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BACHELOR OF COMMERCE (B.COM.

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PAPER 2.1 MANAGERIAL ECONOMICS

UNIT I CHAPTER - I SECTION - I Definition of Managerial Economics Managerial economics refers to those aspects of economics and its tools of analysis most relevant to the firms decision-making process. According to MeNair and Meriam, managerial economies consists of the use of economic models of thought to analyze business situations. Some writers consider managerial economics as the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management. The underlying idea of all these definitions is that managerial economics means economics applied in decision-making. So we may consider managerial economics as a special branch of economics bridging the gap between abstract theory and managerial practice. It may be pointed out here that effective decision-making at the firms level calls for a careful analysis of a choice between alternative courses of action. Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the manager in his decision-making process. In fact actual problem-solving may require many skills and tools which are not available in the traditional economists. For example, knowledge of accounting and of statistical concepts and methods, which are not taught in economics, can help the analyses to apply more effectively the economic tools in a concrete situation. The problems of industrial management do not neatly fall into one academic discipline or another. Rather they tend to out across different disciplines. Managerial economics is pragmatic, it is concerned with analytical tools that are useful, that have proven themselves in practice, or that promise to improve decision making in the future. In the attempt to be practical it cuts through many of the refinements of theory. Managerial economies differs from other discipline in the field of economics in two important respects. First, it is that portion of economics which has to do specifically with managerial decision making. Therefore, it makes a selection from among all the theoretical tools available and those that are directly applicable, empirically based, and thus testable. These qualifications do not mean that these tools are either easier to work with or to comprehend or that they do not require atleast as high an order of economic know-how as the rest of economics. SCOPE OF MANAGERICAL ECONOMIC Haynes and others point out that y definition the scope of managerial economics does not extend to macro economic theory and the economics of public policy an understanding of which is who essential for the manager. This is because there is an important link between the two in so far as the decision at the firm level must take into account the trends in the economy and the impact of a host of environmental factors. Hence in our decision we extend its scope to macro economic theory also. RELATIONS TO OTHER BRANCHES OF LEARNING The simplest way to calrify the scope of field of study is to discuss its relation to other subjects. In this connection it is easy to see that managerial economics has close connection with economics, the theory of decisionmaking, operation research, statistics and accounting. The fully trained managerial economist integrates concepts and methods form all of these disciplines, bringing them together to bear on managerial problems. MANAGERIAL ECONOMICS AND ECONOMICS Managerial economics has been defined as economics applied in decision-making. It is a special branch of economics bridging the gap between abstract economic theory and managerial practice. The primary source of concepts and analytical tools for managerial economics in micro-economic theory or what is popularly termed as Marshallian economics concepts such as the elasticity of demand, marginal cost, the short and long runs, market structures, etc. are all of great significance to managerial economics. Well-known model in price theory such as the models for the monopoly price, the kinked demand theory and the models of price discrimination are also made use of in managerial economics. Macro-economics aids managerial economics in the area of forecasting. Post-Keynesian theory of income and employment has direct implications for forecasting general business conditions. Since the

prospects of an individual firm often depend greatly on business in general, individual firm forecasts depend on general business forecasts, which make use of models derived from theory. A survey conducted in the United Kingdom showed that business economists have found economic concepts such as price elasticity of demand, income elasticity of demand, opportunity casts, the multiplier, propensity to consume, marginal revenue products,. Speculative motive, production function, balanced growth, liquidity preference etc., quite useful and of frequent application. They have also found the following main areas of economics as useful in their works. 1) Demand theory 2) Theory of the firm-price and output 3) Business financing 4) Public Finance and Fiscal Policy 5) Money and banking 6) National income and Social accounting 7) Theory of international trade, and 8) Economics of developing countries. To quote Haynes, et. Al. The relation of managerial economics to economic theory (of either the micro or macro varieties) is much like that of engineering to physics, or of medicine to biology or bacteriology. It is the relation of an applied field to the more fundamental but more abstract basic discipline from which it borrows concepts and analytical tools. The fundamental theoretical fields will no doubt on the long run make the greater contribution to the extension of human knowledge. But the applied fields involve the development of skills that are worthy of respect in themselves and that require specialized training. the practicing physician may not contribute much to the advance of biological theory but he plays an essential role in producing the fruits of progress in theory. The managerial economist stands in a similar relation to theory with perhaps the difference that the dichotomy between the pure and the applied is less clear in management than it is in medicine. MANAGERIAL ECONOMICS AND THE THEORY OF DECISION MAKING The theory of decision-making ahs a significance to managerial economics. Much of economic theory is based on the assumption of a single goal-maximization of utility for the individual or maximization of profit for the firm. It also rests on the assumption of certainty or perforce knowledge. The theory of decision making, on the other hand, recognizes the multiplicity of goals and the existence of uncertainty in the realm of management. The theory of decision making invariably replaces the notion of a single optimum making invariably replaces the notion of a single optimum solution with the view what the objective is to find solution that Satisfice rather than maximize, It inquires into an analysis of motivation, of the relation of rewards and aspiration levels, of patterns of influence on human behaviour. The theory of decision-making, in short, is a reminder of the complexities of decision-making and the frequent needs to compromise pure models to make them useful in actual practice. Again, the theory of decision-making promise to contribute to the improvement of practice by focusing on new problems and suggesting new lines of attack. Managerial economics must take note of these developments. MANAGERIAL ECONOMICS AND OPERATIONS RESEARCH Operations research is very closely related to managerial economics. It is concerned with model building i.e. to the construction of theoretical models that aid in decision-making. Managerial economics applies these models of decision-making. Operations research is often concerned with optimization, econo0mics has long dealt with the consequences of the maximization of profits or minimization of costs. Operations research, as applied to business, generally is concerned with the broad, Overall operation of a company rather than with the details of a specific operation Viewing the business in its entirely, studies are made of he inter-relationship and relative efficiencies of the various aspects of a business in combination, such as sales

production and financing. To find the most effective flow pattern, operations research may encompass the complete cycle of the flow of goods and services from suppliers to company plants, then to consumers. The primary purpose of operations research, as pointed out earlier, is to find the best (optimum) combination of factors to achieve a given objective, whether it be profit, reduction of costs, saving or time, or objectives. The resulting solution serves as a guide to company policy and decision-making. It is the team approach that makes operations research distinctive Operations research teams is usually composed of persons from various disciplines and professions. Because of the company wide approach to problems. Specialists in such disciplines as natural sciences, mathematics, economics, sociology, psychology, etc. are often included in the operations research team. This type of pooling of diverse talents seems to be its distinctive feature. Operations research relies heavily on mathematics and statistics. Most of the best known operations research techniques are mathematical or statistical in character, as opposed to the more subjective and qualitative techniques usually used by management. Thus mathematical or statistical techniques such as linear programming, game theory, queuing theory, and related methods are generally used by operations researchers for analysis and evaluation of the problem. As rightly pointed out by Haynes and others it is not important to determine where managerial economics begins and operations research ends. But it is important to recognize the closer relation of the two subjects and the contribution that each makes to the other. The student who \intends to do mover advanced work in managerial economics should obtain a through training in mathematics and statistics, for the models which are likely to be important, of the future will require considerable sophistication in the use of quantitative methods. MANAGERIAL ECONOMICS AND STATISTICS Managerial economics and statistics are related in number of ways. Firstly it provides the basis for empirical testing of theory. Generalizations in economics, like generalizations in any other science, are subject to empirical test While deductive reasoning has make a central contribution to economics, the results of that reasoning can ever be fully accepted until they are verified against the data from the world of reality. Secondly, statistics is important in providing the individual firm with measures of the appropriate functional relationship involved in decision-making. Thirdly, the theory of probability, upon which many of the statistical studies are made, is also important in managerial economics. Managers generally do not have all or exact information about the variables affecting decision, they must deal with the uncertainty of future events. Under such circumstances the theory of probability comes to the help of the managers in taking decisions. Fourthly, linear programming which is an important statistical technique for treating problems is used by managerial economists to find the best solution or the best alternative. Linear programming is the answer to the dilemmas of the business manager who may find it impossible to undertake personally the study of reports, figures trends and other data necessary in many decision programmes. MANAGERIAL ECONOMICS AND ACCOUNTING Managerial economics is also related to accounting. Accounting is concerned with recording the financial operations of a business firm. Accounting information is one of he primary sources of data required by a managerial economist for the decision-making purpose. For example, the profit and loss statement of a firm indicates how well or ill the firm has done and the informing it contains can be used by he managerial economist to throw some light on the future course of action whether it should try to improve or close down. NORMATIVE VERSUS DESCRIPTIVE ECONOMICS Managerial economics forms a part of normative economics. It tries to prescribe solutions. In other words it is concerned with what decisions ought to be made. The main body of economic theory confines itself to descriptive hypotheses attempting to generalize about the relations among variables, without judgments about what is desirable or undesirable. For instance, the law of diminishing returns is a generalization about what happens to output when variable inputs are added to fixed inputs, involving no judgments about whether the results is good or bad.

Normative economics encompasses those branches of economics which attempt to combine descriptive economics with value judgments to arrive at policy conclusions. Public policy or the economic policy of the government is one form of normative economics and managerial economics is another. There is one interesting feature of normative economics which is of special significance to managerial economics. Some of the main propositions of managerial Economics are heavily deductive. For instance, the statement that profits are at a maximum when marginal revenue is equal to marginal cost is entirely a matter of logic that does not require any check against the facts. A substantial part of economic analysis is of this character, providing a system of logic that is self-contained. But it must be pointed out that it is necessary to fit the correct data into the logical framework to reach specific conclusion about what should be done. And the question of whether a particular line of logic is useful is an empirical issue, requiring a check against the facts. Linear programming is an appropriate illustration. The logic of linear programming is nothing but deduction of mathematical forms. Given certain assumptions, linear programming denotes the logical consequences. But to use liner programming one must have he relevant data on items such as capacities, requirements, cost or whatever is involved. CONCLUSION Economics is the science which studies human behaviour as a relationship between ends and scare means which have alternative uses. In other words, it is concerned with the study of the allocation of scarce resources among competing ends. Problems of resource allocations are constantly faced by individuals, enterprises and nations. During the curse of its development as a science, economics has developed a variety of concepts and analytical tools to deal with the resource allocation problems. The increasing use of mathematical reasoning and statistical methodology in recent years has introduce a great deal of sophistication in this field. Managerial economics refers to those aspects of economics and its tool of analysis most relevant to the firms decision making process. In other words, it is primarily an aid to analysis and decision making in the context of the firm and it stands firmly rooted in the foundation provided by economic theory. It has been enriched by the growing influence of quantitative sciences especially through the medium of operations research. The influence of and advances in management theory ahs strengthened its applied bias and is ability to be an aid in solving the practical problems faced by an enterprise.

UNIT 1 CHAPTER I SECTION II For most purposes economics can be divided into two broad categories. Micro Economics and Macro Economics. Macro Economics is the study of the economic system as a whole. It includes the techniques of for determining the level and change in total exports and imports output total employment, the consumer price index unemployment, rate and exports and imports. Macro Economics address question about the effect of employment and prices. Only aggregate levels of these variables are considered. But concealed in the aggregate data are countless charges in the output levels of individuals firms, the consumption decisions of the individual consumers, and the prices of particular goods and services. Although macro economics issues and policies command much of the attention in the newspapers and television the micro dimensions of the economy also are important end of ten are of most direct application of the day-to-day problems facing the manager. Micro Economics focuses on the behaviour of the individual actors on the economics stage. Firms and Individuals and their interactions in the markets. Managerial economics should be thought of as applied micro economics that is managerial economics is an application of that part of micro economics focusing on those topics of greatest interest and importance to managers. Those topics include demand, production, cost, pricing, and market structure and government regulation. A strong gasping of the principles that governs the economic behaviours of the firms and individuals as an important managerial talent. In general, managerial economics can be used by the goal oriented manager in two ways. First given, an existing economic environment, the principles of managerial economics provides a frame work for evaluating whether resources are being allocated efficiently within a firm for example, economics can help the manager determine if profit could be increased by reallocating labour from a marketing activity to the production lien. Second, these principles help the managers respond to various economics signals. For example, given an increase in the price of output or the development of a new lower cost production technology, the appropriate managerial economics response generally would be to increase output. Alternatively, an increase in the price of one output say labour, may be a signal to substitute other inputs for labour in the production process. The tools developed in the following chapters will increase the effectiveness of decision making by expanding and sharpening the analytical frame work used by Managers to make decisions. Thus, managerial economics can increase the value of both he firms and manager. The Circular Flow of Economic Activity: Individuals own or control resources namely labour capital and natural resources which have value to firms because they are necessary inputs in the production process labour specialties vary from brain surgeons, to street sweepers, capital good range from electronic (Goods to) computers to brooms. Most people have labour resources to sell, and may own capital and or natural resources that are rented, loaned or sold to firms to be used as inputs in the production process. The money received by the individuals fro the sale of these pre sources can then he used to satisfy their consumption needs, demands for goods and services. The interaction between individuals and firms occurs in product market where goods and services are brought and sold and factors market where labour, capital and natural resources are traded.

Product Markets

Product

Firms

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FIGURE 1-1 CIRCULAR FLOW OF INCOME OUTPUT RESOURCES AND FACTORS PAYMENTS These interactions are depicted in Figure 1-1 In the product Market, shown in the top part of the figure, individuals, demand goods and service in order to satisfy their consumption desires. They make these demands known by bidding in the product market for these goods and services. Firms anxious to earn profits respond to these demands by supplying goods and services to the market. The production technology and input costs determine the supply conditions while consumer preference and income (i.e. the ability to pay) determines the price and quantity sold. In the product market, pressing power usually in the form of money purchasing flows, from consumers, to firms. At the sometime, goods and service flow in opposite directions, from firms to consumers. In the factor market shown at the bottom of figure 1-1 the flow are the reverse of those in the product. Individuals are the suppliers, in the tutor market and supply labour services capital, and natural services to firms that demand them to produce goods and services firms indicate their desire for these inputs by bidding for them in the market. The flow of money is from firms to individuals and factors of production, flow in opposite direction. The prices of these products are sets in this market. Prices and profits serve as the signals for regulation the flows of money and resources through the factor markets and the flows of money and goods through the product market. For example, relatively high price and profits in the personal computer industry in the 1990s signaled producers to increase the production and more units of output to the production market. To produce more computer more laborers and capital were required Firms raised the prices they would pay for those resources. The factors market to signal resourced owners that higher returns were not available. The results was rapid growth in the personal computer industry as resources were bid away from the other sources. In the market economy individuals and firms are highly interdependent, each participant needs the others. For example, an individuals labour will have no value unless there is a firm that is willing to pay for it. Alternatively firms cannot justify production unless some consumers want to but their products. As a result, all participants have an incentive to provide what others want. All participate willingly because they have something to gain by going so firms earn profits, the consumption demands of individuals are satisfied, and resource owners receive wages, rent and interest payment of an individuals, does not benefit by buying and selling in these markets, he or she is not required to do so. Thus one can be sure that no individuals is made worse off by voluntary trade in these factor and product markets. THE NATURE OF FIRM:Inside to earn profits, the firm organizes the factors of production to produce goods and services that will meet the demands of individuals consumers and other firms. The other concept of the firms plays a central role in the theory and practice of managerial economics. Thus a significant part of this text is focused on production cost and the organisation of firms in the Market place. These topics for the basis of what is in economics as the theory of the firm. An understanding of the reason for the existence of firms, their role in the economy and their objective provides a background for that theory.

THE REASONABLE FOR THE FIRMSIn a free market economy the Organisation and interaction of production (ie.) firms and the consumers is accomplished through the price system. There is no need for any central direction by the Government, nor is such central control or planning thought to be desirable. Within the firm, however, transactions and the organizations of productive factors are generally accomplished by the general control of one of more managers. For example, workers subjects themselves to also most completely to a management during the work period. Thus there is an apparent dichotomy in the organisation of production in the market economy. The price system guides the decentralized interaction among consumers and firms while central planning and control intend to guide the interaction within the firms. Why does not the price system completely guide the production system) ie. Why do firms exist in a market economy? Essentially firms exist as organizations because the total cost of producing any level of output is lower than if the firms did not exist. Why these costs are lower? First, there is a cost using he price system to organize production. the cost of obtaining information on prices and the cost of the negotiating process would be very burden some firms often the hire labour for long periods of time under agreement that specify only that a wage rate per hour or day will be paid for the workers doing what they are asked. One General contracts covers what usually will be a large number of transactions between workers and entrepreneurs. The two parties do not have to negotiate a new contract every time the worker is given a new assignment. Such Negotiations have transactions costs associated with them. Both Labour and management voluntarily seek out such arrangement. Some Government interference in the market place, applied transaction among firms rather than within the firms. Sales tax, price controls, and rationing usually apply only to transactions between one firm and another. For example, in some area a construction company may have to pay sales tax on cabinet maker By hiring that person this tax is avoided and the cost of production output is reduced. By internalization of some transactions within the firm productions costs are reduced. Because this a secondary factors, firms would exist in the absence of such interference but it probably continues to their bring more and large firms. Given that production costs are reduced by organizing production factors in firms, why wont this process continue until there is just one large firm such as a Giant Honda or Exxon that produce all goods and service for the entire economy? There were two reasons; first, the cost of organizing transaction within the firms tends to rose as the firm gets larger. Logic dictates the firms will internalize the lower cost transactions first and then the higher cost transactions at some point these internal transactions cost will level the cost of transacting in the market at that point the firm will cease to grow. For example all automobile producers in the work by their firms and companies that specialize in the production of rubber products. Hindustan and General parts manufacturers must have considered bulging parts to produce their own tyres. The cost of developing the new management skills required for such a different sort of production and the difficulty of managing an even larger and more complicated business must have been greater than the costs of continuing to buy tyres from the Good year, M.R.F., Modi and Srichakra Another example is legal services. Lawyers are not an integral parts of the production process and their services are contracted on a When needed basis the cost of which for most times is lower in contrast large firms that have a continued need for legal service frequently have on in house legal staff. When the entrepreneur organizational skill is limited sources tithing the company may not be efficiently allocated if the firms size exceeds the managers ability to control the operation to over come this problem, many large firms are organized into a group of division called Profit centers. The Management of each of these seeks to maximize that divisions profit by having a number of smaller organizations each being managed somewhat independently. The problem of limited liability to control the large firms at least partially overcome. Both these reasons for a limit on the size of the firm fall under Diminishing returns to management. Production costs per unit of output will tend to rise as firms grow larger because of limited managerial ability. It should be the problem of excessive size. As a result of decentralization by establishing a number of separate divisions or profit centers that act as individual firms. OBJECTIVE OF THE FIRM

To be able to discuss efficient management of a business or other organisation, to discuss optimal decisions making requires that a goal be established. A management decision can only be evaluated against the goal of the firm in attempting to achieve it. It is generally assumed that manager consistently make decisions in order to maximize profit. But profit in which period? This year? The next five year? Often manages are observed making decisions that reduce current year profits in an effort to increase the profits in future years. Expenditure for research and development, new capital equipment and major marketing programs are but few examples of activities that reduce profits initially but will significantly increase profits in later year. Some managers who must report profit performance monthly or quarterly claim that the pressure for increased short term profits may cause them to make decision that increase the current profits at the expense of long terms profits.

UNIT I CHAPTER - II CONCEPT OF SCARCITY According to Robbins, Economics is the science which studies human behaviour as a relationship between cads and scarce means which have alternative uses. When we analyze this definition, we find out that it lays down three basic prepositions which comprise the main structure of Economic Science. These three are:

1. Ends: Ends here refer to human wants. Our wants are unlimited in number the satisfaction of one want immediately gives rise to another. In view of the multicipility of wants were never reach a stage when al the wants of a person are fully satisfied except after death. Since they are unlimited we have to choose between more urgent and less urgent wants.

2. Scares Means: The wants may be unlimited but the means which are available to satisfy these wants are strictly limited. The economic probe arise because most of the goods are scarce in relation to their demand. According to Prof. Milton Friedeman 66 if the means are not scarce there is no problems at all there is NIRUNA

Here the Scarcity is to be interpreted in a relative and not in our absolute manner. The mere existence of short supply does not lane a commodity scarce, if there is not demand for it.

As Prof Robbin pointed out, the laid eggs though much smaller in number than good ones, are not scarce since in the economics sense, there is no demand whatsoever for laid eggs, which are not at all scarce in relation to their demand. On the other hand, food grains of the order of hundred of millions of tons may be available in the world market are yet food grains maybe scarce because their demand in much greater than the supply.

3. Alternative applications of Scarce Means:

The Scarce means at our disposal should be capable of being put to alternative uses. A commodity with single use alone will not create any economic problem. After being used for a single purpose, the remainder of it becomes free commodity with little economic significance. In reality however, we find that a commodity can be put to several alternative uses, its aggregate demand becomes so large that its existing supply is insufficient to meet it, and the commodity concerned acquires an economic significance.

The alternative uses ot which the commodity can be put should be of varying degree to importance. So that it becomes possible to select the use or the uses to which the commodity is to be put. It case, the various uses hold the same importance then it would become difficult if not impossible to choose the use to which it is to be put.

It is evident that the economic problem. Would not arise unless all these conditions were fulfilled. An economic problem arises either to the manager of the firm or consumer only when ends, Scarce means and alternative applications of Scarce means are fulfilled simultaneously. The Scarcity concept helps us to distinguish

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clearly an economic form a non-economic problem. A country preparing for a war, has to make a choice between GUNS and BUTTER. The problem of choice arises because the means are scarce in relation to the unlimited ends. Time is Scarce and therefore on has to choose between competing ways of spending it. The greatest amount of choice occurs, however in the expenditure of ones income. How much to spend on food, Clothing, rents etc., The managers have to decide the method of production they have to adopt, labour intensive or capital intensive technique. Thus, choice and cost are at the heart of economics.

The Opportunity Cost (also known as Displacement Cost) is the direct outcome of Scarcity of measn in relation to ends. Since all the ends cannot be satisfied with the scarce means at our disposal, choice becomes inevitable. The choice of one alternative means that the other alternative is foregone. A person with a Fifty Rupees note can go to the movie or an One-Day-International Cricket Match because with a fifty rupee note he cannot see both. If he goes to the movie then the opportunity cost of the movie would be the cricket match. Bentham says the opportunity cost of a thing in the last resort is the thing which was most clearly chosen instead of the alternative foregone.

The problem of choice is universal as Eric Roll puts it It exists in the one man community of Robinson Crusoe in the patriarchal Crilo of Central Africa in medieval and feudalist Europe in modern capitalize U.S.A and in communist china. The laws of choice, like the laws of gravitation will be independ of the legal and political frame work. The problem of choice, thus arises in every society irrespective of its legal and political framework.

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CHAPTER II DECISION MAKING AND THE FUNDAMENTAL CONCEPTS AFFECTING BUSINESS DECISIONS No war, no strike, no depression, no depression, can so completely destroy an established business or its profits, as new and better methods, equipment and materials in the hands of an enlightened competitor

Society for the Advancement of Management What is enlightened business management? How can it be identified? What are the methods followed by such management? The answers to these questions lead us to the heart of the management function-decision making. The quality of the decision made by management is the central clue to business success or failure. It is the ultimate test of good (enlightened) management. Let us, therefore, examine the process of decision-making in some detail including the fundamental concepts affecting or facilitating business decision making.

DECISION-MAKING DEFINED A.R.C. Duncan defines a decision as the appropriate response of an intelligent being to a situation which demands action. W Jack Duncan defines decision-making as the act-making as the act of choosing from among alternatives. It is the way in which managers prescribe one course of action in view of the demands of a given situation. According to wheeler, decision-making is the process of selecting a particular course of action from among a number of alternative ways of using resources to accomplish predetermined objectives. Because a decision involves a choice that leads to some specific result the decision-maker must be aware of all the possible consequences that could result from choosing a specific course of action. In other words, the decisionmaker should evaluate the alternatives before taking the decision.

DECISION-MAKING: SOME FEATURES

1) Decision-making is a good-directed activity. Decisions are made to achieve specific objectives or goals.
When the goals or objectives are simple, decision, making also becomes simple. But unfortunately, most decision situations are not that simple. Generally, the choice of an act does not lead to a single certain outcome. The consequence of selecting an act is usually uncertain. This is all the more true when the decision-maker is often forced to strike a balance between sometimes complimentary and sometimes confecting goals. 2) Decision-making is an integral part of management. Decision-making and management are inseparable concepts. It embrances all the functions of management vix., planning, organizing, staffing, controlling and directing. 3) Decision-making conscious intellectual activity. Decision making is a conscious intellectual activity involving judgment evaluation and selection. Though ordinary day-to-day personal decisions are often taken as a matter of habit, business decisions particularly those which involve huge investment of resources are taken after careful analysis. They are subjected to rigorous conceptualization, deliberation, evaluation and verification. 4) Decision-making involves choice. A decision is a choice. More precisely, a decision is a choice among alternative course of action that lead to some pre-determined results. Without alternatives, there is only one course of action available, consequently, no choice can or need be made. However, if a problem can be solved in more than one ways, manages have to make conscious efforts to select the best possible course of action or alternative.

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TYPES OF MANAGEMENT DECISIONS Management decisions are classified under the following head viz. i) ii) iii) iv) v) Organizational and Personal Decisions Basic and Routine Decisions Programmed and Unprogrammed Decisions Individual and Group Decisions Functional Decisions

Organizational and Personal Decision: Organizational decisions are taken by a person in his capacity as a member of an organisation, whereas personal decisions are the individual decisions of a manager. Basic and Routine Decisions: According to McFarland, Basic decisions involve (1) long range commitments of relative permanence or duration (2) large investments or expenditures of funds and (3) a degree of importance such that a mistake would seriously jeopardize the welfare of business Basic decisions cover a longer time period and usually affect the entire organisation or a major segment of it. Such decisions often determine the future direction of the company or organisation. Routine decisions on the other hand, are of, repetitive or recurring nature. They usually cover a shorter time period and affect only a small segment of the organization. Routine decisions are taken on the basis of wellestablished practices, techniques and precedents. Programmed and unprogrammed Decisions: Herbert A Simon groups decisions into programmed and unprogrammed categories programmed decisions refer to the routine and repetitive decision of an organisation. Novel, unstructured and consequential decisions are grouped under unprogrammed decisions. Ingenuity and collective judgment play the most important role in unprogrammed decisions. Individuals and Group Decisions: Decisions which are made by individuals in their capacity as individual managers are known as individual decisions, Group decisions are taken usually on the basis of several individuals, participation. Group decision is also, therefore, known as participative decision. Functional Classification of Decisions: Decisions are also classified into functional categories. Accordingly there can be as many classes of decisions as the number of functions to be performed in a business enterprise. Some examples of such functional decisions are (i) Production decisions (ii) Financial decisions (iii) Marketing decisions, and (iv) Personal decisions.

DECISION-MAKING PROCESS As has already been point out, decision are generally taken on the basis of judgement, intuition, commonsense, logic and/or scientific analysis. Since the biggest problem in managerial decision making is uncertainty no one approach can be considered best in all situations. According to Robert Albense, The best approach depends in such factors, on the nature of the decision problem, time available, the state of technology applicable to the problems, skill and knowledge of the decision-makers, cost-benefit considerations and the degree of certainty in the problem situation. But, when we talk about decision-making process, we are concerned with the rational or scientific approach to decision-making Rational or scientific approach involves a step-by-step analysis of the problem and aims at findings out the most profitable solution. In such an approach, decision-making process is considered to be made up of a number of interrelated steps. Herbert A Simon conceptualizes three major steps in decision-making. They are:

i)
ii)

Intelligence activity i.e. searching the environmental conditions calling for decision Design activity i.e. inventing, developing and analyzing possible courses of action

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iii)

Choice activity i.e. selecting a particular course from those available.

Newman, Summar and Warren classify decision-making process into the following four steps: i) ii) iii) iv) Making a diagnosis Finding alternative solutions Analyzing and comparing alternatives Selecting the plan to flow

In the discussion that follows, the decision-making process is considered to be made up of the following steps. 1) Definition and analysis of the problem 2) Development of alternatives 3) Evaluation of alternatives 4) Selection of the best alternative

5) Communicating and implementing the decision


6) Follow-up action

Definition and analysis of the problem. The first step in decision-making is to define and analyze the problem. Even the most complex decision problems can be solved in they are approached in a logical and consistent manner. Development of alternative solution. The second step in decision-making is the identification and listing of the complete set of viable alternative acts. There is hardly any problem which cannot be solved in more than one way. It is therefore essential for the decision maker to link for as many alternatives as possible. Evaluation of alternative solutions. The nest step in decision-making is the evaluation of alternative course of action. A large number of techniques have been developed for evaluating alternatives. Statistical decision theory or Bayesian decision theory is the foremost among them. But it may be said that judgment and common sense are the primary requirements for evaluating the alternatives. Selection of the best alternative. Evaluation of the different alternatives helps the decision-marker to form an idea of the relative importance of the various alternatives development by him. He has now to select the best alternative in the light of factors such as cost, feasibility and constraints of the critical or limiting factors. Most of the selections are made primarily on the basis of judgment and common sense. Communicating and implementing the decision. Decision taken by managers are generally carried-out by their subordinates. So, decisions have to be communicated properly to those who are expected to implement them. Hence communication assumes a significant role in the implementation of the decision taken. Follow-up action. Follow-up action, as a part of decision-making process, provides a basis for making future decisions or revising he past decisions, if required. So the development of a proper feed back system is a basic requirement for the realization of the objective. The process of decision-making in its simplest form is represented in Fig. 2.1 Definition of the Problem Identification of alternatives Evaluation of Alternatives Selection of the best alternatives Communication and implementation Follow up action

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Variations in the selection Alternatives The simplified model of decision making represented in Fig. 2.1 assumes that only one course of action is selected. But in actual practice, the decision maker may follow a multiple course of action. That is two or more alternatives may be used, or two more alternatives may be continued to form a combined course of action. But

Situation analysis Problem definition Setting up of objective Generating alternatives Evaluation of alternatives Deciding on optical choice Potential problem analysis Implementation Setting up feed back system Must objective Want objective The variation in the decision-making to not in any way modify the essential nature of decision-making process. Only the laternatives are widened. Two famous management experts Charles H Kepner and Benjamin B. Tregore have developed a step-bystep method which has been successfully taught to thousands of managers all over the world and used by renowned organizations such as General Electic. IBM, shell and so on F.G. 2.2 represents the flow diagram of the problem solving process developed by Charles H Kepner and Benjamin B. Tregore. Uncertainty in decision making If everything could be predicted accurately, then decision-making would become a fairly simple process. But when the decision maker cannot control completely then outcome of his decisions, an element of uncertainty is introduced. In business were people are involved and can affect the outcome of decision, there are many circumstances under which the future may be wholly or partly unpredictable. Under such a situation and added burden is placed on the decision maker and this results in three possibilities (1) Complete realization of the objective (2) Partial realization of the objective, or (3) non-realization of the objective. These possibilities are illustrated below. ALTERNATIVE SELECTION OF

COURSE OF ACTION

A COURSE OF ACTION

ACTION CHOSEN

RESOL TO FACTION

Action A Action B Action C Action D DECISOIN A CHOSEN PLAN OF ACTION

COMPLETE REALIZATION OF OBJECTIVES PARTIAL REALIZATION OF OBJECTIVES NON REALIZATION OF OBJECTIVES 15

Because of the presence of uncertainty, the decision-maker must be extremely careful about each step in the process of decision making. He may make use of feedback information system (a simple model of which is given below) for getting better results.

FEEDBACK INFORMATION SYSTEMS FOR DECISION MAKING

SOURCE

INITIAL DATA

PREDICTIONS AND INFERENCES

VALUE AND TARGET

INITIAL ACTION

COMPARE FEEDBACK DATA

SOURCE
Fundamental Concepts That Aid Decisions

PREDICTION AND INFERENCES

VALUES AND CHOICE

ACTION

With full realization that knowledge of the future in uncertain management must nevertheless make decision daily, and they must formulate plants for the future. There are various ways in which decision can be made, ranging from off the cuff guesswork to fully informed conclusions combined with good judgement. Experience has shown that the following five fundamental concepts. Viz the incremental concept, the concept of time perspective, the discounting concept, the opportunity cost concept, and he equip marginal principal, help the management to take correct decisions. Here we propose to discuss each of the these concepts in some detail.

The incremental concept Incremental reasoning involves estimating the impact of decision alternatives on costs and revenues, stressing the changes in total cast and total revenue that result from changes in prices, products, procedures, investments, or whatever may be at stake in the decision. The two fundamental concepts in this analysis are incremental cost and incremental revenue. Incremental cost can be defined as the change in total cost consequent upon a decision. So also, incremental revenue can be defined as the change in total revenue resulting from a decision. A decision is profitable if 1. It increase revenue more than costs 2. It decreases some costs more than it increases others 3. It increases some revenues more than it decreases others 4. It reduces costs more than revenue Implementations of Incremental Reasoning

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Some businessman hold the view that to make an overall profit they must make a profit on every job. Consequently, they often refuse orders that do not cover full cost (variable plus overhead) Plus some provision for profit. But incremental reasoning shows what such action from the side of management is inconsistent with profit maximization in the short run. It can be seen from the following illustration that a refusal to accept business below full cost means a rejection of a possibility of adding more to revenue than to cost. Illustration

Let us assume a case in which a new order will bring in Rs. 100,000/- additional revenue. The cost as estimated by the company accountant is as follows:
Rs. Labour Materials Overhead (allocated at 12% of labour cost) Selling and administrative expense (allocated at 20% of labour and materials cost) Full cost 30,000 40,000 36,000 14,000

1,20,000

From the cost estimates furnished by the accountant the above order appears to be unprofitable. But suppose that there exists idle capacity with which this order could be met. Also suppose that the acceptance of this order will add only Rs. 10,000/- of overhead (the incremental overhead limited to the added use of heat, power and light, the added wear and tear of the machinery, the added costs of supervision etc.) The order in actually doesnt require any selling and administrative expenses as the only part of the labour cost in incremental, since some idle worker already on the pay-roll wil be put to work without any additional pay.

The incremental cost of accepting the above order is given below:


Rs. Labour Materials Overhead Total incremental cost 20,000 40,000 10,000 70,000

From the accountants estimates of costs it appears that this order, if accepted with result in a loss of Rs. 20,000. But from the incremental cost, as it is given above, it appears that the order will result in an addition of Rs. 30,000 in profit.

It may be pointed out here there is some misunderstanding about incremental reasoning. Incremental reasoning does not mean that the firm should price at cost or should accept all orders that cover merely their incremental costs. in fact, changing what the market will bear is consistent with instrumentalism for it implies increasing rates as long as the resultant revenues increase. The acceptance of he Rs. 100,000 order in our example depends upon (i) the existence of idle capacity which would otherwise go unused, and (ii) the absence of more

17

profitable alternatives we would like to stress the fact that incremental concept wants to stress is that a decision is sound if it increases revenue more than costs, or reduces costs more than revenue.

Incremental concept and Merginalism Those who know the elementary principles of Economics will at once recognize the fact that incremental reasoning is very much related to the marginal costs and marginal revenues of economic theory. But it may be pointed out here that there are similaries and differences between incremental reasoning and marginal analysis, both of which demand attention. Firstly marginal costs and revenues are always defined in terms of unit changes in output whereas incremental costs and revenues are not necessarily restricted to unit changes. For example if one unit increase in output results in an increase in costs from Rs. 1000/- to Rs. 1010/- and an increase in revenue analysis (measurement of marginal costs and marginal revenues) enables one to have a micro scopic examination of such unit-by-unit changes. In fact, the decision maker may not be interested in such a microscopic analysis of the situation. His interest may be limited in the sense that he wants to know only whether the decision as a whole is profitable or not. To know this, he will be willing to look at the entire increase in revenue and costs. the defect of this approach is the possibility of ignoring some other change in output within the range that might be even more profitable. But it is often pointed bout that the cost of refinement in much more than the risk involved. Secondly, incremental concepts are more flexible than marginal concepts. As we have already noted, marginal costs and marginal revenue are restricted to the effects of unit changes in put. But decision making, it may be noted, may not be concerned with changes in output at all. For example, the problem may be one of substuting one process for another to produce the same output. The problem is then one of comparing the cost of the first process with that of the alternative. The marginalist language is not particularly suited to this kind of decision. One method of comparing marginal and incremental reasoning is to draw a traditional cost diagram. In the diagram marginal cost is depicted as a curve, rising over most of its range. Let us consider increasing output from 4,000 and 6,000 units what is the marginal cost of this change? It is dangerous to give any answer on the basis of the above diagram. In the range 3000 to 4000 units the marginal cost is comparatively low, but it rises rapidly afterwards. Even to speak of anything like an average marginal cost over this range is to oversimplify and to ignore the dramatic change over the range of output. But many studies of cost functions indicate the existence of constant marginal costs over a wide range of outputs. If this is the case, no error results from substituting a single marginal cost figure for the whole range. Let us consider that the total fixed costs of he firm illustrated below are Rs. 6000/- (per time period). The average variable cost is Rs. 2/- per unit. The marginal cost is also Rs. 2/- per unit. Imagine that the decision involves a choice between an output of 3000 units and one of 6000 units. In the language of marginal cost there is not doubt about how to express the change in cost. It is Rs. 2/- per unit. In the incremental language it is perfectly valid to speak of an addition to total cost of Rs. 6000/-. The question whether marginal costs are in fact constant may be asked at this juncture. If we could be certain of the universal linearity of short run costs, then the problem of decision-making would be greatly simplified. But the difficulty is that there is no consensus of opinion on this point. Studies conducted by Joel Dean Jonston and Yntenia suggest that cost curves are linear and marginal costs are constant in the short run. But studies conducted by Nordin failed to validate the cost linearity hypothesis. So it seems rather dangerous to assume that the constancy of marginal cost in universal.

The concept of Time Perspective Short run and long run are widely known and popularly used economic concepts. The economics use these terms with the precision that is often missed in ordinary discussion. In economics short run refers to a period of time

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which is long enough to allow the variable factors of production to be used in different amounts in order to ensure that maximum profits are earned. But during which the fixed factors cannot be altered in amount. For example, the increase in the output of a department that requires variation in the quantity of labour and materials but not the area of floor space or the number of machines. On the other hand long run refers to a period of time which is long enough to bring about possible, variations in all inputs. Building an entirely new plant is an example. Managerial economists are concerned with the short run and long run effects of decisions on costs as well as revenues. The line between short run of long run revenue (or demand) is even fuzzier than that for costs. the crucial problem in decision-making is to mai9ntain the right balance between the short run and long run and intermediate run perspectives. In other words, the management should take a long-range view of effects on costs and revenue rather than merely a short-sighted view. A decision may be made on the basis of short run considerations, but may, as time passes, have long run repercussions that make it more or less profitable than at first seemed. The following illustration may clarify this better. Assume a firm with some temporary idle capacity. A possible order for 15,000 units comes to managements attention. The prospective e customer is willing to pay Rs. 3 per unit for Rs. 45,000 for the whole lot. The short run incremental cost (which ignores the fixed costs) is Re. 1/- per unit (for Rs. 150,000/- for the whole lot). In spite of this favourable position, before accepting this order, the management must take in to consideration the long run repercussions viz. (1) What will happen if the management commits itself to a series of repeat orders at the same price (2) what will be the reaction of other customers if they come to know about the practice of accepting orders below full cost and (3) will this tarnish the image of the company? The above questions lead to the following conclusion A decision should take in to account the short run and long run effects on revenues and costs, customers reaction and company image etc., giving appropriate weight to the most relevant time periods. DISCOUNTING PRINCIPLE One of the fundamental principles in economics is that a rupee tomarrow is worth less than a rupee today. This means that a differentiation is to be made between cash received at different points in time. Even under conditions of certainty we cannot treat rupees received at different points in time as if they were equal since the earlier we receive a rupee, the earlier we can put ii to use to earn additional money. The underlying assumption there is that, in an economy in which interest and opportunities for investment exist a rupee received today could be invested to earn additional money immediately. A rupee to be received one year hence could not be invested until it is received. Therefore , it is less valuable than a rupee received today. In other words there is a premium for waiting to receive benefits, the longest we have to wait, the more return we should expect on out money. Stated in another way, where there is a time element there is a discounting problem. This demands the decisions-maker in business to use interest theory in the solution of a specific problem with numerical example. It may be pointed out here that discounting is nothing but the inverse of compounding. Both methods seek to demonstrate the fact that a given sum of money in the future differs in terms of purchasing power from an identical sum today. Compounding implies that interest accruing in any one year is added to capital outstanding at the beginning of that year and interest is then charged on the total sum (interest plus capital) during the ensuring year. The following example will make clear the necessity of discounting. Suppose you are offered a choice between a gift of Rs. 100/- today or Rs. 100/- next year. Naturally you will select the Rs. 100/- today. This is true even if there is certainty about the receipt of either gift, as todays Rs. 100/- can be invested and can accumulate interest during the year. Suppose that you can earn 10 percent interest on any money you have at your disposal. If so, by the end of the year the gift will accumulate interest a to become a total of Rs. 110/In other words if a sum of Rs. X is invested in an interest rate or R per cent per annum, the capital will have accured by year end to Rs. X(1+) Interest on this amount is then charged during the second year at a rate of percent per annum so that at year and the capital has grown to Rs. X(1+) (1+) or Rs x(1+). To generalize, we can say that the future worth of Rs. X at percent interest for years is Rs. X(1+)n.

19

Another way of putting the matter that brings out the discounting principle more forcefully is to ask how much money today would be equivalent to Rs. 100 a year from now, Again assume a rate of interest of 10 percent. We must discount the Rs. 100/- at 10 percent, which means that we divide it by 1.10. thus

Rs. 100 V = -----------------1+ Where v = Present value r = the rate of interest =

Rs. 100 --------------------1+ 0.10 = Rs. 90/90

in other words, the present value of Rs. X, n years hence, at r percent interest is x ---------------------(1 + ) The discounting concept is most relevant in investment decision.
OPPORTUNITY COST CONCEPT We have already noted that decisions require choices to be made among alternatives. Wherever one a alternative is chosen in preference to thers, an alternative, or opportunity cost, of some sort is incurred. Thus the decisions of company executives to accept a strike of union workers rather than pay higher wages involves costs to the company, in this case the loss of income resulting from a shut down. On the other hand, the decision to pay higher wages also entails a cost in the amount of the increased wage bill. The principle involved here is that the benefit which can be gained from any course of action is offset in part by the benefits or gains which might come from the selection of alternatives course of action. In rejecting one alternative in favour of another, the potential benefits available from the rejected alternative are an offset or cost to be selected alternative. It can be seen, therefore, that a net loss may occur to the decision maker if he chooses a form of action which has fewer benefits, than an alternative or better course of action. This possibility highlights the importance of careful study and evaluations of the comparative advantage of the various available alternatives. The skilful decision-maker recognizes this, so he attempts to fortify his decision by the collections and analysis of needed information to enable him to predict that course of action which will yield the best results in accomplishing an object. According to Harnes and others opportunity cost of a decision means the sacrifice of alternatives required by that decision. The following examples will clarify the meaning of opportunity cost concept. 1. The opportunity cost of the funds tied up in ones own business is the interest for profits corrected for differences in risk that could be carried on those funds in other ventures. 2. The opportunity cost of the time one puts into his own business is the salary he could earn in other occupations (with a correction for the relative psychic income in the two occupations) 3. The opportunity cost of using a machine to product one any other purpose is nil, since its use requires no sacrifice of other opportunities.

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From the above examples it can be seen that opportunity costs require the measurements of sacrifices. If a decision involved no sacrifices, it is cost free. The expenditure of cash (for the employment of labour, for example) involves a sacrifice of other possible expenditures, and so is an opportunity cost as defined here. Under this broad definition the costs that are relevant for decision making are opportunity costs. In any discussion of opportunity cost, it is useful to make a distinction between explicit and implicit costs. explicit costs referred those costs which are recognized in the accounts. Examples are (i) Payments for raw materials, (ii) Payments for labour, and (iii) Payments for land. Implicit or imputed costs refer to sacrifices that are not recognized in the accounts. Examples are i) interest on the owners capital ii) rent to owners land and iii) salary to the owner. In our definition of opportunity cost both implicit as well as explicit sacrifices are included. It seems desirable to point out here that both incremental cost concept and discounting concept are special applications of opportunity cost concept. When excess capacity exists, it may be that the only sacrifice made in increasing a particular output is in employing variable units. Under such circumstances only part of the costs are reflected in incremental costs. Under conditions of full utilization of capacity or even full utilization of certain bottlenecks in production the incremental cost of any alternative must reflect the sacrifices of other alternative opportunities. An estimate of incremental costs thus requires the application of opportunity cost reasoning. Fox example in the simple problem outlines earlier (in the discussion as incremental concept) on accepting the order, materials cost of Rs. 40,000/- labour costs or Rs. 20,000/- and incremental overhead of Rs. 10,000/- etc., are all opportunity costs because they all require a sacrifice in the form of payment for these factors. The other costs are excluded as they require no such sacrifices in view of the existence of excess capacity. If the entire capacity had been used, the estimate of incremental costs would have included estimates of sacrifices of other alternatives and would have been much higher than Rs. 70,000/Similarly the underlying reason for discounting is that when one ties his capital up in a particular project he sacrifices opportunities to earn profits on other alternatives.

THE EQUIMARGINAL PRINCIPLE An important proposition of economics is that an input should be allocated in such a way that the value added by the last unit is the same in all uses. This proposition is popularly known as the equimarginal principal. Imagine a case in which a firm has 100 units of labour at its command. Also assume this amount to be fixed so that the total payroll is pre-determined. The firm is involved in four activities-activity. A activity B, activity C and activity D. All these activities required the services of labour. The firm can increase any one of these activities by employing more labour, but only at cost of other activities. It is adds a unit of labour to activity. A an increase to output will result. The value of the added output may be termed as the value of the marginal product of labour in activity A. similarly the firm can estimate the value of the marginal product in activities B.C and D. If the firm finds that the value of the marginal product is greater inone activity than another, the firm must reaslise the fact that an optimum has not been achieved. This means that it would be profitable to shift laour from the low marginal value activity to the high marginal value activity and thereby increase the total value of all products taken together. If, for example, the view value of the marginal product of labour in activity A is Rs. 20, while that in activity B is Rs. 30/- then it is profitable to shift labour from activity A to activity B. the optimum will be attained when the value of the marginal product is equal in all activities symbolically this is achieved when.

We are of the view that several aspects of the equipmarginal principle need clarifications. i) The value of the marginal products in our formula are not of incremental costs. for instance, in activity A the addition of one unit of labour may result in an increase in physical output of 20 units. Each unit may sell at Rs. 1/- so that the 20 units will fetch Rs.20/-. But the increased production may also be the result of additional raw material, and/or other inputs and hence the variable costs in activity A (not counting the labour cost) are higher. Let us a assume that the incremental costs come to Rs. 10. This

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leaves a net addition of Rs. 10/- The value of the marginal product which is relevant for our purpose is thus only Rs. 10/-. If there is any disparity in time in the realization of revenues that result from the addition of labour, it is necessary to discount these revenues before compressions in the alternative activities are made. For example activity B might not produce revenue almost immediately. In such a situation only the discounting of revenues will make them comparable. It may be pointed out here that the whole subject of capital budgeting discussed in chapter 9 is based on the above principle. In capital budgeting the resources to be allocated consists of the funds available to the firm. The objective is to allocate the funds where the discounted values of the marginal products are greatest, expanding the high-value activities and reducing the low-value activities until an equality of marginal values is achieved. The equimarginal principle holds good only in cases where the law of diminishing returns operates. To return to our earlier.

Value of marginal product

V.M.P .
Fig. 7 Example, as more labour is added to activity A, we except the value of the marginal product of labour to decline as shown in the above figures.

We would also expect the operation of the law in other activities too in the same way, though each marginal product curve, depending.

V.M.P.A .

V.M.P.B .

V.M.P.C .

V.M.P.D .

Quality Of Labour On technology and other relevant factors, will take different shape figure 2.8 shows four marginal product curves having different shapes. Suppose that our firm allocated 25 units of labour to each activities, as shown in the above figure. Clearly the firm has not equated the values of the marginal products. The value of marginal product in activity d

22

is much higher than the value of marginal product in other activities This means that it is profitable to transfer labour to D, from activities A,B, and C . By reshuffling labour in this way the firm can attain optimum under which the value of marginal products is equal in all activities.

The optimum situation is represented in Fig 2.9 But when the values of marginal products are constant (horizontal marginal value product curves) We need an alternative form of the principle, making use of inequalities rather equalities. This form of the principle may be stated as follows Inputs should be applied first to activities with higher marginal product values before moving to lower values. We would point out there that in addition to the five fundamental concepts discussed above there are certain other relevant techniques viz. Linear Programming, Game theory Queuing theory Brain storming method and concepts such as demand, elasticity of demand, cost concepts, market structure etc. Which aid decision making These concepts are discussed in the subsequent chapters.

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UNIT II CHAPTER I DEMAND, SUPPLY AND PRICING SOME : SOME ELEMENTARY CONCEPTS 3.2 The concept of Demand Function What will be the factors that determine the demand for a commodity? In the case of consumption, the willingness to buy a commodity, that is the demand for that, depends on the factors such as: i) ii) iii) iv) The income of the consumer The price of the commodity Prices of other goods and services on which the consumer spends his income Tastes and preferences of the consumer, size of his family, social customs, expectations and advertisement, etc. Similarly, the case of a firm or producer the input demand for commodity depends on the factors like.

i) ii) iii) iv)

The total outlay or expenditure of the firm The price of that commodity Prices of other substitute and complementary inputs. The nature of technology etc.

For the sake of simplicity let us concentrate on consumer demand for a commodity leaving a side the producers demand at this stage since this will be a mere repetition on consumer demand in a slightly changed terminology. A consumers demand function for a commodity specifies the relations ship between quantity of the commodity that he is willing to buy and the demand factors. In other words, in a demand function, the quantity demanded is expressed as a function of the demand factors for the commodity. In mathematical form we can express the demand function for a commodity as: Qx = Dx (Px Ps Pc Y T) ....... (1)

Where Qs is quantity of commodity X demanded, Px is the price of the commodity, P denotes the price of other commodity which can be substituted for X,P is the price of a commodity which is a complement of commodity X,Y is income of the consumer and T represents other demand factors such as tastes, preference, social customs, etc D indicates the functional form of the relationship. There may be more than one substitute and / or complementary goods for commodity X. in this situation the specification of the demand function of commodity X can be expanded by including their prices. The demand function (1) may be linear or non-linear in shape. If it is linear then it can be expresses as: qx = ao + axPx + asPs + ac Pc + By + cT ......(2) Where a is a constant qx = ao + axPx + asPs + ac Pc + By + cT are also constant parameters called marginal coefficients. These are nothing but values of partial derivative of the function. The interpretation of these coefficients is straight forward. If P increase by one unit, the quantity demanded Q will then change by a units, other variables remaining unchanged. Similar interpretation can be given for qx = ao + axPx + asPs + ac Pc + By + cT . Some of these coefficients may e negative like a. a and some positive like a and b in some cases Why? We will find the reasons for this shortly. If the function is non-linear in shape it implies changing marginal coefficients with the levels of the concerned demand factor. For example the coefficient or P, may increase or decrease on increasing P x. One standard non-linear shape of the consumer demand function is logarithmic shows as:

24

Qx = A Pxxx Psss Py Y T Where ax as ac B and Y are constant parameters (these are elasticity coefficients which will be defined latter on) Some of these parameters may be negative and some positive depending on how the quantity demanded responds to its determinants. We cannot find the shape of the demand function a priority. It is to be determined only on estimating or fitting the demand function. The demand function shown either by (2) or (3) is very complex in the sense that if all determinants on right hand side change simultaneously, we will not be able to say on a priority what will be the change in the quantity demanded unless we have estimates of the parameters. Some parameters of these functions will be negative and some positive, so the net results of a change in Q may be negative or positive. To know the precise nature of the effect of change in all the factors of demand on the quantity demanded of commodity by a consumer, we have to examine the factors individually keeping others as constants. This is the assumption of others things being equal ceteras paribus. Let us do this.

a) The Relationship between Q and P It is a common observation that for most of the commodities the willingness to buy decreases as price of the commodity increase. Exceptions are everywhere for certain very essential goods like medicines, however there may not be inverse relation ship between quantity demanded and price. It may be straight like showing fixed quantity of the commodity that the consumer is willing to buy at different prices. Let us concentrate on the normal case of inverse relationship between price and quantity demanded of a commodity. If we plot the relationship using price and x-axis and quantity on y-axis, the graph would be seen as follows. 3.1 Demand Curve In this curve quantity demand (Qs) responds to price Px. It is called demand curve for the commodity. It is a convention in economics to take quantity on x-axis and price on y-axis while drawing a demand curve as shown in Fig. 3.2 This is for the sake of convenience of representing demand and other curves together understand the process of price determination. The demand curve for a commodity shows the relationship between the price of that commodity and the quantity that a consumer is willing to buy. It is drawn on the assumption that other factors of demand remain unchanged. It is normally a downward slopping curve as we told earlier. In the form of a law we can state the relationship as following. The Law of Demand Other things being equal, the quantity demanded of a commodity varies inversely with its price. Why a consumer buys more of commodity when its price deceases and less when the price increase? Two possible explanations may be give for this at this stage.

Inverted demand curve 3.2 i) When price declines the consumers saves one expenditure which brings him may call this as income effect. more of that commodity. We

ii)

A consumer can substitute that commodity, when its price declines and other prices remaining constant, for some other commodity, This is called Substitution effect. There is a third explanation of declining marginal utility as quantity increase but we will discuss this in the chapter on the theory of consumer behavior.

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b) The relationship between quantity demand of a commodity and prices of other commodities. A fall in price on one-commodity may lower the consumers demand for other commodity or may raise it or leave it unchanged. Those are only three possibilities. Let us take two commodities case, S and X. If prices of say S commodity (P) increases then demand for X commodity goes up. This is possible when these two commodities are substitute for each other, ie.., they are used to satisfy same need separately. Why this happens? The answer is simple. An increase in price of S other things being constant, reduces the quantity demanded for S and increases the quantity demanded for X. The reverse of this will also be true. Consider another set of commodities C and X. If price of commodity C increases, other things being constant, the quantity demanded of C declines and also the quantity demanded of X declines and if the price of C declines then the quantity demanded of C increases but the quantity demanded of X may increase or remain unchanged. This is possible when these two goods are complementary goods i.e. they are used jointly to satisfy same need of the consumer. The third situation concerns with the neutral or unrelated goods. In an increase or decrease in price of one commodity has no effects on quantity demanded of other commodities then they are neutral or unrelated goods. The prices of other goods and services will not appear in the demand function as determinations for such commodities. Fig 3.3 shows graphically the relationships for substitute and complementary goods as discussed above.

Graph

c) The Relationship between Quantity Demanded and Income There are three possibilities for this type of relationship. An increase (decrease) in income of the consumer increases (decreases) the demand for he commodity. The commodities for which we get this type of positive relationship are called normal goods. For certain commodities like foodstuff, a rise in income causes and increases in quantity demanded in the initial stage but after a certain level of the consumers income the quantity demanded becomes invariable with respect to the income i.e. it remains at constant level. For certain commodities, after a certain level of income of the consumer. The quantity demanded starts decreasing with increase in income. The commodities which deposit this type of relationship are called inferior goods. Through a diagram, we can show all the three situation of the income consumption relationship are called as following (See Fig. 3.4)

26

There is a simple generalization of the relationship between consumption of goods and income for a consumer. This is known as Engels Law. According to this la as income increases the proportion of income spent on food declines and the proportion spent on comforts and luxuries increase. This law is quite valid as we see form our own experience as consumers.

d) Tastes and Preferences, Social Customs and Demand These are quite important factors of demand for different commodities. If the tastes and preference of consumes are in favour of a commodity then its demand will increase otherwise not. Social customs are also positive factors of demand for a large number of commodities. Some examples showing the relevance of all such factors for demands are as follows:

i) ii) iii) iv) v)

There is no demand for wheat in South India as there is no preference for bread in this part of the country. People prefer different brand of same commodity because their tastes differ Some students prefer to write by dot-pen and some by fountain-pen Ladies buy sindoor in India since it is social custom to use it on the forehead by Indian ladies. Sweets are offered to Gods in temple in India because of social and religious customs.

Advertisement and other kinds of sales promotion activities are used by business units to induce consumers preference or tastes in favour of the commodities and hence an increase in their demand. From this point of view such activities are treated as additional demand factors.

e) Expectations and other Factors In prices and income are expected to increase, the quantity demanded for certain commodities may go up them. In the situation of rising prices. Consumers generally buy more and stock the commodities for future consumption. If the prices are expected to fall, they may not buy more or postpone certain type of consumption for future. Apart from expectations there might be some other seasonal or temporary factors affecting the demand for a commodity in some way or other Similarly, if income is expected to rise then a consumer may buy more of a commodity since he would be able to pay for this later on.

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3.3 Market Demand By estimating the demand function as discussed above we can find the demand for a commodity for a consumer. What will be the total demand for the commodity in the country as a whole is the next question that we should try to answer. Suppose there are no consumers or customers for a commodity in the market. The total demand or market demand for the commodity will be the sum of quantity demanded by each one of them at a given price for the commodity. In the terminology of economics we call it as horizontal summation of individuals demand to get the market demand for the commodity. Figure

PRICE

PRICE

PRICE

P1

P1

P1

P2 O X1 X2 N2

P2 O Y1 Y2 N2

P2 O Z1 Z2 N2

The demand curves for three consumers 1, 2 and 3 are given in the above diagram. At P price of the commodity consumer 1 buys Ox units of the commodity, consumer 2 but Oy1 units and consumer 3 buys Oz1 units Total market demand for this three consumers economy would be Ox1 + Oy1 + Oz1 units at P1 price and similarly Ox2 + Oy2 + Oz2 + P2 price. Making such additions at different prices, we can finally find the market demand curve for the commodity as shown below.

PRICE

P1

P2 O X1 X2 Qty

The market demand for a commodity depends on the factors like (1) Number of customers in the market, total population or a segment of that may be used for this depending on who uses the commodity (2) level of income in the society and its distribution, say per capital income of the country (3) prices of the commodity (4) prices of the substitute and complementary goods for the commodity and (5) Expectations, lags, preferences and other

28

miscellaneous factors. All of these factors may not be equally relevant for finding the market demand for a commodity. Their contributions depend on the solely depends on population. Demand for writing paper depends on number of students or literate people in the society. One has to be careful in identifying the relevant market demand factors for the concerned commodity.

3.4 Shift of Demand Curve and Movement Along the Demand Curve If income and other determinants of demand remain constant and only price of the commodity changes then we move along the demand curve. These will be a change in quantity demanded simply because of a change in price of the commodity. In this case, the demand curve remains unchanged. The movement along the demand curve is designated as change in quantity demanded. But, if the price of the commodity remains constant and other factors changes then the demand curve shifts it position. This kind of movement of the demand curve is designated as change in demand Remember quantity demanded do change in this case also but it is because of a shift of the demand curve. Panel (a) of Fig. 3.7 shows movement along the demand curve while panel (b) shows the shifts of the demand curves as at a fixed price the consumer buys more or less if his income or any other relevant factor changes.

PRICE

PRICE

O (A) Demand (b) Change in Demand 3.7 Change in Quantity

(B)

If income of the consumer increases (decreases) his demand curve for a commodity shifts to the right (left) indicating increase (decrease) in demand. Other factors remaining the same. In price of any other good increases (decreases) other things remaining the same, then the demand curve for a commodity shifts to the right (left) or left (right) depending whether the other commodity is a substitute good or a complementary good. To explain this let us consider the following situations. Let X be a commodity, say tea, and S be its substitute say coffee. Suppose price of Coffee(P) increases and price of tea (P1) remaining constant. A rise in pride of coffee means less quantity demanded of coffee and more quantity demanded of tea since people now shift to tea. This means at a given priced of tea there is more demand for tea. This implies a rise or shift of the demand curve of tea to the right. The reverse sequences will take place when price of coffee decreases. Now let us take the case of complementary goods say tea leaves and sugar. A rise in the price of tea leaves means less quantity demanded to tea leaves. Since sugar is used in some fixed proportion with tea leaves in preparation of tea, it means less demanded for sugar though is price has not changes. (It is presumed here that tea

29

without sugar is not used by people). The demand cure for sugar therefore shifts to the left showing a decrease in its demand. The demand curve of sugar shifts to the right if the price of tea leaves decline. Now we come to other determinants. If tastes or preferences of consumers change in favour of a commodity then is demand curve shifts to the right showing a rise in demand. Advertisement also shifts the curve to the right but expectations may shift it to the right or left depending on what is expected to change and in what direction. If price of the commodity is expected to rise the demand curve rises i.e., shifts to the right and vice versa. In conclusion, we may summaries the above discussion by saying that a rise in the demand for a commodity i.e., a shift of the demand curve to the right means more is purchased at each price of the commodity. This may be because of increase in income, increase in the price of substitute goods, decrease in the price of complementary goods, an increase in taste, preferences etc. in favour of the commodity and expected increase in taste, preferences etc. in favour of the commodity and expected increase in price of the commodity. The demand curve shifts to the left i.e., a fall in demand means less purchases at each price of the commodity because of decrease in come, fall in the price of substitute goods, rise in the price of complementary goods and changes in tastes, preferences against the commodity.

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UNIT II CHAPTER II 3.8 THE CONCEPT OF ELASTICITY A businessman may not be able to find the contribution of the factors affecting the demand for its product by using the demand function framework and by fitting it to date. It may be too complicated for him. He needs a simple operational approach for this. The elasticity concept is one which meets this requirement of a businessman. The elasticity is used to measure the responsiveness of the dependent variable, say quantity demanded of a commody, to the changes in any one of its explanatory variables like price or income. More precisely, the elasticity in the case of demand is defined as the percentage change in quantity demanded attributable to unit percentage change in a demand factor (ie. Its determinants). Symbolically, we define elasticity as:

% change in Qty Demanded Elasticity Coeff. = ---------------------------------------------% change in Qty Demanded Say X = ( / a) 100 a x (4)

------------------ = ------------ --------x/x 100 x a

This formula is applicable for discrete change in Q and X ie. When we move from one point to another point. Its version for continuous changes in Q and X is give as:

dQ Elasticity Coeff = --------dX

(log

) (5)

--------- -------------Q (log )

This formula gives us the elasticity of demand at a point on the demand curve. It is therefore called pointelasticity. Using the above two general specifications for finding the elasticity. We now go in discussion of various elasticities relevant for demand analysis. (i) Price Elasticity of Demand This shows the responsiveness of quantity demanded of a commodity when price of that commodity changes, other factors being constant. That is.

% change in Qty Demanded Price Elasticity (ep) = ----------------------------------------% of change in Price

In place of % change we can use the term proportionate change also Proportionate change in Qty Demanded Price Elasticity (eP) = ------------------------------------------------------------

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Proportionate change in price

Consider the changes in quantity demanded and price as we move from point A to point B in the following figure (a2 a1)a1 a P1 .....(6) a1

Price Elasticity (eP) = ----------------------- = ------------- -------(P2 P1) / P1 P

For a downward sloping demand curve eP will be negative since either numerator or denominator of the above mentioned formulae will be negative in Fig. 3.17 as we move from A to B point. Is negative. There is a convention in economics to show price-elasticity by a positive number. For this, we simply take the module or absolute value of the right hand side of the above expression or put a negative sigh before the elasticity expression, ie.

| a/a1 |

Q/Q1 ...........(7)

ep |-----------| = -(------------) | P/P1 | AP/P1

Two things are necessary to find the price-elasticity of demand one of the slope of he demand curve and second, the ratio P/Q, At any point on the demand curve we can find the elasticity coefficient (eg) by using the expression

|da

P| or ep =

dQ -(------ ------) dP a

P .... (8)

ep =|----------| |dP Q|

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Whenever we more along an arc of the demand curve and use the discrete formula (Eq. 7) to find the priceelasticity, we find some discrepancy in the values of the elasticity when we more in different direction along the arc. In Fig. 3.17 we use point. A as base to compute the price-elasticity for this now suppose we change the direction of movement i.e., make B point as base and compute the elasticity for moving from B an A we will get another value. This discrepancy in computation of the price-elasticity arises because of either different slope of the demand curve at B and A points or different values for P/Q ratio at these points. To avoid the discrepancy in ep it is better to take the average base for the arc. AB That is, we use the following expression for this

Q ep = ----P

(P1 + P2)2

P1 + P2

------------------ = ---------- ------------- (9) (Q1 + Q2)/2 P Q1 + Q2

This is called Are elasticity of Demand. At any point on the demand curve however, we use the expression (8) which gives us precise value for the price elasticity as the point. Let us take the demand curve q= a-b P. From this we get dq/dp = -b and Therefore, price elasticity ep = -(b.p/d) Since q = a-bP so e-( bP/(a-bP)

In a straight line demand curve as shown below we can measure price elasticity of demand at any point by taking the ratio of the distance between that point to x-axis to the distance between the point y-axis on the demand curve. That is, if we want to measure price-elasticity at point. A then we have to take the ratio of AC/AB for this.

PRICE

MID POINT

At the mid point of the demand curve BC we will get ep = 1 ep will be less than unity on the lower-half of the demand curve and more than one on its upper half in absolute term. Using the formula ep = -(dQ/dP P/Q) we can test the above results. If the demand curve for a community is a curve of the shape given by the equation. Q=A P .... (9)

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This curve gives us constant price elasticity of demand which is equal to .... We can verify this. Transforming the function into the log form we get, log Q = log A _log P

by taking the differentials we get

dQ/Q = -_dP/p

or

dQ

P .....(10)

----- ---- = -_p#O dP Q

This will be curve like a rectangular hyperbola which never meets either P or Q axes. Why to we take percentages or proportions instead of absolute values of P and Q while computing priceelasticity of demand? Can we write e = dQ/dP since this also gives the response of Q when P changes. The answer to these questions is no, because by taking ratios of absolute terms of Q and P we will face the problem of units of measurements of P and Q. for one kind of measurement units of either Q and P we will get on value of the priceelasticity an for the other units we get different values foe ep. Price-elasticity of demand like any other elasticity concept is a number free from the dimension so measurement of Q and P. for this purpose, we take percentage or proportionate changes in Q and P while computing the price elasticity of demand and, in fact, any other elasticity by taking the percentage or proportionate changes of the concerned variables. Consider a demand function as: Q = A P1 P2 P3 Y (11)

Transforming in logarithmic form and taking the partial derivatives, we will get the elasticities of demand with respect to different prices P1 P2 P3 Y as:

o(logQ)
-1

o(logQ)
-2

= ---------------o(logP1)

-----------------o(logP2)

(11)

o(logQ)
-1

o(logQ)
- 2

= ---------------o(logP3)

-----------------o(logY)

(11)

34

This is a very convenient way to compute the elasticities provided the demand function is of the shape as given by

This magnitude of price elasticity in absolute term varies from zero to infinity. Let us consider different ranges of variation in the price-elasticity for interpretation.

a) ep O. This is defined as perfectly in elastic demand. Quantity demanded will be invariable with respect
to changes in price. The demand cure will be vertical line in this case as shown by D. in fig. 3.19 some essential goods like medicines will have perfectly inelastic demand

b) O<ep < 1. This is the case of inelastic demand. Proportionate change in quantity demanded is less than
proportionate. Change in price giving us ep < 1. Most of the essential goods will be inelastic price elasticity of demand. The demand curve for this will be quite steep as shown by D2 line in Fig. 3.19. c) _ep<1 Price elasticity greater than one but less than infinity is defined as elastic demand. Proportionate change in quantity demand will be more than proportionate change in price of the commodity. Most of the luxuries and comfort show this kind of tendency. The demand cure will be flatter in this case as shown by D3 line in Fig. 3.19.

2) Greater the number of uses of a commodity more will be the price-elasticity of demand for that. For
example, if tennis shoes could be used only for playing tennis then not much change in sales could be expected to result from a price change, but in practice tennis shoes are used for general purposes which increases its overall sales significantly making the demand for its quite elastic. 3) The nature of use of a commodity, whether it is essential or a luxury, is another important factor influencing elasticity of demand. Whatever e the changes in prices of such goods a certain quantity is purchased by the consumer. So quantity does not very much as compared to the price of such a commodity. In the case of luxuries or non-essential goods one can postpone consumption, buy more when price decreases or buy less when price increases. 4) Percentage of consumer income that is spent on a good is another factor which influences demand elasticity. Consider for example, newspaper. The demand for is inelastic. A consumer spends a small

35

proportion of his expenditure on it so even if price of newspapers goes up considerably say fro Rs. 1 to Rs. 1.20 per copy, there may not be any effect on this quantity demanded salt, writing paper, fountain pen ink etc., are other commodities for which the above result may hold true. What we can say it that demand for those goods on which a consumer spends very small proportion of his income will be generally inelastic as compared to the demand elasticity for the goods on which the proportion of income spent is high.

5) Another factor that influence price-elasticity is the time horizon of consumption Demand in the short-run
for some commodities may be inelastic but it may be elastic in the long-term. Cooking gas is an example for this. In the short-run because of absence of substitutes its demand is inelastic but in the long-run, other thing being the same, there might be good substitutes for this such as solar energy, elastic heaters which will make the demand for cooking gas elastic. 6) There are other miscellaneous factors such as habitual consumption, durability of goods etc. which affect the elasticity of demand, but they are not so important as compared to the factor discussed above. It is difficult to separate out the influence of the factors as discussed above on the price-elasticity. This is because more than one factors may operate at any given time for any particular commodity or service. They may affect the demand in the same direction or in the opposite direction. For practical purpose, it will be wise to take all factors together rather than going for the influence of individual factors.

(i)

Some Application of Price Elasticity of Demand

Price elasticity of demand is a very useful concept. Apart from its uses in explanation of several economic theories, it has operational significance in decision making. It is also an important factor which determines the shape and position of the demand curve. Some applications of price-elasticity of demand are as follows:

a) If a producer wants to sell more by reducing price of his products he will be guided by the price-elasticity. To show how he will be reacting in this situation consider the following figure:

P1 P2 N

A B P1 P2

C D

Q1

Q2

QTY

Q1

Q2

QTY

Two demand curve are shown separately in parts (a) and (b) of this figure. The demand curve shown in part (a) is steeper showing inelastic demand while the demand curve in part (b) is elastic. Let us take uniform P 1 price that a producer charges in the two separate situations. He sells OQ1 amount of output at this price. The revenue he gets

36

from the sales in the situation as shown in part (a) is given by the area OQ 1AP1(OQ1xOP1). In the second part, he gets similarly. OQ1CP1 revenue. Now let there be a uniform reduction of price in both the situations. As a result of a decrease in price, quantity sold increases, so the new revenue levels in parts (a) and part (b) would be OQ 2BP2 and OQ2BP2 respectively. In which case he gets greater increase in revenue? The gain of revenue in part (a) of the figure Q1Q2BN while loss is P2NAP1 because of less price charged for the unit which he was selling at higher price (P 1) earlier. The net gain to the producer will be the difference to gain and loss ie. Q1Q2BN P2NAP1. This seems to be very low or even negative. in part (b) the net gain would be the difference of the area Q1Q2DM P2MCP1. Just by seeing the diagram it is positive as Q1Q2DM> P2MCP1. What is the conclusion? We can say that a price reduction will increase revenue more if the demand is elastic. This is very important result for pricing of products. A producer will gain by price reduction when its product has elastic demand. He should not reduce price in the situation of inelastic, demand because proportionate change in quantity demanded will be less than the proportionate change in price. Price is decreasing. So demand will not increase by the same proportion which means even a loss to the producer. The reverse situation is also valid, that is, if he wants to increase his revenue by increasing the price he will not gain much if the demand is elastic. Using simple calculus we can prove this as follows:

Let R = PQ

..... (13)

Where R = Total Revenue, P = Product price Q = Quantity sold

Differentiating R with respect to P we get

dR

dQ

------ = Q + P-----dP dP

Dividing and multiplying the second term on the right hand side by Q we have dR -----dP Q + P -----Q dQ -------- Q dP

or dR ---------- = Q (1+ep) dP .........(14)

where (P/Q) dQ -------dP = ep

Since ep is negative so we modify (14) as

37

dR --------- = Q(1-|(ep)|) dP .....(15)

dR/dP is the change in revenue by increasing price by one unit, We find that dR/dP> O. When ((1-|(ep)|) > O or/ep/<1

This is something as we have said above ie. There will be increase in revenue by increasing price when demand is inelastic ep/>1. Its reverse is that there will be increase in revenue by decreasing price when demand is elastic. This is the revenue test of price-elasticity. We find here how important it is for pricing decisions by a firm. b) Consider another application of price-elasticity, We know items in food will generally show inelastic demand. Suppose there is a good corp. of say, wheat, then price of wheat in the market declines. Because of inelastic demand for wheat even though is price has fallen. With a decline in price and simultaneously without increase in quantity demanded of wheat, incomes of farmers decline in spite of good crop. This has policy implications. Government helps farmer in this situation by fixing higher prices that what market charges or by retracting farm output. In the familiar supply and demand interaction diagram. We can show how the government should help the farmers. The point here is that priceelasticity plays very crucial role in the respect. c) A third example showing the uses of price-elasticity is that of introduction of new technology. Suppose new technology is cost saving. The unit cost of production declines when such a technology is adopted for production. with reduction in cost, product price also declines. It depends however on the types of market which we will discuss later on. If there is a decline in price, producer will gain when there is increase in sales. This depends on the price-elasticity of demand. A new cost saving technology will be feasible only if the demand for the products is elastic. If cost declines but price does not, it is a different situation. Producer gains hereby increasing price-cost margin. Again elasticity is coming into picture even in this situation. d) Price elasticity is very much useful in finding the incidence of a tax. This we will explain in detail later on in Chapter? Whether a commodity should be taxes or not, who bears the incidence of such a tax are obviously very important aspects of public policies. The price elasticity of demand is a tool for formulation of such policies.

ii) Income Elasticity of Demand The Income elasticity shows percentage change in quantity demanded when income of the consumer changes by one percent other things being constant. % change in Qty Demanded (AQ/Q, 100)

ey = -------------------------------------------------- = --------------------------- (16) o/o change in income (AY/Y 100)

or

38

ey = ----- ------- where Y = Income Y Q

(16)

At a point, we define income elasticity of demand as dQ ey = Y (17)

----- ------dY Q

Where dQ/dY is the slope of the Income-consumption cure for the commodity. For most of the goods the income-elasticity of demand will be positive. All such goods are defined as normal goods. An increase in income increases the demand for such goods. If income-elasticity of demand is negative, it means the consumption of the commodity decreases as income increases. Such commodity will be defined as inferior good. Among normal goods thee will be certain goods for which income elasticity of demand is greater than one Such goods are called income-elastic as demand for them increases by greater proportion when income changes. Such goods might be called as luxuries. For certain other goods like food or other essential commodities we may have income elasticity positive but less than one. In this situation, we say that demand is income-inelastic. In between, there might be some commodities which we call semi-luxuries for which income elasticity is unity. A knowledge of income elasticity do demand is quite useful one can forecast demand on the basis of income changes. This kind of exercise is done both at enterprise level as well at national level. If income rises by 10% and if income elasticity for a commodity is 2, then the quantity demanded of the commodity would be expected to increase by 20%. Under planning exercises for a county, targets for income growth are fixed for say, 3 years or 5 years. How much would be the demand for different goods and services at the end of the period would be computer exactly in the way at this example shows.

(ii)

Cross Elasticity of Demand

This is used to measure the responsiveness of quantity demanded of a commodity say X when there is a change in the price of some other commodity, say Y Two commodities may be either substitute goods or complementary goods when they are related together. The cross elastics well tell us about their relationship as well ass the interdependence.

Qx Cross Elasticity exy = ---------Py ---------

or dQx exy = ---------dPx Py --------Qx (18)

Where

Q = Aty of commodity X P = Price of commodity Y

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For substitute goods exy will be positive but for complementary goods it will be negative. if the two goods are unrelated then exy = 0.

A knowledge of cross-elasticity is very much essential when two or more goods, or different varieties of same goods are competing among themselves. Such a knowledge will pay crucial role in certain business decision such as pricing, investment, planning advertisement and so on. The inter-dependence between firms in the same or different industries can analyze apart other things, on the basis of cross elasticities of demand for their products.

The concept of elasticity can be applied to other factors such as advertising and other sales promotion activities. We can find, for example, promotion elasticity of demand as proportionate change in quantity demand divided proportionate change in advertisement expenditure for the commodity. The interpretation of the magnitudes of such elasticities can be done exactly in the same way as for the price or income elasticities.

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UNIT II CARDINAL UTILITY ANALYSIS THEORY OF CONSUMER BEHAVIOUR The basic material relating to demand, supply and market equilibrium has been presented in Chapter 3. The demand side of the market for a commodity concerns with consumer behaviour. Hitherto we have simply defined the term demand, identified is major determinants and examined its role in price determination i.e., in market equilibrium for a commodity without going through the analysis of consumers behavioral patterns upto with it is based. In this chapter we discuss this aspect, i.e. we will present the modern theory of demand. We know that consumer is a very important factor in economic system. The goal of economic activities is ultimately to satisfy consumer needs directly and indirectly. Keeping this in mind, we will examine the principles or laws which gives us the tools for the analysis of consumer behaviour in the market.

4.1 The concepts of Utility and Utility Function We start our analysis of consumer behaviour by posing a simple question : Why does a consumer purchase a particular commodity? The answer is simple: using the commodity the consumer satisfies his need or want. He buys food when he is hungry. In a technical terms a consumer purchases a commodity because it has utility for him. The term utility is defined as power of a commodity or service to satisfy human want i.e., to yield a consumer some satisfaction. Consumers preferences of goods and services or any other thing, economics or non-economic, are formalized by the concept of utility. It is a subjective phenomenon. The feeling of satisfaction or utility derived from consumption of a commodity or use of a service may vary from person to person because each persons physiological and psychological make-up is different from every other. There will be several factors affecting an individuals feeling of satisfaction and measurement of all such factors is an extremely difficult task. It not impossible. In view of such difficult economists concentrate their attention on certain basic quantifiable economic variable for explaining consumers feeling of satisfaction or utility. A number of non-quantifiable factors like aesthetics, love, friendship, security etc., do affect human behaviour but economists treat them constant in the consumption time horizon. In other words, the utility analysis carried on by economics runs in terms of quantities of goods and services, income, and prices, keeping all other things constants. A consumer at a time consumes one or more commodities. He gets satisfaction or derives utility by consuming the goods. The level of satisfaction or utility derived by him depends on quantities of the goods consumer. This is a basis hypothesis of the consumer theory. According to this, we say that utiity derived from consumption of a commodity depends exclusively in its quantity other things being constant. In symbolic form we write the relationship between the level of utility and quantity of a commodity consumer as:

Figure

Where Us is a the level of utility, q is the quantity of o-th commodity and f denotes the shape of the relationship. There are n commodities. When all n commodities are consumer simultaneously, the total utility derived by the consumer will be a sum of utilities derived form consumption of individual commodities. That is Substituting the right hand side of equation (1) for U U......we get This may be simplified as This is called utility function

41

A utility function specifies the relationship between total utility derived and quantities of different goods consumed at a time. We have used simple additive principle for getting total utility by summing up the utilities derived from consumption of different commodities. This implies that the utility derived form one good in independent of the rate of consumption of any other gods. This is an assumption which might no the true in practice. However, we take consumption of all goods simultaneously and derive utility from that, which the utility function shows us. The assumption of additives utility is not necessary for this, only it simplifies the complexity of utility analysis. It is presumed that utility can be measured just like any other economic magnitude. This is a cardinal approach for utility analysis. This approach has been challenged by several economists on the ground that utility being a subject phenomenon cannot be measured in terms of numbers, weight or the like. They suggested a different approach by taking the stand that utility level though no measurable, can be compared with each other. This is ordinal approach for utility analysis. In this chapter, we will study both the approaches initially, we will concentrate on the cardinal approach to explain consumer behaviour. Every consumer will have a utility function showing his preferences. This function is assumed to be singlevalues and continuous. By single valued we mean the consumer gets only one level of satisfaction and not two or more when he consumes a given quantities of different goods. If we change the quantity of any one commodity keeping other constant or change the quantities of other goods also then of course he moves to different level of utility. By continuous function we mean that the first and second order partial derivatives of utility with respect to quantities of goods and services can be derived form it. This is a necessary requirement of the function as on its basis we derived from it. The laws which govern consumer behaviours in practice it the consumption activity embodied in the form of a utility function is not continuous them it may be difficult to get any kind of generalized laws or principles regarding consumer behaviour. The level of satisfaction or utility derived from consumption depends on length of consumption period. From example consumption of 10 cigarettes per liour or per day or per week or per month will give different levels of satisfaction. Keeping this in mine, one has to define he consumption period very clearly for which the utility function has been defined. Let us take the first order partial derivative from the utility function There are: U/q1 = F1(q1....qn) U/q2 = F2(q1....qn) U/qn = Fn(q1....qn) U/q1 = F1(q1,q2,qi )

i = 1, ...n

A partial derivative of the utility function is interpreted as the change in total utility by consuming one more extra unit of a commodity keeping the levels of consumption of other commodities constant. In economic terminology, the partial derivatives are called marginal utilities of the commodities for the consumer. Marginal utility of a commodity is defined as the change (or addition) in total utility by consuming one more extra unit of the commodity, consumption of the other commodities remaining the same. If 10 units of a commodity y give 100 units of utility and if 11 units give 115 units of utility, then marginal utility of 11 unit of the commodity is 15 units..
th

How does marginal utility of a commodity change, if the quantity of consumption of the commodity increases? There is a basic law of economics known as the law of diminishing marginal utility which show this. According to this law.

42

A quantity consumed of a commodity increases, the marginal utility of that commodity tends to decline. This say that declines as = q increases. It means the rate of change of marginal utility is negative. this expressed using the second other partial derivatives from the utility function as One can cite several example from real life in support of the law of diminishing marginal utility. Take the example of a smoker. The first cigarette he consumes bring considerable amount of satisfaction to him. The satisfaction derivated from the second cigarette will be lower and this way succeeding units of cigarette give him less and less satisfaction. In fact, he may stop smoking cigarette alter two or three which implies zero marginal utility for any more cigarettes. It may be negative if he goes beyond the level of consumption which gives him zero marginal utility. The variation in total utility and marginal utility as quantity of consumption of a commodity increases can be shown graphically as following :-

Figure Page No. 68

The total utility as shown on the left hand side in the above diagram increases at a diminishing rate, reaches at maximum level for 6 units of he commodity. The slope of tangent at any point on total utility curve gives us marginal utility. Marginal utility is declining continuously. It is zero when TU is maximum. After this, it is negative as TU declines. A rational consumer would never go beyond the zero level of marginal utility while consuming a commodity. The law of diminishing marginal utility is valid only when (1) there is not time-tap between consumption of successive units of he commodity. In other words, consumption is continuous, (2) tastes or preferences of the consumer remain unchanged during the process of consumption : and (3) all units of the commodity are similar in size, quality and other attributes. There are some exception s to the law of diminishing marginal utility. Consumption of liquor defies the law. The more a person drinks, the more he like it giving a positive relationship between marginal utility and quantity of liquor consumed. This may be true initially but there will come a stage when the drunkard starts taking less and less liquor and eventually stops it. Another exception to the law is that of hobbies like collection of stamps, coins, paintings etc. A person derives satisfaction from such collection and the more he collects the relevant item the more satisfaction he gets. This is not true. We find that under hobbies people collect different varieties of the item and not the similar one. For similar varieties we find that his marginal utility declines very fast. Some economists argue that the law of diminishing marginal utility does not hold true for money. Desire for more and more money is a universal phenomenon. Money is not a commodity, rather a medium of exchange and a standard for valuation. It is not consumed but used to buy goods for consumption. So it is unfair to apply the law of diminishing marginal utility to it. Even if we do so, we can safely say that marginal utility of money for a poor man would be more as compared to a rich man. So we can say that marginal utility of money declines with richness and hence the law is valid even in this case. What about marginal utility of diamond? The situation is similar to that of liquor. Initially it may increase but eventually it will decline when there is no more scope for a man for demonstrating his wealth by having diamonds. Why does the law of diminishing marginal utility hold good in practice? The validity of the law is an empirical fact. It is widely believed despite the absence of a generally accepted measuring rod for utilities. What we find in reality if that a consumer may not be able to satisfy all his wants but his desires or wants for individual commodities are suitable. He consumes a commodity of the commodity at this point because he feels that the additional units of consumption would not increase his total satisfaction rather it would be reduced. This implies zero marginal utility of the commodity at the optimum consumption level and negative beyond that point. If this is not so, the consumer would never be situated with the consumption of the commodity. We do not find any support for this. What we observe in practice as consumer is that the feeling of satisfaction from incriminator consumption of a commodity gradually decreases with increase it consumption of the commodity. Greater the total satisfaction already achieved the lessor would be the effect of an extra or marginal unit of consumption. Thus, our own psychological reactions or feelings of satisfaction to extra consumption of a commodity provide the proof for the validity of the law of diminishing marginal

43

utility to practice. How this law helps us in finding the optimal level of consumption of a commodity by a consumer can be demonstrated through a numerical example. Consider the following one. The utility function for a commodity to a consumer is given as U 100 Q A. Where U is total utility and +Q is quantity of the commodity consumer. How much of Q the consumes? We maximize the total utility which gives us the condition for zero marginal utility and hence optimum consumption of he commodity. Differentiating U with respect to Q we get. MU = dU/dQ = 100-2Q. for maximum utility MU=O ie., 100-2Q=0 which means Q-50 units. Beyond this level of consumption we find that MU is negative i.e., aU/dQ=-2 so the consumer will not cross the limit of consumption of the commodity beyond 50 units. 4.2 Consumer Equilibrium : Derivation of the Law of Equal Marginal Utility

A consumer at a time needs several goods and services for consumption. His income is limited and it may not be possible for him to buy whatever he desires. He faces fixed prices of commodities in the market. In this situation how should he decide buying of the commodities? What commodity he should he decide buy and in what amounts that is to say how should he allocate his limited income on various goods and services so that the gets maximum satisfaction or utility? The problem here is that of maximizing total utility of consuming all goods and services subject to the income constraint. The solution of this problem for further discussion, let us make some assumptions to simplify the analysis. The first assumption is that utility is measurable thought cardinal scale. That is what we are assuming so far in the utility analysis. The second assumption is that goods and services are continuously divisible. The third assumption is that goods and services can be substituted for each other. The consumer can spend money on one commodity or the other. This kind of flexibility has to be assumed for attaining equilibrium conditions. The fourth assumption is that the consumer is rational. He has full knowledge about the market i.e. commodities, their attributes, prices etc. lastly, we assume that there is no negative consumption of any commodity.

Given the assumptions cited above, we can formalize a consumers problem as. max. U = f(q1,q2,.......qn) Subject to yo = p1q1+P2q2+.......+Pnqn

Y is fixed income P P...P are fixed prices for q q...q respectively. The constrains specified consumer budget line. The right hand side of this constraint indicates consumers expenditure on different goods and services. The total expenditure cannot exceed total income. The consumer utilizes all his income, that is why we are equating total expenditure to total income. The utility function is assumed to have a maxima otherwise it may be difficult to find the consumer equilibrium position. For solution of the constrained utility maximization problem as specified here we apply the standard Lagrange Method:

The steps involved here are:

a) Find the first order or necessary conditions for a local interior maximum, (b) verify the second order
conditions for this and (c) make sure that the conditions for global maximum are satisfied. Out interest here is in finding the global maximum for consumers utility. Using the utility function (4) and the budget constraint (6) let us define the lagrand function as V = f(Q1,q2,q3,...qn) + /[Yn-P1q1-P2q2-Pnqn] Where is defined as the Lagrange Multiplier. Taking partial derivatives of V with respect to q, = q q and. We get the first order condition for maximum uitility as

44

v/q1 = f1-/P1 = 0 v/q2 = f2-/P2 = 0 v/qn = fn-/Pn = 0 v//=Yo-P1q1-P2q2...Pnqn = 0 Where Fi = aU/aqi = Marginal utility of fifty commodity I = 1 to n

We have equated the first order partial derivatives of the Lagrange function to zero by assuming that the second order conditions for a local and the conditions for a global maximum are satisfied? From the first n equations of (7) we get the relations

F1=/P1, F2=/P2 .....Fn=/Pn or

F1 ---P1

F2

F3

Fn ------ = /

------ ------- ------P2 P3 Pn

or more explicity MU1 MU2 MU3 MUn

------- = ------- = ------- = ------- = MU of Money (= / ) P1 P2 P3 Pn

2. The second order conditions for constrained maximum with one constraint are that the bordered principal minors.

F11 F12 - P1 F21 F22 P2 -P1 P2 O

F11 F12 F13-P1 F21 F22 F23-P2

F11 F12...FN-P1 F21 F22...F2N-P2 Fn1 Fn2 Fnn - Pn

F31 F32 F33-P1

- P1 P2 P3O -P1-P2....PnO

This is the equilibrium condition for maximum utility with income constraint. This relationship says that for obtaining maximum satisfaction (ie. Utility) from consumption of goods and services, the consumer spends his income on these goods and services in such a way that the last unit of money spent on each good or service brings him the same marginal utility. This is the law of equi-marginal utility or the law of commodity substitution.

This is a very important condition for consumer equilibrium. On the basis of this the consumer allocates his income. He must ensure that marginal utility to the marginal utility of money For any pair of commodities we can further write the equilibrium condition as.

45

MU1

P1

MUi

Pi

------ = ----- = ------- = -----MU2 P2 MUj Pj

The ratio of marginal utilities of two commodities must be equal to the ratio of their prices.

The ratio of marginal utilities of tow goods defines the rate of substitution between these goods ie.,

Rate of substitution of X1 for X2 dX2 MU1 P1

------- = ------- = -----dX1 MU2 P2

Let us consider the two commodity case again. We have the equilibrium condition

MU1

MU2

------ = ---------P1 P2

MU1 Suppose

MU2

-------- >---------P1

Here the consumer is getting greater marginal utility per unit of money spent on commodity 1 than the marginal utility per unit of money spent on commodity 2. How he will react to this situation? He increases his expenditure on commodity 1 ie., buys more of it, but as his consumption of commodity 1 increases, the marginal utility derived from that decreases. It means MU/P decreases which will be eventually equal to MU/P ratio for the second commodity. This way he attains equilibrium. The ratio Mu/P must be equal to marginal utility of money. Consider just one commodity. We have the equilibrium condition for consumer in this case as:

MU1/P1 = / (ie., MU of money)

or MU1 = / P1

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Equation (12) expresses a very useful relationship between marginal utility and price of a commodity. Using this relationship we can establish the link, between marginal utility schedule and demand schedule of a commodity. This was done intuitively by Mashall.

When a consumer buys a commodity he gains utility by having it. At the same time he makes a sacrifice of utility of money by paying for the commodity. A rational consumer will buy a commodity if the gain of utility to him is more or atleast equal to the loss of utility of money. The gain of utility whey he buys the commodity is nothing but its marginal utility and the loss of utility of money. This is the same thing as shown by expression (12) which is the condition for the consumer equilibrium. On order to show this simple relationship between marginal utility and price of a commodity graphically, let us consider the information given in Table 4.1

Table 4.1 Derivation of demand Curve from MU curve for a commodity.

Qty. (No. of units) price 1. 2. 3. 4. 5. 6. 7.

MU of Successive units MUn MU12 MU13 MU14 MU15 MU16 MU17

Price per unit Pn P12 P13 P14 P15 P16 P17

Loss of utility of money (MU of money) x / Pn / P12 / P13 / P14 / P15 / P16 / P17

MUn, MU12...MU17 represent marginal utility of successive units of commodity 1 and P11, P12, P17 represent variation in price of the commodity is marginal utility of money. Total utility of money given up for buying each unit of the commodity will be times the price. This is shown in the last column of the table.

Let us assume that marginal utility of money is constant. From the law of diminishing marginal utility we can derive the implication as follows

MU11 > MU12 > MU13 .... > MU17

Since at the equilibrium MU = P so the right hand side will also show similar variation in the price of the commodity as is constant. Therefore, we say

P11 > P12 > P13 > ....... P17

By plotting (13) and (14) against quantity of the commodity we get, marginal utility and demand curves for the commodity. The two curves will show exactly similar variation. Both will be coinciding when /= 1 Demand curve will be above the marginal utility curve when and it will be below the marginal utility schedule when />1. This is the approach followed by Marshall to derive the demand curve form the marginal utility curve. Since marginal utility declines with increase in quantity consumed, so price of the commodity declines with increase in quantity bought. This gives us the

47

explanation of way the demand curve slopes downward apart from the two other reason mentioned earlier in chapter 3. Figure Page N0. 77

If marginal utility is zero, then equilibrium condition MU = / P shows that price of the commodity will be zero since marginal utility of money is nor zero. This is the situation for all free goods. Such goods are freely available to consumers. They consume these goods at the level which gives them maximum total utility. At that level the marginal utility will be zero. There is not question of consuming less of them when they are freely available. The Paradox of value. In practice we find several commodities like water and air which are essential for life. Without such commodities we cannot survive. Their value to life a very high but they are almost freely available. On the other hand, there are some commodities like diamond, which are quite unnecessary for human life but their price is very high in the market. There is thus, a paradox of value which is to be resolve. We known, air and water are essential goods their use value ie., total utility is very high but being almost free goods their exchange-value in market is very low of zero. This is because their marginal utility is zero. The price of a commodity it., its exchange value depends on marginally utility of that commodity and the use value depends on its utility. Thus there are two concepts of value which value depends must be clearly understood to remove the paradox of value seen in reality.

4.3 Derivation of Demand Functions : Generalized Approach Consider the first order condition of constrained utility maximization as expressed by the set of equations (7) we have n+1 equation in the set and the number of unknowns is also n+1, ie., n commodity levels q1 > q2 and qn and / the value for the Lagrange multiplier. The system of equations is therefore soluable. The solution for the unknown would be to express their values in terms of known variables. There are

q1 = -1(P1, P2, .... PnY0)

q2 = -2(P1, P2, .... PnY0)

qn = -n(P1, P2, .... PnY0) and / = / o(P1, P2, .....Pn, Yo)

Where -1-2,.....-n and /o are functional relations These equations are demand functions for the different commodities. In each specification, we are expressing the quantity demanded as a function of price of the concerned commodity, prices of other commodities used by the consumer and his income level. The other things like tastes, custom, expectations etc. mentioned as additional demand factors are treated to be constants. Intuitively, we have specified such demand function for a commodity in chapter 3. Here we have used the consumer equilibrium theory to derive them. They are related to the utility function from which they hate been deduced. Let us consider an example with two commodities. There utility function and budget constraint for a consumer are given as U = q1.q2 and

48

yo = P1q1+ P2q2 For maximizing (16) subject to (17) as constraint, we write the Lagrange function as

V=q1q2 + / [Yo-P1q1-P2q2] By taking the partial derivatives of V with respect to q1,q2 and / and equating each one of them to zero, we get,

V/q1=q2 - /P1 = O

V/q2=q1 - /P2 = O

and V// = yo-P1q1-P2q2=O and we get Yo Yo

q1 = --------- q2 = ------------2P1 2P2

As we have mentioned earlier, the shape of the demand curve for any commodity depends on the nature of the utility function. In this example the utility function is such that it gives exactly similar demand function for the two commodities. Demand for each one depends directly on income ( ) and inversely with price of the commodity. The marginal utility of money ie., can also be found from the system of firs order maximization conditions. In the above example it is Y / = ---------------2P1P2 If the utility functions are given as U log(q.q) the solution or expressions for demand functions derived from them would be exactly similar to (22) when U = q q. The value of ofcourse, will change. All these utility functions belong to the same class ie. they are monotonic transformation of each other and therefore represent the same preference ordering of the consumer reflecting the same behaviour. We have defined / as marginal utility of money. Let us show how this interpretation of / is valid. Consider the first order conditions of constrained utility maximization expressed by the equations set (7). We find that at the equilibrium / is equal to marginal utility of any good divided by its price. That is Fi = U/q1 = / Pi or / = 1/Pi(U/Pi)

Since, Pi is constant we can take it inside the bracket in the denominator U / = ------------------(P1q1)i

49

P1q1 shows the expenditure on its goods. At the equilibrium and additional unit of money spent on good i(i=q..n) therefore, provides the same increase in utility. (unit change in P is one unit of expenditure ie....of money) We can, therefore, say that is the change in maximized value for utility as income changes.

/ = U/Y or / = 1/Pi U/q1

Further, we can show it by using some mathematical expressions.

U = F(q1, Q2)

By taking total differential of this, we have dU = F1dq + F2dq2

the income constant is Y = P1q1+P2q2

By taking total differentiation of this, we have

dY = P1dq1 + P2sdq2, P1 & P2 are constant

from maximization condition we have the equilibrium condition

F1-/P1=O, F2-/P2 = O

Substituting values for F1 and F2 in (25) we get

dU = / P1dq1 + / P2dq2

dividing (27) by 26) we have

dU

P1dq1+P2dq2

------ = / [ -----------------------------] = / dY P1dq1+P2dq2

So, marginal utility of money equals /

50

The demand functions derived above the homogeneous of degree zero in prices and income ie. if all prices and income change in the same proportion then the consumer equilibrium position, will not change and quantities demands will also be unchanged.

Let us reformulate the budget constraint of the consumer as

KYo = KP1q1 + KP2q2

Using the utility function U = F(q1q2) Langrange function for maximization U will be

V = F(q1,q2) + / [KYo=KP1q1=Kp2q2]

From this we have

V/q1 = F1 - / KP1 = O

V/q2 = F2 - / KP2 = O

V//

= KYo-KP1q1 KP2q2 = O

This gives us the equilibrium situation as F1/F2 = P1/P2 = K/

This is same as before except a change in the marginal utility of money which is now K/. The quantities demanded would be a function of KP1 KP2) and KYo instead of (P1, P2, Uo) but they will not be different in these two situations. The second order conditions will also not change and so, we can safely say that demand functions are homogeneous of zero degree. There is a practical applications of this property. If income and prices are changing in same proportion then one need not to worry about inflation since real consumption of goods and services will not be affected by this. They property of zero degree of homogeneity of the demand function is a kind of restriction. If this is so, we can use it further to derive the relationships between price-elasticity and income elasticity of demand for a commodity. For this, let us take the help of the Eulers there according to which a function Z = _(x,y) is homogeneros of degree r if the following condition is satisfied. z n z

--------- + Y ------------ rz n y

If we take a demand function for a commodity I as: qi = _(P1, P2,P3,.........y) and apply the above theorem to it,

51

we get,

qi P1

qi

qi

qi

----------- + P2 ------------ + .......... + Pi ------------- + .... + y ----------- = O P1 P2 Pi y1

Since r=O (Demand function being homogeneous of degree zero) i=1,...n

Dividing both the sides by qi, we have

P1

qi +

P2

qi

Pi

1i

V -------y

qi

----- -------qi P1

-------- ------- + ... -------- ------- + .... + -----qi P2 qi Pi qi

Each element in this equation is an expression for the elasticity. So, we have the sum of own and cross elasticities of demand for a commodity I equal to minus of its income elasticity of demand. This is an important result which we derive from the property of zero degree of homogeneity of the demand functions for different commodities. 4.4 Limitations of Cardinal Utility Analysis The utility analysis discussed above is essentially based on cardinal approach ie, the basic assumption for this was that utility can be measured through cardinal scale of measurement as, in terms members of utilize . This assumption gives serious doubt about the validity of the entire analysis. Utility being a subjective phenomenon cannot be measured by numbers or weight or anything like that. If this is so, then the theory of consumer analysis based on cardinal approach is not verified. Marshall who was a strong supporter of the cardinal approach of utility analysis to some extend agreed with this criticism but the pointed out that utility is measurable indirectly if not directly. A persons satisfaction on utility derived from consumption of a commodity can be measured indirectly by the amount of money he is willing to pay for that. For each unit of commodity how much price he is willing to pay gives us a measurement of utility of that unit of commodity. the units of price multiplied by the marginal utility of money is equivalent to the marginal utility of the commodity at the equilibrium (MU=/ P as we have been earlier). The marginal utility of money (/) is taken to be constant by Marshall. Even the approach of indirect measurement of utility using monetary units has been challenged by economists. The reason for this was mainly the unstable value of money. When it value is not stable how can it be used as a measuring rod for utility? What is needed of measuring utility at all? We use this concept to understand theoretically the behaviour of a rational consumer and derive the demand function in ex-ante sense from this. The demand function will have all measurable variables, quantity of the commodity on one side, prices and income on the other. Using data for all such variables, we can estimate the demand functions for commodities. This is the objective of the entire utility analysis. Measurement of utility is not necessary for this although it is desirable.

There is another serious limitations of the cardinal utility analysis. We know a demand curve slopes downward because of substitution effect and income effect. These two effects cannot be isolated using he above frame work of utility analysis. There are some other drawn backs such as its failure to analysis demand for indivisible goods, inferior goods, etc. But these are minor issues. By and large, the whole theory based on the cardinal approach

52

is highly abstract in nature, It does not explain all aspects of consumer behaviour but the major issues have been tackled well by this theory.

4.5 The Indifference curve Analysis (ORDINAL UTILITY ANALYSIS) 1. Concept This is an alternative approach developed by economists like Edgeworth, Fisher, Slutsky, Hicks and Allen to analysis consumer behavior. In this approach, the emphasis sis given on comparing different utility levels instead of measuring them through some cardinal scale. In other words, this approach is based on ordinal measurement of utility. Under ordinal measurement scale, the alternatives can only be ranked such as greater or smaller, higher or lower and the like. The approach of indifference curves for analyzing consumer behaviour is based on certain basic assumptions. The assumptions are as follows:

i)

There is complete consistency in ordering of preferences by the consumer. For example if two alternative bundles of consumption goods A and B are available, then the consumer must state either I prefer A to B or I prefer B to A or A and B are equally preferred The consumer is not in the state on indecision. Along with the complete consistency we expect that the consumers preferences are not selfcontradictory or conflicting with each other. This is the assumption of transitivity. This means if A is preferred over B and B is preferred over C then A is preferred over C. An individuals preferences are such that he prefer more or less. It means that the individuals is not satiated atleast not in all goods. Keeping the consumption of other goods constant and increasing consumption of atleast one good is definitely a better situation. The goods consumed by the consumer are substitutable. The satisfaction or utility can be maintained at the same level by consuming more of some good. All commodities in the consumption basket of the consumer are divisible. Individuals are rational in decision-making. This is a requirement for the consumer equilibrium analysis in general and not for only the indifference curve analysis. Further, we assume that eh preference scheduling of one consumer is independent of the preference schedules of other consumers. It means that there is absence of curve analysis is state in nature. It presumes certainty regarding the decisions situation faced by a consumer.

ii)

iii)

iv) v)

vi)

Given the conditions as specified by the above assumption, the indifferences curve technique as we have mentioned earlier, compares the different levels of satisfaction or utility rather than measuring them. This is the approach adopted for utility analysis. The indifference curve is a locus to different combinations of two or more goods which yield the same level of satisfaction or utility to the consumer. Ti is also called as iso-utility curve. Graphically, we can demonstrate an indifference curve as shown in Fig. 4.3

Figure Page no. 86

For the sake of simplicity we take two commodities Q and Q into consideration for drawing the indifference curve. In practice the number of commodities in the consumption basked will be more than two and different combinations of such goods yield some fixed level of satisfaction, but it is not possible to show it graphically. We, therefore, confine the indifference curve analysis to a case of two commodities. Point A,B,C,D and E show the different combinations of Q1 and Q2 commodities that yield a constant level of utility U 1. By joining these points we get

53

the difference curve as shown in the figure. The shape of he curve is convex towards the origin and it is downward sloping. We will be showing why it is so and what are the other possibilities for this. When we mover from point A to point B the consumption of commodity Q2 decreases by two units and consumption of commodity q1 is therefore -2/Q1. Minus sign indicates decrease ion Q2. This is approximately the slope of the indifference curve between A and B. when we more further from point B to point C the decrease in consumption of Q2 is only by one unit and increase in consumption of +Q2 for also by one unit. This implies that the consumer is giving up now only one unit of Q 2 for one additional unit of Q1. The rate of substitution of Q2 per unit of Q1 is now -1. As we move still further to D or E we observe that the consumer gives up less and less quantity of Q2 per additional of Q1 ie., the rate of substitution of Q2 by declines in magnitude. The rate of substitution of Q2 by Q1 is called Rate of commodity substitution (RCS) in expanded from. It is computed at the margin (implying very small changes) so alternatively we call it Marginal Rate of Commodity Substitution (MRCS). When we use the term RCS for this it is implicit that it is MRCS. The rate of commodity substitution or marginal rate of commodity substitution is that amount of a commodity, say Q2 to be given up per unit of another commodity say Q1 for consumption if the consumer remains on the same indifference curve. In the consumption process we are substitution one commodity for the other but maintaining a constant level of utility derived from this. This is precisely what the RCS of MRCS tells us. In symbolic form the RCS or MRCS is denoted by. qe or dq2 where q2 or dq2 express the change in q1 dq1 quantity of commodity Q2 and q1 or dq1 is the change in quantity of commodity Q1. Why does the marginal rate of commodity substitution decline when we move along the indifference curve? Is it because we have drawn the indifference curve as a convex line towards the origin or these is a sound economic reason for that? Let us examine this issue. A consumer (s marginal rate of commodity substitution between the gods (Q2 and Q1) for a constant levels utility will in some way, depend on how many units of Q2 and Q1 he or she is currently consuming. Consider the point A in Fig 4.3 At this point the consumer consumes much more (6 units) quantity of Q2 as compared to the quantity of Q1 (two units). He is willing to give up two units of Q 2 for one unit of Q1 and thus, moves to point B. at this point consumption of Q2 decreases to 4 units and consumption of Q1 increases to three units. He is interested in increasing consumption of Q2. But this time, he is willing to give up only one unit of Q2 for one additional unit of Q1. As he moves down further, the willingness to give up units of Q2 for each additional unit of Q1 decreases further. Thus what we are observing here is that the willingness to give up the commodity Q2 in favour of the other commodity (Q1) directly relates to the quantity of Q2 greater the quantity of a commodity already consumer the higher will be the willingness to give up a part of the commodity in favour of some other commodity and vice-versa. This explain why the magnitude of the marginal rate of commodity substitution of Q2 for Q1 declines as we decrease quantity of Q2 and increase quantity of Q1. The consumer prefers a balanced consumption of different goods. Too much consumption of one good induces him to substitute it for the other good in greater extent as compared to the extent of its substitution for the other when its consumption is low. The declining of the MRCS can be explained in a better way by using the marginal utility concept. From the law of diminishing marginal utility we know that there is an inverse relationship between quantity of consumption and marginal utility. When we decrease quantity of consumption of a commodity in favour of another, We marginal utility of the other commodity decreases. In the above diagram we have the sequence of decreasing quantity of Q 2 and increasing quantity of Q1 as we move from A to E point on the indifference curve. Decrease in the quantity of Q 2 means increase in its marginal utility and increase in the quantity of Q1 means decrease in its marginal utility. When marginal utility of Q1 declines then lees and less quantity of Q2 will be substituted for one unit of Q1. To make it easier to understand we can bring the analogy of falling value of money. When the value of money falls then one rupee will fetch lesser amount of any commodity. This is the reason for diminishing rate of substitution and its is this diminishing rate of commodity substation which makes the indifference curve convex towards the origin. Details of the indifference curve convex towards the origin. Details of this property of the indifferences cure are presented in the following section.

54

Properties of Indifference Curve (a) An indifference curve is downward stopping and convex towards the origin. To prove this mathematically, let us consider the utility function.

U = F(q1,q2)

By taking total derivaties of this function we have

U dU =

------------ dq1 + ---------- dq2 q1 q2

By the definition of the indifference curve, utility does not change when we move along the curves. So we can write dU=O. This gives us.

U O =

------------ dq1 + ---------- dq2 q1 q2

or dq2 ------------ = dq1 U/q1 ------------U/q2 F1 = --------F2

dq2/dq1 is the slope of the indifference curve. Its negative i.e., - dq2/dq1 is the marginal rate of commodity substitution. So equation (35) simply says that marginal rate of commodity substitution is equal to the ratio of marginal utilities of the two goods. A rational consumer will not consumer a commodity beyond the level of when its marginal utility is zero. So we have U/ O&U/q2 O. The ratio (U/q1)/U/q2) is therefore, positive. This means the left hand side of equation (35) is also positive. That is dq2/dq1 is positive . this is possible when there is one more negative sing attached to it. This condition is satisfied when the indifference curve is negative sloped, so negative of negative slope makes the MRCS positive. This proves that the indifference curve is downward sloping. Again, as quantity q2 decreases, its marginal utility (F2) appearing in the denominator of the ratio (U/q1)/U/q2) increases, and since q1 is being substituted for so the quantity of q2 increases and so its marginal utility (F1) in the numerator of the marginal utility ratio decreases. A decrease in F1 simultaneously an increase in F2 when q1 is substituted for q2 means a fall in the magnitude of the ratio which implies a fall in the marginal rate of commodity substitution. This gives us the reason for the indifference curve being convex towards the origin. The property of convexity of the indifference curve will be proved if we show that the rate of change of slope of the indifference curve is positive i.e. d2q2/dq21>O By taking the derivatives of (35) with respect to q1 and simplifying the expressions we get the final condition for the rate of change of slope of the indifference curve as d2q2 1

----------- = - ----------- [ F11F22-2F1F2F12+F22F21] >0

55

dq21

F32

where

U/q1 = F1>O, q2 = F2>O

2U/q21 = F11<O(MU1 Declines with increase in q1)

2U/q22 = F22<O(MU2 declines with increase in q2)

2U/q1q2 = 2U/q2 q1 = F12>O

In view of such restrictions, the bracketed terms in (36) is ve so d2Udq21 is positive. Thus implies that the indifference curve in convex towards the origin.

b) The curvature of the indifference curve indicates the degree of substitution between the goods
represented by it. If the goods are perfect substitutes for each other then the indifference curves will be a straight line slopping downward and intersecting the commodity axes. Such line will show constant marginal rate of commodity substitution for the goods. The line intersects the commodity axes which means the utility level indicated by the line can be attained by consumption of one commodity alone keeping the other one at zero level. This is what perfect substitution implies. The minimum required proportion of the goods will be shown by a point through which the indifference curve will pass. On either side of this point the indifference curve will be straight line parallel to commodity axes. In other words, the indifference curve will be pass in the shapes of a right angle at the point showing the minimum proportion of the two goods. The marginal rate of substitution will be zero in this case. In Fib. 4.4 these two extreme types of indifferences curve are shown in panel(a) and (b) respectively, Panel (c) shows the normal indifference curve.

Figure Page no. 90

Between the two extreme cases of indifference curve we have normal curves sloping downward. Greater the curvature of the indifference curve lesser will be the degree of substitution for the goods. This reflects low MRCS. On the other hand if the curve is flater i.e., of less curvature, the degree of substitution between the goods will be quite high and MRCS will tend towards constancy.

An indifference curve parallel to X-axis or Y-axis would not be possible. Suppose a consumer consumes a few units of d2 and O units of q1 to get some satisfaction U1. Now without reducing the amount of q2 he increases q1. This would give him higher level of satisfaction. So there would not be indifference between these two situations. It implies that a parallel line to q1 axis or a parallel line to q2 axis cannot be called as indifference lines. The indifference curve has to be downward sloping whether it is a straight line or a curve. c) Two indifference curves cannot intersect each other for the given pattern of preference. The reason for this can be explained by referring to Fig. 4.5.

56

Figure Page no. 91

I1 and I2 are two indifference curves showing different levels of utility. They are intersecting at E1 point.

By the definition of the indifference curve, a consumer would get same utility by consuming OA 1 + OB1 combination of q1 and q2 at E1 and OA2 + OB2 combination of the goods at E2 point on I1. Similarly OA1 + OB1 combination of q1 and q2 would give same utility as OA2 + OB2 combination at E on I2 in other words.

Utility of E1 bundle = utility of E2 bundle of q1,q2 Utility of E1 bundle = utility of E2 bundle of q1,q2 Since the consumer is indifferent between E1 and E2 bundle of q1 and q2 and E1 and E2 bundles of q1 and q2 he would therefore be indifferent between E3 and E2 bundles of q1 and q2. But this is not so, the combination of q 1 and q2 at E2b is (OA2 + OB2) and the combination of these goods at E3 is (OA2 + OB2) OA2 is common but OB2 > OB2. It is, therefore, clear that OA2 + OB2 is preferable over OA2 + OB2 would give more utility than OA2 + OB2 when E3 preferred to E2, E1 cannot have the same utility as shown by E2 and E1. What we find that it would be inconsistent to compare utility at E1 and E2 to utility at E1 and E3. It is not possible. So we can say that intersection of two indifference curve is not possible at all given the definition of indifference curve and the assumptions behind it.

d) In the non-negative consumption space i.e., positive quadrant of the graph (see Fig. 4.6) we find a set of
indifference curves each one showing a different level of utility and sequenced on orderly way. An indifference curve that lies father fro the origin represents a greater level of utility than one closer to the origin. This also follows from the assumption or observation that more in preferred to less. In fig 4.6 as we move up, the level of utility shown by the indifference curve increases, that is I3>I2>I1>I0. All combinations of q1 and q2, shown by I3 are preferred over the combination of q1 and q2 shown by I2 similarly.

Figure Page no. 93

We say that the combination of q1 and q2 shown by I2 are preferred to the combinations shown by I1 and so on.

The difference curves will be parallel for a given utility function showing constant preferences. But that is not a necessary requirement. The necessary thing is that they will never intersect each other inspiet of being unparalled for some reasons. Difference individuals may have different sets of indifference curves because of differences in their preferences for the some types of goods.

e) The space between consecutive indifference curves reflects the strength of diminishing marginal utility.
For a given level of q2 how much q1 is needed to sustain one unit increment in the total utility? It will be more and more when the law of diminishing marginal utility holds true. If this figure the quantity of q2 is kept at a constant level q1. A1, A2 quantity of q1 is needed to push the total utility by one unit ie., from level 1 to 2 of indifference curve. Similarly A 2 and A3 units of q1 are needed for increasing

57

the satisfactions by one unit, say from level 2 and 3. This way we find more and more of q1 for the consecutive increase in the utility levels as reflected by the indifference curves of higher levels. A4A5 > A3A4 > A2A3 > A1A2 implies that the law of diminishing marginal utility is operating for consumption of additional units of commodity Q1. 4.6 Consumer Equilibrium of Indifference curve. We have seen in the earlier sections how a consumer attains equilibrium when he spends his limited income on various goods and services. He simply follows the principle of constrained utility maximization for this. Now we will see how his equilibrium position can be analysed using the indifference curve. We presume that the entire set of indifference curve ie., the indifference map is given for the consumer. The problem is to identify that particular indifference curve will be showing several plausible combinations of the goods that the consumer consumes. Which particular combination he will finally pickup? The indifference curve as such taken alone cannot help us to find the equilibrium position. For this we need some additional information. This information is provided in the form of a budget constraint showing a fixed income and expenditure relationship. That is, the income of the consumer is fixed (Y o). The prices of the goods are also fixed. Let these be P0 and P2 for two commodities Q1 and Q2 respectively. In symbolic form, the budget constraint for two commodities consumption situation is

Y0 = P1q1 + P2q2 In the cardinal utility maximisatoin we used expanded version of this budget line i.e., Y 0 = P1q1 + p2q2 + ....... + Pnqn but in this section we confine to two commodities for which we draw the indifference curve. A budget constraint is a locus of all combination of two goods (or more) which can be purchased with fixed income at fixed prices. It is a boundary of consumption for both the commodities. The consumer cannot cross this boundary line since his income would not allow this. The budget constraint is a downward sloping line, its slope would be equal to P1/P2 as we see below: Y0 = P1q1 + P2q2 So,

Y0 q2 = ---------- P2

P1 ------------ q1 P2

By maximizing total utility UF(q1, q2) subject to the budget constraint Y0 = P1q1 + P2q2 the equilibrium condition for the consumer would be as shown by equation (10) earlier.

MU1 -------MU2 =

P1 --------P2

Also we have seen earlier that the marginal rate of commodity substitution equal the ratio of marginal utilities of the commodities Q1 and Q2 that is dQ2 MRCS = - ---------- = dq1 MU1 ------------ = ----------MU2 P2 P1

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combining this with the above equation ie. (eg. No. 10) we have MU1 / MU2 is the slope of the indifference curve and P1/P2 is the slope of the budget line. At the equilibrium situation the slopes of the two curves ie., of the indifference curve and of the budget line are equal. This implies that the budget constraint is tangent to the indifference curve. Thus the indifference curve (and hence the utility level represented by it) which is touched by the budget line would be preferred. The combination of the goods shown by the point of tangency would give the optimum level of satisfaction to the consumer. This can be shows diagrammatically as follows.:

Figure Page no. 96

AB is the budget line Y0 = P1q1 + P2q2. This line shows the various combinations of the two goods Q1 and Q2 what the consumer can purchase by his fixed income Y1. He may prefers any point on this line. If he buys only Q2 then the quantity of Q2 he can afford will be q2 = Y0.P2 shown by the point A. similarly if he buys only Q commodity then the maximum quantity of Q1 ie., q1 will be equal to Y0/P1 shown by the Point B. since his preferences are shown by the indifference curves and these curves are not intersecting the commodity axes it implies that he prefers both the commodities in some combination and the two commodities are not perfect substitutes. So point A and B on the budget line cannot be considered for equilibrium position in this case. Any point above the budget line will also be unattainable since consumers income is fixed, commodity prices are fixed so the attainable boundary given by the budget line is fixed. Any indifference curve which is above the budget line but untouched by it would not be considered for examining the equilibrium position of the consumer. The points on the budget line and below this in the commodity space are of course feasible or attainable. For simplicity we consider a few point such as F on I 01 C and D on I1 cure and finally E point. Let us consider point F on the indifference cure I0. The combination of the two commodities Q1 andQ2 shown by point F would not yield maximum satisfaction because the consumer can move to higher indifference curves by moving either horizontally or vertically as shown by the arrows (1) and (2) respectively or between them diagonally towards the budget line. These movements from point F indicate that the consumer gets either more to q1 or q2 or both without decreasing the quantity of other commodity. He thus moves to a higher level of satisfaction by such movements. He has not move away from point F since it is far below are budget line and so the income is not utilized fully. For full utilisiation of income and for maximum satisfaction the consumer has to move long the budget line. So all points like F are inefficient combinations of Q 1 and +Q2. Now let us consider point C on the budget line at which the indifference curve I0 and the budget line (AB) intersect. The slope of the indifference curve is greater than the slope of the budget line at this point. That is :

MU1 > P1

or rearranging it we have the marginal utility per unit of money spent on commodity Q 2 is greater than the marginal utility per unit of money spent on Q1. The consumer reacts to this situation by increasing his expenditure on Q2 and hence increasing its consumption in order to increase his utility. This measn he moves on higher indifference curves by moving up along the budget line. By such movements the quantity q increases and its marginal utility decreases and q decreases its marginal utility increases. The inequality (MU 1/P1) <MU2/P2 is thus changing towards equality. The upward movement continuous till the slope of the indifference curve and the slope of the budget line coincide, that is, equilibrium is reached at point E. thus, for the consumer equilibrium eventually we find that the slopes of the indifference curve and of the budget line must be identical. This implies that the budget line must be a tangent to the indifference curve at the equilibrium position. This will be the level of maximum satisfaction attained by the consumer from his fixed income and fixed prices of the commodities q1* q*2 will be the bundles of the commodities corresponding to the maximum level of satisfaction.

4.7 Effects of Income and Price Changes on Consumer Equilibrium

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We have already seen that the quantity demanded of a commodity primarily depends on its price, prices of other commodities and services and income of the consumer. Now let us examine the effects of income and price changes on the consumer equilibrium situation within the indifference curve frame work. Through the budget line we have specified he expenditure pattern of the consumer using fixed income, fixed prices of the commodities (P1 and P2) and the quantities q1 and q2. Let us change income and prices one by one said see what happens to consumer behaviour by this.

i)

Change in Income, Prices Being Constant

When for instance, income of the consumer increases the budget line shifts upward. The shift of the budget line would be parallel as we keep prices of the goods constant and so slope of the budget line does not change. Because of parallel shifts of the budget line, the equilibrium position will be on higher indifference curves implying increasing utility derived. This is shown in Fig. 4.9

Figure : Page no. 98

That line formed by joining the equilibrium points on the indifference curves which we get by shifting the budget line up because of increasing income, other things being constant, is called income-consumption curve. This shows how a consumer will consume the goods when his income rises. The income consumption curves need not to be a straight line. It may be a straight line or a curve depending on the consumers preference for the goods as reflected by eh indifference curves. If the changes in quantities of the goods are uniform in proportions in moving up on the indifference curves then income consumption curve will be linear otherwise not. A non-linear income consumption curve will show either increasing or diminishing proportions of the changes in quantities of the goods. If the income-consumption curve this towards a commodity axis then that commodity is treated as superior as compared to the other as income-consumption curve is positively sloped then both the commodities will be normal goods. If it is negatively sloped then one of the commodities is inferior. The income-consumption curve may be positively sloping upward for a certain ranges of income shifts and then negative sloping indicating that the commodity from whose axis it is deviated away is inferior. The other commodity is a normal one. From the knowledge of the income-consumption curve ICC we can draw the Engel curves. An engel curve is a relationship between quantity of a commodity say Q purchased and income of the consumer, prices being constant. The name Engel curve is derived after the name of Prussian economist Ernst Engel (1821 1946) who first studied the income consumption relation ship for goods. In the case of luxury goods, the demand increases proportionately more rapidly than income, while for necessities the demand grows proportionately less rapidly than income. For inferior gods the Engle curve will not negatively sloped. Consider the Fig. 10. In part (a) of the figure we find the income-consumption curve ICC sloping negatively and tilting towards q axes. The commodity Q is therefore superior and the commodity Q is inferior because its quantity declines as income increases.

Figure Page no 100

In part (b) of the figure three Engel curves have been shown, one each for a luxury good, for a necessary and for an inferior goods. The trends of the changes in these curves when income increases are self-explanatory.

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(ii) Changes in Commodity Price We keep income of the consumer at constant level and change the prices of the goods in order to find the effect of such changes on the equilibrium position. Changing both the prices simultaneously is a complex situation for analysis. Let us keep this pending for some time and just take the price of one commodity constant and that of the other varying. Here we keep P unchanged and P decreasing. Because of a decrease in P the slope of the budget lien will also be decreasing which means it will shift to the right. Consider the following figure.

Figure Page no. 101

A B is the initial budget line. When price of Q decreases the consumer will be able to buy more of Q with his fixed income when spent entirely on it. This means shifting of the line to A B position. This new budget line will, be a tangent to a higher indifference curve at E. The total satisfaction goes up and the quantity consumed of q also goes up. Quantity of Q may decrease or increase or remain constant. Further decrease in the price of Q shifts the budget line to AB position which again brings higher level f satisfaction to the consumer as this new budget line touches a higher indifference curve U at E point. This way the equilibrium position shifts to higher and higher indifference curves when price of Q continuously decreases. The line joining the equilibrium points on different indifferences curve is called Price Consumption Curve (PCC). It indicates how quantities how quantities of both the commodities vary when price of Q changes, price of the other commodity and income remaining unchanged. It is not an ordinary demand curve. It shows variation in quantities of both the goods with the changes in the price of one of them. We can of course, find the ordinary demand curve from this. we know the changes in price of Q which are exogenously given and also we know how much quantity q the consumer buys with different price levels for Q. as can be seen in Fig. 4.11 we can draw the demand curve for the commodity without any difficulty. The price-consumption curve need not to be a straight line. It may be a straight line. It may be a straight line or a curve slopping upward or downward depending on the two important effects associated with price changes which we will discuss in the following section.

Substitution and Income Effects from a Fall in Price As we have seen in the preceding section, the effect of a price change on the quantity of a commodity is more complex to analyze than is the effect of income change. In this case, the budget line shifts and its slope also changes with changing price of the commodity. consequently, the equilibrium shifts on a new indifference curve. The quantity demanded of the commodity changes with price changes because of Substitution effect and Income effects. These two effects have been listed as reasons for downward slope do the demand curve. (Vide Chapter 3). By using the equilibrium analysis within the indifference curve framework these two effects can be isolated from each other. We will see now how this can be done. Some clarification is needed about the precise nature of the substitution and income effects. If utility is held constant, consumer will move along an indifference curve substituting the commodity that has become relatively cheaper for the one that has become relatively more expensive because of the price change. The type of movement shows the substitution effect. Further, when there is a decrease in price, the consumer saves expenditure which means his real purchasing power increase. Because of a change in purchasing power, the consumer moves on to a different indifference curve showing a different level of utility. This is income effect. The role of income effect is to push up or down the level of satisfaction depending on decrease in the price of a commodity and thus moving to different indifference curves. The procedure of isolating the substitution and income effects in quite simple. We will use graphical demonstration for this first and then use the algebraic expressions. Consider the following figure. AB is the budget line for the two commodities Q and Q. The budget line touches the indifference curve for U and E point showing the equilibrium position for the consumer with X and Y quantities of Q and Q commodities. Now let use consider the effect of a decrease in price P for O other things remaining constant.

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The budget line now shifts to AB position since the consumer will be able to buy more of Q with fixed income if he wants to spend it entirely on Q. the new budget line (AB) touches a higher indifference curve for U level of utility at point E. The consumer now buys X quantity of Q and Y quantity of Q for consumption. Because of a decrease in price of Q the consumer is buying more of Q and less of Q. The total change in quantity of Q is shown by X X distance on q axis. The total effect on quantity demanded of Q ie. X X is the sum of substitution effect and income effect

Figure Page no. 103

To isolate these tow effects, we keep the prices of the two commodities Q and Q same as shown by the new budget line AB and somehow push back the consumer to his old level of satisfaction ie., to the indifference curve marked by U. This type of exercise helps us to find these two effects separately. Because of a decrease in price P there is increase in real income of the consumer which causes an increases in his satisfaction from U to U level. Suppose we tax the consumer ie., withdraw the increased amount of real income from him. This pushes him to the original level of satisfaction U. how much tax is to be imposed on the consumer? We do not know it but we can have an idea of this by shifting down the budget line AB parallelly till it touches the indifference curve for U level of utility. The shifted budget line A B which is parallel to AB touches the U indifferences curve in the diagram at E level. This point(E) shows the equilibrium position for the consumer with substitute effect only ie., because of a decrease in price P1 the consumer substitutes some quantity of Q for relatively costly commodity. Q This is substitution effect which is shown by the distance X X. The difference between total effect X X and substitution effect X X that is X X is the income effect. So what we are getting here is an identity showing the sum of the two effects. Total effect = Substitution effect + Income effect.

X1 X2 = X1 X3 + X3 X2 (-) (-) (-)

Both the effect and unidirectional. Substitution effect is always negative in the sense that an increase in price of a commodity means a decrease in the quantity of that commodity which is substituted for anther commodity ofr maintaining constant utility level and a decrease in price means an increase in such a quantity of the commodity. the income effect may be working in the same direction or opposite to the direction of change of the substitution effect. In the above case it is in the same direction because a change in real income increases the quantity demanded of the commodity Q total effect is thus a sum of both the effects. This is the case of a normal good. A normal good is that one whose quantity demanded increase with increase in income. For inferior goods the income effect will operate in opposite direction to the substitution effect but the net effect will still be negative it., in the direction of he substitution effect. Let us show this through a diagram In this diagram (Fig. 4.13) the total effect is market by X X. The substitution effect is X X. The income effect is therefore X X. What we find in this is that the total effect is less than the substitution effect but still it is negative working in the direction of substation effect. That is, quantity bought is increasing with decrease in price of the commodity. the income effect is operating in the opposite direction of he substitution effect. The quantity demanded of the commodity decreases with increase I real income but because of greater magnitude of the substitution effect the total effect is negative.

X1 X2 = X1 X3 + X2 X3 (-) and X1X3 | > |X2X3| |X1X2| < |X1X3| (-) (+)

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This result holds for an inferior commodity. There is still another possibility. There may be a decline in quantity purchased and consumed with decline in price of the commodity. This is a situation when there is positive relationship between charges in price of the commodity and quantity demanded at least for a certain range of variation in the price of the commodity. to understand this situation consider the following diagrams (fig. 4.14) E1 is the original equilibrium position and E2 is the one when price P1 decreases. The quantity OX2 of Q1 corresponding to E2 is less than the quantity of Q which the consumer was buying earlier. Thus, there is a decrease in

Figure Page no. 105

Quantity of Q when price of Q is decreasing. The commodity Q which is depicting this type of result is called as Giffen Good. This peculiar type of behaviour is called Giffen Paradox after the name of English economist Giffen who first observed it. A Giffen good is an inferior good for which the income effect is very strong completely out-striping the substitution effect in magnitude. This would be in opposite direction as in eh case for an inferior good. A consumer spends a large proportion of the income on such a commodity and if price of the commodity declines he saves considerable amount of his expenditure from which he can buy a better substituted for the commodity. Hence the consumer reduces its consumption and moves to the other commodity. Form the diagram (Fig. 4.14) are find that. X1 X2 = X1 X3 + X3 X2 (-) (-) (+)

The direction of total effect (X X) is similar to that of income effect (X X) and opposite to the substitution effect (X X) and

|X1X3 | < |X3X2|

It is difficult to find a Giffen good in practice. Nevertheless, it is very useful at least concentually to understand income and substitution effects in indifference curve framework.

We have gone through a graphical analysis for separation of the substitution and income-effect. Let us use the algebraic expressions for this purpose now. By maximizing total utility U = F(q q) subject to the income constraint Y = P q + p q we got the first order conditions for maximization as shown by the equations set (7) in section 4.2 Our objective is to find the magnitude of the effect of price and income changes on the consumer equilibrium when all variables vary simultaneously. For this we take the total differentiation of Equations (7). This gives us

F11 dq1 + F12dq2

- Pd/ = /dp1

F12 dq1 + F22dq2

- P2d/ = /dp2

-P1sq1 - P2dq2 = -dy+q1dP1 + q2dp2

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We have three equations for finding the values for three unknown dq dq and. The right hand side is known to us. Assuming that only P price changes by dP other things being constant ie., dP = O dy = O. We can solve (39) using the Cramers route to get the following final expression.

q1

q1 -q1 (---------)

q1

--------- = (--------------) P1 P1 U=constt

Y Price = Constt.

This is Slusky Equation, named after the Russian Economist E E Slutsky defines the effect when P changes, other things remaining constant is the substitution effect. The quantity demanded of Q changes but utility remains at the consent level. This much quantity of Q is being substituted for other commodity without moving from the indifference curve. The substitution effect will be negative since with a rise in the price of the commodity less of it would be substituted for other commodity and vice-versa. The last term q1(q1/Y) price=constt. is the income effect. It may be positive or negative depending whether the commodity is a normal good or an inferior good. We know, for a normal good or an inferior good. We know, for a normal good q1/Y is positive so (q1/q1/Y) is positive. There is a negative sing before it in the Slytsky equation that means it works in the negative direction with the substitution effect. Both have negative signs so we add them to find the total effect. For an inferior commodity q 1/Y is negative. So, (q1 q1/Y)p=constt. in negative and in the Slutsky equation, because of double negative sign. It is positive. This means it is working in the opposite direction of the substitution effect. The net result ie., total effect depends on the sign of the effect which has greater magnitude for inferior goods total effect will be negative because of greater absolute size of the substitution effect than that of income effect. For a Giffen good the total effect will be positive because of greater absolute size of the income effect as compared to the substitution effect. All these three possibilities have been shown above through graphs in Fig. 4.12 to 4.14. Some further deductions can be made from the Slutsky equation. Multiplying both the side of (40) by P/q and multiplying and income-effect term on the right by y/y alos, we get the Slutsky equation in terms of elasticities as: E11 = e11 = -1n1 Where En price elasticity of the ordinary demand curve, e is the price elasticity of compensated demand curve, is the proportion of total expenditure spent on commodity Q and is income elasticity of demand for Q (The compensated demand curve shows the change in quantity Q demanded when price of the commodity changes but the utility level remains unchanged. We will derive it shortly in this chapter itself. This equation says that ordinary demand curve will have a greater demand elasticity than the elasticity of demand is positive (n 1>O) and E is less than when n1 <0 is in the case of inferior goods. For a Giffen good E will be positive. The slutsky equation (40) and its elasticity version (41) can be extended to account for change in the demand for one commodity resulting from changes in the price of the other commodity. The expression for this is

qi --------- = Pj

qi ----------Pj U = constt. -q (----------) y

qi

Price = constt

and Eij = eij - -jni for i,j = 1,2

The interpretation of these equation is straight forward. If i=j then we get the original Slutsky equations (40) and (41) which we have already interpreted. When i=j then q1/Pj or q1/Pj) u=constt. will show the cross effects indicating the change in quantity demanded of ith commodity when price of jth commodity changes. The signs of cross

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effects are not known in general. They depend whether the commodities concerned are substitutes if this crosssubstitution effect is independent of the income effect. In other words, if Q and Q are substitute gods and if the consumer remains on th same indifference curve, an increase in price of Q will induce the consumer to substitute Qi Qj then (qi/Pj) U=constt. is greater than zero and if +Qi and Qj are complement then (qi/Pj)u-constt will be negative. There are other uses of the generalized Slutsky equation. With the help of this equation and its elasticity version, it can be shown that (i) the substitution effect on the ith commodity resulting from a change in the juthy price is the same as the substitution effect on the jth commodity resulting from a change in the ith price (ii) the sum of compensated demand elasticities for commodity Q as a result of changes in price P and P would be zero, and (iii) the income elasticity of demand for a commodity equals the negative of the sum of ordinary price elasticities of demand for the commodity with respect to its won and other prices. For proof of all these results and for their generation to n various some advance text-books on Microeconomic. Theory may be consulted. How Slutsky equation for a commodity is derived can be explained by using a specific utility function, Let us utility function be U=q q and the income constraint for this, is given as y=P q + P q Putting them together in the form of the lagrange function we have V = q1q2 + / [Y-P1q1 P2q2] Setting the partial derivatives equal to zero, we have V -------- = q1 q2 - / P1 = O

V -------- = q2 q2 - / P2 = O

V -------- = / By taking the total differentials for each of these first order partial derivatives we have y- P1q1 - P2q2 = O

dq2 - P1d/ = / dP1

dq1 - P2d/ = / dP2

-P1dq1 P2dq2 = -dy+q1dp1 + q2dp2

The right hand side of these equation is known. Concentrating on the lefthand side, the value of the determinants of the coefficients for dq.dq by denoted by D is.

O I

I O

-P1 -P2

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D= -P1 =P2 O

= eP1P2

Let the cofactor of the element in the ith row and jth column be denoted as D so we have.

D11

= P22, D21 = P1P2, D31 = -P2

Solving for dq by the Cramers rule we get

dq1=

/D11dq1 + / D21dp2 + D31 (-dy+q1dP1+d2dP2) ---------------------------------------------------------------------D

or dq1= -P22/dp1 P1P2 / dP2-P2 [-dy+q1dP1+q2dp2] ---------------------------------------------------------------------2P1P2

Since we assume that only P, changes so dP2 = O, dy = O so dq1 = -P22/dP1 P2q1dP1 -----------------------------2P1P2

or dq1 ------- = dP1 P2 q1

------- - -------2P1 2P1

substituting the value of / = y/2P1P2 obtaining from the first order maximization condition we have

dq1 -------- = dP1

-P2 Y

q1

--------------- - ---------2P12P1P2 2P1

dq1

q1

----------- = - --------- - --------dP1 4P21 2P1

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Let y Rs. 100, P1 = Rs. 2, P2 = Rs.5 & q1 = 25 at the equilibrium, So, dq1 100 25

----------- = - --------- - --------- = -12.5 units dP1 4x4 2x2

The total effect of change in price P 1 is a reduction of demand for q by 12.5 units. Out of this, the substitution effect is -6.25 (=P2/ /2P1) and the income effect is also -6.25 (=0q/2P1). The commodity q1 is a normal good since both the effect are unidirectional.

4.8 Consumer Equilibrium on Extreme Types of Indifference Curve. While examining the properties of the indifference curve we can across two extreme types of indifference curves, one downward sloping straight line in the positive commodity space ie., quadrant, and second, fixed properties ie., right angle type. The former one reflects perfect substitution among he commodities concerned and the later one showing only one fixed proportion for the use of commodities together ie., perfect complements of each other. What would be the equilibrium position for the consumer with such types of other. What would be the equilibrium position for the consumer with such types of indifference curves and how to isolate the substitution and income effect associated with price changed in such situations? This is quite an interesting question. Let us examine this: If the indifference curve is a downward sloping straight line, it reflects constant slope and hence constant marginal rate of substitution between the goods. Such line as we said earlier intersects the commodity axes. This implies that the level of utility of or which the straight line indifference curve stands can be achieved by consumption of either of the two commodities. This is what we mean by perfect substitution. It is not necessary that both the commodities should be consumed. The budget line for the consumer will also be a downward-sloping straight line. One straight the cannot be a tangent to the other straight line except when they coincide with each other. In this situation how to find the equilibrium position for the consumer? The equilibrium will be attained at the corner point share the budget line and ht eindifference line meet each other on the axes of the commodities. That corner point through which the indifferent lines showing the maximum attainable utility level posses will be the equilibrium point Consider the following diagram (fig. 4.15

Figure Page no. 112

AB is the budget line Y = P1q1 + P2q2 and U1, U2, U3 & U4 represent the indifference curves U4>U3>U2>U1. The equilibrium position for the consumer is shown by B point from where the highest attainable indifference curve U 4 passes. If the budget line shifts upward parallel to the origin then the equilibrium will shift outwards on q1 axis. To clarify the equilibrium position at either of the two corner points, let us use algebraic equations and find the solution. Let the utility function be given us. U = q1 + q2 and budget line y = P1q1 + P2q2 The marginal utilities of q1 and q2 are 1 and 2 respectively.

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An increase in q1 by one unit gives a units of utility to the consumer. The consumer spends P1 units of money to get one unit of q1 means from P1 expenditure he gets 1 utility. Similarly from P2 expenditure on one unit of q2 the consumer gets a units of utility. Simple calculation shows that from y units of money the consumer gets 1/P1 units of utility when entire money is spent on Q1 commodity, and 2/P2 when y is spend on Q. If 1y/P1 (or 1/P1) in greater then 2y/P2 or 2/P2) equilibrium lies on q axis where budget line meets if (e.g. Point B in fig. 4.4) and if 2Y/P2 (or 1/P1) is greater that it will be at A point on q axis. The way we find the corner solution for the equilibrium position when goods are perfect substitutes. Then the budget line and indifference curve coincide and every combination of q and q will be optimal
1

y/P1 = 2y/P2 P1 = -----------------P2

What will be the substitution and income effects in this case when price of a commodity changes other things remaining? If and price decreases further, the budget line shifts to the right on q axis, this means equilibrium will be further away on a q axis implying increase in utility for the consumer. If we withdraw the increased real income associated with the decrease in P by taxing the consumer, he will be pushed back to the old level of utility and the equilibrium will be at B point. this means there is only income effect when price P decrease which pushes the consumer on higher indifference curve. There is no substitution effect because it is a corner case. The other commodity has already been fully substituted earlier. Suppose P increases then the budget line shifts inwards i.e., to the left on q axis. The equilibrium position will depend on the magnitude of increase is still greater than then the equilibrium will be on q axis meaning less quantity of q and hence the reduced level of utility shown by a lower indifference curve. However, then the consumer shifts of q commodity q will be completely replaced by q. the new equilibrium and q axis will however, show lower level of utility attained than the level of utility given by the original budget line AB. It is obvious from the figure. The new utility level will be shown by indifference curve passing through point A which is less even than U. The earlier attainable level was U.

Let us now examine the case of complementary goods. The indifference curve for complementary goods will be right angle shape showing on fixed combination of the goods. The budget line touches such an indifference curvet the corner showing the fixed proportion of the commodities. In figure 4.16 AB is the budget line. This line is touching he corner of U indifference curve at E it is this. the equilibrium point. if there is a decline in price of Q then the budget line shifts to AB position touching the higher indifference curve U at E corner. The quantities q and q of Q and Q will change in such a way, while moving for E to E that the original proportion of consumption of the goods together is maintained. This means the locus of equilibrium points will be a straight line emerging from the origin. Since the two goods are complementary, there will be only income effect associated with the price changes for a given level of income. This can be checked by pushing back the consumer to the original level of utility (E) by shifting down the budget the AB to AB touches the U indifference curve exactly at E point showing no substitution effect.

Figure Page no. 112B

4.9 Some Applications of Indifference Curve Analysis Indifference curve is a tool to analyse economic behaviour of a consumer. We have seen how consumer attains equilibrium position on an indifference curve and changes in prices of the goods and income affect his equilibrium position. Beside this, the technique of indifference curve is applicable to solve a number of other problems related to consumer behaviour. A few of them are being discussed here.

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a) Measurement A consumer buys a commodity only when the gain of utility from that is greater or atleast equal to the loss of utility of money spent on the commodity. using he equilibrium concept we can show this condition by the expression. gain of utility loss of utility of money ie. where = marginal utility of money. when the consumer actually buys the commodity he says uniform price for all the units of it, but we know the marginal utility of different units will be different, first unit of the commodity having higher and then declining gradually as quantity increases. It means the total gain of utility will be more than the total loss of utility by giving up the money when the commodity is purchased by the consumer. This gain of excess utility is the consumer surplus. How to measure it precisely is a problem. Marshall who first coined the concept of consumer surplus used simple demand curve to measure it. He defind consumer surplus as the difference between total amount of money the consumer would be willing to pay for a given quantity of some good and the total amount he actually pays. Here, both gain of utility and loss of utility are being assessed on the b basis of money. The willingness to pay depends on the utility gained by having the commodity. To explain how consumer surplus occurs, let us consider the following figure. In this figure we have shown a downward sloping demand curve for the commodity. Let the market price fort the commodity be Rs. 4 which is determined by the interaction of supply and demand for the commodity. At this price the consumer buys 4 units of the commodity. According to the demand curve, the consumer is willing to Pay Rs. 7 as price of the first unit of the commodity. He actually pay Rs. 4 for that. This means that there is a gain to the consumer of Rs. 3 from the first unit of the commodity. The second unit of the commodity is giving him Rs. 6 Rs. 4 Rs. 2 as surplus. The third unit give Rs. 5 Rs. 4 = Rs. 1 as surplus ant last unit pays nothing (Rs. 4-Rs. 4 = 0). Total surplus from all four units is Rs. 6.

Figure Page no. 112D

Actually, the surplus is nothing but the area of the triangle over the total expenditure rectangle. This is equal to Rs. 8 when we take continuous change in the demand rather than discrete changes. Analytically the difference between the areas OLCA and OLCD is the consumer surplus. Using the demand equation P=f(Q) and Q and P as given set of quantity and price for the commodity, the consumer surplus can be expressed in money terms as. If the given set of quantity and price changes to q and P then the change in consumer surplus (BC) would be. Q2 BC = Sjglhljkj hkgygjhljuhji ;i8u jnm j hu huh ji hj ij Page no. 112E

This is Marshallian approach of measuring consumer surplus. Hicks in his book Value and Capital (1939) and later on in the revision of Demand Theory (1956) has provided an alternative approach for this using the indifference curve technique. A full discussion on the Hicksian approach is not intended here, rather we will go briefly through its conceptualization within the indifference curve framework. For this, let us consider the following figure. IC represents various combinations of income and a commodity say which yield the same level of utility to the consumer. OA is the amount of income that the consumer had. The indifference curve IC originates from point. A showing the stage when he retains all of his income and zero units of X for a given level of utility. He moves along the curve IC down. This curve is not touching the quantity axis for X showing consumers preference for money rather than for more of X. Suppose the price for X is known to him and so AB line shows the income-price frontier for the consumer.

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Figure Page No. 112E

The income-price line touches the indifference curve IC at point R. The consumer and OS quantity of X and OY amount of income corresponding to this point. He gives up AY income to buy OS units of X. Now suppose the consumer does and know the price of X, but plans the same quantity of X ie. OS units to get IC units of utility. He is willing to sacrifice AY amount of income for this. But having known the price of he commodity he caually spends only AY income on OS units of X. Moreover, he moves up to higher utility curve IC by this. Thus, we can infer from this that AY-AY ie. Y Y is the consumer surplus because this is the difference between the amount of income the consumer was willing to spend and what he actually spends. This surplus is shifting the consumer on higher level of satisfaction from IC to IC. This is infact, MArshallian concept of consumer surplus which we are measuring using the indifference curves. The consumer moves to IC curve from Ic because of lower price of X and hence gets consumer surplus. If we withdraw some income from him through a tax and push him to the old level of utility Ic by shifting down the line Ab parallel, he would attain equilibrium at L point on Ic by this. His consumption of X decrease in this situation. However, we allow him to buy the same units of X as before i.e, OS units. The consumer would nto be able to cross the new income-prince line, so hypothetically we say that he will be in equilibrium at R point on the line. The amount of income deducted from the consumers income i.e., RR or AA which leaves him in a position still to consumer the same quantity of X ie.., OS is called Compensating Variation of Income which is also a type of consumer surplus according to Hikes. If the consumer is not buying any units of X how much income subsidy should be given to him to move from IC to IC. This is equal to Ac. This is called Equivalent variation of income which is yet another concept of consumer surplus. There are several other types of surplus which are associated either with a fall or a rise in price of a commodity in whose details we are not interested at this stage. They may be read from the other sources. (b) Income tax Vs-Commodity Tax. The indifference curve technique can also be used be demonstrate that taxes on purchasing power such as income tax are more efficient than taxes imposed on commodities i.e., indirect taxes. The term more efficient means that even if the two types of taxes reduce yield the same amount of revenue to the government, income or direct taxes reduce consumers utility of lesser magnitude as compared to the commodity taxes. To show this result, let us take the budget line Y = P q + Pq. In fig 4.19. this is shown by the line AB which touches an difference curve IC at E showing the equilibrium position. Corresponding to this, the optional combination of q and q is and = q. This point lines of the budget line, so we have Y = P. Now let us consider a commodity tax of I per unit of commodity Q. The price P will now be changed to P + 1 and the budget line would be. This line is shown by AB and the new equilibrium at E on IC in the Fig. 4.19. The choice of Q and Q commodities would now be qq. The satisfaction or utility derived now declines to IC level. Total tax revenue would be occurring to government. Suppose the government collects amount of tax in the form of income or lumpsum tax i.e. As a result o this the new budget line would be. This means the original budget line AB shifts down parallelly because of a reduction in disposable income and unchanged commodity prices. This is shown by AB. This line passes through the equilibrium point E and also. T which causes the intersection of AB and AB since the line AB is passing through point E it will be a tangent to an indifference curve between IC and IC say to CI. This implies higher utility than IC level, So it is proved that direct taxes would be more efficient as compared to indirect taxes from the point of view of consumer welfare. There are several other applications of the indifference curve technique such as in the field of exchange between individuals or countries, rationing, subsidy programmes, product quality improvement, supply or labour, index numbers, etc. Due to paucity of space we are excluding then from the scope of this chapter.

4.10 Composite Commodity Theorem

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The indifference curve analysis carried on so far runs in terms to two commodities Q an Q. in practice a consumer at a time may buy several commodities and if we consider all of them together it is impossible to draw indifference curves of multiple dimensions. What is the use of having a two commodity indifference curve analysis then? The analysis is logically consistent and provides us useful insights to understand consumer behaviour in ordinal utility framework, but because of its abstract nature if cannot be applied in practice to derive simultaneously the demand functions for all commodities and several related results such as income and substitution effects associated with price changes, except in the limiting case of one or two commodities. We know that price and income changes are not equiproportional, the optimal consumption bundle is generally changed then. The simple approach for this is to consider first the effect of an income change, holding all prices constant, and then the effect of a change in one prive, holding all price constant, and then the effect of a change in one prive, holding all other prices nd income constant. The analysis for two commodities case has been done using this approach. Now suppose we want to consider more than two commodities to find the effect of an income change and that of a change in one price, other prices remaining constant, we can still do it using the two dimensional indifference curve diagram. For this what we have to do is to take the commodity whose price is changing on one axis and the aggregate expenditure on all other commodities on the other axis for drawing the indifference curves and then carry on the analysis as we have done earlier. The total expenditure on all other commodities is interpreted as a Composite commodity. the results of such analysis we give us optimal consumption of the commodity concerned and optimal expenditure on all other commodities. Hicks, in his Values and Capital has proves this and generalized the outcome in the form of the Composite commodity theorem. According to this theorem, If the prices of all but the its commodity are fixed, utility can be expressed as a differentiable function of the consumption of the its commodity, x and expenditure on all other commodities, m i.e. Moreover, the indifference curves in x and m space representing U are continuous and strictly convex to the origin, Finally maximizing this utility function subject to Y = m+P x yields the optimal consumption of the its commodity and optimal expenditure on all commodities.

4.11 The Revealed Preference Theory The theory of revealed preference was originally developed by Samuelson He tried to provide an alternative approach to study consumer behavour free from the cardinal and ordinal concepts of utility samuelson has shown that significant generalizations concerning consumer choice can be derived from the observing the choices that a consumer makes. The consumers choice reveal his preferences. For a given set of prices of he prefers a combination of quantities of different gods or what we call consumption bundle it means al other consumption bundles that could have been purchased with the fixed income of the consumer are inferior to him. The basic relationship of the revealed preference theory is thus the comparison of the commodity bundle that the prefers to all other commodity bundles that are rejected by him for given prices and income. In order to develop the theory, Samuelson took help of some basic, axis regarding consumer behaviour. These are (i) the tastes of the consumer are unchanged during the period of analysis (ii) the consumer choices are transitive . That the to say they are consistent. It means if a commodity bundle A is chosen form a set of alternatives that includes B bundle, then any set of alternatives from which B is chosen must not contain. A (iii) It is possible to induce a person to purchase a good if price is appropriately changed i.e. if the price is lowered sufficiently. On the basis of these assumptions or axis, as argued by Samuelson, most of the standard results of the theory of consumer behaviour such as the existence of demand functions, their homogeneity of degree zero, and the fundamental theorems of consumption theory in its weaker form can be derived. The fundamental theorem of consumption theory states that if the demand for a good always increases (decreases) when income increases (decreases), then the quantity of the good demanded will always decrease (increase) when price of a good rises (falls). In order words this theorem means that positive income elasticity implies negative price elasticity for a good.

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Let us consider two commodity diagram to explain the theory of revealed preference. As usual, we consider a given budget constraint for the consumer in the form Y = Pq + Pq. The income and price of the two commodities are given. In fig. 4.20 this is shown by the line AB. Following the basis axiom of the revealed preference theory let us take R as the combination of Q and Q commodities chosen by the consumer. The consumer has revealed or shown his preference for this combination whatever be the reason for this ie. either this is cheaper or he likes, or all other combinations of Q and Q shows by the line AB or below this, inside the triangle OAB are inferior to R. The consumer, following the axiom of consistency will not prefer any other combination of Q and Q so long his income and prices of Q and Q are constant. The can prefer the combinations on the right hand side of AB but his budget line is a constraint for this. if his income increases of price of Q or Q declines the he must prefer some combination of Q and Q from this side of the line AB as compared to R. Let us consider the situating when price of commodity Q decreases, price of Q and income remaining unchanged. The budget line AB shifts to AB position. The consumer responds to this new situation by shifting his preference to the combination S on the new budget line AB. He does this because his real income, due to a fall in P increase so he buys more of Q. The consumer is buying more of Q because of positive income effect or there is a substitution effect. We cannot say anything about the substation effect since there is no indifference curve. In order to find the substitution or effect since there is no indifference curves. In order to find the substitution of quasi-substitution effect in movement form R to S let us eliminate the income and effect associated with purchase of Q in the new situation and then evaluate budget in such a way that he buys the same done by reducing consumer budget in such a way that he buys the same amount of Q and Q as before. For this, the new budget line AB is shifted down parallelly till it passes through point R. The effective budget line without income effect is nor AB is flatter than AB since the price of Q has fallen. What will the consumer do now? He may continue to be at point R since it lies on the line AB. But since price of Q has declined the consumer would now prefer to move form this point. he will not move to the left or R and RA section since all such combination fall within the triangle OAB which the consumer had already rejected earlier. Similarly, moving along RA was ruled out earlier because of revealed preference to combination R over the others. One possibility to shifting from R is now on the line RB which gives superior combinations of A and A as compared to R. The other possibilities including moving along AB. All such possibilities including moving along RB segment of AB line implies that the quasi-substitutions effects of a fall in price of Q cannot reduce the quantity of Q contained in R but may leave it unchanged. Assuming that the consumer acts in a rational way and utilizes his full income, We may take T as the new combination which in now revealed preferred to R. so we infer from this that the movement from R to T is because of substitution effect, i.e., a decrease in price of Q increase the quantity purchased or Q. if we give back the income with drawn from the consumer, he would move to point sampling positive income effect for the commodity i.e., an increase in quantity of Q demanded with a rise in income of the consumer. Suppose price of Q decrease further. We would then have AB as the new budget line and U as the revealed preferred combination of Q and Q. as in the earlier step, we withdraw the increased income associated with further decline in price P to trace the associated quasi-substitution effect. This is done by shifting AB line down paralled till it passes through point T. the new effective budget line would now be A B. for the same reasons as given above, the consumer would now prefer any combination on segment TB and A B. Let this be W. This again implies that the substitution effect is working in negative direction implying more of Q with a fail in P. the locus of the preferred points RTW is a convex boundary towards the origin. This is not the indifference curves since W is preferred over T and T is preferred over R. Any pointy on an indifference curve is equally preferred such as R between R and T and T and W. The locus of all such points will be a part of the indifference curve. Now suppose we have sufficient data on revealed preferences then we can drawn an indifference curve from that. We keep income (Y) and other price (P) constant and vary the price (P) in both the side to get a convex boundary showing an indifference curve. The revealed preference theory provides empirical approach to fit an indifference curve and from this link we can argue that indifference curve analysis and revealed preference analysis are complementary each the. Houthakkar, in fact, has demonstrated the fundamental equivalence between the utility theory and the revealed preference theory.

1.12 The Duality Approach in Utility Analysis

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Duality is an important feature of several of modern economic theories. Consumer theory which we have discussed so far in one of them. Duality, in general is defined as the of two logical systems characterized by certain interrelationships. The essence of a dual system is a correspondence or similarly between concepts in one system and concepts in the other which help us to derive similar results from both the systems. The dual approach in studying economic phenomena is very helpful in applied econometrics research as well as in development of economic theories. We will show its importance in this section by taking concrete exemptless from the consumer theory. Major contribution in the duality of consumer theory came from Hetelling. Following his contribution and of other we will go through indirect utility function showing dependence of utility on prices and income and the consumer expenditure function showing the minimum cost of attaining a given utility level for a given set of prices.

a) The Indirect Utility Function The Utility function introduction in section 4.1 is direct in the sense that total utility derived by a consumer depends directly on the level of quantities of different goods and services he consumes at a time, i.e., U=F(q q..q). Through constrained maximization of such utility function we get ordinary demand equations for the goods which are expressed in terms of prices and income. That is, reproducing the set of demand function derived earlier (see equation set (15) Sec. 4.3) we have qi = i(P1,P2,.......Pny0); i=1, .....n Substituting the value or Qqi(i=1,....n() in the utility function we get maximum attainable utility in terms of prices and income levels as: U* = F[(iP1,P2,.....,Pny0), O2(P1,P2,...Pn,y0).....0n (P1,P2,.....Pn,y0) This, on simplification can be expressed as: U* = F* (P1,P2, ....,Pnyo)

This is, the maximum attainable utility is functions of prices and income this is called Indirect Utility Function U is the highest utility that may be obtained with given prices and income to the consumer. We have seen earlier that the demand functions obtained from the direct utility function are homogeneous of degree zero in income and prices (see sec. 4.3). Since the direct utility function is expressed in terms of prices and income, if these variable change in the same proportion, the optimal utility level U will not be changed. The price-income difference surface will be fixed i.e.,

F* (P1, P2,......y0) This surface can be represented by three dimensional graph (P 1,P2 and y) y being on vertical axis. The shape is like a cone having its vertex at the center. The maximum value is shown by the point of origin. The duality between U=Fq1,q2) and U*=F*(P1, P2 and Y) that both of them represent the same preference ordering. Maximization of U=F(q1,q2...qn) with respect to qi(7=1...n) with given income and price leads to the same demand functions as minimization of U*=F*(P1,P2,....PnY0) with respect to prices and income for given quantities. The direct utility function can be expressed in normalized form also. For this, we have to change the constraint slightly. Let y-=P1q1+P2q2+....+Pnqn be the budget constraint. Dividing both the sides of this by y0 and letting vi=Pi/Yo i=1, n we write the utility maximization problem as Max U = F(w1,w2.....wn) subject to I=V1w1+V2w2+....Vnwn. By solving the first order maximization condition from this, we find the demand relations for in terms of normalized prices. V1 = (i=1,n) as , wi = qi (V1V2....Vn) = 1,n 50 By substituting (51) in the utility function we get the indirectly utility function.

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U* = F[ U | V1V2....Vn) = 1,n (51) That is, the maximum value of utility is a function of normalized prices, Vi,V2....Vn F0 denotes the functional shape of the relationship. The properties of this function are the same as described above. The indirect indifference curves generated by the utility function (51) will be very much similar to the indifference curves generated by the direct utility function with the difference that on the axes we will have now V the origin will show lower level of the utility and the one which is the nearest to the origin will show the highest level of utility. The optima will of course coincide with the origin. b) Derivation of Demand Function : Roys Identity To derive the demand functions for difference commodities we minimize the indirect utility subject to the budget constraint. That is Min: U* = F*(P1,P2...Pn,y) Subject to y = P1q1+P2q2+Pnqn Transforming the problem of minimization in the form of the Lanrange function, we have Z = F*(P1,P2,Pn,y)+K(Y-P1q1-P2q2,........,Pnqn) The first order conditions for minimization of this function are: F*(.) ----------P1 -kq1 = 0

F*(.) -------------- -kq2 = 0 P2 F*(.) -------------- -kq2 = 0 Pn

F*(.) F*(.) ------------ +k = 0, ----------- = y-P1q1-P2q2...Pnqn = 0 y k From the first n equation we have F*(.) --------- = P1 -----q1 or U* U* U* -U* ----- q1= ------- q2 = ------ qn = k = ------P1 P2 Pn y -U*/P1 q1 = ---------------U*/y

F*(.) F*(.) ----------- =........ --------= K = 0 F*(.) P2 Pn ------------------------------------, y q2 qn

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-U*/P2 q2 = ---------------U*/y

qn=

-U*/Pn U*/P1 ---------------- or q1 = ------------- , U*/y U*/y

i= 1,.......n

Page no. 119 This is defined as Roys Identify which express the demand function for the commodity in the consumption bundle of the consumer.

Let us take a simple example for this. the indirect utility function is given as:

U* = a1(y/P1)b1 + a2(y/P2)b2 From this, U*/P1 = -a1b1, yb1,P1-b1-1 U*/P2 = -a2b2, yb2,P2-b2-1 U*/y = a1b1yb1-1 P-1-b1+a2b2yb2-1P2-b2

By using the Roys Identification we get U*/P1 q1= --------------U*/y {0a1b1yb1P1-b1-1] = ---------------------------------a1b1yb1-1P1-b1+a2b2yb2-1P2-b2

q1 =

U*/P2 [0a2b2yb2P2-b2-1] ----------------- = ----------------------------------------U*/y a1b1yb1-1P1-b1+a2b2yb2-1P2-b2 aibiybiP1-b1-1 -----------------------------bj-1 -bj Pj j jajbjy

q1 =

i=

2;

j =

1, 2

There are the demand equations for and derived from the given utility function. In general, by solving the first order minimization conditions (53) we will get the standard demand functions for

q1 =

01[P1,P2,.........Pn,y],

i = 1,.............,n

There are similar as the demand functions derived from the direct utility function (Ref. Eq. Set No. 15) c) The Expenditure Function and Compensated Demand Relations A compensated demand function expresses the relationship between quantity demanded of a commodity and prices to maintain constant utility. Due to a change in price of a commodity the quantity demanded of that commodity will be affected and there may be effects on quantities demanded of other commodities as in the case of substitute and

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complementary goods. The change in the quantities of the commondities in turn will affect the utility derived from consumption. In order to maintain the same utility level, the consumer is provided either a subsidy or taxes depending on rise or fall n the price. In this situation, the compensated demand curve plays very crucial role. This type of demand function can be derived by minimizing consumer total expenditure subject to the constraint that total utility is fixed. That is Min y = p1q1 + p2q2 + .... + Pnqn Subject to U = F(q1,q2,......,qn) Using the Lagrange Multiplier method we write the function

L = P1q1+P2q2+......+Pnqn+[U-F(q1,q2...qn)]

Setting the partial derivatives of the function with respect to q 0,q2,....qn equal to zeros, we get the conditions for minimum (provided the second order conditions are satisfied) as

L/q1 = P1-F1 = O L/q2 = P2-F2 = O L/qn = Pn-Fn = O L/ = U = F(q1,q2,.......qn)= 0

These equations on solution for q1,q2,....qn will give us the compensated demand functions for the commodities as:

qI =i[P1,P2,....PnU], i=1,.....n =[P1,P2,....Pn,U]

Let us take a specific utility function U = q1q2 as we have taken earlier

Minimizing y = P1q1 + P2q2 Subject to U0 = q1q2

P1-bq2 = 0 P2-bq1 = 0 U0-q1q2 = 0

From these we have

q1 = [P2/P1 U0]1/2, q2 = [P1/P2 U0]1/2

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It can be verified easily that the compensated demand function (57) like ordinary demand function, is homogenous of degree zero and at the optimum level of utility we get the familiar identify.

Pi ----Pn =

U/q1 --------------U/qn

Substituting the compensated demand functions for q1q2,....qn in the budget equation

y = P1q1 + P2q2 + ....+Pnqn y = P1h1(P1,P2,.....,Pn,U0)+ P2h2(P1,P2,.....,Pn,U0) + ....+ Pnhn(P1,P2,.....,Pn,U0)

Since we are substituting optimal values commodities, we can write y-y indicating minimal level of expenditure to attain an constant level of utility U the expression (59) can be now simplified as:

y0 = H (P0,U0) = P1h1[P0,U0]; P0 is a nectar of prices ie [P1, P2,....Pn]

This function is called Consumers Expenditure Function. It can be shown that this function is continuous in U and P concave, homogeneous of degree zero and non-decreasing in prices, m and increasing in U.

The expenditure function has an important property which is given by the Hotellings theorem. According to this theorem, if the expenditure function is differentiable, the optimal consumptions bundle is given by

H(P,U) q0i h1 (P,U) = ----------------, i = 1, ........n Pi P is the vector of Prices [P1, P, Pn]

That is, optimal consumption of the ith commodity is obtained by the partial differentiation of the expenditure function with respect o the ith price.

To prove the theorem, let q0 be chosen at prices P and utility U i.e. q0i = Hi(P0U0). Comparing the expenditure function and budget equation we can write.

By taking total differentiation of both the sides we get:

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H1(P0U0)dP1+Hu(P0U0)dU = q01dPq + P01dq1

(62)

Where H1(P0U0)dP1+Hu(P0U0)dU = q01dPq + P01dq1

and H1 (P0U0) = H (P0U0) /dP1

H1 (P0U0) = H (P0U0) /dn Again, at the optimum we had the relationship P0n = U/qi = F (q0) /qi (63)

Substituting (63) in (62) and setting dU = o we get,

H1 (P0U0) dP1

= q01dPq + F1(q0)dq1 = F (q01/q1 = F1(q0)

Since U = F (q1...q3...qn) U/qn

If there is a change in jth price, all other prices being contant ie., dP = oi# then we get Hj (P0,U0) = qj (64)

The second term on the right hand side vanishes when utility is constant.

(d) Linear Expenditure System Let us consider utility function of the type This is liner expenditure system. This expression is telling us that quantity demanded of a commodity Q1 is a function o total expenditure y and prices of all commodities in the consumption basket of the consumer q is a constant interpreted as basic or committed consumption of ith commodity Y is defined as super-numerary income or uncommitted income. And B are simply the marginal propensities to consumer. In terms of expenditure we interpret (66) as the expenditure (P q) on a commodity at the optimum which is a sum of committed (or essential) expenditure on that commodity and a protion of the super-numerary income B. The linear expenditure system is based on the utility function having al properties of the conventional utility function. The system has additive property i.e., the cum of different types of expenditure equals local expenditure. The system is homogenous of degree zero in income and prices. Stone has used this system to estimate and demand for various goods and services in the United Kingdom.

1.13 Lancasters Theory of Consumer Demand Kelvin Lancaster has developed a new approach to analyse consumer demand for different goods. The essence of his theory is to provide a fully integrated theory of consumer choice and demand, in which the characteristics of good are taken explicit into account. Such a theory provides a basic structure which product variations and new products fit easily while analyzing the demand. The traditional theory of demand is too abstract according to Lancaster as it is based upon preferences along ignoring highly pertinent and obvious information about the properties of goods which play crucial role in consumer decision-making. The physical properties, for example, size, shape, colour, smell, chemical composition, ability to perform a variety of functions and so on are quite important. If we look at the analysis of demand from the point of view of marketing. Some of these properties which Lancaster termed as characteristics

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are relevant for making choices and they must be incorporated explicitly in the demand analysis for goods and services. Lancasters theory is quite interesting and complex. We will not go into its details here buys simply cover the basic reference model to understand its conceptual functions. The crucial element of Lancaster theory is the concept of the consumption technology which specified a relationship between goods and characteristics. The characteristic are assumed to be objectively measurable. The unit in which a particular characteristic is measured is not important except that it must be same for all goods possessing that characteristics. Defining as the quantity of ith characteristics possessed by a unit amount of ith good, and x as quantities of its characteristics and jth good, a linear relationship has been postulated by Lancaster as:

z1 = bijXj

i,e bij

= ZiXj

(65)

If there are more than one good then the above relationship changes to Z1 = bijX1 + bizX2 + .....binXn This additively assumption for the model showing that the total amount of ith characteristics posses by the goods collection of x1x2....xn) is the sum of the amount of the characteristics by the good separately. Suppose there are characteristics and n goods then we have

In matrix from we write this as:

Z = Bx

Where Z = Zi a vector of characteristics it is called as consumption technology matrix X = { Xj } a vector of goods

Where Z = { Zj } a vector of characteristics

B = { bij } a matrix of coefficients relating of good and characteristics

It is called as consumption technology matrix

X = { Xj } a vector of goods This is a kind of input-output model. Inputs are gods and putouts are characteristics. Sizes of B matrix is r x n. r may be greater than n or equal to n or less than n. Nothing can be said about this at this stage. A simple example of this type of relationship can be given as that of different foods such as milk. Eggs, oranges, bread having characteristics like calories, protein vitamins in specified units. B matrix represents these characteristics possessed by the different foods. For the sake of simplicity it was assumed that all elements are non-negative and all goods are non-negative. a some what stronger assumption made by Lancaster about the consumption technology matrix is that it is semipositive having atleast one positive element in each row and each column. This ensures that the tabulation of the technology does not include any good which has none of the relevant characteristics or any characteristics which is not possesses by atleast one of the goods. Further the consumption technology is assumed to be universally valid in

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the sense that all consumer see it in the same say. This simples that there is no difference between consumers as to what collection of characteristics is associated with any specific collection of goods. As mentioned earlier the consumption technology express the relationship between characteristics and good. The relation-ship between characteristics and people is expressed by their preference. It is assumed that the interest of consumer is in characteristics, and not in good purifies. Any preference for a collection of goods is because of preference of the characteristic. Lanchasters adopted the traditional preference theory of consumer with such a modification. The assumptions of traditional consumption theory were adopted by him with modification e.g. characteristics in place of goods, preferences for characteristics rather than goods etc., Complete quasi-ordering of preferences, transitivity of preferences, completeness, convexity non-satiation etc., are the standard requirements of consumer theory which are applicable to Lancasters theory also The behavioral assumption for the demand analysis made by Lancaster can be stated as follows:The consumer acts in accordance with his preferences, that is, gives the opportunity to choose from some set Z of characteristics collections, the consumer will choose that collection which maximize U(Z) over Z. The consumers budget line can be postulated as usual

P1X1+P2X2+ ........ + PnXn

or PX Y where P is a vector of prices, is a vector of goods, Y is income. The consumers choice problem under the regular budget constraint will be as:

Max U(Z) Subject to Z=BX PX Y

Simplifying this we can write

Max U(Z) = U(BX) = V(X) since Z=BX Subject to PX y X O

We cannot say that this is similar to the simple utility maximization case. There will be major differences if the member of characteristics is less than the number of goods. In this case, the partial derivatives of v with respect to the gods (x) and the partial derivatives of U with respect to the characteristics Z are related by Since there are only r derivatives U/2, it follows than n-r of the derivatives U/x can be expressed in terms of the remaining r. thus, all first order conditions of the traditional utility maximization model ie., v/xj = /Pj cannot be satisfied. The simple new-classical optimizing technique cannot the applied here. The problem can only be tackled by complex techniques of non linear programming.

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The concept of consumption technology, its universal validity etc., are no doubt simple in conception but when it is the question of application, it may create complexity as we have been just above. Lancaster, however analysed the different situations arising by the inequalities between r and n and gave equilibrium position. He extended this model further and gave examples from real life indicating operational usefulness of this demand theory in terms of characteristics of goods rather than the goods per sec. it hs potential uses in industrial and managerial economics.

1.14 Consumer Choice Under Uncertainty The analysis of consumer behaviour through which we have gone so far is based on certainty of events. The consumer has full information or data for decision-making. Real world, however, is full of uncertainties. The consumer may not posses complete information concerning the problem he is trying to solve. He may buy a TV but whether it works satisfactory or not is not known to him. There may be uncertainty about the earnings of the consumer itself. How should a consumer take decisions about his choices in such situations? There is not unique procedure for this. different people may have their own individual ways of tacking uncertainties, but the one that is widely used to economics or statistics is the approach of probability and expected value maximization. The probability of an event happening is, roughly speaking, the relative frequency with which it will occur. Consider two players A and B playing a game. Both are equally strong. What will be the chance or probability of either winning? It may be say 50-50 i.e., 50 percent chance for each one to win the game. Here we say that the probability of winning the game is 0.50 for A and also 0.50 for B. Suppose a is stronger than b then a may have a 80% or 0.80 probability of winning the game and B a probability of 20% or 0.20. When outcome of nay event is uncertain it may be guessed on basis of probability. This helps us in finding expected value of the outcome. Let us take two possible outcomings of an event say Z 1, and Z2. The probability of Z1 is P1 and the probability of Z2 is P2. The expected value of the outcome in the situation of uncertainty would therefore be E(2)=P1Z1+P2Z2... If there are some more than two plausible outcomes, we can extend this formula to E=Z=P1z1+P2z2+P3z3+...Pnzn Remember P1+P2+P3+......Pn = 1. So, under certainly a rational decision maker will maximize the expected value of outcomes. This principle we do apply in the analysis of consumer behavior also. The first major work in this direction came from D Bernoulli more than 200 year ago. Bernoulli argues that individuals, in deciding on their bahaviour in uncertain situations, consider the expected utility of their various options rather tan the expected money value of these options. It is the average utility value of a game that matters and not its monetary value. Bernoulli thought of diminishing marginal utility of income as income increases. Because of diminishing marginal utility of money or what Bernoulli called as physic value it is quite reasonable for an individual to refuse to pay a large amounts for the right to play a game since the game is not worth very much in utility term. The expected utility hypothesis has been applied by Von Neumann and Morgenstern to constructed a utility index which can be used to predict choices in uncertain situations if the consumer conforms to the following basic assumptions. a) Complete ordering : This is transtigity assumption. According to the if the consumer prefers alternative B and alternative B to alternative C, then the prefers alternative A to alternative c. b) Continuity assumption: If A is preferred to B and B to C, then this assumption asserts that there exists some probability P, O P 1 such that the consumer is indifferent between outcome B with certainty and expected value of outcomes of A and C with probability P and 1-P respectively. c) Independence Assumption : If one lottery ticket or investment offers outcomes A and C with probabilities P an 1-P respectively and another the outcomes B and C with same probabilities P an 1-P, the consumer is indifferent between the lottery ticket or investment plans. d) Unequal Probability Assumption : The essence of this assumption is that, other things being equal, we will always prefer the investment opportunity with greater probability of favourable outcome. e) Compound Probability Assumption: If the individual is offered a lottery ticket whose prizes are, in turns, other lottery ticket, he will view the compound lottery ticket in the same manner as if he has gone through all the probability calculations of ultimate odds of winning and losing. Each one of these assumptions has considerable implication for constructed of the utility indices.

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In construction of the utility index, Neumann and Morgenstern implicit assumed cardinal measurement for utility. There is not set origin for this type of measurement of utility in N-M (i.e. Neumann & Morgenstern) framework rather it starts for some arbitrarily chosed point. Consider three events A,B,C for which the order of the individuals preferences is to be stated. Let us take that outcomes of A and C are uncertain. Then the consumer while making the choice will use the expected utility derived from these two events jointly that is, if P is the probability of occurring A and (1-P) is the probability of C then expected utility from then is PU+(1-p)U cUA and Uc are utilities derived from the event A and C respectively. Suppose an event B has U utility which is certain. If we compare between the expected utility of A and C and the utility of B, we may have the possibilities of UB PUA+(1-P)Uc. Even B ie., alternative B is preferred if UB>P(UA) +(1-P)Uc and it is rejected if UB<PUA+(1-P)c1. There will be indifference between these alternatives if UB = PUA+(1P)Uc. In this situation we can say that these exist a probability level P for which the consumer is indifferent between B with certainty and a chance between A and C. Let us now take some arbitrary value for U A=1---Uc = 10 and take the probability level is 0.10. This give PB = 0.10 (100) + (1-0.10) 10=19. We are not having any idea of U B earlier. But given P and an arbitrary chosen set for UA and Uc we got U = 19. If U = 59, U= 20, P=0.5 then U=0.5x50+0.5x20=35 proceeding in this way we can find utility numbers UAUBUCUn for all possible quantities and combinations of all goods and hence a complete utility index can be derived by taking two arbitrary starting points and successfully conform the consumer with various choice situations involving probability for risks. Consumers choices can thus be predicted seeing the utility index numbers. Some times the consumer may face complicated alternatives. They can also be predicted on the basis of such utility number. For example, if there is a 40-60 chance of alternative D and B to a 50-50 chance of A and C, the alternative B and D is preferred if 0.50(100)+ 0.50(10) <0.4 (122.5) + (0.6) 19 where UA = 100 U = 10 U = 122.5 U = 19. The N-M utilities as described above are useful (a) for complete ranking of alternatives in the situations characterized by certainty (b) in comparison of utility differences in cardinal scale and (c) in calculation of expected utilities, thus making it possible to deal with the consumer behaviour under uncertainty. On the basis of such utility numbers however, it will not be possible to have interpersonal comparison of utilities. The method suggested by Neumann and Morgenstern is fairly general applicable to deal with uncertainties related to consumption or production or an other activity.

1.15 Conclusion Remarks This is a fairly long chapter dealing with various aspects of consumer theory starting from the conventional the theory of utility to the contemporary approaches. Some of the advance topics like duality approach of utility analysis. Lancaster theory of demand analysis, Von Neumann & Morgenstern approach of deling with uncertainty were discussed in brief. It is expected that an interested student will cover them in full from the relevant original that an readings. Emphasis has been given in this chapter on understanding consumer behaviour in different decision situations. No attempt has been made to go into details of measurement or estimation of the functions. This is the task of applied economies or econometrics.

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UNIT II CHAPTER : 6 DEMAND FORECASTING Forecasting is like trying to drive a car blind-folded and following directions given by person who is looking out of the back-window. PHILIP KOTLER INTRODUCTION The area of production planning and control is one in which the firm concerns itself with means for the attainment of two objectives the production of required quantities of a given product and the production of these quantities at appropriate time. This means that the producer must anticipate the future demand for this product and on this basis, provide the production capacity which will be required. This calls for forecasting the future demand of a given product, translating this forecast into the demand it generates for various production facilities and arranging for the procurement of these facilities. The discussion of demand forecasting is divided into seven sections. The first describes the meaning, nature and the vital role played by demand forecasts in the operations of business. The second deals with the type of forecasting which arise out of the planning needs of business firms. The third explores the various approaches to demand forecasting. The fourth explains the major determinants of demand. The fifty deals with the major methods adopted in estimating future demand. The sixty explains the forecasting methods for new products. The last discussed how forecasting methods can be evaluated in terms of their accuracy and costs.

1. MEANING, NATURE AND THE ROLE PLAYED BY DEMAND FORECAST IN THE OPERATIONS OF BUSINESS.

Estimates of expected future conditions are called forecasts and estimates of expected future demand conditions are called demand forecasts. Precise forecasts of future developments are clearly impossible. Expectations depend on the assumption made. The reliability of the forecasts, hence depends on the reliability of the assumption. The assumptions and methods employed in forecasting depend upon the nature of the planning required. There are two major types of planning which require the use of forecasts. They are (i) Short term planning and (2) longterm planning. In industrially well developed countries, these grow out of planning which the need to predict shortterm and long-term changes in demand conditions facing industries. This has been so because demand conditions were always more uncertain than supply in industrially advance countries. In recent times forecasting has come to play an important role in business decision making. A company is in business to serve its customers needs in some way or the other. Its survival and properity depends on its ability and willingness to adopt its operations to customers needs, to create or simulate the need. And serve it adequately and efficiently when the need arises. Demand forecasts serves as the link between the evaluation of external factors in the economy which influence the business and the management of the companys internal affairs. The very term planning is intimately connected with forecasting because it is concerned with the future. More often than not, one finds forecasting decisions which have an important influence on production planning operations being made by store-keepers or stockroom clerks with little or no procedural or policy guidance. Determination of the types of forecasts required and establishment of procedures governing generation of these forecasts are fundamental steps in the organization of well-conceived production control system.

For production planning purpose it is particularly important to distinguish between forecasts of sales may be important for estimating revenue, cash requirements, and expenses, a production planning system is designed

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primarily to react to customer demand. Demand may differ from sales for a variety of reasons. For example, there may be substantial lag between customer orders and billings, or sales may understate demand to the extent that the manufacturing and distribution system is unable to cope up with the volume of customer demand. The particular characteristics of demand forecasts demand are pertinent of production and inventory control and the timing, detail and reliability of forecasts, and the assignment within the organizations of the responsibility for making forecasts and controlling or improving the quality of forecasts.

II. TYPES OF DEMAND FORECASTING From the point of the view of the time span and from the planning requirements of business firms, demand forecasting can be classified under two headings (i) short-term demand forecasting, and (2) long-term demand forecasting. SHORT TERM FORECASTING

Short-term forecasting is limited to short periods, usually not exceeding an year. It relates to policies regarding sales, purchasing, pricing and finances. Hence the reference is only to the existing production capacity of the firm. In most companies, a knowledge of conditions in the immediate future is essential for formulating a suitable sales policy-production schedules have to be geared to expected rather than actual sales. Often, bu assuming that prevailing conditions will continue, a firm may find itself faced with a problem of over production or short supply. An understanding of near future prospects would make it possible to avoid some of the violent fluctuations which occur in production scheduling and sales planning. Knowledge of immediate future conditions is important in pricing. If prices of materials are expected to go up or shortage are expected, businessman may take advantage of the rise by earlier buying. Proper price forecasting may, thus help the firm in reducing the cost of operation. Demand forecasting is also useful to the businessman in determining his price policy. An increase of prices is avoided when future market conditions are not expected to be good and the lowering of prices is avoided when costs or sales levels are likely to rise considerably. Many companies use forecasting for setting sales targets and for establishing controls and incentives. Sales targets will not accomplish their objectives if not geared meaningfully to the sales levels likely to be achieved. If set too high, the targets will be discouraging to those who have to meet them. If the targets are very low, they will be met very easily and incentives will prove meaningless. Above all, demand forecasting of the types mentioned above will be considerable assistance in short-term financial forecasting also. Cash requirements will depend upon the levels of sales and production sales. Some prior information is usually neede to procure additional funds on reasonable terms. Neglect of demand forecasting will complicate financial planning through its repercussion on production scheduling and inventory accumulation. In the preparation of budgets, therefore, short-term forecasts have come to play and important part. LONG TERM FORECASTING In short-term forecasting a company is concerned only about the use of its existing production capacity. But when questions of long-term planning are involved the businessman must know something about the long-term demand for this product. Thus the planning of a new production, unit or the expansion of an existing unit must start with an analysis of the long-term demand potential of the products in question. A multi-product firm must ascertain not only the total demand situation, but also the demand for different items. This will involve the study of consumer preferences and trends, the economy, and technological developments and trends. Once the demand potential is assessed, it will be easier for the company to engage in long-term financial planning. Again manpower planning for existing as well as new firms must be based on long-term forecasts of the companys growth.

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When forecasts covering long periods are made, the probability of error is high. Competent forecasts predict he conditions that are likely to prevail in the near future with comparative confidence, and with a relatively high degree of accuracy; the results are much less reliable when they attempt to forecast conditions over longer periods. This is because, as the period becomes longer certain factors that forecasters take into account in making their estimates becomes more volatile. It is very difficult to predict over extended periods such items as the probable costs of production, the trend of prices and the changing nature of competition. Moreover the longer the term covered by the prediction, the more likely it is that unanticipated events such as international conflicts including wars, periods of major depression and prosperity and inventions and technological advances will upset the calculation. It is function of the top management in each firm to make it own decision regarding the span of time to be covered by demand forecast. It is safer to forecast for longer periods, when the volume of demand has held fairly constant from year to year. If demand has been erratic for reasons that are largely unexplainable, the forecasting period should be shorter. III. APPROACH TO FORECASTING The following four distinct steps must be kept in view in dealing with any demand forecasting problems.

i)

Identify and clearly state the objectives of the forecasting problem. In certain cases the required forecasts may e short term nature. The approach needed here may be quite different from what longterm forecasts will call for. In certain other cases forecasts of market shares may be required which calls for an approach different from that needed for a general industry forecast. Ascertain the determinants of demand for the particular product or product group. The factors influencing demand differ widely depending on the products or industry or industries involved. Economists have a tendency to categories goods and services into three broad categories for facilitating demand analysis. These three categories are:a. Consumers non-durable goods b. Consumers durable goods c. Capital goods

ii)

We follow here the same kind of categoristation for purpose of demand analysis. The determinants of demand pertaining to these categories are different, they are discussed in detail in the next section. iii) Select appropriate methods of forecasting. The method selected will depend upon the purpose or objective of the demand forecasts, the nature of the products involved, the types of data available etc. Present the findings in a readable form. This is important because the management will be interested only in the actual forecast, its meaning and implications for policy.

iv)

Once a product forecast for the whole industry is available it is easy for the company to estimate its share of the market. Analysis of past data can indicate the trends in market share among the competitions. In preparing company forecasts the management may relay on two varying assumptions. i) ii) The ratio of company sales to total industry sales will continue as in the past. The ratio of company sales to total industry sales will change

Demand forecasts for the company mat be made based on either of these assumptions. And often companies prepare alternative forecasts based on them.

Forecasting must be a continuing activity. Every forecast is based on a given set of data and assumptions and is relevant only as long as the underlying assumptions hold good. As improved information becomes available, forecasts must be relieved and revised so that the management is provided with a better basis for decision making.

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IV. DETERMINANTS OF DEMAND 1. NON-DURABLE CONSUMER GOODS

There are atleast three basic factors indulencing the demand for non-durable consumer goods. They are (a) Purchasing power income (b) price and (c) demography. (a) Purchasing power: One of the major determinants of demand is the purchasing power of the consumer and this is determined by the income or rather disposable personal income. (Personal income minus direct taxes and other deductions, if any) of the consumer. In India, data on disposable income is not directly available. The Central Statistical Organization has not yet started the publication of data or disposable income, indirect estimates can, however, be obtained from the published data. Use of disposable income for estimating demand has been criticized by some writers on the place that it does not constitute free purchasing power. Hence they prefer to use the concept discretionary income in place of disposable income. Discretionary come can be estimated by deducting three items from disposable income, viz imputed income and income in kind, major fixed outlay payments such as mortgage debt payment, insurance premium payments and rent and essential expenditures such as food and clothing and transport expenses based upon consumption in a normal year. But here is may be pointed out that the disposable income concept is considered to be equally satisfactory by many experts. b) Price: The importance of price of a particular product and its substitutes in determining the demand has always been emphasized by economists. A measure of the price-demand relationship for a product is given by the concept elasticity of demand. Concepts such as price elasticity, income elasticity, cross elasticity etc of demand are used in economic analysis. c) Demography: Experiences shows that the demand for a product is determined by certain population characteristics also. For example, a study of the demand for lipstions must take into the account the number of women by age. Again, in a study of the demand for tyres, the populations consists of the number of cars, buses trucks and other motor vehicles in use. This shows that demography does not necessarily relate exclusively to human population. In fact, this uses is in differentiating, between total market demand on the one had and market segments on the other. The segments on the other. The segments represent divisions of the total market into homogenous groups. The idea is to construct one or more segments the demand for the product Demography or population groups can be defined in terms of educational background, sex, age, income, social status, geographic location etc. The segment if qualified, can be used as an independent variable affecting the demand for the product in question.

Purchasing power (Y) Price (P) and Demography (D) can be combined in an additive relationship in order to get a formula which can be used for predicting the demand (d) for a consumer good. The formula may take the form: d= Y + P + D DURABLE CONSUMER GOODS Three different purchase characteristics can be distinguished in the case of durable consumer goods, they are i) ii) iii) Time use characteristic; Use-facilities characteristics; and Demographic characteristics. This use characteristics consumer durable have get extended use and as such they are never used up in a single act as are match-stricks or ice-cream. This feature enable the consumers to go on using them by repairing if necessary, or to scrap them and get new ones. Experience shows that

i)

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emergencies such as war or sacristy force people to postpone replacement of durable goods and thereby to lower the effective scraping rate. The decisions to replace goods is influence also by considerations such as social prestige and status, income and product obsolescence. ii) Use-Facilities characteristics: Generally durable goods require special facilities for their use. For example, to use or truck, one needs to have roads and petrol or diesel stations. Again, to use a refrigerator or a radio, one needs electricity. The existence and growth of such facilities is an important variable in determining the volume of sales or quantity demanded of the products in question. Hence due consideration must be given in choosing the variables influencing the demand for durable consumer goods. Demographic characteristics. The decision to purchase consumer durables is influence also by factors such as size of families age distribution of adults and children, population groups in different income state, price and other considerations. Demography here includes a study of populations other than human also. A study of the demand for commercial airlines has used the number of commercial airports as both a use facilities characteristics and as a demographic different purchase characteristics may be considered independently, or in combination depending on the product and the economic judgement of the analyst.

iii)

The total demand for durable goods, in fact, is the sum of two demand viz i) a new owner demand and ii) a replacement demand and ii) a replacement demand. The new owner demand will increase the stock of the goods. Replacement demand tends to grow with the growth in the total stock with consumers and at times it may even exceed the new demand. For certain well established products, life expectancy tables are made available in advanced countries in order to estimate the average or near average replacement rates. The basic demand equation for durables may be stated as follows: d=N+R Where (d) represents total demand, (N) new-owner demand and (R) replacement demand. Each of these independent variables may be forecast separately. It must be borne in mind that in the case of most durable goods there is an upper limit beyond which demand cannot grow. This upper limit refers to the saturation point. for example, even if income goes up, there is a limit to the number of radios that people will buy. it is to this level towards which the actual volume of consumer stocks tends to gravitate. The difference between the saturation point or the maximum ownership level and the actual stock shows the growth potential of the demand for durable goods. CAPITAL GOODS Capital goods are produced means of further production. They are used to facilitate the production of other goods. Examples are machinery of all kinds, factory buildings etc., The demand for capital goods is a case if derived demand. Hence, the demand for capital goods depends upon the profitability of the industries using the capital goods. The ratio of profitability of the production to capacity in user industries, the level of wage rates, the policy of the Government, business prospects etc., Where the wage rates go exceptionally high. The management will have an added tendency to go for labour saving equipments. Two types of data are required for forecasting the demand for capital goods intermediate of industrial goods. They are:i) ii) The growth prospects of the user industries and The criteria or norm of consumption of the capital goods per unit of each end use. The critical assumptions underlying the end-use approach are: a) The demand estimates for the end use products are available. b) The norms of consumption (the technology of the industry) will remain unchanged during the period under consideration.

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c) Norms based on present consumption patterns in industry may, impart, reflect existing shortages
are import restrictions in the economy. In building bridges, for example, mild steel might be in use at present instead of constructional steel (which is more suitable for the purpose . This might be due to the non-availability of high cost of constructional steel. But as the pattern of availability changes, the consumption pattern in the industry may also vary, changing the norms of consumption in the process. VI FORECASTING METHODS Several methods are employed for forecasting demand. However, this usual starting point is to have an ideal of the general business forecasts relating to the economy for the period under consideration. Such macro-economic or GNP forecasts enable an industry or firm to construct its own micro-economic demand forecasts. Macro economic forecasting is a highly developed technique in western countries, especially in the United States of America, but in India it is only in its infancy. In India the perspective planning Division of the Planning Commission periodically prepares aggregative forecasts of national income and its components which can be made use of by industries and firms for their own individual purposes. Here we propose to discuss the most commonly used methods by industries of firms for forecasting demand for established products.

1. SURVEY METHODS a. Opinion Surveys The first method we shall consider is called opinion surveys or survey of buyer intentions. Forecasting is essentially the art of anticipating what buyers are likely to do under a given set of conditions. This immediately suggests that a most useful source of information would be the buyers themselves. Ideally, a list of all potential buyers themselves. Ideally, a list of al potential buyers could be drawn up, each buyers would be approached, preferably on a face-to-face basis, and asked how much he plans to buy of listed products in the stipulated future time period under the given conditions. He would also be asked to state what proportion of his total needs he intends to buy from the particular firm or atleast what factors would influence his choice among suppliers. With this information, supposing it is both obtainable and valid, the firm would seem to have an ideal basis for forecasting its demand. This method is most useful when bulk of the sales in made to industrial producers. Here the burden of force casting is shifted to the consumer (Customer). But unfortunately, this method has a number of limitations in practice. It would not be wise to depend wholly on the buyers estimates since the buyers are likely to exaggerate their requirements if shortages are expected. Again, this method is not very useful in the case of household consumers for several Reasons, vix irregularity in consumers buying intentions,. Their in ability to forecast what choice they will make when faced with multiple alternatives or choices, prohibitive costs etc. a basic limitation of this method, according to Dufty, is that it is passive and does not expose and measure the variable under managements control. The favourite forecasting technique employed by industrial manufacturers appears to be the sales fore composite method. Under this system the company asks its salesmen to submit estimates of future sales in their respective territories. The sales force composite method is popular with industrial concerns because they have a limited number of customers needs. Forecasts prepared by salesman may be biased, however, due to the following reasons. Firstly, a salesman may be consistently pessimistic or optimistic or he may go to one extreme or another because or a recent sales setback or success. Secondly, he is often unaware of larger economic developments and of company marketing plans that will shape future sales in his territory. Thirdly, he may understate demand so that the company will set a low sales quota. Finally he may not have the time or concern to prepare careful estimates. Because of these defects, salesmans estimates are aggregated, reviewed and adjusted at higher management levels. In making the necessary adjustments the higher management takes into consideration such factors as expected salutary changes in product design, a plan for increased advertising, a proposed increase or decrease in selling prices, new production methods which will improve the products quality, changes in competition and changes in such economic forces as purchasing power, income distribution, credits, population and employment. This method is often termed as jury of executive opinion method.

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An evaluation The opinion survey method is relatively simple and straight forewarned. One of its advantages is that it make use of the people in the organization who are directly involved in the activities which will influence the level of sales, who are in a position to become acquainted with the forces and factors which will affect sales, and who probably have the opportunity to acquire the experience and judgments which will enable them to evaluate the effects of these factors and factors. Another advantage of this method is that, unlike some of the other techniques discussed in this chapter, it requires no special technical skill. Finally, this method leads itself to use in the forecasting of sales of new products. However, this method is subjected to a number of criticism the most important among them then is that it is almost completely subjective. This is of no consequence if the firm is fortunate enough to have personnel in its sales and managerial ranks who have the inherent ability to make this type of subjective analysis. But unfortunately many organizations are not endowed with personnel of such quality and caliber. The appropriateness of the sales force opinion method increases to the extent that (1) the salesman are likely to be the most knowledgeable source of information, (2) the salesman are co-operative (3) the salesman are unbiased or their biases can be corrected and (4) there are some side benefits from the salesmans participation in the procedure.

b) Expert Opinion Taking the opinion of well-informed persons other than buyers or company salesmen, such as distributor or outside experts is an other method of forecasting. In the United States of America the automobile companies slicit estimates of sales directly from their dealers. But according to Philip Kotler these estimates are subject to the same strengths and weakness as salesman estimates, like salesman, distributors may not give the necessary attention to careful estimating, like salesmen, distributors may not give the necessary attention to careful estimating, their perspective concering future business conditions may be too narrow, and they may supply biased estimates to gain some immediate advantage. Firms in advanced countries also tap outside experts for assessments of future demand. In effect, this happiness when a firm uses or buys general economic forecasts of special industry forecasts prepared outside of the firm. In the United States of America, for examples, various public and private agencies issues or sell periodic forecasts or short or long term business conditions. While the experts are supplying what amounts to opinion, the opinion may be the joint outcome of specially conducted surveys among buyers and suppliers as well as statistical mathematical analysis of past data. A related but a slightly variant of the expert opinion method is used by Lockhead Aircraft Corporation. As a manufacturer of aircraft frames and missiles, the company deals with a relatively small number of customers, each of which accounts for a relatively large percentage of sales. Therefore Lockheads forecasting problems is to predict what each particular customer will order during the forecast period. The marketing research group works up a preliminary forecast on the basis of surveys and statistical or mathematical technique. Independently, a group of Lockheed executives assume the roles of different major customers and in a hardheaded way they evaluate Lockheeds offering in relation to his competitors offerings. A decision on what and where to by is made for each customer. The purchases from Lockhead are totaled and reconciled with statistical forecast to become Lockheeds sales forecase.

An Evaluation on the use of Expert Opinion The use of expert opinion has a number of advantages and disadvantages. Its main advantages are (1) forecasts can be made relatively quickly and cheaply (2) Different points of view are brought out and balanced in the process and (3) There may be no alternative if basic data are locking or difficult to collect, as in the case of new products. The important disadvantages are (1) opinions are generally less satisfactory than hard facts, 2) responsibility is dispersed, and good and had estimates are given equal weight, and (3) the method usually is more reliable for aggregate forecasting than for developing reliable breakdown by territory, customer group or product.

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c) Delphi Method Delphi Technique is an extension of systematic analysis into the areas of opinion and value judgements. It countries the limitations of traditional quantitative methods. In areas where information is dispersed and scanty, judgements and expert opinions are valuable, historical data can lend itself to many interpretations. Delphi offers a scientific and systematic procedure for evaluation. In a way, it is sophisticated statistical method to arrive at a consensus. One of the drawbacks of any quantitative procedure is its inability to incorporate behavioural elements like personality, institution and retrospection. Delphi has a built in capacity to take account of these variables. Delphi technique was initially developed by Olaf Helmer and T.J. Gordon of Rand corporation, U.S.A. since then it has found its application in technological and environmental forecasting, selection of industrial targets in war, estimation of strength of bombardment and in futurology. In the business management area its relevance is in manpower planning, Bayesian probability estimation, business forecasting and demand estimation. Other applications are in civil defence policy, computer applications, education, urban planning and other policy, determinants, evaluations of research prospects, foreign affairs and information processing. In fact, Delphi is the most applied of the technological forecasting methods and it has acquired a good standing among forecasters a long range planners.

MAJOR FEATURES OF DELPHI TECHNIQUES The major features of Delphi techniques are the following: 1) A panel is selected to give suggestion to solve the problems in hand Both internal and outside experts can be the members of this panel. 2) Panel members are kept physically apart from each other and express their views in an anonymous manner.

3) There is a programme coordinator who acts as in intermediary among the panelists. His role is essentially
of a coordinating nature. He prepares questionnaire and sends it to the panelists. He also prepares summary at the end of each round of anonymous discussions and provides composite feedback to the panel members.

4) The views of the members of the panel are obtained in a number of rounds. In the first round, panel
members are asked to express their views on the forecasting problem. These views are analysed by the programme coordinator. The panel members are given a second questionnaire together with the summary report of the first round of discussion. On the basis of the summary report, the panel members are supposed to give more anonymous suggestions. They are asked whether they could revise their opinions in the light of the summary report of the first round. The estimates received in the second round are also summarized, and, if required, a further questionnaire together with the second summary report is sent to the panel members. The process is repeated several times till the panel members stop changing their opinion.

II. Time Series Analysis Time series analysis or trend projections rely on past data. In this approach, a company analysis its past sales to determine the nature of existing trend. This trend is then extrapolated into the future, and the resultant indicated sales are used as the basis for forecast. The mechanics if this technique can be best illustrated by means of an example. Suppose that a manufacturer of radios decides to forecast the next year sales of his product by this method. He begins by collecting data on his sales for the past five year When he does this be obtains the following results.

Year 1989

Sales 45

90

1990 1991 1992 1993

58 45 55 60

Graph Page no. 147

If the sales are plotted against the years in which they take place, a graph representing th time series is obtained. The graph for our data is shown in the figured. An examination of this graph reveals that the sales are definitely following an upward trend. The next step is to develop an equation which can give the nature and magnitude of this trend. This is done by fitting a so called trend line to the points depicting the firms sales. A number of ways for doing this exist, but a fairly common one is to construct the line of best fit by the method of least squares. Doing so means that the trend is assumed to be linear. Whereas it may actually be curvilinear. If the later is true, more complex methods of constructing the trend line must be used. However, we shalllimit ourselves in this presentation to linear trends for purposes of simplicity. In simple linear regression, the relationship between he dependent variable (y) and some independent variable (x) can be represented by a straight line. The equation of this line is where a is the intercept and b shows the impact of the independent variable. The key step in deriving linear regression equations is finding values for the coefficients (a, b) that give the best fit to the data. One way to determine these coefficients is to plot the data on a graph and make free hand estimate of the line that represents the relationship between the two variables. Since in our case sales are to be forecast, they are considered to be the dependent variable, Y also, since sales will be assumed to vary with time, the time period (years) will be the independent variable, X. The Y intercept and the slope of the line are found by making the appropriate substitutions in the following normal equations. Calculating the magnitudes of the required from our original data, we get the following: 1 Year 1989 1990 1991 1992 1993 2 (sales 000 units) 45 52 48 55 60 3 X 1 2 3 4 5 4 X 1 4 9 16 25 5 XY 45 104 144 220 300

When we substitute the value of EX,-EX,-EXY,-EY and n in equations I and II, we get 260 = 5a + 15b ...... 813 = 15a + 55b III ...... IV

Solving equations III & IV, we get b = 3.3 substituting value of b in equation III above we get, 260 = 5a + 15 (3.3) 260 = 5a + 49.5 260 49.5 = 5a

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210.5 ----------- = a = 42.1 5 Therefore the equation of the line of best fit in equal to Y = 42.1 + 3.3 X Using this equation we can find the trend values for the previous years and estimate the sales for 1977. The trend values and estimates are given below: Y 1989 = 42.1 + 3.3 (1) = 45.4 Y 1990 = 42.1 + 3.3 (2) = 48.7 Y 1991 = 42.1 + 3.3 (3) = 52.0 Y 1992 = 42.1 + 3.3 (4) = 55.3 Y 1993 = 42.1 + 3.3 (5) = 58.6 Y 1994 = 42.1 + 3.3 (6) = 61.9 The trend line represented by this equation is shown in the following figure. An examination of this line reveals that most of the points representing actual sales do not fall on it. For this reason, one would be hesitant to forecast sales by projecting the line and reading off the value of sales for some future year. Instead, consideration would be given to the fact that, in the past, actual sales varied from the sales as calculated from the equation of the line. Since these variations existed in the past, there is reason to believe that they will exist in the future, and therefore, it would be only natural to modify the value of future sales obtained from the trend line to reflect the expected variation. Ti is said that the real test of this method relates to prediction of turning points. Time series are characterized by fluctuations and turning points. Fluctuations and turning points occur because of four factors. They are (1) a secular trend (T) (2) seasonal variations (S) (3) Cuclical fluctuation in economic conditions (C) and (4) Irregular, random or residual forces (I) so the real problem in forecasting is to separate and measure each of these four factors. Unfortunately no reliable quantitative methods for handling cyclinical and residual variations exist. Classical time-series analysis involves procedures for decomposing the original sales series (Y) into the components T.S.C and 1 (trend, season, cycle and irregular or random events) respectively. According to one model, these components interact additively that is Y=T+S+C+I according to another model, they intract multiplicatively that is Y=TSCI. The multiplicative model makes the more realistic assumption that the seasonal and cyclical effects are proportional to the trend level of sales. T is stated in absolute values, and S,C and I are stated as percentages. The decomposition of time series data is a useful analytical tool for understanding the nature of business fluctuations. But it is of limited value in actual business forecasting. This is because of the fact that the prediction of cycles in difficult as there is no regularity in the cyclical behaviour.

MOVING AVERAGES Another method used to follow trends in demand data is the moving average. The forecaster simply computes the average volume achieved in several recent periods and uses it asa prediction of demand in the next period. This approach assumes that the future will be an average of past acthievements. Although moving average can provide good forecasts when demand is stable, they are apt to lag behind when there is a strong trend in the data. A decisive issues in moving averages is determining the ideal number of periods, to include the average. With a large number of periods, forecasts tend to react slowly whereas low values lead to predictions that respond core quickly to changes in a series. For a better understanding of the assumptions underlying he techniques od moving averages and some of its advantages and limitations it is necessary to look briefly at the mathematical representation of this method. In simple terms the techniques of forecasting with moving averages can e represented as follows:-

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Page no. 152

Where S_ = the forecast for time t, X_ = the actual value at time t, N_ = the number of values included in the average In can be seen from the above equation that the method of moving averages, equal weight as given to each of the last N values observed before that time. In can also be seen from the equation that to compute the moving average we must have the values of the last N observations. a somewhat shorter from of the above equation (1.1) for calculating the moving average can be developed. Page no. 153 Now it can be seen from equation (1.1) That S+I is simply

Page no. 153. Written in this form it is obvious that each new forecast based on moving average is an adjustment of the preceding moving average forecast. All the forecast needs to do is to apply moving averages to obtain historical data and them use either (1.1) or (1.2) to compute the forecast for the coming period. But it is necessary that he must also specify the number of periods to be used in the moving averages.

EXPONENTIAL SMOOTHING A feature of the moving averages that detracts from their ability to follow trends is that all time periods are weighted equally. This means that information from the oldest and newest periods is treated the same way in making up the forecast. But a strong argument can be made that since the most recent observations contain the most information about what will happen in the future they should be given relatively more weight than the older observations. what we should like is a weighting scheme that would apply the most weight to the most recent observed values and decreasing weights to the older values. Exponential smoothing satisfies this requirements and eliminates the need for storing the historical values of he variables.

In principle exponential smoothing operates in manner skin to moving averages by smoothing historical observations to eliminates randomness. The technical of exponential smoothing can be developed by using equation (1.2) for computing the moving average. Suppose we had the most recent observed value and the forecast made for that same period. In such a situation equation (1.2) might he modified so that in place of the observed value in period (t-n) we could employ an approximate value. A reasonable estimate would be the forecast value from the proceeding period. Thus equation (1.2) could be modified to give equation (1.3)

Page no. 154 This equation can be written as What we not have is a forecast the weights the most recent observation with the weitht of value I/N and the most recent forecast with the value of (1-1)/N. if we substitute x in place of I/N we have

Page no . 155

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This equation is the general form used in computing a forecast by the method exponential smoothing The main decision with exponential forecasting is selecting an appropriate value by the smoothing constant smoothing factors can range in value from zero to one with low values providing stability and high value allowing a more rapid response to demand change.

THE BOX JENKINS METHOD OF FORECASTING Perhaps the most common forecasting situation encountered in business is that of a time series in which a number of observation are taken over several periods of time and a forecast of some future time period is desired. As we have already seen all forecasting methods designed to handle such situations assume that there is a basic underlying pattern represented by the historical data and that in addition to that pattern some randomness has been exhibited. Thus the focus of the forecasting method is to isolate that basic pattern as far as possible and to sue it as the basic for future forecasts. Although a method such a exponential smoothing may be suitable for short term forecasting of time series in which there is not much fluctuation and the pattern is made up of combination of trend, a seasonal factor, and a cyclical factor as well as the random fluctuation. In such situation a much more complex forecasting method is needed. The Box-Jenkins method of forecasting is one that is particularly well suited to handling complex time series and other forecasting situations in which the basic pattern is readily apperent. The real power and attractiveness of this forecasting approach is that is can handle complex pattern with relatively little effort on the part of the forecaster. However, because it is dealing with much more complicated situation, it is much more difficult to understand the fundamentals of this technique and the limitations of its applications. In addition, the cost associated with the BoxJenkins approach in a given situation in generally much greater than any of the other quantitative methods, but with this greater cost, much greater accuracy be can achieved.

BAROMETRIC TECHNIQUES We have noted that simple trend projections are incapable of forecasting turning points. Barometric techniques are based on the ideas that certain events of the present can be used to predict the direction of change in future. This is accomplished with the help of relevant economic and statistical indicators which are selected time series related to the variable to be predicted. Here the key issue is finding indicators that have forecasting value for particular products. Some of the most commonly used indicators are listed below: 1. Construction contracts awarded 2. Personal income 3. New orders for durable goods 4. Employment 5. Agricultural income 6. Non-agricultural placements 7. Gross National income 8. Industrial Materials prices 9. Wholesale commodity prices 10. Industrial production 11. Change in manufacturing and trade inventories 12. Bank deposits etc.

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ECONOMETRIC MODEL BUILDING Econometric model building holds considerable promise as a method of forecasting demand. The best starting point towards an understanding of the basis of econometric forecasting is regression analysis. But the difficulty with regression analysis is that it is used to forecast a single dependent variable based on the value and the relations between one or more independent variables. each of these independent variables is assumed to be exogenous or outside the influence of the dependent variable. This may be true in many situations. But unfortunately, in most broad economic situations an assumption that each of the variable, is independent is unreaslistic. For example, let us assume that demand is a function of GMP, price and advertising. In tegression terms we would assume that all three independent variables are exogenous to the system and hence are not influenced by the level of demand itself or by one another. This is farily correct assumption so far as GNP is concerned. If, however, we consider price and advertising, the same assumption may not hold good, for instance, of the per unit cost is of some quadratic form, a different level of cost. Again, Advertising expenditures will often influence the price of the product, since the production and selling cost influence the per-unit price. The price, in turn, is influenced by the magnitude of demand, which can also influenced by the magnitude of demand, which can also influence the level of advertising or promotional expenditure. All of these point to the independence of all four of the valuables in our equation. When this independence is strong, regression analysis cannot be used. If we want to be accurate, we must express this demand relationship by developing a system of four simultaneous equation that to be accurate, we must express this demand relationship by developing a system of four independence idredtly.

Thus is econometric form we can have

Demand Cost Selling expenses Price

= f (GNP, price advertising) = f (production and inventory levels) = f (advertising, other selling expenses) = f (Cost and selling expenses)

That is, instead of one relationship, we now have four. As in regression analysis, we must (a) determine the functional form of each of the equations (b) estimate in a simultaneous manner the value of their parameters and (c) test for the statistical significance of the results and validity of the assumption. It should be realized that the advantages of econometric forecasting is that is provides the values of several of the independent variables from within the model itself, thus freeing he forecaster from having to estimate them exogenously. The estimation of the equation parameters involves problems for more complex than those encountered in regression analysis. This makes the application of econometric forecasting difficult and expensive. A number of mathematical techniques have been developed to help solve, econometric models. Some with manages may be familiar are the method of least squares, the full information maximum likelihood method of estimation, twostage least square methods and three stage least square methods. The details of these techniques are well beyond the scope of our discussion. An econometric model includes a number of simultaneous equation that can be of different types and functional forms. The translation of econometric theory to the right type of form of equation and their development into a set of functional relationship is termed as specification. The accurate and most appropriate specification of an econometric model is a key step in use of this technique of forecasting. A major part of specification is the identification of the exogenous and endogenous variables. one must arbitrarily decide on the degree of influence of the different factors and choose those that are least determined within the system as exogenous factors. This is kind to the distinction made in regression analysis between the independent variables and the dependent variables. in an econometric model we will want to separate those factors that are most

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strongly influenced by one another into the endogenous group and those than can be assumed to be determined outside the system of simultaneous equations into the exogenous group. Once the choice of endogeneous and exogenous variables has been made, on equation must be specified for each of the endogenous variables. When the number of the equations specified is equal to the number of exogenous variables, the model is said to be just specified. When the number of equations, the model is under specified and one or more of the variables has to be set arbitrarily to some initial value. these variables then become exogenous variables is greater than the number of equations, the model that is most often used for estimating the parameters of a set of simultaneously equations. Econometric models are used most widely to forecast macro series of inter related economic data such as income, consumption and capital spending and much less for business forecasts. The great advantage of an econometric model is indirect. It can be used to predict the direction and extent of change of the overall economic activity or any its components. This information can then become the input required to estimate the independent variables of a single equation forecasting model. Since this information can be obtained from outside sources, organizations do not have to develop their own models but can rely on outsiders to provide them with forecasts when they are required. Thus individual companies can forego all the high costs associated with developing maintaining, and running a large scale econometric model and obtain he information it offers through third parties. An additional experience is gained in the use of econometric models for forecasting, their application will undauntedly become more widespread at both government and industry levels. These econometric model of the future should be substantially more accurate than they have been in the past and should provide the managers with additional information he can use in applying other forecasting techniques that are less costly and more suitable for his purpose. In addition to these mostly commonly used methods, there are certain other methods of forecasting which are used by certain companies in advanced countries. For the benefit of our readers we propose to discuss these methods very briefly in the following paragraphs.

I.

Controlled Experimental Method:-

Under this method an attempt is made to vary separately certain important determinants of demand such as price, advertising etc., which can be manipulated and conduct the experiments assuming that the other factors will remainconstant. Thus, the effect of price, advertisements, packaging etc., on demand can be assessed by either varying them over different markets or by varying them over different time periods in the same market. For instance, different prices would be associated with different sales and on that basis the price-quantity relationship is estimated in the form of regression equation and used for forecasting purposes. It must be noted that the market division here must be noted homogeneous with reference to income, tasks etc. In the U.S. the parker pen company used this method to find out the effect of a price raised on the demand for Quick Ink. But this method is yet to establish itself as a variable one. This is due to a number of reasons. They are (1) Such experiments are expensive and time consuming. (2) They are risky because they may lead to unfavorable reactions on dealers, consumers and competitors 3) there is great difficulty in planning the study so far as it is not always easy to determine what all factors should taken to be constant and what factors should be considered as variables so as to segregate and measures their influence on demand. 4) it is difficult to satisfy the condition of homogeneity of markets. 2. Input Output Model Industry sales potentials can also be derived from input output tables for states and nations that show how businesses buy and sell goods from one another. Potentials can be extracted from input output data by dividing sales to particular industries by the total sales made to all sectors of the economy. The derivation of relative market potentials from input-output tables allows a firm to compare its own sales to particular market segments with the levels achieved by all firms in the industry. Although these comparisons look backward in time, they can reveal important market sectors that have been ignored by current marketing programmes.

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Input-Output tables provide a useful way to construct relative sales potentials for areas based on current levels of sales achieved by different industries. Input-output tables can also help in estimating the impact of some change within the market (an input-output table for a simplified economy is attached).

Purchased by Sales by Ordinary Manufacturing Service Primary Inputs Total inputs

Primary Industry 50 100 20 180 400

Manufacturing Industry 250 500 200 550 1500

Servicer Industry 10 40 100 350 500

Final Buyers Consumer 60 500 100 Investment 0 200 0 Government 30 160 30

Total output 400 1500 500

Gross domestic product = 1800 2400

3. Chain Ratio Method Demand potentials for individuals products can be determined by applying a series of ratios or usage rates to an aggregate measure of demand. A firm might start with a total population figure for an area and then multiply by average annual per capital expenditures to give an estimate of maximum possible sales for a general products class (Radios). This number could then the reduced by multiplying by a percentage that reflected sales of a particular type of radio (two Transistors) and still further by a percentage customers that bought a particular type (two bands). The resulting estimate of total sales for two band radios could then be divided among the firms in the industry.

4. Computer Assisted Forecasting Computers are frequently used to demand forecasting because they are fast and they can make predictions from masses of figures using complex procedures. This allows the firm to make more frequent forecasts for much wider range of products. The computer can also be programmed to make adjustments in raw date, compare predictions generated by alternative methods and keep track of forecasting errors. It may be pointed out here that no single method in foolproof. All are characterized by certain pita fails into which the unwary analyst is prone to fail. Therefore, the forecaster should beware of putting all his eggs in one basket. It is better not to rely entirely upon a single method. The wiser course and the one best for most forecasting situations, is to solve the problem from a number of different angles. If all individually constructed forecasts seem to point in the same direction, more confidence can be placed in the forecast that is finally transmitted to top management.

Demand Forecasting for New Products Demand forecasts for new products call for more ingenuity and skill. Forecasting methods need to be tailored to the particular product. Joel Dean has suggested six possible approaches for forecasting demand for new products. They are :

1) Evolutionary Approach Under this approach, the demand for the new product is projected as an outgrowth and evaluation of an existing old product. For instance, the demand forecast for colour television sets starts with the assumption that colour television picks up from where black and while left off. But this approach is useful only when the new product

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is so close to being merely an improvement of an existing product that its demand can be pretty a projection of the potential development of the underlying product. 2) Substitute Approach Under this technique, the new product is analysed as a substitute for some existing product or service. This approach has great promise when applicable.

3) Growth-Curve Approach Here the rate of growth and ultimate level of demand for the new product is estimated, on the basis of the patterns of growth of established products. For instance, analyze the growth curves of all established motor cars and try to establish an empirical law of market development applicable to a new brand of car. This method, even if it can be developed, has narrow applicability, and is useful primarily at the latter stages of demand projection.

4) Opinion Polling Approach Under this approach, demand for new products is estimated by making direct enquiries form the ultimate purchasers, either by the use of samples or on a full scale. The method is widely used to explore the demand for new products. But this method encounters problems of sampling, probing real intentions, and conveying the complexity of multiple alternative choice, even for established products. For new products these problems become more complicated. The forecaster has to clarify what a new produce is and what it will do. 5) Sales Experience Approach New product is offered in a sample market either by direct mail or through a chain store and thus attempts to estimate the total demand for all channels and fully developed market. The main problem here lies in determining what allowance is to make for the immaturity of the sample market and its peculiar characteristics.

6) Vicarious Approach Under this technique consumer reactions to a new product are surveyed indirectly with the help of specialized dealers who are supposedly informed about consumers needs and alternative opportunities. This method is temptingly easy and distressingly hard to quantify. Generally, it is usable only as cheap horseback sally. The various methods adopted for forecasting demand for new products are not mutually exclusive. A combinations of several of them is often desirable when the can supplement and check each other.

FACTORS AFFECTING THE DEMAND FOR NEW PRODUCERS DURABLE GOODS Generally a producer will not purchase new durable producers good unless he can reasonally expect that the return attributable to the new good over its life span will be sufficient to cover all the costs (including a reasonable profit) attributable to the purchase must be expected to be a profitable one. According to Joel Dean the most important factors determining the profitability of such purchasers are:a) The current demand and the future demand expected by the producer5 for his output of goods and services. b) His present stock (number of units, age and efficiency of the units and expected life span of the stock) durable goods.

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c) The expected life span and efficiency of the new durable good i.e. the expected life capacity of the new durable good. d) The cost of using the good i.e. the labour material, managerial costs etc., involved in the use of the good. e) The expected sale price per unit of the output of the good. f) The current and anticipated cost of (including the cost of using) substitutes, such as labour, for the new durable goods. CRITERIA FOR A GOOD FORECASTING METHOD The ideal forecasting method, according to Joel dean, is one that yields returns over cost in accuracy, seems reasonable (consistent with existing knowledge) can be formalized for reasonably long periods, can meet new circumstances adeptly, and can give up-to data results. Demand Forecasting Summary In recent times forecasting has come to play an important role in business decision-making. Determination of the types of forecasts required and establishment of procedures governing generation of these forecasts are fundamental steps in the organisatoin of a well-concerned production control system. From the point of view of time span and from the planning requirements, firms will be interested in estimating both short term demand, the firm may use one or may combination of the following forecasting methods. Opinion surveys expert opinion, chain ratio method, trend projections, barometric techniques, econometric models, inputoutput model, computer-assisted forecasting etc., these method very in their appropriateness with the purpose of the forecast, the type of product and the availability and reliability of data. Probably every firm can be improve the accuracy of its forecasts by collecting more data and/or adopting a better methodology.

Demand forecasting for new products calls for more ingenuity and skill. Forecasting methods need to be tailored to the particular product. The ideal forecasting method, according to Joel Deam is one that yields returns over cost in accuracy, seems reasonable (consistent with existing knowledge) can be formalized for reasonably long. Periods, can meet new circumstances adeptly, and can give up-to-date results.

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UNIT 3 CHAPTER V COST ANALYSIS SHORT RUN COST FUNCTIONS

Managerial decision making is facilitated by information that shows the cost of each rate of output. But short-run and long run cost functions are considered in this section. Consider a production process that combines variable. Amounts of labour with a fixed capital stock, say, then ten machines. In this process, the rate of production is changed by varying the rate of labour input. Assume that the firm can vary the labour input freely at a cost of Rs. 100/- per unit of labour per period. Therefore, the expenditure for labour is the variable cost. If the ten machines are rented under a long-term lease at Rs. 100/-, per machine per production period, the fixed cost would be Rs. 100/- per period. The table be low summarize the relevant production and cost data for this production process. The total cost data from the table are shown graphically in the following figure. Note that fixed cost is indicated by a horizontal line. That is, it is constant with respect to output. Total variable cost (TVC) begins at the origin, increases at a decreasing rate upto an output rate between (3) and (4) and then increases at an increasing rate. Total cost (TC) ahs the same shape as total variable cost but is shifted upward by Rs. 1,0000/- . The amount of fixed cost. Average or per unit cost functions often are more useful for decision making than are total cost functions. This is because managers must compare cost per unit of output to the market price of that output. Recall that market prices is measured per unit of output. By dividing a total cost function by output, a corresponding per unit cost function is determined that is, Average total cost Average variable cost : AC = TC/Q : AVC = TCV/Q ....(2) ...(1)

TABLE 1 SHORT RUN PRODUCTION AND COST DATA Input Rate Capital 10 10 10 10 10 10 10 10 10 0 2.00 3.67 5.10 6.77 8.77 11.27 14.60 24.60 Labour 0 1 2 3 4 5 6 7 8 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 Rate of output Total fixed cost Total variable cost 0 200 367 510 677 877 1727 1460 2460 Total cost 1,000 1,200 1,367 1,510 1,677 1,877 2,727 2,460 3,460

Figure Page no . 168

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Figure Page no. 169

FIGURE COST FUNCTION

AVERAGE FIXED COST : AFC = TEC/Q

...(3)

The Marginal cost per unit of output (MC) is the change in total cost associated with a 1-unit charge in output that is

Marginal cost : MC = STC/SQ

....(4) TABLE 2 PER UNIT COST FUNCTION

Output 0 1 2 3 4 5 6 7 8

Average fixed cost (AFC) 1,000 500 333 250 200 167 143 125

Average variable cost (AVC) 200 185 170 169 175 188 209 307

Average total cost (ATC) 1,200 684 503 419 375 355 351 432

Marginal cost (MC) 200 167 143 167 200 250 333 1,200

As it is true of all associated total and marginal functions, marginal cost is the slope of the total cost functions, using calculus, marginal cost is determined as the as the first derivative of the total cost function. That is, if the total cost function is, TC = T(Q) Marginal would be MC = d(TC)/dQ Based on the total cast function in table 1, data for each per unit cost function are reported in table 2 and shown graphically in figure 1b. there average cost, average variable cost, and marginal cost functions are important in managerial decision making. In contract the average fixed cost function ahs little value for decision making. Further the difference average total cost and average variable cost is average fixed cost. Thus the Ac and AVC curves contained the information on fixed cost per unit in the unlikely event that such information is needed.

The per unit cost functions fore many production systems have the U shape shown in the figure 1.b. If two low rates are production, there is too little of the variable input variable to the fixed output. At the variable, input is increased, output is increased, output raised rapidly, and therefore the cost per unit falls, Initially total cost increases but at a decreasing rate. This implies that marginal cost (the slope of the total cost) is falling. Because of the low of diminishing marginal returns, additional units of the variable output result in smaller additions to output and thus marginal cost rises. When marginal cost exceeds cost, the average cost functions begin to rise.

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At it is true of all marginal and average functions as long as marginal cost is below the average cost curve, the average functions will decline. When marginal is above average, the average curve will rise. This implies that marginal cost intersects both the total cost and variables cost functions at the minimum point of the average curves (points a & b in figure 1.b) FINDING MINIMUM AVERAGE VARIABLE COST:Given the total cost function TC = 1,000 + 10Q - 0.9Q2 + 0.04Q3 find the rate of output that results in minimum average variable cost. Solution: Marginal cost is the first derivatives of the total cost function

d(TC) = MC = 10 1.8Q + 0.12 Q --------dQ now, find the total variable cost function (TVC) by substracting the fixed cost component (Rs. 1000) from the total cost function that is, TVC = 10Q = 0.9Q + 0.04Q3 Then find average variable cost (AVC) by dividing TVC by output (Q). That is AVC = TVC = 10Q 0.9Q2 + 0.04Q3 ------- -------------------------------Q Q AVC = 10-0.9Q + 0.04Q 10-0.9Q + 0.04Q = 10 = 108Q + 0.12Q Rearrangind terms yields the quadratic equation. -0.08Q + 0.9Q = 0 Or Q(-0.08Q + 0.9) = 0 Which has the roots Q1 = 0 and Q2 = 11.25 Disregarding the root associated with a zero output rate, it is seen that the minimum AVC is achieved at an output rate of 11.25 units. Alternatively, the minimum point of AVC could be found by getting the first derivative of AVC equal to zero and solving for Q that is,

D(AVC) = 0.9 + 0.8Q = 0 -----------dQ 0.08 Q = 0.9 Q = 11.25

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Average cost functions and production theory:There is a correspondence between the production functions developed and the per unit cost of functions. Recall that average product is defined as output divided by the variable input. If labour is the variable output, the average product function is AP1 = Q/L Or 1 -----AP1 L ------Q

Because, labour is the only variable input, average variable cost is the expenditure, on labour (WL) divided by output. Or AVC = WL/Q

But between L/Q = 1/APL It follows that AVC = W 1/APL .... (5)

Thus there is an inverse relation between average product and average cost. If average product is increasing, average variable cost will be decreasing and vice-versa. The marginal product of labour is defined as the change in output divided by the change in labour, that is MPL = Q/L or 1/MPL = L/Q And marginal cost is the additional expenditure on labour (W L) divided thus. MC = TC/Q = W.L/Q But because L/Q = 1/MP 1 it follows that MC = 1/MPL .......... (6)

This is, marginal cost is the price of the input times, the reciprocal of marginal product. As before, if marginal product is increasing. Marginal cost will be decreasing and vice-versa. The law of diminishing marginal returns implies that as input increases due to the addition of name of a variable input to a fixed input a point will be reached where marginal product will decrease. As that point

Figure Page no. 174

Figure 2 Relation between product functions and per unit functions The total marginal cost of function will begin to increase.

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These relationships between the product and per unit cost function are depicited in figure 2 is efficiency in the production process are captured initially by using more variable input in combination with the fixed input, marginal cost falls. When these efficiencies are exhausted, marginal cost increases. Thus the concept of U shaped average and the marginal cost curves is slopes the principles of marginal production. Key concepts: Per unit or average cost functions tend to be more useful than total cost functions in making, sound decisions. The average cost functions are found by divided the relevant total cost of function by output, that is, Average cost Average variable cost Average fixed cost : : AC = TC/Q

AVC = TVC/Q : AFC = TFC/Q

Marginal cost per unit is the change in the total cost function associated with a 1 unit change in output, that is, MC = TC/Q There is an important relation between the product and the per unit function. When average or marginal cost per unit will be decreasing and vice-versa. The law of diminishing marginal returns implies that as more of a variable input is combined with a fixed amount of another input, a point will be reached where marginal product will decreases and therefore marginal cost will increase. Long run cost functions:Firms operate in the short run but plan in the long run. At any point in time, the firms has one more fixed factors of production. Therefore, production decisions must be made based on short run cost curves. However, most firms can plant to change the scale of their direction by varying all inputs in the long run and by doing so, more to a preferred short run cost functions. Returns to scale are increasing, decreasing or constant depending on whether a proportional change in both inputs results in output increasing more than in proportion less than in proportion or in proportion to the increase in input. These possibilities are shown in the left had panels of figure 3.

Figure Page no. 176

(a) Increasing Returns to scale

Figure page no. 177

(b) Decreasing returns to scale Figure page no. 177 (c) Constant returns to scale There is a direct correspondence between returns to scale in production and the long run cost function for the firm. It returns to scale re increasing, inputs are increasing less than in proportion to increases in output. Because input prices are constant, it follows that total cost of also must be increasing less than in proportion to output. This relationship is shown in figure 3(a). if decreasing returns to seak apply, the total cost function increases at increasing rate. Constraint returns to seak implies that total cost will change in proportion to changes in output. The later two relationship are sho0wn in the parts (b) and (c) figures 3.

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The production process of many forms is characterized first by increasing returns and then by decreasing returns. In this case, the long run total cost function first would increases to a decreasing rate of and then increase at an increasing rate as shown in the figure 4. Such a total cost of function would be associated with a U shaped long run average cost function. Suppose that a firm can expand the scale of operation only in discrete units. For example, the generators for large electric power plants are made in only a few sizes. Often, these power plans are built in multiples of 759 megawatts (MV). That is, output capacity of alternative plants would be 750 MV 2250 MV and soon. The short-run average cost functions in figure 5 (Labeled (sac., through SAC) are associated with each of four discrete scales of operations. The long run average cost function for this firms is defined by the minimum average cost of each level of output. For example, output rate Q1 could be produce by plant size 1 at an average cost of C1 or by plant size 2 at a cost of c2, clearly, the cost is lower for plant size 1, and thus point a is our point on the long run average cost curve. By repeating this process for various rates of output, the long run average cost is determined. For output rates of zero to Q2, plant 1 is the most efficient and that part of SAC 1 is part of the long run cost function. For output rate Q2 to Q3 for output is the most efficient, and for output rates Q3 to Q4, plant 3 is the most efficient, and for output rates Q3 to Q4, plant 3 is the most efficient, and for output rates Q3 to A4, plant 3 is the most efficient. The scallop shaped curve shown in bold face in figure 5, is the long run average cost curve for this firms. This bold faced curve is called an envelops curve. In general, a firm will have a great many alternatives, plant fixed to choose front, and there is short run average cost curve corresponding to each. A few of the short run average cost curves for these plants are shown in figure 6. Only one point or a very small of each short run cost curve will lie on the long run average cost functions. Thus long run average cost can be shown as the smooth U shaped curve labeled LAC. Corresponding to this long run average cost functions is a long run marginal cost cure LMC which intersects LAC is at its, minimum point and which is also the minimum point of short run average cost curve 10. The short run marginal cost curve (SMC 10) corresponding to SAC 10. But SMC 10 = SAC 10. Thus at point a and only at a point a the following unique reduce occurs. SAC = SMC = LAC = LMC ......(7) The long run cost curve serves as a long planning mechanical for the firm. For example, suppose that the firm is operating an short run average cost curve SAC, in figure 6, and the firm is currently producing an output rate of Q*, by using, SAC7 it is seen that the firms cost per unit is C2. Clearly, if projections of future demand indicate that the firms could expects to continue, selling Q* units per period. At the market price profit would be increased significantly by increasing the scale of plant to the size associated with short run average curve SAC 10, with this plant cost per unit for an output rate of Q* would be C1 and the firms profit per would increase by C1-C2. Thus total profit would increase by (C1-C2). Q*. Key concepts:This firms long run average cost function will be: Decreasing where returns to seak in production are increasing Constant where returns to scale are constant Increasing where returns to scale are decreasing The long run average cost function is the envelope curve consisting of point arcs on a number of short run average cost curves.

UNIT 3 CHAPTER 2 COBB DOUGLAS PRODUCTION FUNCTION The Cobb Douglas production function owes it origin to Douglas observations of certain characteristics in a vast amount of data be analyzed. In particulars he had observed that: That is (W/Y) = a (Wh)/Y = a ...(1)

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or w = a(Y/L) where W Wage hill Y Value of national output a a constant w money wage rate L total labour employed In other words, Douglas observed that the wage bill was a constant proportions of the value of the national output. Note that this observation implies that the real wage per head is a constant proportion of the output per head, Now according o the marginal productivity theory, in competitive, equilibrium the money wage rate w is equal to the value of the Marginal product of labour that is, w = (SY/SL) using (2), we have (SY/SL) = a (Y/L) ...(3) ...(2)

This means that the marginal product of labour is a constant proportion of the average output product of labour. Lobb. Suggested such a result would follow from a production function. Q = AKBL Where Q = Total physical product L = Total labor input K = Total physical capital input = Elasticity of output with the respect of labour B = Elasticity of output with respect of capital A = A constant is the efficiency parameter. Differentiating (4) with respect of labour we obtain, (SQ/SL) = (Q/L) But in competitive equilibrium, (SQ/SL) = w* Where w* is the wage rate in real terms, Therefore, W*L)/L or W* = (Q/L) ...(5) ....(4)

Allowing for a given commodity price, the experience in (2) & (5) are similar. Thus, lobbs formulation confirms, to Douglas observation of the wage bill being constant proportions of the National income. CHARACTERISTICS OF THE FUNCTION

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We now turn to the characteristics of the function first, its slope, since on a single isoquent the level of output is constant Q = Q. Taking the total derivaties of the production function and putting d-Q=O, we obtain after rearranging the term. (DK/DL)O = (K/L) ...(6)

The ratio dK/dL defined the marginal rate of technical substitution between the inputs k and l. in view of the implicit assumption that both inputs are necessary to produce any positive output K and L, and are both positive. Moreover, L and B are assumed to be positive, that is O/......& / _____1; similarly for B, hence the slope of a Cobb-Douglas constant product curve is negative We can also show that an isoquant obtained from such a function is convex to the origin. Connexity implies that the marginal product of an input decreases as the quantity of the input increases. Now;

(SQ/SL)

= AKBL-1

.... (7)

Note that the O/____& / ______ 1, (-1) is negative. Hence, as L increases, SQ/SL, the marginal product of labour increases, K increases similarly, it can be shown that the marginal product of capital decreases as K increases and increase as L increases hence the isoquant is connex to the origin. The elasticity of substitution, is obtained as follows. We know that the marginal rate of technical substitution of labour for capital.

(DK/DL)

= -(K/L)

...(8)

Let R = 1-(K/L) And K = K/L Therefore, R = -(L/B) k Now, = (dk/kj)/dR/R) = (dk/DR) (R/K) = -(B/L) (-1K) (BL) -------------------------- =1 (K/L)

The elasticity of substitution in a Lood Douglas function is equal to unity note that this value of does not depend on the specificaoitn of L + B = 1. Any general form of the Cobb-Douglas function will have an elasticity of substitution equal to one.

We now examine the nature of the returns to seak. If we specify L + B = 1, the Cobb Douglas function becomes linera homogenous in capital and labour input. In particular, after substitutin (4) (1-L) for , the exponent of the capital input, we obtain,

Q = Ak-1 L

...(10)

Note that the sum of the exponents of capital and labour is unity. If we now substitute mk for k and ML for L, observe that output is increased m fold. Hence with the constraint of L + B = 1, the Cobb Douglas function has the written in per capital terms.

METHODS OF ESTIMATION

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There are several ways of estimating a Cobb-Douglas production function. The first, is to estimate the function in its logarithmic form. Assume that he function to be estimated in for the I and h firm. The function may be written as Log Qi = a + B logn Ki + L Log Li + Ui ....(11)

Where a = Log A and Ui is the Stochastic disturbance term. If we have a data on output, capital and labour inputs, then the parameters a, B can be estimated. In the above form of the equation, no assumption is made of the nature of the returns to scale. If, however, we assume constant return to scale, so that L + B = 1, It can be written as Log (Qi / Li) = a (1- ) Log (Ki / Li) + Ui ...(12)

In this tem, output per head is a function of capital per head. With data on these, the parameters, as a and can be estimated. Note that is the elasticity of output with respect to labour and (1- ) is the elasticity of output with respect of capital.

A second method of estimating the production function is to assume perfect competition and the waxination, of profit. Then the real returns to capital and to labour are given by their respect marginal products. It w is the money wage r is the price of the services of capital, and p the price of the product, we have, W/p = SQi / SLi and r/p = SQiSKi ...(13)

These conditions may, as before be written as, = WLi / Yi + B = rKi / Yi ...(14)

Where Yi is the value of the output of the firm 1. The parameters and may be obtained from data on relative chares of wages and profits in the total value of the output of the firm.

A variant of the above method, of estimation, may be obtained by adding to the above, this assumption of the constant returns of scale, we know that the share of labour is = (WLi/Y) and the share of capital B=1. If, therefore, we have data on the share of labour estimated of can be obtained. Alternatively the equation for the share of labours may be written as, Log ( Qi/Li) = log (w/p) - Log x ......(15) That is a log linear relation between output per head and real wage with data on these can be estimated.

EMPIRICAL FINDINGS:The Cobb-Douglas production function is the most widely used function at the applied level. It has been used in both, time series, as well as cross section studies of industrial sectors of most economics. It has also been sued in its specific level, in which the exponents of capital and labour add to unity, capital and labour ad to unity and in its more general form, where the exponent of capital is not ... to the exponent of labour. There has been a fair amount of unifernity in the empirical findings. Broadly, these are as follows. First, the fit has in general, been good. This means that, if in an given situation, due to the quantities of capital and labour inputs are known, the output can be predicted with fair accuracy. Secondly when as in the earlier studies, it has been assumed that the sm of and is equal to one, the exponent of labour has in general been estimated at 0.78, so that , the exponent of capital is 0.25. Even in studies in which the constant returns to scale assumption has nto been invoked, the sum of the estimated exponents

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of laour and capital has continued to a approximately unity, thus suggesting either constant returns to scale or only marginal deviation from them. There has also been considerable measure of conformity in the numerical values of the exponents of capitals and a labour obtained for a particular sector over several years, and also for difference sectors. The numerical values of he exponents of labour & capital have corresponded fairly closely with the respective shares of labour and capital in the national income of various countries. This appears to indicate that the factors of production, capital and labour, receive the share they expect to under competitive conditions.

OBSERVATIONS ON THE FUNCTIONS:The function is generally estimated at he aggregate level, for example, for the non-form or the manufacturing sector of the economy. They assumption that labour and capital inputs are homogeneous has limitations. The Batergeneous output is measured by the value added method, that is the difference between the gross name of output and the new material cost and the resultant series in defeated by prices of output, in order to obtain an index of physical production. Capital is generally measured in value terms, as the sm of net investments overtime. This method implicit assumes that depreciation is correcting estimated. However, it fails to take note of changes in the quality of capital assets. Moreover, it igneous the difficulties in estimating the correct degree of utilization of capital stock. Further input is measured in physical units. In terms of the number of persons, employed or if TA/DA are available, in man hours or may-days. Where labour is measured as a stock, two precautions, appears to be necessary. First, adjustment for changes in the degree of utilization of labour which in view of the better data available, may be easier for labour than for capital and second correction for changes in the working week. An additional precaution is to allow for changes in the quality of labour over time. Secondly, there is the problem concerning aggregation, in in particular, the question whether an aggregate CobbDouglas production function preserves the characteristics of the neoclassical micro production, function. The condition so far such valid aggregation appear to be rather stringent. For example it has been shown that for consistent aggregation, the production function should be additively separately this means that output is them equal to a labour component plus a capital components. The fixed proportion production function satisfies this conditions.

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UNIT 4 MARKET STRUCTURE PRICING AND OUTPUT The determinations of prices and output levels is very much affected by the competitive structure of the market. Here, competitive structure is a phrase which refers to the nature and extent of the monopolistic elements, if any, that are present in any particular market situation. There exists a large body of literature which discusses various types of competitive conditions running the range from perfect competition to pre monopoly, and which seeks to analyze their effects on prices and output. It is convenient to start oru discussion by listing some of the important market situations which have been investigated.

MARKET STRUCTURES

Perfect

Imperfect

Monopolistic Competition
Perfect competition

Oligopoly

Duopoly

Monopoly

An industry is said to be operating under perfect competition when the following conditions are satisfied.

i)

Large Number of Firms:

There must be a large number of firms in the industry. Each firm controls only a very insignificant share of total output so that any action (addition to or removal from the market) on its own part will have little or no effect on the price and output of the whole industry. The same holds god in the case of consumers.

ii)

Homogeneous Product

Each firm in the industry must be making a product which is accepted by buyers as being identical, or homogeneous, with that made by all the other producers in the industry. This ensures that no producer can put his price up above the general level.

iii)

Freedom of Entry and Exit:

Any individual or company with the funds and inclination must be able no enter the industry without artificial hindrances being erected against him, and any owner of affirm in the industry, who wants to leave the field in free to do so. iv) v) Independent Decision Making: Firms take independent decisions. There should not be any collusion or agreement between firms in decision making. Perfect Knowledge about the Market: There is perfect knowledge on the part of all producers consumers, and resource owners regarding the conditions prevailing in the market.

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vi)

Perfect mobility of Factors: There is perfect mobility of factors of production among different firms in the industry and among different industries in response of pecuniary signals and transport costs are ignored.

Now let us examine some immediate consequences of the definition of perfect competition. Under perfect competition the demand curve of the firm is always a horizontal straight line. The follows from the first two features of he definition of perfect competition, viz large number of producers and homogeneous product. For example, no single wheat farmer can do anything about the days price in Madhya Pradesh or Uttar Pradesh. If he raises his wheat price above the going price he can sell any amount he can be expected to produce. For him, then, there is no price decision to be made-the price figure is simply handed to him. In the short run the firm may make either profit or less. But in the long run the free entry and exit feature of perfect composition sees that these profits or losses will disappear altogether. If the Industry earns profits, new firms will be prompted to enter it and compete with the already established firms. The resulting increase in demand for inputs may enhance their prices and hence raise costs on the other hand, the increased product supply may result in a reduction in its market price. The result of third double pronged action will be that profit will be squeezed down towards zero or atleast until no additional firms find it worth moving in. Similarly, if there is initially a net loss to firms in the industry, the exist of concerns especially those who are not earning any profit, will raise profits and ultimately it will eliminate loss. The above reasoning holds good only if there are no autonomous changes in demands or casts during the period the adjustment. For example, a crop failure or the invention of more efficient equipment may suddenly restore high profits to wheat farming and so offset the influence of new entrants. Since, to some extent, such changes are always taking place, the adjustment toward zero profits will always be imperfect. However, the forces working in that direction will never the less be there. In the following paragraphs we propose to examine in some what greater detail the nature of this competitive equilibrium towards which the market tends to adjust. Such a situation is shown in figure 12.1 (1) and 12 (b). In these diagrams the horizontal line DD is the firms demand curve. The curve is a horizontal straight line because, as already pointed out, no change in the firm output is a sufficiently significant contributions to total market supply to affect the price. As there is no price discrimination, the firms demand curve will also be its average revenue curve. The rationable is that if all units of a commodity are sold at the same price, the revenue brought in by an average unit must be its price. Hence DD is also the average revenue curve. It is known fact that where an average curve is neither rising nor falling it will coincide with the corresponding marginal curve. Here, since the average revenue curve is horizontal throughout its length, it must everywhere coincide with the marginal revenue curve.

Figure Page no. 191 Figure12.1(a) represents the situation of a competitive profix maximising firm in short run equilibrium. Its profitmaximising output id OM where its marginal cost curve MC intersects the marginal revenue(demand) curve DD. At this point it is earning a profit RP on each unit it produce (=unit revenue minus unit cost ) Thus its total profit (=unit profits multiplied by the number of units produced0 id represented by area ERPD. Note that output ON where also its marginal cost curve .MC intersects the marginal revenue (demand) curve DD is not the profit maximising output. A careful examination of the figur12.1(a) will make this point very clear. At output ON marginal cost has only just become equal to marginal cost is less than marginal revenue and has previously been greater. Beyond output ON marginal cost is less than marginal revenue and the shows that it is profitable to produce more. The favourable situation continues upto OM where marginal cost and marginal revenue are equal .So if output in fixed at ON, the firm would b rearing only minimum and not maximum profit. So here we may state that at the profit maximizing point the marginal cost curve must out the marginal revenue curve from below. A firm can never earn maximum profits unless this happens.

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Figure12.1(b)represent a long run equilibrium situation . here the average cost curve must be a tangent to the demand cureve.DD the reason is that if the units costs were everywhere higher than price, every output would be unprofitable, and firms would leave the industry, thus shift the curve as well. Similarly, if the average cost curve were to interest the demand curve. There would be some output at which profits could be earned and an influx of new firm would soon shift the cost and revenue curves sufficiently to wipe out these profits. Only when there is tangency will the no-profit ,no-less position of long-run equilibrium be the best the firm can do, and no firm will tempted to enter or leave the field if this is the typical situation of all firms in the area. Since the demand curve is horizontal, the profit of tangency. Q of the average cost curve with the demand curve must occur at an output at which the unit costs are at a minimum. For that reason the marginal cost curve will also intersect the average cost curve at that point .In short, at the point of equilibrium we have the impressive set of eqalifies, marginal cost equals marginal revenue equals average cost equals a average revenue equals price.

(MC = MR = AC = AR = P) It is to be noted that two essential conditions are to be fulfilled if there is to equilibrium in a perfectly competitive industry. First ,each and every individual firm must be in equilibrium. This will happen when each and every individual firm must be in equilibrium. This will happen when each firm in the industry is earning maximum profits by equating marginal revenue with marginal cost. Second , the industry as a whole must be in equilibrium. This will occur when there is not tendency for firms either to enter or leave the industry, which will only happen all the produce in the industry are earning enough money to induce them to stay in the industry, and when no producer outside the industry thinks that he could earn enough money, where he to enter it, to make the move worthwhile. EQUILIBRIUM IN THE COMEPTITIVE INDUSTRY The equilibrium position of an industry under perfect competition can be depicted with the help of an industry supply curve and industry demand curve. The supply curve can give an interpretation in terms of costs. In fact, in the long run it tends to approximate a curve of average costs for the industry. This, as we know, is a consequence of the free-entry-and exist assumption and its zero profit result if the industry were to supply its commodity at a price which exceeds its average cost, some firms would be making a profit. But we know tat the entry of new firm will wipe out that profit. We must analyze the stability of this industry equilibrium in order to see whether this equilibrium point can be expected to be of direct relevance to any real market situation .i.e. whether there is any mechanism which pulls competitive priced and output into line with their equilibrium levels. It is neither deasible nor appropriate here to go into a full dynamic analysis of this stability question. But we propose to examine the mechanism which can work in the direction of stability. Fig.12.2(a) shows the usual supply and demand diagram for the competitive industry. Figure no.193 The equilibrium occurs at the point of intersection of industry supply curve SS and industry demand curve DD at E and PE and Me constitute the equilibrium price-quantity combination of the industry. Imagine now that, for one reason or another, the market price falls below the equilibrium price, say to Pr. In this case the quantity demanded will exceed the quantity supplied by quantity DR-SR and we may expect price to be pushed back toward the equilibrium price. Similarly, a price PW, which is above the equilibrium at least give an appearance of stability which dynamic analysis can rationalize. But it need not and often does not follow that the supply demands equilibrium position will always be stable. On the other hand, it is easy to find a case where the system worked in the wrong direction fig.12.2(b) depicts such a system. Here ,when the price falls to PQ, below the equilibrium price supply will exceed demand (by quantity SR.DR) Hence price will by driven down even further. In the same way, we can see instability on the upward side. Of course such cases are rare in practice ,nevertheless the illustration atleast that we must be cautious in assuming that our models are always well behaved.

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Figure no.194 equ EQULIBRIUM AND TIME There id one other type of change in demand and supply conditions which id important enough to merit special study. We know that the longer the period of them which we take into consideration, the greater the difference in the supply conditions. For instance, if demand suddenly increase, price is likely to rise sharply in the short run because firms will be expanding output along fairly steep run marginal cost curves. But in the long-run, firms will be reorganized so as to produce the new and higher output more efficiently. For firms will now be producing along their rather flatter long-run marginal cost curves. Moreover, new firms will have been able tot enter the industry. The initial change in equilibrium prices is caused by the changed conditions of demand, but the succeeding changes in price over time depend on the response of conditions of supply to the new demand situation. And the magnitude of such changes in supply will usually differ according to the length of time being considered. Figures 12.3(1), (b) and (c) depict the impact of changes in supply and demand positions upon price under three different situations.

Figure Page no. 195 Figure 12.3(a) represents the market period. The fundamental features of this period is that supply is absolutely limited. Under such a situation demand exerts a dominating influence on the price. A rise in demand will push the market price from OP to OPO and a fall in demand will push down price from OP to OP. Figure 12.3(b) depicts the position in the short period. Under this situation. Supplies can be altered by increase or decreases in current output. But the time is not enough to bring about changes in fixed equipments and there by adjust production. so when demand increases from DD to DD price is pushed up from OP to OP. but as the supply is also adjusted to some extent, the rise in price is not so sharp as in Figure 12.3(a). Figure 12.3(c) represents the long period situation. In the long period there is time for firms fixed equipment to be altered to that output is capable of adapting itself more fully to changes in demand conditions that it was in the short period. In figures 12.3(c) SS is the original supply curve and DD the original demand curve. They intersect at point E and the resultant market price is given by OP. Now demand increases from DD to DD. Consequently the price is pushed up to OP. but now supply is enhanced and this is indicated by the new supply curve SS. The new supply curve S S intersects the new demand curve DD at point G. the resultant price is OP which is a bit higher than the original equilibrium price OP but much lower than OP the price resulting from the original shift in demand. MONOPOLISTIC COMPETITION Under prefect competition, the market of each seller is perfectly merged with those of his rivals. But under monopolistic competition the market of each seller is in some measure isolated, so that the whole market is not a single large market of many sellers, but a network or related markets, one for each seller. This is because of the special feature of monopolistic competition viz. product differentiation. Differentiation of product means that no two firms put out the same item. Products are differentiated either by trade marks or wrappers or through some other device. Under perfect competition, the individual sellers market being completely merged with the general one, be can sell as much as he pleases at the going price. Under monopolistic competition, however, his market being separate to a degree from those of his rivals, his sales are limited and defined by three new factors 1) his price, 2) the nature of his product, and 3) his advertising outlays. The divergence of the demand curve for his product from the horizontal straight line imposes upon the seller a price problem which is absent under perfect competition. The problem is very similar to that associated with the monopolist. Depending upon the elasticity of the curve and upon its position relative to the cost curve for the product,

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profits may be increased, either by raising the price and selling less, or by lowering it and selling more. That figure will be sought which will ensure maximum profit. The adjustment of his product similarly is a new problem imposed upon the seller by the fact of differentiation. The volume of his sales depends in part upon the manner is which his product differ from that of his competitors and in part upon the skill with which the good is distinguished form others and make to appeal to a particular group of buyers. Again, the seller may influence the volume of his sales by incurring advertisement expenditures. Such expenditures increase both in demands for his product, and his costs, and their prices will be adjusted as are prices and products so as to render the profits of the enterprise a maximum. The advertisement expenditure is peculiar to monopolistic competition in the sense that it has no purpose to serve under perfect competition where any producer can sell as much as he wants without it. Gains from advertisement un monopolistic are possible on two accounts. i) ii) Imperfect knowledge on the part of buyers as to the means whereby wants may be most effectively sansfied, and The possibility of altering wants by advertising or selling appeal.

INDIVIDUAL EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION Under monopolistic competition the demand curve for the product of the firm may be expected to have negative slope, even though the firm is as small as one operating under conditions of perfect competition. This is because customers will have different degrees of loyalty to the firms from whom they make their purchases. A small reduction in one firms (price may only attract is competitors most mercurial customers. But as larger and larger price reduction are instituted, it may acquire more and more customers from its rivals by drawing on customers who are less anxious switch. The equilibrium of the firm involves the usual conditions marginal cost is equal to marginal revenue. In the short-run the firms may or may not earn a profit. Under monopolistic competition oven can even expect something like freedom of entry. Since firms are small, relatively very small amount of capital is required to set up business and turn out a product not quite the same as but still very like those already in the market. The consequence is that, as under perfect competition, both profits and losses will tend to be eliminated in the long run. The two situations explained above i.e. equilibrium with profit and no profit are represented in figure 12.4(a) and 12.4(b). In figure 12.4(a) the firm is in equilibrium when it produces OM units. At this level of output the firm is equating marginal cost and marginal revenue and each unit is sold at a price OP and there by earns a profit to the area of the shaded rectangle PTQR. Figure 12.4(b) depicts a situation where the firm is not earning any profit. The equilibrium output here is attained by the tangency between the average cost curve and the negatively sloping demand curve DD. It can be seen from this figure that at any other output, unit cost will be larger than price and so such as output will involve loss to the firm. Figure Page no. 199

The average cost curve is generally taken to have the U shape indicated in the diagram on the assumption that both very small and very large output are difficult and expensive to produce. Even economics of large scale apply only up to appoint, beyond which administrative costs and diminishing returns, because of the presence of source (bottleneck) inputs, are generally expected to raise the unit costs of production. If this a valid, the point of tangency R between the U-shaped average cost curve and the negatively sloping demand curve must be found somewhere to the left of the minimum average cost point Q. This is in direct contract with the equilibrium of the competitive firms whose long run position is Q (of Figure 12.1(b) above). Therefore, the output of the firm under monopolistic competition must be smaller, and its unit cost and price higher than it would be under perfect competition.

GROUP EQUILIBRIUM WITH PRICE COMPETITION

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The analysis of group equilibrium with price competition is accomplished in two phases. The first, depicted in Figure 12.5(a) certain to the situation in which the proper or optional number of firms is already in the product group.

In figure 12.5(a) DD and dd (solid) give two demand curves dd shows the increased sales any entrepreneur can expect to enjoy by lowering price provided all other entrepreneurs maintain their original prices. DD on the other hand, shows the actual sales to be gained as a general downward movement of price take place. LAC is the long-run average cost curve for the typical firm in question. We assume an initial (short-run) equilibrium attained at point. a with output OM and price OP. Short run profit is represented by the area of the shaded rectangle P ABC Each entrepreneur, regarding dd as his demand curve, realizes he can increase profit by reducing price and expanding output (according to the elastic dd) Therefore each reduces price. But instead of expanding along dd each in fact moves along DD. In chamber lines terminology, dd slides downward along DD.

Figure Page no. 200

Despite the frustration of their initial plans, producers hold firm in their belief that dd represents their demand curve. So they continue to reduce price in an attempt to augment profit and dd continues to slide downward along DD. The downward movement will continue until it comes to point Q. where it is shown as the broken curve. Of course dd might fall below the broken curves position in that case all entrepreneurs would incur loss and so price would be raised shifting dd upward. The position of long run equilibrium is Q where dd is tangent to LAC. Each firm while having a monopoly of its own product, is pushed to zero profit position by the competition of rivals producing readily substitutable products. In summary we can state that long run group equilibrium under price competition is attained when the anticipate demand curve (dd) is tangent to the long-run unit cost curve. If dd lies above LAC each producer believes he can increase profit by reducing price if dd is below LAC price must be increased to eliminate the loss incurred. Now let us see what happens if the anticipated demand curve dd does not have precisely the right slope so as to be tangent to LAC at the point where DD cut LAC. For getting an answer to this question we have to se how long run equilibrium adjustments take place when there is entry of new firms. This situation is explained with the help of Fig. 12.5(b).

Figure Page no. 201

Consider that in Fig. 12.5(b) DD represents the initial demand curve and LAC the long run unit cost curve. The firm in question and any other in the product group reaps a very substantial pure profit. Since entry into the product group is open, new firms selling slightly differentiated products are attached. The greater variety of available products causes the demand for each sellers product to shrink. In the process DD shifts to the left and probably becomes somewhat more elastic. Side-by-side if entrepreneurs experiment with price policy, dd slides down the instantaneously existence DD and also probably becomes somewhat more elastic. The change from the initial DD curve to the ultimate long-run equilibrium at point E cold come about in several ways. One method is illustrated in fig 12.5(b) which it is assumed new firms enter the product group until the proportional demand curve shifts from DD to DD. It might seem that equilibrium is attained at F. With output OM and price OP per unit, in as much as pre profit is zero at that point. however, each entrepreneur thinks dd is his demand curve. A reduction is price would in his belief cause an expansion along dd profit would accordingly be expanded. But each entrepreneous has the same incentive. So as price is reduced by all, dd slides down DD for each.

Suppose now that price has fallen to OP with output OM Each firm incurs a pure loss represented by the area of the rectangle CBAP. It might seem that each firm could eliminate its pure loss by reducing price to OP and moving to

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point E. Yet with the number of firms giving rise to DD and reduction in price to OP would shift the subjective demand curve further down DD to the position dd Temporary equilibrium would be attained at G with sales of OM rather than OM per firm. The situation is necessary transitory, however, as each firm incurs a pure loss at G ultimately some firms must leave the product group and there is an incentive to do so. As firms leave the group the proportional demand curve shifts to the right, together with the anticipated demand curve and both probably become somewhat less elastic. The exist of firm must continue until the proportional curve becomes DD and the anticipated curve dd. Long run equilibrium is attained at E with identical long-run conditions explained above. OLIGOPOLY Oligopoly exists where a few sellers sell either similar products or slight differentiated products. When the products are slightly differentiated, oligopoly. The oligopoly situation (including the limiting case of duopoly) has one feature on which most of the economists attention had been centered. This is the interdependence in the decision making of the various firms, an interdependence of which is recognized by all of them. In an industry which consists largely of a small number of sizeable companies, each seller must be actually conscious of the actions of his rivals and of their reactions to changes in his policies. This is because a major policy change on the part of one firm is likely to have obvious and immediate effects on the other firms which comprise the industry. In other words there exists sufficient cross-elasticity of demand so that each seller must take in his pricing decisions, the rivals reactions into account. As a result, the oligopolist has developed an armoury of aggressive and defensive marketing weapons. For example, it is only under oligopoly that advertising comes fully into its own. Oligopolistic interdependence has another consequence. That is under oligopolistic interdependence a very wide variety of behaviour patterns becomes possible. Rivals may decide to together and operate on the pursuit of their objective, at least so far as the law permits or, at the other extreme, they may try to fight each other and perish. Even if they enter into agreement it may follow a wide variety of patterns. Because of this, the literature of oligopoly theory if full of different models, many of which described, at most, one particular arrangement a price leadership agreement or some particular method of using fright charges as a means for sharing (dividing) market territories. Here we are more concerned with the explanation of rigidity of oligopoly prices or what is known as the kinked demand curve.

KINKED DEMAND CURVE Now we propose to examine why, once a price-quantity combination ahs been decided upon, it will not readily change. The answer can be given with the help of kinked demand curve illustrated in figure 12.6 Consider the impace on quantity demanded of a reduction in the price of a commodity. this is illustrated by the demand curve for the product. Suppose, first that the reduction in the price which is charged by one firm is matched by other competing firms. In that case the firm may expect to increase its sales slightly, but since it is not possible to get any customers away from its rivals in these circumstances, no large addition to its sales is to be expected. Its demand curve (DD in Figure 12.6) will be relatively inelastic. Imagine, on the other demand, the turn in question is the only one to reduce its price. If so, a much larger increase in its demand is to be anticipated. Thus, where no other firm follows its price moves, the firm in question is likely to have a relatively elastic demand curve such as dd. In figure 12.6 let point G represent the firms current price combination. It has often been suggested that the large oligopolistic firm is likely to anticipate the following competitive reaction pattern to a price change. 1) Price reductions: If the firm in question reduced its price, its competitors will feel the drain on their customer quickly and so they will be forced to match this price reduction. On other words, for downward price movements from G the relevant portion of the firms demand curve will be GD of the demand curve DD (see fig. 12/6) 2) Price hike: If the firm increases its price, it may expect that its competitors will welcome the new customers which they gain from the price-raising firm as a result, and they will have no inclination to

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match the price hike. Hence, for price hikes the relevant part of the demand curve will be elastic segment dG.

Figure Page no. 204

In short, given this view of competitive reaction patterns the firms demand curve will be the composite curve dGd. Characterized by the kink (a bent) at the point G which represents the current price output combination. Now it is easy to visualize that a firm with such a competitive response pattern will be extremely reluctant to vary its price. For a fall in its price will not bring about any substantial increase in its sales. While a price hike will results in a substantial cut in business, and neither of these is a very attractive proposition. It may be noted here that the kink in the demand curve causes a finite discontinuity (break) in the marginal revenue curve, which is given by the dashed line dRQV dR is the segment corresponding the dG portion of the demand curve QV corresponds to the less elastic Gd segment. At point G there is a finite discontinuity represented by the segment RQ. The chief feature is the absolutely vertical section RQ. If the marginal cost curve happens to pass through anywhere through gap RQ in the marginal revenue curve, the profit maximizing firm will have no motivation to leave the current price OP Event if there is a sharp rise in costs, as long as the marginal cost curve does not rise above R it will lead to no price change. George J Stigler ahs questioned this proposition on empirical grounds. It seems evident that in an inglationary situation oligopoly firms do often follow one anothers price rises. However, as pointed out by Baumol the (oligopoly) analysis does show how the oligopolistic firms view of competitive reaction patterns can affect the chargeability of whatever price it happens to be charging. DUOPOLY Duopoly is a limiting case of oligopoly. Under duopoly there are only two sellers. A certain move, say a price reduction, any be advantageous to one seller in view of his rivals present policy i.e., assuming it not to change. But if rival is sure to make a counter move, there is no reason to assume that he will not, and for the first seller to recognize the fact that his rivals policy is not a datum, but is determined in party by his own, cannot be construed as a negation of independence. It is simply to consider the indirect consequences of his own-acts-the effect on himself of his own policy, mediated by that of his competitor. Of course, he may or may not take them into account, but he is equally independent in either case. If a seller determines upon his policy under the assumption that his rivals are unaffected by what he does. We may, say that he takes into account only the direct influence which he has upon the price. Since the problem od duopoly has usually been conceived of in this fashion. We shall analyze first the results under such an assumption. Following this, it will be argued that the only solution fully consistent with the central hypothesis that each seller seeks his maximum profit is one in which he does take into account the effect of his policy upon his arrivals ( and hence upon himself again). In this latter case, we may say that he considers his total he considers his total influence upon the price, indirect as well as direct. One more distinction is made before we analyze the problem, i.e. his rivals policy may remain fixed with respect either to the amount he offers or to the price at which he offers it. The solution will be different in the two cases. First we give the solution offered by curnot? Here mutual dependence is ignored. Each seller assumed his rivals supply constant.

Curnot assumed that each seller determines the supply which is most profitable for himself in the light of his rivals present offering which do not change. He gives the example of two mineral springs, exploited by two owners without expenses of production, and contribution to the same market. For simplicity it is assumed that the demand curve for the mineral water is a straight line. DQ This is illustrated in figure 12.7.

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Figure Page no. 206

In figure 12.7 OA = AQ the daily output of each spring. The price is zero when the total possible output (OQ) is put upon the market. Suppose there is initially only one seller in the market. To maximize his profit he sells OA nits of mineral revenue with the zero cost. Price is OP(=AC) per unit and profit is OACP. Now suppose that the other seller enters the market. Here come curnots crucial assumption. To get an analytical solution of a duopoly one must make a behavioral assumption concerning each entrepreneurs expectation of his rivals policies. Curnots assumption is that (as already stated at the outset) each entrepreneur expects his rival never to change his output. So the best encroachment that his rival can make is to offer AB rendering area ABRT, being the largest which can be drawn in the triangle AQOC). The first producer now finds his profits reduced to OATP. Thereupon he tries to increase them by reducing his output to (OQ-AB). The process will continue, the first producer being forced gradually by the moves of the second to reduce his output, the second producer being able slowly to increase his share of the market until each one is contributing equally to the total market. In these adjustments, each producer will always find his maximum profit by making his supply equal to (OQ minus the supply of the other). The total output will be OQ ( 1 Y gedgdf gefgd gdf gdfgdgd gdfg dg dgdf g 2/3 QCgdfgj Page no. 207 The output of the first producer will be OQ ghjdgkd gdgdfgd gdfg df gdfg df gdf The output of the second producer will be Gdgdf gdg stss s gs gsd gdg The successive terms of each series indicate the successive adjustments, as they have been descried. The ultimate equilibrium will be the same, however, no mater from which point the movements start. It will also be the same if, instead of the wide movements described here, the two producers increase their outputs gradually and at the same time, from OA ech, or if they move in any other conceivable way, so long as the initial conditions of the problem, are kept, that each tribes to maximize his profit independently of the other, and neglecting his influence upon the other. It is clear from Figure 12.7 that if either producer is offering OF (=1/3 OQ) the best his rival can do is to offer (OQ-OF) which is FE and equal to OF, securing profits of FEWS. Since the other is in the same position, stable equilibrium is attained at this point. Similarly, it can be shown that if there were three producers the total supply would be OQ. Each supplying 1/3 of this amount, and so on for larger number. If there were 100 producers the supply would be 100/101 OQ. And if the number were extremely large, it would be virtually OQ. When supply tends to OQ price tends to zero. The addition of cost curves will not in any way affect the essential conclusion, which is that as the number of producers increases form one to infinity the price is continually lowered from what is would be under monopoly conditions to what it would be under pure or perfect completion. The price is perfectly determinants irrespective of the number of sellers, would be closer to the purely competitive price diminishing cost than under constant cost, and closer under constant cost than under increasing cost.

EDGEWORTHS SOLUTION : Edgeworths analysis is based on Joseph Bertrands criticism about Curnots analysis. Curnot assumed, as we have already noted, that each seller assumes his rival supply constant. Bertrand, on the other hand, believed that a solution should be worked out on the assumption that entrepreneurs believe their rivals maintain a constant price. this suggestion was developed by Edgeworth into duopoly solution. Mutual Dependence Ignored: Each seller assumes His Rivals Price Constant. Edgeworths solution is illustrated in Fig.12.8

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As in Curnots situation, let us suppose two firms situated side by side. Selling a homogeneous product produced at zero marginal cost. The entire market is pictured as being divided equally between entire preneurs X and Y DD is the demand facing entre preneur X and DQ is the demand Facing Y Each producer has a maximum achievable rate of output and, therefore rate of sale. These maxima are represented by CO units for X and OC units for Y. finally thrordinat OD is the price axis. Figure no209 By construction OB=BD and Ob=BQ If X enters the market first, he will produce and market OB units, selling each for OP price. He thus will reap the maximum monopoly profit OBEP. Now Y enters the market under the assumption that X will not change his price. So he set his price alightly below that of X (=OP) and sells his maximum producible output OC. In other words, Y price being lower than that of Xs and their products being identical,Y sells as much as he can produce, capturing a substantial portion of Xs market. Now it is Xs turn to evaluate the situation Assuming (as he does) Y will never change his price. X can lower his price slightly below Ys and sell his maximum producible output OC. In the process he captures most of Ys market. Then Y still assuming X will not change his price, reduces price below that of X and so off. Thus, according to Edgeworth, will ne successively lowered by Y and X until the level of OP is reached. OP is the total disposal price both X and y can sell their maximum outputs. But once the price OP is attained, one of the entrepreneurs (say X) will notice an interesting fact. At price OP, Y sells his entire output. Thus if Y retains that price, X can raise the monopoly profit OBEP. Consequently, X raise the price to OP. then Y observes that if he raises his price from OP to an amount slightly below OP, he can dispose of his entire output and enjoy a greater profit. So he raises his point accordingly. Them X recognizes that if he lowers his price slightly below that of Y he can sell his entire output and so on. Consequently price continuously move between OP and OP. the duopoly situation, according to Edgeworth, is unstable and indeterminate. The Edgeworth case, just at the Curnot case, requires no comment because it is based upon a nave assumption that is itself continually shown to be wrong by market results. CHAMBERLINS SOLUTION Chamberlins analysis is based on the assumption of mutual dependence. Chamberlins analysis is very similar to that of Curnot except for the result. Chamberlins analysis is illustrated in Figure 12.9 In figure 12.9 CC represents the linear demand for mineral water X first enters the market and sells Om un its at price OP thereby reaping a monopoly profit OMEP. Now Y enters the market. Seeing that x produces Om units Price falls to OP ad total profit for both produce is given by OMFP. FIGURE NO 211 The difference between Curnot and Chamberlin is take according to Chamberlin X will survey the market situation after Ys entry, recognize heir mutual interdependence and recognize also that sharing monopoly profit OMEP is the best either he or Y can do. Consequently X reduces his output to OM=1/2 OM. Y also recognizes the best solution and as such he maintains is OM price is OP and X abd Y share equally the monopoly profit OMEP The most important thing that is to be noted in Chamberlins solution is that his entrepreneurs behave in a sensible manner. This is a great improvement: but in addition he obtains a stable solution that is not too far from reality in homogeneous oligopoly situations. REACTION CURVES AND DUOPOLY PRICING (Baumols Analysis) Figures 12.10(a) 12.10(b) illustrate the price output policy under duopoly. Reaction curve R r in figure 12.10(a) contains the relevant information about the price reaction of one firm Y to the pricing decision if another firm X. For example, point p on this curve indicates that if firm X sets price OP= for its product, and if firm Y reactw in accordance with the information given by its reaction curve, the price of Ys product will become OP. If Y does stick to this reaction pattern, Xs optimal price decision can be represented quite easily. The broken curve in Figure12.10(a) represent the indifferent curve of Xs objective function i.e they are his iso profit curves if X is a profit maximize.

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Than the highest indifference curve which x can attain ?(the highest indifference our a compatible with Ys reaction pattern) is II which is tangent to Ys reaction curve at point Q. To get this point X must set his price OX and accordingly. This must be his optima price. Do far so good. But unfortunately for the analysis, two can play at optimization. Figure 12.10(b) contains in addition to Ys reaction curve R R which indicates the manner in which expects X to react to his price. Y in turn may mow pick an optimum point, say R on Xs reaction curve. R R and thus he will set price at OP. But if both X and Y choose these optimal price they will end up neither on point Q nor on R. Rather the resulting point combination will be represented by T a point which lies on neither reaction curve. FIGURE NO 212 The result will be that both producers will be surprised at their earnings- they may either be pleasantly surprised (on higher indifference curves than they expected) or they may be disappointed. More important, they will realize that the reaction curves have become falsehoods, for neither producer is now reacting in accordance with the dictates of hos reaction curve. Once they realize this , they will also know that their optimality calculations have gone astray. What was optimal for X so long as y struck to his reaction curve need no longer be optimal once Y struck to his reaction curve need no longer be optimal once both firms must began their calculations afresh and according to Baumol we cannot say where they are likely to go from here. MONOPOLY In the beginning of the chapter we analyzed one limiting case perfect competitionwhere completion is keen and the demand curve is horizontal. Here we propose to analyze the other limiting case where competition, far from being keen is completely absent. This case is called monopoly. In case of pure or perfect monopoly a producer is so powerful that he is always able to take the whole of all consumers incomes whatever the level of his output. In the case of pure monopoly the elasticity of the average revenue curve for the monopolists firm is unitary. (This is shown in fig.12.11) To put in other words, the total outlay on the firms product is the name at all price and therefore the marginal revenue is always zero i. e the marginal revenue curve coincides with the X axis.

Under this situation all consumers spend all their incomes on the firms product irrespective of high or low price it charges. but this does no mean that the pure monopolist can fix both the price and the output at the same time. When he fixes the price quantity demanded will be decided by what the consumers will take at that price. On the other hand, when he fixes his output, the price will be decided by what his customers will play for that much of output. The pure monopolist can fix either the price or the output, but not both at the same time, anyhow, within these limitations his power is complete.

Figure Page no 214 However, pure monopoly like perfect competition, is just a theoretical limit. A producer who controls the whole supply of a single commodity without close substitutes is called a monopolist and it is to his analysis that we must give attention. To interpret strictly a monopolist is the sale producer of his produce and there is no distinction between the firm and the industry ie. the firm of the monopolist is not only a firm but it is also an industry. It is the only one firm which produces that particular product. The firms average revenue curve slopes downwards just as the deman curve for the product of an industry sloped downwards. The main differences between perfect competition and monopoly are the following:-

1) In case of perfect competition the price is the result of the interaction of the forces of demand and supply,
whereas, in monopoly the price is deliberately fixed by the monopolies. 2) In perfect competition a single price prevails for each commodity. on the other hand, the monopolist ahs got the possibility of discriminating between different customers and might charge from them different prices for the same commodity.

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3) Under perfect competition any attempt from the part of a producer to charge higher price will only face
with failure, because the customer has got the choice of deserting this particular producer and going to a different producer (seller). But under monopoly there is only a single producer and the customer is forced to buy the commodity from him at whatever price he (the monopolist) charges for it. SOURCES OF MONOPOLY Now we shall analyze the following sources of monopoly. 1. There are occasions when a producer possesses certain scarce raw materials or secret methods of production. and their possession gives him monopoly power. 2. Sometimes the Government grants licence to some particular individual to produce some particular commodity. this is a special privilege conferred on him by the state. This kind of privilege creates monopoly conditions. 3. Another sources of monopoly is the ignorance, laziness and bias of the buyer himself. Sometimes a producer convincers him customers that his commodity is superior to the commodities produced by other producers and this gives him monopoly power. For maintaining this illusion he (the producer) makes use of different types of advertisement and publicity. MONOPOLY PRICE As we already saw, unlike in perfect competition in monopoly price is deliberately fixed by the monopolist. He will fix that price at which the excess of gross receipts (revenue) over total costs will be the greatest. He can achieve this by regulating output in such a say, that the marginal revenue is than he saved of cost, and if he produced one unit more, he would incur more of cost than the gained of revenue. Both will result in the reduction of profit. Now we shall analyses the price determination under monopoly. First of all we shall analyze the situation where there is absolutely no cost of production e.g. the case of a mineral spring. This situation is illustrated in fig. 12.12. The monopolist maximizes his profit when the equates his marginal revenue with his marginal cost. And this happiness when he produces OM quantity of output and sell at the price of GP per unit. Note that the elasticity of demand at the point R on the average revenue curve is equal to one and therefore at this point the total receipts will be the maximum. At this point marginal revenue and marginal cost will be zero.

Y R AR
Another situation is the one with positive marginal cost. Fig. (12.13). this is a more useful situation. To simplify the analysis we shall assumes that those costs are constant. Beyond the point R in the average revenue cure the elasticity of demand is less than one and so the monopolist is not interested beyond point R. between the points R and R the curves elasticity is equal to one. And since the monopolists marginal costs are positive, it will be better for the monopolist to O reduce his output atleast as far as A. A is shown in the figure, to the left of point R it is likely that all M monopolists will have ranges on their average revenue curves with elasticities of demand for their products greater than one. Thus the monopolist will produce upto OM quantity where marginal revenue equals marginal cost. At this point the elasticity of the average revenue curve will be greater than one.

Figure Page no. 217

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Next is the situation where the marginal cost is rising and the monopolist is working under diminishing returns. Such a situation is illustrated in Fig. 12.4 In fig. 12.14 the monopolist is in equilibrium when the equates his marginal cost with marginal revenue. This happens when he producers OM units of output.a t this output he earns a profit which is shown by the rectangle PRLW. Another situation to be analyzed is that of constant marginal costs or constant returns. This situation is illustrated in Fig. 12.15. Here the monopolist is in equilibrium when the producer OM units of output. At this level of output his marginal cost and marginal revenue are equal. The monopoly price is OP and the area PRLW represents monopoly profit.

Figure Page no. 218

The last situation is the one where the monopolists produces under conditions of failing marginal cost or increasing returns. This is shown in Fig. 12.16 Here also equilibrium position is possible, provided marginal cost curve falls less rapidly than marginal revenue curve. In fig. 12.16 the monopolist is in equilibrium when he produces OM units of output. At this output his marginal cost and marginal revenue are equal. The monopoly price is OP and the monopoly profit PRLW. If the marginal cost curve falls throughout more rapidly than the marginal revenue curve equilibrium will be impossible and this is the only situation under monopoly when equilibrium is impossible. In the other hand for a firm under perfect competition equilibrium position can only occur when the marginal cost curve of he firm is rising at the near the equilibrium output.

PRICE DISCRIMINATION UNDER MONOPOLY Discriminating monopoly or Price discrimination occurs when a monopolist charges different prices for different units of a commodity, even though there units are in fact homogeneous so far as their physical nature is concerned. Depending on the nature of the circumstances the possible extent of discrimination will vary. There is a theoretical possibility that every individual unit of a commodity is charged a different price, which situation is called perfectly discriminating monopoly. But, in practice, discrimination between buyers is more common than between units of a homogeneous good. In the case of perfect competition price discrimination between customers is nor alt all possible, because the customer who is charged more by one particular seller has got the opportunity of going to a different seller and buying form him. But even under monopoly it is not always possible to discriminate between different customers. The fundamental condition for price discrimination to take place is that there should not be any possibility of resale of the commodity from one consumer to another. In case of the following three main types of situations price discrimination can occur even if there is no fundamental difference between the goods sold to the different buyers. 1. Discrimination owing to Consumers Peculiarities discrimination in this type of case can occur for three reasons: a. It can happen where consumer A in unaware that consumer B gets the same good more cheaply. Or, to put it more generally, it can happen when consumers in one part of the market do not know that prices are lower in another. b. It can exist where the consumer has an irrational feeling that though be is paying a higher price he is paying it for a better good. For instance, it is probably irrational to think that one gets a better view of the firm from the front row of the Rs. 3.00 seats than from the back row of the Rs. 1.50 seats.

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Even in case of the same good different prices can be charged from the same consumers depending on the purpose for which it is used e.g. different rates charges for electricity for different purposes such as domestic, agricultural and industrial uses. In the foregoing paragraphs we have analyzed the conditions where price discriminiation is possible. Now we propose to examine the situations when price discrimination is profitable. For analyzing this we can apply the equilibrium theory of the firm to a case where there are two markets. If the monopolist is to be in equilibrium the following conditions should be fulfilled. First of all, marginal revenue in both the markets must be equal. Moreover, marginal revenue should be equal to the marginal cost of a producing the whole output. Figure page no. 220 In fig. 12.17 the seller is a monopolist in market H the home market, where the elasticity of demand for his product is not very great. Therefore his average revenue curve AR and marginal revenue curve MR slope downwards. In the World W there is perfect completion and the demand is perfectly elastic. For the World Market the average revenue curve (AR) and the marginal revenue curve (MR) coincide and that is a horizontal straight line. The curve MC represent the marginal cost. To determine the equilibrium output the meeting point of marginal cost curve and the combined marginal revenue curve must be found. The total output should be allocated for the two different markets is such a way that the marginal revenues are equal in each market. The composite curve ZARQ represents the combines marginal revenue curve. The marginal cost curve and the combined marginal revenue curve intersect at R. Thus OM is the equilibrium output. As is already mentioned equilibrium output is at that point where the marginal revenue of both the markets are equal and at the same time equate with the marginal cost. Therefore OE quantity should be sold in the home market at a price of OP. at this point the marginal revenue is AE. The rest of the quantity should be sold in the home market at a price OP. here the marginal revenue is MR which is equal to Op. MR and AE are equal. Thus the price OP in the monopolistic home market is higher than the price (OP) in the world market. The equilibrium profit, which is contributed to by both the markets is equal to the area ZARF. Figure 12.18 shows the monopolists price-output when both the markets are monopolistic. Figure Page no. 221 Figure 12.18(a) and 12.18(b) show the marginal and average revenue curves of a particular firm for two different markets. The elasticities of demand at each price are different in these markets. Figure 12.12(c) illustrates the profitmaximising output. This is determined at that point where the marginal cost curve for the monopolists whole output (MC) and the curve showing the combined marginal revenue received from the two markets (CMR) intersect. It is by adding the curves MR and MR together sideways that we get the curve CMR. Thus the equilibrium output in OM and the marginal revenue is OK-MN. The total output is OM and the marginal revenue is OM should be allocated for the two different markets in such way that the marginal revenue in both the markets is OK. Thus in the first market (Fig. 12.18(a)) the price is OP and the quantity sold OM. In the second market (Fig 12.18(b)) the equilibrium output is OM the price OP and the marginal revenue OK. The area ZNL in Fig. 12.18(c) represent the monopoly profit.

UNIT IV PRICING STRATEGIES Pricing Methods: Formulating price policies and setting the price is often a critical factor in the successful operation of business organizations. Even through the basic pricing ingredients are the same for all firms (costs, competition, demand and profit), the optimum mix of these factors varies according to the nature of products, markets and the overall objectives of the firm. Thus, the job for the management is to develop and implement an appropriate pricing strategy that meets the needs of the company. Here we propose to discuss at first the most widely used pricing methods adopted by firms. These include cost-plus or mark-up pricing, break-even pricing, rate of return pricing, variable cost pricing peak-load pricing, going-rate pricing, product tailoring, cyclical pricing, and other related pricing techniques. The chapter concludes with a discussion on new product pricing and environmental pricing factors.

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Practical Pricing Methods: Generally businessmen prefer a pricing procedure which is easy to implement and require only very few assumptions on demand. The simplest method which satisfied the above conditions is known as cost-plus pricing or mark-up pricing. Cost-Plus or Mark-up pricing: Two studies of pricing behaviour have been made in the United Kingdom, one by a group at Oxford University. Who interviewed business magnates and another by Clive Saxton who depended on a mial questionnaire? These studies revealed that a majority of businessmen set prices on the basis of cost plus a fair profit percentage. By cost they usually mean full allocated cost at current output and wage levels. By fair profit is meant a fixed percentage mark-up which differs greatly among industries and firms. Some of this variation may be due to differences in cost base and some to difference in turn over rate and risk. Evaluation of Cost Plus Pricing: Does the use of rigid customary mark-up over cost make logical sense in the pricing of products? The answer is usually, no any pricing technique that ignores current demand elasticity in formulating prices is not likely to lead, except by chance to the achievement of maximum profits, either in short-run or in the long-run. As elasticity of demand changes, as it is likely to do seasonally, cyclically or over the product life cycle, the optimum mark-up should also change. If mark-up remains a rigid percentage of the cost then under ordinary conditions it would not lead to maximum profits. Under special condition it may be possible that a rigid mark-up at the right level may lead to optimum profits. The two conditions are that average (unit) costs must be fairly constrantover the range of likely output and price elasticity must be fairly constant for different points on eh demand curve and over time. In spite of the shortcomings mentioned above, cost-plus pricing continues to be popular with a sizeable population of the business community. The reasons for this popularity are mentioned below: i) ii) There is less uncertainty about costs than about demand so by relying on cost, pricing a simplified and the seller does not have to make frequent adjustments as demand conditions change. Where all firms in the industry use cost-plus pricing approach, their prices are likely to the similar. This helps to minimize price competition which would not be the case if firms paid attention to demand fluctuations when the priced. There is the feeling that cost-plus pricing is socially fairer to both the buyer and the buyer when his demand becomes acute. Yet the seller earns a fair return on his investment. Cost plus pricing is the safest though not the most profitable method of pricing

iii)
iv)

In short, the popularity of a cost-oriented approach to pricing rests on considerations of administrative simplicity, competitive harmony and social fairness. Break-even Pricing: Break-even pricing indicates how may units must be sold at selected prices to regain the funds invested in a product. A break-even chare prepared for ABC Ltd., is given below. The figure assumes that production and selling of ABCs product involve annual fixed expense of Rs. 85000 and the variable production costs for direct labour materials, and factory overhead are Rs. 2 per unit. When the fixed and variable costs are added, total cost intersect the revenue price curves at points A,B and C. These points show the volume neede to recover full costs at factory prices of Rs. 3 Rs. 3.60 and Rs. 4.60. Profits are generated when sales exceed break-even points and losses occur when sales fails to reach the break-even levels.

Figure page no. 225

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Although a break-even chart provides a useful visual representation, it lacks some of the details that can be included in a tabular analysis. The following table gives break-even volumes for xis potential ABCs prices by dividing total fixed costs by the margin generated at each price. The table also indicates the final prices the consumer would pay when the wholesale and retain margins are added to ABCs selling prices. It may be pointed out that the price of Rs. 2.60 requires sales of about 141.700 units to break-even while a price of Rs. 5 required only 28,300 units to be sold. The most serious defect associated with break-even pricing is its inadequate treatment of demand. The relationship between the final retain price and the number of ABCs products that will be purchased by consumers is crucial to the selection of the optimum price is obvious. Break-even diagrams, however, usually indicate total revenue as straight lines implying that larger volume can be sold without lowering prices (see the break-even charts). This is rather unrealistic and the company management must consider which combination of price and break-even volume will lead to maximum profits. Some of the factors influencing this decision are rivals offerings, previous pricing experience, and the special features (if any) of ABCs products. Finally, the decision depends on the ability of the company management to estimate the number of units that will be sold at each possible price. Rate of Return Pricing Pricing to achieve a planned rate of return on investment is popular among a number of business firms. It is also closely associated with the pricing policies of the public utility concerns.

Calculating Break-even Volume for ABC Ltd. Using Margin Per Unit. Rs. Sales Forces salary and expenses Advertising and Propaganda Expenses relating to Amortization of R&C Overhead expense allocation Other expenses 25,000 40,000 5,000 10,000 5,000 85,000

Retail Price (Rs.) (including wholesale & retail margins Possible manufacturing (seeing price (Rs.) Variable Cost (Rs.) Margin (Rs.) Break-even volume in 1000s of units (Rs. 85000 mfgs margin)

5.42

6.25

7.50

8.33

9.58

10.42

2.60 2.00 0.60 141.7

3.00 2.00 1.00 85.00

3.60 2.00 1.60 53.0

4.00 2.00 2.00 42.5

4.60 2.00 2.60 32.7

5.00 2.00 3.00 28.3

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* The fixed costs could be increased to include a profit so that the break-even volumes would show the sales needed to return planned profit. The pricing procedures used in rate of return pricing can be illustrated by referring to ABCs Ltd. mentioned earlier. Here the managements first task is to estimate its total costs at various levels of output. The total cost curve is shown rising (see fig. 13.1) at a constant rate until capacity is approached. Managements next task is to estimate the percentage of capacity at which is likely to operate in the coming period. Suppose that ABCs capacity is 1,00,000 units and the total cost of producing this volume is Rs. 250000 Assume Further that the firm expects to operate at 70 percent capacity. This means that it expects to sell 70,000 units. The total cost of producing 70000 units, according to figure (No. 13.1) is Rs. 2.25000 or about Rs. 3.21 per unit. Managements next task is to specify a target rate of return so that the planned return on investments will be achieved. If ABC aspires for a 20 percent after-tax rate of return on its Rs. 250,000 (0.20X Rs. 250,000 = Rs. 50,000) and the tax rate is 50 percent, then the price must be set to product Rs. 1,00,000 in total profits. Since ABC plans to sell 70,000 units a factory selling price of approximately Rs. 4.64 per unit well generate the desired profit and return on investment. Rate of return pricing, however, has a major defect. Sales estimates are used to derive a price ignoring the fact that price is an important factor that influences sales. A price of Rs. 4.64 may be too high or too low to sell 70,000 units. What is missing from the analysis is a demand functions, indicating how many units ABC Ltd., could expect to sell at different prices. With an estimate of the demand curve and with the requirement to each 20 percent on costs. ABC Ltd., could solve for those prices and volumes that would be compatible with the each other. In this way, ABC Ltd. would avoid setting at a price that failed to generate the estimated level of output.

Variable Cost Pricing Variable-cost pricing is often based on the idea that the recovery of full costs is not always realistic or necessary for the profitable running of business firms. Instead of using full costs or standard costs as the lowest possible price, this system suggests that variable cost of incremental cost represents the minimum price that can the charged. For instance, assumed that company ABC Ltd products have been marketed successfully through normal whole saleretail channels and a total of 70000 units have been sold in the past year at a price of Rs. 4.64 per units. This price covers full cots of Rs. 3121 and allows company ABC Ltd, a 20 percent after-tax return on its investment of Rs. 2,50,00. Company ABC Ltd., is now approached by a new customer who wants to make a special purchase of 20,000 units of its product at a price of Rs. 2.50 per unit. To evaluate this proposal company ABC Ltd., must know how much it will cost to produce this 20,000 units. If the variable cost per unit comes to Rs. 2 per unit ABC Ltd., cold make a contribution of Rs. 10,000 out of this order.

Under what circumstances company ABC Ltd. can accept this order is a big question. Some would suggest that the order can never be accepted as the price offered does not cover full costs. others would point out that if company ABC Ltd. were to cut prices for this particular customer other customers would demand an equal cut in prices. This could result in losses because there would be no way for Company ABC Ltd., to recover full expenses. While there is an element of truth in this line of argument, the crucial point is that the full costs of manufacturing each unit is not constant but, in reality, is quite sensitive to changes in volume. This is shown in Fig. 13.2 where unit cost decline as the fixed expenses are distributed over a larger volume. If we assume that ABC Ltds variable costs are produced for Rs. 62.5 per unit and 70,000 for Rs. 3.21 per unit. If volume could be expanded further to 170,000 unit cost would be reduced to Rs. 2.50 offered by the new customer. This indicates that a very low price can cover full costs if volume of production expands sufficiently. In the present situation, adding 20,000 units to the current production of 70,000 units lower estimated fixes costs per unit to Rs. 0.94(85000/90,000). When fixed cross are added to variable costs of Rs. 2.00 (which is constant) total costs (Rs. 2.94) exceed the Rs. 2.50 offered by the new customer. Since the order will bring less than full costs, it is important to consider whether the two markets being served are really insulated. Will sales to the new customer in any way reduce existing sales. If the two markets are really separated, then the new order will look more attractive. Acceptance of the new order will also depend upon the availability of unused capacity.

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Variable cost pricing is often encountered in situation where fixed costs make up a large proportion of total unit costs. the rail roads and airlines are two industries with high fixed costs that have made effective use of the volume-gene acting aspects of variable costs pricing. The underline idea is that it is better haul bulk-commodities and special classes of travelers at low rates and make some contributions than not to have the business at all. Railways typically face a declining unit-cost curve except when volume approaches capacity and tracks and yards become congested. This means that more volume usually increases profits by reducing the average cost of hauling merchandise. The airlines have used variable cost pricing when they set fares for excursions or special groups of customers. Variable cost pricing when they set fares for excursions or special groups of customers. Variable cost pricing is not a panacea for all products or for all firms, but it can lead to higher revenues and profits for sophisticated firm who understand the potential and limitations. Peak-Loand Pricing: A special form of variable cost-pricing can be used when there are definite limits to the amount of goods and services a firm can provide and customer demand tends to vary over time. For instance, the telephone industry builds capacity to satisfy 80 to 90 percent of its callers during peak periods that occur during week days. This results in a lot of unused phone circuits at night and weekends. Peak-load pricing suggests that phone rates should raised above average costs during high-demand periods and reduced towards variable costs during low demand periods. This tends to shift price sensitive callers to low demand periods and allows the phone industry to operate with below full capacity, Again, the very low off-peak rates may help to increase revenues by attracting some callers that normally do not use the phone for communication purposes. This form of pricing is also adhered by Telegraph departments electricity undertakings etc., The most important advantage of peak-load pricing is that it depresses peak demands and thereby reduces the total resources needed to satisfy customer demand. Again, it stimulates off-peak consumption and allows more efficient utilization of existing facilities. Going rate Pricing: The most popular from of competition-oriented pricing exists when a firm tries to keep its price at the average level charged by the industry. This form of pricing is knows as going-rate or imitative pricing. This system of pricing is popular for a number of reasons., some of them are mentioned below: i) ii) iii) Where costs are difficulty to measure, it is felt that the going rate represents the collective wisdom of the industry concerning the price that would yield an attractive return. It is also felt that conforming to a going price would be least disruptive or industry harmony. The difficulty to knowing how buyers and competitors would react to price differentials compel the producers to adhere to the going rate-pricing.

Going-rate pricing primarily characterizes pricing practice in homogeneous product markets, although the market structure itself may vary from pure competition to pure oligopoly. Under pure or perfect competition a firm has actually no choice about the setting of its price. There is about to be a market-determined price for the product which is not established by any single firm or group of firms but through the collective interaction of a multitude of knowledgeable buyers and sellers. The firm daring to charge more than the going rate will attract no customers. The firm need not charges less than the going rate as it can dispose of its entire output at the going rate. Thus, under highly competitive conditions in a homogeneous product market the firm really has not pricing decision to make. The major challenge facing such a firm is good cost control. In pure oligopoly also the firm tends to charge the same price as competition, although for different reasons. Product Tailoring:

Product tailoring refers to a policy of determining the selling price in advance and then working back to the design of the product. It is an inverted cost-price relationship in which the price of the product appears to determine its cost, instead of the other way round discussed for far. Product tailoring is directly applicable only when product design in

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fluid and when the target price is sharply defined by the economic situation in respect of substitutes and demand. This approach has the virtue of starting with market-price relatives it looks at the problem from the view point of the buyer in terms of what he wants and what he will pay. This technique may profitably be employed in an aircraft industry.

Refusal Pricing: Refusal pricing is related to products that are designed to the specification of a single buyer. Such products are priced on the basis of estimated incremental cost plus a gross margin equivalent to the opportunity cost. The producers pricing is called refusal pricing because he is deciding whether or not to make the product at all in other words, he has the option to refuse the order if he wants. but it may be noticed that even here cost sets only a floor for prices otherwise, the seller might miss potential immediate profits and ignore the effects of price upon future business.

Cyclical Pricing The pricing decisions of a firm have to take to account flunctionations in inventory, in capital outlays, in national income and in employment. It is of common knowledge that the prices of agricultural products and certain raw materials and manufactured goods have been predominantly flexible over the cycle. But the prices of certain other raw materials and the products of price leaders are relatively inflexible over the cycle. This is because of the fact that the price leaders are reluctant to change their prices frequently and they often try to limit price costs in periods of declining demand. They also refrain from major price increases in periods of rising demand. The main reasons for this type of price inflexibility can be grouped under four heads on the basis of cyclical changes in conditions of (1) demand (2) competition (3) Costs and (4) Profits. On the demand side, producers often believe that the demand for their products is highly in elastic and hence price change will not lead to any appreciable change in demand. From the point of view of competition, it may be stated that much industrial pricing is done under oligopoly conditions and that been the price leaders has to maintain a degree of price stability in order to ward off retaliation from others. This effect freezes prices and delays changes, usually until other prices have started moving. On the cost, side variable costs per unit tends to remain relatively constant over long periods and widely differing outputs on account of the rigidity of prices of raw materials and labour. Fixed cost per unit, as reported in conventional accounts, varies inversely with volume and with cyclically sensitive materials prides. Current full costs-pricing imports some of the cost rigidity to prices. On the side of profits, many firms, especially the price leaders who have considerable latitude in price-making, have generally as their goal a reasonable profit rather than profit maximization. Hence they many not lower or raise prices appreciably during business cycles. The main practical problems of cyclical pricing arise as to the degree, the timing and the pattern of cyclical price changes. The actual changes affected in net prices may take many forms of which the most important are: 1) changes in list prices 2) changes in product-mix and product-line differentials and 3) changes in the structure of discount and merchandising allowance. In formulating policy on crucial pricing, a potential price leader or firm having substantial independence in price determination can consider several possible policies some of which are mentioned below: 1. Price rigidity 2. Price fluctuations that conform to cost changes a. Current full cost b. Standard full cost c. Incremental cost

3. Price fluctuation that conform to prices of substitutes 4. Price fluctuations that conform to price of substitutes 5. Price fluctuations that stabilize market share

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6. Price fluctuations that conform to change in industry demand determinants. These policies might be characterized more accurately as objectives, since some of them cannot be fully attained.

Price Rigidity: Absolute or approximate stability of the firms price level over the course of the business cycle is a policy followed by some producers of industrial materials and equipment. It is largely based upon two assumptions 1) what the wide cyclical fluctuations in demand are caused by basic economic changes (e.g. in income, profits, expectations etc) and 2) that changes in the firms prices within the range of feasibility will be ineffective in altering these conditions or in tempering these cyclical fluctuations in demand.

Price Fluctuating that conform to cost changes: Confining cyclical changes in price to changes in production costs in another popular price policy. This policy has several variants depending upon which of the cost concepts viz full cost, incremental cost, or some forms of standard cost, that are employed.

Price fluctuations that Conform to prices of Substitutes: The use of substitute products as a cyclical pricing guide is an appropriate price policy in many situation. By keeping the spread between the firms product and substitute products stable, or by manipulating it to obtain specified volume objective, this cyclical pricing policy can protect pricing policy can protect or improve the companys market position. Such a policy may also help to stabilize the industrys share of the vast substitute market. Under conditions of homogeneous oligopoly, where there is strong price leadership, the cyclical price policy followed by many price followers of this types.

Conformity to changes in purchasing power: Keeping the price in line with the declining purchasing power of money is a depression pricing standard that has strong appeal. But it may be pointed out that this kind of blanker index of purchasing power is an inferior pricing guide. Price Fluctuations that Stabilize Market Share: Price is one important background determinant of that market share especially when products and services are dissimilar. Again, price policy has considerable effect upon the larger share of the substitute market. Market share can be a useful pricing guide for cyclical pricing. But the administration of such a policy are suppose moderately accurate and current information about what is happening to market positions. It also demands alertness and flexibility in pricing. Price Fluctuations that Conform to Changes in Demand Determinants: It is a known fact that the demand schedules, both of the Industry and of the firm, shift continuously consequent upon changes in general business conditions and changes in special outside conditions that affect the product. If these shifts in demand are marked, they should be taken into account in formulating prices. In reality, they are often more important than the elasticity of demand. Changing prices in relation to some appropriate index of shifts in demand for the product is a form of recession pricing policy. Sometimes it is possible to find a direct relationship between some index like disposable income and past fluctuations of the price of the product. This functional relationship can then provide a rough criterion of the appropriate price at any given or forecasted level of demand.

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The use of any such historical relationship as an absolute recession pricing criterion has severe limitations that destroy its usefulness in most industries. This pricing method implicitly assumes that (1) flexible rather than rigid prices are appropriate (2) changes in the price in the past have adjusted for changes in demand correctly (3) Past pricing objectives are todays objectives and (4) cost behaviour and competitive reactions will be the same as in similar periods in the past. So far we have been discussing the different pricing techniques that are popularly followed by business firms under different situations. Here we propose to start a discussion on new product pricing. In this discussion we focus attention on the specific plans and strategies needed during each phase of the product life cycle to improve the competitive position of the firm.. All successful products follow a four-phase life cycle that includes introduction, growth, maturity and decline. These typical stages are illustrated for a hypothetical product in the following figure.

Figure Page no. 236

At the introductory stage products are not known to the consumers. So here the emphasis should be on promotional activities so as to acquaint customers with the product and gain acceptance. The sales of the product rise slowly and if it catches on, follows a period of rapid growth in sale volume. This stage is characterized by increase in the number of competitors, major product improvements, line productions methods, penetration of other market segments etc., So during this phase emphasis must be given in opening new distribution channels and retail outlets. When the product reaches maturity, sales grow slowly or remains stables. Special promotions are needed to cope with such a situation. Finally the product reaches a stage of prolonged or rapid sales decline. At this stage the products need to be redesigned or the cost of production should be reduced so that they can continue to make some contribution to the company. When products become unprofitable, the firm must decide whether the products should be carried at a loss or phased out to make room for more profitable lines.

Product cycles very in length from few weeks for fashion goods to a number of years for appliances and food items. The length of time a product stays in any one stage of the life-cycle depends on customer adoption rates and the amount of news product competition. Three strategies that can be employed to stretch product markets are promotion of more frequent and varied usage among current users, finding new uses for the basic material, and creating new users for the product by expanding the market. Pricing a New Product: Formulating prices for new products is one of the most difficult problems, faced by company management these decisions are often complicated by lack of adequate information on both demand and costs. as the product has not been sold before, price elasticity cannot be estimated from an analysis of past data. Even the simple expedient of following the competitors price is not a practical alternative for new products. In spite of all these problems the firm must set a price that will help to sell the product and at the same time contribute something to the profits of the firms. A common approach to new product pricing is to make an intuitive appraisal of the product and to supply either a skimming or penetration price strategy. Skimming Price: The basic idea is to set a relatively high price that skim the cream of demand coupled with heavy promotional expenditures in the early stages of market development. The price is lowered atleast stages. The objective of skimming price is to gain a premium from those buyers who always stand ready to pays much higher price than others because the product, for one reasons or another, has high present value for them.

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The skimming lowered atleast stages. The objective of skimming price is to gain a premium form those buyers who always stand ready to pays much higher price than others because the product, for one reason or another, has high present value for them. The skimming price policy assumes that demand for the product is likely to be more inelastic with respect the price in the early stages than it is when the product is full-grown. The situation is illustrated by the downward sloping curve DD in the following figure.

Figure Page no. 238

The high initial price (P) us designed to skim of the segment of the market that is insensitive to price, and subsequent price cuts (P P) broaden the market by tapping more elastic segments of the market. The logic of skimming price strategy is further supported, by the assumption that many new products have no technical substitutes and price is not as significant as it is for traditional products. The skimming pricing strategy has the advantages that it generates greater profits per unit than would be possible with lower prices. By setting a high initial price and then gradually lowering the price, the company is able to reap the maximum that each market segment is willing to pay for the product. Another advantage of a skimming price strategy is that helps to restrict sales at a time when the firm may be unable to keep up with customers orders. A policy of slowly lowering prices to expand sales makes it easier for the firm to increase production capacity to meet the growing demand. The strongest argument for adhering to the skimming price strategy is that it generally is the safest and most conservative approach available. By starting with a high price the company can find out how many customers are willing to pay for the product while retaining the ability to lower the price of competitive conditions warrant such an action. If the company should accidentally set a price that is too high, it can always be reduced, whereas a price that is too low may be difficult to raise.

The most important disadvantage of the skimming price strategy is that the high margins associated with such a strategy attract competitors into the field. This suggests that the skimming price strategy can be best used when the products has patent protection or when there is barrier to entry such as technical know-how or high capital requirements. Penetration Price: A Penetration price is a relatively low price designed to stimulate the growth of the market and to capture a large share of it. The penetration price strategy is based on the following assumptions. (1) Demand for the D1 product is highly elastic such as shown by the curve DD in the following figure (Fig. 13.5) (2) There is no elite market that can be exploited with high. Initial prices. Under these conditions, a high price (P) may actually result in zero sales.

Price

131 Fig. 13.5 Quantity demander

(3) The unit costs of production and distribution fall with increased output. (4) A low price would discourages actual and potential competition. But it may be pointed out that penetration pricing is a high risk strategy that can lead to losses if sales do not live up to expectations. Another problem is the low margins which suggest that it will take longer time to recoup development expenses than it would with a skimming price policy. Pricing in Maturity: The problem here is to determine a pricing policy for later stages of the cycles, i.e. after imitators have involved the market of the once unique product. To formulate such a policy the producer must know when a product is approaching maturity. Hence, we propose to list some of the symptoms of product maturity.

Symptoms of Product Maturity: 1) Weakening in brand preference is the first symptom of product maturity. This is evidenced by a higher cross-elasticity of demand among leading products. Now the leading brand will not stand as much price premium as it started with, without losing position. 2) Reducing physical variations among products in another symptom of product maturity. This happens when the best designs are developed and standardized.

3) The third symptom of product maturity is market saturation. This is generally indicated by an increase in
the ratio of replacement sates to new sales. 4) The stabilization of production methods is the last symptom of product maturity. As soon as the products show the maturity the management must think in terms of granting appropriate price reductions taking into account the cross-elasticity of demand.

Environmental Pricing So far we have been focusing our attention on the immediate demand and factors that influence pricing activities in mono products firms. There are however, a number of other consideration that frequently influence pricing policies. These include the effects of multiple product lines, restriction imposed by government. All these factors tend to influence profit and revenue maximizing prices derived from an analysis of demand and cost data.

Product line pricing Since almost every firm has several items in its product line, product line pricing becomes an important phase of price policy. The problem of product-line pricing is to find the proper relationship among the prices of numbers of a product group. Product-line pricing may refer to product group. Product-line pricing may refer to products physically the same but sold under different conditions. This gives the seller an opportunity to charge different prices. Thus sue differentials (e.g. hot coffee versusiced coffee) seasonal differentials (e.g. night fights or night telephone calls), and style cycles differentials are all phases of product-line pricing. The rationale for this heterodox approach to pricing is

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that the essential economic features of the product line is the cross-elasticity of demand that exist among parts of the sellers output.

General Approach to Product Line Pricing The underlying principle in product-line pricing is that demand elasticities and competitive situations rather than cost should form bases for determining the patterns of relative prices of the firms products. And the role of cost should be confined to set lower limits for price and to help select the price. Output combination that is most profitable. But in reality this principle is not widely employed in product-line pricing. Instead firms fix prices in such a way that they are proportional to full cost (i.e. that produce the same percentage net profit margin for all products) or (incremental cost) (i.e. that produce the same percentage contribution margin over incremental costs for all products) or with profit margins that are proportional to conversion cost. Prices are also set in such a way that type produce contribution margins that depend upon elasticity of demand of different market segments or that are systematically related to the stage of market and competitive development of individuals members of the product line.

Demand Relationship in the Product-line: There are two demand relationship that are important in product-line pricing. The first is the interdependence of the demand for various members of the product line. This interdependence may result from their nature as substitute or complementary products. The second demand characteristic is the importance of the products as instruments for market segmentations and price discrimination. Product-line pricing has also to take account of competitive differences in respect o fhte different products in the line. The number of competitors, the extent of the firms market share and he degree of substitutability of the competitors product are symptoms with which the existing competition can be measured and the price adjusted accordingly.

The relevant concept of cost applicable in product line pricing is incremental cost. Normally, the incremental costs of each members of the product line can be compared with its price. The margin between incremental costs and price will differ greatly from products to product depending on the depend conditions. Incremental cost set a floor below which the price should not go normally. Sometimes strategic considerations warrant the continuance of a product in a line even when its contribution to the profit margin is below average, such a product may be loss-limiter (i.e. it completes a product line by offering a fall range of colours, sizes, design etc.) or price meter (i.e. its role is to carry out the firms policy of meeting every competitive price with some member of the product line).

Price Differentials: The two parts of price are (1) the basic list price and (2) the net price actually charged. The difference between the two are due to the trade status of the buyer, the amount of his purchase, the location of the buyer, the promptness of payment, the time of purchase and the personal situation. The total returns realized by the manufacturer depends on the price charged on each section of the buyers and also on the size of their purchase.

An important aspect of price differentials is price discrimination. By price discrimination is meant a policy of chargin different prices for the same product, in other words, price discrimination, exists when differences in prices charged by a seller do not exactly match difference is cost. The relevant cost concept applicable in this context is the marginal cost, though it has limitations when the plants do not function as full capacity and also when joint products involving common costs go into the product mix. From the welfare point of view, price discrimination often acts as an instrument for the equalization of real burden. And even governments increasingly resort to various measures of price discrimination in the form of farm price support. The practical problem of price discrimination is to break the market into segments that differ in price elasticity of demand. Market segmentation can be justified only on the basis of he incremental concepts cost and revenue i.e. only on the basis of the incremental concepts cost and revenue. The

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extreme from of price discrimination is practiced by medical practitioners in whose case market segmentations may extent to the level of individual clients.

The manufacturer will have various goals in adopting differential prices for his products. Some of such goods are 1) Implementation of a marketing strategy. Differential prices may be part of an over-all marketing strategy in order to reach particular sectors of the market. 2) Market differential prices help in achieving profitable market segmentation when legal and competitive considerations permit price discrimination 3) Market expansion differential pricing that is designed to encourage new uses or to attract new customers is a common goal of product-line pricing, but it also extends to discount structure. 4) Competitive adaptation differential prices are a major device for selective adjustment to competitive situation. When there are standardized products in the industry, differential prices help to achieve competitive partite with customers of different backgrounds. 5) Ruction of productions cost seasonal discounts and the like reduce the over all production costs by encouraging off season purchases.

Distributor Discounts These are price deductions that systematically make the net price very according to the buyers po.

B.COM / BBA MODEL QUESTION PAPER MANAGERIAL ECONOMICS PART A 6 * 5 = 30 Answer any six questions. Answer shall not exceed one page for each question. 1. Explain the scope of Managerial Economics. 2. Indicate the role of uncertainty indecision-making. 3. Compare incremental reasoning with managerial analysis. 4. How do you define the term demand and demand function for a commodity? What are the general determinants of demand for a commodity that appear in the demand function for that? 5. How do you determine consumer choice under uncertainty 6. Enumerate the steps in demand forecasting. 7. Define a) Break even pricing b) Peak loud pricing 8. Define price leadership. 9. Explain opportunity cost concept PART B 5 * 14 = 70 Answer to each question shall not exceed three pages.

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10. Managerial economics is the integration of economic theory with business practice fort the purpose of facilitating decision making and forward planning by management. Explain. 11. Enumerate the steps in demand forecasting. 12. Explain how an individual firm attain equilibrium in the short and long periods and under perfect competition. 13. How is price determined under conditions of duopoly. 14. Define price-elasticity of demand. How it is computed and what are its determinants and uses in economic analysis. 15. Explain the term marginal rate of commodity substitution (MRCS) What is the significance of this term in the theory of consumer behaviour? 16. What are the points based on which indifference curve analysis is regarded superior to Conventional Utility Analysis.

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