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between Total Revenue (TR) and Total Cost (TC). = TR TC Given this objective, the business options which a firm faces would relate to: increasing TR or decreasing TC or both i.e. some combination of TR & TC.
To understand the implications of profit maximization, let us begin by assuming unchanging TC. This restriction translates into a situation where increase in profits leads to increase in TR. = TR TC
= TR, where TR = (P xQ )
How can TR increase? By definition TR is P x Q. If we
assume that Prices (P) are unchanging then increases in Q will lead to increases in TR. In other words, if the demand for a product (Q) increases then TR also rises (under the above assumptions).
This
depends on how a firm is able to influence consumers to buy more of its product (X) i.e. Qx.
washing machines increased significantly in most Indian metros over the last ten years. Why did this happen? Even while the prices of washing machines have reduced significantly there have been other changes as well. With more working women and the associated
difficulties in the availability of domestic help, there has been an inherent rise in the demand for household appliances.
Compare this situation with the demand for Vaccumizer which was launched in the 1990s. The product was based on a novel idea wherein freshness is maintained through vaccumising.
This
concept did not pick up in India. Why? With easy access to Kirana
stores that have a high turnover and availability of fresh fruits & vegetables at the doorstep, the perceived consumer utility for the product would not be high. Therefore, it is not surprising that this product was not successful in the Indian market.
The above examples indicate that at the firm level, Qx implies: Identification of what consumers want Understanding what factors determine consumers demand decisions.
1.2
Understanding Consumers demand curve For an individual consumer, utility perception is the first step for the buying decision. To understand how a consumer takes a decision to buy a product consider a situation where a person is very hungry. To satisfy his hunger, the person has to decide on what products to consume and how much?
Why apples? He likes apples. This would mean demand for a product exists when a consumer perceives utility generally defined as tastes and preferences Utility is defined at an individual consumer level and is multi-dimensional. For example, a person who drinks tea for its flavour would demand tea leaves. But the person who looks for convenience would demand tea bags. In this case, the utility dimension in former case is taste while in the latter case it is convenience.
Lets say he decides to eat apples. How many apples will he decide to eat and What is the basis for this decision? Suppose the utility derived for consuming apples is assigned a
number where an increase in the number implies utility is increasing and a decrease would men that utility is decreasing. The following table presents the utilitiy derived from apples. Consumption of Apples Number of Apples 0 1 2 3 4 5 6 7 (TU) Total Utility (Cumulative) 0 30 55 75 90 100 100 90 MU 0 30 25 20 15 10 0 -10
We observe that upto 5 apples, the utility (in this case, satiating hunger) is increasing. At the 6th apple, the utility derived is constant and thereafter it
declines. Given this relationship between consuming apples and utility, how does a consumer decide how much to consume? For this, we need to see the incremental utility derived by successive units of apples of consumed. This is defined as Marginal utility (MU) MU TU (i.e change in TU (Total utility) due to one unit change in Q quantity consumed)
Why should a consumer not consume the 7th apple? The consumer experiences disutility as is reflected in negative MU.
In the above example, MU in the highest for the first apple and declines for the successive units, reaches zero for the 6th unit and thereafter turn negative based on the law of diminishing marginal utility. This implies that as long as MU is positive (or TU is would tend to consume more of that product.
consumer is to maximize TU, consumption will be stopped when TU is maximum or MU = 0 (i.e. at the 6th apple). Extending this framework to consumer choice i.e. How does a consumer decide when faced with a number of consumption alternatives? Suppose instead of apples, the consumer has the choice of two fruits, namely, apples and oranges. Given the TU and MU of apples and oranges (i.e. defined by tastes of individual consumers) as in the table below, how will the consumer decide?
Number Consumed 1 2 3 4 5 6 7 Apples (Rs 5) TUA MUA 30 55 75 90 100 100 90 30 25 20 15 10 0 -10 MUA PA 6 5 4 3 2 Oranges (Rs 10) MUO Number TUO Consumed 1 40 40 2 75 35 3 100 25 4 115 15 5 125 10 6 125 0 7 115 -10 MUo PO 4 3.5 2.5 1.5 1
The differences in TU values reflects the differences in preferences for the fruits. From the above, it is evident that the consumer likes oranges more than apples. For understanding consumer choice under a set of constraints assume that the consumer faces a constraint of 5
Can a business firm influence these consumption decisions? Yes, if through advertisement or any other method a firm enhances utility perceptions of a consumer, demand or consumption of that product will rise.
fruits. In other words, consumer choice has to maximize utility given the restriction of consuming 5 fruits. As such incremental utility (or MU) for successive units of apples and oranges need to be compared. Based on MU, the consumers choice of fruits will be as follows: 1st orange, 2nd orange, 1st apple, 2nd apple and 3rd orange. If the constraint is relaxed to 8 fruits, then 3rd and 4th apples and 4th orange will also be consumed. 1.3 Deriving the demand curve (Price & Quantity relationship) Suppose apples are priced at Rs 5 per piece and oranges at Rs 10 per piece, and the budget for the purchase of fruits is Rs 20. How does this change the earlier choice of fruits?
When the MU for successive units of apples and oranges are compared to their respective prices, the choice of fruits for consumption is not same as indicated earlier. For example, assume the income
Suppose price of apples increase to Rs 10 per piece and that of oranges to Rs 5 per piece, how would the choice of fruit undergo a change
(or budget of a consumer is Rs. 20). Given a budget of Rs 20, two apples and one orange would be bought by the consumer. Thus, in the absence of prices, consumer choice is based on MU of individual products. With prices
included, the choice will be determined by the comparison of MU relative to respective prices.
Assuming unchanging tastes (or unchanging MU schedules), a price reduction of product X will lead to an increase in the value of the ratio
thereby increasing the demand for Product X relative to other products. Following from this, we have Qx = f MUx . When Px MU x MUX is constant, then Px will lead to Qx and as such the ratio Px MUx Px increases. And, the converse holds true for an increase in price. Hence, Qx = f (Px, T ). This is the demand curve for product X. The changes in quantity demanded due to changes in prices would vary between products depending on consumers tastes and preferences.
1.4
consumers budget increases from Rs 20 to 35 and the relative prices are unchanging. What would be the implications on the demand for Apples and Oranges? Instead of 2 apples and 1 orange, the consumer would now demand 3 apples and 2 oranges. In other words, changes in incomes, influences the demand for
products. The extent of change in demand for a product would depend on the nature of the product.
By definition, if income increases and the demand for product X increases, we call these products normal or superior goods. Alternatively, when demand for products decrease with increase in income, we call these products inferior goods.
QX : demand for scooter (in 000) I : Average Income (Rs 000 per month) At the market level, as income increases from 10 to 25; demand for scooters decreases from 40 to 29. Hence, scooters are defined as inferior good. Note: there may be some consumer in the market for whom demand increases as income increases.
1.5
Given a budget of Rs 25, 3 oranges and 2 apples will be purchased by the consumer. In other words, when relative prices change or prices of other products (PY) relative to product X change, the demand for X or (QX) will change. On the basis of the direction of influence of PY on QX, we broadly categorize the products into Substitute and Complementary goods. For example,
(i)
Assume that if Maruti reduces the price of Zen (Pz), the demand for Santro (Qs) decreases. Pz QZ Qs
Here, Zen and Santro are substitute goods and the sign of coefficient PY on QX will be positive (+). (ii) Assume that if prices of tyres (Pt) rise, and the demand for scooters (Qs) decreases. Pt Qt Qt Qs
Pt
Qst
Here, Pt and Qs are negatively related. Thus, tyres and scooters are Complementary goods.
1.6
Qx = f (Px, I, Py, T ).
changes in the above demand factors would lead to a change in Qx. The direction of
change would depend on whether the individual demand factors have a positive (move in the same direction) or negative (move in the opposite direction) impact.
From the above discussion on demand factors, Px is Endogenous and I and Py are Exogenous factors. Px is Endogenous because the firm can induce a change in the variable.
For example, when a firm is a late extrant into a market, a firm has the option to price its product below its competitors and change the same according to
its strategies. Thus, changes in Px are induced by the firm in accordance to its strategic objectives. As against this, the firm cannot influence the changes in I and Py. Thus, a firm reacts to the changes in exogenous variables. For
example, when a competitor decides to reduce the price, a firm can only respond to this change rather than influence the competitors decision (unless both firms are colluding).