Managerial Economics MBA01C102 S1S02 PDF

 Message for the Students Dr. Babasaheb Ambedkar Open (University is the only state Open University, established by the Government of Gujarat by the Act No. 14 of 1994 passed by the Gujarat State Legislature; in the memory of the creator of Indian Constitution...

 Message for the Students Dr. Babasaheb Ambedkar Open (University is the only state Open University, established by the Government of Gujarat by the Act No. 14 of 1994 passed by the Gujarat State Legislature; in the memory of the creator of Indian Constitution and Bharat Ratna Dr. Babasaheb Ambedkar. We Stand at the seventh position in terms of establishment of the Open Universities in the country. The University provides as many as 54 courses including various Certificate, Diploma, UG, PG as well as Doctoral to strengthen Higher Education across the state. On the occasion of the birth anniversary of Babasaheb Ambedkar, the Gujarat government secured a quiet place with the latest convenience for University, and created a building with all the modern amenities named ‘Jyotirmay’ Parisar. The Board of Management of the University has greatly contributed to the making of the University and will continue to this by all the means. Education is the perceived capital investment. 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With all these efforts, Dr. Babasaheb Ambedkar Open University is in the process of being core centre of Knowledge and Education and we invite you to join hands to this pious Yajna and bring the dreams of Dr. Babasaheb Ambedkar of Harmonious Society come true. Prof. Ami Upadhyay Vice Chancellor, Dr. Babasaheb Ambedkar Open University, Ahmedabad.  MBA SEMESTER-1 MANAGERIAL ECONOMICS BLOCK: 1 Authors’ Name: Dr. Beena Patel Ruchir Pandya Review (Subject): Prof. (Dr.) Manoj Shah Dr. Avani Patel Dr. Natubhai Patel Review (Language): Dr. Ketan Gediya Editor’s Name: Prof. (Dr.) Manoj Shah, Professor and Director, School of Commerce and Management, Dr. Babasaheb Ambedkar Open University, Ahmedabad. Co-Editor’s Name: Dr. Dhaval Pandya Assistant Professor, School of Commerce and Management, Dr. Babasaheb Ambedkar Open University, Ahmedabad. Publisher’s Name: Registrar, Dr. Babasaheb Ambedkar Open University, 'Jyotirrmay Parisar', opp. Shri Balaji Temple,Chharodi, Ahmedabad, 382481, Gujarat, India. Edition: 2022 (First Edition) ISBN: All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any other means without permission in writing from Dr. Babasaheb Ambedkar Open University, Ahmedabad.  Dr. Babasaheb Ambedkar Open University (Established by Government of Gujarat) MANAGERIAL ECONOMICS SEMESTER-1 BLOCK 1 Unit-1 01 Introduction of Managerial Economics Unit-2 22 Fundamentals and Advanced Concepts of Managerial Economics-Types of Market Unit-3 59 Business Cycle, Inflation, Deflation Unit-4 94 Demand Analysis and Forecasting Unit-5 114 Supply and Market Equilibrium BLOCK 2 Unit-6 127 Consumption and Investment Function Unit-7 175 Production Analysis Unit-8 212 Price Determination Unit-9 230 Revenue Analysis Unit-10 241 Relationship of Managerial Economics with other Disciplines  Unit 1 INTRODUCTION OF MANAGERIAL ECONOMICS 1.0 INTRODUCTION 1.1 DEFINITIONS OF MANAGERIAL ECONOMICS 1.2 SCOPE OF MANAGERIAL ECONOMICS 1.2.1 NATURE OF MANAGERIAL ECONOMICS 1.3 ROLE OF MANAGERIAL ECONOMICS 1.4 CHIEF CHARACTERISTICS OF MANAGERIAL ECONOMICS 1.5 SIGNIFICANCE OF MANAGERIAL ECONOMICS 1.6 FUNDAMENTALS CONCEPTS IN MANAGERIAL ECONOMICS 1.6.1 THE OPPORTUNITY COST CONCEPT: 1.6.2 EQUI-MARGINAL CONCEPT: 1.6.3 DISCOUNTING CONCEPT: 1.7 ROLE AND RESPONSIBILITY OF A MANAGERIAL ECONOMIST: 1.8 RESPONSIBILITIES OF A MANAGERIAL ECONOMIST IN BUSINESS  CHECK YOUR PROGRESS 1.0 INTRODUCTION Economics is the study of the production, distribution, and consumption of goods and services. Also, it is the study of choice related to the allocation of scarce resources. Managerial economics is defined as the branch of economics. Managerial Economics refers to the firm's decision-making process. The purpose of managerial economics is to provide economic terminology and reasoning for the improvement of managerial decisions. It could also be interpreted as “Economics of Management” or “Industrial economics “or “Business economics”. Therefore, the understanding of managerial economics is essential. According to Spencer and Siegelman: “It is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.” It means management of limited funds available in the most economical way. It deals with basic problems of the economy i.e. What How For Whom to Produce. 1 Introduction of Managerial Economics Managerial economics is a management science that gives you more idea about the economic aspects of a market and how they affect your decision-making. This is very important because economic profits play a pivotal role in a market-based economy. While above-normal profits are indicators of expansion and growth, below-normal profits caution you about tightening or retrenchment. Business economics is comprised of several tools of micro and macroeconomic analysis which are useful in management decision-making that acts as facilitators to solve business problems. 1.1 DEFINITIONS OF MANAGERIAL ECONOMICS Several economists have given various definitions of managerial economics.  In the words of Joel Dean, “The purpose of managerial economics is to show howeconomic analysis can be used in formulating business policies”.  According to McNair and Meriam, “Managerial economics deals with the use ofeconomic modes of thought to analyze business situation”.  According to Henry and Hayne: “Managerial economics is economics applied in decision making. It is a special branch of economics. That bridges the gap between abstract theory and managerial practice.”  In the word of Salvatore, “Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organization can achieve its objectives most effectively.”  Brigham and Poppas believe that managerial economics is "the application of economic theory and methodology to business administration practice."  Davis and Chang say:  "Managerial economics applies the principles and methods of economics. By applying the concept, the branch of economics analyzes problems faced by the management of a business, or other types of organizations and to help find solutions that advance the best interests of such organizations.”  In the most accepted definition, Prof. Evan J. Douglas defines it thus: “Managerial economics is concerned with the application of economic principles and methodologies to the decision-making process within the firm or organization under the conditions of uncertainty.” (The study of economic phenomena at micro level i.e. individual and firm- level.) Please check Microeconomics is the study of how individual firms or consumers do and/or should make economic decisions taking constraints into account. Since the purpose of managerial economics is to apply economics for the improvement of managerial decisions in an organization, most of the subject material in managerial economics has a microeconomic focus. However, since managers must consider the state of their environment in making decisions and the environment includes the overall economy, an understanding of how to interpret and forecast macroeconomic measures is useful in making managerial decisions. Micro economic instruments used in this context include demand analysis, production and cost analysis, breakeven analysis, theory of pricing, technical progress, location decisions, and capital budgeting. 2  Introduction of Managerial Economics 1.2 SCOPE OF MANAGERIAL ECONOMICS Managerial economics refers to its area of study. Managerial economics provides management with a strategic planning tool that can be used to get a clear perspective of the way the business World works and what can be done to maintain profitability in an ever-changing economic environment of the world. Managerial economics is primarily concerned with the application of economic principles and theories to five types of resource decisions made by all types of business organizations. a. The selection of product or service to be produced. b. The choice of production methods and resource combinations. c. The determination of the best price and quantity combination d. Promotional strategy and activities. e. The selection of the location from which to produce and sell goods or services to the consumer. 1) Demand Analysis and Forecasting: A major part of managerial decision-making depends on accurate estimates of demand. By forecasting future sales manager prepares production schedules and employs resources which helps management to strengthen its market position as well as profit. 2) Cost and production Analysis: A manager prepares cost estimates of a range of output and chooses the optimum level of output at which cost is minimized. The manager is supposed to carry out the production function analysis to avoid wastage of materials and time. 3) Pricing Decisions: The success of a business firm depends upon correct pricing policy decisions taken by it. Different pricing method is used for different market structure, price to a great extent determines the revenue of the firm. 4) Profit Management: Business firms aim to earn profits in long run and profits are a reward for uncertainty and risk- bearing in the business organization. A manager should be able to take a calculated risk and tryto avoid uncertainty for higher profits. 5) Capital Management: Managerial economics also helps in the appropriate planning and controlling of capital expenditure since it involves a huge amount of money as well as time. 3 Introduction of Managerial Economics 1.2.1 Nature of Managerial Economics ALLOCATION OF RESOURCES: Since resources are scarce and they have multiple uses, Managerial Economics focuses on optimum allocation of funds available, which also reduces the wastage level. MICROECONOMIC NATURE: Managerial Economics is microeconomic in character. It deals with business firms. A firm is the smallest decision-making unit of production. Since the study is about firm, the problems faced by the firms also falls underthe purview of microeconomics. MARKET KNOWLEDGE: A firm is open to threats as well as opportunities in the marketplace. So knowledge of the market must be perfect. MACRO-SETTING: A firm has to operate within a given economy. So it's also governed and affected by the trends in income, consumption, investment, savings levels in an economy. Positive and Normative Approach: Positive approach is concerned with what is, was, or will be, while the normative approach is concerned with what ought to be. Positive economics is of two types: Economics description shows the state of operation of the firm at a point in time whereas an economic theory explains why it happened. 1.3 ROLE OF MANAGERIAL ECONOMICS A managerial economist helps the management by using his analytical skills and highly developed techniques in solving complex issues of successful decision- making and future advanced planning.  The role of managerial economist can be summarized as follows:  Studies Business Environment: Managerial economics properly analyzes the external environment within which the business operates. These factors influence the working of the business and therefore should be considered while taking any decisions and framing policies. Managerial economic studies all factors like economic scenario, government policies, price trends, national income growth, etc.  Production Scheduling: Managerial economics manages and prepares schedules for all production activities of the business. It estimates all future demands using various quantitative tools which helps in makingproduction plans.  Control Cost: Controlling the cost is vital for achieving the desired profitability and growth. Managerial economics estimates the cost of all business activities and identifies all those factors that cause variations in cost from time to time. It aims at minimizing the cost through optimum utilization of all available resources. 4  Introduction of Managerial Economics  Set Prices: Setting the right price is a very challenging task for every business organization. Managerial economics helps management in fixing the correct price by supplyingall information regarding competitor's pricing methods.  Bring Coordination: Managerial economics brings coordination and flexibility in all operations of the business. It supports effective decision-making by providing all relevant data using economic theories and tools.  Investment Analysis: Managerial economics ensures that all business funds are allocated to profitable means. It properly analyzes the profitability of all investment avenues before investing any amount into it.  Specific Decisions: There are several specific decisions that managers might have to take alike: Production scheduling, demand forecasting, market research, security management analysis, economic analysis of the industry, advice on trade, pricing decisions.  General Tasks: It includes understanding external factors and suggesting to the firm which policy is to be used. External factors include- economic condition of the economy, demand for the product, market conditions of raw materials, input cost of the firm affected by outside forces. 1.4 CHIEF CHARACTERISTICS OF MANAGERIAL ECONOMICS (i) Managerial economics deals with the problems and principles of an individual business firm or an individual industry. It aids in management. Management utilizes managerial elements in forecasting and evaluating the trends of the market. (ii) It also discusses various aspects of corrective measures that management undertakes under various circumstances. It discusses goal determination, goal development, and realization of these goals. Future planning, policymaking, decision-making, and optimal utilization of available resources fall under the umbrella banner of managerial economics. (iii) Managerial economics is practical. According to pure microeconomic theory, analysis is contingent on certain exceptions, which are far from reality. However, in managerial economics, managerial issues are resolved daily. But, difficult issues of economic theory are kept at bay. (iv) It provides a platform for economic concepts and principles, which are known as the theory of Firm or “Economics of the Firm”. Thus, the economics‟ scope is narrower than that of pure economic theory. (v) Managerial economics involves certain aspects of macroeconomic theory. They are essential in dealing with the circumstances and environments that feature the working conditions of an individual firm or an industry. (vi) Managerial economics functions for supporting the management in taking counteractive decisions and charting plans and policies for the future. (vii) The subject is an applied discipline. It concerns the application of economic principles concerning policy formulation, decision-making, and future planning. It is not only concerned with the goals of an organization but also is prescribed with the means of achieving these goals. 5 Introduction of Managerial Economics 1.5 SIGNIFICANCE OF MANAGERIAL ECONOMICS Management is concerned with decision-making. Decision-making needs a balance between simplification of analysis to be manageable and complications for handling a variety of factors and objectives. Managerial economics accomplished several objectives. Moreover, it also needs common sense and good judgment. Managerial economics helps the decision-making process in the following ways: 1. It helps in decision making 2. Decision-making means a balance between simplification of analysis to be manageable and complication of factors in hand. 3. Managerial economics also incorporates useful ideas from other disciplines such as psychology, sociology, etc.; if they are found relevant for decision- making. 4. Managerial economics takes the aid of other academic disciplines having a bearing on the business decisions of a manager because of the various explicit and implicit constraints subject towhich resource allocation is to be optimized. 5. Managerial economics helps a manager to b e a more competent model builder. Thus, he can capture the essential relationship, which characterizes a situation while leaving out the cluttering details and peripheral relationships. 6. It helps in providing most of the concepts that are needed for the analysis of business problems, the concepts such as elasticity of demand, fixed cost, variable cost, Short Run and Long Run costs, opportunity costs, NPV, etc., 7. At the level of the firm, where various functional areas, functional specialists or functional departments exist, such as finance, marketing, personal, production, etc. Managerial economics serves as an integrating agent by coordinating the different areas and bringing to bear on the decisions of each department or specialist the implications about other functional areas. 8. Managerial economics helps in reaching a variety of business decisions in a complicated environment such as what products and services should be produced? It helps in making decisions in the following. What should be the product mix? Which is the production technique? What should be the level of output and price? How to take investment decisions? How much should the firm advertise? 9. Managerial economics takes cognizance of the interaction between the firm and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare. It has come to be raised that a business, apart from its obligations to shareholders, has certain social obligations. 10. Managerial economics focuses attention on those social obligations as constraints subject to which business decisions are to be taken. It serves as an instrument in furthering the economic welfare of society through socially- oriented business decisions. 1.6 FUNDAMENTALS CONCEPTS IN MANAGERIAL ECONOMICS Managerial Economics is both conceptual and metrical. Before the substantive decision problems which fall within the purview of managerial economics are 6  Introduction of Managerial Economics discussed, it is useful to identify and understand some of the basic concepts underlying the subject. Economic theory provides several concepts and analytical tools which can be of considerable and immense help to a manager in taking many decisions and business planning. This is not to say that economics has all the solutions. Actual problem- solving in business has found that there exists a wide disparity between the economic theory of the firm and actual observed practice. Therefore, it would be useful to examine the basic tools of managerial economics and the nature and extent of the gap between the economic theory of the firm and the managerial theory of the firm. The contribution of economics to managerial economics lies in certain principles which are basic to managerial economics. There are some basic principles of managerial economics. They are: 1.6.1 The Opportunity Cost Concept Both micro and macroeconomics make abundant use of the fundamental concept of opportunity cost. In everyday life, we apply the notion of opportunity cost even if we are unable to articulate its significance. In Managerial Economics, the opportunity cost concept is useful in a decision involving a choice between different alternative courses of action. Resources are scarce, we cannot produce all the commodities. For the production of one commodity, we have to forego the production of another commodity. We cannot have everythingwe want. We are, therefore, forced to make a choice. The opportunity cost of a decision is the sacrifice of alternatives required by that decision. The sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue foregone by pursuing one course of action rather than another. The concept of opportunity cost implies three things: 1. The calculation of opportunity cost involves the measurement of sacrifices. 2. Sacrifices may be monetary or real. 3. The opportunity cost is termed as the cost of sacrificed alternatives. Opportunity cost is just a notional idea that does not appear in the books of account of thecompany. If the resource has no alternative use, then its opportunity cost is nil. In managerial decision-making, the concept of opportunity cost occupies an important place. Theeconomic significance of opportunity cost is as follows: 1. It helps in determining the relative prices of different goods. 2. It helps in determining normal remuneration to a factor of production. 3. It helps in the proper allocation of factor resources. The opportunity costs or alternative costs are the return from the second-best use of 7 Introduction of Managerial Economics the firm’s resources which the firm forgoes to avail itself of the return from the best use of the resources. The concept of opportunity cost can best understand with the help of illustrations, which are as follows:  The funds employed in one's own business are equal to the interest that could earn on thosefunds if the employee in other ventures.  The time an entrepreneur devotes to his own business is equal to the salary he could earnby seeking employment.  Using a machine to produce one product is equal to the earnings forgone which would havebeen possible from other products.  Using a machine that is useless for any other purpose is zero since its use requires nosacrifice of other opportunities. How to Calculate Opportunity Cost The formula of Opportunity cost = Return of Investment from the best option available – Return of investment from the chosen option. Opportunity Cost Graph – Let’s assume that the farmer can produce either 50 quintals of rice (ON) or 40 quintals of wheat (OM) using this land. Now, if he produces rice, then he cannot produce wheat. Therefore, the OC of 50 quintals of rice (ON) is 40 quintals of wheat (OM). Further, the farmer can choose to produce any combination of the two crops along the curve MN (production possibility curve). Let's say that he chooses to point A as shown above. Therefore, he produces OD amount of rice and OC amount of wheat. Subsequently, he decides to shift to point B. Now, he has to reduce the production of wheat from OC to OE to increase the production of rice from OD to OF. Therefore, the OC of DF amount of rice is CE amount of wheat. 8  Introduction of Managerial Economics  Applications of Opportunity Cost  Determining factor prices  Determining economic rent  Consumption pattern decisions  Determining factor prices  Product plan decisions  Decisions about national priorities Determining factor prices The factors for production need a price equal to or greater than what they command for alternative uses. If the factor price is less than the factor’s opportunity cost, then the said factor moves to the better-paying alternative. Determining economic rent Many modern economists use this concept for determining economic rent. As per them, economic rent = The factor's actual earning – Its opportunity cost or transfer earning. Consumption pattern decisions According to this concept, if with a given amount of money a consumer chooses to have more ofone thing, then he needs to have less of the other. Further, he cannot increase the consumption of all the goods at the same time. Therefore, hedecides his consumption pattern using the concept of opportunity cost. Product plan decisions Let’s say that a producer has fixed resources and technology. If he wants to produce a greater amount of one commodity, then he must sacrifice the quantity of another commodity. Therefore, he uses this concept to make decisions about his production plan. Decisions about national priorities Every country has certain resources at its command and needs to plan the production of a wide range of commodities. This decision depends on the national priorities which are based on opportunity costs. For example, if a country is at war, then it will use its resources to produce more war-related goods as compared to civilian goods.  Types of Opportunity Cost in Production  Explicit Cost  Implicit Cost  Marginal Opportunity Cost 9 Introduction of Managerial Economics  What is Explicit Cost? Explicit costs are the cost which includes the monetary payment from the producers. Wages, utility expenses, payment for raw materials, interest paid to the holders of the firm’s bonds, and rent on a building are all examples of explicit expenses. For example, if the company is paying $1000 per month in food by providing free lunch and breakfast, then its explicit OC is $1000. The expenditure on food could have been used somewhere else.  What is Implicit Cost? Implicit cost aka notional cost can be defined as the OC which a company used to produce something. The implicit costs associated with any decision are much more difficult to compute. These costs do not involve cash expenditures and are therefore often overlooked in decision analysis. Because cash payments are not made for implicit costs, the opportunity cost concept must be used to measure them. The rent that a shop owner could receive on buildings and equipment if they were not used in the business is an implicit cost of the owner's retailing activity, as is the salary that an individual could receive by working for someone else instead of operating his or her own establishment. For example, a company purchased small electronic devices to produce mobile phones, laptops, etc. This cost is used to produce something, the electronic devices are not sold or rented. On the contrary, implicit (or imputed) costs are those sacrifices (such as the interest on the owner's own investment) that are not reflected in accounts. Some writers equate O.C.s with implicit costs. The truth is that O.C.s cover all sacrifices, implicit or explicit.  What is Marginal Opportunity Cost? Marginal opportunity cost is a cost required to produce something extra. For example, currently, a company is producing 1000 burgers per day, but due to heavy demand, they are running out of burgers. So, the company decided to hire more people and cook more burgers. Now marginal opportunity cost will include – payment of new employees, cost required for ingredients required to cook more burgers, profit company was missing before and many other extra costs required for producing additional burgers. The cost involved in any decision is the sacrifices of alternatives required by that decision. In case there is no sacrifice, there is no cost either. Large firms often make use of the opportunity cost concept. They use linear programming models, replacement models, and other optimization techniques. These are all based on the opportunity cost concept. 1.6.2 Equi-Marginal Concept One of the widest known principles of economics is the equi-marginal principle. The 10  Introduction of Managerial Economics principle states that input should be allocated so that value added by the last unit is the same in all cases. This generalization is popularly called the equi-marginal. The cornerstone of the economists‟ marginal analysis is that purchases, activities, or productive resources should be allocated to ensure that the marginal utilities, benefits, or value-added accruing from each, are identical in all uses. Optimality requires that it should not be possible to increase the total benefit or reduce the total cost by moving one unit from one application to another. If this Equi marginal condition is violated, the system is operating below its optimum and it is possible to gain some improvement by reallocation of inputs or purchases. The key assumption underlying this result is the law of diminishing returns or variable proportions. For the Equi marginal principle to operate, the law of diminishing returns is held to apply. The law implies that the marginal product will decline as more of one resource is combined with fixed amounts of another. This proposition holds well over a wide range of economic activity. For example, successive applications of fertilizer tend to raise cereal yields per acre, but increasing quantities of fertilizer are successively required to give equal output increases. The microeconomic theory of the demand for labour asserts that the profit: maximizing entrepreneur will continue to employ labor so long as the resulting addition to his costs is covered by the addition to his receipts from the sale of his products. One of the fundamental principles of economics is the proposition that in input such as labour it should be so allocated among different activities or lines of production that the value added by the last unit is the same in all uses. This generalization is known as the equimarginal principle. Let us assume a case in which the firm has 100 units of labor at its disposal. And the firm is involved in five activities viz., А, В, C, D, and E. The firm can increase any one of these activities by employing more labor but only at the cost i.e., the sacrifice of other activities. An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. It would be, therefore, profitable to shift labor from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together. If, for example, the value of the marginal product of labor inactivity A is Rs. 50 while that inactivity В is Rs. 70 then it is possible and profitable to shift labor from activity A to activity B. The optimum is reached when the values of the marginal product are equal to all activities. This can be expressed symbolically as follows: VMPLA = VMPLB = VMPLC = VMPLD = VMPLE Where VMP = Value of Marginal Product.L = Labour 11 Introduction of Managerial Economics ABCDE = Activities i.e., the value of the marginal product of labor employed in A is equal to the value of the marginal product of the labor employed in В and so on. The equi-marginal principle is an extremely practical notion. The principle is also applied in investment decisions and allocation of research expenditures. For a consumer, this concept implies that money may be allocated over various commodities in such a way that marginal utility derived from the use of each commodity is the same. Similarly, for a producer, this concept implies that resources be allocated in such a manner that the marginal product of the inputs is the same in all uses. 1.6.3. Discounting Concept: This concept is an extension of the concept of time perspective. Since the future is unknown and incalculable, there is a lot of risk and uncertainty in the future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that "a bird in hand is more worth than two in the bush." This judgment is made not on account of the uncertainty surrounding the future or the risk of inflation. It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called „discounting The concept of discounting is found most useful in managerial economics in decision problems about investment planning or capital budgeting. The formula of computing the present value is given below: V = A/1+I where: V = Present value A = Amount invested Rs. 100i = Rate of interest 5 per cent V = 100/1+.05 = 100/1.05 =Rs. 95.24 These formulas are usually to be made use of in any discussion of investment decisions and capital budgeting. The essence of the principle, the discounting principle may now be summed up in the following words: If a decision affects both costs and revenues at future dates, it is essential to discount those cost and revenue to make them comparable to some present value before a valid comparison of alternatives is possible. We often find the application of the principle in the business world. Suppose one borrows Rs. 10,000 from a bank on a note. If the note is for Rs. 10,000, the borrower will not get the full value but rather the amount discounted at the appropriate rate of interest. 12  Introduction of Managerial Economics If the discounting rate is 6% and if the note is for one year, the borrower will receive approximately Rs. 9,420. In this case, we can say that the present value to the bank of the borrower's promise to pay Rs. 1,000 in a year is only Rs. 942 at the time of the loan. The principle operates in the bond market as well. The market price of a bond reflects not only its face value at maturity and interest payments but also the current discount rate. As the market discount rates vary, bond prices, vary inversely. Suppose you receive a bond that promises to pay you Rs. 10 per annum, in perpetuity. If the market rate of interest (the discount rate here) is 10% its present value will be Rs. 10/5% = Rs. 200. If the rate of interest goes down to IM-f/o its market prices will rise to Rs. 10/5% = Rs. 400. So it is possible to make a capital gain of Rs. 200 by selling the bond. The same principle can be applied in the case of an individual firm. Suppose a firm is considering buying a new machine. It should estimate the discounted value of the added (net) earnings from that machine before venturing out. The same principles apply if the firm is considering the acquisition (purchase) of another firm or a merger. Likewise, a firm that produces output maturing at varying ages cannot compare the profitability of changing the product mix without invoking the discounting principle. 1.7 ROLE AND RESPONSIBILITY OF A MANAGERIAL ECONOMIST: With the advent of the managerial revolution and transition from the owner-manager to the professional executive, managerial economists have occupied an important place in modern business. In real practice, firms do not behave in a deterministic world. They strive to attain a multiplicity of objectives. Economic theory makes a fundamental assumption of maximizing profits as the basic objective of every firm. The application of pure economic theory seldom leads us to direct executive decisions. Present business problems are either too obvious in their solution or purely speculative and they need a special form of insight. A managerial economist with his sound knowledge of theory and analytical tools can find out the solution to business problems. In advanced countries, big firms employ managerial economists to assist the management. Organisationally, a managerial economist is placed nearer to the policymaker simply because his main role is to improve the quality of policymaking as it affects short- term operation and long- range planning. He has a significant role to play in assisting the management of a firm in decision-making and planning by using specialized skills and techniques. 13 Introduction of Managerial Economics The factors which influence the business over a period may lie within the firm or outside the firm. These factors can be divided into two categories: (i) External and (ii) Internal. The external factors lie outside the control of the firm and these factors constitute the 'Business Environment'. The internal factors lie within the scope and operation of a firm and they are known as 'Business Operations'. 1. External Factors: The prime duty of a managerial economist is to make an extensive study of the business environment and external factors affecting the firm's interest, viz., the level and growth of national income, the influence of the global economy on the domestic economy, trade cycle, volume of trade and nature of financial markets, etc. They are of great significance since every business firm is affected by them. These factors have to be thoroughly analyzed by the managerial economist and answers to the following questions have also to be found out: (i) What are the current trends in the local, regional, national, and international economies? Whatphase of the trade cycle is going to occur in the near future? (ii) What about the change in the size of the population and the resultant change in regionalpurchasing power? (iii) Is competition likely to increase or decrease with reference to the products produced by thefirm? (iv) Are fashions, tastes, and preferences undergoing any change, and have they affected thedemand for the product? (v) What about the availability of credit in the money and capital markets? (vi) Is there any change in the credit policy of the government? (vii) What are the strategies of the five-year plan? Is there any special emphasis on industrialpromotion? (viii) What will be the outlook of the government regarding its commercial and economicpolicies? (ix) Will the international market expand or contract and what are the provisions given by the trade organizations? (x) What are the regulatory and promotional policies of the central bank of a country? Answer to these and similar questions will throw more light on the perspective of business and these questions present some of the areas where a managerial economist can make effective contributions through scientific decision making. He infuses objectivity, broad perspective, and thought of alternatives into the decision- making process. His focus on long-term trends helps maximize profits and ensures the ultimate 14  Introduction of Managerial Economics success of the firm. The role of the managerial economist is not to take decisions but to analyze, conclude and recommend. His basic role is to provide a quantitative base for decision-making. He should concentrate on the economic aspects of problems. He should have a rare intuitive ability of perception. 2. Internal Factors: The managerial economist can help the management in deciding on the internal operations of a firm in respect of such problems as cost structure, forecasting of demand, price, investment, etc. Some of the important relevant questions in this connection are as follows: (i) What should be the production schedule for the coming year? (ii) What should be the profit budget for the coming year? (iii)What type of technology should be adopted in the specific process and specify it? (iv) What strategies have to be adopted for sales promotion, inventory control, and utilization of manpower? (v) What are the factors influencing the input cost? (vi) How different input components can be combined to minimize the cost of production? Apart from the above studies, the managerial economist has to perform certain specific functions. He helps to coordinate practices relating to production, investment, price, sales, and inventory schedules of the firm. Forecasting is the fundamental activity that consumes most of the time of the managerial economist. The sales forecast acts as a link between the external uncontrollable factors and the internal controllable factors and is intimately related to general economic activity. The managerial economist is usually assigned the task of preparing short-term general economic and specific market forecasts to provide a framework for the development of sales and profit. He has to help the firm to plan product improvement, new product policy, and pricing and sales promotion strategy. The managerial economist often needs focused studies of specific problems and opportunities. He should indulge in a market survey, a product preference test, an advertising effectiveness study, and marketing research. Marketing research is undertaken to understand a marketing problem better. The managerial economist has to undertake an economic analysis of competing firms. He should also undertake investment appraisal, project evaluation, and feasibility study. The managerial economist has to provide the necessary intelligence. To conclude, a managerial economist has a very important role to play. He should be held in the confidence of the management. A managerial economist can serve the management best only if he always keeps in mind the main objective of his firm, which is to make a profit. 15 Introduction of Managerial Economics 1.8. RESPONSIBILITIES OF A MANAGERIAL ECONOMIST IN BUSINESS: We have analyzed the nature, scope, and methods of managerial economics. We shall now proceed to discuss the last part of our investigation the responsibilities of a managerial economist. As mentioned above, the managerial economist has an important role to play. The managerial economist can play a very important role by assisting management in using the increasingly specialized skills and sophisticated techniques which are required to solve the different problems of successful decision making and planning. The functions of a managerial economist can be broadly defined as the study and interpretation of economic data in the light of the problems of the management. The managerial economist should be in a position to spare more time and thought on problems of an economic nature than the firm’s administration. His job may involve a number of routine duties closely tied in with thefirm's day to day activities. The managerial economist is employed primarily as a general adviser. The advisory service refers to the opportunities open to the managerial economist because of the growing role of government in business life. He is responsible for the working of the whole business concern. The most important obligation of a managerial economist is that his objective must coincide with that of the business. Traditionally, the basic objective of business has been defined in terms of profit maximization. As a managerial economist, he must do something more than routine management to earn profit. He cannot expect to succeed in serving management unless he has a strong conviction which helps him in enhancing the ability of the firm. The other most important responsibility of a managerial economist is to try to make as accurate a forecast as possible. The managerial economist has to forecast not only the various components of the external business picture, but he has also to forecast the various phases of the company's activity, that is the internal picture of the company. The managerial economist should recognize his responsibilities to make a successful forecast. By making the best possible forecasts, the management can follow a more closely course of business planning. Yet another responsibility of the managerial economist is to bring about a synthesis of policies pertaining to production, investment, inventories, price, and cost. Production is an organized activity of transforming inputs into output. The process of production adds to the value of the creation of utilities. The money expenses incurred in the process of production constitute the cost of production. Cost of production provides the floor, to pricing. It provides a basis for managerial decisions. There are several areas that have attracted the attention of the managerial economist, such as maximizing profit, reducing stocks, forecasting sales, etc. If the inventory 16  Introduction of Managerial Economics level is very low, it hampers production. A managerial economist's first responsibility, therefore, is to reduce his stocks, for a great deal of capital is unprofitable- ably tied up in the inventory. The managerial economist's contribution will be adequate only when he is a member of full status in the business team. The managerial economist should make use of his experience and facts in deciding the nature of the action. He should be ready to undertake special assignments with full seriousness. The managerial economist can put even the most sophisticated ideas in simple language and avoid hard technical terms. It is also the managerial economist's responsibility to alert the management at the earliest possible moment in case he discovers an error in his forecast. In this way, he can assist the management in adopting appropriate adjustments in various policies and programs. He must be alert to new developments both economic and political in order to appraise their possible effects on business. The managerial economist should establish and maintain many contacts and data sources that would not be immediately available to the other members of management. For this purpose, he should join professional, trade associations, and take an active part in them. To conclude, a managerial economist should enlarge the area of certainty. To discharge his role successfully, he must recognize his responsibilities and obligations. No one can deny that the managerial economist contributes significantly to the profitable growth of the firm through his realistic attitude.  CHECK YOUR PROGRESS 1. LONG QUESTIONS 1) What is managerial economics? Explain various definitions of managerial economics. 2) Discuss the scope, nature and role of managerial economics. 3) Explain the role and responsibility of managerial economist in business. 4) Discuss the opportunity cost concept and discounting concept of managerial economics. 5) Explain the equi-marginal concept of managerial economics. 2. SHORT QUESTIONS 1) What is the meaning of managerial economics? 2) State the factors influencing management decisions. 3) What is the nature of managerial economics? 4) What is the scope of managerial economics? 5) State the significance of managerial economics. 6) Explain the concept of an opportunity cost 7) What do you mean by Equi-marginal cost? 8) What is explicit cost? 17 Introduction of Managerial Economics 9) What do you mean by implicit cost? 10) State the meaning discounting cost 3. MULTIPLE CHOICE QUESTIONS 1. Managerial economics generally refers to the integration of economic theory withbusiness.._________ A. Ethics B. Management C. Practice D. All of the above 2. Managerial Economics is _____ A. Dealing only micro aspects B. Only a normative science C. Deals with practical aspects D. All of the above 3. demand forecasting is related to the business conditions prevailing inthe economy as a whole. A. Macro level B. Industry level C. Firm level D. None of these 4. The function of combining the other factors of production is done by A. land B. labour C. Capital D. Entrepreneurship 5. is the base of marketing planning. A. Demand Estimation B. Demand analysis C. Demand function D. Demand forecasting 6. Basic economic tools of managerial economics do not include _____ A. Principle of time perspective B. Equi‐ marginal principle C. Incremental principle D. None of these 7. What is the nature of Managerial economics? A. Metrical. B. conceptual C. A and B Both D. None of Above 18  Introduction of Managerial Economics 8. Economic profit refers to ------------------ minus all relevant costs, both explicit and implicit.Profit A. Cost B. Expenses C. Revenues 9 focuses on the behavior of the individual actors on the economic stage, that is, firms and individuals and their interaction in markets. A. Macroeconomics B. Microeconomics C. Managerial Economics C. Economics 10. Opportunity cost is. A. A cost that cannot be avoided, regardless of what is done in the future. B. The cost incurred in the past before we make a decision about what to do in the future. C. That which we forgo, or give up, when we make a choice or a decision. D. The additional benefit of buying an additional unit of a product. 11. The opportunity cost of a machine which can produce only one product is: A. Low B. Infinite C. High D. Medium 12. It is defined as a state of knowledge in which one or more alternatives result in a set of specific outcomes but where the probabilities of the outcomes are neither known nor meaningful. A. Risk B. Uncertainty C. Peril D. All of the above 13. Opportunity cost is term which describes _________ A. A bargain for a factor of production B. Costs related to an optimum level of production C. Average variable cost D. None of these 14. An input should be so allocated that the value added by the last unit is the same in all cases. A. Opportunity Cost Principle B. Equi-Marginal Principle C. Incremental Principle D. Discounting Principle 19 Introduction of Managerial Economics 15. One of the most important differences between a firm’s economic profit and its accountingprofit is the subtraction of: A. Costs incurred when hiring labor, capital, and land. B. Any explicit cost incurred by the entrepreneur for risk taking. C. Any implicit charges for the use of capital owned by the entrepreneur. D. Any taxes on the retained earnings of the firm. 16. Decision making and ________ are the two important functions of executive of businessfirms A. Forward planning B. Directing C. Supervising D. Administration 17. Which of the following is the characteristics of managerial economics? A. Deals with both micro and macro aspects B. Both positive and normative science C. Deals with theoretical aspects D. Deals with practical aspects. 18. What are the applications of opportunity cost? A. Determining Economic Rent B. Consumption Pattern Decisions C. Determining Factor Prices D. All of the above 19. “The purpose of managerial economics is to show how economic analysis can be used in formulating business policies”. This definition is given by _________ A. Joel Dean B. Henry and Hayne: C. McNair and Meriam D. All of the above 20. Managerial economics is primarily concerned with the application of economic principlesand theories to types of resource decisions made by all types of business organizations. A. 5 B. 6 C. 7. D.10 21. The value of an entrepreneur’s resources that she uses in production are known as: A. Explicit costs. B. Sunk costs. C. Operating expenses. D. Implicit costs. 20  Introduction of Managerial Economics 22. What are the types of Opportunity Cost in production?: A. Explicit Cost B. Implicit Cost C. Marginal Opportunity Cost D. All of the Above 23. Which are the important relevant questions in the internal operation of a firm? A. What should be the production schedule for the coming year? B. What should be the profit budget for the coming year? C. What type of technology should be adopted in the specific process and specify it? D. All of the Above 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 C D A D D D C C B C A B D B C A D D A A D D D 21  UNIT 2 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET 2.1 PERFECT COMPETITION 2.1.1 FEATURES OF THE PERFECT COMPETITION 2.1.2 DEMAND CURVE FACING THE FIRM AND INDUSTRY UNDER PERFECT COMPETITION 2.1.3 SHORT RUN EQUILIBRIUM OF A FIRM – MR-MC METHOD: 2.1.4 SHORT RUN EQUILIBRIUM OF FIRM AND INDUSTRY 2.1.5 LONG RUN EQUILIBRIUM OF FIRM AND INDUSTRY 2.2 MONOPOLY 2.2.1 CHARACTERISTICS OF MONOPOLY 2.2.2 CAUSES FOR MONOPOLY 2.2.3 THE NATURE OF DEMAND AND MARGINAL REVENUE CURVES UNDER MONOPOLY 2.2.4 PRICE AND OUTPUT UNDER MONOPOLY IN SHORT- RUN 2.2.5 PRICE AND OUTPUT UNDER MONOPOLY IN LONG- RUN EQUILIBRIUM 2.3 MONOPOLISTIC COMPETITION: FEATURES 2.3.1 NATURE OF DEMAND CURVE (AVERAGE REVENUE) & MARGINAL REVENUE CURVES 2.3.2 CONCEPT OF INDUSTRY AND GROUP 2.3.3 THEORY OF GROUP EQUILIBRIUM 2.4 OLIGOPOLY 2.4.1 CLASSIFICATION OF OLIGOPOLY 2.4.2 CHARACTERISTICS OF OLIGOPOLY: 2.4.3 KINKED DEMAND CURVE 2.5 COURNOT’S MODEL OF DUOPOLY 2.5.1 THE COURNOT MODEL OF DUOPOLIES IN MANAGERIAL ECONOMICS REACTION APPROACHES 2.5.2 CHAMBERLIN’S DUOPOLY MODEL  Check Your Progress 22  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET 2.1 PERFECT COMPETITION: Meaning: A Perfect Competition market is that type of market in which the number of buyers and sellers is very large, and all are engaged in buying and selling a homogeneous product without any artificial restrictions and they are possessing perfect knowledge of the market at a time. In this connection Mrs. Joan Robinson has explained —"Perfect Competition prevails when the demand for the output of each producer is perfectly elastic." 2.1.1 Features of the Perfect Competition: 1. A Large Number of Buyers and Sellers: The first condition is that the number of buyers and sellers must be so large that none of them individually is in a position to influence the price and output of the industry as a whole. 2. Homogeneity of the Product: Each firm should produce and sell a homogeneous product so that no buyer has any preference for the product of any individual seller over others. If goods will be homogeneous then the price will alsobe uniform everywhere. 3. Free Entry and Exit of the Firms: (The firm should be free to enter or leave the firm. If there is the hope of profit the firm will enter into business and if the loss is profitable, the firm will leave the business.) Please check 4. Perfect Knowledge of the Market: Buyers and sellers must possess complete knowledge about the prices at which goods are being bought and sold and of the prices at which others are prepared to buy and sell. This will help in having uniformity in prices. 5. Perfect Mobility of the Factors of Production and Goods: There should be perfect mobility of goods and factors between industries. Goods should be free to move to those places where they can fetch the highest price. 6. Absence of Price Control: There should be complete openness in buying and selling goods. Here prices are liable to change freely in response to demand and supply conditions. 7. Perfect Competition among Buyers and Sellers: In this purchasers and sellers have got complete freedom for bargaining, no restrictions in charging more or demanding less, competition feeling must be present there. 23 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET 8. Absence of Transport Cost: There must be an absence of transport cost. Having less or negligible transport costs will help the complete market in maintaining uniformity in price. 9. One Price of the Commodity: There is always one price of the commodity available in the market. 2.1.2 Demand curve Facing the Firm and Industry under Perfect competition In a perfectly competitive market the market demand curve is a downward sloping line, reflecting the fact that as the price of an ordinary good increase, the quantity demanded of that good decreases. Price is determined by the intersection of market demand and market supply; individual firms do not have any influence on the market price in perfect competition. Once the market price has been determined by market supply and demand forces, individual firms become price takers. Individual firms are forced to charge the equilibrium price of the market or consumers will purchase the product from the numerous other firms in the market charging a lower price. The demand curve for an individual firm is thus equal to the equilibrium price of the market. The demand and supply curves for a perfectly competitive market are illustrated in Figure 1 (a); the demand curve for the output of an individual firm operating in this perfectly competitive market is illustrated in Figure1 (b). Figure 1 Market and Firm Demand Curves in a Perfectly Competitive Market Note that the demand curve for the market, which includes all firms, is downward sloping, while the demand curve for the individual firm is flat or perfectly elastic, reflecting the fact that the individual takes the market price, P, as given. The difference in the slopes of the market demand curve and the individual firm's demand curve is due to the assumption that each firm is small in size. No matter how much output an individual firm provides, it will be unable to affect the market price. 24  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET Demand Curve for a Firm in a Perfectly Competitive Market: The demand curve for an individual firm is equal to the equilibrium price of the market. The market demand curve is downward-sloping. The demand curve for a firm in a perfectly competitive market varies significantly from that of the entire market. The market demand curve slopes downward, while the perfectly competitive firm‘s demand curve is a horizontal line equal to the equilibrium price of the entire market. The horizontal demand curve indicates that the elasticity of demand for the good is perfectly elastic. This means that if any individual firm charged a price slightly above market price, it would not sell any products. A strategy often used to increase market share is to offer a firm‘s product at a lower price than the competitors. In a perfectly competitive market, firms cannot decrease their product price without making a negative profit. Instead, assuming that the firm is a profit-maximize, it will sell its goods at the market price. 2.1.3 Short Run Equilibrium of a Firm – MR-MC Method: The MR-MC method is more often used to find out the equilibrium of a firm since it is simpler and accurate. In this method, we have to just locate the point at which MC intersects MR and the slope of MC is positive. Figure 2 Equilibrium of Competitive Firm The MR (= AR = P) curve is a straight line parallel to the quantity axis while the MC curve is a U- shaped one that can intersect the MR curve at more than one point. i. There are two points, R and R1, at which the first-order condition, i.e. MR = MC, is satisfied. ii. At point R, the slope of SMC is less than that of MR since the SMC is downward sloping. This shows that the second-order condition is not satisfied at point R. Thus, equilibrium at this point or theoutput level OQ1 will be unstable. iii. To show that the equilibrium is unstable, let us consider that output increases beyond OQ1. As such, MC will further decline while MR will remain the same 25 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET and, hence, profit will rise. Thus, the firm will not return to OQ1 level of output. This shows that the equilibrium at point R will be unstable. iv. At point R1, the slope of SMC is more than the slope of MR or, SMC is positively sloped. This satisfies the second-order condition. Hence, the equilibrium at R1 will be stable at which the firm will produce OQ2 level of output. v. If, for any reason, output increases beyond OQ2, the SMC becomes more than MR resulting in a loss to the firm. Hence, the firm will stick to point R1 or OQ2 output level. If the output level remains below OQ2, the firm will earn supernormal profit and, hence, increase the output up to OQ2. This shows that equilibrium once reached point R1 will be a stable one. Any deviation from it will lead market forces to work in a fashion to return to OQ2 level of output. 2.1.4 Short Run Equilibrium of Firm and Industry In the short run, a firm may earn supernormal profit or normal profit or incur losses. Each of the three situations has been attempted in the following paragraphs: i. Super Normal Profit: A firm will earn supernormal profit in the short run if its SAC is less than the AR at the point ofequilibrium. Such a firm has been depicted in Figure 2. Figure 2 Competitive Firm Earning Supernormal Profit It shows the firm's equilibrium at point R where its output is OQ1. At this point, both the equilibrium conditions are satisfied, i.e. MR = MC and, the MC curve is positively sloped at the point of intersection. The average cost of the firm, as represented by the SAC curve, is OT (= SQ1) at this output level. Based on it, profit can be estimated as — Total revenue – Total cost Given that total revenue is OPRQ1 and the total cost is OTSQ1,Profit = PTSR = OPRQ1 – OTSQ1 26  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET This is the profit that the firm earns over and above the normal profit and, hence, termed as supernormal profit. It has been shown by the shaded area in the figure. ii. Normal Profit: Figure 4 depicts the case of a firm that has been earning only a normal profit. Figure 4 Competitive Firm Earning Normal Profit The figure shows equilibrium at point R where the output is OQ1. At this level of output, AC is RQ1, as shown by its SAC curve. It is equal to the per-unit revenue which is also RQ1. It means that firm is making only a normal profit which is a part of the average cost. In this case — Total revenue = Total cost = OPRQ1 iii. Firm Incurring Losses: A firm can incur a loss in the short run. Such a firm is represented in Figure 5. Figure 5 Loss Making Competitive Firm In the given situation, the firm's equilibrium is at point R where the output level is OQ1. The average cost of the firm is represented by the SAC curve and the average variable cost by the SAVC curve. The gap between SAC and SAVC will represent the average fixed cost (SAFC). The figure 5 shows that at output level OQ1, the average cost (SQ1) is more than its 27 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET average revenue (RQ1). Thus, the firm has incurred a per-unit loss of SR (= SQ1 – RQ1). Total loss = Total cost – Total revenue Given that total cost = OTSQ1 and total revenue = OPRQ1 in the figure, Total loss = TSRP = OTSQ1 – OPRQ1 In this situation, one may ask what a firm should do to minimize its losses. Should it continue production and bear the losses or should it stop production and wait for a higher price level to come for a re-entry in the market? Answer to such questions will depend upon the fact that, is the firm able to recover at least the variable cost from its revenue or not? i. If the firm can recover the variable cost or a little more, it should continue production and bear the loss which will be equal to or less than its fixed cost. In such a scenario, the firm will minimize lossesby way of continuing production. ii. The firm will continue to do so in the short run even if AR = SAVC. It is because its loss will be equal to the fixed cost whether it stops production or continue to produce. In such a situation, the firm may be advised to continue the production and remain in the market. iii. However, if the AR < SAVC, the firm should stop production and minimize the loss which will be equal to its fixed cost. If the firm continues production, in this situation, per unit loss will be — AFC + (SAVC – AR) > AFC Since, SAVC > AR Thus, it will minimize losses (= AFC) by stopping the production altogether. Based on the above, we can discuss two situations in which a firm will minimize losses (i) by continuing production and (ii) by stopping it altogether.  Short Run Equilibrium of the Industry: In the short run, new firms can neither enter the industry nor the old firm's exit from the industry. Therefore, the industry will be in equilibrium when the above given first two conditions are fulfilled. The short-run equilibrium of industry has been 28  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET shown in Fig. 6. Figure 6 Short Run Equilibrium of the Industry In part A of the Figure, the equilibrium of the industry has been shown. The demand curve and supply curve of the industry intersect each other at point E. 0P is the equilibrium price and 0Q is the equilibrium output. The firm will take 0P price as given and adjust its output in such a way that it may earn maximum profit. In part B of the diagram equilibrium of the firm has been shown. E0 is the firm‘s equilibrium. 0M is the equilibrium output. Average revenue and average cost are equal to E0M and CM, respectively. Since average revenue is greater than average cost, the firm is earning supernormal profit equal to area EOCGP. Suppose; cost of all the firms is identical, all the firms are earning normal profit. If the demand for the product declines, the price of the product will also decline and the equilibrium will be at a lower level of output. The industry will be in equilibrium, although firms might be incurring losses. In this case, too the industry will be in short-run equilibrium. 2.1.5 Long Run Equilibrium of Firm and Industry Therefore, the condition for long-run equilibrium of the firm can be written as: Price = Marginal Cost = Minimum Average Cost. 29 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET Figure 7 Long-Run Equilibrium of the Firm under Perfect Competition Fig. 7 represents the long-run equilibrium of the firm under perfect competition. The firm cannot be in the long-run equilibrium at a price greater than OP in Fig. 7. This is because if the price is greater than OP, then the price line (demand curve) would lie somewhere above the minimum point of the average cost curve so that marginal cost and price will be equal where the firm is earning abnormal profits. Since there will be a tendency for new firms to enter and compete away these abnormal profits, the firm cannot be in long-run equilibrium at any price higher than OP. Likewise, the firm cannot be in long-run equilibrium at a price lower than OP in Fig. 7 under perfect competition. If the price is lower than OP, the average and marginal revenue curve will lie below the average cost curve so that the marginal cost and price will be equal at the point where the firm is making losses. Therefore, there will be a tendency for some of the firms in the industry to go out with the result that price will rise and the firms left in the industry make normal profits. We, therefore, conclude that the firm can be in long-run equilibrium under perfect competition only when the price is at such a level that the horizontal demand curve (that is, AR curve) is tangent to the average cost curve so that price equals average cost and firm makes only normal profits It should be noted that a horizontal demand curve can be tangent to a U-shaped average cost curve only at the latter's minimum point. Since at the minimum point of the average cost curve the marginal cost and average cost are equal, price in long- run equilibrium is equal to both marginal cost and average cost. In other words, the double condition of long-run equilibrium is fulfilled at the minimum point of the average cost curve. 30  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET  Long-Run Equilibrium of the Industry: The long-run is that period under which new firms can enter and old firms can leave the industry. If firms in the industry are earning supernormal profits, new firms will enter the industry. On the other hand, if the firms in the industry are incurring losses, then some existing firms will leave the industry. Therefore, the industry will be in equilibrium, when the above-given conditions are fulfilled. In part, A of Fig. 8. Industry equilibrium is shown. E is the equilibrium point. 0P and 0Q are the equilibrium level of price and output. The firms will adjust their output in such a way that they may earn maximum profits. In part B of Figure 8, the equilibrium of the firm has been shown. Fig. 8 Long Run Equilibrium of the Industry 0M is the equilibrium level of output. The firm will get only normal profits because the LAC curve is tangent to the AR curve at the equilibrium level of output 0M. If the cost curve of all the firms is identical all the firms in the industry will earn only normal profits. Under these circumstances, there will be no tendency for the firms to enter or leave the industry. 2.2 MONOPOLY: CHARACTERISTICS AND CAUSES A monopoly is a market structure in which there is a single seller, there are no close substitutes for the commodity it produces and there are barriers to entry. 2.2.1 Characteristics of Monopoly 1. Single Seller: There is only one seller; he can control either price or supply of his product. But he cannot control demand for the product, as there are many buyers. 2. No close Substitutes: There are no close substitutes for the product. The buyers have no alternatives or choice. Either they have to buy the product or go without it. 31 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET 3. Price: The monopolist has control over the supply to increase the price. Sometimes he may adopt price discrimination. He may fix different prices for different sets of consumers. A monopolist can either fix the price or quantity of output; but he cannot do both, at the same time. 4. No Entry: There is no freedom for other producers to enter the market as the monopolist is enjoying monopoly power. There are strong barriers for new firms to enter. There are legal, technological, economic, and natural obstacles, which may block the entry of new producers. 5. Firm and Industry: Under monopoly, there is no difference between firm and industry. As there is only one firm, that single firm constitutes the whole industry. 2.2.2 Causes for Monopoly 1. Natural: A monopoly may arise on account of some natural causes. Some minerals are available only in certain regions. For example, South Africa has the monopoly of diamonds; nickel in the world is mostly available in Canada and oil in Middle East. This is natural monopoly. 2. Technical: Monopoly power may be enjoyed due to technical reasons. A firm may have control over raw materials, technical knowledge, special know-how, scientific secrets and formula that enable a monopolist to produce a commodity. e.g., Coco Cola. 2. Legal: Monopoly power is achieved through patent rights, copyright and trade marks by the producers. This is called legal monopoly. 4. Large Amount of Capital: The manufacture of some goods requires a large amount of capital or lumpiness of capital. All firms cannot enter the field because they cannot afford to invest such a large amount of capital. This may give rise to monopoly. For example, iron and steel industry, railways, etc. 5. State: Government will have the sole right of producing and selling some goods. They are State monopolies. For example, we have public utilities like electricity and railways. These public utilities are undertaken by the State. 2.2.3 The Nature of Demand and Marginal Revenue Curves under Monopoly But in the case of monopoly one firm constitutes the whole industry. Therefore, the entire demand of the consumers for a product faces the monopolist. Since the demand curve of the consumers for a product slopes downward, the monopolist faces a downward-sloping demand curve. If he wants to increase the sale of his good, he must lower the price. He can raise the price if he is prepared to sacrifice some sales. To put it another way, a monopolist can lower the price by increasing his level of sales and output, and he can raise the price by reducing his level of sales or output. A perfectly competitive firm merely adjusts the quantity of output it has to produce, price being a given and constant datum for him. But the monopolist encounters a more complicated problem. He cannot merely adjust quantity at a given price 32  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET because each quantity change by him will bring about a change in the price at which the product can be sold. Consider Fig. 9. DD is the demand curve facing a monopolist. At price OP the quantity demanded is OM, therefore he would be able to sell OM quantity at price OP. If he wants to sell a greater quantity ON, then price to the OL. If would he restricts his quantity to OG, fall price will rise to OH. Thus every quantity change by him entails a change in price at which the product can be sold. Thus the problem faced by a monopolist is to choose a price-quantity combination which is optimum for him, that is, which yields him maximum possible profits. Demand curve facing the monopolist will be his average revenue curve. Thus, the average revenue curve of the monopolist slopes downward throughout its length. Since average revenue curve slopes downward, marginal revenue curve will lie below it. This follows from usual average- marginal relationship. The implication of marginal revenue curve lying below average revenue curve is that the marginal revenue will be less than the price or average revenue. Figure 9 Demand Curve of the Monopolist Slopes Downward Figure 10 Average and Marginal Revenue Curves under Monopoly 33 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET When monopolist sells more, the price of his product falls; marginal revenue therefore must be less than the price. In Fig. 10 AR is the average revenue curve of the monopolist and slopes downward. MR is the marginal revenue curve and lies below AR curve. At quantity OM, average revenue (or price) is MP and marginal revenue is MQ which is less than MP. 2.2.4 Price and Output under Monopoly in Short-Run A. Short-run equilibrium: The conditions for Equilibrium in Monopoly are the same as those under perfect competition. The marginal cost (MC) is equal to the marginal revenue (MR) and the MC curve cuts the MR curve from below. In this article, we will understand Equilibrium in Monopoly in detail. A Firm’s Short-Run Equilibrium in Monopoly 1. The firm earns normal profits – If the average cost = the average revenue 2. It earns super-normal profits – If the average cost < the average revenue 3. It incurs losses – If the average cost > the average revenue I. Normal Profits A firm earns normal profits when the average cost of production is equal to the average revenue forthe corresponding output. Figure 11 Normal Profits II. Super-normal Profits A firm earns super-normal profits when the average cost of production is less than the averagerevenue for the corresponding output. 34  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET Figure 12 Supernormal Profit In the figure above, you can see that the price per unit = OP = QA. Also, the cost per unit = OP'. Therefore, the firm is earning more and incurring a lesser cost. In this case, the per-unit profit is OP – OP‘ = PP‘ Also, the total profit earned by the monopolist is PP‘BA. III. Losses A firm earns losses when the average cost of production is higher than the average revenue for thecorresponding output. Figure 12 Loss situation In the figure above, you can see that the average cost curve lies above the average revenue curve for the same quantity. The average revenue = OP and the average cost = OP'. Therefore, the firm is incurring an average loss of PP' and the total loss is PP'BA. In the short run, a monopolist sometimes sets a lower price and incurs losses 35 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET to keep new firms away. 2.2.5 Price and Output under Monopoly in Long-Run Equilibrium In the long run, the monopolist would adjust the size of his plant. The long-run average cost curve and its corresponding long-run marginal cost curve portray the alternative plants, i.e., various plant sizes from which the firm has to choose for operation in the long run. The monopolist would choose the plant size which is most appropriate for a particular level of demand. In the short run, the monopolist adjusts the level of output while working with a given existing plant. His profit-maximizing output in the short run will be where only the short-run marginal cost curve (i.e., marginal cost curve with the existing plant) is equal to marginal revenue. But in the long run, he can further increase his profits by adjusting the size of the plant. So in the long run he will be in equilibrium at the level of output where the given marginal revenue curve cuts the long-run marginal cost curve. Fixing the output level at which marginal revenue is equal to long-run marginal cost shows that the size of the plant has also been adjusted. That is, a plant size has been chosen which is most optimal for a given demand for the product. It should be carefully noted that, in the long run, marginal revenue is also equal to short-run marginal cost. Figure 14 portrays the long-run equilibrium of the monopolist. He is in equilibrium at OL output at which long-run marginal curve LMC intersects marginal revenue curve MR. Given the level of demand as indicated by positions of AR and MR curves, he would choose the plant size whose short- run average and marginal cost curves are SAC and SMC. He will be charging a price equal to LQ or OP and will be making profits equal to the area of rectangle THQP. Figure 14 Long- Run Equilibrium under Monopoly 36  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET It, therefore, follows that for the monopolist to maximize profits in the long run, the following conditions must be fulfilled: MR = LMC = SMCSAC = LAC P ≥ LAC The last condition implies that in the long-run monopoly equilibrium price of the product should be either greater than the long-run average cost or at least equal to it. The price cannot fall below long- run average cost because in the long run, the monopolist will quit the industry if it is not even able to make normal profits. 2.3 MONOPOLISTIC COMPETITION: FEATURES Monopolistic competition refers to the market situation in which a large number of sellers produce goods that are close substitutes for one another. The products are similar but not identical. The particular brand of the product will have a group of loyal consumers. In this respect, each firm will have some monopoly and at the same time, the firm has to compete in the market with the other firmsas they produce a fair substitute. The essential features of monopolistic competition are product differentiation and the existence of many sellers. The following are examples of monopolistic competition in the Indian context. 1. Shampoo - Sun Silk, Clinic Plus, Ponds, Chik, Velvette, Kadal, Head and Shoulder, Pantene,Vatika, Garnier, Meera 2. Tooth Paste - Binaca, Colgate, Forhans, Close-up, Promise, Pepsodent, Vicco Vajradanti, Ajanta,Anchor, Babool. 2.3.1 Nature of Demand Curve (Average Revenue) & Marginal Revenue Curves The demand curve is relatively elastic, due to the availability of close substitutes in the monopolistic competition have limited power to decide and regulate the prices of their products. This is because if sellers increase the prices of products, customers may switch to the nearest competitors to avail of the close substitutes. Due to a large number of sellers with close substitute products, the level of competition is very high in the market. As a result, the demand curve shows a negative slope and relative elasticity. In other words, the demand curve is not perfectly elastic in monopolistic competition, but it is relatively elastic. This is because the output generated by an organization is different from the output generated by other organizations, as the prices of their products are different. Each seller under a monopolistic competitive market can sell a wide range of output within a relatively narrow range of prices. Consider Fig. 15. DD is the demand curve facing an individual firm under 37 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET monopolistic competition. At price OP the quantity demanded is OM. Therefore, the firm would be able to sell OM quantity at price OP. If it wants to sell a greater quantity ON, then it will have to reduce the price to OL. If it restricts its quantity to OG, the price will rise to OH. Thus, every quantity change entails a change in the price at which the product can be sold. Thus the problem faced by a firm working under monopolistic competition is to choose the price-quantity combination which is optimum for it, that is,which yields maximum possible profits. The demand curve facing a firm will be his average revenue curve. Thus the average revenue curve of the monopolistically competitive firm slopes downward throughout its length. Since the average revenue curve slopes downward, the marginal revenue curve lies below it. This follows from the usual average- marginal relationship. The implication of the marginal revenue curve lies below the average revenue curve is that the marginal revenue will be less than the price or average revenue. When a firm working under monopolistic competition sells more, the price of its product falls; marginal revenue, therefore, must be less than price. In Fig. 16 AR is the average revenue curve of the firm under monopolistic competition and slopes downward. MR is the marginal revenue curve and lies below the AR curve. At quantity OM average revenue (or price) is OP and marginal revenue is MQ which is less than OP. That average and marginal revenues at a level of output are related to each other through price elasticity of demand and in this connection we derived the following formula: MR= AR (e – 1/e), where ‘e’ stands for price elasticity of demand. Figure 15 Demand Curve Facing a monopolistically Competitive Firm 38  FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET Figure 16 Average and marginal Revenue Curve under Monopolistic Competition 2.3.2 Concept of Industry and Group: The word "industry" refers to all the firms producing a homogeneous product. But under monopolistic competition, the product is differentiated. Therefore, there is no “industry” but only a ―group‖ of firms producing a similar product. Each firm produces a distinct product and is itself an industry. Chamberlin lumps together firms producing very closely related products and calls them product groups. So in defining an industry, Chamberlin lumps together firms in such product groups as cars, cigarettes, breweries, etc. According to Chamberlin, ―Each producer within the group is a monopolist, yet his market is interwoven with those of his competitors, and he is no longer to be isolated from them.‖ In the product group, the demand for each product has high cross elasticity so that when the price of other products in the group changes, it shifts the demand curve. 2.3.3 Theory of Group Equilibrium: Chamberlin develops his theory of long-run group equilibrium using two demand curves DD and dd, as shown in Figure 17. The demand curve facing the group is DD. it is drawn on the assumption that all firms charge the same price and are of equal size, dd represents an individual firm‘s demandcurve. The two demand curves reflect the alternatives that face the firm when it changes its price. In the figure, the firm is selling OQ output at OP price. As a member of the group with product differentiation, the firm can increase its sales by reducing its price for two reasons. 39 FUNDAMENTALS AND ADVANCED CONCEPTS OF MENEGERIAL ECONOMICS-TYPES OF MARKET Figure 17 First, because it feels that the other firms will not reduce their prices; and second, it will attract some of their customers. On the other hand, if it increases its price above OP, its sales will be reduced because the other firms in the group will not follow it in increasing their prices and it will also lose some of its customers to the others. Thus the firm faces the more elastic demand curve dd. But if all firms in the product group reduce (or increase) their prices simultaneously, the firm will face the less elastic demand curve DD. Assumptions of Chamberlin’