Managerial Economics GS Gupta PDF

UNIT I GENERAL FOUNDATION OF MANAGERIAL ECONOMICS Economics can be broadly divided into two categories namely, microeconomics and macroeconomics. Macroeconomics studies the economic system in aggregate on the other hand micro-economics studies the behavior of an individual decision-making economic unit like a firm, a consumer, or an individual supplier of some factor of production. Macroeconomics relates to issues such as determination of national income, savings, investment, employment at aggregate levels, tax collection, government expenditure, foreign trade, money supply and price level, etc. In simple terms, managerial economics can be taken as applied micro- economics. It is an application of that part of micro-economics which is directly related to decision making by a manager. Thus, managerial economics analyses the process through which a manager uses economic theories to address the complex problems of business world, and then take ‘rational’ decisions in such a way that the preconceived objectives of the concerned firm may be attained (Barla: 2000). Like an economy, the manager of a firm also faces five basic issues:- (1) Choice of product, i.e., the products a firm has to produce - A manager has to allocate the available resources so as to maximize the profit of the firm. (2) Choice of inputs – After determining the profit maximising level of output, the manager has to identify the input-mix which would produce the profit maximizing level of output at a minimum cost. (3) Distribution of the firms’ revenue – The revenue received by the firm through sales has to be distributed in a just and fair manner by the manager. Workers, owner of factory building, bankers, and all those who have contributed their materials and services in the process of production, storage and transportation, have to be paid remunerations according to the terms and conditions already agreed upon. The residual after such payments constitutes the firm’s profit which has to be distributed among the owners of the firm after tax payment. (4) Rationing - This constitutes an important function of a manager. He/she should utilize the scarce resources optimally, which involves expenditure. As the manager has to often look after several plants simultaneously, he/she must prioritize not only the allocation of resources but also the time. (5) Maintenance and expansion – In addition, the manager has to plan strategies to ensure that the level of output is maintained, the efficiency of the firm is retained over time, and also to plan the future expansion of the firm. Expansion of the firm involves making adequate provisions for mobilizing additional capital from the market and/or borrowing money from banks. A dynamic manager always aspires to expand the firm’s scale of operation so as to increase the profits. 1.1 Circular Flow of Economic Activities Economic analysis attempts to explain the working of economic systems. Assume a simple economic system consisting of two sectors, whose activities are systematically connected with one another. (there is no link between both the sentence) The economic activities performed by economic agents are generally classified into three inter-related activities:- (a) Supplying factor inputs like land, labour, capital, organisation and enterprise, which enable the agents to earn income which in turn could be used for purchasing consumable goods; (b) Using the factor inputs like raw materials, machines, labour, land, etc., for producing goods to be supplied to the consumers; and (c) Providing intangible and specialized services directly to the people (example, lawyers, teachers, doctors, and porters) or working for the government (example, soldiers, judges, police, etc.). The nature and dimensions of economic activities are generally determined by the extent of overall economic development. For instance, a developed economic system like that of the United States or Japan, has more specialized activities and division of labour, as compared to a traditional economic system. In an extremely primitive economic system, the extent of interdependence among economic agents tends to be limited, with some kind of division of labour in them. The extent of monetization and foreign trade also determine the nature and scope of economic activities in a country. Foreign trade adds various dimensions to the process of identification of economic activities. Further, the extent of government intervention also complicates this process. Hence, to study the flow of income among different economic agents, a simplified economy with non-existent government economic activities and foreign trade may be considered, wherein the inflow and outflow of income among different economic agents are always equal. expenditure on commodities Commodities households firms factor services money income Diagram – 1 Circular flows in a two-sector economy 1.2 Forms of Organisation In modern times, organisation of business assume several forms, viz., sole proprietorship, individual entrepreneur or one-man business, partnership, joint–stock companies, industrial combination, co-operative enterprises and state enterprises. a) Individual Entrepreneur: Under the ‘one-man’ concern, organiser invests his/her own capital and may also borrow some. He/she rents a shop and employs a worker, if necessary. He/she personally make purchases and attend to the sales, and who also takes the entire risks. Thus, an entrepreneur organizes, directs all economic activity and takes the full risks, and is the sole proprietor. b) Partnership: In partnership firm, two, three or more people join together, contribute capital, and share the profits and risks of losses in agreed proportions. c) Joint-stock company: It is the most important type of business organisation today. It overcomes the disadvantages of the partnership arising out of small financial resources and limited business talent. d) Co-operative enterprise: They are of two types – 1) Producer’s cooperation, and 2) Consumer’s cooperation. 1) Producers cooperation: Under it, the workers take up the entrepreneurial work; contribute some capital and borrow the rest; elect their own foreman and managers and employ other staff. After all expenses on rent, capital, salaries and wages, the profits are divided by the workers. This type of co-operation is called the productive co-operation or producer’s co-operation. ii) Consumer’s cooperation: Under it, the consumers of a region contribute small shares of capital and start a store. These co-operative stores buy goods from wholesalers or, and sells them to the members at the market price. The profits are shared by the members in proportion to their purchases or, commonly, in proportion to their capital share. Usually, the capital share is contributed equally and therefore profits are also equally shared by the members. State enterprise: The organisation of state enterprise is similar to that of the private enterprises. It consists of general manager, foremen, works manager, accountants, treasurer, departmental heads, etc. It functions in a similar way like a joint-stock company. But, the fundamental difference is that all its employees are government servants with fixed tenure and pension benefits on retirement. The capital comes from the state revenue, which are attributed by the tax-payers. Therefore, the profit, if any, goes to the state. Public enterprises: Public enterprises may be in the form of i) Departments, i.e., run by a government department, e.g., railways and postal and telegraph in India, ii) Corporation, e.g., Life Insurance Corporation of India which is established by a special Act of Parliament, and iii) Limited Liability Company registered under the Companies Act. 1.2 Objectives of the Firm Traditionally, the objective of a firm is to maximize profit. It is assumed that managers consistently make decisions to maximize profit for the firm. They make decisions that reduce current year profits, so as to increase profits in the future years. To achieve this objective, they incur expenditures on research and development activities, new capital equipments and major marketing programs, which reduce the profits initially but significantly, raise it in the future. Thus, given that both the current and future profits are important, it is assumed that the goal of a firm is to maximize the present or discounted value of all future profits {PV (πt)}. The goal or objective function for the firm may be expressed as:- π1 π2 πn Maximize: PV (πt) = + + …… 1+r 1+r 1+r where πt is profit in time period t, and r is an appropriate discount rate used to reduce future profits to their present value. Using the Greek letter ∑, which indicates that each of the terms on the right-hand side of the given equation have been added together. Then, the objective function can be rewritten as: - nπt Maximize: PV (π) = ∑ t=1 (1 + r)t 1.3 Theory of Demand The theory and analysis of demand provides several useful insights for business decision making. Demand for a commodity is defined as the quantity a consumer is willing to purchase at the prevailing price, given sufficient purchasing power or income for that purpose. As against the demand of an individual consumer or a household, the manager of a firm may consider the market demand which is the aggregation of demand levels of all the consumers at a given price. 1.3.1 The law of demand The law of demand explains the behaviour of consumers; either a single consumer/household or all the consumers collectively. The law of demand states that other things remaining the same (ceteris paribus), the quantity demanded of a commodity is inversely related to its price. In other words, as price falls, the consumers buy more. Or, the demand for a commodity falls when its price rises. Thus: (1) The concept of demand generally refers to the quantity demanded at a given time, which may be a point of time, a day or a week. (2) The law of demand is based on the assumption that within the given time frame, there would be no change in the quality of the goods in question. To put it differently, among the various determinants of demand, the price of the commodity is only variable. (3) The term ceteris paribus associated with the law of demand implies that taste and preference, income, the prices of related goods and social status, all remains constant over the period in which the impact of price variation on the quantity demanded is being analysed. (4) The law of demand is a partial analysis of the relationship between demand and price, in the sense that it relates to the demand for only one commodity, say X, at a time or over a period of time. 1.3.2 The demand function A demand function shows the relationship between the demand for a good, say X, and the various factors which cause a change in it. The demand function may be expressed as follows:- Dx = f(Px, Py, M, T, W) where, Dx = quantity of commodity X demanded per unit of time, Px = price of X, Py = mean price of all other substitute commodities, M = consumer’s income, T = taste, and W = wealth of the consumer Of the variables mentioned, tastes are difficult to quantify, whereas wealth does not have a direct influence on the demand Dx. Hence, T and W are held constant, and Dx is assumed to be a function of Px, Py and M only. Demand functions are generally homogenous of degree zero. Homogeneity means that changes in all the independent variables, namely, Px, Py and M are uniform. If the degree of a homogenous function is zero, then it would imply that when all prices and income change in the same proportion, Dx would remain unchanged (Barla: 2000). Py and M are generally assumed to be the parameters. For simplicity, the demand for X is assumed to be a function of only Px. The quantity demanded and price has an inverse relationship, except in the case of a Giffen good. The demand curve for a Giffen good is upward sloping, indicating that the price and quantity demanded move in the same direction. Meanwhile, the demand curve for a normal commodity is negatively sloped. The slope of the curve, however, depends upon the price elasticity of demand for the commodity. The demand for a commodity X, depends on its own price Px, the price of other substitute good (Py), consumer’s income, tastes and preference, etc. In reality however, demand depends upon numerous factors. The main determinants of demand are as follows:- a. Price (Px) - As already discussed, the price of a commodity and its demand are inversely related. Hence the negative (inverse) slope of the demand curves. b. Price of other associated good (Py): A change in Py also influences the change in Dx. However, the direction of such change depends upon the nature of relationship between the two goods, namely X and Y: i) X and Y are complementary goods, when both goods satisfy a single want. Eg. ink and pen, milk and sugar, car and petrol, etc. When price of Y rises, the consumer will buy less of Y and also less of X, although the price of X remains unchanged. Thus, Dx and Py , are negatively related. ii) X and Y are substitutes, if the consumer can use more of X at the cost of Y, or vice versa. That is, with a fall in Py, the consumer would buy more of Y because it has become cheaper compared to X. Therefore, the demand for X will fall and that of Y will increase. For e.g., if the price of apple falls then it would induce the buyers to buy more. Besides, many buyers of orange may also switch over to apple, even though the price of orange has not changed. iii) When X and Y have no relationship, the two commodities are said to be independent. For example, the demand for wheat and milk has no relationship. Under such a situation, even if the price of X ( Px) falls significantly, demand for Y (Dy) remains unchanged. c. Income of the consumer (M) - With an increase in the income, of a consumer, the demand also increases. Hence, the demand curve for X will have a positive slope in relation to income. However, for an inferior good, an increase in income would result in buying smaller quantities of it. Therefore, the demand curve for an inferior good is negatively sloped in relation to income. For eg., ragi is inferior to rice or wheat for consumption. d. Status of the consumer – Often, even when Px, Py and M are constant, the consumer’s status in the society induces him/her to buy less or more of a good. They have to maintain certain level of living standards, regardless of the problems like that of incidence of loans taken, etc. e. Demonstration effect – Sometimes, a consumer is motivated to buy some commodity not because it has become cheaper or the income has increased, but because the neighbours have purchased it. This is also called as the “Bandwagon effect”. According to it, demand for X is determined not by its utility, price or income, but by what other consumers in the society are doing. On the other hand, there are also consumers who like to behave differently from the others. For instance, when all other consumers buy more units of X when Px falls, such consumers prefer to buy less of X. This is known as the “Snob effect”. f. Seasonal variations in demand – The demand for a good also rise or falls according to the variations in temperature or climate conditions. Demand for air conditioners, ice cream, cool drinks, etc, are extremely high in summers, whereas demand for blankets and woolens are low. g. Spatial variations in demand – Demand for a good also varies according to the place or profession in which a consumer is engaged. h. Taste of the consumer – The demand for a good is also determined by the taste and preference of a consumer. Other things remaining constant, a consumer would buy more or less of a good depending upon his/her choice or preference function. A consumer may like coffee over tea, while another may prefer tea over coffee. Thus, a consumer’s taste is also an important determinant of demand for a commodity. 1.3.3 Derivation of demand curves Other things remaining the same, a demand curve is negatively sloped due to the law of diminishing marginal utility. This law of diminishing marginal utility states that as more and more units of the same commodity initially are consumed without any time gap, then the total utility (TU) derived increases at an increasing rate, then starts increasing at a decreasing rate from the point of inflection, becomes maximum and then starts declining. A consumer gets maximum utility from the consumption of a commodity X, when its marginal utility (MUx) is equal to Px, i.e., MUx = Px. Marginal utility (MU) refers to the additional utility derived by the consumer from the consumption of an additional unit of commodity to the total units consumed. It starts from the origin and becomes maximum at the point of inflection, after which, it starts declining and becomes zero when total utility is maximum. This is shown by diagram 2. MUx = 0 MUx < 0 TUx / MUx Inflection TUX MUx > 0 0 Quantity MUX Diagram-2: Law of Diminishing Marginal Utility Only the positive slope of the MUX curve is considered for the derivation of the demand curve DX, as there can be no negative demand. A demand curve may be derived from the negative slope of the MUX curve, and the consumer equilibrium condition MUx=Px. By this logic, the Y axis represents Px, which is represented MUx in diagram -2. This is shown in the following diagram. Y D Px2 Px1 D 0 X1 X2 Quantity Demanded Diagram -3: The Demand Curve Diagram - 3 shows that a rise in the price of X from Px1 to Px2 leads to a contraction in the quantity demanded from Ox1 to Ox2 along the demand curve DD. Further, DD indicates that even a small or large change in Px would still support the law of demand. Alfred Marshall assumed that every consumer maximizes total utility only at that level of X where MUx = Px. That is, where Px decreases, the consumer consumes more of X such that MUx equals price level. Therefore, the MU curve and demand curve in the Marshallian analysis are similar. The fall in the quantity demanded due to an increase in Px results from three reasons: i) increase in price affects the utility maximizing quantity of consumption, and to restore the equilibrium, the quantity of X must decrease with an increase in Px. This is because, only with smaller quantity of X, MU will increase and approach close to the higher level of Px; ii) due to substitution and income effects, the consumer will reduce the quantity of X consumed when its price rises, so as to maximize utility; iii) the demand curve is negatively sloping demand due to the rise in consumption as a result of a fall in price, or conversely, due to fall in consumption when price increases. When there are two goods namely X and Y, then the ratio of their marginal utilities must be equal to the ratio of their respective prices. This is known as the law of equi-marginal utility maximization. The consumer is in equilibrium when the ratio of marginal utility and prices for all the goods is equal, i.e., MUx MUy MUx Px = or = Px Py MUy Py The consumer maximizes utility by buying certain combination of X and Y. If Px increases and the consumer consumes the same quantity of X, thus holding the level of marginal utility of X at the original level, then equilibrium will be disturbed, i.e. MUx MUy < Px Py Thus, if in spite of a rise in the price of X, the quantity demanded is held constant, the marginal utility of Y will change due to a decrease in its quantity because the consumer now spends more on X. Then, the consumer no longer maximizes utility. For maximization of utility, the consumer has to reduce the quantity of X in response to the increase in Px. Thus, when price increases, a consumer can maximize utility only by reducing the quantity demanded. Conversely, the quantity demanded has to increase when the price of X falls. In the process, the equilibrium is restored at a new equilibrium at a new combination of X and Y. 1.3.4 Demand schedule A demand schedule shows the list of prices and the corresponding quantities of a commodity. While preparing the demand schedule, it is assumed that the marginal utility of money is constant and that the quantity demanded depends only on price. 1.3.5 Elasticity of demand In economics, the term elasticity measures a proportionate (percentage) change in one variable to a proportionate (percentage) change in another variable. In other words, it measures the responsiveness of the dependent variable to a given change in one of the independent variables, other variables remaining constant. Elasticity of demand is the responsiveness of the quantity demanded to a given change in the price of a commodity, the prices of other commodities and consumer’s income remaining the same. The elasticity (e) of X with respect to Y may be written as: - percentage change in X Exy = percentage change in Y ∆X/X or, Exy = ∆Y/Y Given the demand function: - Dx = f (Px, Py, M) Where, Dx = quantity of X demanded by a consumer; Px = price of X; Py = the (weighted) price of all other commodities; and M = consumer’s income. Demand (Dx) responds to a given change in each of these independent variables, when the other two variables are held constant. For the concept of elasticity of demand to be meaningful, a direct reference has to be made to the nature of change in the independent variable (Px, Py, or M) although their relative significance may be different in different context. Since demand varies with fluctuations in different variables, there are different kinds of demand elasticities, one with respect to each of the causal variable. In modern analysis of consumer behaviour, the important demand elasticities of significance are:- (a) Price elasticity of demand, (b) Cross elasticity of demand, (c) Income elasticity of demand, and (d) Promotional elasticity of demand (a) Price elasticity of demand: Price elasticity of demand measures the responsiveness or percentage change in demand to a given percentage change in price, holding the other determinants of demand, namely other prices (Py) and consumer’s income (M) constant. This elasticity is also known as ‘own elasticity’ Due to the negative relationship between demand and price, the coefficient of price elasticity has a negative sign, which in practice is generally ignored. Price elasticity may be measured under two alternative conditions (i) when the change in price is very small, and (ii) when price variation is finite. (a) when change in price is very small or infinitesimal, point elasticity method of measurement is used: - dDx Px Exx =. DPx Dx where Exx = the price elasticity; dDx /dPx = change in demand with respect to a change in price; Px = original price; and Dx = original quantity of demand. Algebraically, dDx/dPx is the first derivative of demand function with respect to price. (b) When change in price is finite, arc method of measurement is used. Here, rather than taking the first derivative of demand function, an attempt is made to measure the elasticity of demand in relation to a finite change in price using the following formula: - ∆Dx Px1 + Px2 Exx =. ∆Px Dx1 + Dx2 where X1 and Y1 = the values of X and Y at point A; and X2 and Y2 = values at point B. While the first part of formula {i.e. ∆Dx /∆Px }, measures the change between the new and previous levels of demand in response to a finite variation in price, the second part represents the summation of the two prices divided by the sum total of the two levels of demand. Both the methods of measuring price elasticity (point and arc) are useful. While point elasticity is used to find out a change in one variable in relation to a small change in the other variable, arc elasticity is used to find out a change in one variable due to a large change in the other variable. For example, to find the effect of a price change from Rs. 5 to Rs. 4.80 per unit on demand, the point elasticity would be more appropriate, whereas if the change is from Rs. 20 to Rs. 15 per unit on demand, then arc elasticity would be more suitable. The significance of both point and arc elasticities methods arise from the fact that elasticities are independent of the unit of measurement. This makes the use of elasticities popular in demand studies, as the variables in a demand function are measured in different units which makes the analysis of their marginal effects difficult. The categories of price elasticity are: - (i) Perfectly elastic demand; (ii) Highly elastic demand; (iii) Unit elasticity of demand; (iv) Inelastic demand; and (v) Perfectly inelastic demand All these elasticities can be computed both at different points on a demand curve, and also at a given arc. For simplicity, the point definition formula is used to express price elasticity of demand. b) Cross elasticity of demand: It is the responsiveness of demand for commodity X to a percentage change in the price of commodity Y. It can be expressed as: - percentage change in DX EXy, PY = percentage change in PY ∆DX PY or, Exy =. ∆PY DX For substitute commodities, the cross elasticity of demand is positive. This implies that when the price of Colgate falls, the demand for Peposdent will fall, as the two commodities are substitutes. When two commodities are complements, the cross elasticity of demand will be negative. This indicates that when the price of coffee falls, the quantity demanded of sugar will go up as the two goods are complementary. Thus, while the signs of cross elasticity show whether two commodities are substitutes or complements, their magnitude indicate the degree of their relationship. The greater the cross elasticity, the more closely related the two goods are. If the two goods have no relationship, the cross elasticity between them will be zero. The concept of cross elasticity of demand is useful in measuring the interdependence of demand for a commodity and the prices of its related commodities. Its knowledge thus helps a firm to estimate the likely effects sales of pricing decisions of its competitors on its own sales. c ) Income Elasticity of Demand Income elasticity of demand (eD X, I) measures the responsiveness of demand for a commodity, say X (DX) to a change in consumers’ income (I). It can be computed from the following formula: percentage change in DX EXI = percentage change in I ∆DX/DX = ∆ I/I ∆DX I or EXI =. ∆I DX For superior goods income elasticity is positive, whereas for inferior good it is negative. Positive income elasticity can assume three forms: greater than unity (one) elasticity, unity elasticity and less than unity elasticity. When a change in income results in a direct and more than proportionate change in the quantity demanded, the income elasticity is said to be positive and more than unity. Luxury goods are its example. When a change in income leads to a direct and proportionate change in the quantity demanded, then it is known as positive and unit income elasticity. Its examples include semi-luxury and comfort goods. When an increase in income results in a less than proportionate increase in quantity demanded, then the elasticity is positive and less than unity. Necessary goods fall under this category. The income elasticity is negative when an increase in income leads to a decrease in quantity demanded. Inferior quality goods came under this category. Knowledge of income elasticities of demand for various commodities is useful in determining the effects of changes in business activity on various industries. d) Promotional elasticity of demand: It measures the expansion of demand through advertisement and other promotional strategies. It is also known as advertisement elasticity of demand. It may be expressed as: - percentage change in DX EX A = percentage change in A DX A or, E XA = ° A DX where, A = expenditure on advertisement and other promotional strategies. The advertisement elasticity is always positive. This is because both informative and persuasive types of advertisements are used which increase sales. The higher the elasticity, the better it is for the firm to spend on promotional activities. This elasticity helps a decision maker to decide upon the firm’s advertisement outlay. 1.3.6 Demand analysis and forecasting Demand is crucial for the survival of any business enterprise. A firm’s own profit and/or sales depend mainly upon the demand for its product. A management’s decisions on production, advertising, cost allocation, pricing, inventory holdings, etc. all requires an analysis of demand. Demand analysis attempts to identify and measure the factors that determine sales, on the basis of which alternative methods of manipulating or managing demand can be worked out. Demand forecasting attempts to estimate the expected future demand for a product, which helps to plan production better. In this context, it is important to understand the types and determinants of demand and their relative importance. Demand is broadly classified as: - (a) Demand for consumers’ goods and producers’ goods, (b) Demand for perishable and durable goods, (c) Derived and autonomous demands, (d) Firm and industry demands, and (e) Demand by total market and by market segments. a) Consumers’ goods and producers’ goods - Consumers’ goods are directly used for final consumption. Meanwhile, producers’ goods are used for further production of other goods, which may either be in the form of consumers’ or producers’ goods. The former includes clothes, houses, food, etc., while the latter includes machines, tools, raw materials, etc. Consumers’ goods are also known as direct demand. Whereas producers’ goods is known as derived demand. b) Perishable and durable goods’ demand - Consumers’ and producers’ goods are further classified as perishable and non-durable goods. Those goods which can be consumed only once are known as perishable goods, whereas the durable goods can be used more than once during a period of time. For example, vegetables, fruits and milk are perishable consumer goods, while oil, raw materials and coal are non-durable producer goods. On the other hand, car, refrigerator and furniture are durable consumers’ goods, while industrial buildings, machine and tools are durable producers’ goods. c) Derived and autonomous demand – When the demand for a good is associated with another parent good, it is called derived demand. For example, the demand for steel is not for its own sake, but for satisfying the demand for construction. In this sense, the demand for all producers’ goods is derived. On the other hand, autonomous demand is wholly independent of all other demands. It is difficult to name a product which is fully autonomous d) Firm and industry demands – Firm demand represents the demand for products of a single company, while industry demand refers to the demand of an industry. e) Demands by total market and by market segments – The total market demand for a product refers to the total demand, while the demand arising from different segments of the market is market segment demand. Segments include different regions, product use, distribution channels, customer sizes, and sub-products. Each of them differs significantly with respect to delivered prices, net profit margins, competition, seasonal patterns and cyclical sensitivity. Wide differences in them call for a demand analysis restricted to an individual market segment, which in turn would help a firm to manipulate the total demand. Hence, a company/ industry would be interested in the both these demands. Risk and uncertainty are involved in every decision-making process. The producer, manager or any decision-making authority should be aware of the existing level of demand for the products being produced, and estimate the gap between demand and supply. In a growth-oriented decision-making process, the manager decision-maker is expected to know the changes that are expected to take place in the future demand. Such knowledge would help to determine the targets to be achieved to match the future demand with the available supply. Thus, the manager decision-maker, whether a firm or a state planning agency, must not only estimate the present level of demand, but should also forecast the future demand (Barla: 2000). The extent of objectivity and precision with which demand for a product is estimated and projected for the future would determine the ability of a decision-making agent in dealing with further uncertainties. For example, if there is a possibility of rise in the prices of petroleum products, the automobile producers may plan to switch over to the production of smaller cars. Such switch-over decisions need to be made on the basis of accuracy of demand forecasts. Thus, major decisions in business enterprises depend upon forecasts of one kind or the other. 1.3.7 Stages in forecasting demand Based on the scope of demand forecasting for a commodity, the following sequence is generally adopted in projecting demand: - (1) Specification of objective(s): Specification of the purpose of demand forecasts is the foremost task in forecasting demand. (2) Selection of appropriate technique: Next, selection of appropriate technique for the purpose is important. If it is proposed to use regression method, the model has to be specified properly by identifying the necessary variables and the nature of relationship between X and Yj. (3) Collection of appropriate data: Collection of quality and adequate data for the demand forecasting would determine the quality and reliability of results. Hence, the data collected should also be representative. (4) Estimation and interpretation of results: The results obtained through the analysis of collected data, either manually or with the help of computers, should be interpreted carefully in correspondence with the objectives examined. (5) Evaluation of the forecasts: A model used for demand forecasting with objectivity, would yield good results. The results, however, need to be verified by persons possessing professional acumen and expertise. 1.3.8 Levels of forecasting Demand projections may not be cent per cent correct/accurate, more so when the scope of a demand forecast is wide. Different levels of demand forecast may be attempted by business firms. They are:- a. Micro-level – Under it, the forecasting is restricted to a particular brand or specific product, like the demand for BPL televisions or Maruti cars. b. Meso level – Here, a firm attempts to project the demand for a product group, like the demand for washing machines. c. Macro level – When a firm attempts to examine the future demand for all automobiles or TV sets rather than the demand for a particular brand name or product group, it is known as macro level forecasting of demand. 1.3.9 Data and techniques of demand forecasting A good set of data is required for the estimation of present level of demand and forecasting the future demand. A private sector forecasts demand on the basis of past experience and the data collected from various sources. Similarly, a public sector uses data collected by different government and research agencies for the purpose. The following are some of the techniques adopted for estimating the existing and future demands. 1) Delphi Technique: This technique is based on the assumption that collective judgment of knowledgeable persons may serve as an important source of information. The personal insights of such persons may help in forecasting the demand for some products. These key persons use their own perceptions and evaluate future prospects. It is quite likely that due to different perceptions, different experts may view the future demand differently. Under such circumstances, they are requested to revise their estimates until consensus is reached through upward adjustments by some experts and downward adjustments by the others (Barla 2000). In this method, an individual is assigned the task of forecasting the demand by personally studying the changes that have taken place in the national and international scenario and then come out, without any personal bias, with a forecast. He/she carefully studies the demographic changes, per capita income changes, trends in government policies, mood of the investors, availability of substitutes and complementary goods, and on the basis of all such data or information, predicts the future level of demand for a product. This technique has the merit that each expert or panel member is expected to assess their own forecast. However, this is an expensive and time consuming technique. Besides, sometimes one or more experts may refuse to revise the forecasts once given, which would create problem. 2) Forecasts based on the projected population and per capita income: Usually, large producers get market surveys conducted for estimating the existing level of demand for their products and to know consumers’ preferences. Some magazines/newspapers also publish reports on such market surveys. 3) Market Survey Technique: There are different types of market surveys, viz., i) complete enumeration, ii) sample survey, and iii) market study based on experiments. These techniques provide relevant information depending upon the extent of survey conducted. 4.) Trend Projections: It is the most widely used and the simplest technique for extrapolating the demand for a product on the basis of past trend, assuming that the past trend would continue in the future. There are two methods of conducting trend projections: (a) time series analysis, and (b) constant percentage method. (a) Time series analysis – Under this method, sales of a commodity over the past 15 to 20 years are plotted on a graph. The year to year oscillations are smoothened and a trend line is fitted using a statistical method, so that the squared values of upward and downward deviations from the trend add to zero. (b) Constant percentage method – This method is based on the assumption that the percentage growth rate of sales between the base year and the terminal year would remain unchanged. The following formula is used for projecting this demand:- Yn = Y0 [1+g]n where, yo = demand in the base year; g = annual rate of growth; and n = number of years. In other words, g is the compound growth rate. 5). Econometric method: In this method of demand forecasting, it is assumed that demand is determined by one or more variables, e.g., income, population, exports, etc.. A demand function determined by only one variable is expressed as follows: - X = f(Y) This equation may be expressed as:- X = a+bY Here, with a change in the independent variable (Y) with a positive intercept a, and constant coefficient b, the dependent variable (X) will also change. An econometric model involving two or more independent variables may be shown as: - X= f (Y1, Y2, Y3, …..Yn) Its multiple regression equation will be of the form:- X = a+b1Y1+b2Y2+b3Y3+…..+bnYn) If X is assumed to have non-linear relationship with Y, then the exponential regression function will be as follows: - X = aYα1 Yβ 2Yγ3Y4Ω…. (bj = α, β , γ, Ω …..) In sum, the econometric forecasting of demand for X would be based on: (i) the nature of demand model, i.e., simple or multiple regressions, and (ii) the expected nature of relationship between the dependent and independent variables, i.e., whether constant or exponential, besides the negative or positive relationship with the dependent variable. 6). End use method: This method is widely used to forecast the demand for a commodity, which is used as an input for producing other goods/services and a good (X) for direct consumption. For example, cement may be used for constructing houses, hotels, bridges, roads, etc. Therefore, while estimating its present demand and for forecasting its future demand, the demand for the good in different uses has to be taken into consideration. 7). Barometric forecasting: At times, a business concern may assign the task of demand forecasting to some expert agency, which would attempt to forecast the demand on the basis of signals received from the policies adopted or the events that had taken place within the country or in other countries. 1.3.10 Significance of demand forecasting Estimating and forecasting demand are crucial to the following types of decision-makers for knowing the present level of demand and the expected increase in demand over time. (i) Producers: A producer allocates various factors of production for maximization of profit, for which knowledge of both the present and future demand is important. Future demand estimates helps the producer to plan the extent of expansion in scale of operations, so as to deal with the increased demand and earn higher profits. (ii) Policy makers and planners: It helps government to formulate economic policies through the planning boards or planning commissions to allocate resources for economic development through production in the public, private and export sectors to achieve the targets set for a given time period. It also ensures adequate supply of inputs for achieving the objectives of industrial policy, import-export policies, credit policy, public distribution system, and other related policies, which involves forecasting of future demand. (iii) Other groups of the society: Demand forecasts are also useful to researchers, social workers and others with futuristic approach, to understand the levels of future demand or supply, the gaps, and their expected impact on prices or the economy. 1.4 Production Function A production function expresses the technological or engineering relationship between the output of a commodity and its factor inputs. Traditionally, economic theory considers four factors of production, namely, land, labour, capital and organisation or management. Now, technology is also considered as an important determinant, as it contributes to output growth. Therefore, output is a positive function of the quantities of land, labour, capital, the quality of management, and the level of technology employed in its production (Mote, et. al, 1997). This relationship may be expressed as follows:- X = f (A, L , K, M, T) Where, f1,f2, f3, f4, f5 > 0 X = output of commodity X, A = land employed in the production of X, L = labour employed, K = capital employed, M = management employed, T = technology used, f = unspecified function, and f1 = partial derivative of f with respect to the ith independent variable. This function describes a general production function. For the production of different commodities, one or all the factor inputs may not be equally important for all commodities. The importance of a factor of production varies from product to product. For instance, while land is the most important factor in the case of an agricultural product, its importance is relatively lower in the case of a manufacturing product. Meanwhile, the significance of management and technology may be greater in the case of an industrial product, rather than for an agricultural product. Therefore, researchers modify the production function according to the product and the specific objectives analysed. Generally for the analysis of production decision problems, labour and capital are the only two factor inputs considered for convenience. Then, the production function reduces to:- X = f (L.K) For a given level of output of commodity X, various combinations of L and K may be used, which is known as production process or technology. Further, these combinations would also vary with variations in the level of X. Usually for production, both labour and capital are necessary and they substitute each other. When an entrepreneur employs more of labour than capital, then the production process is known as labour intensive production technique. Whereas, if more of capital is used in relation to labour, the production technique becomes capital intensive. 1.4.1 Producer’s equilibrium A producer is in equilibrium when he or she maximizes output for the given total outlay. In other words, a producer is in equilibrium when the highest isoquant is reached, given a particular isocost or price line. An isoquant (IQ) represents different combinations of labour and capital which yields the same level of output of a commodity. An isocost/price line represents the different combinations of labour and capital that an entrepreneur can purchase, given the prices of the two factor inputs and the total outplay available to him/her at a point of time. Producer’s equilibrium occurs when an isoquant is tangent to the isocost line. At the point of tangency, the absolute slope of the isoquant is equal to the absolute slope of the isocost line. That is, at equilibrium, MRTSL,K = PL/PK. Since MRTSL,K = MPL/MPK, at equilibrium, MPL PL MPL MPK = or = MPK PK PL PK Here, MP = marginal product; and MRTSL,K = marginal rate of technical substitution of labour(L) for capital (K). MRTSL,K is defined as the number of units of K given up to employ one more unit of L. PL and PK represent the prices of labour and capital respectively. The slope of the isocost line represents the price ratios of the two factor inputs, L and K, given the total outlay. Marginal product (MP) is the addition of output made to total output by employing one more unit of the factor input. The slope of the isoquant represents the MP ratios of L and K. At equilibrium, the MP of the last unit spent on labour is the same as the MP of the unit spent on capital. The same applies to the other factors, if the firm’s production function is expressed in terms of more than two factors of production. Diagram-4 shows a producer’s equilibrium. K A E IQ3 IQ2 IQ1 0 B L Diagram 4: Producer’s equilibrium Given the total outlay constraint AB, IQ2 is the highest isoquant the firm can reach. IQ3 is desirable, but not attainable with the given isocost line. Further, at IQ1 the firm would not be maximizing output. Therefore, a rational producer who aims at maximum output with the given total outlay, would be at equilibrium at point E, where MRTSL,K = PL/PK 1.4. 2 Law of variable proportions The production function shows the maximum quantity of the output that can be produced per unit of time for each set of alternative inputs, given the best available production technology available. In the short-run, at least one factor of production remains fixed. For instance, in the case of an agricultural production function, various alternative commodities of labour or capital per unit of time may be used in relation a fixed amount of land. The total product curve increases at an increasing rate first until the point of inflection, after which it starts increasing at a decreasing rate, reaches its maximum and then starts declining. The average product of labour (APL/APK) is then obtained from total product (TP) divided by the number of units of labour/capital used. The marginal product of labour (MPL/ MPK) represents the change in TP per unit change in the quantity of labour/capital used. The shapes of curve determine the shape of the APL and MPL curves. The APL, at any point on the TPL curve is given by the slope of the straight line from the origin to that point on the TP curve. The AP curve usually first rises, reaches a maximum, and then falls, but remains positive as long as the TP is positive. The MPL is equal to the slope of the TP curve, reflecting the change in output due to a unit change in input between the two points. The MP curve also rises first, reaches a maximum (before the AP curve reaches its maximum), and then declines. The MP becomes zero when the TP is maximum. This is the law of diminishing returns. If labour is factor input considered, the relationship between the APL and MPL curves can be used to define the three stages of production. Stage I starts from the origin to the point where the APL is maximum. Stage II starts from the point where the APL is maximum to the point where the MPL is zero. Stage III covers the area over which the MPL is negative. A rational producer will not operate in stage III, even with free labour, because it is possible to increase total output by using less labour on the given land. Likewise, a rational producer will not operate in stage I because it corresponds to the area where full TP is still increasing with an additional unit of labour employed. Therefore, a rational producer would only operate in stage II. In stage I; MP2 > 0, when TP is maximum MPL = 0, and when TP falls MPL AB > BC. (c) Decreasing returns to scale: It indicates that output increases in less than proportion to the increase in factor inputs. This may be due to the scale of operation beyond the optimum plant capacity, over-utilization of machineries resulting in wear and tear and break-down leading to increased maintenance cost, overworking labour, managerial constraints in over-seeing expanded business, wastage of raw materials, etc. This is known as diseconomies of scale. Diagram-8 shows this. K F C IQ 300 B IQ 200 A IQ 100 0 L Diagram 8: Decreasing Returns to Scale The diagram shows that the distance between the successive isoquants along the product line goes on increasing, due to increased input requirements resulting from diseconomies of scale. That is, OA < AB < BC. 1.5 Cost Concepts A cost function expresses the relationship between the cost of production and levels of output. The various cost concepts are:- (1) Social and private costs: Social cost of producing a commodity refers to the opportunities of producing other commodities foregone, given the scarce resources. In simple terms, it is the cost of alternative good sacrificed by a community in producing a certain amount of one good. Private costs, on the other hand, include the costs incurred by an individual firm to obtain the resources used for the production of commodity. The reduction in private cost of a product would result in the reduction in of social cost, due to the emergence of a divergence between the social and private motives. (2) Explicit and implicit costs: Production of a commodity generally requires different kinds of labour and capital in many forms. Modern economists call the direct production expenses as the explicit costs of production. It includes the expenses incurred by a producer on buying the productive services owned by others. Whereas, implicit costs include the evaluation of a producer’s efforts and sacrifices incurred in production process. In other words, it refers to the reward a producer would like to pay self for self-owned and self-employed resources. They include a normal return on own investment, and the opportunity cost (alternative earnings) of own labour. (3) Economic versus accounting costs: Accounting cost includes the expenses incurred on production process, in addition to the wear and tear of machines and equipments, which can be translated into monetary terms. The accountant records all the explicit costs in the account book, so as to compare them with the sale proceeds in order to compute profits. Whereas, economic cost includes all the implicit and explicit costs of production. It involves the estimation of opportunity cost, which is the price a factor of production can receive in any alternative use, including the implicit costs of the factors owned by the entrepreneur. (4) Sunk costs: They are the costs which cannot be recovered, and therefore, are not included in the decision making process. They include the costs of highly specialized resources or inputs, which once installed, cannot be put to any alternative use. For e.g., a big plant or machine installed by a firm which has become obsolete or inoperative due to non-availability of some parts, then the money spent on it is known as a sunk cost. It is sunk because neither can the firm uses it, nor sell it, or put it to any alternative use. Hence, sunk costs have no relevance in decision making. (5) Fixed and variable costs: In production process, some factors are constant in the short run, while others are variable. Fixed costs are costs which do not vary with a change in output. The examples are interest on capital, rent on building, salaries to the staff, etc., which must be incurred, regardless of the level of output. On the other hand, variable costs change with the variations in the level of output. They include the payments made to the variable factors, such as wages paid to workers, raw materials, electricity, transportation cost, etc., Total cost is the sum total of fixed and variable costs. Total Cost = Fixed Costs + Variable Costs or TC = FC + VC TC FC VC ATC or Average Total Cost = = + Q Q Q where, Q = quantity of output produced. Thus, average cost of production is the sum total of average fixed cost and average variable cost. In ordinary accounting statements generally only explicit or money costs incurred in production process are considered. However, for a realistic computation of costs, two additional variables must be included, viz., normal profit and implicit costs or opportunity costs (already seen). Normal profit refers to the returns which the owners expect to receive from the business done by the firm, in the absence of which they would prefer to quit. When total revenue (TR) is equal to total cost (TC), the firm earns only the expected minimum return on the capital invested, i.e. normal profit. Hence, normal profit is a part of the cost of production. When TR exceeds TC, the firm gets super normal profit, which is more than what a firm needs to remain in business. But when TR = TC, the firm earns only normal profit. 1.5.1 Theory of cost in the short run Short-run is the duration of time in which some factors of production remain fixed, while other factors are variable. It is the time period during which a firm cannot vary its production capacity. This capacity is determined by the amount of fixed inputs or the size of the plant, and the costs associated with it, which must be paid by a firm regardless of the level of output. Meanwhile, the level of variable costs varies directly with the level of output. When returns to variable inputs increase at an increasing rate, variable costs would increase at a decreasing rate, and when returns to variable inputs increase at a decreasing rate, variable costs increase at an increasing rate Thus, while the variable cost increases directly with the level of output, but total fixed cost remains unchanged. Diagram-9 shows the fixed, variable and total costs. TC Cost (Rupees) TVC N TFC Q Quantity of Output Diagram - 9 Fixed, Variable and Total Cost Curves The diagram shows that both total variable cost (TVC) and total cost (TC) curves are increasing functions of the level of output. TVC initially increases at a decreasing rate and then at an increasing rate. However, the total fixed cost curve remains constant at all output levels. The shape of total cost curve (TC) reflects that at each level of output, total cost exceeds the variable cost. The vertical distance between TC and TVC represents total fixed cost. Initially, the distance between TC and TVC is relatively high when the proportion of fixed to total cost is high. But, as the level of output increases, fixed cost constitutes a small fraction of total cost and hence the TC converges towards TVC. This is because, with the rise in the level of output produced, the fixed cost gets distributed across larger units of output. This reduces the fixed cost per unit of output. Total product and total variable cost: Logically, TVC is expected to be a strictly increasing function of output. Further, larger levels of output generally require greater outlays. This relationship may be expressed as follows: - TVC = f(Q) But, Q = g(X), Therefore, TVC = h(X) ---- (1) Equation (1) states that since total variable cost is a function of the level of output (Q), the output itself is a function of the level of variable input (X). Therefore, TVC is a function of variable input. However, as larger levels of Q require higher amounts of variable input, with constant price of X; this relationship can be written as follows: - G(X1) > f (X0) if and only if X1 < X0 Hence, H(X1) > h(X0) ---- (2) Equation (2) indicates that TVC will increase as the level of input use increases from X0 to X1, which in turn results in an increase in output from Q to Q1, thus affecting TVC (Barla , 2000). Average and marginal cost: Unit cost and the incremental cost of production can also be computed. It has been seen that total cost of production is the sum total of total fixed cost and total variable cost, i.e., TC = TFC + TVC ----- (3) Dividing both sides of equation (3) by the quantity of output (Q) would give average cost or unit cost of production. Therefore, average cost is the sum total of average fixed cost and average variable cost. i.e., TC TFC TFC = + Q Q Q or AC = AFC + AVC ------ (4) As output increases, average fixed cost registers a decline. Average variable cost, average total cost and marginal cost, decline initially and then show an upward trend. Total fixed cost divided by the quantity of output (Q) is average fixed cost (AFC). Section A of diagram - 10 shows that, the average fixed cost has an inverse relationship with the quantity of output, such that as the output increases, AFC decreases. This makes AFC a rectangular hyperbola, because total fixed cost is divided by different levels of output. Thus, Q.AFC = C, a constant. That is, the area under AFC is always equal to TFC = C, The AFC curve is a rectangular hyperbola (Q.AFC = C), which never touches the axes even if extended indefinitely upward or downward to the right. It only approaches the axes asymptotically. That is, as output increases AFC curve will approach closer to the X axis, but will never touch it because the numerator is still a positive constant. The two axes in section A of diagram - 10 represent the asymptotes of the AFC function. Section B of diagram-10 shows the derivation of AFC from in section A. Choice of certain points on TFC and dividing the vertical distance by the corresponding quantity of output would give the slopes of different rays starting from origin and extending to the TFC. The slopes of OA1, OA2, OA3, OA4 and OA5 indicate average fixed cost at different output levels. Thus: A1X1 TFC OA1 = = OQ1 OQ1 A B Y Y Average fixed cost (Rupees) Cost (Rupees) A1 A2 A3 A4 A5 TFC AFC X X 0 Q1 Q2 Q3 Q4 Q5 Quantity of Output Quantity of Output Diagram–10: Derivation of Average Fixed Cost It clearly shows that as OQ1 increases, the slope of OA1 declines. This illustrates the inverse relationship between AFC and the level of output (Barla 2000). It is also possible to derive average variable cost (AVC) by measuring the slopes of different rays from the origin to the corresponding points on the TVC curve. However, analyzing the pattern of variation in AVC is more complicated as compared to the AFC, because both of these elements determine its change. Since AVC = TVC, both the numerator (TVC) and the denominator (output) increase together, but not necessarily in the same proportion. The traditional AVC curve is ‘U’ shaped due to the operation of law of variable proportions. Decreasing costs arise due to economies of scale reaped by a firm, whereas increasing costs occur due to diseconomies of scale. Section B in diagram-11 shows TVC at different levels of output. The change in slope indicates that TVC increases at different rates at different quantities of output. For instance, for producing OQ1 units of output, the AVC is OC1, which is nothing but the slope of the ray OC at A on the TVC curve. A B Y Y TVC E C3 C Cost (Rupees) Cost (Rupees) AVC C2 B A C1 X X 0 Q1 Q Q2 Q1 Q Q2 Quantity of Output Quantity of Output Diagram-11: Derivation of Average Variable Cost Curve Marginal cost (MC) is the change in total cost due to an additional unit of output produced, i.e., MC = ∆C / ∆Q. Since total fixed cost remains fixed at all levels of output, the MC reflects the change in TVC only. The slope of TVC represents the marginal cost, i.e., ∆C/ ∆Q = MC. The MC significantly influences the behaviour of a rational profit maximizing firm. It falls faster than the fall in AVC, becomes constant and cuts the AC and AVC at minimum and rises faster than the AVC. This is because it reflects the immediate changes in per unit cost in response to the increased in the level of output. This is the consequence of the law of variable proportions, the AC has its minimum to the right of AVC, because it combines AFC. Diagram -12 illustrates this behaviour of the MC curve. Y MC AC Cost (RS.) AVC Output X Diagram–12: Cost Curves 1.5.2 Long-run costs Long-run is defined as the period in which all factors of production are variable. While, in the short-run some costs are fixed and others vary (variable costs), in the long-run all the costs are variable. Hence, the long run cost reflects the returns to scale. When a manager decides to increase all the factors of production, it is known as a change in the scale of a firm’s operation. In response to the change in the scale, the firm may experience increasing, constant and/or diminishing returns to scale. These changes in returns may be expressed in terms of cost conditions as decreasing costs, and constant costs and/or increasing costs. This is shown by diagram – 13. SAC7 SAC6 SMC1 SAC1 LMC SMC2 LAC SAC2 c3 SMC3 SAC3 SAC5 SAC4 c1 SMC4 c2 Average cost (Rs.) 0 Q1 Q2 Q3 Output Diagram-13: Long Run Cost Curves At the initial short-run average cost SAC1, the firm produces OQ1 units of output at per unit cost OC1. When the manager plans to increase output to OQ2 units, the average cost would be OC3 on the rising part of the SAC1 cost curve if the same plant is used. On the other hand, if an additional plant is installed, the cost would fall to OC2 (OC2 < OC1). Thus, the installation of a new plant decreases the cost per unit of output. The diagram shows that average cost will successively fall till the installation of the fourth plant. The lowest AC level is reached at output level OQ3. This level is known as the optimum level of output, at which the long run average cost (LAC) is minimum and the LMC cuts it from below. Here, the long run equilibrium condition of LAC = LMC and LMC cutting LAC from below have been reached. If output increases beyond OQ3, the LAC would rise for every additional plants installed. No rational manager would install new plant beyond it, as they wish to make atleast normal profits in the long run. The long run average cost curve (LAC) is also known as envelope curve as it envelopes several average cost curves corresponding to different plant size. Further, it is also known as a planning curve, as it guides the manager in planning the future expansion of plant and output. References: Barla C.S., Managerial Economics, National Publishing House, Raipur, 2000. Craig Petersen H., W. Cris Lewis, Managerial Economics, Prentice-Hall of India, New Delhi, 2003. Dominick Salvatore, Theory and Problems of Micro Economic Theory, Schuam’s outline series, McGraw-Hill, Inc., 1992. Dewet K.K., Modern Economic Theory, Shyam Lal Charitable Trust, S. Chand and Company Ltd., New Delhi, 2005. Mote V.L., Samuel Paul and G.S. Gupta, Managerial Economics Concepts and Cases, Tata McGraw Hill Publishing Company Ltd., New Delhi, 2001. Koutsoyiannis. A, Modern Micro Economics, Macmillan Publishers Ltd., London, 1979. Questions: 1) Distinguish between micro and macro economics. 2) Explain the concept of managerial economics. 3) List the function of a manager. 4) Illustrate the circular flow of economic activity 5) State the objectives of a firm. 6) Explain the law of demand. 7) What are the determinants of demand? 8) How is a demand curve derived? 9) Define elasticity of demand. What are its types? 10) What is demand forecasting? Discuss its stages and significance. 11) Describe the techniques of demand forecasting. 12) What is production function? 13) When is producer’s equilibrium achieved? 14) How is the law of variable proportions different from the law of returns to scale? 15) Distinguish between economies and diseconomies of scale. Unit – II 1. Markets 2. Classification of Markets 3. Perfect Competition 4. Monopoly 5. Price discrimination 6. Monopolistic Competition 7. Oligopoly and Duopoly 8. Wage 9. Wage Differential OBJECTIVES The main objectives of the chapter are: i) To examine the features of differential market ii) To identify price, output and profit determinants of various forms of market iii) To examine the reasons for wage differentials I MARKETS Meaning of market A market is a place where commodities are bought and sold at retail or wholesale prices. In economics, however, the term “market” does not refer to a particular place as such but it refers to a market for a commodity or commodities. Thus, the market is an arrangement whereby buyers and sellers come in close contact with each other directly or indirectly; to sell and buy goods is described as market. Hence, the term “market” is used in economics in a typical and a specialized sense. They are:- (i) It does not refer only to a fixed location. It refers to the whole area of operation of demand and supply. (ii) It refers to the conditions in which transactions between buyers and sellers take place. (iii) A group of potential sellers and potential buyers are required at different places for creating market for a commodity. (iv) Markets may be physically identifiable, e.g., the cutlery market in Pondicherry situated at Jawaharlal Nehru Street. (v) Existence of different prices for a specific commodity means existence of different markets. Products and factor markets Markets may be classified into two. They are:- (i) Product market and (ii) Factor market. (i) Product market A ‘product market’ or ‘commodity market’ refers to an arrangement in effecting buying and selling of commodities. In fact, each commodity has its market. Thus, we speak of the cotton market, the wheat market, the rice market, etc. Markets for precious metals such as gold and silver are called the bullion exchanges or bullion markets. Markets for capital change such as government securities bonds, shares, etc., are called the Stock Exchange. (ii) Factor market. Factor markets are markets in which factors of production such as land, labour and capital are transacted. There are, markets called labour market, land market, and capital market. The households or the consumers are the buyers in the product markets. Their demand is the direct demand for the consumption goods. The firms or the producers are the buyers in the factor markets. Their demand for productive resources or factors or production is a derived demand. In the product market, the commodity price of a specific commodity is determined individually in the concerned commodity market by the interaction society. Factor prices such as rent of land, wages of labour and interest for capital are determined in the factor markets as the price of each factor is determined by the interaction between its demand and supply in its respective market. Thus, factor markets; facilitate distribution of income in the form of rents wages, interest and profits. II CLASSIFICATION OF MARKETS Classification of market structures The market is a set of conditions in which buyers and sellers come in contact for the purpose of exchange. The market situations vary in their structure. Different market structures affect the behaviour of buyers and sellers. Further, different prices and trade volumes are influenced by different market structures. Again, all kinds of markets are not equally efficient in the exploitation of resources, and consumers’ welfare also varies accordingly. Hence, the different aspects of the pricing process should be analysed in relation to the different types of markets. Markets may be divided on the basis of different criteria. They are:- (i) geographical space or area, (ii) time element and (iii) the nature of competition. Markets based on geographical area may be classified as:- (a) local markets, (b) regional markets, (c) national markets, and (d) world markets, (a) Local markets:- Markets pertaining to local areas are called local markets. When commodities are bought and sold at one place or in one locality only, then it is known as local markets. (b) Regional markets:- Goods are sold within a particular region, is known as regional market. For example, most of the films produced in regional languages in India have their regional markets only. (c) National markets:- Goods in a National market are demanded and sold on a nationwide scale. A large number of items such as TV sets, cars, scooters, fans, vanaspati ghee, cosmetic products, etc., produced by big companies have national markets. A good network of transport and communication and banking facilities are required in promoting national markets. (d) World markets:- In world markets goods are traded internationally. In international markets, goods are exchanged between buyers and sellers from different countries and we use the terms “exports” and “imports” of goods. Classification of markets CLASSIFICATION CLASSIFICATION OF OF MARKETS MARKETS AREA AREA WISE WISE TIME TIME ELEMENT ELEMENT COMPETITION COMPETITION LOCAL LOCAL VERY VERY SHORT SHORT PERIOD PERIOD PERFECT PERFECT MARKETS MARKETS MARKET MARKET COMPETITION COMPETITION REGIONAL REGIONAL SHORT SHORT PERIOD PERIOD MARKETS MARKET MARKET MONOPOLY MONOPOLY MARKETS NATIONAL NATIONAL LONG LONG PERIOD PERIOD OLIGOPOLY OLIGOPOLY MARKETS MARKETS MARKET MARKET WORLD WORLD VERY VERY LONG LONG PERIOD PERIOD MONOPOLISTIC MONOPOLISTIC MARKETS MARKETS MARKET MARKET COMPETITION COMPETITION Markets based on time element. In this context, time element is used to the functional or operational time period pertaining to market forces at work. The time element may be classified as: (a) Very short period, (b) short period market, (c) long period market, and (d) Very long period market. (a) Very short period market:- On functional basis, the market period is regarded as a very short time period during which it is physically impossible to change the stock of a commodity even by a single unit. The basic characteristic of a very short period market is that in this market it is not possible to make any adjustments in the supply to the changing demand conditions. (b) Short period market:- The market of a commodity during short period is referred to as “the short period market”. During this period, it is possible for a firm to expand output of a commodity to some extent by changing the variable inputs such as labour, raw materials, etc., under its fixed plant size. Thus, the firm is in a position to make some adjustment in the supply on the basis of changing demand conditions. Besides, the equilibrium price is established by the intersection of short period demand and short period supply. (c) Long period market:- The market for a commodity in the long period is referred to as “the long period market”. Here, long period is sufficient to permit changes in the scale of production to a firm by changing its plant size. Further, the firm is in a position to make better period market; the equilibrium price of a commodity is established by the interaction of long period demand and long period supply. The price in this market is normally normal. (d) Very long period market:- The market for a commodity in the secular time period is referred to as “the very long period market”. This period runs over a series of decades. During this period, dynamic changes take place in demand and supply conditions. There can be perfect adjustment between demand and supply in the secular period. Type of market structures formed by the nature of competition Traditionally the nature of competition is adopted as the fundamental criterion for distinguishing different types of market structure. The degree of competition may vary among the sellers as well as the buyers in different market situations. Usually, the market structures are classified in accordance with the nature of competition among the sellers. The nature of competition among the sellers is viewed on the basis of two major aspects: (1) the number of firms in the market; and (2) the characteristics of products, such as homogeneous or differentiated. On supply side of the market, the main types of market are:- (i) Perfect competition, (ii) Monopoly; (iii) Oligopoly, and (iv) Monopolistic competition. III PERFECT COMPETITION In the perfectly competitive market, a singly market price prevails for the commodity, and it is determined by the forces of demand and supply in the market. Under perfect competition, every participant (whether a seller or a buyer) is a price-taker, and no one is in a position to influence it. Characteristics of perfect competition: The main characteristics of perfectly competitive market are:- (a) Large number of buyers and sellers:- A perfectly competitive market is basically formed by a large number of actual and potential buyers and sellers. Their number is sufficiently large and the size of each seller and buyer is relatively small in terms of market. So, the individual seller’s buyer’s and supply and demand are negligible in terms of market supply and demand. Hence, individual seller and buyer do not have a control over supply and demand of the market. (b) Homogeneous Product:- The commodity supplied by each firm in a perfectly competitive market is homogeneous. This means that the product of each seller is virtually standardized. Since each firm produces an identical product, their products can be readily substituted for each other. Hence, the buyer has no specific preference to buy from a particular seller and his purchase from any particular seller is a matter of chance and not of choice. (c) Free entry and exit of firms:- New firms are not having any legal, technological, economic, and financial or any other barrier to their entry in the industry. Similarly, existing firms are free to quit the market. Thus, the mobility of firms ensures that whenever there is scope in the business, new entry will take place and competition will remain always stiff. Due to the natural stiffness of competition, inefficient firms would have to eventually quit the industry. (d) Perfect knowledge of market conditions:- Perfect competition requires that all the buyers and sellers must possess perfect knowledge about the existing market conditions such as market price, quantities and sources of supply and demand. The perfect knowledge ensures transactions in a perfectly competitive market at a uniform price. (e) Non-intervention of the Government:- A perfect competition also implies that there is no government intervention in the working of market economy. This means that there are no tariffs, subsidies, rationing of goods, control on supply raw materials and licensing policy. Government non-intervention is essential to permit free entry of firms and for automatic adjustment of demand and supply through the market mechanism. (f) Absence of transport costs element. It is essential that competitive position of no firm is adversely affected by the transport cost differences. Hence, it is assumed that there is absence of transport cost as all firms are closer to the markets. Price and Output determination under perfect competition Price for an individual firm under perfect competition is given. It cannot influence the price by its own action. Hence, the demand curve or average revenue curve facing a firm under perfect competition is perfectly elastic at the ruling price. Perfectly competitive firm can sell as much as it wishes without affecting the price, and the marginal revenue is equal to the price (average revenue) of the commodity. So, the average revenue (or demand) curve, (AR) and marginal revenue curve (MR) must coincide with each other for a firm under perfect competition. Y MC REVENUE/COST P B C A (MR = AR) 0 OUTPUT X1 X Fig. 1 Conditions of Equilibrium Under Perfect Competition In Fig. 1 if price prevailing in the market is OP, then PA is both the average and marginal revenue curve. MC is the marginal cost curve. It may be noted that under perfect competition, a firm’s upwards rising position of MC curve is also its supply curve. Given the price OP, the firm will fix its output where its profits are maximum. Profits are the greatest at the level of output for which marginal cost is equal to marginal revenue and marginal cost curve cuts the marginal revenue curve from below. In point B MC is equal to MR but MC is cutting MR from above rather than from below. Therefore, B cannot be a position of equilibrium. At point C or output OX1, the marginal cost equals MR and marginal cost curve is also cutting MR curve from below. Hence, at the output OX1, the profits would be maximum and the firm would be in equilibrium position. Thus, the conditions of firm’s equilibrium under perfect competition are: - (i) MC = MR = Price (ii) MC must cut MR from below. Equilibrium in the Short Run The short run has been defined as a period of time sufficient to allow the firm to adjust its output by increasing or decreasing the amount of variable input and fixed factors of production remains constant. Thus, in the short run, the size and kind of plant cannot be changed, nor can new firms enter the industry. Assume that all firms are working under identical cost conditions to explain the equilibrium of firm under perfect competition both in the short run and long run. The entrepreneurs of all the firms are equally efficient. Further, let us assume that the factors of production used by the different firms are homogeneous and are available at given and constant prices. The above twin conditions of equilibrium ensure that profits have been maximized or losses minimized, but they do not tell about the firm’s absolute profit or loss position. Hence, there are three possibilities. They are:- (a) The firm makes supernormal profits, (b) It makes only normal profits, and (c) It incurs losses. Let us explain them one by one. (a) When the firm makes supernormal profits in the short run:- In Fig 2, if the price is OP1, the average-marginal revenue curve is P1A1 and the firm is in equilibrium at point C1 of output OX1. The average cost is X1G, and price is OP1. Hence, profit per unit is GC1. The output is OX1. Hence, the firm is making supernormal profits, and it is equal to the area P1C1GH. As all the firms in the industry have identical cost curves with the firm represented in Fig.2, and all would be making supernormal profits. There will be a tendency for the new firms to enter the industry and it will compete away these supernormal profits. But the time period is not sufficient for the new firms to enter, the industry and hence the existing firms will continue to earn supernormal profits at the price OP1 in the short period. SMC Y SAC Q P1 A1 REVENUE/COST F E G H P A R P2 S A2 Q OUTPUT X2 X X1 Q Fig.2 Firm’s Equilibrium: Short Run (b) The Firm just makes normal profit:- Let us assume that the ruling price in the market is OP. PA will then be the average marginal revenue curve and the firm will be in equilibrium at the point R. At the point R, besides marginal cost being equal to marginal revenue and MC curve cutting MR curve from below, average revenue (or price) is also equal to average cost, and the firms in the industry will be making only normal profits which included in average cost. Since all the firms in the industry are making only normal profits, the time period is not sufficient enough either for the new firms to enter or for the existing firms to quit the industry. (c) The Firm incurring Losses, but does not shutdown:- If the short-run price in the market were OP2, instead of OP1 and OP, the firm will be in equilibrium at point S, since with price OP2, only at S the marginal cost is equal to marginal revenue or price OP, and MC curve cuts MR P2A2 from below. But, at S or output OX2, the firm is incurring losses, The total losses in this situation are equal to the area P2SEF. This is the smallest loss that a firm can incur under the given price-cost situation, if it is to produce at all. Given the price OP2 in the market, the loss of the firm would be greater if it tries to produce at a point other than S. The important question arises are:- Why at all should the firms continue operating if they are incurring losses ? If they cannot leave the present industry, why do they not at least shut down to avoid losses? As mentioned earlier, the short run is a period in which firms cannot alter their fixed capital equipment. Hence, they will have to bear fixed costs in the short run even if they shut down. Only variable cost can be avoided by stopping production. Shut-down point: The whole argument can be easily understood with the help of Fig 3, where AC and MC are average cost and marginal cost curves respectively. AVC is the average variable cost curve. If price is OP2, the firm is in equilibrium at point S and incurring losses to the extent of P2SNF. Further, the firm is covering total variable cost and a part of the fixed costs, due to the fact that the price OP2 = M1S is greater than the average variable cost M1K at the equilibrium output OM1. So, in the short run, it is in the interest of the firm to keep operating at price OP2. AC Y MC K H AVC REVENUE\COST F N P2 L1 S K P3 L D P4 L2 SHUT-DOWN POINT M M1 OUTPUT X Fig.3 Equilibrium of Firm – Short Run: Shut Down Point. But if the price is less than OP3 or MD (i.e., if price is less than the bottom of AVC), the firm would shut down, because it would not cover even variable cost. Therefore, point D is, called the shut down point. For example, at price OP4, the firm would not cover even variable cost since OP4 is less than the average variable cot at every level of output. With price OP4, the firm’s losses would be equal to fixed costs plus a part of the variable cost not covered by the total revenue. Hence, it can be concluded that a firm will shut down if the price falls below the bottom of average variable cost curve in the short run. Equilibrium in the Long Run The long run is a period which is long enough to permit changes in the variable as well as in the fixed factors of input. Hence, firms can change their output by increasing their fixed equipment. They can enlarge the old plants or replace them by new plants or add new plants. Moreover, in the long run, new firms can also enter the industry. On the contrary, if the situation so demands, in the long run, firms can diminish their fixed equipments by allowing them to wear out without replacement and the existing firms can leave the industry. So, it is the long run average and marginal cost curves are relevant for making output decisions. Further, in the long run, average cost is of no particular relevance. It is the average total cost which is of determining importance, since in the long run all costs are variable and none are fixed. For a perfectly competitive firm to be in equilibrium in the long run, in addition to marginal cost equal to price, price must also be equal to average cost. If the price is greater than the average cost, the firms will be making supernormal profits. Lured by these supernormal profits, new firms will enter the industry and these extra profits will be competed away. When the new firms enter the industry, the supply of output of the industry will increase and hence the price of the output will be reduced. The new firms will keep coming into the industry until the price is depressed down to average cost, and all firms are earning only normal profits. On the other hand, if the price happens to be below the average cost, the firms will be incurring losses. Some of the existing firms will quit the industry. As a result, the output of the industry will decrease and the price will rise to equal the average cost so that the firms remaining in the industry are making normal profits. Thus the following two conditions must be satisfied. (i) Price = Marginal Cost (ii) Price = Average Cost. But if price equals both the marginal and the average costs then for the long-run equilibrium of the firm under perfect competition, we have a combined condition. Price = Marginal Cost = Average Cost. Now when average cost curve is falling, marginal cost curve is below it, and when average cost curve is rising, marginal cost curve must be above it. Hence, marginal cost can be equal to the average cost only at the minimum point of average cost curve. Therefore, it is at the point of minimum average cost curve that marginal cost curve intersects the average cost curve, and the two are equal. Thus, the conditions for long-run equilibrium of perfectly competitive firm can be written as: Price = Marginal Cost = Minimum Average Cost. The conditions for the long-run equilibrium of the firm under perfect competition can be easily understood from the Fig 4 where LAC is the long-run average cost curve and LMC is the long-run marginal cost curve. The firm under perfect competition cannot be in long-run equilibrium at price OP1 because though the price OP1 equal MC at Q but it is greater than the average cost at this output and, therefore, the firm will be earning supernormal profits. Y LAC LMC Q REVENUE\COST P1 L1 R P L1 S L1 P2 0 M2 M M1 OUTPUT X Fig. 4 Equilibrium of Firm: Long Run Hence, there will be incentive for the new firms to enter the industry. As a result, the price will be declined to the level OP at which price, the firm is in equilibrium at R and is producing OM output. At this point, the price is equal to average cost. Hence, the firm will be earning only normal profits and there will be no tendency for the outside firms to enter. Thus, the firm will be in equilibrium at OP price and OM output. On the contrary, a firm under perfect competition cannot be in the long- run equilibrium at price OP2. Though price OP2 is equal to marginal cost at point S, or at output OM2 but price OP2 is lower than the average cost at this point and thus the firm will be incurring losses. To avoid these losses, some of the firms will leave the industry. As a result, the price will rise to OP, where again all firms are making normal profits. When the price OP is reached, the firms would have no further tendency to quit. Thus, the firm under perfect competition is in equilibrium in the long run when: Price = MC = Minimum AC. An important conclusion that follows from the above discussion of firm’s equilibrium in the long run is that the forces of competition force all the firms to produce at the minimum point of the average cost curve. In other words, all the firms under perfect competition tend to be of the optimum size in the long run. This is advantageous from the viewpo

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