Economics Final

---Swami Vivekananda---
Economics
It’s a Social Science.
Social science studies social activities which create
social relation.
Economics-
Economics studies particular type of social
activities = Economical activities.
Production
Exchange
Consumption.
2
Definition of Economics
Adam Smith
( Father of Modern Economics)-
"Enquiry into nature & Causes of wealth of
nation". (1776).
Robbins -
Economic is a science which studies human
behavior as a relationship between ends and
scares means which have alternative uses.
3
Economic Problem
Why this problem arises-

i. Human wants are unlimited.
ii. The means are limited
iii. Alternative uses of the limited resources.
4
Economic Resources
Land:-

Labor:-

Capital:-

Organizer:-

5
Economics answers three basic
questions-
Economic problem.
What to Produce?
How to Produce ?
Whom to Produce?
6
Economics can be studied under
two heads
Micro Economics.

Study of individual unit.
Macro Economics.

It studies economics as a whole.
7
Managerial Economics
Management + Economics = Managerial Economics

Management =

Coordinating work activities so that they are completed efficiently and effectively with and through people.

Managerial Economics

It is defined as the integration of economic theory with business practice for the purpose of facilitating decision making.
8
Decision Making
"Decision making as the process of selecting the

suitable
action from among several alternative course of action".
Characteristic of Decision Making.

Risk
Uncertainty
9
Uncertainty
Change in demand and supply.
Changing business environment.
Government polices.
External influence on the domestic market.
Social and political change.
10
Process of Decision Making.
Defining the objective to be achieved.

Collections and analysis of information.

Selecting the best course of action.

Implement the course of action.

Continuous monitoring.

11
Scope of Managerial Economics
Scope study how far a particular subject will go.
Demand Analysis
Consumption Analysis
Production Theory.
Cost Analysis
Market Structure.
Pricing System.
12
Relationship Between ME & other
subject
Mathematics & Managerial Economics
Linear programming (LP) is a technique for
optimization of a linear objective function.
Game theory -An individual's success in making

choices depends on the choices of others.
Inventory Model. Such as EOQ, EBQ, MRP & MRPII
Differential calculus provides a technique of

measuring the marginal change in the dependent
variables, say Y due to change in the independent
variables,
13
Relationship Between ME &
other subject
Statistic & Managerial Economics
Regression analysis
Probability theory
Hypothesis testing
14
Regression Analysis
Regression analysis helps us understand how

the typical value of the dependent variable
changes when any one of the independent
variables is changed.
15
Relationship Between ME &
other subject
Operations Research
Economics + Mathematics + statistic.
Management, Accountancy theory & ME.
Computer & ME
16
Opportunity cost
The concept of opportunity cost related to the alternative
uses of scares resources. Though resources are scares they
have alternative uses.
The scarcity of resources and alternative use of resources
give rise to the concept of opportunity cost.
The opportunity cost of availing and opportunity is an
opportunity foregone income, expected from the second
best opportunity of using the resources.
The difference between actual earning & its opportunity
cost is called economic profit.
The concept of opportunity cost is not just limited to finance
but it involved in every kind of managerial decision.
17
Marginal Principle
The concept of marginal value is widely used in economic
analysis, for ex- marginal utility in consumer analysis,
marginal cost in production analysis, & marginal revenue in
pricing analysis.
Marginal principle assumes special significance where

maximization or minimization problem is involved.
The term marginal refers to change in total quantity or

value due to a one unit change in its determent.
18
Marginal Principle
Marginal cost-
MC = TCN- TCN-1
Marginal Revenue-
MR = TRN- TRN-1
Marginal Utility-
MU = TUN- TUN-1
19
Marginal Principle
The decision rule-
One simple decision rule under the marginal
principle is that a business activity must be
carried out so long as its MR>MC.
The necessary condition for profit
maximization output is that MC must be equal
to MR.
MC=MR
In simple words, the profit of a firm is
maximised at that level of output where the
cost of producing one additional unit equal the
revenue from the sale of that unit of output.
20
Incremental Principle
The concept of marginal can be applied only where
MC & MR can be calculated precisely-
Firms find it difficult to estimate MC & MR reason
firms produce & sell their product in bulk.
So business managers use incremental principle in
their business decisions.
The incremental principle is applied to business
decisions which involved bulk production & large
increase in total cost & total revenue.
Such an increase in total cost and total revenue is
called incremental cost & incremental revenue.
21
Incremental Principle
Incremental Cost-
Incremental cost can be defined as the arise due to a
business decision. For ex. Cost arise due to adding new
plant.
Incremental cost includes both fixed cost & variable cost.
Incremental Revenue-
In the increase in the revenue due to a business decision,
for ex. Revenue arise due to adding new plant.
The use of the incremental concept in business decision is
called incremental reasoning. The incremental reasoning is
used in accepting or rejecting a business proposition.
22
Equi Marginal Principle
The equi marginal principle was originally
associated with consumption theory.
The law state that the utility maximising
consumer distributes his consumption
expenditure between various goods & services in
such a way that the marginal utility derived from
each unit of consumption is the same.
The law was over a time applied to business
manager to allocation of resources between
alternative uses with a view to maximising profit
in a case firm carries more than one business
activity.
23
The principle suggests that available resources
should be allocated between the alternative
options that the marginal productivity gain from
the various activities are equalized.
For ex. Firm have 100 million Rs. Which can be
spend on three project. A,B & C. Each project
requires expenditure of 10 million.
Marginal productivity
Unit Exp/ Project ASchedule
Project B Project c
10M
1 50 (1) 40 (3) 35 (4)
2 45 (2) 30 (5) 30 (6)
3 30 (7) 20 (8) 20 (9)
4 20 (10) 10 15
5 10 0 12
24
Going by the equi marginal principle the firm
will allocate it total resources among the
project in such a way that marginal
productivity of each project is the same.
MP(A)= MP(B)=MP©
25
Time Perspective
All business decision are taken with a certain time perspective. But all this decisions do not have
same time perspective, some have short run outcome or some have long run.
Long run decisions would not earn any profit in short period but incur huge amount of initial cost
but may be prove profitable in long run.
Such as investment in plant, building, machinery, advertisement, or spending in labour well fair.
So while taking any investment & business decision business manager has to thing on the time
perspective and long run return from the investment.
 he equi marginal principle was originally associated with consumption theory.

The law state that the utility maximising consumer distributes his consumption expenditure
between various goods & services in such a way that the marginal utility derived from each unit of
consumption is the same.
The law was over a time applied to business manager to allocation of resources between
alternative uses with a view to maximising profit in a case firm carries more than one business
activity.
26
Economic theory of firm
A firm is an entity that draws various types of factors of
production in different amounts from the economy, and
converts them into desirable output(s), through a process
with the help of suitable technology.
Why do people do business? What motivates the

owners /investors / promoters to take so much of risk and
conduct their own businesses, rather than going for a
secured employment?
The theory of firm was based on the assumption that the

goal or objective of the firm was to maximize of profit.
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Profit Maximization Theory
Objective of business is generation of the largest amount of Profit = (Total Revenue-Total Cost)
Traditionally, efficiency of a firm measured in terms of its profit generating capacity
There are two condition for profit maximisation.

The necessary or first order condition –
 Requires that marginal revenue (MR) must be equal to marginal cost.
The secondary or the second order condition

 Requires that the necessary condition must be satisfied under the stipulation of decreasing MR & rising MC.
Traditionally, efficiency of a firm measured in terms of its profit generating capacity
 Confusion on measure of profit

 Confusion on period of time
 Validity questioned in competitive markets
28
Controversy over profit Maximisation.
Though traditionally theory assume profit maximisation is the sole objective in business practice firms have been pursuing many objective than it.
The large firms pursue goals such as sale maximisation, retaining & gaining, market share, achieve the target profit, increase the net worth of share holders.
The firms do not posses perfect knowledge of their costs, revenue, and future business environment. They operate in world of uncertainty.
Though pricing theories are not exactly applicable in business practice it provides the analytical frame work for decision making.

All business decision are taken with a certain time perspective. But all this decisions do not have same time perspective, some have short run outcome or
some have long run.
Long run decisions would not earn any profit in short period but incur huge amount of initial cost but may be prove profitable in long run.
Such as investment in plant, building, machinery, advertisement, or spending in labour well fair.
So while taking any investment & business decision business manager has to thing on the time perspective and long run return from the investment.

he equi marginal principle was originally associated with consumption theory.

The law state that the utility maximising consumer distributes his consumption expenditure between various goods & services in such a way that the marginal
utility derived from each unit of consumption is the same.
The law was over a time applied to business manager to allocation of resources between alternative uses with a view to maximising profit in a case firm
carries more than one business activity.
29
Behavioral Model of firm
Following the crisitisum of the economists
theory of firm some economist highlighted the
behavioral theory of firm t0 explain its
objective.
Some of this models are as follow

Baumal’s Sales maximisation firm.
Stackleberg’s Reaction oriented firm.
Cyert & March Behavioural model.
30
 W.J.Baumol suggested sales revenue
maximization as an alternative goal to profit
maximization.
 RATIONALISATION OF THE SALES
MAXIMIZATION HYPOTHESIS
a) There is evidence that salaries and other
earnings of top managers are correlated
more closely with sales than with profits.
b) The banks and other financial institutions
keep a close eye on the sales of firms and are
more willing to finance firms with large and
growing sales.
c) Trend in sales revenue is a indicator of the
performance of firm. It helps also in handling31
 Large sales, growing over time, give prestige to the
managers, while large profits go into the pockets of
shareholders.
 Large growing sales strengthen the power to adopt
competitive tactics, while a low or declining share of
the market weakens the competitive position of the
firm and its bargaining power vis-à-vis rivals.
 But this theory is also question on the following
ground-
 It is argued that in the long run sales maximisation
and profit maximisation objective will convert into
same.
32
Marris’ Hypothesis of Maximization of
Growth Rate
According to him firms balance growth rate

subject to managerial and financial constraint.
He defines firms balance growth rate (G) as

G=GD =Gc
Growth rate of demand for the firm’s
products (GD) and
Growth rate of capital supply to the firm (GC)
33
Growth Rate
He translate this objective into two set of utility
function.
Owners utility(shareholders)- aim at maximising
profits and market share (Uo )
Managers utility- aim at better salary, job security
and growth (Um)
Owners utility function implies that growth of
demand for the firm’s product & supply of the
capital.
Therefore (Uo) owner utility means
maximisation of demand for product as well as
supply of capital.
34
Growth Rate
But this model fail to deal with oligopolistic

interdependency .
The serious shortcoming of this model is that it

ignores the price determination which is the
main concern of profit maximisation.
35
 Williamson’s Model of Managerial Utility
Function
As per him in modern corporations, owner &
managers are two separate entities with separate
objective.
The relationship between owner and manager is
principle & agent nature, so determining the
objective of firm is call principle & agent problem.
Managers apply their discretionary power to
maximize their own utility function
But they face constraint of maintaining minimum
profit to satisfy shareholders
36
Williamson’s Model of Managerial Utility Function
Utility function of managers (Um) depends on: salary, Job
security, power of discretionary investment (ID)
Um = f (S, M, ID)
S= additional expenditure on staff
M= managerial emoluments
ID= ( is discretionary investment)
The managers of modern organization seek to maximize
their own utility subject to minimum level of profit. A
minimum profit is required to satisfy the shareholders
otherwise their job security is endangered.
But this model fail to deal with oligopolistic
interdependency .

37
Behavioral Theories
 Simon’s Satisfying Model
Simon had argued that real business world is full of

uncertainty.
Biggest challenge before modern businesses is lack
of full information and uncertainty about future.
Where data are available they have little time &
ability to process. They work under many
constraints.
The objective of maximizing either profit, or sales,
or growth is not possible.
 Instead they seek to achieve a satisfactory level of
profit, sales and growth.
38
Behavioral Theories
 Behavioral theory has criticized on the following ground-
 It does not explain the firm’s behavior under dynamic

condition in the long run.
 It can not be used to predict exactly future course of action.
 This theory does not deal with the equilibrium of the firm or
industry.
 It fails to deal with interdependence of the firms & its impact

on firm’s behavior.
39
Behavioral Theories
Model by Cyert and March
 According to him apart from dealing with inadequate information and
uncertainty, businesses managers also have to satisfy a variety of
stakeholders,(shareholders, customers, financiers, input suppliers
etc) who have different and often conflicting goals.
 Managers responsibility is to satisfy them. This firms behavior is
known satisfying behavior.
 ‘Satisfying behavior’ aims at satisfying all stakeholders.
 In order to bridge the gap between this conflicting interest & goals,
managers form the aspiration level of the firm combining the
following goals.
 A) Production goal B) Sales & market share goal
 C) Inventory goal D) profit goal.
40
Behavioral Theories
Model by Cyert and March
Managers form an Aspiration level on basis of

past experience, past performance of the firm,
performance of other similar firms, and future
expectations.
The aspiration level are modified & revised on

the basis of achievement & changing business
environment.
41
Behavioral Theories
 Behavioral theory has criticized on the following ground-
 It does not explain the firm’s behavior under dynamic

condition in the long run.
 It can not be used to predict exactly future course of action.
 This theory does not deal with the equilibrium of the firm or
industry.
 It fails to deal with interdependence of the firms & its impact

on firm’s behavior.
42
Optimization Techniques
Managerial economics use some basic tools from
mathematics and other applied sciences to quantify the
economic concept and variables.
It is known as mathematical economics and econometrics.
An optimization techniques is helps to find value of the
dependent variable which maximize or minimize the value of
independent variable.
For ex. Same firms are interested to find out the value of
output that maximize their total revenue.
Or same firms want to find the level of output that minimize
the total cost.
An optimization techniques is one of the technique which
helps to find maximizing (profit) & minimizing (cost). Or such
value of such variables.
43
Economic variables-
Any economic quantity, value or rate that varies
on its own or due to change in its determinants is
an economics variables.
For ex. Demand for product, supply of product,
price of the product, cost of the product, sales
revenue etc.
Many of this variables are interdependent and
interrelated.
Even this economic variables have cause and
effect relationship & this relationship can be
expressed in a tabular, graphical & functional
form.
In optimization technique functional relationship
between variables are solved. 44
The Functional

A function is a mathematical technique of stating the relationship between any two or more variables having cause

and effect relationship.
Dp= f(Pp)

Demand for pizza and Pp= Price of pizza.

Given mathematical demand function would be

Dp=500- 5Pp

It shows that at 0 pizza price demand equal to 500 units

Minus sign shows minus relationship between price & demand,

5 implies that for 1 rupee change demand will change by 5 units.

This functions can be solved with differential calculus.

Any economic quantity, value or rate that varies on its own or due to change in its determinants is an economics

variables.
For ex. Demand for product, supply of product, price of the product, cost of the product, sales revenue etc.

Many of this variables are interdependent and interrelated.

Even this economic variables have cause and effect relationship & this relationship can be expressed in a tabular,

graphical & functional form.
In optimization technique functional relationship between variables are solved.

45
Differential Calculus
Differential calculus provides a technique of
measuring the marginal change in the dependent
variables, say Y due to change in the independent
variables, say X when the change in X is
approaches zero.
Differential calculus is applied to analyze & to find
solutions to a wide range of economic problem and
business decision making.
Rules of Differentiation-
1.Derivative of a constant function-
The derivative of a constant function equal zero.
For ex.
Y = f(X)
∂Y/∂X = 0
The constant function implies that whatever the
value of X the value of Y remain constant.
46
Rules of Differentiation-
2)Derivative of a power function-

The derivative of a constant function equal zero.
For ex.
Y = f(X)=aXb
∂Y/∂X = b aXb-1
Y= 5X3
∂Y/∂X = 3*5*X3-1
= 15X2
47
Technique of Maximizing Total Revenue.
Suppose a price function is given as P= 500 –
5Q
Find out the optimum quantity that maximize
the total revenue.
 Total revenue of firm can be defined as-
TR= P * Q
Where P= price & Q= Quantity sold.
So TR= (500 – 5Q)Q
= 500Q-5Q2
By rule total revenue is maximum at the level of sale
(Q) at which MR=0.
That is to total revenue to be maximize, the marginal
revenue(MR) the revenue from sale of marginal unit
of the product must be equal to zero. 48
 Technique of Maximizing Total Revenue.
TR= 500Q-5Q2
∂TR/∂Q = 500-10Q
By setting equation to zero & solving for Q we
get
O= 500 –10Q
Q=50
Thus to maximize the revenue firm need to sale
50 units.
TR= 500*50-5*(50)2
=25000-12500
= 12500
So at this point total revenue earn by the firm
will be 12500 Rs. 49
Technique of optimizing out put.
Suppose a TC function is given as P=400+ 60Q+4Q
2
Find out the optimum level of out put.

The optimum level of output is the level of out put which minimizes average cost of
production.
So Ac= TC/Q
 AC= (400+ 60Q+4Q2 ) / Q
 AC= (400/Q)+ 60 + 4Q.
The rule of minimization is that its derivatives must be equal to zero.
∂AC/∂Q = -400/Q + 4
2
-400/Q + 4 = 0
2
Q = 10
It shows that optimum size of output is 10 Units.
 Total revenue of firm can be defined as-

TR= P * Q
So TR= (500 – 5Q)Q
= 500Q-5Q2
By rule total revenue is maximum at the level of sale (Q) at which MR=0.
MR is given by the first derivative of the TR function.
point where derivative of a constant function equal zero.
50
Maximization of Profit.
TP= TR -TC P=400+ 60Q+4Q2
There are two condition for profit maximization.
The necessary or first order condition –
 Requires that marginal revenue (MR) must be equal to marginal cost.

MC=MR
 can be written as
This first order condition
 ∂TR/∂Q = ∂TC/∂Q Or ∂TR/∂Q - ∂TC/∂Q
 the second order condition
The secondary or
 Requires that the necessary condition must be satisfied under the stipulation of decreasing MR & rising MC.

2 2 2 2 2 2
∂ TR/∂ Q < ∂ TC/∂2Q OR ∂ TR/∂ Q+∂ TC/∂2Q<0

Find out the optimum level of out put.

The output level of out put which minimizes the total level of output.
So Ac= TC/Q
 AC= (400+ 60Q+4Q2 ) / Q
 AC= (400/Q)+ 60 + 4Q.
As per the rule of minimisation function its derivatives

must be equal to zero so the value of Q which minimise as can be obtained.
∂AC/∂Q = -400/Q2 + 4
-400/Q2 + 4 = 0
Q = 10
It shows that optimum size of output is 10 Units.

Total revenue of firm can be defined as-

TR= P * Q

So TR= (500 – 5Q)Q 51
= 500Q-5Q2
 Maximization of Profit.
Suppose that the TR & TC function are given respectively
TR= 600Q – 3Q2 & TC= 1000+ 100Q+2Q2
With this functions MR & MC can be obtained as follows.
MR = ∂TR/∂Q= 600 – 6Q
MC = ∂TC/∂Q= 100 +4Q
MC=MR
600 – 6Q= 100 +4Q
Q=50
As per first order condition of profit maximization the total
profit is maximum at Q = 50
 ∂2TR/∂2Q= ∂MR/Q=-6
 ∂2TC/∂2Q= ∂MC/Q=4
 -6 < 4 Or -6+4 < 0
 S0 second order of profit maximization is also satisfied at Q
=50 52
Demand and its
Determinants
Demand-
“Necessity is the mother of invention”
Meaning of Demand-
• Desire for commodity.
• Ability to pay.
• Willingness to pay.
Specific reference to
 Time , Price & Place.
53
Demand Function
It specify the factors that influence the
demand for the product.
Px = its own price
Py = the price of its substitute
B, = the income of the purchaser
W, = wealth of the purchaser.
A, = Advertisement
E, = the price expectation.
T, = taste or preference of user.
U, = all other factors.
So Dx = D(Px, Py, B, W, A, E, T, U,) 54
Types of Demand
1. Direct Demand & Derived Demands.
2. Domestic & Industrial Demand.
3. Autonomous & Induced Demand.
4. Perishable & Durable goods Demand.
5. New & Replacement.
6. Final & Intermediate Demand.
7. Individual & Market Demands
8. Total market & Segmented market
Demands.
9. Company & Industry Demands.
55
Law of Demand
It state that when other thing remain same,
higher the price, lower the demand and vise
versa.
Assumption-
Income of the consumer is constant.
Availability of complementary & substitutes.
No future price expectation.
Taste & preference remain same.
No change in population & its structure.
56
Demand Curve
Y
D
R
4
Price
Q
3
O
16 25
X
Quantity
Demanded
57
Characteristics
Inverse relationship between Price & quantity
demanded.
Price is independent variable & quantity

demanded is dependent variable.
Reasons underline the law of demand-

Income effect.
Substitute effect.
58
Exceptions
Conspicuous Consumption (Vabline Goods) .
Speculative Market.
Gffens goods
Ignorance.
59
Utility Concept.
“Consumer demand the commodity because they
derive or expect to derive utility from the
commodity”.
Product or absolute angle.

Utility is the want satisfying propensity of a
commodity.
Consumer or relative angle

Utility is the psychological feeling of satisfaction,
pleasure, happiness or wellbeing, which a
consumer a consumer derives from the
consumption, possession or the use of a
commodity.
60
Utility Concept.
Total Utility-
sum of the utilities derived by a consumer from the various
units of goods & services he consume.
Tux = u1 + u2 + u3+…….un
Marginal Utility
change in the total utility( TU) obtained from the consumption
of an additional unit of a commodity.
MU = TU
Q
61
Law of Diminishing Marginal Utility
As the quantity consumed of a commodity

goes on increases, the utility derived from
each successive unit goes on decreases,
assuming consumption of all other
commodities remaining the same.
No. ofTC & MC
Unit Utility
Total Utility schedules
Marginal
Consume Utility
1 30 30
2 50 20
3 60 10
4 65 5
5 60 -5
6 45 -15
3
Assumption for the law
The unit of the consumer good must be a

standard one.
The consumer taste and preference remain
same.
There must be continuity in the consumption.
Consumer is a rational.
63
Limitation of the law
Utility is a psychological phenomenon. It is feeling of

satisfaction, measurability of utility is not possible.
It does not explain the impact of the complementary and

substitute goods of demand.
It is applicable only for one commodity.
64
Utility Approach.
Cardinal Utility Approach-
it believed that utility can cardinality or
quantitatively measurable , like weight length
temperature etc .
Ordinal Utility Approach

Utility is immeasurable in cardinal
term.
65
Ordinal Utility approach
It is based on the fact that it may not be possible for the
consumer to express the utility of the commodity in
absolute term, but introspectively whether a
commodity or less or equally useful as compared to
other.
The higher order of preference is given to the

commodity which will give a higher utility.
(Pioneered by J.R. Hicks & R.G.D Allen also known as

Indifference Curve Analysis)
66
Indifference Curve analysis.
Defined as locus of point, each representing a different

combination of two substitute goods, which yield the
same utility or level of satisfaction to the consumer.
He is indifference between any two combinations of

goods when it comes to making a choice between them.
It is also called Isoutility curve or Equal utility curve.
67
Indifference Schedule of Commodity X
& Y.
Combination Units of Units of Total
Commodity Y Commodity X Utility
A 25 3 U
B 15 6 U
C 8 9 U
D 4 17 U
E 2 30 U
Five combination A, B, C, D, E of two

substitute commodities X & Y as presented
in table yield the same level of satisfaction.
68
Properties of Indifference Curve
Indifference curves have a Negative slope.
Indifference curves do not intersect nor are they

tangent to one another.
Upper indifference curves indicate a higher level

of satisfaction.
69
Properties of Indifference Curve
Indifference curves are convex to the origin.
Why- 1). The two commodities are imperfect substitutes for one another.
2)The marginal rate of substitutes (MRS) between to commodity goes
decreases.
(MU of a commodity increases as its quantity decreases and vise versa)
Indifference Units of Change in Change in MRS

Point Commodity Y X
Y + X
Upper indifference
A curves
25 + indicate
3 -a higher level
- of satisfaction.
B 15 + 6 10 3 3.3
C 8 + 9 7 3 2.3
D 4 + 17 4 9 0.4
E 2 + 30 2 13 0.2
70
Consumer Equilibrium
Budget Line-
The budget line shows the market
opportunities available to the consumer given
his income and the price of X & Y.
Consumer Equilibrium-
Consumer is equilibrium where the
indifference curve is tangent to the budget line.
71
1). Price Effect-
It is the change in consumption of goods because of the change in the
price of the goods.
2).Income Effect-
The increase or decrease in the income can be shown by the
parallel shift of the budget line.
Income effect result from the increase in real income caused by the
change in price of the goods consumed by the consumer.
72
3). Substitute Effect-
It is defined as the change in quantity demanded
resulting from a change in relative price after real
income effect of price is eliminated.
Price Effect = Substitute Effect + Income Effect.

PE = SE + IE
73
1).Income Effect-
The increase or decrease in the income can be shown by
the parallel shift of the budget line.
Income effect result from the increase or decrease in real

income caused by the change in price of the goods
consumed by the consumer.
74
Income Effect-
Y
A1
ICC
A
Q
P
O
X1 X3 B B1
X
75
Income Consumption Curve-
Define as the locus of points representing various

equilibrium quantizes of to commodities consumed by
a consumer at different level of income, all things
remaining constant.
76
3). Price Effect-
It is the change in consumption of goods because of the change in the price
of the goods.
Income effect.
Substitute effect.
Price consumption curve(PCC) shows the change in consumption basket

due to change in the price of the commodity.
77
Price effect
Q PCC
O
X1 X3 B B1
X
Price Effect
78
3). Substitute Effect-
Arises due to the consumer inherent tendency to
substitute cheaper goods for relatively expensive.
It is defined as the change in quantity demanded

resulting from a change in relative price after real
income effect of price is eliminated.
79
Price Effect = Income Effect + Substitute Effect
PE = IE + SE
Price Effect-
It is the change in consumption of goods because of the change in the price
of the goods.
Income effect.
Substitute effect.
80
Price Effect = Income Effect. + Substitute Effect
PE = IE + SE
Y
A1
P
Q
R
IC1
SE
IE
O
X1 X2 X3 B B3 B1
X
Price Effect
81
Demand Elasticity
The degree of responsiveness of the demand to the change
in its determinants is called elasticity of demand.
Type of demand elasticity's-
1.Price elasticity.
2.Income elasticity.
3.Substitute elasticity
4.Advertise elasticity.
82
Demand Elasticit
y
The degree of responsiveness of the demand to the change
in its determinants is called elasticity of demand.
Type of demand elasticity's-
1.Price elasticity.
2.Income elasticity.
3.Substitute elasticity
4.Advertise elasticity.
83
Demand Elasticity
Type of demand elasticity-
1.Price elasticity
Price elasticity is generally define as the
responsiveness or sensitivity of demand for
commodity to the changes in its price.
it is percentage change in demand as a result
of percentage change in the price of the
commodity.
% Change in Quantity demanded
% Change in the price of the

Price Elasticity =
commodity
84
Demand Elasticity
Y
D
R
4
Price
Q
3
O
16 25
X
Quantity
Demanded
85
Calculating Elasticity
ARC Elasticity
The measure of elasticity of demand between
any two finite points on a demand curve is
known as ARC elasticity.
Q2 - Q1
ARC Elasticity = ( Q1 + Q2 ) / 2
P2 - P1
( P1 + P2 ) / 2
where
Q1 = Initial quantity
Q2 = Final quantity
P1 = Initial price
P2 = Final price
86
Calculating Elasticity
Point Elasticity
For an infinitesimal (very, very small )change
in price we use point elasticity.
Y
M
Ep = PN
PM
P
R
O
N X
87
Supply Analysis
Supply
The supply of a commodity means the amount
of that commodity which producers are
Ability to supply
Willing to supply
At a given price.
 Quantity supplied refers to a specific

amount of the commodity that will be supplied
at a specific price.
88
Supply Function
It specify the factors that influence the supply
for the product.
Px = its own price
Py = the price of its substitute
F, = Price of the factors of production.
T, = State of technology
E, = Means of transportation &
Communication.
T, = Taxation policy.
U, = Future expectation of prices.
So Sn = F(Px, Py, F, T, , E,T,U)
89
Supply Analysis
The Law of Supply
“Other thing remaining the same, as the price

of a commodity rises, its supply increases;
and the price falls, its supply decrease”.
There is a direct positive relationship between

price and quantity supplied.
90
Supply Analysis
The law of supply is accounted by two factors:
Assuming firm’ cost is constant.
When prices rise, firm substitute production of

one commodity for another.
Higher price means higher profits.
91
Supply Schedule
Price Supply (A Supply (B Supply (C Aggregat

Firm) Firm) Firm) e Supply
2 25 50 75 150
4 100 100 150 350
6 200 150 225 575
8 300 200 300 800
10 400 250 375 1052
92
Supply Curve
Y S
4 R
Price
2
Q
S
O
25 100
X
Quantity
Supplied
93
Supply Analysis
Supply Curve:-
The supply curve shows the minimum price which the firm would be
prepared to receive for different quantities the of the commodity .
It has a positive slope.
Supply curve rise upward from left to right.
When prices rise, firm substitute production of one commodity for another.
Higher price means higher profits.
94
Supply Analysis
Shift in Supply Curve:-
The shift in supply curve occurs when the

producers are willing to offer more or less of a
commodity because of reasons other than the
price of the commodity.
This change in supply which occurs because of a

change in any of the determinants of supply, other
than price is known as increase or decrease in
supply.
95
Supply Analysis
Elasticity of Supply :-
Elasticity of supply of a commodity measure s

changes in the quantity supplied as a result of
a change in the price of commodity.
It is percentage change in quantity
supplied as a result of percentage change
in the price of the consumer.
% Change in Quantity supplied
Supplied Elasticity% =
Change in Price of the
commodity
96
Supply Elasticity
Determinant of Supplied elasticity.-
1.Nature of the commodity.

2.Time lag.
3.Techniques of production.
4.Estimates of future prices.
97
Production
“Creating an utility is known as production”.
The term production means a process by which

resources are transformed into a different and useful
commodity or service. In general production means
transform input into output.
Production also involved intangible input to produce

intangible output.
Wholesaling, retailing, packaging, assembling are all

production activity.
98
Production
Fixed input & Variable input.:-
Fixed input is one whose supply is inelastic in
the short run or which remain constant up to
certain level of output.
Variable input is defined as one whose supply

in the short run is elastic or variable input
which changes with the change in output.
In long run all inputs are variable.
99
Production
Short Run & Long Run:-
Short run refers to a period of time in

which the supply of certain inputs ( plant,
building, machinery etc) is fixed.
The long run refers to a period of

time in which the supply of all the inputs can
be changed.
100
Production Function.
Production Function:-
Production function is tool of analysis

used to explain the input output relationship.
It describes the technological relationship
between inputs and output in physical term.
More specifically it represent the quantitative
relationship between inputs and outputs.
101
Production Function:-
Economically it stated as below-
Q= f(L,L,K,O).
More specifically it can be stated as-

Q= f(Ld, L, k, M, T, t)
Q= quantity produced, Ld = land & building, K= capital

T= technology, & t= time.
for the sake of convenience the number of variable used

in a production function to only two-
Q=f(L,K)
102
 Production Function-
Economically it stated as below-
Q= f(L,L,K,O).
More specifically it can be stated as-

Q= f(Ld, L, k, M, T, t)
Q= quantity produced, Ld = land & building, L= labor

K= capital, M= Material T= technology, & t= time.
for the sake of convenience the number of variable used

in a production function to only two-
Q=f(L,K)
103
 Production Law-
Law of production state the relationship
between input and out put.
It can be studied under two conditions
Short Run law of production.

Law of return to variable inputs. Law of
Diminishing return to scale.
Long Run.
Law of return to scale.
104
 Short run law of production-
a)Can employee unlimited variable factors of

production.
b) Fixed production factors can not be changed.
c) Law state the relationship between varying

factors of production and out put therefore known
as law of return to variable input or law of
diminishing return.
105
 Short run law of production- (Diminishing returns)
“The law of diminishing returns state the

relationship between varying factors of production
and out put therefore known as law of return to
variable input or law of diminishing return”.
Assumption of the law-

1. The state of technology is given
2. Labor is homogeneous.
3. Input prices are given.
106
“The law of diminishing returns state that when more &

more units of a variable inputs are applied to a given
quantity of fixed inputs, the total output initially increase at
a increasing rate & then at constant rate but it will
eventually increase at diminishing rates”.
Stages of production-
1.Stage one increase at increasing rate.
2.Stage two increase but at constant rate.
3.Stage three total production decrease.
107
Stages of Production
N0 0f Total Marginal Average Stages of
Workers Production Production Production Production
TP MP AP .
0 0 0 0
1 24 24 24
2 72 48 36
I
3 138 66 46 Increasing
4 216 78 54 Return
5 300 84 60
6 384 84 64
7 462 78 66 II
8 528 66 66 Diminishing
Return
9 576 48 64
10 600 24 60
11 594 -6 54 III
12 552 -42 46 Negative
return 108
More specifically the law of diminishing returns can be state as

follows-
“Given the employment of fixed factor (capital) when more and
workers are employed the return from the additional worker
may initially increase but eventually decrease”.
Reason for the law-
1.Indivisibility of fixed factor
2.Division of labour.
3.Per worker marginal productivity decrease after optimum
utilization of capital.
109
Application of Short run law of production-
(Diminishing returns)
It provides answer to what number of workers

to be employed at a given fixed input.
How much to produce.
More application in agriculture sector.
May not apply universally to all kinds of
production activities.
110
Long Term laws of production.(Law of return to scale)
Production with Two variable inputs.
In this section, we will discuss the relationship between

inputs & outputs under the condition that both the inputs
capital and labour are Variable factors.
The technological relationship between changing scale of
inputs and outputs is explained under the laws of returns
to scales.
the law of return to scale can be explained through the
1) Laws of returns to scales through Production
function.
2) Isoquant Curve technique.
111
Law of return to scale, Production function.
Laws of returns to scale explain the behavior of

output in response to a proportional and
simultaneous change in inputs.
When a firm expands its scale there are three

technical possibilities.-
i) Increasing Returns to scale
ii) Constant returns to scale,
iii) Diminishing returns to scale.
112
i) Increasing Returns to scale

Output more than doubles when all
inputs are doubled.
Causes of increasing returns to scale-
Technical and marginal indivisibility
Higher degree of specialization.
It is known as economics of scale.
113
ii) Constant returns to scale,

When the change in output is
proportional to the change in inputs, it
exhibits constant returns to scale.
for ex if quantities of both the

inputs, K and L are double and output is also
double the return to scale is said to be
constant.
114

The firm are faced with decreasing returns to
scale when a certain proportionate change in
inputs K, and L leads to a less than
proportional change in output.
Causes of Diminishing return to scale

The diminishing return to management.
Exhaustibility of natural resources.
115

The firm are faced with decreasing returns to
scale when a certain proportionate change in
inputs K, and L leads to a less than
proportional change in output.
Causes of Diminishing return to scale

The diminishing return to management.
Exhaustibility of natural resources.
116
Law of return to scale, Isoquant curve.
Isoquant.
Iso (Greek word)= equal
And quant ( Latin word) = quantity.
Equal production curve, or Production indifference
curve.
“ it is locus points representing various
combinations of two inputs capital and labour
yielding the same output”.
Assumption-
1.There are only two inputs (L, K)
2.Two inputs (L,K) can substitute.
117
Insoquant Schedule of input L & K.
Combination Input Units Input Units Total
k L Output
A OK4 OL1 100

B OK3 OL2 100
C OK2 OL3 100
D OK1 OL4 100
Five combination A, B, C, D of two substitute

inputs L & K as presented in table yield the
same level output.
118
Properties of Insoquant Curve
Isoquant curves have a Negative slope.
 The negative slope in the of the insoquant implies substitution between the inputs. If one
input is increase reduced other input has to be increased.
Isoquant curves do not intersect nor are they tangent to one

another.
Upper isoquant represent upper level of output.
Indifference curves are convex to the origin
 It is because diminishing Marginal Rate of Technical Substitution.
 A rate at which a marginal units of labour can substitute a marginal units of
capital.
 Reason for MRTS- 1. No two factors are perfect substitute.
2. Inputs are subject to diminishing

marginal return.
119
Optimal Input Combination.
Isocline, Budget Line Budget Constraint Line-
Which represents the alternative combinations
of K & L that can be purchased out of the total
cost.
Optimal input out put combination. Or least

cost combination.-
Least cost combination exists at a point where
isoquent is tangent to the isocost line.
120
Cobb Douglas Production
The Cobb–Douglas functional form of production

functions is widely used to represent the relationship of
an output to inputs. It was proposed by Knut Wicksell
(1851–1926), and tested against statistical evidence by
Charles Cobb and Paul Douglas so it is called Cobb
Douglas production function.
The theory is depended on the real practical experience

they get in U.S automobile industry.
121
 The cobb Douglas function indicates constant returns to scale.
 That is if factor of production are each raised by 1% then out
put will also increase by 1%.
 Mathematically, the function can be stated as-
 Y = ALαKβ,
where:
Y = total production (the monetary value of all goods produced
in a year)
L = labor input
K = capital input
A = total factor productivity
α and β are the output elasticity's of labor and capital,
respectively. They are the exponent equal to 1. These values
are constants determined by available technology.
122
Out Put elasticity or Elasticity of production
 Output elasticity measures the responsiveness of output
to a change in levels of either labor or capital used in
production, when other thing remaining same.
For example if α = 0.50, 1% increase in labor would
lead to approximately a 0.50% increase in output.
Or β = 0.50, 1% increase in capital would lead to
approximately a 0.50% increase in output.
So as per the cobb Douglas Production function.
Y = ALαKβ,
Α+β,=1
Means
 1% increase in input would lead to approximately
a 1% increase in output.
123
Consider a cobb Douglas production function
with parameters A= 100, α = 0.50, β=.50
Production table for the production
function
Y = Rate
ALαKofβ, Y = 100L.50K.50,
capital Total Out Put
input
1 100
2 200
3
4 400
5
1 2 3 4 5
Rate of labour Input(L)
124
Cost Function
Some basic costs & Cost concept.
Fixed cost:-
Fixed costs those which are fixed in
volume for a certain given output. Fixed cost
does not vary with variation in the output
between zero & certain level of output.
Variable Cost
Variable costs are those which vary with
the variation in the total output.
125
Cost Function
Average variable cost. Counted
Average Variable cost(AVG)= Total Variable cost (TCV)
Total out put. (Q)
Total cost, Average Fixed cost, Average variable cost.
Total cost= Total fixed cost+ Total variable cost.
Average Total Cost

Average Total Cost(TCV)= Total cost (TC)
Total out put.
126
Cost Out Put Relations
Q FC TVC TC AVC AC MC
0 10 0 10
1 10 5.15 15.2 5.15 15.2 5.15
2 10 8.8 18.8 4.4 9.4 3.65
3 10 11.3 21.3 3.75 7.08 2.45
4 10 12.8 22.8 3.2 5.7 1.55
5 10 13.8 23.8 2.75 4.75 0.95
6 10 14.4 24.4 2.4 4.07 0.65
7 10 15.1 25.1 2.15 3.58 0.65
8 10 16 26 2 3.25 0.95
9 10 17.6 27.6 1.95 3.06 1.55
10 10 20 30 2 3 2.45
11 10 23.7 33.7 2.15 3.06 3.65
12 10 28.8 38.8 2.4 3.23 5.15
13 10 35.8 45.8 2.75 3.52 6.95
14 10 44.8 54.8 3.2 3.91 9.05
15 10 56.3 66.3 3.75 4.42 11.5
16 10 70.4 80.4 4.4 5.03 14.2 127
Cost Function
Some Important cost relationship-
When MC falls Ac follows. But the rate of fall in
MC is greater than AC. Reason MC decreasing
cost is attributed to single marginal unit while
in case of AC, decreasing marginal cost is
distributed over entire out put.
When MC increases AC also increases but at a

lower rate for the same reason.
MC intersects AC at its minimum point. That is

output optimization point.
128
Cost Function
Cost Curves and the law of diminishing
returns -
Given the employment of fixed factor (capital)

when more and more variable inputs are
employed the output from the additional input
may initially increase but eventually decrease”.
Given the employment of fixed factor (capital)

when more and more variable units are
employed the cost from the additional input
may initially decrease but eventually increase”.
129
Relationship between Production & Cost
function.
Cost function is the relationship between a firms

costs and the firms output.
The cost function is closely related to production
function.
Production function specifies maximum quantity of
out put that can be produced from various
combinations of inputs.
Where as the cost function combines this
information with input price on various outputs
and their prices.
Thus cost function is combination of production
function and input prices.
130
Market Structure and Pricing Decision
Market-
Is a system by which buyers and sellers bargain for the
price of product, settle the price and transact their
business.
Buyer
Seller.
Commodity.
Price.
How is the price of a commodity can be determined?
The market structure influence firms pricing decisions.
The nature and degree of competition make the market
structure.
Depending on the market structure the degree of
competition varies between 0 to 1.
Higher the degree of competition the lower the firms
degree of freedom & control over the price of its own
product & vice versa.
131
Types of the market Structure-
1. Perfect Competition-
2. Imperfect Competition-
a). Monopolistic competition.
b). Oligopoly
c). Monopoly.
The theory of pricing explains pricing decisions

and profit behavior of the firms in different kinds of
market structure.
132
Perfect Competition-
1.Large number of sellers & buyers.
2.Homogeneous product.
3.Perfect mobility of factors of production.
4.Free entry & free exit.
5.Absent of collusion or artificial collusion.
6.No government intervention. Competition-
As characteristic perfect competition is

uncommon phenomenon. Up to some extant we
can find perfect competition in Financial market &
agriculture market. But it provides starting point
and analytical framework for pricing theory.
133
Price Determination Under
Perfect Competition.
Price in perfectly competitive market is determined by the
market forces-
Market demand & Market supply.
Market Demand- refers to the demand for the industry as a

hole. It is sum of quantity demanded by each individual
consumer.
Market Supply – refers to the sum of quantity supplied by

the individual firms in industry.
So market price is determined for the industry and given to
the firm.
So sellers are not price makers but they are price takers.
134
Market Firm
Price Market supply Price
$10 $10
8 8
Individual firm
6 6 demand
4 4
Market
2 demand 2
0 0
1,000 Quantity
3,000 10 20 30 Quantity
135
Profit-Maximizing Level of
Output
What happens to profit in response to a
change in output is determined by marginal
revenue (MR) and marginal cost (MC).
A firm maximizes profit when MC = MR.
136
Profit-Maximizing Level of
Output
Marginal revenue (MR) – the change in total
revenue associated with a change in quantity
sold.
Marginal cost (MC) – the change in total

cost associated with a change in quantity
produced.
A perfect competitor accepts the market price

as given.
As a result, marginal revenue equals price
137
Costs MC
Quantity
Price = MR Margi
Produce nal
35.00 0 d Cost
60
35.00 1 28.00
20.00 50
35.00 2 16.00
35.00 3 40 A C P=D=
14.00
35.00 4 12.00 30 B MR
35.00 5 A
17.00
35.00 6 22.00 20
35.00 7 30.00
35.00 8 10
35.00
35.00 9 54.00 0
35.00 10 68.00 1 2 3 4 5 6 7 8 910Quantity
138
The Marginal Cost Curve
Is the Supply Curve
The MC curve tells the competitive firm how
much it should produce at a given price.
The firm can produce the quantity at which

marginal cost equals marginal revenue which
in turn equals price.
139
Determining Profit and
Loss From a Graph
Find output where MC = MR.
The intersection of MC = MR (P) determines
the quantity the firm will produce if it wishes to
maximize profits.
The firm makes a profit when the ATC curve is
below the MR curve.
The firm incurs a loss when the ATC curve is
above the MR curve.
140
Price MC Price MC Price MC
65 65 65
60 60 60
55 55 55
50 50 50 ATC
45 45 ATC 45
40 D A P = MR 40 40 Loss P = MR
35 35 35
P = MR
30 Profit B ATC 30 30 AVC
25 C AVC 25 AVC 25
20 E 20 20
15 15 15
10 10 10
5 5 5
0 0 0
1 23 4 5 67 891012 1 23 4 5 67 891012 1 23 4 567 89 1 12
Quantity Quantity Quantity 0
(a) Profit case (b) Zero profit case (c) Loss case
141
The Shutdown Point
The firm will shut down if it cannot cover
average variable costs.
A firm should continue to produce as long as

price is greater than average variable cost.
If price falls below that point it makes sense to

shut down temporarily and save the variable
costs.
142
Long-Run Competitive
Equilibrium
Profits and losses are inconsistent with long-
run equilibrium.
Profits create incentives for new firms to enter,
output will increase, and the price will fall until
zero profits are made.
The existence of losses will cause firms to leave
the industry.
143
Output, Price, and Profit
in Perfect Competition
Long-Run Adjustments
In short-run equilibrium, a firm may earn an
economic profit, earn normal profit, or incur an
economic loss and which of these states exists
determines the further decisions the firm makes
in the long run.
In the long run, the firm may:
 Enter or exit an industry
 Change its plant size
144
Monopoly Market
 Monopoly-
The term pure monopoly signifies an absolute
power to produce and sell a product which has
no close substitute. In other words a monopoly
market is one in which there is only one seller of
product having no close substitute.
Causes & Kinds of Monopolies-

1. Legal Restrictions
2. Control over key raw materials
3. Efficiency.
145
Pricing under pure Monopoly
 Monopoly Pricing and output decision-
As under perfect competition, pricing and

output decision in monopoly market are also
based on revenue and cost conditions.
AC & MC curves in a competitive and

monopoly market are generally identical but
revenue conditions differ.
146
(a) (b)
ATC
MC ATC MC AVC
50
E E
40 40
32 Total Loss
Total
Profit
D D
10,000 Number of 10,000 Number of
MR Subscribers MR Subscribers
147
Profit And Loss
Monopoly firm faces a downward sloping demand curve,
marginal revenue is less than price of output
Monopoly will always produce at an output level where

marginal revenue is positive
A monopoly earns a profit whenever P > ATC
A monopoly suffers a loss whenever P < ATC
148
Long run pricing decision in
monopoly
In the long run a Monopolist gets an

opportunity to expand the size of the firm
sale, more units can be produce at lower
price with a view to enhance its long run
profits.
So in long run monopolist will earn an

economical profit.
149
Pricing under pure Monopoly
 Monopoly Pricing and output decision-
As under perfect competition pricing and

output decision in monopoly are also based on
revenue and cost conditions.
AC & MC curves in a competitive and

monopoly market are generally identical but
revenue conditions differ.
150
Price discrimination.
Under certain conditions, a firm with
market power is able to charge different
customers different prices. This is called price
discrimination.
Price discrimination is the ability to

charge different prices to different individuals
or groups of individuals.
151
Monopoly &Price Discrimination
Necessary conditions for price discrimination.
 Market can be separable.
 Limit the customers ability to resell its product from one

market to another.
 Different market must have different elasticity of demand;
 Profit maximizing output is much larger then the quantity

demanded.
152
Monopoly &Price Discrimination
A price-discriminating monopolist can

increase both output and profit.
 Itcan charge customers with more

inelastic demands a higher price.
 Itcan charge customers with more elastic

demands a lower price.
153
Discrimination
First degree-
A firm with market power could collect the entire
consumer surplus if it could charge each customer
exactly the price that customer was willing and able
to pay. This is called perfect price discrimination
or first degree.
Second degree-
Under this monopolist divide the potential buyers into
the blocks e.g rich, middle class, poor class & sell the
product at different price.
Third degree-
Set the different price in different market having
deferent price elasticity.
154
Monopolistic Competition
Monopolistic competition
Is a market structure in which there are
many firms selling differentiated products.
The model of price & output determination

under monopolistic competition was
developed by Edward H Chamberlin.
155
Characteristics:
Many number of firms in the industry.
The products produced by the different firms are

differentiated.
Entry and exit from the industry is relatively easy .
Consumer and producer knowledge imperfect.
156
Major Automobile player in India
Ashok Leyland HMT Tractors Royal Enfield
Audi AG Honda Motors Co. Ltd. San Motors
Bajaj Auto Hyundai Motors Scooters India Ltd
BEML Indofarm Tractors Skoda Auto India
BMW Kinetic Motor Co. Ltd. Sonalika Tractors
Bentley Motors Limited Lamborghini Suzuki Motors
Chevrolet LML India Swaraj Mazda Ltd.
Daewoo Motors Mahindra & Mahindra Tafe Tractors
Ltd.
Eicher Motors Maruti Suzuki India Ltd. Tata Motors
Escorts Ltd. Mercedes Benz Telcon
Fiat India Pvt Ltd Mitsubishi Motors Terex Vectra
Force Motor Monto Motors Toyota Kirloskar Motors
Ford Motors Nissan Motors TVS Motor Co.

General Motors Porsche Volkswagen
Hero Honda Reva Electric Co. Volvo
157
Hindustan Motors Rolls-Royce Motor Yamaha Motor
Product Differentiation
Product differentiation
Implies that the products are different
enough that the producing firms exercise a
“mini-monopoly” over their product.
The firms compete more on product

differentiation than on price.
Entering firms produce close substitutes, not

an identical or standardized product.
158
Product Differentiation
Firms may differentiate products by perceived quality,
reliability, color, style, safety features, packaging,
purchase terms, warranties and guarantees, location,
availability (hours of operation) or any other features.
 Marketing is often the key to successful differentiation.
The goals of advertising include shifting the demand
curve to the right and making it more inelastic.
Brand names may signal information regarding the
product, reducing consumer risk.
159
This is a short run equilibrium
position for a firm in a
monopolistic market
structure.
Short run profit determination
diagram:
MC Marginal Cost and
Cost/Revenue The demand
Average Cost curve
will befacing
the
the firm
same will be
shape. downward
However,
Since sloping and
the additional
because represents
the products
AC revenuethedifferentiated
are AR earned
received from
from in sales.
eachsome
unit sold
way,falls, the will
the firm
1.00
MR curve
only be lies under
able the
to sell
AR curve.
extra output by lowering
If the firm produces Q1 and
Abnormal Profit price.
sells each unit for 1.00 on
average with the cost (on
0.60 We firm produces
average) for each unitwhere
being
MR =
60p, MC
the (profit
firm will make 40p x
maximising
Q1 in abnormal output).
profit.At this
output level, AR>AC and
the firm makes abnormal
profit (the grey shaded
area).
MR D (AR)
Q1
Output / Sales
160
Monopolistic or Imperfect
Competition
Long run profit determination
diagram:
MC
Cost/Revenue Because there is
relative freedom
AC of entry and exit
into the market,
new firms will
enter
encouraged by
the existence of
abnormal profits.
New entrants will
increase supply
AR1 causing price to
MR1 MR D (AR)
fall. As price
Q Output / Sales falls, the AR and
1 MR curves shift
inwards as 161
Monopolistic
diagram:
MC
Cost/Revenue Notice that the
existence of
AC more substitutes
makes the new
AR (D) curve
AR = AC more price
elastic. The firm
reduces output to
a point where MC
= MR (Q2). At
this output AR =
AR1 AC and the firm
MR1 MR D (AR)
will make normal
Q Q Output / Sales profit.
2 1
162
Monopolistic
diagram:
MC
Cost/Revenue Notice that the
existence of
AC more substitutes
makes the new
AR (D) curve
AR = AC more price
elastic. The firm
reduces output to
a point where MC
= MR (Q2). At
this output AR =
AR1 AC and the firm
MR1 will make normal
Q Output / Sales profit.
2
163
Monopolistic Competition profit
loss situation
Monopolistic competitor may make profit, loss
or no profit no loss (normal profit) in short run.
Monopolistic competitor make zero economic

profit in the long run.
164
Oligopoly
Oligopoly
“Is a market structure in which there is

few sellers selling homogenous or
differentiated products”.
For ex industries like cement, steel, petrol

cooking gas, chemicals, aluminum, etc.
165
Oligopoly Market
Characteristic of Oligopoly Market.
1.Small number of sellers.
2.Interdependence of decision making.
3.Barriers to entry.
• significant economies of scale
• strong product name recognition
1.Indeterminate price and output.
Firms rarely engage in price decrease
that is considering a price reduction may wish to
estimate that competing firms would also lower
their prices and it will give rise to price war.
Or if the firm is considering a price
increase it may want to know whether other firms
will also increase prices or hold existing prices
constant. 166
Oligopoly
Oligopoly
Since firms can compete on different levels, and
with respect to many choice variables, no one model can
neatly capture oligopoly behavior.
– Kinked Demand curve

-Price leadership
– Limit pricing and entry deterrence
– Quality competition
– Game theoretic models that focus on strategies
167
Oligopoly
Kinked Demand Curve
Kinked demand curve model of oligopoly

was developed by Paul M Sweezy.
He has tried to show through his kinked

demand curve analysis that price and output
once determined under oligopolistic
conditions, tend to stabilizer rather than
fluctuating.
168
Oligopoly
Kinked Demand Curve
An oligopolistic faces a downward sloping demand curve
but the elasticity may depend on the reaction of rivals
to changes in price and output.
(a) rivals will not follow a price increase by one firm -

therefore demand will be relatively elastic and a rise in
price would lead to a fall in the total revenue of the firm.
(b) rivals are more likely to match a price fall by one

firm to avoid a loss of market share. If this happens
demand will be more inelastic and a fall in price will also
lead to a fall in total revenue.
169
Oligopoly
Kinked Demand Curve.
The kinked-demand curve is a demand curve
comprised of two segments, one that is
relatively more elastic, which results if a firm
increases its price, and the other that is
relatively less elastic, which results if a firm
decreases its price. These two segments are
joined at a corner or "kink."
This demand curve is used to provide insight

into why oligopoly markets tend to keep prices
relatively constant.
170
Oligopoly
Kinked Demand Marginal Revenue Curve.
As always, the marginal revenue curve lies

below the relevant demand curve. If the firm
lowers price below P* a strong reaction from
competitors occurs in the form of industry
wide price drops. This causes MR to drop
dramatically, causing a gap in the curve.
171
Pricing Strategies
Price Leadership.
Marginality rules determines the profit
maximization at the level of output where
MR=MC. But in real business world, business
follow a variety of pricing rules and methods
depending on the conditions faced by them.
Some important pricing strategies and methods
as follows.-
1.Cost plus pricing
2.Multiple Product pricing.
3.Skimming pricing policy.
4.Penetration price policy .
172
Pricing Strategies
Cost Plus Pricing.
Cost plus pricing is also known as mark up pricing,
average cost pricing or full cost pricing.
The general practice under this method is to add a

fair percentage of profit margin to the average
variable cost(AVC).
P= AVC+AVC(m).
173
Pricing Strategies
Product line Pricing.
Establishing a single price for all products

in a product line, such as for dress material-
price of 2550 for the high-priced line,

1450 for the medium-priced line,
and 350 for the lower-priced line.
174
Pricing Strategies
Multiple Product Pricing.
Almost all companies have more than one product

in their product . Portfolio. For example refrigerators,
TV sets, radio & car models produced by the same
company may be treated as different product for at
least pricing purpose.
The pricing under these conditions is known as multi

Product pricing or product line pricing.
175
Pricing Strategies
Skimming Pricing policy.
This pricing strategy is intended to skim

the cream of the market, by setting a high
initial price. This initial price would generally
accompanied by heavy sales promotion
expenditure.
Such pricing is more effective if there is no

close substitute product is available.
176
Pricing Strategies
Penetration Pricing policy.
In contrast to skimming price policy the

penetration pricing strategy involves a
reverse strategy. Under this they fix a lower
initial price to trap the market as quickly as
possible and intend to maximize the profit.
Such pricing strategy they use where

there is more substitute products are
available.
177
Almost an eighth Wonder
The Indian economy grew at 7.9% in the July-
September period, its fastest pace in the last
six quarters.
The growth figure surpassed individual

projections of more than 25 economists
surveyed by various agencies and is second
only to China’s among major economies.
Chinese economy grew 8.9% in the September

quarter.
178
179
KEY DRIVERS
High govt expenditure, funded largely through borrowings
Increased incomes in rural areas due to greater social

spending and high farm goods prices
Higher govt salaries & Pay Commission arrears
Low interest rates & higher incomes driving demand
Private consumption growth has picked up at 5.6% in the

quarter against the dismal 1.6% in the previous quarter.
Pickup in investments. Gross fixed capital formation up

7.3% compared to 4.2% in the previous quarter
180
IMPLICATIONS
Growth forecast for 2009-10 likely to be hiked

to over 7%.
More pressure on govt to start unwinding

stimulus moves, but cloud on demand support
if govt expenditure drops.
RBI could tighten rates sooner than expected.
‘GDP NOS IN LINE WITH 8%

GROWTH PROJECTION’
181
National Income Concept and
Measurement.
“National income is the outcome of all economic

activities of a nation valued in term of money during
a specific period”.
Economic activity-
all human activity which create goods & services that
can be value in term of money.
Non Economic activity-

all human activity which create goods & services that
can not be value in term of money.
182
Measurement.
Different ways of Measuring national income-
Production Method
GNP- Gross national Product.
Income Method.
GNI- Gross national Income.
Expenditure Method
GNE- Gross national Expenditure.
GNP=GNI=GNE.
National income is the outcome of all economic activities of a nation valued in term of money
during a specific period”.
Economic activity-
all human activity which create goods & services that can be value in term of money.
Non Economic activity-

all human activity which create goods & services that can not be value in term of money.
183
Revenue Spending
Market for
Goods
Goods & Goods &
Services and Services
Services
sold bought
Firms Households
Inputs for Labor, land,

production Market for and capital
Factors
Wages, of Production Income
rent, and 184
Resource Income
Businesses Investment FINANCIAL Saving Households

MARKET
Government Taxes
Spending
Spending for Goods and Services

185
The circular flow of income
Consumption of
Factor domestically
payments produced goods
and services (Cd)
186
Consumption of
Factor domestically
BANKS, etc
and services (Cd)
Net
saving (S)
187
Investment (I)
Consumption of
Factor domestically
BANKS, etc
and services (Cd)
Net
saving (S)
188
Investment (I)
Consumption of
Factor domestically
BANKS, etc GOV.
and services (Cd)
Net
Net taxes (T)
saving (S)
189
Investment (I)
Government
Consumption of expenditure (G)
Factor domestically
BANKS, etc GOV.
and services (Cd)
Net
Net taxes (T)
saving (S)
190
Investment (I)
Government
Factor domestically
BANKS, etc GOV. ABROAD
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
191
Export
expenditure (X)
Investment (I)
Government
Factor domestically
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
192
Export
expenditure (X)
Investment (I)
Government
Factor domestically
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
WITHDRAWALS
193
INJECTIONS
Export
expenditure (X)
Investment (I)
Government
Factor domestically
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
WITHDRAWALS
194
Measurement.
Production Method (GNP).
This method views national income from output side.
This method consists of finding out the Net value of all

commodities & services of the economy for the period &
adding them.
To avoid double counting only the value of final goods and
service in included.
GNP = All goods & services produced in the economy

Net Prices
195
Measurement.
Income Method (GNI)
This method is also known as factor income

method.
It counts the National income from distribution side.
GNI is obtained by totaling all the incomes earn by

factors of production.
means GNI= R+W+P+I+NFIA
(net factor income from abroad)
But transfer payment is not the part of national

income.
196
Measurement.
Expenditure Method (GDP).
It is additions of all expenditure made on goods &
services in the economy during the specific period.
means it is summation of expenditures made by
households, firms and government together
Y = C + I + G + (X – M)
Y = GDP,
C = consumption expenditure,
I = investment expenditure,
 G = Government expenditure,
X = exports, M = imports
197
Concepts of National Income
 Gross national product (GNP)
GNP is defined as the value of all final goods and services
produced during a specific period, usually one year plus income
earned abroad by the national minus incomes earned locally by
the foreigners.
Gross Domestic product (GDP)

 The Gross domestic product is defined as the market value of
all final goods & services produced in the domestic economy
during year , plus income earn locally by the foreigners minus
income earned abroad by the nationals.
 GDP= GNP-NFIA (net factor income from abroad).
 GDP= C + I + G + (X – M)
198
 Net national product (NNP)
It is derived by deducting depreciation or capital
consumption from GNP.
National Income
 Net national product income at factor cost is properly
known as National Income. It is obtained by deducting
indirect taxes and adding subsidies to Net national product.
Private Income
 Private income may be defined as the income obtained by
private individual from any sources, it includes retained
earning of corporations.
199
Personal income
Personal income means the spendable income at current prices
available to individuals before personal taxes are deducted.
It excludes undistributed profit.
 Disposable personal income

is the income that household and noncorporate businesses have
left after satisfying all their obligations to the government.
It equals personal income minus personal taxes.
200
 Some Accounting Relationship-
At Market price.
GNP= GNI (Gross National Income)
GDP= GNP less Net Income from abroad.
NNP= GNP less depreciation.
At Factor price.
GNP(at factor cost)=GNP at market price less indirect
tax + subsidies.
NNP(at factor cost)= NNP at market price less indirect
tax + subsidies.
NDP (at factor cost)= NDP at market price less indirect
tax + subsidies.
201
Particular Rs. Million
1 Wages & Salaries 430
2 Imports of goods & 220
services
3 Rent 50
4 Value added in 100
Agriculture
5 Govt. current 140
expenditure
6 Capital Consumption 70
7 Value added in 50
Construction
8 Consumers Expenditure 450
9 Dividends 500
10 Income from self 60
employment
11 Exports of goods & 650
services
12 Undistributed profit 110 202
Gross RS. Gross National Gross National
National millio Expenditure Income
Product ns
Value added 100 Consumer Exp. 450 Wages & Salaries 430
in agri.
Value added 600 Govt exp 140 Self employment 60
in
Manufacturin
g
Construction 50 Gross Fixed inv 150 Company profit 500
dividends
Distribution 150 Change in stock 10 Retained profits 110
Other sectors 270 Exports 650 Public corporations 20
GNP 1170 less imports -220 Rent 50

Less Dep -70 GNE 1170 GNI 1170
less dep -70 less dep -70
NNP 1100 NNE 1100 NNI 1100
203
Unemployment
If a person has ability to work, willingness to
work but not able to get job at the given market
wage rate then he is called unemployed person.
In common parlance, anybody who is not

gainfully employed in any productive activity, is
called unemployed.
Unemployment can divided in Two type.

Voluntary unemployment.
Involuntary unemployment.
204
Unemployment
Voluntary unemployment
Means the persons within working
population, who may be interested in jobs at
wage rate higher than the prevailing wage
rates in the labour market. And wiling to be
unemployed.
Involuntary unemployment
Is situation in which person fail to get jobs even
when they are prepared to accept such jobs at
the prevelling wage rate.
205
Unemployment
Types of Involuntary unemployment
Structural unemployment.
Seasonal unemployment
Disguised unemployment.
Cyclical unemployment.
Technological unemployment.
Frictional unemployment.
the persons within working population, who may be interested in jobs at wage rate higher than the
prevailing wage rates in the labour market. And wiling to be unemployed.
Involuntary unemployment
Is situation in which person fail to get jobs even when they are prepared to accept such jobs at the
prevelling wage rate.
206
Unemployment
Structural unemployment.
Unemployment caused as a result of the
decline of industries and the inability of
former employees to move into jobs being
created in new industries.
Seasonal unemployment
Unemployment caused because of the
seasonal nature of employment – tourism,
skiing, cricketers, beach lifeguards, etc.
207
Unemployment
Disguised unemployment.
If the total marginal contribution of the worker
to the total is zero then it is called as
Disguised unemployment.
Cyclical unemployment.
Cyclical unemployment is that which occurs
due to cyclical nature of business. During
recession phase over all demand for labour is
low and during growth demand for labour is
high.
208
Unemployment
Technological unemployment.
Unemployment caused when developments in
technology replace human effort –
e.g in manufacturing, administration etc.
Frictional unemployment.
It is the nature of temporary unemployment
caused by continual movement of people
between one region to another region and one
job to another job.
209
Inflation
Inflation is an increase in the overall level of prices.
According to Milton Friedman- inflation is a
sustained increase in price.
Defined as:
A SUSTAINED RISE IN THE AVERAGE LEVEL OF
PRICES
It implies a continuously rising trend in general
prices.
Deflation, is an continuously decreasing in the

overall level of prices.
210
Inflation
Causes of Inflation
Demand Pull Factors

Defined as:
- Excess demand condition pulls up prices of
goods and services and lead to price rise.
Cost pull factors.

Some factors of production are responsible for
rising the cost of production it leads to price
rise.
211
Inflation
Demand pull factors are as follows.
Population pressure.
Mounting govt. expenditure
Growing supply of money
Growing deficit financing
Growing black money.
212
Inflation
Cost Push factors are as follows.
Oil price hike.

Slow growth rate of agriculture production.
Increase in wages and bonus.
Rise in administered prices.
Increase in tax rate.
213
Inflation
Other factors.
Increase in procurement prices.

Creation of artificial crisis.
Devaluation of domestic currency.
214
Costs and Consequences of Inflation
Title: Overflowing Riches. Date: 1922.

Description: A shopkeeper using a tea chest to store money which
won't fit in the cash register during Germany's high inflation.
215
Description: Children using
notes of money as building
blocks during the 1923 German
inflation crisis.
216
Costs and Consequences of Inflation
 Money loses its value and people lose confidence in
money as the value of savings is reduced
 Inflation can get out of control - price increases
lead to higher wage demands as people try to
maintain their living standards.
 Consumers and businesses on fixed incomes lose
out because the their real incomes falls
 Employees in poor bargaining positions lose out
 Inflation can favor borrowers at the expense of
savers – because inflation erodes the real value of
existing debts
 Inflation can disrupt business planning and lead to
lower investment
 Inflation is a possible cause of higher
unemployment
 Rising inflation is associated with higher interest
rates - this reduces economic growth and can lead 217
to a recession
Types of inflation
 Creeping inflation
 It is a situation in which the rise in general
price level is at a very slow rate over a period
of time. Under creeping inflation, the price
level raises upto a rate of 2% per annum. A
mild inflation is generally considered a
necessary condition of economic growth.
 Walking inflation
 Walking inflation is a marked increase in the
rate of inflation as compared to creeping
inflation. The price rise is around 5% annually.
218
Types of inflation
 Running inflation
 Under running inflation, the price
increases is about 8% to 10% per annum.
 Hyper inflation
 Galloping inflation is a full inflation. Keynes
calls it as the final stage of inflation. It is a
stage of inflation which starts after the
level of full employment is reached. Here
price level rise
219
Inflation
Way to control inflation.
 (1)Monetary Policy
Monetary policy is a policy that influences the
economy through changes in the money
supply and available credit.
(a) Quantitative controls
(b) Qualitative controls .
220
Inflation
Fiscal Policy
 It is the budgetary policy of the government
relating to taxes, public expenditure, public
borrowing and deficit financing.
Changes in taxation
Changes in Govt. Expenditure
Public borrowing
Control of deficit financing

221
Inflation
Others Measures:
Price support programme.
Provision subsidies.
Imposing direct control on prices of essential
items.
Rationing of essential consumer goods in case
of acute emergency.
222
Business Cycle
Gross Domestic Product is a measure of the value of all
outputs in an economy in a single year - the value of all
goods and services produced
Gross domestic Product does not increase at a constant

rate over time – there are variations in growth rate.
There can be times of negative growth or positive growth

i.e. GDP decreases & GDP increase.
 These periodic movements in output, prices, and

employment are known as the Economic or Business Cycle
223
Various phases of business
Cycle
Expansion of business activities.
Peak of boom or prosperity.
Recession
Trough the bottom of depression
Recovery & expansion.
224
225
Expansion Recession Expansion
Peak
Do n
ur
Total Output
wn t
tu Up
rn Secular
growth
trend
Trough
0
Time
226
Various phases of business
Cycle
Expansion of business activities.
Peak of boom or prosperity.
Recession
Trough the bottom of depression
Recovery & expansion.
227
Parts of Economic Cycle -
 Low levels of
Boom
unemployment – shortages of labour occur pushing
up wage rates
High levels of consumer borrowing and spending
Firms working at full capacity
Profit levels high
Inflation Increasing
Interest rates increasing
Boom in housing market
228
Parts of Economic Cycle –
Recession
Growth rate of GDP is falling or negative
Firms decrease production and reduce stocks
Unemployment rises
Inflation falls
Investment falls
Firms suffer from falling profits, falling returns
of investment, redundancy costs.

229
Parts of Economic Cycle –
Recovery
Consumer confidence grows – leading to increased

borrowing and spending
Firms increase output – build up stock levels
Spare capacity used, then
Investment occurs
Unemployment falls – it make take more than a year of

recovery for large changes in unemployment levels
230
Government and Economic
Cycle
The government will attempt to control
fluctuations in economic growth

Aims to achieve growth at around trend level
Use Fiscal and Monetary policy to achieve
this objective.
231
Profit
P
rofit means different thing to different people.
B
usinessman, Accountant, and Economist used the term
profit with different meaning.
F
or Layman profit means all income flow to the investor.
F
or Accountant profit means excess of revenue over all the
paid-out cost.
F
or economist concept of profit is of pure profit called as
“economic profit”. Pure profit is return above the
opportunity cost.
232
Profit
A
ccounting Profit Vs Economical profit.
A
ccounting Profit -
A
ccounting profit is surplus of revenue over and above paid
cost. Including manufacturing and administration cost.
A
ccounting profit can be calculate as follows
= TR- (W+R+I+M)
Wh
ere W = wages, R= Rent,
I = Interest, M = Material. 233

Profit
ccounting Profit Vs Economical profit.
conomical Profit -
t takes into account the implicit and explicit

costs. Implicit cost is opportunity cost.
conomical Profit=
TR- (Explicit Costs +Implicit costs) 234

Theories of profit
Wh
at are the source of profit?
Eco
nomist have given various opinion on this question which has
created controversy and led to emergence of various theories
of profit.
Prof
it as Rent of ability -
This
theory is given by F.A. Walker.
Acc
ording to him profit is the rent of “exceptional abilities that
entrepreneurs may posses”.
As
like land profit is the difference between the earning of least
and most efficient entrepreneur.
235
Dynamic Theory.
This theory is given by J. B.Clark’s F.A.
Walker.
According to him profit arise in only a
dynamic economy not in a static one.
Static economy is one in which
absolute freedom of competition, population capital are stationary, product are homogeneous
(perfect competition).
Dynamic economy is one which
1) Increase in population.
2)Increase in capital formation.
3)Improvement in production technique
4) Multiplication of consumer wants.
Entrepreneur how take advantage of
changing condition make profit.
In dynamic economy dis appearance
and re emergence of profit is continuous process.
236
Hawleys Risk
Theory of profit. -
This theory is
given by F.B. Hawley in 1893.
According to
him profit is simply the price paid by society for assuming business risk.
In business risk
arise for such reason as obsolescence of product, fall in price, non
availability of certain raw material etc.
According to
him profit consist of two part- 1) Risk which is all ready suffered or
assumed by entrepreneur.
2)Inducement to
suffer the consequences of being exposed to risk in their entrepreneur
adventure.
The reason why
he mentioned profit above actuarial is because risk taking is annoying,
trouble some, disturbance anxiety of various kind.
237
Knights
theory of profit--
 Accordin
g to him profit is residual return for bearing uncertainty not risk.
 He
divided risk into two part. Calculable & non calculable risk.
Calculable risk is those whose probability of occurrence can be
estimated with available data. (Fire, theft, accident etc). Next is
the risk of which occurrence can not be estimated such as change
in test of consumer, change in government policy etc. that is
uncertainty faced by entrepreneur.
 Entrepre
neurs are making decisions under uncertain condition. In this
condition if their decision proved right they would earn profit.
238
Theories of profit
Schumpeter’s innovation theory of profit--

This theory was developed by Joseph Schumpeter.

His theory of profit is embedded in his theory of

Economic development.
His theory start with the stationary of static economic

equilibrium. In such profit can be made only by introducing innovations in business, it may includes-
1.Introducing of new product.
2.New method of production.
3.Opening of new market
4.New sources of raw material
5.Organising the industry in new innovative manner.
According to him profit is residual return for bearing


uncertainty not risk.
He divided risk into two part. Calculable & non

calculable risk. Calculable risk is those whose probability of occurrence can be estimated with available data.
(Fire, theft, accident etc). Next is the risk of which occurrence can not be estimated such as change in test of
consumer, change in government policy etc. that is uncertainty faced by entrepreneur.
Entrepreneurs are making decisions under uncertain

condition. In this condition if their decision proved right they would earn profit.
239
MONETARY POLICY
240
MONETARY POLICY
INTRODUCTION
Monetary Policy is essentially a programme of

action undertaken by the Monetary
Authorities, generally the Central Bank, to
control and regulate the supply of money with
the public and the flow of credit with a view to
achieving pre-determined macro-economics
goals.
At the time of inflation monetary policy seeks

to contract aggregate spending by tightening
the money supply or raising the rate of
241
MONETARY POLICY
OBJECTIVES
 To achieve price stability by controlling inflation

and deflation.
 To promote and encourage economic growth in

the economy.
 To ensure the economic stability at full

employment or potential level of output.
242
SCOPE OF MONETARY POLICY
The scope of Monetary policy depends on two factors
1.Level of Monetization of the Economy –

In this all economic transactions are
carried out with money as a medium of exchange .
This is done by changing the supply of and demand
for money and the general price level. It is capable of
affecting all economics activities such as Production,
Consumption, Savings, Investment etc.
2. Level of Development of the Capital Market

Some instrument of Monetary Policy are
work through capital market such as Cash Reserve
Ratio (CRR) etc. When capital market is fairly
developed then the Monetary Policy effects the level
of economic activities by the change in capital 243
OPEN MARKET OPERATIONS
• The open market operations is sale and purchase of

government securities and Treasury Bills by the
central bank of the country.
• When the central bank decides to pump money into

circulation, it buys back the government securities,
bills and bonds.
• When it decides to reduce money in circulation it

sells the government bonds and securities.
• The central bank carries out its open market

operations through the commercial banks.
244
Discount Rate or Bank Rate policy
 Discount rate or bank rate is the rate at which

central bank rediscounts the bills of exchange
presented by the commercial bank.
 The central bank can change this rate

increase or decrease depending on whether it
wants to expand or reduce the flow of credit
from the commercial bank.
245
Working of the discount rate policy
• A rise in the discount rate reduces the net

worth of the government bonds against which
commercial banks borrow funds from the
central bank. This reduces commercial banks
capacity to borrow from the central bank.
• When the central bank raises its discount rate,

commercial banks raise their discount rate too.
Rise in the discount rate raises the cost of bank
credit which discourages business firms to get
their bill of exchange discounted.
246
Cash Reserve ratio
• The cash reserve ratio is the percentage of total deposits
which commercial banks are required to maintain in the form
of cash reserve with the central bank.
• The objective of cash reserve is to prevent shortage of cash for

meeting the cash demand by the depositors.
• By changing the CRR, the central bank can change the money.
• When economic conditions demand a contractionary monetary

policy, the central bank raises the CRR. And when economic
conditions demand monetary expansion ,the central bank cuts
down the CRR.
247
Statutory Liquidity Requirement
• In India ,the RBI has imposed another reserve

requirement in addition to CRR. It is called
statutory liquidity requirement.
• The SLR is the proportion of the total deposits

which commercial banks are statutorily
required to maintain in the form of liquid
assets in addition to cash reserve ratio.
248
Credit Rationing
 When there is a shortage of institutional credit available
for the business sector, the large and financially strong
sectors or industries tend to capture the lion’s share in
the total institutional credit.
 As a result the priority sectors and essential industries

are of necessary funds.
 Below two measures are generally adopted:
 Imposition of upper limits on the credit available to large
industries and firms
 Charging a higher or progressive interest rate on the
bank loans beyond a certain limit.
249
Change in Lending Margins
• The banks provide loans only up to a certain

percentage of the value of the mortgaged
property.
• The gap between the value of the mortgaged

property and amount advanced is called Lending
Margin.
• The central bank is empowered to increase the

lending margin with a view to decrease the bank
credit.
250
Moral Suasion
 The moral suasion is a method of persuading

and convincing the commercial banks to
advance credit in accordance with the
directives of the central bank in overall
economic interest of the country.
 Under this method the central bank writes

letter to hold meetings with the banks on
money and credit matters.
251
Expansionary Policy / Contractionary Policy
An Expansionary Policy increases the total supply of

money in the economy while a Contractionary Policy
decreases the total money Supply into the market.
Expansionary policy is traditionally used to combat a

recession by lowering interests rates.
Lowered interest rates means lower cost of credit which

induces people to borrow and spend thereby providing
steam to various industries and kick start a slowing
economy.
252
Expansionary Policy /
Contractionary Policy
A Contractionary Policy results in increasing interest
rates to combat inflation.
An Economy growing in an unconstrained manner leads
to inflation
Hence increasing interest rates increase the cost of
credit thereby making people borrow less.
Due to lesser borrowing the amount of money in the
system reduces which in turn brings down inflation.
A Contractionary Policy is also known as TIGHT POLICY
as it tightens the flow of money in order to contain
Inflationary forces.
253
Mahatma Gandhi
Quoted by
Pranab Mukherjee
254
Fiscal Policy
 The word fisc means ‘state treasury’ and fiscal policy
refers to policy concerning the use of ‘state treasury’
or the govt. finances to achieve the macroeconomic
goals.
 The term fiscal policy refers to the expenditure a
government undertakes to provide goods and services
and to the way in which the government finances these
expenditures.
 “Any decision to change the level, composition or
timing of govt. expenditure or to vary the burden
,the structure or frequency of the tax payment is
fiscal policy.” - G.K. Shaw
255
Fiscal Policy
Fiscal Policy Objective-
Economic Growth: By creating conditions for
increase in savings & investment.
Employment: By encouraging the use of labour-
absorbing technology
Stabilization: fight with depressionary trends and
booming (overheating) indications in the economy
Economic Equality: By reducing the income and
wealth gaps between the rich and poor.
Price stability: employed to contain inflationary
and deflationary tendencies in the economy.
256
Fiscal Policy
• TYPES OF FISCAL POLICY
• DISCRETIONARY FISCAL POLICY

• Deliberate change in government expenditure and taxes to
influence national output and prices.
• NON-DISCRETIONARY FISCAL POLICY:

• Built-in tax and expenditure mechanism so designed that
taxes and government spending vary automatically with
changes in national income.
257
Fiscal Policy
Instruments of Fiscal Policy
Fiscal policy instruments are operated by

government at various levels Central, State &
local. Broadly these instruments are listed
below:-
Public Revenue
Public Expenditure
Public Debt.
258
Fiscal Policy
 Public Revenue
 Government normally raise revenue
through taxation.
 Direct taxes-
 Direct taxes are imposed on income, wealth
and property of the individual or corporate
unit.
 Direct taxes like income tax and wealth tax
are imposed to insure distributive justice.
259
Fiscal Policy
 Public Revenue
 Indirect taxes-
 Indirect taxes are imposed on commodities.
 Such as Central Sales Tax, Customs, Service
Tax, excise duty & octroi.
 Indirect taxes are normally used to revenue
rising. Means a small amount of taxes
spread widely over a large number of
commodities, a huge amount of revenue can
be raised.
260
Fiscal Policy
 Public Revenue
 Non tax revenue-
 With tax revenue Gov. also earn revenue
through non tax sources such as –
 Profit of public enterprise.
 Disinvestment of share of public enterprise.
 Even borrowing internally and externally.
261
Fiscal Policy
Government Expenditure
Government spending on the purchase of
goods & services.
Payment of wages and salaries of government
servants
Public investment
Transfer payments
262
Fiscal Policy
Public Debt.
If public expenditure exceeds public revenue then
government has to rise public debt.
 Internal borrowings
1. Borrowings from the public by means of
treasury bills and govt. bonds
2. Borrowings from the central bank (monetized
deficit financing)
 External borrowings
1. Foreign investments
2. International organizations like World Bank &
IMF
3. Market borrowings
263
Fiscal Policy
Budget
“A budget is a detailed plan of operations for

some specific future period”.
It is an estimate prepared in advance of the

period to which it applies.
264
Fiscal Policy
Budget.
“A budget is a detailed plan of operations for some
specific future period”
Keeping budget balanced (R=E) or deficit (R<E) or
surplus (R>E) as a matter of policy is itself a fiscal
instrument.
An accumulated deficit over several years (or
centuries) is referred to as the government debt
A deficit is a flow. And a debt is a stock. Debt is
essentially an accumulated flow of deficits
265
From where Rupees Come
266
Where the rupee Goes
267
Capital Budgeting
Definition-
Capital budgeting is essentially a process of
conceiving, analyzing, evaluating and selecting
the most profitable project for investment.
Is the process of evaluating and selecting long

term investments that are consistent with the
goal of shareholders wealth maximization.
Significance of capital budgeting.

Capital expenditure is generally irreversible.
The survival of the firm depends on how well the
firm planned is its capital expenditure. 268
Capital Budgeting
Capital expenditure-

Capital expenditure means the expenditure of acquiring assets that yield returns over a number of years.

For the purpose of capital budgeting only long term expenditure will be taken in to consideration.

For ex.-

Expenditure on new capital expenditure.

Expenditure on long term assets by new firm.

Expenditure on diversification of assets.

Expenditure on advertisement.

Expenditure on research & developments.

process of evaluating and selecting long term investments that are consistent with the goal of shareholders wealth maximization.

Capital budgeting is essentially a process of conceiving, analyzing, evaluating and selecting the most profitable project for
investment.
Significance of capital budgeting.


Capital expenditure is generally irreversible.

The survival of the firm depends on how well the firm planned is its capital expenditure.

269
Choice of decision rules-
Capital Budgeting
One of the essential requirement of capital budgeting is the choice of criteria for accepting or rejecting a project.
While deciding the criteria objective of the firm should be considered.
Such as profit maximisation, asset building, regular cash flow, or maximisation of short or long run gain.
 Steps in determining the decision rule-
1). Define the objective of the investment.

 2). Select the criteria for evaluating the project.
 A) Pay back period
 B). Discounted cash flow (present value criteria)
 C). Internal rate of return.
 3) The third step is to decide the approach for the final selection.
A)
 Accept reject approach
B) Ranking approach.
Capital expenditure is means the expenditure of acquiring assets that yield returns over a number of years.
 For the purpose of capital budgeting only long term expenditure will be taken in to consideration.
 For ex.- scolded
Expenditure on new capital expenditure.
Expenditure on long term assets by new firm.
Expenditure on diversification of assets.
Expenditure on advertisement.
Expenditure on research & developments.

process of evaluating and selecting long term investments that are consistent with the goal of shareholders wealth maximization.
Capital budgeting is essentially a process of conceiving, analyzing, evaluating and selecting the most profitable project for investment.

Significance of capital budgeting.

Capital expenditure is generally irreversible.
The survival of the firm depends on how well the firm planned is its capital expenditure.

270
Capital Budgeting
Criteria for evaluating the project.
Pay Pack Period Method
The pay back period is also known as “pay off” period.
The pay back period method is the simplest & one of the
most widely used methods of project evaluation.
The pay back period is defined as the time required to
recover the total investment outlay from the gross
earning.
Pay back period = Total Investment / gross return per
period.
For example if a project costs Rs. 40,000 million and is
expected to yield an annual income of Rs. 8000 million
then its pay-off period is computed as follows:-
Pay off period = Rs 40,000 million/ 8000 million
Pay off period= 5 years.
271
Capital Budgeting
 In case of projects yield cash in varying amount, the pay
back period may be obtained through the cumulative total
of annual returns until the total equal the investment
outlay.
Year Total fixed Annual cash Cumulative
outlay flows total of col.
1 10,000 4000 4000

2 3500 7500
3 2500 10,000
4 1500 11,500
5 1000 12,500
 As the table shows, the cumulative total of annual cash

flows breaks even with the total outlay of the project (Rs.
10,ooo million)at the end of 3rd years.
272
Capital Budgeting
 After the pay back period of each project is calculated
projects are ranked in increasing order of their pay back
period. The project with shorter pay off period is preferred
to those with longer pay off period.
Project Pay back Rank
period
year
1 6 4
2 3 1
3 4 2
 Drawbacks- 4 5 3
 It assumes that cash inflows are known with a high degree
of certainty.
 It ignores the period and the subsequent returns, after the
pay off period.
273
Capital Budgeting
The concept of present value: (Time value of
money)
 Money earn today is more valued more than money receivable
tomorrow.
 Because Liquidity
 An opportunity to invest it and earn return on it.
 This is known as time value of money. It is applied to
investment decisions.
 There is difference between investment and the return from
the investment. That is the time lag between investment and
return.
 During this time lag investor loose interest on the expected
incomes.
 Suppose that Rs. 100 is deposited in a bank @ 10% interest
rate. After one year it will increase to 110.
 Rs. 110 expected return, this means that Rs 100 is the
present value of Rs. 110.
274
Capital Budgeting
The concept of present value: (Time value of money)
Future Value is the value at some future time of a present amount of money, or a series
of payments, evaluated at a given interest rate.
 FV1 = P0 (1+i)n
Present Value is the current value of a future amount of money, or a series of payments,
evaluated at a given interest rate.
 PV0 = FVn / (1+i)n
Here –
FV= Future value i= interest rate
PV= Present value n= number of year.
 Money earn today is more valued more than money receivable tomorrow.
 Because Liquidity
 An opportunity to invest it and earn return on it.
 This is known as time value of money. It is applied to investment decisions.

 There is difference between investment and the return from the investment. That is the time lag
between investment and return.
 During this time lag investor loose interest on the expected incomes.
 The rate of interest is 10% Rs. 110 expected return, this means that Rs 100 is the present value
of Rs. 110.
275
Capital Budgeting
money)
Present Value of income streams (An Annuity )
represents a series of equal payments (or receipts)
occurring over a specified number of equidistant
periods.
 Means income is earn over the years. current
value of a future amount of money, or a series of
payments, evaluated at a given interest rate.
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
R = Periodic Cash Flow.

276
Capital Budgeting
The concept of present value: (Time value of money)
Net Present Value & Investment decision.
The investment decision accepting or rejecting a project is
taken on the basic of net present value.
The net present value (NPV) may be defined as the
difference between the present value (PV) of an income
stream & the cost of investment(C).
 NPV= PV-C
If investment is a recurring expenditure, the total present
cost(TPC) for n years can be calculated
TPC = C/(1+i)1 + C/(1+i)2
+ ... + C/(1+i)n
The net present value (NPV)can be calculated as
 NPV= PV-TPC
277
Capital Budgeting
money)
The investment decision rule can be stated as

follows
If NPA>0 then the project is acceptable

If NPA=0 the project is accepted or rejected on the
economic considerations.
If NPA<0 the project is rejected.
278
Capital Budgeting
Internal Rate of return.
Is also called marginal rate of investment. Or break even rate.
It can be defined as the rate of interest or return which renders the discounted present
value of its marginal yields exactly equal to the investment cost of the project.
IRR is the rate of return (r) at which the discounted present value of receipts and
expenditure are equal.
The project is accepted which gives higher IRR- means higher return on investment.
279
Capital Budgeting
Internal Rate of return.
Cost of 1st year 2nd year
project
Project A 100 O 140
Project B 100 130 0
IRR for project A = 18.3%

IRR for project B= 30%
The project is accepted which gives higher IRR-

means higher return on investment.
280
Capital Budgeting
Capital budgeting is not only one of the most
important tasks of business management, but also
a complicated procedure. Managers skills,
experience, intuition, and forecasting are perhaps
needed more in taking appropriate investment
decisions.
281
DEMAND FORCASTING
Production is often made in anticipation of demand.

ANTICIPATION of demand implies demand forecasting.
 Demand forecasting means expectation about the
future course of the market demand for a product.
 Demand forecasting is based on the statistical data
about past behaviors and empirical relationships of
the demand determinants .
 Demand forecasting gives a reliable approximation
regarding the possible outcome ,with a reasonable
accuracy. It is based on the mathematical laws of
probability
282
LEVELS OF DEMAND FORECASTIONING
MICRO LEVEL: It refers to the demand
forecasting by the individual business firm for
estimating the demand for its products.
INDUSTRY LEVEL: It refers to demand
estimate for the product of the industry as the
whole. It relates to the market demand as a
whole.
MACRO LEVEL: It refers to the aggregate
demand for the industrial output by the nation
as the whole.
283
THE SIGNIFICANCE OF DEMAND
FORECASTING
 PRODUCTION PLANNING
 SALES FORECASTING
 CONTROL OF BUSINESS
 INVENTORY CONTROL
 GROWTH AND LONG TERM INVESTMENT
PROGRAMS
 ECONOMIC PLANNING AND POLICY MAKING
284
TYPES OF DEMAND FORECASTING
SHORT TERM FORECASTING
 Relate to a period not exceeding a year.
 Usually day to day information's which are
concerned with tactical decisions under the given
resource constraints ;
 In short term forecasting a firm is primarily
concerned with the optimum utilization of its existing
production capacity.
285
SHORT TERM FORECASTING SERVE THE
FOLLOWING PURPOSE
 EVOLVING SALES POLICY

 DETERMING PRICE POLICY
 EVOLVING A PURCHACE POLICY
 FIXATION OF SALES TARGETS
 DETERTERMING SHORT-TERM FINANCIAL
PLANNING
286
LONG TERM FORECASTING
 Refers to the forecasts prepared for long

period during which the firm’s scale of
operations or the production capacity may be
expanded or reduced.
Relates to in formations which are vital for
undertaking strategic decisions of the
business pertaining to its expansion or
contradiction over a period of time.
287
LONG TERM FORCASTING SERVE THE PURPOSE
BUSINESS PLANNING:-
Long demand potential will provide the required guidelines for
Planning of a new business unit or for the expansion or
Of the exiting one. Capital budgeting by a firm is based
on the long term demand forecasting.
MANPOWER PLANNING:-
It is essential to determine long-term sales forecast for
an appropriate manpower planning by the firm in view of its
long –term growth and progress of the business .
LONG-TERM FINANCIAL PLANNING:

In the view of the long and sales forecasting and the production
planning, it becomes easier for the firm to determine
its long-term financial planning and programmers for
raising the funds from the capital market.
288
FORECASTING METHODS
SURVEY METHODS STATISTICAL

METHODS
Customer Collective
Market Time series Regression
survey opinion
experiments analysis analysis
method method
method
Graphical Moving Least

method average square
method method
289
QUALITATIVE METHODS
- SURVEY OF BUYERS INTENSIONS
- A) Complete enumeration method
- B) Sample survey method
- C) The end use method.
- OPINIONS METHOD
- A)Experts Opinion method
- B) Delphi method
- C) Market Experimentation method.
290
QUANTITATIVE METHODS
- TIME SERIES MODELS

 A) Graphical method
B) Moving Average method
C) Least square method.
- CAUSAL MODELS
 - Regression Model.
291

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---Swami Vivekananda---

i. Human wants are unlimited.

ii. The means are limited

iii. Alternative uses of the limited resources.

"Decision making as the process of selecting the

Characteristic of Decision Making.

Game theory -An individual's success in making

Inventory Model. Such as EOQ, EBQ, MRP & MRPII

Differential calculus provides a technique of

Regression analysis helps us understand how

Management, Accountancy theory & ME.

Marginal principle assumes special significance where

The term marginal refers to change in total quantity or

 he equi marginal principle was originally associated with consumption theory.

Why do people do business? What motivates the

The theory of firm was based on the assumption that the

There are two condition for profit maximisation.

The secondary or the second order condition

Traditionally, efficiency of a firm measured in terms of its profit generating capacity

 Confusion on measure of profit

he equi marginal principle was originally associated with consumption theory.

Some of this models are as follow

According to him firms balance growth rate

He defines firms balance growth rate (G) as

But this model fail to deal with oligopolistic

The serious shortcoming of this model is that it

Simon had argued that real business world is full of

 It does not explain the firm’s behavior under dynamic

 It can not be used to predict exactly future course of action.

 It fails to deal with interdependence of the firms & its impact

Managers form an Aspiration level on basis of

The aspiration level are modified & revised on

 It does not explain the firm’s behavior under dynamic

 It can not be used to predict exactly future course of action.

 It fails to deal with interdependence of the firms & its impact

2)Derivative of a power function-

Find out the optimum level of out put.

 Total revenue of firm can be defined as-

Find out the optimum level of out put.

Total revenue of firm can be defined as-

Price is independent variable & quantity

Reasons underline the law of demand-

Product or absolute angle.

Consumer or relative angle

As the quantity consumed of a commodity

The unit of the consumer good must be a

Utility is a psychological phenomenon. It is feeling of

It does not explain the impact of the complementary and

It is applicable only for one commodity.

Ordinal Utility Approach

The higher order of preference is given to the

(Pioneered by J.R. Hicks & R.G.D Allen also known as

Defined as locus of point, each representing a different

He is indifference between any two combinations of

It is also called Isoutility curve or Equal utility curve.

Five combination A, B, C, D, E of two

Indifference curves have a Negative slope.

Indifference curves do not intersect nor are they

Upper indifference curves indicate a higher level

Indifference Units of Change in Change in MRS

Price Effect = Substitute Effect + Income Effect.

Income effect result from the increase or decrease in real

Define as the locus of points representing various