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LECTURE NOTESON MANAGERIAL ECONOMICS 1st SEMESTER Mr. BIMAL SATAPATHY ASST. PROFESSOR DEPARTMENT OF BUSINESS ADMINISTRATION GANDHI INSTITUTE OF TECHNOLO...

LECTURE NOTESON MANAGERIAL ECONOMICS 1st SEMESTER Mr. BIMAL SATAPATHY ASST. PROFESSOR DEPARTMENT OF BUSINESS ADMINISTRATION GANDHI INSTITUTE OF TECHNOLOGY AND MANAGEMENT(GITAM) Affiliated to BPUT & SCTE&VT, Govt. of Odisha Approved by AICTE, New Delhi 0  MODULE – I Introduction to Managerial Economics What is Economics? The science of economics is concerned with the allocation of resources to alternative uses so as to achieve maximum possible satisfaction of the people. To Adam Smith “Economics is a science of wealth” To Marshall “Economics is a science of material welfare” To Robbins “Economics is a science of scarcity” “Economics is the study of the behaviour of human beings in producing, distributing and consuming material goods and services in a world of scare resources” Why we Studying Economics? Economics is the study of how societies use scare resources to produce valuable commodities and distribute them among different people. Behind this definition are two key ideas in economics: those goods are scare and that society must use its resources eff iciently. Indeed, economics is an important subject because of the fact of scarcity and the desire for efficiency. But no society has reached a utopia of limitless possibilities. Ours is a world of scarcity, full of economic goods. A situation of scarcity is one in which goods are limited relative to desires. Efficiency denotes the most effective use of a society’s resources in satisfying people’s wants and needs. The essence of economics is to acknowledge the reality of scarcity and then figure out how to organize societies in a way which produces the most efficient use of resources. That is where economics makes its unique contribution. So, economics is the study of behaviour of individual in production, consumption and distribution in the world of scare resources at individual level (micro) as well as at aggregate level (macro). The ultimate goal of economic science is to improve the living conditions of people in their everyday lives. What is Management? To Koontz and O’Donell, “management as the creation and maintenance of an internal environment in an enterprise where individuals, working together in groups, can perform efficiently and effectively towards the attainment of group goals.” “Management is the discipline of organizing and allocating a firm’s scarce resources to achieve its desired objectives” These two definitions clearly points, a close relationship between management and economics has led to the development of managerial economics. What is Managerial Economics? In simple terms, managerial economics is an application of that part of micro-economics and macroeconomics, which is directly related to decision making by a manager.  To Mansfield, “Managerial economics is concerned with the application of economics concept and economics to the problems of formulating rational decision making”  To Spencer and Seigelman, “Managerial economics is the integration of economic theory and practices for the purpose of facilitating decision making and forward planning by management”  Managerial economics refers to the application of economic theory and methods of decision sciences to arrive at the optimal solution to the various decision-making problems faced by managers of business firms. 1  Difference between Managerial Economics and Economics Managerial Economics Economics Managerial economics involves Economics deals with the body of application of economic principles to the principles itself problem of the firm Managerial economics deals with micro Economics deals with both micro economics at large economics and macro economics Managerial economics, though micro in Micro economics as a branch of character deals only with the firm and economics deals with both economics of has nothing to do with an individuals the individual as well as economics of economic problem firm. The scope of managerial economics is The scope of economics is wider then narrow in comparison to economics managerial economics Economi Managerial economics adopts modifies c theory hypothesizes economic and reformulates economic models to Relationships and builds simplified suit the specific conditions and serves the economic models specific problem solving processes. Economi Managerial economics introduces certain c theory makes certain feedbacks such as objectives of the firm, assumptions. environmental aspects and legal constraints. Scope of Managerial Economics In general the scope of Managerial Economics comprehends all those economic concepts, theories and tools of analysis which can be used to analyze the business environment and to find solution to practical business problems. In other words Managerial Economics is the economics applied to the analysis of business problems and decision-making. Broadly speaking it is applied economics. The areas of business issues to which economic theories can be directly applied may be broadly divided into two categories A) Operational or internal issues and B) Environment or external issues. (1) Demand Analysis and Forecasting: a business firm is an economic organism which transforms productive resources into goods that are to be sold in a market. A major part of managerial decision making depends on accurate estimates of demand. Before production schedules can be prepared and resources employed, a forecast future sales is essential. Demand analysis helps to identify the various factors influencing the demand for a firm’s product and thus provides guidelines to manipulating demand. Demand analysis and forecasting therefore is essential for business planning and occupies a strategic place in managerial economics. It mainly consists of discovering the force determining sales and their measurement. The chief topic s covered are demand determinants, demand forecasting 2 (2) Cost Analysis: a study of economic costs, combined with the data drawn from the firms accounting records, can yield significant cost estimates that are useful for managerial decisions. The factors causing variations in costs must be recognized and allowed for if management is to arrive at cost estimates which are significant for planning purposes. The chief topics covered under cost concepts are: cost concept and classifications, cost -output relationships, economics and diseconomies of scale, and cost control and cost reduction. (3) Production and Supply Analysis: production analysis is narrower in scope than cost analysis. Production analysis frequently proceeds in physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals with different production functions and their managerial uses. Supply analysis deals with various aspects of supply of a commodity. Certain important aspects of supply analysis are: supply schedule, curve and function, law of supply and its limitations. Elasticity of supply and factors influencing supply. (4) Pricing Decisions, Policies and Practices: pricing is a very important area of managerial economics. In fact, price is the genesis of the revenue of a firm and as such the success of a business firm largely depends on the correctiveness of price decisions taken by it. The important aspects dealt with under this area are: price determination in various market forms, pricing methods, differential pricing, product line pricing and price forecasting. (5) Profit Management: business firms are generally organized for the purpose of marking profit and, in the long-run; profits provide the chief measure of success. However, in a world of uncertainty, expectations are not always realized so that profit planning and measurement constitute the difficult area of managerial economics. The important aspects covered under this area are: nature and measurement of profit, profit policies and techniques of profit planning like break-even-analysis. (6) Capital Management: the most complex problem is related to the firm’s capital investment. Briefly capital management implies planning and control of capital expenditure. The main topics dealt with are: cost of capital, rate of return and selection of projects Significance of Managerial Economics,  It presents those aspects of traditional economics which are relevant for business decision - making in real life.  It also incorporates useful ideas from other disciplines such as psychology, sociology etc.  Managerial economics helps in reaching a variety of business decisions in a complicated environment.  Managerial Economics makes a manager a more competent model builder.  Managerial Economics serves as an integrating agent by coordinating the different functional areas such as finance, marketing, HR, production and bringing to bear on the decisions of each department or specialist the implications pertaining to other functional areas.  Managerial Economics takes cognizance of the interaction between the firms and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare. Relevance of economics for business decisions: 1. Studies Business Environment: Managerial economics properly analyze 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. 3  2. Production Scheduling: Managerial economics manages and prepare schedules for all production activities of business. It estimates all future demands using various quantitative tools which helps in making production plans. 3. Control Cost: Controlling the cost is vital for achieving the desired profitability and growth. Managerial economics estimates the cost of all business activities and identify all those factors that cause variations in cost from time to time. It aims at minimizing the cost through optimum utilization of all resources. 4. 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 supplying all information regarding competitors pricing methods. 5. 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. 6. 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. Role of Managerial Economist in Business decision making: Managerial economist is a person who manages business efficiently using various economic theories and methodologies. He supports the management team in better decision making through his analytical skills and specialized techniques. A Managerial Economist is also termed as an economic advisor or business economist. He is responsible for analyzing various internal and external environmental forces that influence the functioning of business organizations. Managerial economist makes several successful business forecasts and updates the management team regarding the economic trends from time to time. Managerial Economist always remains in touch with all the latest economic developments and environmental changes for informing the management. He has an efficient role in earning reasonable profits on invested capital as it supplies all relevant information which helps in making proper plans and strategies. Managerial economist has three important roles in every business organization: Demand analysis and forecasting, capital management and profit management. Studies Business Environment The managerial economist is responsible for analyzing the environment in which business operates. Proper study of all external factors that affect the functioning of organization is must for proper functioning. He studies various factors like growth of national income, competition level, price trends, phase of the business cycle and economy and updates the management regarding it from time to time. Analyses Operations of Business He analyses the internal operation of business and helps management in making better decisions in regard to internal workings. Managerial economist through his analytical and forecasting skills provides advice to managers for formulating policies regarding internal operations of the business. 4 Demand Forecasting and Estimation Proper estimation and forecasting of future trends helps the business in achieving desired profitability and growth. Managerial economist through proper study of all internal and external forces makes successful forecasting of future uncertainties or trends. Production Planning Managerial economist is responsible for scheduling all production activities of business. He evaluates the capital budgets of organizations and accordingly helps in deciding timing and locating of various actions. Economic Intelligence He provides economic intelligence services by communicating all economic information to management. Managerial economist keeps management always updated of all prevailing economic trends so that they can confidently talk in seminars and conferences. Performing Investment Analysis A managerial economist analyzes various investment avenues and chooses the most appropriate one. He studies and discovers new possible fields of business for earning better returns. Focuses on Earning Reasonable Profit He assists management in earning a reasonable rate of profit on capital employed in the business. Managerial economist monitors activities of organizations to check whether all operations are running efficiently as per the plans and policies. Maintaining Better Relations A managerial economist maintains better relations with all internal and external individuals connected with the business. It is his duty to develop a peaceful and cooperative environment within the organization and aims to reduce any opposition taking place. Demand Analysis: - Demand & Demand Function, Demand condition for a firm’s product has profound influence on its financial decisions, HR decisions, and marketing and operation decisions. If the demand for a product is quite large, then it may cause a large number of firms producing a product which may ensure a high level of competition in the industry. What is Demand? Quantities of goods and services that people are ready to buy at various prices with in some given time period, other factors besides price remains constant. Conceptually, demand means desire for a commodity backed by the ability and willingness to pay for it. Why people demand goods and services? People demand goods because they satisfy they want of the people. The utility means the amount of satisfaction which an individual derives from consuming a commodity. It also defined as want satisfying power of a commodity. Utility is a subjective entity resides in the mind of the consumer. Being it subjective it varies with different 5 persons derive different amount of utility from a given a good. People know it by introspection. Thus, in economics the concept of utility is ethically neutral. Demand analysis and Management (Decision Making) Objective of business firm may differ but the basic objective is to produce and sell the goods or services which is demanded by the customers. As necessity is the mother of invention, demand is the mother of production. If the demand for a particular product increases, then there is good prospect of business in future. Demand analysis is a necessary informational input into the business decision process since, in a sense, demand fundamentally determines what is to be produced and at what price. Accordingly, business economists use demand analysis to discover the various factors determining the demand for a given product or service. E.g. increasing demand for computers and mobile phone in India has enlarged the business prospect for both home countries and foreign countries. On the other hand declining demand for B&W TV is forcing the companies to switch over modern substitutes or to go out of business. So, every manager should have the knowledge regarding the following aspect of demand.  Who will demand how much?  At which price  Time period over which the product is demanded  Market is in which the commodity is demanded. So, for a business decision both quantities demanded statement with specific price at a particular period in a particular market is relevant. e.g. the annual demand of Hero Honda Glamour in Bhubaneswar at an average price of Rs 65,000 and quantity is 20,000. Factors Determining Demand  The Price of a Product: it is one of the most important determinants. The price of a product and its quantity demand are inversely related. Law of demand states that quantity demand of a product states that quantity demand of a product increases when its price falls and decreases when its price increases other factor remains constant. These other factors are income of consumer, prices of substitute and complementary good, consumer taste preference etc.  Income of the People: Purchasing powers of the consumer also determine the demand of the product. People with higher income spend larger amount on consumer goods then those with lower income. It means if income increases, consumption demand increases, if income falls, consumption decline at a lower proportion. But the impact of income on demand of the product differs according to the nature of product, i.e. Essential Consumer Goods: it is otherwise called basic needs e.g. food grains, salts, fuel, cloth& housing. In this type of goods as income increases the quantity demand increases up to a certain limit after that the proportion of income in demand become slow or remain constant. Inferior Goods: in case of inferior goods demand for these good decreases with increase in consumers income beyond a certain level e.g. millet is inferior than wheat and rice, bidi is inferior than cigarette, kerosene is inferior than cooking gas and so on. Luxury and Prestige Goods: beyond a certain level of consumer’s income, consumption enters in to the area of luxury goods. Producer of such item should consider the income changes in richer section of the society e.g. AC car, diamond jewellery.  Price of the Related Goods: demand for a commodity is also affected by the demand in the price of related goods. These related good may be substitute goods or complementary goods. 6 Substitute Goods: if change in price of one commodity affect the demand of other commodity in the same direction, then both the commodity are substitute to each other. It shows that there is positive relationship between demand and price of two substitute product e.g. tea & coffee, alcohol & drugs. Complementary Goods: when the use of two goods goes together so that their demand changes simultaneously is called complement goods. Its means if the demand of one commodity increases, the demand for its complement goods will decrease even if at lower price. There is inverse relationship between the demand for goods and price of its complement. e.g. petrol & car, ink & pen, butter & bread, milk & tea. An increase in the price of milk causes in the decreases of demand of tea other thing remain same.  Taste and Preferences of Consumer: taste and preference generally depend on life-style, social customers, religious values attached to a commodity, habit of the people age & sex of the consumer etc. change in these factors change consumers taste & preference as a result demand for goods or commodity increases or decreases. E.g. following the change in fashion people switch their consumption pattern. The change in demand for various goods occur due to the change in fashion and also due to the pressure of advertisements by the manufacturers and sellers of different products.  Advertisement Expenditure: it increases the demand for the product in four ways.  Informing consumer about availability  Superiority of the product  Influencing consumers  Setting new fashion With increases in the advertisement sales volume increases.  Number of Consumer in the Market: the greater the number of consumers of a good, the greater the market demand for it. Another cause for the growth of number of consumers is the growth of population in India the demand for many essential goods, especially food grains, has increased because of the increase in the population of the country.  Consumers Expectation: consumers expectation regarding the future prices, income and supply position of goods etc play an important role in determining demand. If the consumer expects the high rise in price, the consumer current demand increases even at high price and vice -versa. Similarly, with expectation of increases in income or scarcity of product in future leads increases in quantity demand in current period.  Demonstration Effect: some of the people purchase commodity not because of necessity but because their neighbours have bought these goods. It is otherwise called as Band-Wagon effect. These effects have positive effect on demand. On the contrary, when the commodities are commonly used rich class people decrease the consumption. Or there are also consumers who like to behave differently from the others. This is known as Snob effect and it has negative effect on demand.  Credit Facility: availability of credit to the consumers from the sellers, banks, friends encourage the consumer to buy more. It mostly affects the demand of durable commodity. So, manager of durable commodity should provide easy instalment facilities to sell his product.  Distribution of National Income: if the national income is equitably distributed, demand for necessity goods increases but demand for luxury goods decreases. Law of demand: The demand schedule shows the quantity of goods that a consumer would be willing and able to buy at specific prices under the existing circumstances. Some of the more important factors affecting demand are the price of the good, the price of related goods, tastes and preferences, income, and consumer expectations. Economists record demand on a demand schedule and plot it on a graph as a demand curve that is usually 7 downward sloping. The downward slope reflects the relationship between price and quantity demanded: as price decreases, quantity demanded increases. This behaviour of the consumer is governed by a law as the law of demand The law of demand explains the behavior 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 good 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 remain constant over the period in which the impact of price variation on the quantity demanded is being analyzed. (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. Price (Rs.) Quantity demanded (Units) 0 10 1 8 2 6 3 4 4 2 5 0 When we represent the above data in a graph, we get the demand curve. 12 10 8 Price 6 Demand curve 4 2 0 0 1 2 3 4 5 6 Quantity 8 Reason for the Law of Demand: why does demand curve slope downwards? (1) Income effect: - as a result of the fall in the price of a commodity, consumers real income or purchasing power increases. This increase in real income induces the consumer to buy more of that commodity. This is one reason why a consumer buys more of a commodity whose price falls. (2) Substitution effect: - when the price of a commodity falls, it becomes relative cheaper than other commodities. This induces the consumer to substitute the commodity whose price has fallen for other commodities which have now become relatively dearer. As a result of substitution effect, the quantity demanded of the commodity, whose price has fallen, rises. This substitution effect is more important than the income effect. (3) New consumers: - when the price of commodity falls, many new consumer who were not consuming that commodity will start consuming the commodity. (4) Several Uses: - some commodity can be put to several uses which leads to downward slope of the demand curve as prices falls (5) Psychological effects: - when the price of a commodity falls people favour to buy more which is psychological. (6) Law of Diminishing Marginal Utility: - It is the basic cause of the law of demand. The law of diminishing marginal utility states that as an individual consumes more and more units of a commodity, the utility derived from it goes on decreasing. So as to get maximum satisfaction, an individual purchase in such a manner that the marginal utility of the commodity is equal to the price of the commodity. When the price of commodity falls, a rational consumer purchases more so as to equate the marginal utility and the price level. Thus, if a consumer wants to purchase larger quantities, then the price must be lowered. This is what the law of demand also states. Exception to the Law of Demand (1) Goods having Prestige value: Veblen Effect. One exception to the law of demand is associated with the name of the economist, Thorstein Veblen who propounded the doctrine of conspicuous consumption. To Veblen, some consumers measure the utility of a commodity entirely by its price i.e., for them, greater the price of commodity, the greater it’s utility. E.g. Diamond, Luxury cars. (2) Giffen goods: - another exception to the law of demand was pointed out by Sir Robert Giffen who observed that when price of bread increases, the low paid British workers in the early 19th century purchased more bread and not less of it and this is contrary to the law of demand described above. The reason given for this is that these British workers consumed a diet of mainly bread and when the price of bread went up they were compelled to spend more on given quantity on bread. Therefore they could not afford to purchase as much meat as before. Thus they substituted even bread for meat in order to maintain their intake of food. It is important to note that with the rise in the price of giffen goods, its quantity demanded increases and with the fall in its price its quantity demanded decreases, the demand curve will slope upward to the right and not downward. Relationship between demand function and demand curve Demand Function Demand function is a mathematical function showing relationship between the quantity demanded of a commodity and the factors influencing demand. 9  Dx = f (Px, Py, T, Y, A, Pp, Ep, U) In the above equation, Dx = Quantity demanded of a commodity Px = Price of the commodity Py = Price of related goods T = Tastes and preferences of consumer Y = Income level A = Advertising and promotional activities Pp = Population (Size of the market) Ep = Consumer’s expectations about future prices U = Specific factors affecting demand for a commodity such as seasonal changes, taxation policy, availability of credit facilities, etc. Market Demand Function Market demand is the combined response of individual demand. Manager of a firm is more interested in the size of total market demand for the commodity and firm’s share in it. This is because it will provide a basis of his pricing and output decision. Apart from the factors affecting individuals demand, market demand for a product depends on an additional factor namely number of consumers which in turns depend on the population of a region or a city or country. With this we write the market demand function as Qd = f (Px, I, Pr, T, A, N) Where the additional factor is N which stands for the number of consumers or population. Suppose there are two individual buyers of a good in the market. In the above diagram the fist consumer and second consumer shows the demand curve of the two independent individual buyers. Now the market demand curve can be obtained by adding together the amounts of the good which individuals wish to buy at each price (4+2=6 and 5+8=13). The market demand curve slopes downward to the right since the individual demand curve whose lateral summation gives us the market curve, normally slopes downward to the right. Besides, as the price of the goods falls, it is very likely that the new buyers will enter the market and will further raise the quantity demanded of the good. This is another reason why the market demand curve slopes downward to the right. 10 Bandwagon Effect & Snob Effect; Bandwagon Effect: - The bandwagon effect is a well-documented form of groupthink in behavioral science and has many applications. Some of the people purchase commodity not because of necessity but because their neighbours have bought these goods. It is otherwise called as Band-Wagon effect. These effects have positive effect on demand. The tendency to follow the actions or beliefs of others can occur because individuals directly prefer to conform, or because individuals derive information from others. In layman’s term the bandwagon effect refers to people doing certain things because other people are doing them, regardless of their ow n beliefs, which they may ignore or override. Snob Effect: - when the commodities are commonly used rich class people decrease the consumption. Or there are also consumers who like to behave differently from the others. This is known as Snob effect and it has negative effect on demand. This situation is derived by the desire to own unusual, expensive or unique goods. Elasticity of demand and its uses for Managerial decision-making, The law of demand shows the direction of change in quantity demanded due to change in its price. But it does not state the extent or degree of change in quantity demanded due to change in price. The elasticity of demand shows the degree or extent of commodity with reference to change in its price, What is Elasticity of Demand? The elasticity of demand refers to the degree of responsiveness of quantity demanded due to change in its price, consumer’s income and price of related goods. Elasticity of Demand Price Elasticity (ep) Income Elasticity (ei) Cross Elasticity (ec )  Price Elasticity (ep) is the degree of responsiveness of quantity demanded due to change in its price  Income Elasticity (ei) is the degree of responsiveness of quantity demanded due to change in consumers income  Cross Elasticity (ec) is the degree of responsiveness of quantity demanded due to change in price of related goods which may either a substitute for it or a complementary with it. Price Elasticity of Demand (ep) Price elasticity is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall. More often the price elasticity is commonly known as elasticity of demand. In general price elasticity of demand is the ratio of percentage change in quantity demanded due to percentage change in price ep = Percentage change in quantity demanded / Percentage change in price 11 Measurement of Price Elasticity of Demand The elasticity of demand can be measured with the following methods: - Gradient method, Percentage method, Total outlay method, Point method, Arc method. Types of Price Elasticity of demand: In gradient method elasticity of demand is measured with the gradient or slope of a demand curve. A flat curve shows elastic demand and steep curve less elastic demand. A curve in the nature of 45degree line from y axis shows unity elasticity. The gradient or slope of a curve is represent (1) Unity Elastic: in diagram B, the elasticity of demand is unity because the percentage change in quantity demanded is equal to percentage change in price. So this is called unity elasticity of demand. |ep| or |Ep| =∆Q/∆P = 1 , demand is unitarily elastic (2) More Elastic: the diagram A, represents more elastic of demand. Here the change in quantity demanded ∆Q is greater than change in price ∆P. so elasticity of demand is more elastic |ep| or |Ep| = ∆Q/∆P (where ∆Q>∆P) |ep| or |Ep |> 1, demand is elastic (3) Less Elastic: in the figure C the elasticity of demand is less elastic because the change in quantity demanded is less than of the change in price; the ratio of change in quantity demanded to price is less then one |ep| or |Ep| = ∆Q/∆P (where ∆Q 0, goods are substitutes If ec < 0, goods are complementary If ec= 0, goods are independent Demand Forecasting Demand forecasting is predicting the future demand for a product. The information regarding future demand is essential for planning and scheduling production, purchase of raw materials, acquisition of finance and advertising. The information regarding future demand is also essential for existing firms to be able to avoid under or over production. Various methods to demand forecasting have been divided into two types: qualitative methods and quantitative methods. The techniques of forecasting are many but the choice of a suitable method is a matter of purpose, experience and expertise. To a large extent it also depends on the nature of the data available for the purpose. Qualitative Methods of Demand Forecasting: (1) Jury Method/Executive Opinion Method: The jury method is one of the commonly employed methods of sales forecasting. It is also known as executive opinion method. Judgment is the basis in this method. This is true for both the jury method and the percolated jury method. The difference that in the former the participants are limited to the top executives and in the latter, a large number of marketing and sales executive participate. In both, the participants exercise their judgment and give their opinions. The final forecast is arrived at by averaging these opinions. Evidently for the forecasts arrived at by this method is reliable, the executives participating must have versatile experience and sound knowledge of the business. (2) Survey of Experts Opinion: This is yet another judgment-based method of sales forecasting but is somewhat different from the jury method. In this jury method, opinion of executives gives rise to the forecast. In survey of expert opinions, experts in the concerned field, inside or outside the organizations are approached for their estimates. This method is used more in developing total industry forecast than company sales forecast. (3) The Delphi Method: It is a kind of survey of expert opinion method. It is used more for working out broad-based, futuristic estimates, rather than sales forecasts. In this method a panel of experts in the field is interrogated by a sequence of questionnaires. Any information that is available with any one member of the panel is passed on to others as well as enabling all members to have access to all the available information. The panel members are asked to react to a checklist of questions, which are significant to the forecast that is attempted. Their opinions and reactions are analyzed and where there is a sharp difference on an issue, interchanges are permitted and the final forecasts are presented. 16 (4) Sales Force Composite Method: Here the sales forecasting is done by the sales force. It is also judgment- based method. Each salesman develops the forecast for his respective territory, the territory wise forecasts are consolidated at branch/area/region level; and the aggregate of all these forecasts is taken as the corporate forecast. Composite method seeks to aggregate the judgment of entire sales force. It is a grassroot method; the forecasting originates at the grassroot level people who are close to the market place form the basis for the forecast. (5) Survey of Buyer Intensions: Forecasting is the art of anticipating what buyers are likely to do under a given set of condition. The various surveys also enquire into a consumer’s present and future personal finances and their expectation about the company. Buyer intension surveys are particularly useful in estimating demand for industrial products, consumer durables, product purchases where advanced planning is required and new products. (6) Market Test: It is essentially a risk control method or it is experiential marketing at minimum cost and risk. When firm decides on full scale manufacturing and marketing of the product on the basis of results of experiment, it helps avoid costly business errors. This method is useful for new product, with the support of the chosen marketing mix, is actually launched and marketed in a few selected cities/ towns/ other territories. The selected test markets will be representative of the final market. Quantitative Methods of Demand Forecasting (1) Simple Projection Method: The simple projection method is the one in which the current year’s forecast is arrived at by simply adding an assumed growth rate to last years sales; same firms go by the industry growth rate and project the sales; some others take the growth rate achieved by the No1 firm in the industry. Another formula, as shown below is also used by same firms Next years sales = (This year’s sales)2 / Last years sales Only where the year-by-year sales are stable and show an increasing trend, this formula will provide a reasonably reliable estimate (2) Extrapolation Method: Extrapolation is a projection method, but is a bit more complex compared to the simple projection method. It involves the plotting of the sales figure for the past several years and stretching of the line or the curve as the case may be. The extrapolation will give the figures for the coming years. Extrapolation basically assumes that the variable well follows their previously established pattern. In other words, the assumption is that the past will show the future. (3) Time Series Method: It is also known as trend cycle analysis. A time series is a set of chronologically ordered raw data, for example, the monthly sales of given product for several continue years. Time series analysis helps to identify and explain:  Systematic variation or seasonal variation, which arises due to seasonality in the series of data.  Cyclical pattern that repeat themselves every two or every three years and soon.  Trend in the data  Growth rates of these trends The main assumption in time series analysis is that the factors influencing sales will not changes very much over a period of time and that the future will reflect the past. In this sense this method is basically a projection method. Projections of future sales are made by studying the interaction of the basic and significant influence of sales. A through and systematic analysis of data is carried out. All the basic factors underlying the sales fluctuations are analyzed. The four main types of sales variations are as follows. 1. Long-term growth trends (Secular trends) 2. Cyclical changes 17  3. Seasonal variations 4. Irregular or random fluctuations - Are isolated and measured using the statistical procedure. The trend lines for each type of variations are studied and sales estimates are made. (A) Simple Moving Average Method: This method helps eliminate the effects of seasonality and other irregular trends in sales while forecasting future sales. The method delivers a time series of moving averages. Each point of the time series is the arithmetical or weighted average of a number of preceding consecutive points of the series. If seasonal effects are present in the demand pattern of the product, a minimum of two years sales history is needed for applying this model. Example: The table below shows the demand for a new after shave in a shop for each of the last 7 months. Month: 1 2 3 4 5 6 7 Demand: 23 29 33 40 41 43 49 Calculate a two-month moving average for months two to seven. What would be your forecast for the demand in month 8? The two-month moving average for months two to seven is given by: m2 = (23 + 29)/2 = 26.0 m3 = (29 + 33)/2 = 31.0 m4 = (33 + 40)/2 = 36.5 m5 = (40 + 41)/2 = 40.5 m6 = (41 + 43)/2 = 42.0 m7 = (43 + 49)/2 = 46.0 The forecast for month 8 is just the moving average for the month before that i.e. the moving average for month 7 = m7 = 46. (B) Weighted Moving Average Method: Weighted moving averages assign a heavier weighting to more current data points since they are more relevant than data points in the distant past. The sum of the weighting should add up to 1 (or 100%). Suppose in the above example we want to calculate three-month weighted moving average: weight of last three month as: 0.6, 0.3, 0.1. The weighted moving average for 8th month = (0.6*46) + (0.3*42) + (0.1*40.5) = 27.6 + 12.6 + 4.05 = 44.25 (C) Exponential Smoothing: It is yet another projection method used for sales forecasting. It is similar to moving averages and is used fairly extensively. It too represents the weighted sums of all past numbers in a time series, with the heaviest weight placed on the most recent data or information. This method involves estimating the value of the ‘smoothing constant’ usually designated by symbol alpha and then using it to smooth the raw sales data. The assumption in this method is that actual sales are a function of environmental factors and the method helps to smooth out these factors. This can be represented symbolically as Ft = α Xt- 1 + ( 1 – α ) St-1 Ft Refers to forecasted sales in period t α is smoothing constant with a value between 0 to 1 At- 1 is actual sales in period t-1 18  Ft- 1 is smoothed sales in period t-1 This method is particularly useful when forecasts of a large number of items are made. It is not necessary here to keep a long history of past data. Example: The table below shows the demand for a new after shave in a shop for each of the last 7 months. Month 1 2 3 4 5 6 7 Demand 23 29 33 40 41 43 49 Apply exponential smoothing with a smoothing constant of 0.1 to derive a forecast for the demand in month eight. Solution Applying exponential smoothing with a smoothing constant of 0.1 we get: F1 = A1 = 23 F2 = 0.1A2 + 0.9F1 = 0.1(29) + 0.9(23) = 23.60 F3 = 0.1A3 + 0.9F2 = 0.1(33) + 0.9(23.60) = 24.54 F4 = 0.1A4 + 0.9F3 = 0.1(40) + 0.9(24.54) = 26.09 F5 = 0.1A5 + 0.9F4 = 0.1(41) + 0.9(26.09) = 27.58 F6 = 0.1A6 + 0.9F5 = 0.1(43) + 0.9(27.58) = 29.12 F7 = 0.1A7 + 0.9F6 = 0.1(49) + 0.9(29.12) = 31.11 As before the forecast for month eight is just the average for month 7 = F7 = 31.11 = 31 (4) Regression Analysis: It is another analytical technique used for demand forecasting. This technique combines economic theory and statistical technique of estimation. Economic theory is employed to specify the determinants of demand (Demand function) and to determine the nature of relationship between the demand for a product and its determinants. Statistical techniques are employed to estimate the values of parameters in the estimated equation. In regression technique of demand forecasting, the analysts estimate the demand function for a product. In the demand function, the quantity to be forecast is a ‘dependent variable’ and the variables that affect or determine the demands are ‘independent variable’ or ‘explanatory variables’. The simple regression technique is based on the assumptions (i) that independent variable will continue to grow at its past growth rate, and (ii) that the relationship between the dependent and independent variables will continue to remain the same in the future as in the past. The regression method, in general will give more accurate forecasts than the trend method since regression takes into account causal factor. (5) Econometric Models: This model basically attempts to express economic theories in mathematical terms so that they can be verified by statistical methods and used to measure the impact of one economic variable upon another predicting future event. The econometric model is constituted by a set of interdependent equations that describe and simulate the total demand situation. The forecast is derived through this set of equations. Econometric models are quite complex and expensive to develop. But they predict the turning points more accurately. Econometric models are used more in forecasting the demand of durable goods, industrial as well as consumer durables, where replacement demand is significant factor to be projected. Significance of Demand Forecasting Estimating and forecasting demand are crucial to the following types of decision-makers for knowing the 19 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 demands are important. Future demand estimates help 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. Demand Estimation: Why Demand Estimation? When running a small business, it is important to have an idea of what you should expect in the way of sales. To estimate how many sales a company will make, demand estimation is a process that is commonly used. With demand estimation, a company can measure how much to produce and make other important decisions. What is Demand Estimation? Demand estimation is a process that involves coming up with an estimate of the amount of demand for a product or service. The estimate of demand is typically confined to a particular period of time, such as a month, quarter or year. Various Methods for Demand Estimation There are a variety of ways that can be used to estimate demand, each of which has certain advantages and disadvantages 1. Consumer Survey: Survey is a method for collecting quantitative information about items in a population. Firms can obtain information regarding their demand functions by using interviews and questionnaires, asking questions about buying habits, motives and intention. Advantages:  They give up-to-date information reflecting the current business environment.  Much useful information can be obtained that would be difficult to uncover in other ways. Disadvantages:  Validity: Consumers often find it difficult to answer hypothetical questions, and sometimes they will deliberately mislead the interviewer to give the answer they think the interviewer wants.  Reliability: It is difficult to collect precise quantitative data by such means.  Sample bias: Those responding to questions may not be typical consumers 1. Market Experiments: Market experiments seek to test consumer reactions to changes in variables in the demand function in a controlled environment. For example, consumers are normally given small amounts of money and allowed to choose how to spend this on different goods at prices that are varied by the investigator. However, such experiments have to be set up very carefully to obtain valid and reliable results. 20 Advantages:  Direct observation of consumers’ actual spending behavior is possible Disadvantages:  There is less control in this case, and greater cost.  The number of variations in the variables is limited because of the limited number of market segments available.  Experiments may have to be long-lasting in order to reveal reliable indications of consumer behavior. 2. Regression Analysis: Statistical techniques, especially regression analysis, provide the most powerful means of estimating demand functions. This is a statistical technique by which demand is estimated with the help of certain independent variable. Moreover, multiple regression analysis is used to estimate demand as a function of two or more independent variables that vary simultaneously. Advantages:  Regression techniques have become the most popular method of demand estimation  software packages are available to use regression techniques Disadvantages:  They require a lot of data in order to be performed.  They necessitate a large amount of computation. Supply Analysis: The supply of a product refers to the various quantities of the product, which a seller is willing and able to sell at different prices in a given period of time. Factors affecting Supply (a) Cost of production: Variations in cost of production occur due to changes in cost of labor, raw materials, capital, technological advancements, etc. An increase in the cost of production leads to a decrease in supply. If due to technological advancement and large -scale production, the cost of production decreases in the long run, there would be an increase in supply. (b) Availability of other products: The supplier can switch over their production to any of their complementary or substitute product if their cost of production is less. (c) Climatic changes: Climatic conditions also affect the supply of products. When the climatic condition is favorable, production is usually more, which may lead to fall in prices. For example, agricultural production is largely dependent on climatic conditions. (d) Changes in government policies: A rise in direct or indirect taxes has an immediate effect on the prices of commodities. If a new tax is imposed or existing tax rates are increased, price of the product will go up resulting in decline of supply of the product. The Law of Supply: The law of supply states that other factors remaining constant, higher the price, greater the quantity supplied and lower the price, lower the quantity supplied. Hence, the price and quantities supplied are positively related. This explains the reason why the supply curve slopes upwards. The law of supply takes into account only the most important determinant of supply i.e. the price of the product. 21 Assumptions: The input price should remain unchanged. Production technology should not change. There should not be any change in government policies. There should not be any change in foreign trade policies. There should not be any climatic changes. Supply Schedule: The supply schedule refers to the quantity of products a producer or seller wishes to sell at a given price level. It explains the behavior of sellers at various price levels. The supply schedule can be represented in a tabular form where it depicts the quantity supplied and price of the product at a given period of time. Quantity Supplied Price (Rs.) (Units) 0 0 1 2 2 4 3 6 4 8 5 10 Supply Curve: When we represent the supply schedule in the form of a graph we get the supply curve. 12 10 8 Price 6 Supply curve 4 2 0 0 1 2 3 4 5 6 Quantity When we represent the supply schedule in the form of a graph we get the supply curve. In Figure the above figure, we have plotted the data given in the table in the form of a supply curve. Here, it is a typical upward- sloping supply curve. At a very low price, the seller supplies smaller quantity of output. But as the price of the good increases the manufacturers find it more profitable to sell more goods. Thus, higher the price of the good, the greater the amount of goods supplied. 22 Market Equilibrium. The market for a particular good or service consists of all buyers and sellers of that good or service. In economics, the word market always implies bringing together of demand and supply in relation to goods or services. The interaction of potential buyers and potential sellers establishes a market. A market is an arrangement as well as an institution, where both buyers and sellers come closer for a predefined transaction. Market equilibrium refers to a situation where quantity demanded for a commodity is equals to quantity supplied. We have seen that the demand and supply of any product depend on its price. The equilibrium price is that price at which the total demand for any product in the market is equal to the total supply of that product. The market demand curve gives us an idea of the total quantity demanded by all the buyers in the market at different price levels. In the same way, each seller takes the price as given and decides to offer a certain quantity for sale in the market. Thus, each seller has a n individual supply curve and by summing up the individual supply curves of all the sellers in the market, we get the market supply curve. From the market supply curve we get to know the total supply by all sellers at different prices. Price (Rs.) Quantity demanded (Units) Quantity supplied (Units) 0 10 0 1.00 8 2 2.00 6 4 2.50 5 5 3.00 5 5 4.00 2 8 5.00 0 10 23  Demand and supply shifts Effect on price and quantity If demand rises… The demand curve shifts to the right Both price and quantity increases If demand falls… The demand curve shifts to the left Both price and quantity falls If supply rises… The supply curve shifts to the right Price falls but quantity increases If supply falls… The supply curve shifts to the left Price increases and quantity decreases 24  MODULE: II What is Production? The relationship between input and resulting in output is called production. The word production in economics is not merely confined to physical transformation in the matter, it is creation and addition of value, therefore production in economics also covers the rendering of services. The theory of production provides a formal framework to help the managers of firms in deciding how to combine various factors or inputs most efficiently to produce the desired output of a product or service. What is 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. During this process every entrepreneur wants to maximize his profit as profit maximization is his prime motto. This relationship may be expressed as follows: - Q = f (N, L , K, M, T) Q = quantity of output, N = land employed in the production of X, L = labour employed, K = capital employed, M = management employed, T = technology used. 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 analyzed. 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: - Q = f (L.K) For a given level of output Q, 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 output Q. 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 proce ss is known as labour intensive production technique. Whereas, if more of capital is used in relation to labour, the production technique becomes capital intensive. Production function carries the input and output relationship and according to economics the relationship is of two kinds when some inputs are fixed and some inputs are varied we call it short run period production function. When all inputs are varied and resulting output is called long run production function. The short run production function is also known as Law of Variable Proportion and the long run production function is known as Law of Returns to Scale. 25 Concepts of TP, AP & MP: Total Product The total product refers to the total amount (or volume) of output produced with a given amount of input during a period of time. Therefore, a firm wanting to increase its Total Product in the short run will have to increase its variable factors as the fixed factors remain unchanged (that is why they are ‘fixed’ in the short run). In the long run, as we know that all factors become variable, the firm can increase its total product by increasing any of its factors as all factors become variable. The concept of Total Product helps us understand what is called the Marginal Product. Marginal Product The total product can be calculated by adding subsequent marginal returns to an input (also known as the marginal product). The increase in output per unit increase in input is called Marginal Product. Thus, if we were to assume Labour as the input used in the production process (say), then Marginal Product can be calculated as- MP = Change in output/ Change in input (here, labour) TP = ƩMP Average Product Average product, as the name suggests, refers to the per unit total product of the variable factor (here, labour). Hence, the calculation of Average Product is also very simple. AP = Total Product/ units of variable factor input = TP/L Note that Total Product can also, therefore, be calculated as TP = AP x L Production Function with one variable inputs (Law of variable proportions) The law of variable proportion is one of the fundamental laws in economics. Thus, law deals with the behavior of production function in the short run. This kind of input -output relation forms the subject matter of the law of diminishing marginal returns which is also called law of variable proportions and describes returns to a factor. To S.J. Stigler, “as equal increments of one input are added; the input of other productive services being held constant, beyond a certain point the resulting increments of product will decrease, i.e., the marginal products will diminish.” To Samuelson, “an increase in some inputs relative to other fixed inputs will, in a given state of technology, causes output to increase; but after a point the extra output resulting from the same additions of extra inputs will become less and less.” In the short run factors of production are two types they are fixed factors and variable factors. In the short- run the volume of production can be changed by varying the variable factor only. This is because fixed factor like plant size, machinery etc. can’t be changed in short period when the production function with one factor variable where other factors production are kept constant. Thus, the short -run two factor production function can be written as Q = f (L, K) 26  Where Q stands for output, L for labour and K for capital which is held constant in the short run The ratio of variable factor to fixed factor in the production function increases. E.g. suppose in production function two factors are assumed that is land and labour. It also assumed that 10ac res of land is available. Suppose the labour is engaged the ratio would 1:10, if the same labour is increased to 15 the ratio would be 15:10 this variation in the ratio of various factors causes the change in the size of output. At first there will be increasing in returns there after there will be diminishing returns and finally there will be negative return. Assumption of the Law 1. Constant technology: This law assumes that the techniques of production are constant. Because if there are any technological changes instead of diminishing of marginal and average product it goes on increasing. 2. Short run: This law specially operated in short run only because here some factor are fixed and some factor are variable. More over if it is a long run there is a cha nce that all the factors are variable. 3. Homogeneous factors: This law is based on the assumption that the variable resources are applied unit by unit and each factor unit is homogeneous or very much identical to each other both in quantity and quality. 4. Changeable input ratio: It is necessary to use various amounts of a variable factor with fixed factor of production. Explanation of the Law The short-run production function can be explained with the help of a table and diagram. Suppose a firm has 10 acres of land which is a fixed input and the variable input is labour. In order to increase his firm output, the producer can vary the quantity of labour inputs. There will be changes in the output or response of the output is shown on the table. AP = TP/ Units of labour MP = ∆Q/∆L K L TP AP= TP/Q MP=∆TP/∆Q Stages 10 1 75 75 75 10 2 160 80 85 Increasing Return 10 3 255 85 95 10 4 360 90 105 10 5 430 86 70 10 6 490 82 60 Decreasing Return 10 7 505 72 15 10 8 505 63 0 10 9 492 55 -13 Negative Return 10 10 475 48 -17 According the above table when the labour is increased from the one to two the MP as well as AP increases that is called Stage- I. But as more men are employed first the MP starts to fall and then AP starts to fall this stage we call it Stage – II. As we increase more and more labour MP goes negative that is stage-II. TP increases at a diminishing rate whereas the stage -III TP starts to diminishing because here MP is negative these stages can be shown on diagram. 27 Stage I: Increasing Returns We characterize this stage with the total output increasing at an increasing rate with each additional unit of the variable input. The MP curve rises upto the point corresponding to the point F on the TP curve, also known as the point of inflexion. After point F, the TP curve continues to rise but now at a decreasing rate. The end of this stage sees the maximum point of the average product, where the AP and MP curves intersect. Causes of increasing return:  Effective utilization of fixed factor: We get increasing returns in the first stage because initially, the fixed factors are abundant relative to the variable factor. The introduction of additional units of the variable factor leads to the effective utilization of the fixed factors. Evidently, production increases at an increasing rate. For example, if a machine requires four workers for its optimum utilization, and in the current scenario is two workers are operating the machine, the factor would be underutilized. Addition of another worker would definitely lead to an increase in the output. Further addition of a worker would lead to optimum utilization and hence production would increase.  Indivisibility of fixed factor: Now we cannot divide the fixed factor (here the machine) to suit the availability of the variable factor (here the workers) because generally the fixed factors are indivisible. Indivisibility of a fixed factor means that due to technological requirements, a minimum amount of the factor must be employed whatever the level of output.  Specialization and division of labour: Another reason for rising returns is the increase in the efficiency of the variable factor itself. This is because, with a sufficient quantity of variable factor, 28  the introduction of specialization and division of labour becomes possible which leads to higher productivity. Stage II: Diminishing Returns Throughout the stage of diminishing returns, the total product keeps on increasing. However, unlike the stage of increasing returns, here the total product increases at a diminishing rate. This happens because the marginal product falls and becomes less than the average product, which also sees a downwards slope.Thus, this stage is known as the stage of diminishing returns. The end of this stage is marked by the total product attaining its maximum value and the marginal product becoming zero. Further, this stage is very important because the firm will seek to produce in its range. Causes of decreasing return: After the addition of a certain amount of variable inputs which lead to the optimum and efficient utilization of fixed input, the output starts diminishing. This is because any further addition to the variable factor after the point of efficient utilization renders the fixed factor inadequate relative to variable factor. Again, this is the reason why the marginal and average product decline at this stage. In other words, the contribution of extra variable inputs is actually nil. This further means that the fixed indivisible factor is being worked too hard. Another reason for the law of diminishing returns is the lack of availability of a perfect substitute of factors of production. It means that one factor of production cannot be substituted for another factor. Substitute for every factor of production is not always available. In case of the availability of a perfect substitute, an increase in its quantity would have made up for the scarcity of the fixed factor. This, in turn, would have prevented the ineffective utilization. Stage III: Negative Returns The origin of stage 3 starts from the maximum point of the TP curve. In this stage, the TP curve now starts to decline. Moreover, the MP curve becomes negative coupled with a fall in the AP curve. Causes of negative return: The excessive addition of variable inputs leads to negative returns at this stage. This is because of the crowding of the variable factors. The variable and fixed factors now start getting into each other’s ways. Effectively, there is no coordination and hence the output falls. Ideal Stage of Operation A major dilemma in the world of the law of diminishing returns is deciding the stage where a rational producer would look to operate. Let’s examine each of these stages from his perspective. The stage of negative returns or stage III is probably not a stage of the producer’s choice. This is because the fixed factors here are over utilized. Thus, a rational producer would know that he is not having optimum production. Further, production can be increased by decreasing the number of variable inputs. Effectively, even if the inputs are free of cost, the producer would stop before the advent of stage III. 29 Stage I or the stage of increasing returns is a better stage, to start with. However, a rational producer would again not operate in this stage. This is because he would know that he is not making efficient utilization of the fixed inputs. In simpler words, the fixed inputs are underutilized. Furthermore, the producer would have an opportunity to increase production by employing more variable inputs and hence firing production on all engines. Eventually, even if the fixed factor is free of cost in this stage, a rational producer would continue adding more units of the variable factor. So now we understand that both stage I and stage III are not viable stages of production. Evidently, they are also known as the stages of economic absurdity or economic non-sense. This brings us to the conclusion that a rational producer would operate in the second stage of production, where both average and marginal products tend to decline. At which particular point in this stage, the producer decides to produce depends upon the prices of the factors. Production Function with two variable inputs Concept of Isoquant: An isoquant shows all the combination of two factors that produce a given output. In this diagram, the isoquant shows all the combinations of labour and capital that can produce a total output (Total Physical Product TPP) of 4,000. In the above isoquant, this could be  20 capital and 18 labour.  9 capital and 35 labour. An isoquant is usually shaped concave because of the law of diminishing returns. With fixed capital employing extra workers gives a declining increase in the marginal product (MP) 30 Marginal rate of factor substitution The marginal rate of substitution is the amount of one factor (e.g. K) that can be replaced by one factor (e.g. L). If 2 units of capital could be replaced with one-factor labour, the MRS would be 2 Diminishing marginal rate of substitution If the firm employs 2 L and 40 K. Then employing one extra worker can enable it to save 10K. This is quite an efficient saving. The firm only has to pay one extra worker but can save more by saving 10 K. However, at a combination of 9 Labour, employing an extra worker enables a saving of only 2 capital. Therefore, the more that workers are employed, there is a diminishing rate at which you can substitute the other factor. There comes a point, where employing more workers barely saves any capital at all. This is when diminishing returns of labour is very high – workers effectively get in each other’s way. As one moves down the isoquant, output remains the same. Therefore the output gained from employing more labour must equal the output lost from employing more capital. MPP (L) x ΔL = MPP (K) x ΔK 31 This equation gives us Isoquant map An isoquant map shows different levels of output. For example  I1 may show the combinations of capital and labour that can produce 4,000 TPP.  I2 may show the combinations of capital and labour that can produce 5,000 TPP.  I5 is a higher output than I4 In the short-term, a firm faces a trade-off along one particular isoquant. But, in the long-term, a firm can invest in increasing capital stock and produce at a higher output for the same quantity of labour. 32 Concept of Iso-cost line: An Iso-cost line shows all the combination of factors that cost the same amount to employ. In this example, a unit of labour and capital cost £6.666 each.  If we employ 30K and 30L, the total cost will be £200,000 + £200,000  If we employ 10 K and 50L, the total cost will be £66,666 + £333,333 = £400,000 Cost minimization and output maximization (Optimum combination) To maximize profits, a firm will wish to produce at the point of the highest possible isoquant and minimum possible Iso-cost. 33 In this example, we have one Iso-cost and three isoquants. With the Iso-cost of £400,000 the maximum output a firm can manage would be a TPP of 4,000. If it produced at say 13 K and 48 Labour, it would only be able to produce a TPP of 3,500. A total TPP of 4,500 is currently not possible without increasing costs beyond £400,000. Another way of seeking to maximize profits is to target an output of say 4,000 and then find the Iso-cost with the lowest possible cost. In this case, the Iso-cost which touches the tangential point of the TPP is a TC of £400,000. Law of Returns to scale The law of returns to scale explains the proportional change in output with respect to proportional change in inputs. In other words, the law of returns to scale states when there is a proportionate change in the amounts of inputs, the behavior of output also changes. The degree of change in output varies with change in the amount of inputs. For example, an output may change by a large proportion, same proportion, or small proportion with respect to change in input. On the basis of these possibilities, law of returns can be classified into three categories: 1. Increasing Returns to Scale: If the proportional change in the output of an organization is greater than the proportional change in inputs, the production is said to reflect increasing returns to scale. For example, to produce a particular product, if the quantity of inputs is doubled and the increase in output is more than double, it is said to be an increasing returns to scale. When there is an increase in the scale of production, the average cost per unit produced is lower. This is because at this stage an organization enjoys high economies of scale. 34 Reasons for increasing returns to scale: i. Technical and managerial indivisibility: This implies that there are certain inputs, such as machines and human resource, used for the production process are available in a fixed amount. These inputs cannot be divided to suit different level of production. For example, an organization cannot use the half of the machine for small scale of production. Similarly, the organization cannot use half of a manager to achieve small scale of production. Due to this technical and managerial indivisibility, an organization needs to employ the minimum quantity of machines and managers even in case the level of production is much less than their capacity of producing output. Therefore, when there is increase in inputs, there is exponential increase in the level of output. ii. Specialization: This implies that high degree of specialization of man and machinery helps in increasing the scale of production. The use of specialized labor and machinery helps in increasing the productivity of labor and capital per unit. This results in increasing returns to scale. 2. Constant Returns to Scale: The production is said to generate constant returns to scale when the proportionate change in input is equal to the proportionate change in output. For example, when inputs are doubled, so output should also be doubled, then it is a case of constant returns to scale. 35 3. Diminishing Returns to Scale: Diminishing returns to scale refers to a situation when the proportionate change in output is less than the proportionate change in input. For example, when capital and labor is doubled but the output generated is less than doubled, the returns to scale would be termed as diminishing returns to scale. Reasons for decreasing returns to scale: Diminishing returns to scale is due to diseconomies of scale, which arises because of the managerial inefficiency. Generally, managerial inefficiency takes place in large-scale organizations. Another cause of diminishing returns to scale is limited natural resources. For example, a coal mining organization can increase the number of mining plants, but cannot increase output due to limited coal reserves. Cost concepts: The followings are the different cost concepts: Fixed Costs (FC) The costs which don’t vary with changing output. Fixed costs might include the cost of building a factory, insurance and legal bills. Even if your output changes or you don’t produce anything, your fixed costs stay the same. In the above example, fixed costs are always £1,000. Variable Costs (VC) Costs which depend on the output produced. For example, if you produce more cars, you have to use more raw materials such as metal. This is a variable cost. Semi-Variable Cost. Labour might be a semi-variable cost. If you produce more cars, you need to employ more workers; this is a variable cost. However, even if you didn’t produce any cars, you may still need some workers to look after an empty factory. Total Costs (TC) = Fixed + Variable Costs 36  TFC Costs TVC TC Quantity Marginal Costs – Marginal cost is the cost of producing an extra unit. If the total cost of 3 units is 1550, and the total cost of 4 units is 1900. The marginal cost of the 4th unit is 350. Opportunity Cost – Opportunity cost is the next best alternative foregone. If you invest £1million in developing a cure for pancreatic cancer, the opportunity cost is that you can’t use that money to invest in developing a cure for skin cancer. Economic Cost. Economic cost includes both the actual direct costs (accounting costs) plus the opportunity cost. For example, if you take time off work to a training scheme. You may lose a weeks pay of £350, plus also have to pay the direct cost of £200. Thus the total economic cost = £550. Accounting Costs – this is the monetary outlay for producing a certain good. Accounting costs will include your variable and fixed costs you have to pay. Sunk Costs. These are costs that have been incurred and cannot be recouped. If you left the industry, you could not reclaim sunk costs. For example, if you spend money on advertising to enter an industry, you can never claim these costs back. If you buy a machine, you might be able to sell if you leave the industry. See: Sunk cost fallacy Avoidable Costs. Costs that can be avoided. If you stop producing cars, you don’t have to pay for extra raw materials and electricity. Sometimes known as an escapable cost. Explicit costs – these are costs that a firm directly pays for and can be seen on the accounting sheet. Explicit costs can be variable or fixed, just a clear amount. Implicit costs – these are opportunity costs, which do not necessarily appear on its balance sheet but affect the firm. For example, if a firm used its assets, like a printing press to print leaflets for a charity, it means that it loses out on revenue from producing commercial leaflets. Average Cost Concepts: Average Fixed Cost (AFC) = TFC / Q 37 Average Variable Cost (AVC) = TVC / Q Average Total cost (TC) = TFC + TVC TC = TFC + AFC = TFC / AVC = TVC / ATC = TC / MC = ∆TC / Q TFC TVC TVC Q Q Q ∆Q 0 100 0 100 1 100 200 300 100.00 200.00 300.00 200 2 100 300 400 50.00 150.00 200.00 100 3 100 380 480 33.33 126.67 160.00 80 4 100 440 540 25.00 110.00 135.00 60 5 100 480 580 20.00 96.00 116.00 40 6 100 520 620 16.67 86.67 103.33 40 7 100 580 680 14.29 82.86 97.14 60 8 100 660 760 12.50 82.50 95.00 80 9 100 760 860 11.11 84.44 95.56 100 10 100 880 980 10.00 88.00 98.00 120 Because the short run marginal cost curve is sloped like this, mathematically the average cost curve will be U shaped. Initially, average costs fall. But, when marginal cost is above the average cost, then average cost starts to rise. 38 Marginal cost always passes through the lowest point of the average cost curve. Example: A biscuit producing company has the following variable cost function: TVC = 200Q + 9Q2 if the company’s fixed costs are equal to Rs.150 lakhs find out Total cost function, MC function, AVC function, AC function and at what output levels AVC and MC will be minimum. Solution: since the TC is the sum of TFC and TVC, we get the TC function as under: TC = 150 + 200Q + 9Q2 To determine MC we take the first derivative of the TVC function with respect to output Q. Thus, MC = ∂TC / ∂Q = 200 - 18Q To derive the AC and AVC we derive the respective TC by the output level. AC = TC/Q = (150 + 200Q + 9Q2 ) / Q = 150/Q + 200 – 9Q AVC = TVC / Q = (200Q + 9Q2 ) / Q = 200 – 9Q Long run Cost Function 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. Long- run is a composed of series of short-run. So Long-run curves are composed of short-run curves Derivation of LAC from SAC: In every short-run Total cost curve there is one short-run average cost curve i.e. SAC1 , SAC2 , SAC3 every SAC has its minimum point the LAC curve are derived from the SAC curves by joining the minimum point, or diminishing point or increasing point, depending upon STCs. The relation between LTC & LAC is at the initial stage, LTC increases at diminishing rate and later it increases at an increasing rate. So the LAC in first instances it declines then it increases 39 At the initial short-run average cost SAC1, the firm produces OQ1 units of output at the 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 at least 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. Economies of scale  Commercial economies: Bulk buying of materials through long-term contracts.  Managerial economies: Increasing the specialization of managers.  Financial economies: Obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial.  Marketing economies: Spreading the cost of advertising over a greater range of output in media markets.  Technological economies: Taking advantage of returns to scale in the production function. Each of these factors reduces the long run average costs (LRAC) of production by shifting the short - run average total cost (SRATC) curve down and to the right. Economies of scale are also derived partially from learning by doing. Economies of scale is a practical concept that is important for explaining real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to fail". The exploitation of economies of scale helps explain why companies grow large in some industries. Economies of scale also play a role in a "natural monopoly." Long-run average total cost increases as output increases. While economies of scale are more likely at low levels of output, diseconomies of scale are more likely at higher output levels. In Figure, you can see that the firm does not experience diseconomies of scale until its output reaches more than 185 units. 40 Economies of Scope Economies of scope is a term that refers to the reduction of per-unit costs through the production of a wider variety of goods or services. Economies of scope are cost advantages that result when firms provide a variety of products rather than specializing in the production or delivery of a single product or service. Economies of scope also exist if a firm can produce a given level of output of each product line more cheaply than a combination of separate firms, each producing a single product at the given output level. Economies of scope can arise from the sharing or joint utilization of inputs and lead to reductions in unit costs. Scope economies are frequently documented in the business literature and have been found to exist in sectors like healthcare, banking, publishing, distribution, and telecommunications. Economies of Scope (S) = [C(qa) + C(qb) – C(qa + qb)] / C(qa + qb)  C(qa) is the cost of producing quantity qa of good a separately  C(qb) is the cost of producing quantity qb of good b separately  C(qa+qb) is the cost of producing quantities qa and qb  S is the percentage cost saving when the goods are produced together. Therefore, S would be greater than 0 when economies of scope exist. Example of Economies of Scope For example, a restaurant produces both burgers and sandwiches. The cost of separately producing 10,000 burgers is Rs. 20 each. Likewise, if 40,000 sandwiches are produced separately, the cost is $10 each. If 10,000 burgers and 40,000 sandwiches are produced together (by using the same preparation and storage facility), the total cost is $1,500,000. To determine the economies of scope: 1. Determine C(qa) = 10,000 * 20 = $200,000 2. Determine C(qb) = 40,000 * 10 = $400,000 3. Determine C(qa+qb) = $500,000 4. Plug the numbers into the Economies of Scope formula ($200,000 + $400,000 – $500,000) / $500,000 = 20%. Therefore, the cost of producing burgers and sandwiches together is 20% less than the cost of producing them separately. How to Achieve Economies of Scope? 1. Flexible Manufacturing 41 If multiple products can be produced using the same manufacturing systems and inputs. For example, using the same preparation and storage facilities when making hamburgers and fries as opposed to separate facilities. 2. Related Diversification If a company is able to use its operational expertise, resources, and capabilities across their organization. For example, hiring designers and marketers who can use their skills across different product lines allows for the production of a wide range of products. 3. Mergers If a company is able to share research and development expenses to reduce costs and diversify its product portfolio or knowledge. For example, pharmaceutical companies combining their research and development expenses to create new products. Economies of Scope vs. Economies of Scale Economies of scope are often confused with economies of scale. The former refers to the decrease in the average total cost of production when there is an increasing variety of goods produced. On the other hand, economies of scale refer to the cost savings achieved from increasing the scale of production of the same goods. Economies of scope: Savings in cost due to the increased production of distinct products using the same operations. Economies of scope reduce the average cost of producing multiple products. Economies of scale: Savings in cost due to the increased production of the same product. Economies of scale reduce the average cost of producing one product. Concept of Revenue: The term revenue refers to the income obtained by a firm through the sale of goods at different prices. In other words, the revenue of a firm is its sales, receipts or income. The revenue concepts are concerned with Total Revenue, Average Revenue and Marginal Revenue. Total Revenue: The income earned by a seller or producer after selling the output is called the total revenue. In fact, total revenue is the multiple of price and output. The behavior of total revenue depends on the market where the firm produces or sells. Total revenue at any output is equal to price per unit multiplied by quantity sold. 42 2. Average Revenue: Average revenue refers to the revenue obtained by the seller by selling the per unit commodity. It is obtained by dividing the total revenue by total output. “The average revenue curve shows that the price of the firm’s product is the same at each level of output.” Stonier and Hague 3. Marginal Revenue: Marginal revenue is the net revenue obtained by selling an additional unit of the commodity. “Marginal revenue is the change in total revenue which results from the sale of one more or one less unit of output.” Ferguson. Thus, marginal revenue is the addition made to the total revenue by selling one more unit of the good. In algebraic terms, marginal revenue is the net addition to the total revenue by selling n units of a commodity instead of n – 1. Therefore, 43 A. Koutsoyiannis, “The marginal revenue is the change in total revenue resulting from selling an additional unit of the commodity.” If total revenue from (n) units is 110 and from (n – 1) units is 100. in that case MRnth = TRn – TRn _ 1 = 110 – 100 MRnth = 10 MR in mathematical terms is the ratio of change in total revenue to change in output MR = ∆TR/∆q or dR/dq = MR The relation of total revenue, average revenue and marginal revenue can be explained with the help of table and fig. Table Representation: The relationship between TR, AR and MR can be expressed with the help of a table 1. From the table 1 we can draw the idea that as the price falls from Rs. 10 to Re. 1, the output sold increases from 1 to 10. Total revenue increases from 10 to 30, at 5 units. However, at 6th unit it becomes constant and ultimately starts falling at next unit i.e. 7th. In the same way, when AR falls, MR falls more and becomes zero at 6th unit and then negative. Therefore, it is clear that when AR falls, MR also falls more than that of AR: TR increases initially at a diminishing rate, it reaches maximum and then starts falling. 44 In fig. 1 three concepts of revenue have been explained. The units of output have been shown on horizontal axis while revenue on vertical axis. Here TR, AR, MR are total revenue, average revenue and marginal revenue curves respectively. In figure 1 (A), a total revenue curve is sloping upward from the origin to point K. From point K to K’ total revenue is constant. But at point K’ total revenue is maximum and begins to fall. It means even by selling more units total revenue is falling. In such a situation, marginal revenue becomes negative. Similarly, in the figur