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S4 BBA
Managerial economics MODULE 1
INTRODUCTION
Economics is a science that deals with human wants and their satisfaction. Human beings
have unlimited wants and these wants are satisfied with the help of goods and services.
Definition
Prof. Lional Robins defines economics “a science which studies human behaviour as a
relationship between ends and scarce means which have alternative uses”
The study of economics is broadly divided into Two:

 Micro economics
 Macro economics
Micro economics is that branch of economics analysis which studies the
economic behaviour of an individual unit ‘may be a person, a household, or a business firm.
Macroeconomics is that branch of economic analysis which studies the behaviour of not one
particular unit but all the units taken together. It is a study in aggregates.
MANAGERIAL ECONOMICS (BUSINESS ECONOMICS)

Managerial economics is the application of economic theories and methods

to solve business decision making problems.
In the words of Edwin Mansfield “managerial economics is concerned with application of
economic concept and economic analysis to the problem of formulating rational managerial
decision.
IMPORTANCE OF BUSINESS ECONOMICS

 It provides economic concept

 It helps to build analytical model
 It helps in understanding external force
 It helps to answer business question.
Characteristics of managerial economics
 Micro economic character
 Managerial economics is normative economics
 Managerial economics is pragmatic
 Managerial economics make use of macro economics
 Managerial economies theory of the firm

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Application of economic theories in decision making.

1. Demand theory:- There are various Factors which influence the demand of a product, like
price ,consumer’s income etc. The theory of demand helps a business firm to understand
consumer behavior in terms of change in demand in response to change in any of these
factors.
2. Production theory:- Production theory helps a business firm to understand how much
output can be produced from a given combination of input. The least cost combination of
inputs can also be found out with the help of this theory.
3. Cost Theory:- Cost theory provides an understand of the various concept of costs and
their relevance in decision making .The theory helps a decision maker to study the cost
output relationship both in the short run and long run.
4. Price theory :- Price theory provides a basic understanding of the market condition like
perfect competition ,monopoly ,monopolistic competition and oligopoly .With the help of
price theory a firm can determine its equilibrium price and output level.
5. Price theory :- Profit theory gives an understanding about the various concept of profit,
its functions and its measurement . with the help of profit theory a firm can manage and
measure its profit and also plan future profit.
6. Theory of capital:- Allocation of a firm’s capital in various long term investment
opportunities requires a detailed analysis of the cost and benefit associated with each
investment opportunity.
7. Theory of business cycle:- The recurring ups and downs in the level of economic activity is
called business cycle
DISTINCTION BETWEEN MANAGERIAL ECONOMICS AND TRADITIONAL ECONOMICS
a. Traditional economics is concerned with the concepts ,principles and theoretical
aspects of economic analysis but managerial economics is concerned the
application of economic principles to the problem of the firm.
b. Traditional economics is broader in nature, but managerial economics is narrow in
nature .
c. Traditional economics deals with both economics of the individual as well as
economics of the firm, but managerial economics deals with economics of the firm
and has nothing to do with an individual ‘s economic problems.
d. Rent , wage, interest and profit theories are studied in traditional economic while
only profit theory is used in managerial economics.
e. Traditional economics , economic theories hypothesize economics relationship and
build economic models. But managerial economics adopts and modifies economic
models in such way that it suit the specific conditions for solving specific economic
problems.
f. Traditional economics also provide abstract model of micro and macro economic
theories .but managerial economics ignores abstract models.
g. Traditional economics study only the economic aspect of the problems ,but
managerial economics study both the economic and non economic aspects of the
problems.

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Role of a managerial economics

 Role of a managerial economist in a business

 To apply economic principles and theories to practical business problems
 Study of the behaviour of economy as a whole
 Helping the management in business planning

Responsibility of a managerial economist

 Responsibility to help the firm in achieving its goal

 Responsibility to make accurate forecasts
 Responsibility to maintain relationship

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MODULE 2
BUSINESS CYCLE
Business cycle refers to the recurring ups and downs in the level of economic activity which
may last even for several years .
According to J M Keynes “A trade cycle is composed of periods of good trade characterized
by rising price and low unemployment percentage, altering with periods of bad trade
characterized by falling prices and high unemployment percentages”.
Features of business cycles

1. A business cycle has a wave like a movement.

2. It is repetitive nature
3. It has an all-embracing nature
4. The impact of business cycles will be reflected in aggregate economic variables like
production ,income ,employment and price .
5. It is characterized by upward and downward movement .

PHASES OF BUSINESS CYCLES

PROSPERI
BOOM
TY

RECOVER RECESSIO
Y N

DEPRESSI
ON

 DEPRESSION
This is the downswing of the business cycle .At this stage the economic activities are
very much below the normal .the following are the characteristics during the
depression period
 Decline in production
 Increase in the rate of unemployment
 Low income and profit
 Low price level
 Less demand for bank credit.
 RECOVERY :- This phase is also called revival .the period of depression is not
permanent .At this stage the economic activities starts picking up .
 PROSPERITY :- In the prosperity phases of business cycle the economy’s
production reaches its full potential.

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 BOOM
Boom is the peak stage of business cycle .the prosperity phases of business cycle
does not end up with full employment level of output .it grows beyond full
employment situation because of heavy investment by producers.
 RECESSION :- Symptoms of recession appear once in the economy reaches the
peak of boom. There is fall in demand at this stage and it will take some time for
producers to be fully aware about the decline in demand of their products .
CONTROL OF BUSINESS CYCLE.
I. MONETARY POLICIES
Monetary policies refers to the measure taken by the central bank of a country in
order to control the volume of bank credit available in the country . The important
monetary measures to control bank credit are discussed below:-
a. Change in Bank Rate
Bank rate is the rate of interest on loans and advances given to commercial
bank by the central bank .The lending rates of commercial banks are
dependent on bank rate .During boom period there is greater demand for
bank credit and bring it down the central bank raises the bank rate so that
commercial banks also raise their lending rate .
b. Open Market Operation :- Open market operation means purchase and sale of
securities by the central bank in the open market .
c. Change in cash Reserve Ratio :- Cash reserve Ratio (CCR) is the ratio of reserves kept
with the central bank in proportion to the total deposit of a commercial bank .
d. Change in Statutory Liquidity Ratio
Every bank is required to maintain a certain percentage of their demand and
time liabilities as statutory Liquidity Ratio(SLR).

FISCAL POLICY :- Fiscal policy refers to the measures taken by the government of a country
to control the business cycle .T he important tools of fiscal policy are :-

a. Taxation policy
One of the important reason for the occurrence of business cycle in the
existence of excessive purchasing power .Through imposing taxes
government take away the excessive purchasing power.
b. Public expenditure
The government of a country are supposed to spent money on public work
scheme such as construction of road ,canals ,parks ,school, Hospital etc..
Uses of business cycle in business decisions

 Demand forecasting :-
 Inventory management
 Pricing decisions

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 Business expansion
 Marketing decisions

Inflation :- Inflation is described as a situation of rising prices which cause a decline in the
purchasing power of money . prof . Crowther has defined inflation” as a state in which the
value of money is falling “.
According to prof. golden weiser “ inflation occurs when the volume of money actively
binding for goods and services increases faster than the available supply of goods”.

Causes of inflation:
Economist identified the main causes of inflation as the emergence of excess demand for
goods and services in a country ,The excess demand may arise on account of two factors of
two factors:
 Increase in demand for goods and services
 Decrease in supply of goods and service.
Factors responsible for increase in demand
1. Increase in both private and public expenditure
2. Reduction in tax rates increases purchasing power of people .
3. An increase in population result in more demand
4. Liberal credit policy .
Factors responsible for decrease in supply

1. Excess export will leads to shortage of goods and services in the domestic market
2. Shortage of supplies of factors of production
3. Occurrences of natural calamities
4. Hording by traders in anticipation of further rise in price.

Measuring inflation through PIN

Rate of inflation = PINt- PIN t-1 *100

PINt

CONTROL OF INFLATION ( refer control of business cycle)

1. Monetary measures
Traditional measures
 Bank rate policy (BRP)
 Variable reserve ratio
 Open market operation (OMO)

Non traditional measures

 Statutory liquidity ratio(SLR)
 Selective credit control ( qualitative credit control)

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2. Fiscal measures ( refer monetary policy and fiscal policy )

3. Wage control : The government control the wage rise directly by imposing a ceiling on the
wage incomes in both private and public sector .
4. Price control :- when a government resorts to price control ,a maximum retail price of
goods and services is fixed .

DEFLATION
As a situation of fall in prices which causes an increases in the purchasing power of money
,According to the crowther “ deflation is that state of economy where the value of money is
rising or the prices are falling “.

Characteristics

 It is a situation falling price

 Deflation increases the purchasing power of money
 The volume of output invariably goes down due to fall in demand
 Banks face the problem of excess liquidly
 Decline in the national income of a country
 Discourage investment in a country .

BANKING
A bank is an institution which accept deposits from the pubic and makes it available for
those who need it .
The Banking Regulation Act 1949 defines the term banking as “ accepting for the purpose
of lending or investment ,of deposit of money from the public repayable on demand or
otherwise ,and withdrawal by cheque ,draft ,and order or otherwise “.
Modern bank refers to:

 An institution that accept deposit and lend money .

 An institution that create credit .
 An institution that aims at making profit .
 An institution that perform a number of agency and general utility services .

COMMERCIAL BANK
Commercial banks are those banks which accept deposit from the public and lend them for
short periods for trade and industry.

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Commercial bank can be classified into:

Scheduled bank:- banks which are included in the second schedule of the RBI Act is
known as scheduled bank
Non-scheduled bank:- bank which are not included in the second schedule of RBI Act
is known as non-scheduled bank .
Functions of commercial bank

Primary function secondary function

Accepting deposit Lending money

 Fixed deposit over draft

 Current deposit cash credit
 Saving deposit discount of bill of exchange
 Recurring deposit term loan
Money at call and short notice

I. Primary function
a. Accepting deposit :- The most important function of a bank is to accept
deposit from the public .The different types of deposit accepted by a
commercial bank are:-
 Fixed deposit/ Time deposit : - fixed deposits are those amounts deposited for a fixed
period of time and can withdrawn only after the expiry of fixed period .
 current deposit / demand deposit :- Current deposit are those deposit into which
money can be deposited any number of times and from which money can be withdrawal
as many times the depositors wants .
 Saving deposits :- Saving deposits are those deposit which are intended to encourage
saving habit among the general public .
 Recurring deposit :- Recurring deposits are those deposit in which depositor deposit a
fixed sum of money every month for an agreed period .The period for which a recurring
deposit is opened varies between one year to ten year .

Lending money

 Over draft :-An overdraft is a temporary financial arrangements under which a current
account holder is permitted by the bank to draw more than the amount standing to his
credit .

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 Cash credit :-A cash credit is a financial arrangement under which a borrower is allowed
an advance under a separate account called cash credit account up to a specified limit
called cash credit limit .
 Discounting of Bills of Exchange :- A Bill of exchange is an assurance given by a debtor to
his creditor to pay the amount mentioned in the bill on the expiry of a stated period .
 Money at call and at short notice :- This type of loan given by one bank to another bank
or financial institution .
 Term loans:-Term loans are loan granted by a bank for a period exceeding one year .The
amount of such loans is either paid or credited to the account of the borrower. Interest
will charged on the entire amount of the loan and loan is to be repaid either on maturity
or in installments.
 Bridge Loans:- A bridge loan is a form of short term temporary financing for an
individual or business firm until a more comprehensive long term financing is arranged
.Bridge loans useful for venture capitalist ,real estate industry and small investors

Secondary function

Agency function general utility function

Transfer of fund providing locker facility
Collection of cheque , bill promissory notes issue of travelers’
cheque
Execution of standing orders issue of letter of credit
Purchase and sale of securities collection and
dissemination
Collection of dividend on shares of information
Income tax consultancy dealing foreign exchanges
Acting as trustee and executor acting as referee
Issue of ATM card etc…
I. Secondary functions :-
The secondary functions of commercial bank include agency services and general
utility services.
a) Agency services :- commercial bank act as agents for their customers .
Following are the agency services given by a banker on behalf of their
customers .
 Transfer of fund :- Banks helps their customers in transferring funds from one place to
another through cheque ,draft etc..
 Collection of cheque ,bills and promissory notes :- On behalf of the customers ,banks
accept cheque ,bills ,promissory notes for collection .

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 Execution of standing orders :- A standing order is an order given by customer in

writing to his bank for making certain payment on behalf of him .
 Purchase and sale of securities :- Bank undertake purchase and sale of various securities
like shares, stocks, bonds, debentures .
 Collection of dividend on shares :- Banks collect dividend onshares and interest on
debentures for their customers.
 Income tax consultancy :- Bank help their customers in preparing income tax return and
give advice on various issues on tax matters .
 Acting as trustee and executer:- Bank preserve the wills of their customers and execute
them after their death .
b) General utility services:- A modern banker provides many other services in
addition to the agency services .:-
 Providing locker facility :- Bank locker is a place where customers can keep valuables
and important documents for safe custody .
 Issue of traveller’s cheque :- Bank issue traveler’s cheques to facilitate their customers
to travel without the fear of theft or loss of money .
 Issue of letter of credit :- Letter of credit is an important document in foreign trade .A
banker certifies the credit worthiness of his customers .
 Collection and dissemination of information :-Bank collect important information
relating to trade ,commerce ,industry money and baking and publish the same in journal
and bulletins.
 Underwriting securities:- Banks underwrite the securities issued by the government
,public or private bodies .
 Dealing in foreign exchange :- Bank deals in the business of foreign currencies to enable
foreign trade .
 Acting as a referee :- bank act as a referee in cases where any one wants to know
about the customers financial position and business reputation .
 Issue of ATM Cards
 Merchant banking :- commercial banks offer a wide range of services like financial
,technical, managerial services .
 Lease finance :- lease is a mechanism by which a person acquires the use of an assets by
paying a pre –determined amount called rental periodically over a period of time .
 Housing finance :- commercial banks provides factoring services to business concern by
purchasing their book debts and receivables for the purpose of collection ,management
and for providing other similar services .

Credit creation

Credit creation is an important function of commercial bank .credit creation refers to

capacity of a bank to create derivative deposits out of the primary deposit .Primary deposit
means a deposit arising from the entrustment of currency by a depositor . The primary

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deposit enables the banker to create additional deposit which can be called derivative
deposit .
Limitations of credit creation

 Availability of primary deposit :- Higher amount of primary deposit , higher will be its
capacity to create credit.
 Cash reserve requirements :- if the cash reserve requirements is very high then the
capacity to create credit will be very low .
 Availability of good securities :- A bank will lend money only if the borrower are able to
provide good securities .
 Banking habit of the general public :- if the public make increasing use of cheque facility
for settling transactions , then the banks will have better capacity to create credit .
 Economic condition :- during Depression ,there is fall in business activities and
therefore there is less demand for bank credit .hence the bank will be in a position to
create less credit .
 Monetary policy of the central bank :- Depending on economic situation ,the central
bank fro time to time direct the commercial bank to follow a liberal or tight credit policy.
 Availability of borrower :- Availability of borrowers is a preventing force in the process
of credit creation.
 Behavior of other banks :- if some banks do not grant loan to the extent required of the
banking system ,the credit expansion will be restricted .
 Attitude of people .

Reserve Bank Of India

The Reserve Bank of India (RBI) is the central bank of India .It is apex institution that
regulate the monetary system in the country .It was constituted by passing the Reserve
Bank of India Act 1934.
Functions of RBI
RBI perform all the traditional functions of a commercial bank and ,it carries out a number
of development and promotional functions :-
I. Issuing Currency Notes
The RBI hasthe monopoly of issuing currency notes in india .,except one rupee notes
and coin which are issued by the ministry of finance .government of India .RBI issue
and distribute currencies through its two major departments
 Issue department
 Banking department

The issue department is entrusted with the task of proper and efficient
management of the notes issue .The issue department maintain currency chest
.currency chest are boxes where stocks of notes and coins are kept . The banking
department of RBI manage seasonal fluctuations in currency circulation . RBI follows

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minimum reserve system of note issue . According to this system , RBI has to keep a
minimum reserve of Rs .200 crores , out of which Rs .115 crores are to be kept in the
form of gold reserves and Rs .85 crores in the form of foreign exchange reserve .
II. Bankers to the government

RBI acts as a banker to both the central government and state government as a banker to
the government it provides the following services.

 It maintain and operate the deposit account of the central and the state
government.
 It receive and make payment on behalf of the central and state government .
 It manage public debt and the issue of new loans and treasury bills of the central
government .
 It advance money to the central government in times of emergency .(Way and
Means Advances )
 It provides fund remittance facilities to central and state government .
 It act as an advisor to the government on all financial matters
 It represent government of India as a member of IMF and World Bank (IBRD).
III. Bankers bank
RBI controls and regulates the activities of all scheduled commercial bank in India.
 It keeps reserves of commercial banks
 It serves as lender of last resort by meeting the immediate cash requirements
of commercial bank .
 It provides clearance and remittance facilities to commercial bank
 It rediscount the eligible bills of commercial banks during the period of
financial stringency .
IV. Control and management of for foreign exchange :
RBI is entrusted with the task of controlling and managing of country’s foreign
exchange reserves and to maintain the external value of Indian Rupees.It is the RBI
that controls the receipt and payments of foreign currencies .
V. Credit control
RBI control the availability of credit in the Indian economy .It is the commercial
banks that makes the credit available in the economy .
VI. Collection of data and their publication
RBI collects statistical data and economic information through it’s department of
economic analysis and policy .This department conducts research and reviews
financial and banking conditions in the country .
VII. Other development and promotional function
 Providing training facilities to banking personnel at different levels
through various training institutions set up by RBI
 RBI channelizes credit to priority sectors .

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 It make institutional arrangement for rural and industrial finance by

setting up various cells and institutions under it’s control .
 It assist the government in economic planning and take suitable steps
to improve the working of Indian Money Market .
 RBI appoint committees , time to time, to enquire into the problems
of money and banking and to suggest measure to resolve them .

Credit control

Credit control is a mechanism through which the central bank exercises control over the
total money circulation in the country . control of credit means the regulation and control
of bank advances .
Objectives of credit control

 Price stability
 To achieve stability of foreign exchanges
 Elimination of business cycle .
 Economic growth

Methods or weapons of credit control

Quantitative credit control (refer ) Qualitative credit control

Bank rate policy Fixation of margin

requirements
Open market operations Regulation of consumer credit
variable reserve ratio Moral suasion
Variation in SLR Direct action

Qualitative credit control: - aims at regulating the use of credit in order to diversify credit
towards more essential productive use .
a. Fixation of margin requirements: - margin is the difference between the
market value of a security and the amount of loan granted by commercial
banks against a security.
b. Regulation of consumer credit :- means maintaining economic stability by
regulating the demand for consumer durable goods .
c. Moral suasion :- the central bank when the commercial bank request the
entire commercial banks to cooperate with the general monetary policy of
the central bank .

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d. Direct action :- direct action is resorted to by the central bank when the
commercial banks do not follow its instruction and directives .
Fiscal policy
Fiscal policy refers to the policy of the government as regards taxation, government
borrowing and government expenditure with specific objectives in view .

Objectives of physical policy

 Achievement of full employment :-
 Economic stability
 Reducing inequalities of income :-
 Reducing unemployment
Control of inflation :- aggregate demand is reduced by making a cut in government
expenditure or increase in tax .
Instrument of fiscal policy
1. Taxation :- taxis an important source of revenue to the government . It is through taxes
,government finds its resources for public spending .
2. Public expenditure :- public expenditure or government expenditure means the sum of
expenditure of the government on purchase of goods and services, investment in public
sector and transfer payments .
3. Deficit financing :- when the government spends more than its expected revenue ,it is
following a deficit budget policy .
4. Pubic borrowings:- public borrowings include internal and external borrowings by the
government .internal borrowings can be either borrowings from the public through
government bond and treasury bills or borrowings from the central bank .

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Module 3
DEMAND ANALYSIS

According to prof. Hibdon “ demand means the various quantities of goods that would be
purchased per time period at different prices in a given market “.The time may be a day, a
week ,a month ,a year or any period .
The constitute demand for a product the following three conditions should be fulfilled :-
 There should be desire to acquire the product
 The person desirous of acquiring the product should have the ability to pay for it .
 The person should also have the willingness to pay for the product .

Utility :- Goods are demanded to satisfy human wants. Utility means want satisfying power
of a commodity .
Total utility. Economist uses an imaginary measure known as ‘Utils’ to quantify utility .
Total utility is the sum of all utilities which a person obtain by consuming a certain number
of units of a commodity during a given period .
Marginal utility:- Marginal utility is the additional utility obtained from the consumption of
an additional unit of the same commodity .

Law of diminishing marginal utility :- Law of diminishing marginal utility states that
marginal utility obtained from the consumption of a commodity goes on diminishing when a
person consumes more and more units of the same commodity.
According to Alfred Marshall.” the additional benefit derives from a given increase of his
stock of a thing diminishes with every increase stock that he already has”.

Assumptions
The law of diminishing marginal utility operates the following assumption :-
1. All the units of the commodity should be identical in size and quality .
2. The consumer is expected to be a rational human being and main objective is to maximize
satisfaction.
3. There should not be any time gap between the assumption of successive units .
4. The price of the commodity remains constant for all the units .
5. The utility is measurable and can be compared with the price.

Application of the law of diminishing marginal utility

Taxation policy of government
Helps in planning
Increases social welfare
Downward sloping of demand curve
A tool for decision making.

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Exception or limitation of the law

1. The law does not operate in case of money ,alcohol, reading literature and rare
collections .
2. Sometimes marginal utility increases whenever there is a change in other people ‘stock.

Consumer surplus :- consumer surplus is the difference between the price a customer is
prepared to pay for a commodity and the actual price he pays.

Law of demand :- The law of demand states that there is a negative relationship between
price of gods and quantity demanded , holding other factors constant .
Assumption
The income of a buyers remain constant
The taste , preference and habit of the buyers do not change
There should not be any change in the prices of relatedgoods.
Demand curve:- Demand curve is a graphical representation of the inverse relationship
between price and quantity demanded .

Why is demand curve always sloping downwards ?

So the curve DD shows the relationship between price and demand . that is why the
demand curve is sloping downward from the left to right bottom ,
Income effect :- whenever there is a fall in the price ,consumer need to pay less for the
same quantity of goods as he was purchasing before. This will increase his purchasing
power and will have an increasing effect on his income in real terms .
Substitution effect:- when the price of a commodity increases there is a natural
tendency to among customers to substitute more costly products with less costly
products .

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Law of diminishing marginal utility:- demand curve slopes downward because of the
operation of law of diminishing marginal utility .
Various uses :- the inverse price demand relationship will be more in the case of a
commodity which can be put to various uses .
Change in number of buyers :- A fall in price of commodity will attract new buyers who
could not buy it before on account of high prices .
Limitations to the law of demand
 Inferior goods or giffen goods
 Prestige goods
 Consumer expectation
 Consumer misconceptions
 Change in fashion

Determinates Of Demand Of a Commodity .
1. price of the product :-as per the law od demand a commodity will find more demand if
its price is low and less demand if its price is high .
2. consumer income :- whenever there is an increase in consumer income their
purchasing power increases and they can afford to buy more .
3. price of related goods
4. Amount spend on advertisement.
5. consumer preference
6. money supply
7. seasonal goods etc..
8. consumer expectation
9. number of buyers in a market
10. taxation policy
Types Of Demand
1. Direct and derived demand
2. Individual demand and group demand
3. Company demand and industry demand .
Extension and contraction of demand ;- whenever there is a change in quantity demanded
as a result of a change in price extension and contraction in demand take place .
Shift of demand :- when demand changes as a result of a change in factors other than price
,it is called shift of demand .

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Elasticity of demand :- It refers to the degree of response to a change in demand

determinants may vary considerably from the product to product .

1. Perfectly Elastic Demand:- When a small change in price of a product causes a major
change in its demand, it is said to be perfectly elastic demand.

.
2. Perfectly Inelastic Demand:- A perfectly inelastic demand is one when there is no change
produced in the demand of a product with change in its price.

3. Relatively Elastic Demand:- Relatively elastic demand refers to the demand when the
proportionate change produced in demand is greater than the proportionate change in
price of a product.

4. Relatively Inelastic Demand: :-Relatively inelastic demand is one when the percentage
change produced in demand is less than the percentage change in the price of a product.

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5 Unitary Elastic Demand: - When the proportionate change in demand produces the same
change in the price of the product, the demand is referred as unitary elastic demand. The
numerical value for unitary elastic demand is equal to one (ep=1).

Law of demand :- The law of demand states that there isa negative relationship between
the price of a good and the quantity demanded ,holding other factors constant .
Assumption

 The income of buyers should remain constant .

 The taste habit and preference of the buyers do not change
 The buyers should not anticipate any shortage in the supply of a particular
commodity.
 There should not be any change in the number of buyer in the market .
Managerial uses of price elasticity of demand
 determining selling price
 to practice price determination
 helps the government
 pricing of joint products
 international trade
 controlling business cycle
 economic of large scale production
Measurement of Price Elasticity
 percentage method
pe= percentage change in quantity demand
percentage change in price
ep= ∆Q X P
∆P Q

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 Arc method
Pe =∆Q X P+P1
∆P Q+Q1
 Total expenditure
 Income elasticity of demand
ei = percentage change in quantity demand

Percentage change in income

ei = ∆Q X Y
∆Y Q
 Cross elasticity
ei = ∆Q X Py
∆Py Qx
 Advertisement elasticity
ei = ∆Q X A
∆A Q

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Module 4
Production function
Production is the process of transforming physical inputs into physical output .
Production function may be defined as the functional relationship between physical inputs
and physical outputs . It can be expressed as;
Q = f(a,b,c…)
Assumptions
 It has reference to a particular time period
 State of technology does not change
Total product :- Total product of a particular quantity of input is the amount of output
produced by a given amount of input ,keeping the level of all other inputs unchanged .
Average product :- Is the amount of output produced by that input divided by the quantity
of that input used .
Marginal product :- marginal product of any factor of production is the addition to total
product as a result of employment of an extra unit of a factor .
Law of diminishing returns or law of variable proportion
Law of diminishing marginal utility , when more and more units of variable factors are added
to constant other factors , total product and marginal product pass through 3 stages

Stage 1- Increasing Return To A Factor :- In the first stage TP increases at an increasing

rate , then MP also increases and reaches the maximum , AP increases .
Stage 2 – Diminishing Return To A Factor:- In the second stage , TP increases at decreasing
rate , here MP falls and become Zero AP decline , this stage represent diminishing return
factor .

Stage- 3- Negative Return To A Factor :-In the 3ed stage TP starts declining ,then MP
become negative ,AP continuous to decline . this stage represent Negative return to a
factor .

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Assumptions

 Production technology does not change

 The variable inputs is identical
 Only one inputs is varied
 Fixed inputs are indivisible

 Law of return to scale :- return to scale is a long run production . In the long run
,there is no distinction between fixed or variable factors . When all inputs are
changed in the same proportion .TP responds in 3 ways .

 Increasing returns to scale (IRS):- When the percentage change in output is

more than the percentage change in inputs.
 Constant return to scale (CRS):- When the percentage in output is eual to
percentage change in input.
 Diminishing return to scale (DRS):-When the percentage change in output is
less than the percentage change in inputs.
Isoquant :-isoquant represent various combinations of two inputs that can produce same
output .

Properties of isoquant

 Isoquants slope downward from left to right

 Isoquants are convex to the origin .
 Two isoquant never intersect .
Economies of scale
Economies of scale are present when an increase in output causes long run average cost to
fall .The fall in average cost of production is because of increased productivity resulting

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from specialization specialisation increase like production ,marketing ,research and

development etc. The economies of large scale operations may be classified into internal
economies and external economies :-
 internal economies :- According to Alfred Marshall “the chief advantage of
production on a large are economy of skill ,economies may be of the following kinds
;
1. Technical economics :- Technical economies arise out of the use of most modern
production technology which can reduce the cost of production per unit .
2. Economies of labour :- A large firm division of labour is much more specialized than
small firms . Division of labour and specialization increases efficiency of a firm.
3. Managerial economies:- when production is carried on a large scale it is profitable to
group the activities of a business enterprise into production., marketing , finance
,human resources etc.. The qualified and experienced professionals who can direct
their subordinates to perform their tasks in the most efficient way.
4. Commercial economies:- A large firm can have economy in buying and selling of
goods . The economies occurring from buying and selling is called commercial
economies .
5. Economy of capital :- A large firm can satisfy its fixed capital and working capital
requirements without much difficulty .
6. Risk bearing economies :- A large firm is healthier enough to bear the risks
associated with business .
 External economies :- external economies are those economies that accrue to the
whole industry arising from the localization of industry . External economies may be
grouped under the following two heads :-
1. Economies of concentration
2. Economies of information

Diseconomies of scale
Through firms can enjoy economies of scale by expanding the scale of operations , there is a
limit for expanding the size of the firm , beyond a certain limit diseconomies of scale
appears .
“Diseconomies of scale are present when an increase in output causes long run average
costs to increase”.
Pricing policies

1. Cost oriented pricing policy :-

Under cost oriented pricing policy , cost of production is the base on which price of
a price fixed. In this pricing policy the objective of the firm is fix a price that recover
the entire cost of production with a reasonable profit margin .

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a. Cost plus pricing:- The price of a product is fixed by adding a certain

percentage to the average variable cost . The percentage added is called
mark up or margin. The mark up cover the per unit fixed cost and profit .
b. Rate of return pricing :- Target pricing or rate of return pricing is a modified
form of cost plus pricing .Target pricing is a method of pricing in which a pre –
determined target return on capital employed is added with the total cost of
a product .
c. Break even pricing :- break even point is that point of sale where the total
revenue is equals the total cost .It helps a firm to determine the selling prie at
which there is neither profit or loss.
2. Demand pricing policy
Under this pricing policy , the demand of a product ,here cost of production is only
the secondary factor. A high price is charged when the demand is greater and low
price is charged when the demand is low. Demand oriented pricing policy is also
known as customer oriented approach to pricing .
3. Competition oriented pricing policy
The price is charged by competitors is the deciding factor behind the price of a
product .It means that even if there is a change in the cost of production a firm
maintain its price in line with the prices of competitors.
Pricing of new products
1. Skimming pricing
Skimming pricing is a pricing strategy where a high prices charged in the initial
stages of the introduction of a product . This is due to the following reason :-
 There is no competition in the initial stage
 As the product is entirely new customers would like to have the product even
at a higher price .
 More customers can be encouraged to use the product by gradually reducing
the price .
 It helps a firm to skim the cream off the market before entry of of rival firm in
the market .
 High prices can create an impression of a superior product in the firms in the
market .
2. Penetration pricing
Penetration pricing is a pricing strategy where a low price is charged in the initial
stage s of the introduction of a product for the purpose of penetrating into a market
to hold a market position .It suitable for a product having close substitute and face
competition from the existing firms :-
 It helps a firm to gain an entry into the market
 Low price help to attract the customers of competitors
 It helps a firm to make large volume of sale
 It helps to attract customers with low incomes.

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Product life cycle

Product passes through different stages during its life time is called product life cycle

C
B D A=introduction
Sales/profit B=Growth
A C=Maturity
D=Decline
Different stages

1. Introduction stage - I t is a first stage in the life cycle of a product .consumer

awareness is minimum at this stage ,promotional expenses are high and sales
volume is low .
2. Growth stage :- It is a stage of rapid market acceptance and increased sales volume .
3. Maturity stage :- At this stage sales increases but at a diminishing rate., because of
the acute competition from rival firms .
4. Decline stage:- At this stage sales and price decline .In order to sustain in the market
fix very low price and sometimes even below the prices of competitors .

PROBLEMS IN PRICING A NEW PRODUCT

1. Lack of market information
2. Lack of standard:-anew product there is no slandered to compare product attribute
like quality, colour ,weight etc..
3. Heavy promotional expenses
4. Fear of customer rejection
5. Test marketing
6. Production planning
7. Estimation of cost of production .

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Module 5
Market equilibrium
A firm reaches its profit maximizing price and output level , the firm said to be in equilibrium
.In order to determine the equilibrium price and output economist have classifies the
various market :
I. Perfect market competition .
II. Imperfect competition
A. perfect competition :- perfect competition is the name given the industry or market
characterized by a large number of buyers and sellers all engaged in the purchase
and sale of homogeneous commodity , with perfect knowledge of market price and
quintiles , no discrimination and perfect mobility of resources .

FEATURES

 Existence of large number of buyers and sellers – the most distinguishing feature of
perfect competition is the existence of large number of buyers and sellers. In this
market situation, no individual seller or buyer can influence the price of a product,
because the position of an individual seller or buyer is just like a drop in an ocean.
 Identical products – the products dealt with in a perfectly competitive market are
homogenous or identical.
 Free entry and exit – free entry and exit of firms means that a new firm can enter the
industry at any time it wants and an existing firm can leave the industry whenever it
feels so.
 Buyers and sellers have perfect knowledge- in a perfectly competitive market both
the buyers and sellers have perfect knowledge about the market conditions. It
means that each firm in the industry are fully aware about the the price at which
buyers are prepared to buy their products and the extent of business opportunities
open to them.
 Perfect mobility of factors of production – mobility of factors of production like raw
materials, labour etc. is essential for every firm to adjust their production (supply ) in
tune with the demand.
 Assumption into transportation cost – as no individual firm can influence the market
price, the price charged by all firms in a perfectly competitive market will be
uniform.to have uniformity in prices it is assumed that there is no transport costs.

Equilibrium price:- the price at which the quantity demanded is equals the quantity
supplied .The price of a commodity is determined by the forces of demand and supply .

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1. Process of price determination under perfect competition

Prof . Alfred Marshall introduced three times periods for the purpose of determining price
under perfect competition. They are:-
1. Very short period/ market period
2. Short period
3. Long period

Price determination in the market period:- market period is a very short period of one or
two days or up to maximum of one week depending upon the nature of the product.

Perishable goods

The perishable nature of commodities forces the sellers

to sell off the products within time limits they cannot be
stored for the next period. Products likes , fish ,vegetables
etc ..the supply curve in the curve in the case of these
goods will be perfectly inelastic .

Non –perishable goods :- Then non- perishable goods is that these goods
can be stored by the seller if the current market price is not acceptable to them .If the price
is high the whole stock can be sold, and if the price is low some of the stock can be hold
back .

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2) Price determination under short period :- short period is a period during which
producers can adjust to a certain extent the supply of goods in accordance with the
demand situation .supply can be increased or decreased by making changes in the variable
inputs like , material ,labour etc ..The short period supply curve will be less steep than the
market period supply curve .
3) Price determination under long period :- Long period is a period sufficient enough to
make changes in both the fixed as well as as variable factors of production .The long period
supply curve is more flatter than short period supply curve indicating more elasticity in the
supply . The price determined in the long period is called natural price.
B. Imperfect completion
It is a market condition where individual firms can exercise control over the price in
varying degrees depending upon the degrees of imperfection preventing in the
market. Imperfect competition are
 Monopoly
 Monopolistic competition
 Oligopoly

Monopoly :-The word monopoly is derived from the Greek word ‘mono’, means single and
‘poly’ means seller .thus monopoly means ‘single seller
“.Monopoly is that market form which a single producer controls the whole supply of a
single commodity which has no close substitute “.
Features

 There is only single producer or seller for a product

 There is only single seller, the distinction between firm and industry under monopoly
becomes irrelevant .
 The product produced by the monopolistic will not have no close competing
substitutes.
 The cross elasticity of demand for the product of a monopolist is either zero or even
negative.

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 The entry into a monopoly industry is protected by barriers ,legal or otherwise.

 Competition is absent

Process of process and output determination under monopoly

The conditions for Equilibrium in Monopoly are the same as those under perfect competition.
The marginal cost (MC) is equal to the marginal revenue (MR) and the MC curve cuts the
MR curve from below. In this article, we will understand Equilibrium in Monopoly in detail.

A Firm’s Short-Run Equilibrium in Monopoly

Like in perfect competition, there are three possibilities for a firm’s Equilibrium in Monopoly.
These are:

1. The firm earns normal profits – If the average cost = the average revenue

2. It earns super-normal profits – If the average cost < the average revenue

3. It incurs losses – If the average cost > the average revenue

Normal Profits
A firm earns normal profits when the average cost of production is equal to the average
revenue for the corresponding output.

In the figure above, you can see that the MC curve cuts the MR curve at the equilibrium point
E. Also, the AC curve touches the AR curve at a point corresponding to the same point.
Therefore, the firm earns normal profits.

Super-normal Profit :- A firm earns super-normal profits when the average cost of production
is less than the average revenue for the corresponding output

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Losses :- A firm earns losses when the average cost of production is higher than the average
revenue for the corresponding output.

In the figure above, that the average cost curve lies above the average revenue curve for the
same quantity. The average revenue = OP and the average cost = OP’. Therefore, the firm is
incurring an average loss of PP’ and the total loss is PP’BA. In the short-run, a monopolist
sometimes sets a lower price and incurs losses to keep new firms away.

A Firm’s Long-run Equilibrium in Monopoly :- In the long-run, a monopolist can vary all the
inputs. Therefore, to determine the equilibrium of the firm, we need only two cost curves – the
AC and the MC. Further, since the monopolist exits the market if he is operating at a loss, the
demand curve must be tangent to the AC curve or lie to the right and intersect it twice.

As you can see above, there are two alternative cases for the determination of Equilibrium in
Monopoly:

 With normal profits

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 With super-normal profits

What are the three possibilities for a firm’s Equilibrium in Monopoly?

Answer: The three possibilities are:

1. The average cost = the average revenue: the firm earns normal profits.

2. The average cost < the average revenue: the firm earns super-normal profits

3. Or, the average cost > the average revenue: the firm incurs losses

Monopolistic competition :- “monopolistic competition refers to a market situation in

which :- there are many produces producing goods which are close substitute of one
another or where output is differentiated “.
Characteristics

 Presence of large number of buyers and sellers

 Product differentiation
 Independent price policy
 Non price competition
 Large number of buyers
 Free entry and exit
 Selling cost
 Absence of perfect knowledge
 The group concept

PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION:

Under monopolistic competition, the firm will be in equilibrium position when marginal
revenue is equal to marginal cost. So long the marginal revenue is greater than marginal
cost, the seller will find it profitable to expand his output, and if the MR is less than MC, it is
obvious he will reduce his output where the MR is equal to MC. In short run, therefore, the
firm will be in equilibrium when it is maximizing profits, i.e., when MR = MC.

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Group equilibrium: :Group equilibrium relates to the equilibrium of the “industry” under a
monopolistic competitive market. The word “industry” refers to all the firms producing a
homogeneous product. But under monopolistic competition the product is differentiated.

Theory of Group Equilibrium .:- Chamberlin develops his theory of long-run group
equilibrium by means of two demand curves DD and dd, as shown in Figure 3. The demand
curve facing the group is DD. it is drawn on the assumption that all firms charge the same
price and are of equal size, dd represents an individual firm’s demand curve.

Assumptions of Chamberlin’s Group Equilibrium

1) The number of firms is large

(2) Each firm produces a differentiated product which is a close substitute for the other’s
product.

(3) There are a large number of buyers.

(4) Each firm has an independent price policy and faces a fairly elastic demand curve, at the
same time expecting its rivals not to take any notice of its actions.

5 Each firm knows its demand and cost curves.

(6) Factor prices remain constant.

(7) Technology is constant.

(8) Each firm aims at profit maximization both in the short-run and the long- run.

(9) Any adjustment of price by a single firm produces its effect on the entire group so that
the impact felt by any one firm is negligible. This is the symmetry assumption.

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(10) As put forth by Chamberlin, there is the “heroic assumption” that both demand and
cost curves for all the ‘products’ are uniform throughout the group. This is the uniformity
assumption

OLIGOPOLY :- Oligopoly is that market situation in which the number of firms is small
but each firm in the industry takes into consideration the reaction of the rival firms in the
formulation of price policy. The number of firms in the industry may be two or more than
two but not more than 20.

CLASSIFICATION OF OLIGOPOLY:
The oligopolistic industries are classified in a number of ways:

(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is
further classified as below:
(i) Perfect or Pure Duopoly: If the duopolists in an industry are producing
identical products it is called perfect or pure duopoly.
(ii) Imperfect or Impure Duopoly: If the duopolists in an industry are producing
differentiated products it is called imperfect or impure duopoly.

(b) Oligopoly: If there are more than two firms in an industry and each firm takes
consideration the reactions of the rival firms in formulating its own price policy it is called
oligopoly. Oligopoly is further classified as below:

(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are producing

identical products it is called perfect or pure oligopoly.
(ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry are
producing differentiated products it is called imperfect or impure oligopoly

1. Kinky Demand Curve:

The kinky demand curve model tries to explain that in non-collusive oligopolistic
industries there are not frequent changes in the market prices of the products. The
demand curve is drawn on the assumption that the kink in the curve is always at the
ruling price. The reason is that a firm in the market supplies a significant share of the
product and has a powerful influence in the prevailing price of the
commodity. Under oligopoly, a firm has two choices:

(a) The first choice is that the firm increases the price of the product. Each firm in
the industry is fully aware of the fact that if it increases the price of the product, it
will lose most of its customers to its rival. In such a case, the upper part of demand
curve is more elastic than the part of the curve lying below the kink.

(b) The second option for the firm is to decrease the price. In case the firm lowers
the price, its total sales will increase, but it cannot push up its sales very much
because the rival firms also follow suit with a price cut.

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In the above diagram, we shall notice that there is a discontinuity in the marginal revenue
curve just below the point corresponding to the kink. During this discontinuity the marginal
cost curve is drawn. .
Price Leadership Model: Under price leadership, one firm assumes the role of a price leader
and fixes the price of the product for the entire industry. The other firms in the industry
simply follow the price leader and accept the price fixed by him and adjust their output to
this price.
Types of Price Leadership:
(a) Price leadership of a dominant firm, i.e., the firm which produces the bulk of
the product of the industry. It sets the price and rest of the firms simply accepts this
price.
(b) Barometric price leadership, i.e., the price leadership of an old, experienced and
the largest firm assumes the role of a leader, but undertakes also to protect the
interest of all firms instead of promoting its own interests as in the case of price
leadership of a dominant firm.
(c) Exploitative or Aggressive price leadership, i.e., one big firm built its supremacy
in the market by following aggressive price leadership.
Duopoly :- duopoly is a market situation in which there are only two seller either selling
identical or differentiated products .
Monopsony : monophony is a market condition where there is only one buyer in the market
.The single buyer buys the whole of the output produced by all sellers.
Bilateral monopoly :- The term bilateral monopoly is applied to a situation when a
monopoly of purchase is matched with a monopoly of sale .ie,a monopolist is facing a single
monopsonist .

Oligopsony :- Oligopsony is a market situation characterized by the presence of many

sellers and few buyers.

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