site: land price, labour costs, transportation costs and
access, environmental restrictions, worker unions, population etc. The company will then elect the
best location for the factory to maximize profits. This is anathema to the idea of social responsibility
because firms will place their factory to achieve profit maximization. They are nonchalant to
environment conservation, fair wage policies and exploit the country. The only objective is to earn
more profits. In economics, profit maximization is the process by which a firm determines the price
and output level that returns the greatest profit.

There are several approaches to this problem. The total revenue–total cost method relies on the fact
that profit equals revenue minus cost. Equating marginal revenue and marginal cost is a better and
convenient method for arriving at profit maximizing output. It allows firms to check whether they
are really maximizing profits at a given level of output by comparing additional costs and revenues
generated by the production of an additional unit of output. If this cost of producing an additional
unit is less than the addition it makes to total revenue, the firm must expand as it would increase
total profit.

This expansion must continue till MR and MC are equal. Profits are maximized when this equality is
achieved provided the marginal cost at this level of output envelops the average cost of the firm. In
case MC turns out to be higher than the marginal revenue at the point of investigation, the firm
must contract by reducing its output to a level where MC equals MR. This method is particularly
useful to very large organizations, with multiple divisions and where computation of total revenue
and total cost may be a difficult and complex task.
Module 5: -

MONETARY POLICY AND FISCAL POLICY

Monetary policy refers to the actions of central banks to achieve macroeconomic policy
objectives such as price stability, full employment, and stable economic growth. Fiscal policy
refers to the tax and spending policies of the federal government. Fiscal policy decisions are
determined by the Congress and the Administration; the Fed plays no role in determining
fiscal policy.

Both monetary and fiscal policies are used to regulate economic activity over time. They can
be used to accelerate growth when an economy starts to slow or to moderate growth and
activity when an economy starts to overheat. In addition, fiscal policy can be used to
redistribute income and wealth.

How Do Fiscal and Monetary Policies Affect Aggregate Demand?

Aggregate demand (AD): - is a macroeconomic concept representing the total demand for
goods and services in an economy. This value is often used as a measure of economic well-
being or growth. Both fiscal policy and monetary policy can impact aggregate demand
because they can influence the factors used to calculate it: consumer spending on goods and
services, investment spending on business capital goods, government spending on public
goods and services, exports, and imports. It is often the cause of multiple trilemmas. Fiscal
policy affects aggregate demand through changes in government spending and taxation.
Those factors influence employment and household income, which then impact consumer
spending and investment.

Monetary policy impacts the money supply in an economy, which influences interest rates
and the inflation rate. It also impacts business expansion, net exports, employment, the cost
of debt, and the relative cost of consumption versus saving—all of which directly or indirectly
impact aggregate demand.

KEY TAKEAWAYS

• Aggregate demand is an economic measure of the total demand for all finished goods
or services created in an economy.
• It represents the overall demand regardless of the price level, during a specific period
of time.
• Aggregate demand and gross domestic product (GDP) are calculated the same way
and move in tandem, increasing or decreasing simultaneously.
 • In the same way that fiscal and monetary policy impact GDP, they also impact
aggregate demand.
• Fiscal policy impacts government spending and tax policy, while monetary policy
influences the money supply, interest rates, and inflation.

Business cycle: -
The business cycle, also known as the economic cycle or trade cycle, are the
fluctuations of gross domestic product (GDP) around its long-term growth trend. The length
of a business cycle is the period of time containing a single boom and contraction in
sequence. These fluctuations typically involve shifts over time between periods of relatively
rapid economic growth (expansions or booms) and periods of relative stagnation or decline
(contractions or recessions).
Business cycles are usually measured by considering the growth rate of real gross domestic
product. Despite the often-applied term cycles, these fluctuations in economic activity do not
exhibit uniform or predictable periodicity. The common or popular usage boom-and-bust
cycle refers to fluctuations in which the expansion is rapid and the contraction severe.

Business Cycle Phases

A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its
long-term natural growth rate. It explains the expansion and contraction in economic
activity that an economy experiences over time.

A business cycle is completed when it goes through a single boom and a single contraction in
sequence. The time period to complete this sequence is called the length of the business
cycle. A boom is characterized by a period of rapid economic growth whereas a period of
relatively stagnated economic growth is a recession. These are measured in terms of the
growth of the real GDP, which is inflation-adjusted.
Stages of the Business Cycle

In the diagram above, the straight line in the middle is the steady growth line. The business
cycle moves about the line. Below is a more detailed description of each stage in the business
cycle:

1. Expansion

The first stage in the business cycle is expansion. In this stage, there is an increase in positive
economic indicators such as employment, income, output, wages, profits, demand, and
supply of goods and services. Debtors are generally paying their debts on time, the velocity of
the money supply is high, and investment is high. This process continues as long as
economic conditions are favourable for expansion.

2. Peak

The economy then reaches a saturation point, or peak, which is the second stage of the
business cycle. The maximum limit of growth is attained. The economic indicators do not
grow further and are at their highest. Prices are at their peak. This stage marks the reversal
point in the trend of economic growth. Consumers tend to restructure their budgets at this
point.

3. Recession

The recession is the stage that follows the peak phase. The demand for goods and services
starts declining rapidly and steadily in this phase. Producers do not notice the decrease in
demand instantly and go on producing, which creates a situation of excess supply in the
market. Prices tend to fall. All positive economic indicators such as income, output, wages,
etc., consequently start to fall.

4. Depression

There is a commensurate rise in unemployment. The growth in the economy continues to

decline, and as this fall below the steady growth line, the stage is called a depression.

5. Trough

In the depression stage, the economy’s growth rate becomes negative. There is further
decline until the prices of factors, as well as the demand and supply of goods and
services, contract to reach their lowest point. The economy eventually reaches the trough. It
is the negative saturation point for an economy. There is extensive depletion of national
income and expenditure.

6. Recovery

After the trough, the economy moves to the stage of recovery. In this phase, there is a
turnaround in the economy, and it begins to recover from the negative growth rate. Demand
starts to pick up due to low prices and, consequently, supply begins to increase. The
population develops a positive attitude towards investment and employment and production
starts increasing.

Employment begins to rise and, due to accumulated cash balances with the bankers, lending
also shows positive signals. In this phase, depreciated capital is replaced, leading to new
investments in the production process. Recovery continues until the economy returns to
steady growth levels.

Concept of Inflation: -
Inflation is the decline of purchasing power of a given currency over time. A quantitative
estimate of the rate at which the decline in purchasing power occurs can be reflected in the
increase of an average price level of a basket of selected goods and services in an economy
over some period of time.

• Inflation is the rate at which the value of a currency is falling and consequently the
general level of prices for goods and services is rising.
• Inflation is sometimes classified into three types: Demand-Pull inflation, Cost-Push
inflation, and Built-In inflation.
• Most commonly used inflation indexes are the Consumer Price Index (CPI) and the
Wholesale Price Index (WPI).
• Inflation can be viewed positively or negatively depending on the individual
viewpoint and rate of change.
• Those with tangible assets, like property or stocked commodities, may like to see
some inflation as that raises the value of their assets.
• People holding cash may not like inflation, as it erodes the value of their cash
holdings.
• Ideally, an optimum level of inflation is required to promote spending to a certain
extent instead of saving, thereby nurturing economic growth.

Types and impact of inflation:

Inflation is mainly caused by excess demand/ or decline in aggregate supply or output.
Former leads to a rightward shift of the aggregate demand curve while the latter causes
aggregate supply curve to shift leftward. Former is called demand-pull inflation (DPI), and
the latter is called cost-push inflation (CPI). Before describing the factors, that lead to a rise
in aggregate demand and a decline in aggregate supply, we like to explain “demand-pull” and
“cost-push” theories of inflation.
(i) Demand-Pull Inflation Theory:
There are two theoretical approaches to the DPI—one is classical and other is the Keynesian.
According to classical economists or monetarists, inflation is caused by an increase in money
supply which leads to a rightward shift in negative sloping aggregate demand curve. Given a
situation of full employment, classicists maintained that a change in money supply brings
about an equi-proportionate change in price level.

That is why monetarists argue that inflation is always and everywhere a monetary
phenomenon. Keynesians do not find any link between money supply and price level causing
an upward shift in aggregate demand.
According to Keynesians, aggregate demand may rise due to a rise in consumer demand or
investment demand or government expenditure or net exports or the combination of these
four components of aggregate demand. Given full employment, such increase in aggregate
demand leads to an upward pressure in prices. Such a situation is called DPI. This can be
explained graphically.

Just like the price of a commodity, the level of prices is determined by the interaction of
aggregate demand and aggregate supply. In Fig. 4.3, aggregate demand curve is negative
sloping while aggregate supply curve before the full employment stage is positive sloping and
becomes vertical after the full employment stage is reached. AD1 is the initial aggregate
demand curve that intersects the aggregate supply curve AS at point E1.
The price level, thus, determined is OP1. As aggregate demand curve shifts to AD2, price level
rises to OP2. Thus, an increase in aggregate demand at the full employment stage leads to an
increase in price level only, rather than the level of output. However, how much price level
will rise following an increase in aggregate demand depends on the slope of the AS curve.
(ii) Causes of Demand-Pull Inflation:
DPI originates in the monetary sector. Monetarists’ argument that “only money matters” is
based on the assumption that at or near full employment excessive money supply will in-
crease aggregate demand and will, thus, cause inflation.
An increase in nominal money supply shifts aggregate demand curve rightward. This enables
people to hold excess cash balances. Spending of excess cash balances by them causes price
level to rise. Price level will continue to rise until aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real sector.
Aggregate demand may rise if there is an increase in consumption expenditure following a
tax cut. There may be an autonomous increase in business investment or government
expenditure. Government expenditure is inflationary if the needed money is procured by the
government by printing additional money.
In brief, increase in aggregate demand i.e., increase in (C + I + G + X – M) causes price level
to rise. However, aggregate demand may rise following an increase in money supply gen-
erated by the printing of additional money (classical argument) which drives prices upward.
Thus, money plays a vital role. That is why Milton Friedman argues that inflation is always
and everywhere a monetary phenomenon.

There are other reasons that may push aggregate demand and, hence, price level upwards.
For instance, growth of population stimulates aggregate demand. Higher export earnings
increase the purchasing power of the exporting countries. Additional purchasing power
means additional aggregate demand. Purchasing power and, hence, aggregate demand may
also go up if government repays public debt.

Again, there is a tendency on the part of the holders of black money to spend more on
conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused
by a variety of factors.

(iii) Cost-Push Inflation Theory:

In addition to aggregate demand, aggregate supply also generates inflationary process. As
inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usually
associated with non-monetary factors. CPI arises due to the increase in cost of production.
Cost of production may rise due to a rise in cost of raw materials or increase in wages.

However, wage increase may lead to an increase in productivity of workers. If this happens,
then the AS curve will shift to the right- ward not leftward—direction. We assume here that
productivity does not change in spite of an increase in wages.

Such increases in costs are passed on to consumers by firms by raising the prices of the
products. Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising
prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-price
spiral starts. This causes aggregate supply curve to shift leftward.
This can be demonstrated graphically where AS1 is the initial aggregate supply curve. Below
the full employment stage this AS curve is positive sloping and at full employment stage it
becomes perfectly inelastic.
Intersection point (E1) of AD1 and AS1 curves determine the price level (OP1). Now there is a
leftward shift of aggregate supply curve to AS2. With no change in aggregate demand, this
causes price level to rise to OP2 and output to fall to OY2. With the reduction in output,
employment in the economy declines or unemployment rises. Further shift in AS curve to
AS3 results in a higher price level (OP3) and a lower volume of aggregate output (OY3). Thus,
CPI may arise even below the full employment (YF) stage.
(iv) Causes of Cost-Push Inflation:
It is the cost factors that pull the prices upward. One of the important causes of price rise is
the rise in price of raw materials. For instance, by an administrative order the government
may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher
price. This leads to an upward pressure on cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of petrol
by OPEC compels the government to increase the price of petrol and diesel. These two
important raw materials are needed by every sector, especially the transport sector. As a
result, transport costs go up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions
demand higher money wages as a compensation against inflationary price rise. If increase in
money wages exceed labour productivity, aggregate supply will shift upward and leftward.
Firms often exercise power by pushing prices up independently of consumer demand to
expand their profit margins.

Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of
production. For instance, an overall increase in excise tax of mass consumption goods is
definitely inflationary. That is why government is then accused of causing inflation.
Finally, production setbacks may result in decreases in output. Natural disaster, gradual
exhaustion of natural resources, work stoppages, electric power cuts, etc., may cause ag-
gregate output to decline. In the midst of this output reduction, artificial scarcity of any
goods created by traders and hoarders just simply ignite the situation.

Inefficiency, corruption, mismanagement of the economy may also be the other reasons.
Thus, inflation is caused by the interplay of various factors. A particular factor cannot be
held responsible for any inflationary price rise.

Measures of monetary policy of India

1. 1. Measures of Monetary policy of India In order to carry out its monetary policy the
RBI has adopted the following measures: a) Measures for Expansion of currency
Management of currency is one of the core central banking function of the RBI. In
term of section 22 of Reserve Bank of India Act, the RBI is the sole authority for issue
of currency in India. The Reserve Bank has the objective of ensuring an adequate
supply of clean and genuine notes as required by the public.
2. b) Measures of Credit Control: One of the important functions of the RBI is the
controlled expansion of bank credit and money supply with special attention to the
seasonal requirement for credit without affecting the output. Monetary authority has
control over the decisions regarding the allocation of credit to priority sector and
small borrowers. It is an important tool used by the RBI to control the demand and
supply of money(liquidity) in the economy. RBI focuses on its objective of “Economic
development with stability”. It means bank will not only control inflationary trends in
economy but also boost economic growth which would ultimately lead to increase in
real income with stability.
3. Instruments for Credit Control under monetary policy Control of credit is one of the
main objectives of monetary policy in India. Control of credit means increase or
decrease of the flow of credit in the economy in accordance with its need. Reserve
Bank of India adopts all those measures for the control of credit which central bank
in other countries. These instruments may be classified as: 1. Quantitative Credit
Control 2. Qualitative Credit Control
4. (A) Quantitative Credit Control Quantitative Credit Control means to control the total
quantum of credit in the economy. Under this, RBI has adopted the following
instruments: (1) Bank Rate: Section 49 of RBI Act 1934, defines Bank Rate as “the
standard rate at which RBI is prepared to buy or re-discount bills of exchange or
other commercial paper eligible for purchase under this act. In India: RBI, NABARD,
SID BI etc. allow the banks to re discount such bill with them and provide the fund.
Changes in bank rate are introduced with a view to controlling the price level and
business activity, by changing the demand for loan. Its working is based upon the
principle that changes in the bank rate results in changed interest rate in the market.
Till 15th july,2013 bank rate was 10.25%, but it has been reduced to 9.5% w.e.f 20th
sept,2013.
5. (2) Open Market Operation: An Open Market Operation is an instrument of
monetary policy which involve buying and selling of government securities from or to
the public and bank. This mechanism influences the reserve position of the banks,
yield on government securities and cost of bank credit. The RBI sells government
securities to contract the flow of credit and buys government securities to increase
credit flow. With a view to curbing the prevailing and evolving market conditions, last
month RBI had announced conducting of open market operations by purchasing
Government of India securities worth Rs.8,000 crore to eject liquidity in the
economy.
6. (3) Statutory Liquidity Ratio: Every financial institution has to maintain a certain
quantity of liquid assets with themselves at any point of time of their total time and
demand liability. These assets can be cash, precious metals, approved securities like
bonds etc. The ratio of the liquid assets to time and demand liabilities is termed as
Statutory Liquidity ratio. Previously SLR was 24% but recently it has been reduced to
23%. (4) Cash reserve ratio: Cash reserve ratio is a certain percentage of bank deposit
which banks are required to keep with RBI in the form of reserve or balances. Higher
the CRR with the RBI lower will be the liquidity in the system and vice-versa. RBI is
empowered to vary CRR between 15% and 3%. As of January 2013, the CRR is 4%.
7. (5) Multiple Rates of interest: In October 1960, RBI started ‘multiple rates of interest’
programme. Under this programme, RBI fixes credit quota for various commercial
banks. If commercial banks borrow funds from RBI within their quota, they are
charged interest at repo rate, but if commercial bank borrow more than their fixed
quota, they are charged higher interest rates i.e., more than bank rate. RBI by
changing quotas of commercial banks and by changing interest rate for lending
beyond the quotas limit, can expand or contract credit. If RBI reduces quotas or
increases interest rates it will contract credit and vice versa. (6) Repo Rate and
Reverse Repo Rate: ‘Repo’ and ‘Reverse repo’ are the main monetary policy rate.
Repo rate means the interest rate at which commercial banks can borrow funds from
RBI. Reverse repo rate means the interest rate given by RBI on deposits made by
commercial banks with it. Increase in repo rate will contract credit as now
commercial banks can get funds from RBI at higher interest. Similarly, increase in
reverse repo rate will also contract credit as commercial banks are more inclined to
deposit their funds with RBI earn high interest.
8. Recently, new RBI Governor, Raghuram Rajan has increased repo rate and reverse
repo rate to 7.5% and 6.5% respectively with the motive to fight back the currency
depreciation and secondly to encourage saving as due to high inflation, desired level
of financial sector saving has not been achieved.
9. (B)Qualitative Credit Control This refers to the control of specific credit meant for
certain specific objectives. It refers to regulating and controlling the credit to a
specific sector/commodity/area. Following instruments of selective control are
generally adapted: - (1) Marginal Requirement: Margin is the difference between loan
value and market value of security. It is fixed by the RBI. For different types of loan,
margin requirement is different. If margin percentage is more, then less loan will be
given for a certain value of security and vice-versa. For example: -A person mortgages
his property worth Rs.1,00,000 against a loan. If suppose marginal requirement is
20%, then bank will only give a loan of Rs.80,000.
10. (2) Moral Suasion This method is also known as “Moral Persuasion” as the method
that the Reserve Bank of India, being the apex bank uses here, is that of persuading
the commercial banks to follow its directions/orders on the flow of credit. RBI puts a
pressure on the commercial banks to put a ceiling on credit flow during inflation and
be liberal in lending during deflation. (3) Rationing of credit Under this method there
is a maximum limit to loans and advances that can be made, which the commercial
banks cannot exceed. RBI fixes ceiling for specific categories. Such rationing is used
for situations when credit flow is to be checked, particularly for speculative activities.
11. (4) Publicity RBI uses media for publicity of its views on the current market condition
and its directions that will be required to be implemented by the commercial banks to
control the unrest. Though this method is not very successful in developing nation
due to high illiteracy rate that make it difficult for people to understand such policies
and its implications. (5) Direct Action Under the banking regulation Act, the central
bank has the authority to take strict action against any of the commercial banks that
refuses to obey the direction given by RBI. There can be a restriction on advancing of
loans imposed by RBI on such banks.
Challenges of Monetary Policy Measures
High and sustained growth of the economy in conjunction with low inflation is the central
concern of monetary policy. The rate of inflation chosen as the policy objective has to be
consistent with the desired rate of output and employment growth. An inappropriate choice
can lead to losses of macroeconomic welfare.

Fiscal Policy Measures

Fiscal policy, measures employed by governments to stabilize the economy, specifically by
manipulating the levels and allocations of taxes and government expenditures. Fiscal
measures are frequently used in tandem with monetary policy to achieve certain goals.
The usual goals of both fiscal and monetary policy are to achieve or maintain full
employment, to achieve or maintain a high rate of economic growth, and to stabilize prices
and wages. The establishment of these ends as proper goals of governmental economic
policy and the development of tools with which to achieve them are products of the 20th
century. In taxes and expenditures, fiscal policy has for its field of action matters that are
within government’s immediate control. The consequences of such actions are generally
predictable: a decrease in personal taxation, for example, will lead to an increase
in consumption, which will in turn have a stimulating effect on the economy. Similarly, a
reduction in the tax burden on the corporate sector will stimulate investment. Steps taken to
increase government spending by public works have a similar expansionary effect.
Conversely, a reduction in government expenditure or an increase in tax revenues, without
compensatory action, has the effect of contracting the economy.

Fiscal policy relates to decisions that determine whether a government will spend more or
less than it receives. Until Great Britain’s unemployment crisis of the 1920s and the Great
Depression of the 1930s, it was generally held that the appropriate fiscal policy for the
government was to maintain a balanced budget. The severity of these disturbances gave rise
to a new set of ideas, first given formal treatment by the economist John Maynard Keynes,
revolving around the notion that fiscal policy should be used “countercyclically,” that is, that
the government should exercise its economic influence to offset the cycle of expansion and
contraction in the economy. Keynes’s rule, briefly, was that the budget should be
in deficit when the economy was experiencing low levels of activity and in surplus when
boom conditions (often accompanied by high inflation) were in force.
Under the balanced-budget regime, personal and business tax rates were raised during
periods of declining economic activity to ensure that government revenues were not reduced.
The effect of this was to reduce consumption still further, increase surplus industrial
capacity, and depress investment, all of which exerted a downward pressure on the economy.
Alternatively, if, in order to maintain a balanced budget, taxes remained level but
government expenditures were cut back during such a period of declining economic activity,
a similar downward pressure was exerted. The Keynesian theory showed that, under certain
conditions, the operation of market forces would not automatically generate full
employment, and that governments should abandon the balanced-budget concept and adopt
active measures to stimulate the economy. Furthermore, to be really effective, these
measures should be financed by government borrowing rather than by raising taxes or by
cutting other government expenditures. Initial experiments with this new stabilizing
technique in the United States during the first term (1933–37) of President Franklin D.
Roosevelt’s administration were somewhat disappointing, partly because the amount of
deficit financing was not large enough and partly, perhaps, because the expectations of
business had been dulled to such an extent by the Great Depression that it was slow to
respond to opportunities. With the advent of World War II and soaring government
spending, the unemployment problem in the United States virtually disappeared.

Challenges of Fiscal Policy Measures

The government has two tools to implement its fiscal policy, namely, taxes and government
spending. If the economy is in recession, the government may decide to increase aggregate
demand, or decrease taxes to stimulate the economy and increase aggregate demand.
Similarly, if the economy is facing inflationary economic boom, it may decrease spending or
increase taxes.
When the government takes specific actions to influence aggregate demand, it’s called the
discretionary fiscal policy.
The discretionary fiscal policy does not always work as intended by the government. There
are many reasons as to why the fiscal policy may not be as effective as desired, or sometimes
even be counterproductive. Some of these reasons are discussed below:

1. If the government relies on inaccurate statistics, then it’s likely to make wrong policy
decisions in the first place.
2. There could be a lag in implementing a policy decision, and/or the impact of a policy
decision. For example, by the time the policymakers recognize the problem and take
decision to do something, it may already be too late (Recognition lag and action lag).
Once the government implements a policy, there may be a time lag till the policy has
an impact on the economy (impact lag).
3. An expansionary fiscal policy may end up decreasing aggregate demand because of
crowding-out effect. Increased government borrowing leads to an increase in interest
rates, which leads to a decrease in aggregate demand.
4. The economy may be slow because of shortage of resources rather than lower
demand. In this case, fiscal policy will not help (it may actually increase inflation).
5. Since expansionary fiscal policy increases fiscal deficit, there is constraint over how
much deficit the government can tolerate.
6. While fiscal policy solves one problem, it may aggravate another problem.

5(B). PRICING PRACTICES & STRATEGIES

Pricing a product is one of the most important aspects of your marketing strategy. Generally,
pricing strategies include the following five strategies.
1. Cost-plus pricing—simply calculating your costs and adding a mark-up
2. Competitive pricing—setting a price based on what the competition charges
 3. Value-based pricing—setting a price based on how much the customer believes what
you’re selling is worth
4. Price skimming—setting a high price and lowering it as the market evolves
5. Penetration pricing—setting a low price to enter a competitive market and raising it
later
How do you arrive at a value-based price?
Dolansky provides the following advice for entrepreneurs who want to determine a value-
based price.

• Pick a product that is comparable to yours and find out what the customer pays
for it.
• Find all of the ways that your product is different from the comparable product.
• Place a financial value on all of these differences, add everything that is positive
about your product and subtract any negatives to come up with a potential price.
• Make sure the value to the customer is higher than your costs.
• Demonstrate to customers why the price will be acceptable, which includes
talking to them.
• If there is an established market, the current price range will help educate you
about the customers’ price expectations.
3 ways value-based pricing can provide an advantage
In value-based pricing, the perceived value to the customer is primarily based on how well
it’s suited to the needs and wants of each customer. Dolansky says a company can gain an
advantage over its competitors in the following ways.

1. The price is a better fit with the customer’s perspective.

2. Value-based pricing allows you to be more profitable, meaning you can acquire more
resources and grow your business.
3. When a price doesn’t work, the answer isn’t just to lower it, but to determine how it
can better match customer value. That may mean adapting the product to better suit
the market.
Factors affecting Price Determination

Main factors affecting price determination of product are:

1. Product Cost
2. The Utility and Demand
3. Extent of Competition in the Market
4. Government and Legal Regulations
5. Pricing Objectives
6. Marketing Methods Used.
Product Cost:
The most important factor affecting the price of a product is its cost. Product cost refers to
the total of fixed costs, variable costs and semi variable costs incurred during the production,
distribution and selling of the product. Fixed costs are those costs which remain fixed at all
the levels of production or sales.
For example, rent of building, salary, etc. Variable costs refer to the costs which are directly
related to the levels of production or sales. For example, costs of raw material, labour costs
etc. Semi variable costs are those which change with the level of activity but not in direct
proportion. For example, fixed salary of Rs 12,000 + up to 6% graded commission on
increase in volume of sales.

The Utility and Demand:

Usually, consumers demand more units of a product when its price is low and vice versa.
However, when the demand for a product is elastic, little variation in the price may result in
large changes in quantity demanded. In case of inelastic demand, a change in the prices does
not affect the demand significantly. Thus, a firm can charge higher profits in case of inelastic
demand.

Moreover, the buyer is ready to pay up to that point where he perceives utility from product
to be at least equal to price paid. Thus, both utility and demand for a product affect its price.

Extent of Competition in the Market:

The next important factor affecting the price for a product is the nature and degree of
competition in the market. A firm can fix any price for its product if the degree of
competition is low.

However, when the level of competition is very high, the price of a product is determined on
the basis of price of competitors’ products, their features and quality etc. For example, MRF
Tyre company cannot fix the prices of its Tyres without considering the prices of Bridgestone
Tyre Company, Goodyear Tyre company etc.

Government and Legal Regulations:

The firms which have monopoly in the market, usually charge high price for their products.
In order to protect the interest of the public, the government intervenes and regulates the
prices of the commodities for this purpose; it declares some products as essential products
for example. Lifesaving drugs etc.

Pricing Objectives:

Another important factor, affecting the price of a product or service is the pricing objectives.

Following are the pricing objectives of any business:

(a) Profit Maximisation:
Usually, the objective of any business is to maximise the profit. During short run, a firm can earn
maximum profit by charging high price. However, during long run, a firm reduces price per unit to
capture bigger share of the market and hence earn high profits through increased sales.
(b) Obtaining Market Share Leadership:
If the firm’s objective is to obtain a big market share, it keeps the price per unit low so that there is
an increase in sales.
(c) Surviving in a Competitive Market:
If a firm is not able to face the competition and is finding difficulties in surviving, it may resort to free
offer, discount or may try to liquidate its stock even at BOP (Best Obtainable Price).
(d) Attaining Product Quality Leadership:
Generally, firm charges higher prices to cover high quality and high cost if it’s backed by above
objective.
Marketing Methods Used:
The various marketing methods such as distribution system, quality of salesmen, advertising,
type of packaging, customer services, etc. also affect the price of a product. For example, a
firm will charge high profit if it is using expensive material for packing its product.

Cost Oriented Pricing

There are two broad categories of pricing methods, such as cost-oriented methods and market-
oriented methods. These main categories have various subcategories depending on multiple factors.
In this section, you will learn about all types of pricing methods.

A. Cost-oriented methods:

Cost-oriented or cost-based pricing method is the purest form of pricing method. In this pricing
method, a certain percentage of the desired profit is added to the cost of the product to obtain the final
price of the product. The cost of the product is the total cost spent on the production of the product.

1. Cost Plus Pricing:

The cost-plus pricing method is the simplest, and the price of goods using this method is determined
by following the most basic idea behind the concept of business. The idea is that a businessman
produces and sells a product to generate profit from it.

The advantage of using this method is that it covers all the costs of production and provide a
consistent return on investment, whereas, the disadvantages of using this method is that it does not
take into consideration the consumer of the product and the competition in the market.

2. Mark-up pricing:

Mark up pricing can be determined by adding the cost of a product with a certain percentage of
markup to determine the final price of goods or services. The markup value of a product is the
amount of profit the company wants to earn by selling the product. To determine the markup price
of a product, the company first should specify the exact total cost of production of a product and
mark up value.
The formula to calculate the markup pricing is as follows:
Markup pricing = Production cost + markup cost
The formula to calculate the markup value is as follows:
Markup value = Unit Cost / 1 – Desired Return on Sales
3. Target return pricing:

Target return pricing is a type of pricing method in which companies plan to achieve a certain level
of return on investment by selling a particular quantity of goods.
The formula to calculate target return pricing is as follows:
Target Return pricing = Unit Cost + (Desired Return * Invested Capital) / Unit Sales
The advantage of using target return pricing is that it is easy to calculate and understand. Moreover,
with target return pricing, the company can decide the level of effort of the whole team as a unit
required to generate a certain percentage of profit.

4. Break-Even pricing:
Let me explain to you what is the breakeven point before we get to break-even pricing. The
breakeven point is a point where a company is neither generating profit nor losing any money. That
means the total revenue generated is enough that it covers all the fixed as well as variable costs of
the production of goods or services. It is easy to understand breakeven pricing after learning about
the breakeven point.

5. Early cash recovery Pricing:

The early cash recovery pricing method is concerned with the early recovery of total investment in
the business. This pricing strategy is adopted by those businesses who are aware of the short life of
the market or when they are dealing with fashion-related products or the products which
are technology sensitive.
For example, the life of smartphones is concise because every few months, a new smartphone with
updated features is introduced in the market. Because of this, the lifespan of smartphones is very
short in the market.

B. Market-Oriented Pricing Methods

The market-oriented pricing method or market-based pricing method is also known as a competition-
oriented pricing method. The cost of goods and services is decided as per the current conditions of
the market in a market-oriented pricing method.

1. Perceived Value Pricing

The perceived value pricing method works on the image of the product in the eyes of its customers.
Most companies decide the price of their product depending on its value perceived by customers.

2. Sealed bid Pricing

The sealed bid pricing is different from other types of pricing methods. The sealed bid pricing method
is used in case of large orders. The seller submits sealed bid pricing to get the contract or work. This
type of pricing method is used to get the agreement of a job from big industries or government.

3. Differentiated Pricing

The differentiated pricing is the pricing where the same product or service is sold at different prices.
The difference in the cost of the product or service is made based on various factors. Based on these
factors, differentiated pricing is further divided into four different categories.
The followings are the subcategories of differentiated pricing

1. Time Pricing

The time pricing method works depending on the time of the year when the product is sold. In the
peak season, a product is sold at full price, and the same product is sold at a lowered amount in the
offseason.

2. Customer Segment Pricing

In customer segment pricing, different groups of customers are charged different prices for similar
products or services. This pricing method works on various factors, such as the economic level of
customers, size of the order, etc.

3. Product Form Pricing

Under the product form pricing method, the different versions of goods are charged differently. For
example, the price of different quantities of cooking oil is different and is not decided proportionately.

4.Area Pricing:

The area pricing method works depending on the area where the product is sold. For example, a
company might sell a product at a lower price in a new market to attract new customers.

5. Going Rate Pricing:

The cost of goods and services using a going rate pricing method is decided based on the price set
by the major companies in the market. The small companies change the cost of their products or
services when their giant competitors change

The going rate pricing can be sub-divided into further sub-categories

1.Discount Pricing

In the discount pricing method, the small companies charge less price as compared to the cost of the
goods of their competitors as they lack the features provided by the competitors.

2. Competitors’ parity method

Using competitors’ parity pricing method, a company sets the price of its products the same as the
price of the outcome of its competitor company. Companies use this method to attain a market
share of already established companies.

3. Premium Pricing

A company charges a little higher price than its competitor companies by providing additional features
or by providing other services.
Objectives of pricing methods:

1. Maximum Profit Generation and return on investment.

2. To increase market share and strengthen the position in the market.
3. To make better use of competitive positioning.
4. Give competition to the competitors.
5. Long life of the company in the market.
6. Attain price stability.

Competition-Oriented Pricing

a method of pricing in which a manufacturer's price is determined more by the price

of a similar product sold by a powerful competitor than by considerations of
consumer demand and cost of production; also referred to as Competition-Based
Pricing.

Pricing in large enterprises

A right pricing strategy helps you determine the price point at which you can maximize
profits on sales of your product or service. You need to consider a wide range of factors
when setting prices of your offerings. These include:
• production and distribution costs,
• competitor offerings,
• positioning strategies and
• the business’ target customer base.
Your customers won’t purchase goods that are priced too high. On the other hand, your
company won’t succeed if it prices goods too low. This is because low prices will not
allow you to cover all of the business’ costs.

Thus, product or service price can have a profound effect on the success of your small
business. This is in addition to other factors that impact your business. These include
the product itself, the place where it is sold and its promotion.

Here are some of the strategy’s businesses implement when setting prices for their
products and services.

I. New Product Pricing Strategies

Pricing strategies usually change at different phases of a product’s life cycle. The most
challenging phase of setting a pricing strategy is that of product introduction. During
this phase, marketers face the challenge of setting prices of business offerings for the
first time. There are two strategies that they can follow:
1. Price Skimming
Price skimming involves setting rates high during the introductory phase. This is
designed to help businesses maximize sales on new products and services. Once the
products or services are introduced, company lowers the prices gradually. This is done
eventually as competitor goods appear on the market.
One of the benefits of price skimming is that it allows you to maximize profits on early
adopters. You then drop the prices eventually to attract more price-sensitive
consumers. Not only does price skimming help your small business recoup its
development costs. It also creates an illusion of quality and exclusivity when your item
is first introduced to the marketplace.

2. Pricing for Market Penetration

Penetration strategies aim to attract buyers by offering lower prices on goods and
services. Many new companies use this technique to draw attention away from their
competition. But penetration pricing does lead to an initial loss of income for the
business.

Over time, however, the increase in awareness can drive profits. Furthermore, it can
help small businesses to stand out from the crowd. After sufficiently penetrating a
market, companies often end up raising their prices in the long run. This is done to
better reflect the state of their position within the market.

II. Product Mix Pricing Strategies

The pricing strategy for each of the products is different when you sell different set of
products. This variation in pricing is based on the costs, demand and the different level
of competition that a product has to face in the market. Now, you vary pricing in order
to maximize profits on your total product mix. Accordingly, there are different product
mix pricing strategies. These include:
Product Line Pricing
You have to set different prices for various offerings in a product line in case your
business offers different product lines. This price differentiation takes into account cost
differences between the products in a given product line. Furthermore, it also considers
customer perceptions with regards to the value offered by different products in a given
line.

Optional Product Pricing

You have to add the price of accessories to the base price of the product in case you
offer accessory products along with the main product. This means that accessories are
given as an option to the customers.

Take for example the automobile industry. The basic price of a car is different from the
upper models offering functionalities like automatic windows, alloys, infotainment
system etc.
Captive Product Pricing
This pricing strategy is used by companies manufacturing products that are essential
for using the main product. For example, in the case of razors, cartridges form captive
products. Whereas the razors act as main products. Companies like Gillette offer razors
at low prices, but makes huge amounts of money from the razor cartridges.
By Product Pricing
Some industries generate by-products as a result of manufacturing goods. These by-
products hold no value at times and it is a costly affair to dispose them off. This scenario
may lead to increasing the cost of the core product. However, a company can sell these
by-products to make for the higher cost of disposing them off by using by-product
pricing. Thus, this makes the price of the core product competitive.

For instance, fruit seeds, peels etc that are the leftover in the fruit juice processing can
serve as raw material for cosmetic industry given its medicinal properties.
Bundle Pricing
Bundle pricing means selling a package of goods or services for a lower rate than what
consumers would pay on purchasing each item individually.
This pricing strategy is more effective for companies that sell complimentary products.
For example, a restaurant can take advantage of bundle pricing by including dessert with
every entrée sold on a particular day of the week.
But small businesses should remember that the profits they earn on the higher-value items
must make up for the losses they take on the lower-value product.
Therefore, pricing strategies are important, but it’s also important to not lose sight of the
price itself.

III. Price Adjustment Strategies

Generally, companies adjust the basic price of their products. This is undertaken to
consider customer differences and changing situations. Hence there are many price
adjustment strategies that companies follow. These include:
1. Pricing at a Premium
With premium pricing, businesses set costs higher than their competitors. Premium
pricing is often most effective in the early days of a product’s life cycle. Furthermore, it
is ideal for small businesses that sell unique goods.
A business must work hard to create a value perception. This is because customers need
to perceive products as being worth the higher price tag. There are many things a
business can do to support premium pricing of its offerings.

These include:

• creating a high-quality product,

• intense marketing efforts,
• quality product packaging and
• plush store décor

2. Economy Pricing
Economy pricing aims to attract the most price-conscious consumers. This strategy is
used by a wide range of businesses. These include generic food suppliers, discount
retailers etc. Thus, businesses are able to minimize costs associated with marketing and
production with this strategy. This further helps in keeping the product prices down. As
a result, customers can purchase the products they need without frills.
3. Psychology Pricing
Price is certainly a concern before purchasing products or services. Psychology pricing
refers to technique’s marketers use to encourage customers to respond on emotional
levels rather than logical ones. It considers the psychology of prices and not just the
economics behind the pricing of product. Hence, there are different ways in which a
marketer can use psychology pricing. These include:

• Offering discounts or buy one get one

• Differential pricing
• Price ending

4. Segmented Pricing
This pricing strategy involves selling a product or service at two or more prices.
Provided such difference in pricing is not due to a difference in manufacturing a product
or rendering a service. Rather prices are adjusted based on the customer segment,
location and timing when a product is offered.
5. Discount and Allowance Pricing
Brands usually change the basic price of their offerings in order to honour customers
for their actions. These actions may include volume purchases, early clearance of bills,
off season purchases or stays etc. Thus, discount pricing involves adjustment in two
ways:

Discounts
Discount can be offered in different forms. These include cash discount, quantity
discount, trade discount and seasonal discount.

• Cash discount refers to offering products at prices for customers making prompt cash
payments.
• Quantity discount refers to offering products reduced prices to customers who make
bulk purchases. These discounts instigate the customers to purchase more products
from a single seller rather than approaching different sellers for different products.
• Trade discount is offered by a seller to its channel partners for performing various
functions. These functions include selling, storing and record keeping. This discount is
also known as functional discount.
• Seasonal Discount refers to giving products at reduced prices to customers who
purchase merchandise or services during the off – season.

Allowances
Allowance refers to money paid by a brand to the retailers in return for the retailer
promoting the brand’s products in some way or the other. Such allowances come in two
forms:
Trade in Allowances
Trade in allowances refer to the price reductions given by a brand to the customers for
returning an old item in lieu of purchasing the new one. This pricing strategy is common
in the durable goods industry such as furniture.
Promotional Allowances
These include the promotional money or price reductions given by a brand to its dealers
as a reward for promoting its offerings.
6. Promotional Pricing
Sometimes, companies reduce product price below the marked price or even below cost
for a temporary period of time. This strategy is followed in order to increase sales in the
short run or to reduce inventories. This is known as promotional pricing. This takes
place in several forms.
For instance, sellers follow special event pricing at certain occasions in order to lure
more customers. Such occasions may include festivals, special occasions etc. These
occasions include Independence Day, women’s day, festivals like Diwali, Christmas etc.
7. Geographical Pricing
This pricing strategy refers to adjusting the list price of the products based on the
location of the customer. Thus, Geographical pricing strategy basically reflects the
shipping costs involved in delivering the products from the point of origin to the point
of sale.

Hence, low price may be charged if the customer location is closer to the point of
origination. And higher price is charged in case customers are located at a faraway
place.

Accordingly, there are five different geographical pricing strategies:

FOB Pricing
The goods are placed free on board a carrier at a specific location under this pricing
strategy. It is at this location that the title to and responsibility of the goods gets passed
on to the consumer. Furthermore, the consumer pays for the freight from the factory to
the destination. Hence, the closer the customer destination, lower the price and vice
versa.
Uniform Delivered Pricing
This pricing strategy is in contrast to the FOB pricing. Thus, a company charges the
same price plus freight for the products under this strategy. This is irrespective of the
location of the customers. Furthermore, the freight cost is levied on the basis of average
freight cost.
Zone Pricing
This pricing strategy falls somewhere between FOB pricing and uniform – delivered
pricing strategies. Thus, the company sets up two or more zones under zone pricing.
The customers that fall in a particular zone pay the same price. This is to say farther the
zone, higher would be the price of the products and vice versa.
Basing – Point Pricing
The company chooses a particular city as a basing point as per this strategy.
Additionally, the company charges freight costs to all customers from that city to the
location of the customer. This is irrespective of the city from where the goods are
shipped.
Freight – Absorption Pricing
The seller absorbs all or part of freight charges in order to get more business from a
particular location under this strategy.
Thus, Freight-Absorption pricing strategy might result in declining average cost for the
product and compensating for extra freight cost. This strategy is used to penetrate in a
particular market and clinging to highly competitive markets.
8. Dynamic Pricing
Earlier, fixed price policy was followed by companies while setting the price for goods.
However today, companies are resorting to dynamic pricing. Dynamic pricing involves
adjusting the price of products continuously to meet the needs of individual customers.

For instance, platforms like MakeMyTrip showcase pricing of airline tickets. These
airline companies constantly adjust the price of tickets based on demand dynamics.

Here is an infographic on the different pricing strategies that a business entity can adopt
while pricing its product.

Pricing in small business.

Pricing strategy for your small business will set the standard for your product
or service in the marketplace, and is an important dimension to both your
bottom line and your competitive edge. Early in the life of your small business,
research your intended market as deeply as possible, and pay close attention
to past fluctuations in competition and demand.

When developing a business plan, owners often make the mistake of setting
their pricing strategy to match the lowest-price provider in the market. This
approach comes from a cursory understanding of direct competitors, and the
assumption that the only way to win business is by having the lowest price.

Ceiling Price: The ceiling price is the highest price the market will bear, which
can be explored by surveying both experts and consumers, and by asking
questions regarding pricing limits. Keep in mind that the highest price
available on the market may not necessarily be the ceiling price.

Competitive Analysis: Don't exclusively look at your competitor's pricing;

look at the whole value of what they're offering. Are they serving price-
conscious consumers or an affluent niche? What are the value-added
services, if any? How do you compare?

Price Elasticity: This method shows the responsiveness, or elasticity, of the

demand of a product or service when nothing changes but the price.

Choosing Price Strategy for Your Business

Understand consumer demand within your market, review your own costs,
supply chain, and profit goals as a way to inform your choice on pricing
strategy. Below are a few pricing models to consider:
• Cost-plus pricing: The selling price is determined by adding a markup
to the unit cost.
• Competitive pricing: Setting a price based on the price of the
competition.
• Value-based pricing: The price is based on the perceived or estimated
value of a product or service.
• Price skimming: Setting the price high initially and then lowering as
competitors enter the market.
• Penetration pricing: The price is set low to rapidly enter a competitive
market and provoke word-of-mouth recommendations, only to be raised
later.