DHARMENDRA MISHRA

INTRODUCTION TO MANAGERIAL ECONOMICS

NATURE OF MANAGERAL ECONOMICS MANAGERIAL Economics and Business

economics are the two terms, which, at times have been used interchangeably. Of late,
however, the term Managerial Economics has become more popular and seems to
displace progressively the term Business Economics.
Decision-making and Forward Planning
The prime function of a management executive in a business organization is
decision-making and forward planning. Decision-making means the process of selecting
one action from two or more alternative courses of action whereas forward planning
means establishing plans for the future. The question of choice arises because resources
such as capital, land, labour and management are limited and can be employed in
alternative uses. The decision-making function thus becomes one of making choices or
decisions that will provide the most efficient means of attaining a desired end, say, profit
maximization. Once decision is made about the particular goal to be achieved, plans as to
production, pricing, capital, raw materials, labour, etc., are prepared. Forward planning
thus goes hand in hand with decision-making.
A significant characteristic of the conditions, in which business organizations
work and take decisions, is uncertainty. And this fact of uncertainty not only makes the
function of decision-making and forward planning complicated but adds a different
dimension to it. If knowledge of the future were perfect, plans could be formulated
without error and hence without any need for subsequent revision. In the real world,
however, the business manager rarely has complete information and the estimates about
future predicted as best as possible. As plans are implemented over time, more facts
become known so that in their light, plans may have to be revised, and a different course
of action adopted. Managers are thus engaged in a continuous process of decision-making
through an uncertain future and the overall problem confronting them is one of adjusting
to uncertainty.
In fulfilling the function of decision-making in an uncertainty framework,
economic theory can be pressed into service with considerable advantage. Economic
theory deals with a number of concepts and principles relating, for example, to profit,
demand, cost, pricing production, competition, business cycles, national income, etc.,
which aided by allied disciplines like Accounting. Statistics and Mathematics can be used
to solve or at least throw some light upon the problems of business management. The
way economic analysis can be used towards solving business problems. Constitutes the
subject-matte of Managerial Economics.
Definition:
According to McNair and Meriam, Managerial Economics consists of the use of
economic modes of thought to analyse business situation Spencer and Siegelman have
defined Managerial Economics as “the integration of economic theory with business
practice for the purpose of facilitating decision-making and forward planning by
management”. We may, therefore define Managerial Economics as the discipline which
deals with the application of economic theory to business management. Managerial

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Economics thus lies on the borderline between economics and business management and
serves as abridge between economics and business management and serves as a bridge
between the two disciplines. (See Chart 1)
Chart 1 – Economics, Business Management and Managerial Economics.

Economics Business
-Theory and Management
Methodology -Decision Problems

Managerial
Economics
-Application of Economics to

solving business problems

Optimal solutions
To business problems

Aspects of Application
The application of economics to business management or the integration of
economic theory with business practice, as Spencer and Siegelman have put it, has the
following aspects:
1. Reconciling traditional theoretical concepts of economics in relation to the actual
business behavior and conditions. In economic theory, the technique of analysis is
one of model building whereby certain assumptions are made and on that basis,
conclusions as to the behavior of the firms are drown. The assumptions, however,
make the theory of the firm unrealistic since it fails to provide a satisfactory
explanation of that what the firms actually do. Hence the need to reconcile the
theoretical principles based on simplified assumptions with actual business
practice and develops appropriate extensions and reformulation of economic
theory, if necessary.
2. Estimating economic relationships, viz., measurement of various types of
elasticities of demand such as price elasticity, income elasticity, cross-elasticity,

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promotional elasticity, cost-output relationships, etc. the estimates of these

economic relation-ships are to be used for purposes of forecasting.
3. Predicting relevant economic quantities, eg., profit, demand, production, costs,
pricing, capital, etc., in numerical terms together with their probabilities. As the
business manager has to work in an environment of uncertainty, future is to be
predicted so that in the light of the predicted estimates, decision-making and
forward planning may be possible.
4. Using economic quantities in decision-making and forward planning, that is,
formulating business policies and, on that basis, establishing business plans for
the future pertaining to profit, prices, costs, capital, etc. The nature of economic
forecasting is such that it indicates the degree of probability of various possible
outcomes, i.e. losses or gains as a result of following each one of the strategies
available. Hence, before a business manager there exists a quantified picture
indicating the number o courses open, their possible outcomes and the quantified
probability of each outcome. Keeping this picture in view, he decides about the
strategy to be chosen.
5. Understanding significant external forces constituting the environment in which
the business is operating and to which it must adjust, e.g., business cycles,
fluctuations in national income and government policies pertaining to public
finance, fiscal policy and taxation, international economics and foreign trade,
monetary economics, labour relations, anti-monopoly measures, industrial
licensing, price controls, etc. The business manager has to appraise the relevance
and impact of these external forces in relation to the particular business unit and
its business policies.

Chief Characteristics
It would be useful to point out certain chief characteristics of Managerial
Economics, inasmuch it’s they throw further light on the nature of the subject matter and
help in a clearer understanding thereof.
1 Managerial Economics micro-economic in character.
2 Managerial Economics largely uses that body of economic concepts and principles,
which is known as ‘Theory of the firm’ or ‘Economics of the firm’. In addition, it also
seeks to apply Profit Theory, which forms part of Distribution Theories in Economics.
3 Managerial Economics is pragmatic. It avoids difficult abstract issues of economic
theory but involves complications ignored in economic theory to face the overall situation
in which decisions are made. Economic theory appropriately ignores the variety of
backgrounds and training found in individual firms but Managerial Economics considers
the particular environment of decision-making.
4 Managerial Economics belongs to normative economics rather than positive
economics (also sometimes known as descriptive economics). In other words, it is
prescriptive rather than descriptive. The main body of economic theory confines itself to
descriptive hypothesis, attempting to generalize about the relations among different

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variables without judgment about what is desirable or undesirable. For instance, the law
of demand states that as price increases. Demand goes down or vice-versa but this
statement does not tell whether the outcome is good or bad. Managerial Economics,
however, is concerned with what decisions ought to be made and hence involves value
judgments.
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, curves and function, law of
supply and its limitations. Elasticity of supply and Factors influencing supply.

Pricing Decisions, Policies and Practices

Pricing is a very important area of Managerial Economics. In fact, price is the
ness of the revenue of a firm and as such the success of a business firm largely depends
on the correctness of the pries decisions taken by it. The important aspects alt with under
this area is: Price Determination in various Market Forms, Pricing methods, Differential
Pricing, Product-line Pricing and Price Forecasting.

Profit Management
Business firms are generally organized for the purpose of making profits and, in
long run, profits provide the chief measure of success. In this connection, an important
point worth considering is the element of uncertainty exiting about profits because of
variations in costs and revenues which, in turn, are caused by torso both internal and
external to the firm. If knowledge about the future were fact, profit analysis would have
been a very easy task. However, in a world of certainty, expectations are not always
realized so that profit planning and measurement constitute the difficult are
Of Managerial Economics. The important acts covered under this area are: Nature and
Measurement of Profit. Profit iciest and Techniques of Profit Planning like Break-Even
Analysis.
Capital Management
Of the various types and classes of business problems, the most complex and able
some for the business manager are likely to be those relating to the firm’s investments.
Relatively large sums are involved, and the problems are so complex that their disposal
not only requires considerable time and labour but is a term for top-level decision.
Briefly, capital management implies planning and trolls of capital expenditure. The main
topics dealt with are: Cost of Capital. Rate return and Selection of Project.
The various aspects outlined above represent the major uncertainties which a ness
firm has to reckon with, viz., demand uncertainty, cost uncertainty, price certainty, profit

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uncertainty, and capital uncertainty. We can, therefore, conclude the subject-matter of

Managerial Economic consists of applying economic cripples and concepts towards
adjusting with various uncertainties faced by a ness firm.

MANAGERIAL ECONOMICS AND OTHER SUBJECTS

Yet another useful method of throwing light upon the nature and scope of
managerial Economics is to examine is relationship with other subjects. In this
connection, Economics, statistics, Mathematics and Accounting deserve special mention.

Managerial Economics and Economics

Managerial Economics has been described as economics applied to decision-
making. It may be viewed as a special branch of economics bridging the gulf between
pure economic theory and managerial practice.
Economics has two main divisions: microeconomics and macroeconomics.
Microeconomics has been defined as that branch where the unit of study is an individual
or a firm. Macroeconomics, on the other hand, is aggregate in character and has the entire
economy as a unit of study.
Microeconomics, also known as price theory (or Marshallian economics.) Is the
main source of concepts and analytical tools for managerial economics. To illustrate
various micro-economic concepts such as elasticity of demand, marginal cost, the short
and the long runs, various market forms, etc. are all of great significance to managerial
economics. The chief contribution of macro-economics is in the area of forecasting. The
modern theory of income and employment has direct implications for forecasting general
business conditions. As the prospects of an individual firm often depend greatly on
general business conditions, individual firm forecasts depend on general business
forecasts.
A survey in the U.K. has shown that business economists have found the
following economic concepts quite useful and of frequent application:
1. Price elasticity of demand
2. Income elasticity of demand
3. Opportunity cost
4. The multiplier
5. Propensity to consume
6. Marginal revenue product
7. Speculative motive
8. Production function
9. Balanced growth
10. Liquidity preference.

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Business economics have also found the following main areas of economi9cs as
useful in their work
1. Demand theory
2. Theory of the firm-price, output and investment decisions
3. Business financing
4. Public finance and fiscal policy
5. Money and banking
6. National income and social accounting
7. Theory of international trade
8. Economics of developing countries.
Managerial Economics and Accounting
Managerial Economics is also closely related to accounting, which is concerned
with recording the financial operations of a business firm. Indeed, accounting information
is one of the principal sources of data required by a managerial economist for his
decision-making purpose. For instance, the profit and loss statement of a firm tells how
well the firm has done and the information it contains can be used by managerial
economist to throw significant light on the future course of action-whether it should
improve or close down. Of course, accounting data call for careful interpretation.
Recasting and adjustment before they can be used safely and effectively.
It is in this context that the growing link between management accounting and
managerial economics deserves special mention. The main task of management
accounting is now seen as being to provide the sort of data which managers need if they
are to apply the ideas of managerial economics to solve business problems correctly; the
accounting data are also to be provided in a form so as to fit easily into the concepts and
analysis of managerial economics.

USES OF MANAGERIAL ECONOMICS

Managerial economics accomplishes several objectives. First, it presents those
aspects of traditional economics, which are relevant for business decision making it real
life. For the purpose, it culls from economic theory the concepts, principles and
techniques of analysis which have a bearing on the decision making process. These are, if
necessary, adapted or modified with a view to enable the manager take better decisions.
Thus, managerial economics accomplishes the objective of building suitable tool kit from
traditional economics.
Secondly, it also incorporates useful ideas from other disciplines such a
psychology, sociology, etc., if they are found relevant for decision making. In face
managerial economics takes the aid of other academic disciplines having a bearing upon
the business decisions of a manager in view of the carious explicit and implicit
constraints subject to which resource allocation is to be optimized.

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Thirdly, managerial economics helps in reaching a variety of business decisions.

(i) What products and services should be produced?
(ii) What inputs and production techniques should be used?
(iii) How much output should be produced and at what prices it should be sold?
(iv) What are the best sizes and locations of new plants?
(v) How should the available capital be allocated?

Fourthly, managerial economics makes a manager a more competent model

guilder. Thus he can capture the essential relationships which characterize a situation
while leaving out the cluttering details and peripheral relationships.
Fifthly, at the level of the firm, where for various functional areas functional
specialists or functional departments exist, e.g., finance, marketing, personal production,
etc., managerial economics serves as an integrating agent by co-coordinating the different
areas and bringing to bear on the decisions of each department or specialist the
implications pertaining to other functional areas. It thus enables business decision-
making not in watertight compartments but in an integrated perspective, the significance
of which lies in the fact that the functional departments or specialists often enjoy
considerable autonomy and achieve conflicting coals.
Finally, managerial economics takes cognizance of the interaction between the
firm and society and accomplishes the key role of business as an agent in the attainment
of social and economic welfare. It has come to be realized that business part from its
obligations to shareholders has certain social obligations. Managerial economics focuses
attention on these social obligations as constraints subject to which business decisions are
to be taken. In so doing, it serves as an instrument in rehiring the economic welfare of the
society through socially oriented business decisions.

MANAGERIAL ECONOMIST ROLE AND RESPONSIBILITIES

A managerial economist can play a very important role by assisting the
Management in using the increasingly specialized skills and sophisticated techniques
which are required to solve the difficult problems of successful decision-making and
forward planning. That is why, in business concerns, his importance is being growingly
recognized. In advanced countries like the U.S.A., large companies employ one or more
economists. In our country too, big industrial houses have come to recognize the need for
managerial economists, and there are frequent advertisements for such positions. Tatas,
DCM and Hindustan Lever employ economists. Indian Petrochemicals Corporation Ltd.,
a Government of India undertaking, also keeps an economist.
Let us examine in specific terms how a managerial economist can contribute to
decision-making in business. In this connection, two important questions need be
considered:

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1. What role does he play in business, that is, what particular management problems
lend themselves to solution through economic analysis?
2. How can the managerial economist best serve management, that is, what are the
responsibilities of a successful managerial economist?

ROLE OF A MANAGERIAL ECONOMIST

One of the principal objectives of any management in its decision-making process
is to determine the key factors which will influence the business over the period ahead. In
general, these factors can be divided into two-category (i) external and (ii) internal. The
external factors lie outside the control management because they are external to the firm
and are said to constitute business environment. The internal factors he within the scope
and operations of a firm and hence within the control of management, and they are
known as business operations.
To illustrate, a business firm is free to take decisions about what to invest, where
to invest, how much labour to employ and what to pay for it, how to price its products
and so on but all these decisions are taken within the framework of a particular business
environment and the firm’s degree of freedom depends on such factors as the
government’s economic policy, the actions of its competitors and the like.
Environmental Studies
An analysis and forecast of external factors constituting general business
conditions, e.g., prices, national income and output, volume of trade, etc., are of great
significance since every business from is affected by them. Certain important relevant
questions in this connection are as follows:
1. What is the outlook for the national economy? What are the most important local,
regional or worldwide economic trends? What phase of the business cycle lies
immediately ahead?
2. What about population shifts and the resultant ups and downs in regional
purchasing power?
3. What are the demands prospects in new as well as established markets? Will
changes in social behavior and fashions tend to expand or limit the sales of a
company’s products, or possibly make the products obsolete?
4. Where are the market and customer opportunities likely to expand or contract
most rapidly?
5. Will overseas markets expand or contract, and how will new foreign government
legislation’s affect operation of the overseas plants?
6. Will the availability and cost of credit tend to increase or decrease buying? Are
money or credit conditions ahead likely to be easy or tight?
7. What the prices of raw materials and finished products are likely to be?
8. Is competition likely to increase or decrease?

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9. What are the main components of the five-year plan? What are the areas where
outlays have been increased? What are the segments, which have suffered a cut in
their outlay?
10. What is the outlook regarding government’s economic policies and regulations?
What about changes in defense expenditure, tax rates, tariffs and import
restrictions?
11. Will Reserve Bank’s decisions stimulate or depress industrial production and
consumer spending? How will these decisions affect the company’s cost, credit,
sales and profits?
Reasonably accurate answers to these and similar questions can
Enable management’s to chalk out more wisely the scope and direction of their own
business plans and to determine the timing of their specific actions. And it is these
questions which present some of the areas where a managerial economist can make
effective contribution.
The managerial economist has not only to study the economic trends at the
macro-level but must also interpret their relevance to the particular industry/firm where
he works. He has to digest the ever-growing economic literature and advise top
management by means of short, business-like practical notes.
In a mixed economy like India, the managerial economist pragmatically interprets
the intentions of controls and evaluates their impact. He acts as a bridge between the
government and the industry, translating the government’s intentions and transmitting the
reactions of the industry. In fact, government policies charge out of the performance of
industry, the expectations of the people and political expediency.
Business Operations
A managerial economist can also be helpful to the management in making
decisions relating to the internal operations of a firm in respect of such problems as price,
rate of operations, investment, expansion or contraction. Certain relevant questions in this
context would be as follows:

1. What will be a reasonable sales and profit budget for the next year?
2. What will be the most appropriate production Schedules and inventory policies
for the next six months?
3. What changes in wage and price policies should be made now?
4. How much cash will be available next month and how should it be invested?
Specific Functions
A further idea of the role managerial economists can play, can be had from the
following specific functions performed by them as revealed by a survey pertaining to
Britain conducted by K.J.W. Alexander and Alexander G. Kemp:
1. Sales forecasting

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2. Industrial market research.

3. Economic analysis of competing companies.
4. Pricing problems of industry.
5. Capital projects.
6. Production programs.
7. Security/investment analysis and forecasts.
8. Advice on trade and public relations.
9. Advice on primary commodities.
10. Advice on foreign exchange.
11. Economic analysis of agriculture.
12. Analysis of underdeveloped economics.
13. Environmental forecasting.
The managerial economist has to gather economic data, analyze all pertinent
information about the business environment and prepare position papers on issues facing
the firm and the industry. In the case of industries prone to rapid technological advances,
he may have to make a continuous assessment of the impact of changing technology. He
may have to evaluate the capital budget in the light of short and long-range financial,
profit and market potentialities. Very often, he may have to prepare speeches for the
corporate executives.
It is thus clear that in practice managerial economists perform many and varied
functions. However, of these, marketing functions, i.e., sales forecasting and industrial
market research, has been the most important. For this purpose, they may compile
statistical records of the sales performance of their own business and those relating to
their rivals, carry our analysis of these records and report on trends in demand, their
market shares, and the relative efficiency of their retail outlets. Thus while carrying out
their functions; they may have to undertake detailed statistical analysis. There are, of
course, differences in the relative importance of the various functions performed from
firm to firm and in the degree of sophistication of the methods used in carrying them out.
But there is no doubt that the job of a managerial economist requires alertness and the
ability to work under pressure.

Economic Intelligence
Besides these functions involving sophisticated analysis, managerial economist
may also provide general intelligence service supplying management with economic
information of general interest such as competitors prices and products, tax rates, tariff
rates, etc. In fact, a good deal of published material is already available and it would be
useful for a firm to have someone who understands it. The managerial economist can do
the job with competence.
Participating in Public Debates

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May well-known business economists participate in public debates. Their advice

and views are being sought by the government and society alike. Their practical
experience in business and industry ads stature to their views. Their public recognition
enhances their stature in the organization itself.
Indian Context
In the Indian context, a managerial economist is expected to perform the
following functions:
1. Macro-forecasting for demand and supply.
2. Production planning at macro and micro levels.
3. Capacity planning and product-mix determination.
4. Economics of various productions lines.
5. Economic feasibility of new production lines/processes and projects.
6. Assistance in preparation of overall development plans.
7. Preparation of periodical economic reports bearing on various matters such as the
company’s product-lines, future growth opportunities, market pricing situation,
general business, and various national/international factors affecting industry and
business.
8. Preparing briefs, speeches, articles and papers for top management for various
Chambers, Committees, Seminars, Conferences, etc.
9. Keeping management informed o various national and international developments
on economic/industrial matters.
With the adoption of the New Economic Policy, the macro-economic \
Environment is changing fast at a pace that has been rarely witnessed before. And these
changes have tremendous implications for business. The managerial economist has to
play a much more significant role. He has to constantly gauge the possibilities of
translating the rapidly changing economic scenario into viable business opportunities. As
India marches towards globalization, he will have to interpret the global economic events
and find out how his firm can avail itself of the carious export opportunities or of
establishing plants abroad either wholly owned or in association with local partners.
RESPONSIBILITIES OF A MANAGERIAL ECONOMIST
Having examined the significant opportunities before a managerial economist to
contribute to managerial decision-making, let us next examine how he can best serve the
management. For this, he must thoroughly recognize his responsibilities and obligations.
A managerial economist can serve management best only if he always keeps in
mind the main objective of his business, viz., to make a profit on its invested capital. His
academic training and the critical comments from people outside the business may lead a
managerial economist to adopt an apologetic or defensive attitude towards profits. Once
management notices this, his effectiveness is almost sure to be lost. In fact, he cannot
expect to succeed in serving management unless he has a strong personal conviction that

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profits are essential and that his chief obligation is to help enhance the ability of the firm
to make profits.
Most management decisions necessarily concern the future, which is rather
uncertain. It is, therefore, absolutely essential that a managerial economist recognizes his
responsibility to make successful forecasts. By making best possible forecasts and
through constant efforts to improve upon them, he should aim at minimizing, if not
completely eliminating, the risks involved in uncertainties, so that the management can
follow a more orderly course of business planning. At times, he will have to reassure the
management that an important trend will continue; in other cases, he may have to point
out the probabilities of a turning point in some activity of importance to management. In
any case, he must be willing to make considered but fairly positive statements about
impending economic developments, based upon the best possible information and
analysis and stake his reputation upon his judgment. Nothing will build management
confidence in a managerial economist more quickly and thoroughly than a record of
successful forecasts, well documented in advance and modestly evaluated when the
actual results become available.
A few corollaries to the above proposition need also be emphasized here.
First, he has a major responsibility to alert ‘management at the earliest possible
moment in case he discovers an error in his forecast. By promptly drawing attention to
changes in forecasting conditions, he will not only assist management in making
appropriate adjustment in policies and programs but will also be able to strengthen his
own position as a member of the management team by keeping his fingers on the
economic pulse of the business.
Secondly, he must establish and maintain many contacts with individuals and data
sources, which would not be immediately available to the other members of the
management. Extensive familiarity with reference sources and material is essential, but it
is still more important that he knows individuals who are specialists in particular fields
having a bearing on his work. For this purpose, he should join professional associations
and take active part in them. In fact, one of the best means of determining the caliber of a
managerial economist is to evaluate his ability to obtain information quickly by personal
contacts rather than by lengthy research from either readily available or obscure reference
sources. Within any business, there may be a wealth of knowledge and experience but the
managerial economist would be really useful if he can supplement the existing know-how
with additional information and in the quickest possible manner.
Again, if a managerial economist is to be really helpful to the management in
successful decision-making and forward planning, he must be able to earn full status on
the business team. He should be ready and even offer himself to take up special
assignments, be that in study teams, committees or special projects. For, a managerial
economist can only function effectively in an atmosphere where his success or failure can
be traced not only to his basic ability, training and experience, but also to his personality
and capacity to win continuing support for himself and his professional ideas. Of course,
he should be able to express himself clearly and simply and must always try to minimize
the use of technical terminology in communicating with his management executives. For,
it is well known that hat management does not understand, it will almost automatically

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reject. Further, while intellectually he must be in tune with industry’s thinking the wider
national perspective should not be absents from his advice to top management.

Question Bank

1 Define managerial economics with definition

2 How does managerial economics differ from economics?
3 Write a short note on managerial economist
4 Explain the scope of managerial economics

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Demand
Demand
In economic terminology the term demand conveys a wider and definite meaning than in
the ordinary usage. Ordinarily demand means a desire, whereas in economic sense it is
something more than a mere desire. It is interpreted as a want backed up by the-
purchasing power”. Further demand is per unit of time such as per day, per week etc.
moreover it is meaningless to mention demand without reference to price. Considering all
these aspects the term demand can be defined in the following words,
“Demand for anything means the quantity of that commodity, which is bought, at a given
price, per unit of time.”

Law of Demand
This law explains the functional relationship between price of a commodity and the
quantity demanded of the same. It is observed that the price and the demand are
inversely related which means that the two move in the opposite direction. An
increase in the price leads to a fall in the demand and vice versa. This relationship can
be stated as
“Other things being equal, the demand for a commodity varies inversely as the price”
OR
“The demand for a commodity at a given price is more than what it would be
at a higher price and less than what it would be at a lower price”

Demand Schedule and Demand Curve

These are the two devices to present the law. The demand schedule is a schedule
or a table which contains various possible prices of a commodity and different
quantities demanded at them. It can be an individual demand schedule
representing the demand of an individual consumer or can be the market demand
schedule showing the total demand of all the consumers taken together, this is
indicated in the following table.

Price per Individual Demand Schedule (Quantity in liter Market Demand

Liter in Demand by Different Individuals) (Daily Demand) Schedule
Rs. (Daily Demand
24 1.00 0.75 0.50 0.00 75
22 1.25 1.00 0.75 0.50 100
20 1.5 1.25 1.00 0.75 125
18 1.75 1.5 1.25 1.00 150

It can be observed that with a fall in price every individual consumer buys a larger
quantity than before as a result of which the total market demand also rises. In
case of an increase in price the situation will be reserved. Thus the demand
schedule reveals the inverse price-demand relationship, i.e. the law of demand.

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Demand Curve
It is a geometrical device to express the inverse price-demand relationship, i.e. the law of
demand. A demand curve can be obtained by plotting a demand schedule on a graph and
joining the points so obtained, like the demand schedule we can derive an individual
demand curve as well as a market demand curve. The former shows the demand curve of
an individual buyer while the latter shows the sum total of all the individual curves i.e. a
market or a total demand curve. The following diagram shows the two types of demand
curves.

In the above diagram, figure A shows an individual demand curve-of the consumer A in
the above schedule-while figure B indicates the total market demand. It can be noticed
that both the curves are negatively sloping or downwards sloping from left to right. Such
a curve shows the inverse relationship between the two variables. In this case the two
variable are price on Y axis and the quantity demanded on X axis. It may be noted that at
a higher price OP the quantity demanded is OM while at a lower price say OP, the
quantity demanded rises to OM thus a demand curve diagrammatically explains the law
of demand.
Assumptions of Law
The law of demand in order to establish the price-demand relationship makes a number of
assumptions as follows:
Income of the consumer is given and constant.
No change in tastes, preference, habits etc.
Constancy of the price of other goods.
No change in the size and composition of population.
These Assumptions are expressed in the phrase “other things remaining equal”.

Exceptions of the Law

In case of major bulk of the commodities the validity of the law is experienced.
However there are certain situations and commodities which do not follow the law.
These are termed as the exceptions to the law; these can be expressed as follows.

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(1) Continuous changes in the price lead to the exceptional behavior. If the price shows
a rising trend a buyer is likely to buy more at a high price for protecting himself against a
further rise. As against it when the price starts falling continuously, a consumer buys less
at a low price and awaits a further in price.

(2) Giffens’s Paradox describes a peculiar experience in case of inferior goods. When
the price of an inferior commodity declines, the consumer, instead of purchasing more,
buys less of that commodity and switches on to a superior commodity. Hence the
exception.

(3) Conspicuous Consumption refers to the consumption of those commodities which

are bought as a matter of prestige. Naturally with a fall in the price of such goods, there is
no distinction in buying the same. As a result the demand declines with a fall in the price
of such prestige goods.

(4) Ignorance Effect implies a situation in which a consumer buys more of a commodity
at a higher price only due to ignorance.
In the exceptional situations quoted above, the demand curve becomes an upwards rising
one as shown in the alongside diagram.
In the alongside figure, the demand curve is positively sloping one due to which more is
demanded at a high price and less at a low price.

Determinants of Demand

The law of demand, while explaining the price-demand relationship assumes other factors
to be constant. In reality however, these factors such as income, population, tastes, habits,
preferences etc., do not remain constant and keep on affecting the demand. As a result the
demand changes i.e. rises or falls, without any change in price.

(1) Income: The relationship between income and the demand is a direct one. It means
the demand changes in the same direction as the income. An increase in income leads to
rise in demand and vice versa.

(2) Population: The size of population also affects the demand. The relationship is a
direct one. The higher the size of population, the higher is the demand and vice versa.

(3) Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and preference etc.
of the consumer have a profound effect on the demand for a commodity. If a consumers
dislikes a commodity, he will not buy it despite a fall in price. On the other hand a very
high price also may not stop him from buying a good if he likes it very much.

(4) Other Prices: This is another important determinant of demand for a commodity. The
effects depends upon the relationship between the commodities in question. If the price of
a complimentary commodity rises, the demand for the commodity in reference falls. E.g.
the demand for petrol will decline due to rise in the price of cars and the consequent
decline in their demand. Opposite effect will be experienced incase of substitutes.

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(5) Advertisement: This factor has gained tremendous importance in the modern days.
When a product is aggressively advertised through all the possible media, the consumers
buy the advertised commodity even at a high price and many times even if they don’t
need it.

(6) Fashions: Hardly anyone has the courage and the desire to go against the prevailing
fashions as well as social customs and the traditions. This factor has a great impact on the
demand.

(7) Imitation: This tendency is commonly experienced everywhere. This is known as the
demonstration effects, due to which the low income groups imitate the consumption
patterns of the rich ones. This operates even at international levels when the poor
countries try to copy the consumption patterns of rich countries.

Changes in Demand

The law of demand explains the effect of only-one factor viz., price, on the demand for a
commodity, under the assumption of constancy of other determinants. In practice, other
factors such as, income, population etc. cause the rise or fall in demand without any
change in the price. These effects are different from the law of demand. They are termed
as changes in demand in contrast to variations in demand which occur due to changes in
the price of a commodity. In economic theory a distinction is made between (a) variations
i.e. extension and contraction in demand due to price and (b) Changes i.e. increase and
decrease in demand due to other factors.
(a) Variations in demand refer to those which occur due to changes in the price of a
commodity.

These are two types.

(1) Extension of Demand: This refers to rise in demand due to a fall in price of the
commodity. It is shown by a downwards movement on a given demand curve.
(2) Contraction of Demand: This means fall in demand due to increase in price and can
be shown by an upwards movement on a given demand curve.

(b) Changes in demand imply the rise and fall due to factors other than price. It means
they occur without any change in price. They are of two types.
(1) Increase in Demand: This refers to higher demand at the same price and results from
rise in income, population etc., this is shown on a new demand curve lying above the
original one.
(2) Decrease in demand: It means less quantity demanded at the same price. This is the
result of factors like fall in income, population etc. this is shown on a new demand lying
below the original one.

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Fig (A) Extension/Contraction of Demand

Fig (B) Increase/Decrease in Demand

In figure A, the original price is OP and the Quantity demanded is OQ. With a rise in
price from OP to Op1 the demand contracts from OQ to Oq1 and as a result of fall in
price from OP to OP2, the demand extends from OQ to OQ2.
In figure, B an increase in demand is shown by a new demand curve, D1 while the
decrease in demand is expressed by the new demand curve D2, lying above and below
the original demand curve D respectively. On D1 more is demand (OQ1) at the same
price while on D2 less is demanded (OQ2) at the same price OP.

Elasticity of Demand

The law of demand explains the functional relationship between price and demand. In
fact, the demand for a commodity depends not only on the price of a commodity but
also on other factors such as income, population, tastes and preferences of the
consumer. The law of demand assumes these factors to be constant and states the
inverse price-demand relationship. Barring certain exceptions, the inverse price-
demand relationship holds good in case of the goods that are bought and sold in the
market.
The law of demand explains the direction of a change as it states that with a rise in
price the demand contracts and with a fall in price it expands. However, it fails to
explain the extent or magnitude of a change in demand with a given change in price.
In other words, the law of demand merely shows the direction in which the demand
changes as a result of a change in price, but does not throw any light on the amount
by which the demand will change in response to a given change in price. Thus, the
law of demand explains the qualitative but not the quantitative aspect of price-
demand relationship.
Although it is true that demand responds to change in price of a commodity, such
response varies from commodity to commodity. Some commodities are more
responsive or sensitive to change in price while some others are less. The concept of

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the elasticity of demand has great significance as it explains the degree of

responsiveness of demand to a change in price. It thus elaborates the price-demand
relationship. The elasticity of demand thus means the sensitiveness or responsiveness
of demand to a change in price.
According to Marshall, “the elasticity (or responsiveness) of demand in a market
is great or small accordingly as the demand changes (rises or falls) much or little
for a given change (rise or fall) in price.”
From the above discussion, it will be clear that thought different commodities react to
a change in price in the same direction; the degree of their response differs. Demand
for some commodities is more sensitive or responsive to a change in price, while it is
less responsive for some others. Elasticity of demand is a measure of relative changes
in the amount demanded in response to a small change in price. Certain goods are
said to have an elastic demand while others have an inelastic demand. The demand is
said to be elastic when a small change in price brings about considerable change in
demand. On the other hand, the demand for a good is said to be inelastic when a
change in price fails to bring about significant change in demand.
The concept of elasticity can be expressed in the form of an equation as:

Ep = Percentage change in quantity demanded/Percentage change in the price

Types of Price Elasticity

The concept of price elasticity reveals that the degree of responsiveness of demand to
the change in price differs from commodity to commodity. Demand for some
commodities is more elastic while that for certain others is less elastic. Using the
formula of elasticity, it possible to mention following different types of price
elasticity:
(1) Perfectly inelastic demand (ep = o).
(2) Inelastic (less elastic) demand (e< 1)
(3) Unitary elasticity (e = 1).
(4) Elastic (more elastic) demand (e> 1).
(5) Perfectly elastic demand (e = x)
(1) Perfectly Inelastic Demand (ep = o).
This describes a situation in which demand shows no response to a change in price. In
other words, whatever be the price the quantity demanded remains the same. It can be
depicted by means of the alongside diagram.
The vertical straight line demand curve as shown alongside reveals that with a change in
price (from OP to Op1) the demand remains same at OQ. Thus, demand does not at all
respond to a change in price. Thus ep = O. Hence, perfectly inelastic demand. Fig a
(2) Inelastic (less elastic) Demand (e < 1):
In this case the proportionate change in demand is smaller than in price. The
alongside figure shows this type.

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In the alongside figure percentage change in demand is smaller than that in price. It
means the demand is relatively c less responsive to the change in price. This is referred to
as an inelastic demand. Fig e
(3) Unitary Elasticity (e = 1):
When the percentage change in price produces equivalent percentage change in demand,
we have a case of unit elasticity. The rectangular hyperbola as shown in the figure
demonstrates this type of elasticity. In this case percentage change in demand is equal to
percentage change in price, hence e = 1. Fig c

(4) Elastic Demand (e> > 1):

In case of certain commodities the demand is relatively more responsive to the change in
price. It means a small change in price induces a significant change in, demand. This can
be understood by means of the alongside figure.
It can be noticed that in the above example the percentage change in demand is greater
than that in price. Hence, the elastic demand (e>1) Fig d

(5) Perfectly Elastic Demand (e = x):

This is experienced when the demand is extremely sensitive to the changes in price. In
this case an insignificant change in price produces tremendous change in demand. The
demand curve showing perfectly elastic demand is a horizontal straight line. Fig b

It can be noticed that at a given price an infinite quantity is demanded. A small change in
price produces infinite change in demand. A perfectly competitive firm faces this type of
demand.
From the above analysis it can be concluded that theoretically five different types of price
elasticity can be mentioned. In practice, however two extreme cases i.e. perfectly elastic
and perfectly inelastic demand, are rarely experienced. What we really have is more
elastic (e 1) or less elastic (e 1 ) demand. The unitary elasticity is a dividing line between
these two cases.

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Determinants of Elasticity

The nature of demand for a commodity, i.e. whether the demand is elastic or inelastic
depends upon many factors. Though it is difficult to state precisely the nature of demand
for a particular commodity, it is possible to classify the commodities under broad
categories and make certain generalizations regarding whether the demand for
commodities belonging to a certain group is elastic or inelastic.
(1) Nature of the Commodity: Humans wants, i.e. the commodities satisfying them can
be classified broadly into necessaries on the one hand and comforts and luxuries on the
other hand. The nature of demand for a commodity depends upon this classification. The
demand for necessities is inelastic and for comforts and luxuries it is elastic.
(2) Number of Substitutes Available: The availability of substitutes is a major
determinant of the elasticity of demand.
The large the number of substitutes, the higher is the elastic. It means if a commodity
has many substitutes, the demand will be elastic. As against this in the absence of
substitutes, the demand becomes relatively inelastic because the consumers have no other
alternative but to buy the same product irrespective of whether the price rises or falls.
(3) Number Of Uses: If a commodity can be put to a variety of uses, the demand will be
more elastic. When the price of such commodity rises, its consumption will be restricted
only to more important uses and when the price falls the consumption may be extended to
less urgent uses, e.g. coal electricity, water etc.

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(4) Possibility of Postponement of Consumption: This factor also greatly influences the
nature of demand for a commodity. If the consumption of a commodity can be postponed,
the demand will be elastic.
(5) Range of prices: The demand for very low-priced as well as very high-price
commodity is generally inelastic. When the price is very high, the commodity is
consumed only by the rich people. A rise or fall in the price will not have significant effect
in the demand. Similarly, when the price is so low that the commodity can be brought by all those who
wish to buy, a change, i.e., a rise or fall in the price, will hardly have any effect on the demand.
(6) Proportion of Income Spent: Income of the consumer significantly influences the
nature of demand. If only a small fraction of income is being spent on a particular
commodity, say newspaper, the demand will tend to be inelastic.
(7) According to Taussig, unequal distribution of income and wealth makes the demand
in general, elastic.
(8) In addition, it is observed that demand for durable goods, is usually elastic.
(9) The nature of demand for a commodity is also influenced by the complementarities
of goods.
From the above analysis of the determinants of elasticity of demand, it is clear that no
precise conclusion about the nature of demand for any specific commodity can be drawn.
It depends upon the range of price, and the psychology of the consumers. The conclusion
regarding the nature of demand should, therefore be restricted to small changes in prices
during short period. By doing so, the influence of changes in habits, tastes, likes customs
etc., can be ignored.

Measurement of Elasticity

For practical purposes, it is essential to measure the exact elasticity of demand. By

measuring the elasticity we can know the extent to which the demand is elastic or
inelastic. Different methods are used for measuring the elasticity of demand.

(1) Percentage Method: In this method, the percentage change in demand and
percentage change in price are compared.
ep = Percentage change in demand / Percentage change in price
In this method, three values of ‘ep’ can be obtained. Viz., ep = 1, ep >1, ep <1.
(a) If 5% change in price leads to exactly 5% change in demand, i.e. percentage change in
demand is equal to percentage change in price , e = 1, it is a case of unit elasticity .
(b) If percentage change in demand is greater than percentage change in price, e> 1, it
means the demand is elastic.
(c) If percentage change in demand is less than that in price, e 1, meaning thereby the
demand is inelastic.

(2) Total Outlay Method: The elasticity of demand can be measured by considering the
changes in price and the consequent changes in demand causing changes in the total
amount spent on the goods. The change in price changes the demand for a commodity
which in turn changes the total expenditure of the consumer or total revenue of the seller.

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(a) If a given change in price fails to bring about any change in the total outlay, it is the
case of unit elasticity. It means if the total revenue (price x Quantity bought) remains the
same in spite of a change in price, ‘ep’ is said to be equal to 1.
(b) If price and total revenue are inversely related, i.e., if total revenue falls with rise in
price or rises with fall in price, demand is said to be elastic or e 1.
(c) When price and total revenue are directly related, i.e. if total revenue rises with a rise
in price and falls with a fall in price, the demand is said to be inelastic pr e <1.

(3) Point Method: Another suggested by Marshall is to measure elasticity at a point on a

straight line. This method can be better understood with the help of a diagram as given
below:
In the Fig. DD1 is a straight line demand curve meeting the two axes at D and D1. A is
any point on the demand curve at which the elasticity is to be measured. The formula for
measuring the same at a point say ‘A’ is-
ep = Lower segment of the demand curve AD1/ Upper segment of the demand
curve =AD
It will be observed from Fig. that at different points on the demand curve the elasticity
will be different.
Thus, at mid-point e=1, above the mid-point e I and below the I-point e<1. at a point
where the curve intersects X axis, e = o and point at which it meets Y axis, e =

Income Elasticity of Demand

The discussion of price elasticity of demand reveals that extent of change in demand as a
result of change in price. However, as already explained, price is not the only determinant
of demand. Demand for a commodity changes in response to a change in income of the
consumer. In fact, income effect is a constituent of the price effect. The income effect
suggests the effect of change in income on demand. The income elasticity of demand
explains the extent of change in demand as a result of change in income. In other words,
income elasticity of demand means the responsiveness of demand to changes in income.
Thus, income elasticity of demand can be expressed as:

EY =Percentage change in demand /Percentage change in income

The following types of income elasticity can be observed:
(1) Income Elasticity of Demand Greater than One: When the percentage change
in demand is greater than the percentage change in income, a greater portion of
income is being spent on a commodity with an increase in income- income elasticity
is said to be greater than one.
(2) Income Elasticity is unitary: When the proportion of income spent on a
commodity remains the same or when the percentage change in income is equal to the
percentage change in demand, EY = 1 or the income elasticity is unitary.
(3) Income Elasticity Less Than One (EY< < 1): This occurs when the percentage
change in demand is less than the percentage change in income.

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(4) Zero Income Elasticity of Demand (EY=o): This is the case when change in
income of the consumer does not bring about any change in the demand for a
commodity.
(5) Negative Income Elasticity of Demand (EY< < o): It is well known that income
effect for most of the commodities is positive. But in case of inferior goods, the
income effect beyond a certain level of income becomes negative. This implies that as
the income increases the consumer, instead of buying more of a commodity, buys less
and switches on to a superior commodity. The income elasticity of demand in such
cases will be negative.
Cross Elasticity of Demand

While discussing the determinants of demand for a commodity, we have observed that
demand for a commodity depends not only on the price of that commodity but also on the
prices of other related goods. Thus, the demand for a commodity X depends not only on
the price of X but also on the prices of other commodities Y, Z….N etc. The concept of
cross elasticity explains the degree of change in demand for X as, a result of change in
price of Y. this can be expressed as-

EC =Percentage Change in demand for X / Percentage change in price of Y

The relationship between any two goods is of two types. The goods X and Y can be
complementary goods (such as pen and ink) or substitutes (such as pen and ball pen). In
case of complementary commodities, the cross elasticity will be negative. This means
that fall in price of X (pen) leads to rise in its demand so also rise in t) demand for Y
(ink) On the other hand, the cross elasticity for substitutes is positive which means a fall
in price of X (pen) results in rise in demand for X and fall in demand for Y (ball pen). If
two commodities, say X and Y, are unrelated there will be no change i. Demand for X as
a result of change in price of Y. Cross elasticity in cad of such unrelated goods will then
be zero.
In short, cross elasticity will be of three types:
(1) Negative cross elasticity – Complementary commodities.
(2) Positive cross elasticity – Substitutes.
(3) Zero cross elasticity – Unrelated goods.
Importance of elasticity

The concept of elasticity is of great importance both in economic theory and in practice.

(1) Theoretically, its importance lies in the fact that it deeply analyses the price-demand
relationship. The law of demand merely explains the qualitative relationship while the
concept of elasticity of demand analyses the quantitative price-demand relationship.
(2) The Pricing policy of the producer is greatly influenced by the nature of demand for
his product. If the demand is inelastic, he will be benefited by charging a high price. If on
the other hand, the demand is elastic, low price will be advantageous to the producer. The
concept of elasticity helps the monopolist while practicing the price discrimination.

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(3) The price of joint products can be fixed on the basis of elasticity of demand. In case
of such joint products, such as wool and mutton, cotton and cotton seeds, separate costs
of production are not known. High price is charged for a product having inelastic demand
(say cotton) and low price for its joint product having elastic demand (say cotton seeds.)
(4) The concept of elasticity of demand is helpful to the Government in fixing the prices
of public utilities.
(5) The Elasticity of demand is important not only in pricing the commodities but also in
fixing the price of labour viz., wages.
(6) The concept of elasticity of demand is useful to Government in formulation of
economic policy in various fields such as taxation, international trade etc.
(a) The concept of elasticity of demand guides the finance minister in imposing the
commodity taxes. He should tax such commodities which have inelastic demand so that
the Government can raise handsome revenue.
(b) The concept of elasticity of demand helps the Government in formulating commercial
policy. Protection and subsidy is granted to the industries which face an elastic demand.
(7) The concept of elasticity of demand is very important in the field international trade.
It helps in solving some of the problems of international trade such as gains from trade,
balance of payments etc. policy of tariff also depends upon the nature of demand for a
commodity.
In nutshell, it can be concluded that the concept of elasticity of demand has great
significance in economic analysis. Its usefulness in branches of economic such as
production, distribution, public finance, international trade etc., has been widely
accepted.

Question bank

1. Write a short note on

(i) Law of demand
2 Explain briefly how the demand for a commodity is affected by changes in
price. In come, price of substitute, advertisement ad population.
3 Define price elasticity of demand ad distinguish between its various types.
Discuss the role of price elasticity of demand in business decision
4 Define elasticity of demand .explain with diagrams the cases where the
absolutely value of elasticity is (i) zero (ii) infinity (iii) one (iv) less than one
(v) more than one

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Supply
The term “Supply” is one of the important terms in economic. It implies various
amounts or quantities of a good offered for sale at various prices. Mayers has defined
this term in the following words:
“We may define ‘supply’ as a schedule of the amount of a good that would be offered for
sale at all possible prices at any one instant of time, or during any one period of time, for
example, a day, a week and so on, in which the conditions of supply remain the same.”
Analysis of the above definition implies that:
(i) It is a schedule of the amount of a good which is offered for sale at all possible
prices.
(ii) The amount of a good is offered for sale at a given time, which may be a day, a
week, a month and so on.
(iii) During the given period of time, the conditions of supply remain unchanged.
(iv) The supplier is able and willing to supply the good at a given price.
Thus, supply implies the willingness and ability on the part of a person (supplier) to
sell a good in different quantities at a certain price and time.

Distinction between Stock and Supply

In ordinary languages the two terms viz., stock and supply are used interchangeably.
However, strictly in economic sense the two terms convey different meaning. The
distinction between the two can be explained as follows:
(1) Stock is a reservoir while supply is a flow.
(2) At any time Stock is bigger than supply because supply represents only a part of
total stock.
(3) Supply refers to the actual Quantity offered for sale at the prevailing price while
stock means the potential supply.
(4) Supply is more elastic than stock.

Law of Supply
Supply, like demand, is a function of price. It means a change in price brings about a
change in supply. The law of supply explains the functional relationship between price
and supply. The law is stated in the following words:
“In a given market at any given time, the quantity of any goods which people are ready to
offer for sale generally varies directly with the price.”
If this statement of law of supply is analyzed, it will show that:
(i) Price and supply vary or change in the same direction. This means that if price of a
good rises, its supply will increase and if its price falls, supply thereof will contact.
(ii) The supply position holds good at a particular time. This means that a particular
quantity of a good will be offered at a certain price at a particular point of time.
This law may also be stated in the following words: “Other things remaining the same, as
the price of a commodity rises, its supply is extended and as the price falls its supply is
contracted.”

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Supply Schedule and Supply Curve:

The law of supply can be explained by means of a supply schedule and a supply curve.
Supply Schedule: It is a table or schedule that shows different quantities of a commodity
that are offered for sale at a particular time. Supply schedule can be (i) individual supply
schedule, (ii) Market supply schedule. The former relates to the quantity that an
individual firm or producer or supplier is willing and able to offer for sale at different
prices.
The market supply refers to the sum total of the quantities of a commodity offered for
sale by different individual suppliers at different prices per unit of time. The following
schedule makes the point clear:
Price per kg S1 S2 S3 S4 Total market
supply
2.00 20 35 40 500
3.00 30 45 50 700
4.00 40 50 55 1000
5.00 45 55 60 1200
6.00 50 60 65 1500

In the above schedule supply of different individual firms is shown as S1, S2, S3, etc.
likewise there can be many other supplier in the market. The last column shows the
market supply which is obtained by summing up the individual supplies of different firms
at different prices.
It can be noticed that the reaction of an individual supplier to the change in price is
similar. It implies that as the price rises every individual seller offers a larger quantity for
sale. Since the market supply is nothing but the sum total of the individual supplies, it is
obvious that it changes in the same direction. Hence as the price rises the supply
increases. Thus, the supply schedules explain the direct relationship between price and
quantity supplied.
Supply Curve: Supply curve is a geometrical device to express the price-supply
relationship. Such curves can be obtained for every firm separately as well as for the
entire market. Accordingly, we get individual supply curve as also the market supply
curve.
Supply curve is thus, a graphical presentation of the law of supply. If the points in the
above schedule are plotted and the positions so obtained are joined we get a supply curve
as shown in the following diagrams:

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In the above diagrams price is measured along the vertical Y axis while the quantity
supplied is measured along the horizontal ‘X’ axis. Different positions showing price and
the corresponding quantity supplied are joined to get the supply curve.
S1, S2, S3 are the three individual supply curves while the last figure shows the market
supply (SM). It can be observed that as the price rises more is supplied. Hence the supply
curve is rising upwards to the right or positively sloping. Such curve indicates price
supply relationship.
The law of supply, which states that price and supply are directly related, can thus be
expressed by means of supply schedule and supply curve.

Explanation of the law

Individual Supply: An individual firm is interested in securing maximum profits from

its supply. Obviously, at a certain price it will supply the quantity at which the profits are

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maximum. In order to derive the profits an individual seller has to take into account the
cost of production and compare the same with price to calculate his profits.
Generally, it is observed that as the production and supply increase the per unit cost
goes on increasing. Naturally, a firm will not be able and willing to supply more
quantity unless the price is higher. In other words, higher price offers an inducement
to firm for offering larger quantity. thus, more will be supplied at a high price and less
at a low price. Hence, the direct relationship.
Moreover, every commodity has a reservation price which means the minimum price
expected by the producer. If the actual price is less than the reservation price no supply
will be forthcoming. As the price rises more will be supplied.
Market Supply: As mentioned earlier market supply is the sum total of individual
supply. Naturally, it will behave in the same way as the individual supply in response to
change in price.
Expansion of Market Supply occurs at a high price, because
(i) The Existing suppliers supply larger quantity.
(ii) New suppliers enter the market.
Contraction of market supply occurs due to
(i) Reduction in supply by some firms,
(ii) Exit from the market of certain other firms who cannot supply any quantity at the new
low price.
Thus, both the individual as well as the market supply change in the same direction as the
price.
Determinants of Supply

The law of supply explains the functional relationship between price and supply. Price,
though important, is not the only determinant of supply. There are many factors along
with price which cause changes in supply.
(i) Price: A change in price of a given good may bring about a change in the supply
position. If price rises, generally, supply will increase and vice versa.
(ii) Production cost: If production-cost changes, the supply; position may also change. If
cost of production rises, production may be curtailed and hence, the supply may be
reduced and if the cost of production declines, the situation will be just opposite.
(iii) Factors of production: If the price of factors of production changes, there would be
change in the volume of production and with that there would be a change in the supply
position.
(iv) Transport facilities etc. It means if communications and transport are improved,
supply can be increased. If these means are not adequate, efficient or economical, the
supply may decrease.
(v) Future trends in prices: if future trends in prices indicate the possibility of rise in the
price, the present supply will decrease and vice versa.
(vi) Nature factors: If weather conditions are favorable, supply will increase and in case
of unfavorable weather conditions, the same will decrease, similarly, if natural calamities
occur, the supply will be reduced.
(vii) Abnormal circumstances: It may be pointed out that if some abnormal
circumstances, like war etc. develop, the supply position may change. During the war

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time supply may be reduced. But if hostilities are over, there can be increase in the
supply.

(viii) Monetary policy of the Government: Lastly, it may be pointed out that the monetary
policy of the Government may also change the supply position. If liberal monetary policy
is adopted by the Government, it is possible that production may increase and as such, the
supply may also increase. If however, the Government adopts tight monetary policy,
opposite may happen.

Increase/Decrease and Extension/Contraction of Supply

(a) Extension and Contraction of Supply: The law of supply expresses the functional
relationship between price and supply and states that the two are directly related. The
variations in supply i.e. rise or fall in it, brought about due to changes in the price are
called extension and contraction of supply respectively. Thus, Extension of supply
means higher quantity supplied at a high price while Contraction of supply refers to fall
in supply due to a fall in the price of a commodity. Such changes can be shown by means
of the following
In the alongside diagram price of good is measured along Y axis while quantity supplied
along ‘X’ axis. Originally, at price ‘OP’ the quantity supplied is OQ.

(1) As the price rises to ‘OP1’ the. Supply rises to ‘OQ1’ thus ‘QQ1’ is the extension of
supply.

(2) As the price falls to ‘OP2’ the supply falls to ‘OQ2’. QQ2’ therefore, shows
contraction of supply.

(b) Increase/Decrease in Supply: The law of supply expresses the changes in supply
due to changes in the price of a commodity. It assumes other factors to be constant. In

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reality the supply changes without any change in the price. This happens due to various
factors other than price.
These factors are:
(1) Rise or fall in the cost.
(2) Change in the prices of factors of production.
(3) Change in the techniques of production etc.
All these factors bring about rise or fall in the supply of a commodity. Such change,
i.e. rise or fall in supply due to effect of other factors, are termed as increase and
decrease in supply respectively.
(1) Increase in supply means more quantity supplied at the same price.
(2) Decrease in supply means less quantity supplied at the same price.
Increase and decrease in supply can be shown by means of the following diagram:
Alongside diagram shows three supply curves ‘S1’ S1’ and ‘S2’. Let us assume that
‘S’ is the original supply curve. On this supply curve ‘OQ’ quantity is supplied at
price ‘OP’.
(1) ‘S1’ shows increase in the supply. On this curve, the price remains same i.e. OP but
quantity supplied rises to OQ1. QQ1’ is thus increase in supply.
(2) ‘S2’ shows decrease in supply. On this curve, at the same price ‘OP’ the quantity
supplied is ‘OQ2’. QQ2’ is thus, decrease in supply.
It can, thus, be seen that new supply curves have to be drawn to show increase and
decrease in supply. An increase in supply can be shown by means of a new supply curve
(S1) which lies to the right of the original one, while the new supply curve (S2) which
lies to the left of original curve (S) shows decrease in supply.

Elasticity of Supply
The supply, like the demand, is a function of price. The law of supply expresses the price
supply relationship. It is usually observed that the price and supply are directly related,
which means that more is supplied at a high price and less at a low price. The elasticity of
supply means, the responsiveness of the supply of a commodity to the changes in price. It

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may be noticed that though most of the commodities follow the law of supply, the degree
of response varies from commodity to commodity. Some commodities are more
responsive to a change in price, while certain others are less responsive. Accordingly, we
come across commodities having more elastic supply and those having less elastic
supply. The elasticity of supply can be expressed in the form of a formula as follows:
Es= Percentage change in supply / percentage change in price

= Change in ‘S’ / Original ‘S’ / Change in ‘P’ / Original ‘P’

Various types of elasticity of supply can be mentioned:

(a) If the supply does not at all change, i.e. remains constant, whatever be the
change in price, we have a case of perfectly inelastic supply. This means, the
elasticity of supply is zero. This can be shown by means of a vertical straight line
supply curve as in figure a.
(b) Certain commodities may have perfectly or infinitely elastic supply, which
means that the supply is fully sensitive to even a smallest possible change in
price. This can be represented with the help of a horizontal straight line supply
curve as in figure b.
(c) When the percentage change in supply is the same, as the percentage change
in demand a case of unit elasticity is experienced. In this case, “e” = 1. The case
of unitary elasticity is shown in figure c.
(d) When the percentage change in supply is greater than that of the price, the
elasticity of supply is greater than one. This is the case of elastic supply. This is
shown in figure d.
(e) The supply is said to be inelastic or less elastic when the proportionate change
in supply is lesser than that in the price. In this case, “e” is less than 1. This is
represented in diagram e.

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Measurement of Elasticity of Supply

The elasticity of supply, at a point on a supply curve, can be measured by drawing a tangent to the
curve at the point. This can be better understood with help of a diagram.
In the alongside diagram, SS is the supply curve and the elasticity of supply is to be
measured at any point, say ‘A’ on this curve. A tangent to supply curve is drawn at point
‘A’ to meet the ‘X’ axis at point the perpendicular drawn from point ‘A’ meets ‘X’ axis
at ‘M’. the elasticity at point ‘A’ is measured as:
Es = NM / OM

(1) If the tangent drawn to supply curve passes through the origin. “(o)” the elasticity is
equal to one, i.e. a case of unit elasticity.
(2) If the tangent cuts ‘Y’ axis, ‘e’ is greater than 1.
(3) If the tangent meets the ‘X’ axis to the right of origin, i.e. elasticity is less than 1.

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Determinants of Elasticity

The elasticity of supply depends upon a variety of factors.

(i) The time element: The most important factor, influencing the elasticity of
supply, is the time at the disposal of a firm to adjust the supply to the changes in
prices. During the short period, the supply is more or less inelastic. In case of the
perishable goods, the supply during very short period or market period is perfectly
inelastic. During the short period, the supply can be slightly adjusted to the
changes in price and hence, it becomes fairly elastic. During long period, the full
adjustments in the supply can be made and hence, the supply becomes much more
elastic. In short, the longer the period, the more elastic is the supply.
(ii) The elasticity of supply also depends on the possibilities of changes in the
production techniques. If the techniques of production are improved, the supply
will be fairly elastic. If the techniques are rigid and cannot be changed, the supply
will become inelastic or less elastic.
(iii) The degree of elasticity of supply also depends on the extent to which the
fixed factors are being utilized. If the fixed factors are intensively utilized.
There is very little scope for expanding the supply, in response to the changes in
price and hence, the supply is elastic. If , however, the fixed factor is not much
utilized, more can be produced and supplied, which makes the supply fairly
elastic.
(iv) The elasticity of supply also depends on the Availability of the variable
inputs. If such factors are abundantly available, the production and supply can be
easily adjusted to the changes in price, as a result of which, the supply will be
fairly elastic. However, if the factors are not available, there will be much rigidity
in the supply, making the supply inelastic.
(v) The elasticity of supply is, to a great extent, influenced by the cost of
attracting the productive resources. The higher the cost of attracting the resources
lower will be the elasticity. The lower the cost of attracting the resources, the
higher will be the degree of elasticity.
(vi) In addition to the above factors, the behavior of the cost also determines the
nature of supply. If the rise in the cost is sharp and rapid, it will be difficult to
expand the supply, which means the supply will be less elastic. On the other hand,
if the cost rises gradually, the supply can be easily increased, which means it will
be elastic.
(vii) The availability of markets also determines the degree of elasticity.
Thus, it can be concluded that the elasticity of supply is the result of a variety of
factors, such as time element, utilization of fixed factors, availability of variable
inputs, nature of production technique, behavior of cost, etc.

Question bank

1. Write a short note on

(i) Law of supply

2 Explain the concept of (i) elasticity of supply (ii) cross elasticity of supply

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3 Explain the determinants of supply

4 Distinction between Stock and Supply

Market structures
What is a Market?

Introduction

The term Market is so familiar and commonly used one that it is difficult to offer a
precise definition of the same. It conveys a variety of meanings when viewed from
different angles. It is rightly pointed out that “the infinite variety of meanings involving
anywhere from two people to thousands, one dollar to a millions, is what makes a market
hard to define”.
The original of the term can be tracked back to a Latin word “Marcatus or marcart
which means to trade’. Thus the term basically implies trading i.e. buying and selling. As
mentioned above, the term market means different things to different people. It means
shopping to a housewife, while for a businessman it suggest advertising and sales
promotion for an industrialist it may mean discovery of foreign outlets for his products,
and for a farmer it stands for the sale of his products. Whatever the interpretation, it is
certain that the term is related to buying and selling activities.
In ordinary languages, the term market refers to a place i.e. a geographical location
where the buying and selling of the commodities takes place e.g. Bombay market,
Calcutta market etc. in economic sense there is relevance to a place but to a commodity.
From this angle one speaks of textile market, food grains market etc. truly what the
economic meaning of the term implies is the contact between the buyers and the
sellers. Such a contact may be direct or an indirect one. It means a market can exist even
without the buyers and sellers meeting each other. The best way to know the meaning of
the term in economic sense is to refer to the following features.
• Existence of buyers and sellers.
• Contact between buyers and sellers.
• Identical commodity.
• Existence of price.
Thus from the economic point a market implies a contact, direct or indirect, between
the buyers and sellers of an identical product for which there exists a price.

Classification of market
Markets can be viewed from different criteria such as extent or coverage, time element,
and the structure i.e. extent of competition etc. this can be explained by the following
points.

(A) Classification according to size: One simple way of classifying the markets is
to take into account their size or the area covered by a product. From this angle the

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markets can be classified as Local, National, and International etc. A local market is
said to exist when the buyers and the sellers are confined to a small area like a village. A
town etc. usually the perishable commodities such as vegetables. Flowers, fish, milk etc.
enjoy only local market. Non-perishable consumption goods like wheat, sugar, cotton etc.
have a national market. Finally certain commodities are such that their buyers and sellers
are spread over the entire world. Hence they enjoy an international or a global market.
Electronic goods, vehicles, chemicals, medicines etc. can be included in this category.
This classification is neither scientific nor rigid. With the development of the means of
communications and transport, even the perishable commodities can conquer
international market.

(B) Classification according to time: it was Alfred Marshall who introduced this
important approach. The time element the determination of price, particularly from the
supply side. The adjustability of supply depends on the availability of time. The longer
the period, the greater is the elasticity of supply. Hence in the very short period the
supply is rigid or inelastic and cannot exert any influence on the price which is dominated
by the demand. In the short period some marginal adjustments on the supply side are
possible through the changes in the employment of the variable inputs. Long period
refers to that period during which full adjustments in supply are possible. As a result,
supply, along with demand, begins to play an active role in the price determination. In the
very long period there may occur structural changes on demand as well as supply sides.
The factors affecting demand such as size and the composition of population, habits,
fashions etc. undergo fundamental changes. Similarly, there may be basic changes in the
techniques of production, quality and the quantity of inputs etc. hence during the very
period everything becomes flexible and both the sides can have full impact on the price.

(C) Structural Classification: In the context of the process of price determination

and the equilibrium of the firm this classification is of great significance. The extent of
competition is the basic of his classification. As shown in the chart above, the markets, on
the basic degree of competition, can be broadly divided into two categories viz. the
perfect market and the imperfect markets, with latter having different varieties. Perfect
competition is the most ideal, but the least practicable form of market. The imperfect
markets such as monopoly, oligopoly, monopolistic competition etc. indicate deviations
from the perfectly competitive market in different ways such as, the number of firms,
nature of product, etc. In comparison with perfect competition, the imperfect markets,
particularly oligopoly, monopolistic competition etc. have a greater empirical validity. It
is useful to get acquainted with the characteristic features of different markets forms.

Perfect Competition:

(1) Large Number Of buyer and sellers: This feature implies that an individual
producer or an individual consumer cannot have any influence on the price. This is
because the contribution of an individual either as a consumer or a producer is negligible,
just like a drop of water in the ocean. As a result of this an individual becomes only a
price taker but not a price maker.

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(2) Homogenous product: under perfectly competitive market the products of all
the firms are identical or homogenous which means there is no difference whatsoever
among them. This makes the demand for the product of an individual firm perfectly
elastic and hence the demand curve is a horizontal straight line this feature further
loosens the control of an individual firm on the price of the product. Firm cannot charge
a higher price and a firm does not charge a lower price than one that rules the market.

(3) Freedom of Entry and Exit: Perfect competition allows the existing firms to
leave the industry if they so desire. Generally the firms which suffer the losses even in
the long period are anxious to leave the industry and only the efficient ones can survive.
Similarly there are no obstacles to the entry of new firms as a result of which the
abnormal profits are eliminated from the competitive market. This feature of perfect
competition. Maximizes the welfare of the consumers.

(4) Perfect Knowledge: Another important condition of perfect competition is that

both, the consumers as well as the firms have perfect knowledge about the market
conditions, particularly about the prevailing price of the product. As a result a uniform
price rules the perfectly competitive market. No consumer pays a higher price and no
firm charges a lower one than that prevailing in the market.

(5) Absence of Transport Cost: This feature implies that the price of the
competitive product differs in different places only by the amount of transport cost.

(6) perfect Mobility: The factors of production are assumed to be fully mobile
under the conditions of perfect competition. This ensures a uniform factor reward.

Monopoly:

This form of market is diagonally opposite to perfect competition. In fact it represents

another theoretical extreme which like perfect competition, is rarely experienced in its
pure form. The chief features can be mentioned as follows:
(1) A single Firm: In contrast to infinite number of firms under perfect competition.
A monopoly market is characterized by the existence of a single producer who rules the
entire market for the said product. Naturally. The demand for the product of a monopolist
is perfectly inelastic. This enables the monopolist to charge an exorbitant price and enjoy
super normal profits permanently.

(2) Absence of Close Substitute: Another important feature of monopoly market is

that there is no close substitute available for the product of the monopolist. No doubt
there may exist remote substitute. Such an absence of close substitutes helps the
monopolist to control prices. Even if he charges a high price there is no fear of losing the
customer because there is no substitute available. In other words, the cross elasticity of
demand between the monopoly product and any other product is “zero” or very small.

(3) Barriers to Entry of New Firms: Unlike under perfect competition, monopoly
is characterized by restrictions which prevent other firms from entering the monopoly

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market. These barriers are artificial, economic, legal or institutional. The barriers are
strong enough to block completely all the potential competitors.
The above features reveal the fact that monopolist has a complete control over the
price and the output of a commodity. That he produces and sells. His price output policy
is not affected by that of the other firms. In the words of Stonier and Hague “Pure
monopoly occurs when a producer is so strong that he is able to take the whole of the
consumer’s incomes whatever the level of his output”.

Oligopoly:

The term oligopoly is derived from two Greek words, ‘Oligos’ which means a few,
and ‘Pollen’ meaning, to sell. This market form which consists of a few firms selling
either identical or a differentiated product is known by many names such as, Limited
competition, incomplete monopoly, multiple monopoly, etc. In real world a large number
of products, such as automobiles, cement, steel, electronics goods, etc. is supplied by the
oligopolistic firms.
“Oligopoly is that situation in which, a firm bases its market policy, in a part,
on the expected behavior of a few close rivals.” Stigler,
(1) Few Sellers: In contrast to perfect competition with infinite number of firms and
the monopoly with a single firm, oligopoly is characterized by the existences of a limited
number of firms. Naturally every individual firm in this type of market makes a sizeable
contribution to the total supply. As a result the price-output policy of a firm influences
and is influenced by that of other rivals. It is rightly described as ‘A competition among a
few’.
(2) Interdependence: A distinct feature of oligopoly is the existence of extreme
interdependence among the firms. There is hardly any interdependence under perfect or
monopolistic competition as a number of firms is very large. With the close substitutes
offered by the small number of rivals, the cross elasticity of demand of different products
is very high. Obviously every move of the rival firms has to be closely watched by every
other firm. The decisions to raise or lower the price or the output receives a sharp
reaction from other firms, the interdependence is so strong that every firm has to properly
predict and analyze the possible reaction of the rivals before taking any important
decision.
(3) Indeterminate Demand Curve: Under oligopoly, it is almost impossible to
precisely derive the demand curve i.e. the AR curve of a firm. The extreme
interdependence among the firms creates uncertainty about the possible response of the
rivals and of the consumers to a change in the price output policy. Nobody can derive a
precise demand schedule and a demand curve because of the unpredictable reaction of the
market. Suppose an individual firm decides to lower the price to command a larger
market share. In this case whether the firm will succeed or not depends upon the reaction
of the rivals. In case they also follow the price reduction policy, the firm in question will
hardly be in a position to expand its market share, which means no effect on the demand.
Thus the entire picture is uncertain to all the firms. An oligopolist is thus caught in a
strange situation of an indeterminate demand curve for through he knows that his
decision is bound to cause a reaction, he does not know what and how strong that
reaction will be.

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(4) Price Rigidity: This is a unique feature of oligopoly. This implies that the price
is fixed rigid or stuck-up at certain level. Thus there is no departure from the existing
price. In other words, the price neither rises nor falls from a given level but remains rigid
at that point. This is the result of quick reaction of the rivals. An individual firm will not
raise the price because of fear of losing the customers to rivals neither can it lower the
price as this decision will be immediately followed by the other firms and the firms in
question cannot reap the benefits of wider market. Thus no oligopolistic firm will either
lower or raise the price. Hence the price-rigidity. This leads to a ‘kinky demand curve.
(5) Conflicting Behavior: An element of uncertainty is witnessed even in respect of
attitude of the firms. Sometimes they adopt the attitude of co-operation so as to prevent
the fall in sales and profits. Thus there can be collusion among the firms. In contrast, on
certain occasions they pick up the fight among them especially in respect of distribution
of profits or sharing of markets. Thus there can be a situation of war or peace among the
oligopolistic firms depending upon their attitude or the behavior.
(6) A Monopoly Element: As a result of the existence of only a few firms under the
oligopoly market form, it is but natural that there prevails a strong monopoly element.
With a differentiated product, every firm enjoys a monopoly power, at least among a
small group of buyers. To a certain extent it is possible for an oligopolist to follow it own
independent price-output policy. The monopoly power is further strengthened because of
an attachment of some buyers to a particular product.
(7) Lack Of Uniformity: Finally an oligopoly market is characterized by an absence
of uniformity. The firms widely differ in respect of size. An oligopoly situation exhibits a
composition of small, medium and large sized firms. Thus it is clear that oligopoly
exhibits some unique features which distinguish it from other market forms.

Monopolistic Competition:

It was Prof. Chamberlin who introduced the concept of monopolistic competition.

He disagreed with the traditional view which regarded monopoly and perfect competition
to be mutually exclusive market forms. It means if one is present the other cannot exist.
He emphasized the fact that real market situation exhibits a simultaneous existence of
both the pure forms which are mixed up. He argues,
“Monopolistic Competition is a challenge to the traditional viewpoint of economists
that competition and monopoly are alternatives and that individual prices are to be
explained in terms or either one or the other. By contrast it is held that most economic
situations are composites of both monopoly and perfect competition.”
In practice we come across a number of small firms which produce and sell a
commodity which has its own identity and stands distinguished from other similar
products. A variety of tooth pastes, hair oils, soaps, detergents etc. are available in the
market with different brand names, though these products belong to a similar category of
the commodity. As a result each individual brand enjoys certain amount of monopoly
among a small group of buyers who are attached to that particular brand. In the wider
circle however, these products are exposed to competition to similar but not identical
brands. Thus there exists a competition among the monopolists. Hence the term
Monopolistic Competition.

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Features of Monopolistic Competition:

(1) Large Number of Seller: Like under perfect competition, there exists a sizeable
number of firms under monopolistic competitions also, due to which an individual firm
has no significant control over the market situation. However the firm under this form of
market is not as passive as that under the perfect competition. This is because the number
of firms under monopolistic competition is not as large as that under perfect competition.
Moreover, the firms produce a differentiated product which is similar but not identical. It
means the products are not perfect substitutes as under perfect competition. They are only
remote or the distant substitutes. as a result the small firms have some control or
monopoly over a part of the market which is attached to that particular product. Thus the
market undet the monopolistic competition is constituted of ‘Too Many Too Small’ firms.
(2) product Differentiation: This is most vital feature of monopolistic competition.
The individual firms trade in a product which belongs to the broad category of the
commodity being produced by the rival firms. However each individual product has its
own identity and dissimilarity in comparison with the products of other firms. This is
achieved through the practice of product differentiation. Every firm tries to impress upon
the minds of the buyers that its product is distinct from that of the others, may be in
respect of colour, quality, packing, workmanship etc. thus the individual product is
similar but not identical to that of the rival firms. In other words, The products of
different firms under monopolistic competition are only remote but not the perfect
substitutes.

(3) Selling Cost: This is yet another unique feature of monopolistic competition.
Selling cost refers to those expenses which are incurred in order to create the market or
the demand for the differentiated product of the individual firm. Such expenditure is not
necessary either under perfect competition or monopoly because under the former the
products are homogenous while under the latter i.e. monopoly there exists no close
substitutes. It is only under monopolistic competition with differentiated product that a
firm is required to create demand for the same. Selling costs can take a variety of forms
such as free sampling lucky draws, free sale, discount and above all advertisement.
Propaganda and sales promotion drives through various media such as radio, TV,
newspaper, Magazines etc. is the key to capture the new markets and to strengthen the
existing one. Popular personalities from politics, firms. Television serial. Sports etc. are
made to advertise the product to catch the attention and the demand of the consumers.
Repeated advertising has a profound impact on the psychology of the buyers which
tremendously benefits the concerned product. Selling costs have become so inevitable in
the modern highly competitive market that usually the expenditure of selling costs far
exceeds that on production cost. Selling costs have become so persuasive and aggressive
that on any occasions the buyers are made to purchase a commodity which is of hardly
any use to them.

(4) Freedom of Entry: In this respect monopolistic competition is similar to perfect

competition and opposite to monopoly. As under perfect competition, there is freedom of
entry to the new firms in the monopolistically competitive market. In other words, there
are no restrictions of any type on the entry of new firms. The only peculiarity is that

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under perfect competition the new firms have to produce the existing product, while
under monopolistic competition the new entrant has to introduce a different variety of the
concerned product.

(5) Independence: In contrast to oligopoly, there is high independence among the

firms operating under monopolistic competition. The differentiated product and the
reliance on selling costs render the firms under monopolistic to plan and execute their
own independence policy in respect of price and output. In this context the monopoly
element due to the product differentiation as also the selling costs, it is obvious that an
individual firm can have its independent price output policy without relying on other
rivals. Thus this market claims many distinct and realistic features

.
Price Determination under perfect Competition

In economic analysis there has always been a controversy as to what determines the price
of a commodity. One thing is certain that a market is dependent upon two forces viz.
demand and supply which are represented by the buyers and sellers respectively. Some
economists like Adam Smith and Ricardo attached great importance to supply and argued
that price is determined by the cost of production. Certain others though that demand is
the real determinant of price. Alfred Marshall rightly emphasized the role of both the
forces of demand and supply in the determination of price. In his words,

“We might as reasonably dispute whether it is the upper or the lower blade of a
pair of scissors that cuts a piece of paper as whether value is governed by utility or
cost of production. Neither is more or less important than the other in determining
price.”
Above statement rightly emphasizes that price is the result of both demand as well as
supply. It may happen that at any particular time demand may be active and the supply
passive. But both are essential. Stonier and Hague rightly remark, “The only really
accurate answer to the question whether it is supply or demand which determines
the price, is that it is both.”
From the above analysis it is clear that price is determined by demand and supply.
Another important aspect to be noticed is that under perfect competition, no
individual buyer or seller can determine the price. This is due to large number of buyers
and sellers with a homogeneous product. Since the contribution of our individual seller in
the total supply and of individual buyer in the total demand, is insignificant, none is able
to influence the price. It is determined by the combined action of the entire seller and the
entire buyer taken together. It means the price under competitive conditions is the
result of total demand for the total supply of the industry.
The actual formation of price for the industry as a whole can be determined by the
equality between demand and supply, finally that price rules the market at which a

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quantity demanded is equal to quantity supplied. This can be explained with the help
of following schedule and diagram.
Equilibrium Price of Footwear
Demand Price Supply
1000 100 100
800 200 300
600 300 600
300 400 800
100 500 1000

The total demand for the product (Footwear) of the industry is equal to the total
supply when the price is Rs. 300. Hence it is the price that uniformly exists in the market.
At any other price either the demand will exceed the supply or vice versa. It is shown in
the following diagram:
In the above figure, the supply curve of the industry intersects its total demand curve
at point ‘E’. hence OP (Rs. 300) is the price which will rule the market.
An important point that needs to be mentioned here is that every individual firm has
to adjust its output at the given price. An individual firm cannot fix the price but only
adjust its supply to the given price. The demand for individual firm is perfectly elastic.
This is because it has a large number of perfect substitutes. Hence the demand curve
facing an individual firm is a horizontal straight line. It means it can sell any quantity at
the ruling price. However it has no power to charge a higher price. How much it will
produce will be governed by its cost conditions. If its cost cannot be covered by the given
price it will suffer losses and will be forced to leave the industry.
The firm at a given price produces that output at which its marginal cost (MC) is
equal to marginal revenue (MR) and average revenue (AR) i.e. in the above figure an
individual firm produces ‘QQ’ output and sells it at the given price ‘OP’.

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Price Determination under Monopoly

Like any other producer the monopolist also has to consider the demand for his
product as well as the supply conditions i.e. cost conditions while determining the
price. The monopoly firm however has an advantage because there is no close
substitute for its product. Naturally the demand becomes fairly inelastic. as a result
the monopolist can charge a high price.
It must be remembered that a monopolist faces a down ward sloping demand curve.
It means if he produces and sells a small quantity he can charge a high price. But if he is
interested in selling a large quantity he can do so only at alower proce. He thus has to
make a choice between large quantity (Low price) and small quantity (high price). His

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motive obviously is the maximization of total profits. A monopolist will fix up that price
at which his profits are maximum. Once he decides upon the price he ahs to produce that
amount of output which is demanded at that price. a point to be noted is that though
monopoly producer has a firm grip over the market he cannot dictate both the price and
the output. He has to fix one and accept the other.
While fixing the price output. the monopolist has to take into account various factors
such as
• Nature of demand (elasticity) for his product.
• Substitutes available.
• Cost conditions.
Generally any product considers two things what is the cost of producing one more
unit, which is known as marginal cost (MC) and what revenue or income he gets by
selling that unit which is called marginal revenue (MR). A monopolist also follows
the same rule that he produces that quantity at which MR=MC.
Once this is decided he ahs to compare the revenue per unit i.e. average revenue
(AR) and the cost per unit i.e. average cost (AC). A monopolist follows a trial and
error method for determining the price and output. finally he sells that quantity
which fetches with maximum profit.
This is shown in the following diagram:
The equilibrium point is ‘E’ at which MR curve intersects ‘MR’ the output produced
is OQ which is sold at price OA or PQ. The are ‘APRS’ shows the total profit enjoyed
by the monopolist
Lastly one point has to be cleared. Generally it is believed that a monopolist charges
extremely high price. This is course is possible but not practicable. A monopolist has to
be careful about the following:
• Reaction of the customers – Boycotting the product.
• Reaction of factor owner – demand for higher rewards.
• Reaction for the Gov. – Control over price, nationalization etc.
• Reaction for rival – Introduction of a substitute.
Within these limits the monopolist charges such a price which enables him to get
maximum profit.

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Equilibrium under Perfect Competition

Perfect competition is a form of market in which various firms, which produce a

homogeneous commodity, constitute an industry. The existence of large number
of firms selling and identical product implies that the product of an individual firm
faces a large number of perfect substitutes in the market. As a result of two
characteristics an individual firm does not have any grip over the price of the
product. It is in this sense that a remark is passed that the firm under perfect
competition is only a price taker and not a price market. This implies that a
competitive firm has only to accept the price which is determined by the industry
as a whole. It has no capacity to alter this price in any direction. If it thinks of
raising the price, the consumers will switch on to various alternatives available in
the market and hence there will be no demand for the product of the firm which
raises the price. On the other hand, a firm will not lower the price because it
knows that any quantity it produces can be sold at the prevailing price. Hence,
the price remains fixed and given for a competitive firm. The only decision left to
an individual firm is whether to produce or not and how much to produce. For this
purpose, a firm will compare the given price i.e. AR with its cost situations. Under
the profit maximization principle, a firm will produce and sell that output which
offers it is maximum profits. Thus, equilibrium of a firm implies the fixation of
profit maximizing output. the short run considerations widely differ from the long
run ones. It may be noticed that in the short run, the firm may operate in spite of
losses but in the long run, it will never operate will losses.

Short run equilibrium:

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Short run is a period during which certain factors and costs remain fixed or constant
while certain others can be varied. The fixed cost has to be incurred even if no production
is undertaken. It means, in the short run, it is only the variable cost which is relevant from
the point of view of equilibrium output.
Since the price is given and constant, the demand curve faced by an individual firm
is horizontal straight line and the MR curve coincides with it is all levels of output. it
means for all the output that the firm produces, AR is equal to MR. In order to maximize
the profits, the firms intends to equal MR with MC. Since MR is always equal to AR i.e.
price, it follows that at equilibrium, price i.e. AR is equal to marginal cost. But this price
may be equal to, greater than or less than the average cost. Under any of these conditions,
the firm will continue to produce.
If AR>AC there are abnormal profits. If it is less than AC, there are losses to the
firm and when AR is equal to AC there are only normal profits. The equilibrium with
profits i.e. AR>AC and that with losses i.e. AR<AC is shown in the following diagrams:
In the above diagram, figure (a) shows profits while (b) losses. In figure (a) at
equilibrium output AR is greater than AC while in Figure (b) at equilibrium output “OQ”
AR is less than AC There NEPL shows the total profits in figure (a) and total losses in
figure (b). Thus in short run, firm is equilibrium at the level of output where MC is equal
to MR. At this level, there may be abnormal profits ((AR>AC) or losses (AR<AC).
The abnormal profits enjoyed by the firm during the short period attached the other
firms to enter the industry. On the other hand, the firm incurring losses during short
period, will try to leave the industry. However, neither entry nor exit is possible in the
short run. The industry, therefore, is not in equilibrium. The quality between the total
demand and total supply suggests that the industry is only in temporary or indeterminate
equilibrium.
The decision of the firm to produce if the existing price renders abnormal profits can
be easily understood. However, why should a firm continue to produce when it faces
losses i.e. when AR is less than AC. No doubt, during short period, a firm cannot leave
the industry, but can certainly stop the operation. It is observed that in spite of losses, the
firms continue to produce. Such a decision can be explained with reference to the

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distinction between fixed costs and the variable costs. Fixed costs are those costs which
have no relation with the output produced. It means such costs have to be incurred even if
the firm does not produce any output. Thus, losses to the extent of fixed costs have to be
borne by the firm. A firm, therefore, in the short run concentrates upon the variable costs.
So long as price is greater than average variable costs i.e. AVC, a firm continues to
produce. This decision by the firm reduces losses. It is an attempt to minimize the losses.
Thus. A firm under perfect competition will operate if (1) there are abnormal profits
(AR>AC), and (2) there are losses (AR<AC), but AR>AVC.
However, if the price is less than AVC, the firm will stop the production. This is
known as the close down position of a firm. In short, the short run equilibrium of a firm
indicates three possibilities namely (i) Profit maximization, (ii) Losses minimization and
(iii) close down position. All these positions are explained in the following diagram:

In the alongside diagram along with the SMC and SAC, i.e. short run marginal cost
and short run average cost respectively, AVC (average variable cost) is also shown. Now,
if the price i.e. (AR = MR) is OP, the MC intersects the MR curve at point “E” and the
equilibrium output is “OQ” at this level of output, the total cost (OLNQ) exceeds the total
revenue (OPEQ) by LPEN which means the firm faces losses. It will, even then, continue
to produce because the price “OP” covers not only AVC (QA) but a part of fixed cost
(AE). If the firm stops the production, it will have to bear the losses worth the entire
amount of fixed cost.
Since the prevailing price is covering at least a part of fixed cost, the losses by
producing some are less than by not producing at all. Thus, the firm will continue to
operate. If the prevailing price is OP1, the equilibrium will be reached at point “E1” at
which the level of output is “OQ”. At this point of output, the prevailing price “OP1” just
covers the AVC since the AR – MR curve is tangent to the AVC curve at “E1” price OP1
does not therefore, cover any portion of the fixed cost. At this point, weather the firm
produces or not does not make any difference because the loss in both the cases will be
equal to the fixed cost. Hence, the decision regarding production or otherwise is a matter
of indifference. Lastly, if the price falls below OP1 say to OP2, no rational producer will
operate because this price does not even cover the AVC. Losses by closing down can be
restricted only to the fixed cost in this case. Hence, if any price falls below OP1 the firm
will not operate.

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Thus the short run equilibrium of a competition firm exhibits all of the possibilities.
It may be earning supernormal profits (if AR>AC) only normal profits (if AR=AC) or
losses (if AR<AC).
In this diagram, at price OP there are supernormal profits, at OP1 there normal
profits and at price OP2 losses.
To conclude the discussion regarding the short run equilibrium of a competitive
firm, it may be stated at the given price a firm may be in –
(1) Profit maximization Position (if AR > AC0,
(2) Loss minimization position when (AR < AC > AVC),
(3) Shut down position (AR < AVC).

Long run equilibrium:

long run is defined as the period during which all factors are variable because of
which the firms have sufficient time at their disposal to bring about full adjustment on the
supply side. The supply in the long run can be adjusted through a change not only in
variable factors but also in fixed factors. In other words, the changes in output can be
brought about through the changes in the scale of production i.e. size of the firm. The
existing firms can expand output, by expanding the plant size. Similarly, the new firms
can also enter the market or the old firms can leave the industry, if they face losses. Thus,
full adjustments are possible in the long run. The distinction between fixed and variable
costs no more exists because all costs are variable costs.
In the long run, the equilibrium of a firm will be reached at the quality between MC
and MR i.e. MC and price. In the long run, however, the price equates not only
marginal cost but also the average cost, because if price is greater than AC, the
abnormal profits will attract new firms into the market. The entry of new firms will
wipe out such supernormal profits. On the other hand, a firm may operate in spite of
losses in the short run but it can not do so in the long run. Such firms, incase of which AR
is less than AC will leave the industry, it means in the long run, price can neither exceed
the average cost nor can be less than it. In other words, the long run price must
necessarily be equal to the average cost. The entry of new firms in the context of
supernormal profits will produce a twofold effect.
(i) Increase in supply and therefore a fall in price.
(ii) Increase in demand for productive resources and hence increase in the cost.

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Similarly, the exit of the existing firms will also affect the cost and revenue positions
in two ways.
(i) Decrease in supply and rise in price.
(ii) Fall in demand for productive resources and consequent rise in cost. Thus, the
long run equilibrium exhibits the following:
(1) MR = MC.
(2) AR = AC.
(3) AR = MR = MC.
(4) AR = AC = MC=MR.
Thus in the long run under perfect competition, a grand equilibrium is obtained. This
is shown in the diagram below:

It may be noticed in the alongside diagram that corresponding to the output OQ2 the
grand equilibrium between AR, MR, AC and MC is obtained at price OP. no other
price can prevail in the market because at a price higher than OP there will be
supernormal profits inviting new firms while at any price below OP the losses will
force the firms to leave the industry. Moreover, in the long run, not only an individual
firms but the entire industry reaches a determine equilibrium because of the quality
between AR and AC.
Thus, the long run equilibrium of a firm and industry exhibits the following
remarkable features:
(i) Firms are in equilibrium because MR = MC.
(ii) Industry is in equilibrium because of quality between AR and AC.
(iii) All firms tend to be optimum since they operate at lowest AC.
(iv) Abnormal profits are absent due to equality between AR and AC.
From this, it is concluded that perfect competition is an ideal market situation which
produces most efficiently and sells at the lowest price. Hence it maximizes welfare.
Equilibrium under Monopoly

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Short run Equilibrium: like any other producer, a monopolist aims at maximizing
the profits. He produces that output at which MR = MC. Since a monopoly firm itself
means the entire industry, a demand curve i.e. AR curve facing a monopolist is
downwards sloping which implies that a monopolist can sell more only at a lower price.
Since the AR curve is downwards sloping, the MR curve is always below the former. In
other words, under monopoly, AR>MR, i.e. price is always greater than marginal cost.
Thus, under monopoly,
AR>MR but MR = MC
∴AR> MC.
Now, this price in the short run can be greater than or less than AC. If the price is
greater than AC, it means the firm earns abnormal profits. Such profits can continue even
in the long run because there is no fear of new firm entering and competing away the
profits.
In the short period if AR<AC, there will be losses. But a monopolist will continue to
produce so long as the price covers the average variable cost. In short, in short run
monopolist will be in equilibrium when MR=MC. The price i.e. AR, though higher than
MC, can be higher or lower than AC, implying profits or losses respectively. This can be
observed in the following diagram:
In both (a) and (b) above, a firm is in equilibrium at point ‘E’ at which MR=MC.
The output is OQ. In figure (a) at equilibrium output AR (i.e. QM). Is greater than Ac
9i.e. QL) Hence there are abnormal profits. In figure (b) since the price i.e. at equilibrium
is less than AC, firm suffers losses. But it will continue to produce. Thus, in the short run
there can be profits or losses under monopoly.

Long run Equilibrium:

In the long run, a firm cannot afford to face the losses. It can make full adjustments
in supply according to the change in demand. The price in the long run is necessarily
higher than cost implying abnormal profits. This can seen from the alongside diagram.
Firm is in equilibrium at point E producing OQ output. Since the AR>AC, there are
abnormal profits worth the area PNLM.

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Certain important features of monopoly equilibrium should be noted.

(1) Monopoly equilibrium can occur in any phase i.e. increasing, constant, or
diminishing cost conditions. Under any case a monopolist can permanently enjoy
abnormal profits. This is seen in the following diagram:
in the above diagrams, figure (a) shows equilibrium under diminishing cost, (b)
shows equilibrium under constant cost and (c) the equilibrium under increasing cost.
(2) Monopoly price is a function of marginal cost and elasticity of demand.
It is known that,

A=M (e / (e-1)) where

A = A.R. i.e. price
M=M.R.
e = elasticity of demand
Price = M.R (e / (e-1))
but in equilibrium M.C. = M.R
Price = MC (e / (e-1))
Thus, monopoly price is a function of MC and elasticity of demand.
On a straight line demand i.e. AR curve at midpoint e=1 and below midpoint e<1.
when e<1, MR is negative. Producer equates MR with MC can never be negative no
producer will produce when MR is negative i.e. e<1. it means producers will not be in
equilibrium if the elasticity of demand is less than one.
If MC is zero, the equilibrium may occur at midpoint at which MR is zero.
Since MC is positive, the equilibrium must occur at that level of output at which MR
is positive i.e. e>1.
Thus, equilibrium of the monopolist will necessarily occur at the level of output at
which on the corresponding AR curve the elasticity is greater than one.
Thus, equilibrium under monopoly can be summed up as follows:
(1) A monopoly firm like any other firm is in equilibrium when MR=MC.
(2) Price under monopoly is always greater than MC.
(3) In the short run the price may be greater than AC implying abnormal
profits or less than AC indicating losses.

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(4) The long run price under monopoly will always be greater than AC. It
means monopolist can permanently enjoy the abnormal profits.
(5) Monopoly equilibrium may occur under any cost conditions i.e.
diminishing increasing or constant.
(6) Monopoly equilibrium will necessarily be at that level of output which
corresponds to elastic demand, i.e. e>1.
(7) A monopolist may produce output corresponding to unit elasticity if MC is
zero.

PRICE DISCRIMINATION

Meaning of price discrimination: So far we have discussed the price output determination
under simple monopoly, i.e. under a situation in which the monopolist charges uniform
price for the same product to different consumers. In practice, there are many cases in
which a monopolist charges different price for the same product such a practice of
charging different prices from different prices from different groups of consumers is
known as price discrimination.
Price discrimination, therefore, refers to the act of selling the same commodity at
different prices in different markets whenever it is possible and profitable. Under perfect
competition with large number of producers, the individual firm has no control over the
market-supply. Hence it is not possible to practice price discrimination in a competitive
market. As the monopolist is a single producer in the market, he has control over the
supply of the product. He can sell the commodity at different prices to different
consumer. However, it is rather difficult to offer the identical commodity at different
prices. Therefore, to widen the scope of price discrimination, commodities or services are
slightly differentiated. For example, in railways and airways, price discrimination is
practiced. It should be noted that generally price discrimination in confined to simple
price discrimination, i.e. charging different prices for the same product from different
consumers.
In the words of Mrs. Joan Robinson, “the act of selling the same article produced
under single control, at different price to different buyers is known as price
discrimination.”

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Thus, a monopoly can be a simple monopoly when a uniform price is charged by the
monopoly firm, or it can be a discriminating monopoly when he discriminates
between users or persons and charges different prices for the same product.
Forms of price discrimination: price discrimination by a monopolist may take many
forms. The important forms of price discrimination are discussed as under:
(1) Personal discrimination: Personal discrimination occurs when different prices
are charged from different consumers depending upon their incomes. For example, a
doctor may charge higher fees to the rich and lower fees to the poor. Similarly, other
professionals like lawyers, consultants, teachers, etc. may also discriminate between
rich and poor.
(2) Local Discrimination: in local discrimination, the monopolist charges a lower
price at one place and a higher price at other places. For example, in dumping, the
monopolist charges higher price at home and lower price in a foreign market.
(3) Trade discrimination: this form of price discrimination is based on the use of the
product. For example, there are different tariffs in the supply of electricity for home
consumption, industrial and agricultural uses. Similarly, there are different rates for
trunk calls.
(4) Quality discrimination: Price discrimination may also take place on the basis of
qualitative differences of the same product. For example, a deluxe edition of a book is
sold at a higher price than its paper-back edition.
(5) Special service discrimination: In this situation price discrimination takes place
on the basis of special services provided to the consumers. For instance, railways
charge different rates for different classes of travel. Similarly, cinema houses charge
different admission rates.
(6) Time Discrimination: Different prices for the same commodity or services are
charged at different times. For instance, trunk call charges are higher during day time
and lower during night time. Age discrimination and sex discrimination is also
practiced.

When is price discrimination possible?

Broadly speaking, two important conditions are essential for the price discrimination to
become possible. First, it should be impossible to transfer the commodity from the
cheaper market to the dearer market. Second, there should be no possibility for the
consumers to transfer themselves to the cheaper market.
From the above, it follow that price discrimination will be possible when the monopolist
is able to keep his two markets separate. Other important conditions of price
discrimination are as follows:
(1) Price discrimination often occurs due to consumer’s peculiarities. In this case
there are three possibilities.
(i) The consumers are very often unaware that prices have changed. (Ignorance of
consumers)
(ii) The consumer has irrational feeling that he is paying a higher price for a better
quality. (consumer’s illusion)

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(iii) Price difference are marginal and the consumers simply do not bother about the
changes in price. (Let go attitude)
(2) Price difference also occurs due to legal sanction where customers are divided
into different groups. it is largely prohibited to transfer the use of commodity from a
particular purpose. For example, the electricity company has different tariffs for
domestic and industrial consumers. Likewise in railways it is an offence for one to
travel in other class without a proper ticket.
(3) Price discrimination will be possible due to the nature of the commodity. In this
case price discrimination refers mostly to direct services which can not be resold. These
services are directly given to the consumers and therefore, the resales are impossible.
(4) Discrimination often occurs when the market are situated at large distance and
makes it very expensive to transfer goods from a cheaper market to the dearer market.
Similarly, the monopolist may serve two different markets. Namely a home market with
tariff and a world market without tariff. He can take advantages of tariff barrier to sell the
commodity at a higher price in the home market and at a lower price in the world market.
Above are the circumstances under which price discrimination is possible. Price
discrimination does not necessarily imply that different prices are charged for the same
product. Sometimes different services are rendered or different goods are offered at
different prices, but the differences in the quality are not so high as to justify the price
difference. Hence this also is a way of price discrimination. Most common example is
provided by railways where the first and second class fares widely differ. However, the
facilities provided in the first class hardly are in proportion to the high fare charged.
“price discrimination as the sales of technically similar products at prices no which
are or proportional to marginal costs.”
Thus, it is clear that all these forms of price discrimination depend on his ability to
retain his customers. Further, it also depends on his power to ensure that no one else
sells his products at a lower price.
When is Price Discrimination Profitable?
We have so far analyzed the conditions in which price discrimination is possible. It will
be possible when the monopolist is serving separate markets. But it may not be always
profitable for him to practice price discrimination.
It should be noted that the monopolist seeks maximum profits when he fixes his
output so as to equal marginal revenue with marginal cost. Since he is serving two
markets the marginal revenue (Combined MR) obtained in both the markets must be
equal to MC. He will sell at different prices till the MR obtained in one market is equal to
the MR obtained in another market.
This enables the monopolist to earn maximum profit
However, the most fundamental factor of profitability is the nature of elasticity of
demand at the single monopoly price in these markets. In this case the basic condition is
that the elasticity of demand should be different in different market.
If the elasticity of demand in each market is the same at each price the monopolist
will not resort to price discrimination because marginal revenues are equal. It follows
from the formula M
That MR in two markets is the same and therefore, if different prices are charged by
transferring the output discrimination will not be profitable:

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If elasticties of demand in two markets at a single, monopoly price are different,

price discrimination will be profitable. It is evident from the above formula that MR in
the two markets will be different and the monopolist, by transferring the commodity, can
charge different prices at which the gain in MR will be greater than the loss in MR> he
will continue transferring units of the good until marginal revenue in two markets are
equal. If follows from the above analysis that price discrimination will be profitable only
when the elasticity of demand is different in each market.

Technique of price discrimination

Price-output determination under discriminating monopoly.

The monopolist practices price discrimination for maximizing his total profits. We
are acquainted with the basic principle of profit maximization viz., the equality between
MR and MC. The same principle is equally applicable to discriminating monopoly. The
principle of profit maximization is extended to different markets. Under discriminating
monopoly, there are different AR and MR curves corresponding to different markets. The
monopolist will equate his MC with each MR. Thus, condition of equilibrium of
discriminating monopoly can be stated as MC=MR1 MR2=MR3….MR
This condition means that given the different demand schedules corresponding to
different markets, the monopolist will sell that much output in each market at which MR
in each market is equal to the MC. The monopolist will, thus, equalize the marginal
revenue in the different markets. If the MR in one market is higher than that in the other
market, the seller will be benefited by transferring some quantity from the latter to the
former market. When more is supplied in the market with higher MR, the price i.e. AR,
and therefore, MR in that market will decline. On the other hand, as he withdraws some
quantity from other market, the price, and hence, MR in that market will rise. The process
of shifting will continue till the MRs in the different markets become equal. Once such
equality is achieved any further shifting will be unprofitable.
The discriminating monopolist is required to take two decisions.
(a) How much to produce?
(b) How to distribute the total output among the different markets?

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The answers to the two questions above are found by equating MC of the total
output to the aggregate marginal revenue (AMR) which is obtained by adding up the
marginal revenues in the different markets.
Thus, he will produce at the level of output at which
MC=AMR=MR1+MR2…+MRn.
The following figure clarifies the point.
In the above diagrams Fig. (a) And Fig. (b) Show two different markets with
different degrees of elasticity. It may be observed that fig. (a) depicts a higher market
with less degree of elasticity while Fig. (b) portrays a lower market with higher elastic
demand. AR1 and AR2 are the demand curves and MR1 and MR2 are their
corresponding marginal revenue curves in higher and lower markets respectively. The
aggregate marginal revenue curve (AMR) obtained by lateral summation of MR1 and
MR2 drawn in Fig. (c) above.
The discriminating monopolist will be in equilibrium at point E in fig. © at which
the MC curve intersects the AMR curve. The total output produced by the monopolist is,
therefore, OQ. Thus, equality between MC and AMR provides answer to the first
question faced by the discriminating monopolist viz., how much to produce.
After the equilibrium i.e. profit maximizing output has been fixed, next problem
facing the firm is the distribution of this output among different markets so as to
acquire maximum profits. In solving this problem, again he is helped by the marginal
principle. as explained above, the monopolist will sell that much output in each
market at which MR in each market equates the MC. In the above diagrams, a parallel
line drawn from the point of equilibrium ‘E’ intersects MR1 and MR2 at E1 and E2
respectively. Thus, E1 and E2 are the equilibrium positions in the two markets.
The monopolist will, therefore, sell OQ1 quantity at price OP1 in the first market,
and Oq1 at price OP2 in the second market. It can be easily noticed that he charges higher
price in less elastic market and lower in more elastic market (OP1 >OP2).
Thus, the technique of price discrimination lies in equating the marginal cost of
total output with the aggregate marginal revenue to determine the total output
produced and to marginal revenue in each market to distribute the total output in
different markets.

Monopoly and Perfect Competition – A Comparison

We have so far analysed the market situations under perfect competition and
monopoly. One of the common features of these market situations is that the firms
aim at maximizing profits at the equilibrium output where: marginal cost equal
marginal revenue. However, there are significant dissimilarities between the two
market situations. Hence, we may attempt a comparison between monopoly and
perfect competition with reference to their characteristics, price and output
determination, the size of profit etc.
(a) Market structure: Perfect competition is a market situation is which there is a
large number of buyers nad sellers, each one selling a small proportion of the total output.
The price in the market of the entire industry is determined by the forces of demand and
supply. All competing firms have to accept this price. As them are large numbers of

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firms, selling homogeneous products, as individual firms can sell any amount depending
upon its size, at ruling price. Since it can sell as much as it likes at the prevailing price, it
has no incentive to lower it. Thus, once the price in the market is established, the firm
accepts the price as given and adjusts its output at the level which ensures maximum
profit it is clear, therefore, that under perfect competition there can be only one price in
the market at a point of time because the products are homogeneous. Every firm is, thus,
a price taker and output adjuster in the market.
On the other hand, under monopoly, there is only one firm selling a particular
commodity or service. Hence there is no distinction between the firm and industry under
this type of market situation. The monopoly firm itself fixes the price for its product
unlike perfect competition. He may charge either a single uniform price or different
prices to the consumers, for the same product. Thus, the monopoly firm is a price maker.
(b) Nature of demand curve-and industry: Under perfect competition. There is a
clear distinction between the firm and industry. Accordingly, the demand curve or the
average revenue curve (AR) faced by the firm and industry will be different. The demand
curve (AR) of a firm is perfectly elastic and the marginal revenue coincides with it. But
the demand curve faced by the industry consisting of a large number of firms slopes
downward from left to right. Since, the total output produced by an industry is quite
large, industry cannot sell more at the same price. When the price is reduced, the total
demand for the commodity rises. Thus, the demand curve (AR) of an industry will have a
negative slope.
(c) Price-marginal cost relationship: As pointed out, already there is similarity
between the equilibrium conditions of the firms under perfect competition and monopoly.
But there are differences between the prices – marginal cost relationship.

Sources of Monopoly Power

There are many factors or circumstances responsible for the emergence of

monopoly. In fact, the absence of competition is the essence of monopoly. A monopoly
firm may emerge when there are restrictions to the entry of new firms into the
organization. In this context, there are two important points: (a) the firm emerging as a
monopoly power, and (b) to retain that power in the long run. It implies that if the
product has close substitutes, and the entry of new firms is restricted, the monopoly firm
will continue to enjoy the privileged position even in the long run. According to Prof.
Robinson “ a monopoly firm can exist only so long as it is able to bar the entry of its
potential competitors or rivals.”
(1) Control over raw materials: It may be possible for single firm to acquire
ownership or control of essential raw materials required for production. It would be an
effective barrier to the entry of other firms into the monopoly industry. A monopoly firm
may also acquire raw materials in big quantities at lower prices. Thus, monopoly may
emerge when a single firm has control over the supply of strategic raw materials.
(2) Nature monopolies: Monopoly may emerge due to one single firm’s control of
raw materials, especially those the supply of which depends on natural forces. This is
characterized as natural monopoly, for instance, the geographical distribution of natural
and mineral resources is very uneven. In such a situation a firm may acquire control over

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natural resources. Monopoly power can also be acquired if a firm has control over
professional services, capital equipment, labour etc. for instance, some surgeons, lawyers,
singers, etc. can charge higher fees than others in the same profession. Similarly in public
utility services like water supply, transport, telephone services etc. monopoly is preferred.
These tend to become natural monopolies and competition in such services is avoided.
But the Government subjects such services to certain regulations in the interest of the
consumers.
(3) Legal barriers: This is most important factor to confer the monopoly right and
prevent the entry of the potential competitors. In other words, monopoly may emerge as a
result of certain legal provisions of the government. law may confer patent, trade marks,
copy right etc. On the privileged firms. In this case, a firm gets an absolute monopoly
power in the production of a particular commodity. It is a protected from the threat of
competition from new firms making identical products. Further, the firm is protected by
law against imitation by rival producers.
Similarly, tariffs on imports of certain goods will restrict foreign competition in the
domestic market. This will tend to create a monopolistic position for the domestic
producers.
Again the Government may reserve certain products and services for itself in order
to provide better services to the community. E.g. posts and telegraph, railway etc.
(4) Business combinations: It is possible for a number of big business companies to
acquire a degree of monopoly power through voluntary agreement. This will help them to
eliminate competition among the groups in terms of price; output and sharing of the
market it will also prevent the entry of new potential competitors.
These business combinations are variously called as pools, cartels, trusts, syndicates,
trade associations etc. such combinations exploit the consumers and therefore, socially
least desirable. In order to eliminate monopoly power, anti-trust and anticartel legislation
have been passed in the USA.
(5) Existence of goodwill or reputation: A well established firm possesses a
degree of monopoly power. Such a firm will have considerable goodwill and it is
virtually impossible for potential competitor to enter the industry. It is prohibitively risky
for the new firms to compete with the existing firms.
(6) Technical economies of scale: There are a number of industries which are
dominated by a few giant firms with great technical economies of scale. For instance, the
firms manufacturing types, chemicals, motor cars etc. operate on a large scale and enjoy
economies of large scale production. These economies of scale reduce the cost of
production and thus enable the firms to supply goods at low prices. As a result, it is
impossible for the new firms to enter the industry.
From the above discussion of the sources of monopoly power, it should be noted that
different sources are more or less temporary in nature. They do not confer permanent
monopoly power. Natural monopolies, the existence of giant firms enjoying economies of
large scale production etc. may not be permanent. It is possible for new firms to enter the
industry at one stage or the other because of discovery of a new source of raw materials.
Similarly, existence of economies of large scale production may not always mean the
possibility of only a few giant firms. The liberalization of licensing policy, innovations,
liberal bank credit may result in the emergence of new competitors.

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However, in the case of social monopoly or public utility, there is a tendency to

continue as a monopoly. Such monopolies are socially more desirable.
Economies of Scale
Economies of scale refer to the advantage enjoyed by affirm due to expansion of its
size i.e. the scale of production. During short period, since some factors of production are
fixed, a firm cannot alter the scale of production. Here economies of scale are associated
with long run production function i.e. returns to scale. In the long run, since all factors are
variable, it is possible a form to expand or contract its size as per the requirement. With
the expansion of the scale of production a firm derives certain benefits i.e. economics of
scale due to which the increasing returns to scale are experienced. Beyond certain limit,
however, the expansion of size causes disadvantages or diseconomies, which lead to
diminishing returns to scale. Thus
• Initially expansion of the firm renders advantages and the firms enjoys increasing
returns.
• Beyond desirable limit, the expansion leads to occurrence of diseconomies of
scale and the firm suffers the diminishing returns to scale.
• In between the balances between economies and diseconomies brings about
constant returns to scale.
The economies of scale are classified into two broad categories viz.,
(a) Internal economies: this refers to those advantages which are enjoyed by an
individual firm which expands its scale.
(b) External economies: These are associated with the entire industry. Such
benefits are shared by all the firms in the expanding industry.

(a)Internal Economies
The term refers to those advantages which are enjoyed by an individual firm in
an industry. Such benefits are not shared by all but accrue only to that firm which
grows in size.

Take for example hotel industry. Different individual restaurants are the firms that
constitute that industry. Now if an individual restaurant grows in size i.e. expands
the sale it alone will enjoy certain advantages. These benefits can be termed as
internal economies.
Internal economies enjoyed by an individual firm can be discussed under different
categories as follows:
(1) Technical Economies:
(a) Technical economies are those advantages enjoyed by the firm which emerge due
to greater efficiency of capital equipments. A small firm is unable to install specialized
and advanced machinery. A larger firm is able to employ such machinery and
equipments. The firm enjoys a reduction in cost per unit or increase in output as a result
of such specialized capital equipments. Thus, the technical economies occur due to
application of superior technique.
(b) Another type of technical economies enjoyed by the large firm are the
advantages of division of labour. Experts can be appointed by a large firm to perform
specialized functions. These are the economies of specialization.

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(c) A large firm can make a proper use of wastes for producing by-products. Such
an advantage cannot be enjoyed by a small firm. These are known as the economies of
by-products.
(d) Similarly, a large firm may be able to avail of the economies of linked
processes. When the different processes are linked together under one control the
dependence and inconvenience is avoided.
(e) Dimensional economies are also enjoyed by the use of large sized capital
equipment.
Thus, large firm may be able to enjoy certain advantages which are absent in the case
of a small firm. These economies are essentially associated with the large firm.

(2) Managerial Economies (Administrative Economies):

These economies result from the managerial division of labour. Experts and qualified
persons can be appointed only by a large firm. In a small firm, the owner has to look
after different processes. These economies or advantage are called the advantage of
functional specialization.
(3) Marketing Economies:
These economies emerge from the bulk buying. The large firm buys the raw materials
in big quantities because of which it is assured of regular supply at a cheap rate. Thus,
a large firm can reduce the expenses in the purchase of raw materials. Similarly, a
large firm can enjoy many advantages in the marketing of their product through
advertising. A large firm also enjoys concession in transport charges.
Marketing economies may also arise from specialization. A large firm can afford to
have its own marketing department through which the services of experts can be
obtained.
(4) Financial Economies:
A large and reputed firm enjoys certain gain in the matter of raising funds. A small
firm finds it difficult to sell shares and debentures. A large firm can do as very
smoothly as the public in general is willing to subscribe to their capital needs. An
expanding firm is also in comfortable position in respect of obtaining credit from
banks and other financial institutions. It can raise the loans easily and at cheaper rates.
Thus, various financial economies accrue to an expanding firm.
(5) Risk-Bearing Economies (survival Economies):
Lastly, certain risk-bearing economies are enjoyed by a large firm. A small firm finds
it difficult to face the general and particular risks arising out of economic depression,
fall in demand etc. on the other hand; a large firm with sizable resources can
effectively face such risks and can survive. Business fluctuations and the risks
associated with them bring the every the very existence of such small firm into
danger, whereas large firms are in a position to bear such risks and overcome the
same. Thus, risk-bearing or survival economies are enjoyed by an expanding firm.
Such firm spreads the risk by diversification of products, diversification of markets
and minimizes the risks.
Thus, it can be concluded at a large firm enjoys various internal economies because
of which a firm is in a position to enjoy increasing returns. It means as the size of the firm

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expands, it gets more than proportionate returns. Increasing returns imply diminishing
costs. However, this phase of increasing returns or diminishing costs can not occur
indefinitely. A limit to the expansion of the firm is reached at a point where average
returns are maximum and average costs are minimum. Beyond this point, any further
expansion will lead to diseconomies of scale and the firm will face the diminishing
returns.
(b) External Economies

There are certain advantages which are enjoyed by all the firms in an industry. They are
termed as external economies. As a result of growth of a particular industry many
benefits are shared by all the constituent firms.
If we consider again the hotel industry. It is possible to visualize such external
economies e.g. a particular place becomes a favorite tourist attraction. Restaurants
and hotels in that area can naturally get number of advantages. The external
economies emerge particularly from the localization of industry. Various such
economies can be discussed as follows:
(1) Economies of Concentration:
Certain benefits occur as a result of concentration of localization of industry. When
an industry gets concentrated in a particular area, it receives the following
advantages:
(a) Provision of efficient transport system.
(b) Availability of skilled and trained labour.
(c) Better and cheap credit facilities through the development of banks and other
financial institutions.
(d) Supply of adequate sources of power.
These advantages can not be secured by the firms if they are not localized. Such
economies help in reducing the cost of production i.e. raising the average and marginal
returns.
(2) Economies of Disintegration:
With the growth of the industry, various other firms come up in the area and these
firms supply raw materials to the main industry and also make use of the wastes of
the industry for producing the by-products. Development of such firms helps in
reducing the cost of the main industry. These gains thus accrue to all the firms in the
industry.
(3) Economies of information:
The industry may publish certain trade journals which are useful to the firms.
Technical information may also be made available. Surveys can be undertaken which
help the firm in obtaining the statistical and market information. Similarly, the
industry can establish its own research center which will benefit the different firms.
The expenditure on advertisement and such other sales promotion drive may be borne
by the industry as a whole and to that extent the expenditure of an individual firm can
be reduced.
Thus, when the industry grows, it gains certain benefits or advantage known as
external economies which help the firm in increasing the production or reducing the cost.
It means the increasing returns can be attributed to the external economies along with the

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internal economies. Thus increasing returns occur due to internal as well as external
economies.

Diseconomies of Scale

(1) Internal diseconomies:

As the firm expands in size, it experiences certain economies or advantages as mentioned
above. But as already stated, these advantages can be enjoyed only up to a certain limit
upto which the average returns go on increasing or average costs go on diminishing. Any
expansion of the firm beyond this optimum limit will lead to diseconomies of scale. The
various economies such as technical, managerial, etc. which bring about increasing
returns initially, develop into internal diseconomies.
Thus, the advantages turn into disadvantages and result in diminishing returns or
increasing costs.
Some economists are of the opinion that since entrepreneur is always a fixed factor,
diminishing return to scale is nothing but a special case of the law of variable
proportions. In the long run, all other inputs except the entrepreneur are variable. It
means what really happens is that the proportion between fixed (entrepreneur) and
variable (other inputs) factors go on varying and the diminishing returns to scale occur.
Those who do not admit diminishing returns to scale to be special case of the law of
variable proportions attribute the occurrence of diminishing returns to the various
managerial and technical diseconomies which result from expansion of the firm beyond
the optimum size.
Managerial Diseconomies: Beyond certain limit the growth of the firm creates
many managerial problems and difficulties. The problems faced are mainly of co-
ordination and supervision. When the firm expands, it becomes unwieldy and
uncontrollable; the decision-makers are not directly concerned with productive. Hence,
they have to depend upon second hand information. There is a separation between those
who take decisions and those who execute the same. This result in delay and red-tapism
reducing the efficiency which causes the diminishing returns.
Moreover, with the growth of the firm many important and responsible functions
have to be delegated to lower level officials who are inexperienced and lack the
necessary knowledge to perform such decision-making functions. In addition to this,
when decision-making is done by different groups there can be disharmony.
The large size of the firm reduces the initiative. The personal contact between
management and workers is lost in a large firm. This results in growing labour problems.
Thus, with the growth of the firm beyond the optimum limit, diminishing returns
creep in due to problems and complexities of the management.
Technical Diseconomies: As the size of the firm expands beyond the optimum limit, the
economies arising from specialization and indivisibilities change in diseconomies
Division of labour and specialization beyond certain limits prove to be in efficient.
Similarly the indivisible equipments have a maximum capacity up to which such
equipment work more and more sufficiently but once these limit is crossed , these
equipments become over- burdened & hence inefficient.

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External Diseconomies: the external economics which benefit the firm’s initially
change into diseconomies and result in raising the cost of production the diseconomies
are of different types
Transport bottlenecks causing delay in obtaining raw materials and marketing finished
products
High rent which is inevitable result of localization
Wage rates increase as a result of increasing demand from number of firm’s
The firm’s have to use less and less efficient units of input

Question bank
1 Writes a short note on economics of scale
2 Explain the term price discrimination. How is price determined in a discriminating
monopoly?
3 Distinguish between the perfect and monopolistic competition .explain ad illustrate the
condition for the establishment of firm’s equilibrium under perfect competition
4 In short run cost analysis, explain with diagram giving reasons the following statement
“the MC curve intersects both the AVC curve ad ATC curve at their minimum points”
5 Explain the main features of oligopoly market.
6 Writes a short note on causes ad disadvantages of monopoly
7Explain the main features of monopolistic competition .How does it differs from perfect
competition
8 Describe the short and long run equilibrium under monopoly
9 Writes a short note on imperfect competition
10 name & explain the different types of market

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Demand Forecasting
Accurate demand forecasting is essential for a firm to enable it to produce
the required quantities at the right time and arrange well in advance for the
various factors of production, viz., raw materials, equipment, machine
accessories, labour; buildings, etc. some firms may as a policy produce to order
but generally, firms produce in anticipation of future demand. Forecasting helps a
firm to assess the probable demand for its products and plan its production
accordingly. In fact, forecasting is an important aid in effective and efficient
planning. It can also help management in reducing its dependence on chance.

Demand forecasting is also helpful in better planning and allocation of

national resources. Because of unrealistic estimate of projected demand and
production. India had to spend in 1978 Rs. 1,000 cores on imports of even
essential goods.

Demand forecasting is very popular in industrially advanced countries

where demand conditions are always more uncertain than the supply conditions.
In developing countries, however instead of the demand, supply is often the
limiting factor. High prices and black markets point to supply bottlenecks.
Naturally, in a country like India supply forecasting seems to be more important
than demand forecasting. However, with the relaxation of industrial licensing
regulations and economic liberalization in general in recent years increasing
competition has already begun to change the situation in India as well.
Competition has spread to most areas except those where massive investment is
required. In such areas, supply as far in excess of demand and the producers
have begun to battle for the market place. Thus, demand forecasting is bound to
become important in India also.

The national Council of applied Economic Research has made demand

forecasts for a number of products (consumer as well as industrial) on a macro-
level. These forecasts can be helpful in determining industry demand.

FACTORS INVOLVED IN DEMAND FORECASTING

There are at least six factors involved in demand forecasting:

1.How far ahead? The problem is solved by having both short-run forecasting,
usually defined as covering any period up to one year, and long-run
forecasting covering a period of 5, 10 or even 20 years.
How far ahead can the long-term forecast go, depends upon the nature of
the industry but, beyond ten years, the becomes so uncertain that the projection
becomes rather dubious. However, because of the close link with capital
expenditure forecasting. It may be necessary to look 20 years ahead in case of
certain industries. For example, petroleum companies, shipping companies and
paper mills, in view of the long life of the fixed assets, the very high capital costs

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involved and the possibility of profit only in the distant future, do have to forecast
well deep into the future.

Short-term forecasting may cover a period of three months six months or

one year, the last being the most usual. Which period is chosen depends upon
the nature of business; when demand fluctuates from one month to another, a
very short period should be taken. However, here too, depending upon the
nature of the business. If stocks can be built up in the slack sales period, this
may be preferable to a fluctuating level of production. The latter may cause
problems of labour and machine utilization, which could be avoided if production
is continued during the slack period.

Instead of defining short-term and long-term forecasting in terms of different

periods of time1 an alternative method is to associate them with certain types of
decisions or objectives to be met. Accordingly, short-term forecast is one which
provided information for tactical decisions. It is, therefore, concerned with day-to-
day operations within the limits of resources currently available. A long-term
forecast is one, which provides information for major decisions; it is concerned
with extending or reducing the limits of resources. 2 For example, if it is intended
to establish a factory, and it is thought that the time required to build, equip and
bring it into operation will be five years, then the forecast of the demand for the
products to be made in the factory must start five years ahead, and may be
projected for a further five-year period in order to establish the viability of the
project. Thus the time period involved will be ten years.

When it is intended to replace plant or to buy new or improved machines, the

period chosen will depend upon the expected life of the plant or machinery, the
time required to purchase and to bring it into use, and the time required for the
capital outlay to be recovered.

1 Demand forecasting may be undertaken at three different levels (a) Macro-

level concerned with business conditions over the whole economy measured by
an appropriate index of industrial production, national income or expenditure.
Such external data constitute the basic assumptions on which the business
must base its forecasts. (b) Industry-level prepared by different trade
associations.© Firm-level, which is the most important from managerial
viewpoint
2 Should the forecast be general or specific? The firm may find a general
forecast useful, but it usually needs to be broken down into commodity product-
wise forecasts and forecasts by areas of sale.
3 Problems and methods of forecasting are usually different for new products
from those for products already well established in the market, for which sales
trends are known and the competitive characteristics of the product well
understood.

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4 It is important to classify products as producer goods, consumer durables or

consumer goods and services. Economic analysis indicates distinctive patterns
of demand for each of these different categories.
5 Finally in every forecast special factor peculiar to the product and the market
must be taken into account. The nature of the competition in the market how far
the situation is complicated by uncertainty or non-measurable risk and the
possibility of error of inaccuracy in the forecast must be seriously considered.
Political developments such as general elections are also important.
Sociological factors are of great importance in some markets e.g., in the case of
women’s dresses likewise the role of psychology in demand can hardly be
understated. What people think about the future, their own personal prospects
and about products and brands are vital factors for firms and industries.

PURPOSES OF FORECASTING
The purposes of forecasting differ according to types of forecasting: short-
term forecasting and long-term forecasting.

Purposes of Short-term Forecasting

(i) Appropriate production scheduling so as to avoid the problem of over

production and the problem of short supply. For this purpose production
schedules have to be geared to expected sales.

(ii) Helping the firm in reducing costs of purchasing raw materials and
controlling inventory by determining its future resource requirements.

(iii) Determining appropriate price policy so as to avoid an increase when

the market conditions are expected to be weak and a reduction when the market
is going to be strong.

(iv) Setting sales targets and establishing controls and incentives. If targets
are set too high, they will be discouraging salesmen who fall to achieve them: if
set too low, the targets will be achieved easily and hence incentives will prove
meaningless.

(v) Forecasting short-term financial requirements. Cash requirements

depend on sales level and production operations. Moreover, it takes time to
arrange for funds on reasonable terms. Sales forecasts will, therefore, enable
arrangement of sufficient funds on reasonable terms well in advance.

Purposes of Long-term Forecasting

(i) Planning of a new unit or expansion of an existing unit. It requires an

analysis of the long-term demand potential of the products in question. A multi-
product firm must ascertain not only the total demand situation, but also the

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demand of different items separately. If a company has better knowledge than its
rivals of the growth trends of the aggregate demand and of the distribution of the
demand over various products, its competitive position would be much better.

(ii) Planning long-term financial requirements. As planning for raising funds

requires considerable advance notice, long-term sales forecasts are quite
essential to assess long-term financial requirements.

(iii) Planning man-power requirements. Training and personnel development

are long-term propositions, taking considerable time to complete. They can be
started well in advance only on the basis of estimates of manpower requirements
assessed according to long-term sales forecasts.

The demand forecasts of particular products may also provide a guideline for
demand forecasts for related industries. For example, the demand forecast for
cotton textiles may provide an idea of the likely demand for the textile machinery
industry, dyestuff industry as also for ready made garments industry. At the
macro level demand forecasts may also help the government in determining
whether imports are necessary to meet any possible deficit in the domestic
supply, or in devising appropriate export promotion policies if there is a surplus.
Thus, demand forecasts are useful to the industry as also to the government.

DETERMINANTS OF DEMAND

1. Non-durable consumer goods. There are three basic factors influencing the
demand for these goods:

(A) Purchasing power. This is determined by disposable personal income

(personal income direct taxes and other deductions). Data on aggregate personal
income and personal disposable income are published by the Central Statistical
Organization (C.S.O.). Some people suggest the use of discretionary income in
place of disposable income. Discretionary income can be estimated by
subtracting three items from disposable income vtz. imputed income and income
in kind, major fixed outlay payments such as mortgage debt payment. Insurance
premium payments and rent and essential expenditures such as food and
clothing and transport expenses based upon consumption in a normal year.
Discretionary income can be quite an important determinant in case of consumer
non-durables, which are luxuries.

(B) Price. The price factor is another important variable to be included in demand
analysis. Here, one has to consider the prices of the product and also its
substitutes and complements. One may also consider the price differences
between products concerned and its substitutes and complements.

Price as a determinant of the volume of sales of consumer non-durables is

sometimes more important through cross-elasticity (involving substitute products)

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than it is directly in terms of rice elasticity. Direct price elasticity can be expected
to be more important with respect to those consumer non-durables. Which are
capable of storage and are free from risks of changes in styles.

© Demography. This involves the characteristics of the population, human

as well as non-human, using the product concerned. For example, it may pertain
to the number and characteristics of children in a study of the demand for toys or
the number and characteristics of automobiles in a study of the demand for tyres
or petrol. In fact, it involves distinguishing between the total market demand and
market segments. Such segments may be derived in terms of income, social
status, sex, age, male female ratios, urban-rural ratios, educational level,
geographic location, etc. the segment, when quantified, can be used as an
independent variable affecting the demand for the product in question.

Demand can be forecast by employing the following formula:

D = J (Y, D, P)

Where d is demand. Y is disposable income. D is demography and P is price.

The various determinate of the demand for cotton textiles can provide a
good illustration. The demand for cotton cloth is a function of the price of cotton
cloth, prices of substitute commodities and the income of consumers. It bears a
negative relationship with the price of cotton cloth and with the prices of
complementary commodities; on the other hand a positive relationship exists with
the prices of substitute commodities and with income. However, over a period of
time a change may take place in some or all of these factors. For example,
population may increase and fashions and consumer preferences may undergo a
change. But in a developing country like India, prices of food grains constitute an
important determinant of the demand for cloth. Since the demand for food is
inelastic any increase in the food prices leads to a corresponding increase in the
expenditure on food reducing the part of income available for purchasing other
goods including cotton cloth. This icads to a cut in the demand for cloth. Thus
food prices exert a negative influence on the demand for cloth.

2. Durable consumer goods. The important considerations in the forecasting

of demand for durable consumer goods are as under:

(A) The consumer has to make a choice between: (a) using the goods longer by
repairing it. If necessary or (b) disposing it of and replacing it with a new one.
For example, a person may replace his black and white TV by selling it or just
exchanging it for a colour TV after paying the difference in prices. The choice
may depend upon non-economic factors like social status, prestige etc., or on
economic factors like income and obsolescence. In periods of shortage, there
is no alternative but to continue using the old product.

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(B) These goods require special facilities for their use, e.g., roads for
automobiles, and electricity for refrigerators and TVs. The existence and
growth of such facilities is an important variable for determining their demand.

(C) To the extent that the consumer durable is used by “household” rather than
on an individual basis, the total household figures are more important than
total population figures (and changes therein). The few consumer durables
(for example, electric shavers) that are used individually could be expected to
depend more on population than on households. Disintegration of joint Hindu
family has led to an increase in the number of households.

(D) As consumer durables are used by more than one person, the decision to
purchase may be influenced by family characteristics. Such as the size of
families and the age distribution of adults and children as well as price,
income and other considerations.

(E) The total demand consists of (a) a new owner demand, and (b) a replacement
demand. The replacement demand tends to grow with the growth in the total
stock with the consumers. Once a person gets used to a thing he is unlikely to
give it up at some future date. This makes replacement demand regular and
predictable. For certain well-established products, life expectancy tables have
been prepared in advanced countries in order to estimate the average
replacement rates. When purchasing power increases, the scrap page rate
tends to be high and vice versa again, when demand exceeds production,
scrap page rate is lower. But as production catches up, the scrap page tends
to increase. The total demand is symbolically stated as d = N + R. where N is
New owner Demand and R is the Replacement Demand. Each of these
independent variables may be forecast separately. The purchasing power, the
number of families and some other factors depending on the product
concerned, set an upper limit to the maximum or the optimum level. It is the
level towards which the actual volume of consumer stock tends to gravitate.
The difference between optimum and the actual stock shows the growth
potential of the demand for durable goods.

(F) Price and credit conditions. The ratio of price to the average like of the
product should be considered. If the average life is high, the principal effect
would be dampen the influence of price. Again, changes in credit terms can
offset a price increase: lowering the cash down payment or extending the
credit period or reducing the rate of interest.

The availability of hire purchase facility tends to push up the demand for
consumer durables. Western countries have had this facility as a matter of
routine. In fact, extension of credit is used as a sales promotion measure. This
facility has now been extended in India as well. Many firms specialize in selling
goods on hire purchase. The names of Zarapkars of Bombay and V G Pancreas
of Madras need a special mention in this respect. Among the manufacturers, the

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Indian Sewing Machine Company, the manufactures of Singer, claim to have

pioneered hire purchase in India. Hawkins Pressure Cookers are also available
on hire-purchase basis. The intensified competition between car and two-wheeler
manufacturers has led to many firms extending credit for their purchase.

The relative importance of these various factors will vary from country to
country. For example, the demand for refrigerators in India is mainly a function of
income while in the U.S.A. it is a function of new houses built.

Forecasting demand for consumer durables presents some difficult

problems. Purchases of consumer durables are rather discretionary. They are
not made on the spur of the moment but after considerable deliberations among
members of the family. These deliberations very often involve choice among
many competing consumer durables. Again, usually several months elapse
between the formation of the idea and the culmination of the purchase decision.
Thus durables are bought sporadically. Moreover, there is no compelling need to
make these discretionary purchases at any given time. They are very often made
at unevenly spaced intervals of time. If there are expectations of prices going up,
these purchases may be speeded up or else they may be postponed. So also,
the discretionary purchases may be postponed if there are reports of impending
product improvements. Which is particularly the case in automobiles in foreign
countries.

3. Capital Goods. Capital goods are used for further production. (A particular
commodity may be a producer good for one but consumer good for the other).
As the demand for capital goods is a derived one, it will depend upon the
profitability of industries using the capital goods (called user industries), the
ratio of production to capacity in the user industries, and the level of wage
rates. When wage rates rise in relation to other costs, the management will
seriously consider further investment in labour-saving equipment.

In the case of particular capital goods, demand will depend upon the specific
markets they serve and the end uses of which they are bought. The demand for
textile machinery will for example, be determined by the expansion of textile
industry in terms of new units and replacement of existing machinery. New
demand as well as replacement demand will have to be considered. The demand
for commercial vehicles depends upon (i) The scrap page rate. (ii) The
availability of vehicles, (iii) economics of movement by road vis-à-vis rall, (iv)
availability of bank finance to the prospective customers and (v) growth pattern of
the economy.

The demand for cable extruders would depend primarily on the demand
for cables which in turn would be linked to electrification programmes.
Government spending etc., For estimating the demand for aero planes, the
points to be considered are expected passenger demand and traffic growth,

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airport congestion and landing fees, air and noise pollution, operating costs per
seat mile and the nature and extent of competition (for an individual firm).

The data required for estimating the demand for capital goods are:

(a) The growth prospects of the user industries (demand estimates for the end-
use products in the case of intermediate goods)

(b) The norm of consumption of capital goods per unit of installed capacity (per
unit of each end use product in the case of intermediate products). It is assumed
that norms of consumption would remain stable. However, in some cases the
present norms may reflect shortages (for instance, in the case of imported spares
subject to import controls). For construction of bridges, for example, mild steel
may be in use in place of construction steels which are more suitable, because of
the latter’s non-availability of high costs. In such cases, as the pattern of
availability changes, norms of consumption would also change.

(c) The velocity of their use.

METHODS OF FORECASTING

It should first of all the emphasized that there is no easy method or simple
formula, which enables an individual or a business to predict the future with
certainty or to escape the hard process of thinking. Moreover, two dangers must
be guarded against. First, too much emphasis should not be placed on
mathematical or statistical techniques of forecasting. Though statistical
techniques are essential in clarifying relationships and providing techniques of
analysis, they are not substitutes for judgment. The other danger is that we may
go to the opposite extreme and regard forecasting as something to be left to the
judgment of the so-called experts. What is needed is some commonsense mean
between pure guessing and too much mathematics. The more commonly used
methods of demand forecasting are discussed below.

i. Survey of Buyers Intentions

The most direct method of estimating demand in the short run is to ask customers
what they are planning to buy for the forthcoming time period-usually a year. This
method, also known as Opinion Surveys, is most useful when bulk of the sales is
made to industrial producers. Here the burden of forecasting is shifted to the
customer. Yet it would be wise to depend wholly on the buyer’s estimates and
they should be used cautiously in the light of the seller’s own judgment. A
number of biases may creep into the surveys. If shortages are expected,
customers may tend to exaggerate their requirements. The customers may know
what their total requirements are but they may misjudge or mislead or may be
uncertain about the quantity they intend to purchase from a particular firm. This
method is not very useful in the case of household customers for several reasons

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viz irregularity in customers buying intentions, their inability to foresee their

choice when faced with multiple alternatives, and the possibility that the buyers
plans may not be real but only wishful thinking. Again, household customers
numerous making this method rather impracticable and costly. A basic limitation
of this method is that it is passive and “does not expose and measure the
variables under management’s control”.

I. Delphi Method.

A variant of the opinion poll and survey method is Delphi method. It consists of
an attempt to arrive at a consensus in an uncertain area by questioning a group
of experts repeatedly until the responses appear to converge along a single line
or the issues causing disagreement are clearly defined. The participants are
supplied the responses to previous questions from others in the group by a
coordinator or leader of some sort. The leader provides each expert with the
responses of the others including their reasons. Each expert is given the
opportunity to react to the information or consideration advanced others but
interchange is anonymous so as to avoid or reduce the “halo effect”, bandwagon
effects” and ‘ego involvements’ associated with publicity expressed opinions.
Delphi method was originally developed at Rand Corporation of the U.S.A. in the
late 1940s by Olaf Helmer. Dalkey and Gordon and has been successfully used
in the area of technological forecasting. I.e. predicting technical changes. It has
proved more popular in forecasting non-economic rather than economic
variables.

The Delphi method has some exclusive advantages. First it facilitates the
maintenance of anonymity of the respondent’s identity throughout the course.
This enables the respondent to be candid and forthright in his/her view.
Secondly, Delphi renders it possible to pose the problem to the experts at one
time and have their response. This is nearly as good as the panelists physically
pooled together for the exercise. Thus, this technique saves time and other
resources in approaching a large number of experts for their views. In one case
for example, about 620 experts with different backgrounds such as policy-
makers, technologists, scientists, economists, administrators and advisers were
solicited.

However, the Delphi method presumes the following two conditions. First
the panelists must be rich in their expertise, possess wide knowledge and
experience of the subject and have an aptitude and earnest disposition towards
the participants. Secondly, the Delphi presupposes that its conductors are
objective in their job, possess ample abilities to conceptualise the problems for
discussion, genera tic considerable thinking, stimulate dialogue among panelists
and make inferential analysis of the multitudinal views of the participants. Most
often, the complexity of the subject under debate determines the degree of these
qualities on the part of the conductors.

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II. Collective Opinion

Under this method also called sales force polling salesmen are required to
estimate expected sales in their respective territories and sections. The rationale
of this method is that salesmen, being the closest to the customers, are likely to
have the most intimate feel of the market. I.e. customer reaction to the products
of the firm and their sales trends. The estimates of individual salesmen are
consolidated to find out the total estimated sales. They are then reviewed to
eliminate the bias of optimism on the part of some salesmen and pessimism on
the part of others. These revised estimates are further examined in the light of
factors like proposed changes in selling prices, product designs and
advertisement programmes, expected changes in competition, changes in
secular forces like purchasing power, income distribution, employment,
population, etc. the sales forecast would emerge after these factors have been
taken into account. This method is known as the collective opinion method as it
takes advantage of the collective wisdom of salesmen departmental heads like
production manager, sales manager, marketing manager, managerial economist,
etc. and the top executives.

Advantages
(1) The method is simple and does not involve the use of statistical techniques.
(2) The forecasts are based on first-hand knowledge of salesmen and others
directly connected with sales. (3) The method may prove quite useful in
forecasting sales of new products. Of course, here salesmen will have to depend
more on their judgment than in the case of existing products.

Disadvantages (1) it is almost completely subjective as personal opinions can

possibly influence the forecast. Salesmen may even understate the forecast of
their sales quotas are to be based on it. (2) The usefulness of this method is
restricted to short-term forecasting. i.e. for a period of about one year. These
forecasts may not be useful for long-term production planning. (3) Salesmen may
be unaware of the broader economic changes likely to have an impact on the
future demand. Their jobs usually require full-time attention to the present so that
they do not get time to think about the future. In many cases, they may lack the
necessary breadth of vision for looking into the future, say five years ahead or
more.

III. Analysis of Time Series and Trend Projections

A firm, which has been in existence for some time, will have accumulated
considerable data on sales pertaining to different time periods. Such data when
arranged chronologically yield ‘time series’. The time series relating to sales
represent the past pattern of effective demand for a particular product. Such data
can be presented either in a tabular form or graphically for further analysis. The
most popular method of analysis of time series is to project the trend of the time

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series. A trend line can be fitted through a series either visually or by means of
statistical techniques such as the method of least squares. The analyst chooses
a plausible algebraic relation (linear, quadratic, logarithmic etc) between sales
and the independent variable time. The trend line is then projected into the future
by extrapolation.

This method is popular because it is simple and inexpensive and partly

because time series data often exhibit a persistent growth trend. The basic
assumption of the trend method is that the past rate of change of the variable
under study will continue in the future. This technique yields acceptable results
so long as the time series shows a persistent tendency to move in the same
direction. Whenever a turning point occurs, however, the trend projection breaks
down. Nevertheless, a forecaster could normally expect to be right in most
forecasts especially if the turning points are few and spaced at long intervals
from each other.

The real challenge of forecasting is in the prediction of turning points

rather than in the projection of trends. It is when turning points occur that
management will have to alter and revise its sales and production strategies
most drastically. Many analyses have, therefore, given much thought to the
turning points.

There are primarily four sets of factors which are responsible for the
characterization of time series by fluctuations and turning points in a time series:
trend seasonal variations, cyclical fluctuations and irregular or random forces.
The problem in forecasting is to separate and measure each of these four
factors.

The basic approach is to treat the original time series data (O or observed
data) as composed of four parts a secular trend (T) a seasonal factor (S) a
cyclical element © and an irregular movement (I) It is generally assumed that
these elements are bound together in a multiplicative relationship expressed by
the equation O = TSCI The usual practice is to first compute the trend from the
original data. The trend values are then eliminated from observed data (TSCI/T).
The next step is to calculate the seasonal index, which is used to remove the
seasonal effect (SCI/S). A cycle is then fitted to the remainder, which also
contains the irregular effect.

The foregoing approach to the decomposition of time series data is a

useful analytical device for understanding that nature of business fluctuations.
However, it is of limited value in actual business forecasting. The trend and the
seasonal factor can be forecast, but the prediction of cycles is hazardous for the
simple reason that there is no regularity in the cyclical behavior.

However, there are two assumptions underlying this approach: (1) The
analysis of movements would be in the order of trend, seasonal variations and

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cyclical changes: and (2) The effects of each component are independent of
each other.

IV. Use of Economic Indicators

The use of this approach bases demand forecasting on certain economic

indicators, e.g.,
• Construction contracts sanctioned for the demand of building materials, say,
cement;
• Personal income for the demand of consumer goods;
• Agricultural income for the demand of agricultural inputs, implements,
fertilizers etc; d
• Automobile registration for the demand of accessories, petrol etc.

These economic indicators are published by specialized organization like the

C.S.O., which publishes national income estimates.

For the use of economic indicators, the following steps have to be taken

See whether a relationship exists between the demand for a product and certain
economic indicators.

1. Establish the relationship through the method of least squares and derive the
regression equation. Assuming the relationship to be linear, the equation will be
of the form Y = a + ax. There can be curvilinear relationships as well.

2. Once regression equation is derived, the value of Y,i.e. demand can be

estimated for any given value of x.

3. Past relationships may not recur. Hence the need for value judgment as well.
New factors may also have to be taken into consideration.

Limitations

1. Finding an appropriate economic indicator may be difficult.

2. For new products. It is inappropriate, as no past data exist.

3. This method of forecasting works best where the relationship of demand with
a particular indicator is characterized by a time lag. For example construction
contracts will result in a demand for building materials but with a certain amount
of time lag. However, where the demand does not lag behind the particular
economic index, the utility is limited because may have to be based on projected
economic index itself which may not come true.

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V. Controlled Experiments

Under this method, an effort is made vary separately certain determinates

of demand which can be manipulated, e.g. price advertising, etc., and conduct
the experiments assuming that the other factors remain constant. Thus, the effect
of demand determinates like price, advertisement; packaging etc. on sales can
be assessed by either varying them over different markets or by varying them
over different time periods in the same markets. For example, different prices
would be associated with different sales and on that basis the price quantity
relationship is estimated in the form of regression equation and used for
forecasting purposes. It must be noted that the market divisions here must be
homogeneous with regard to income tastes, etc.

Controlled experiments have often been conducted in the U.S.A. to gauge

the effect of a change in some demand determinates like price, advertising,
product design, etc. for example the Parker Pen Co. used this method to find out
the effect of a price rise on the demand for Quink Ink.

The method of controlled experiments is still relatively new and less tried.
This is due to several reasons. First such experiments are expensive as well as
time-consuming. Secondly they are risky too because they may lead to
unfavorable reactions on dealers, consumers and competitors. Thirdly, there is a
great difficulty in planning the study inasmuch as it is not always easy to
determine what conditions should be taken as constant and what factors should
be regarded as variable so as to segregate and measure their influence on
demand. Fourthly, it is difficult to satisfy the condition of homogeneity of markets.
Despite these limitations, controlled experiments have sufficient potentialities to
become a major method for business research and analysis in future.

VI. Judge mental Approach

Management may have to use its own judgment when: (i) analysis of time
series and trend projections is not feasible because of wide fluctuations in sales
or because of anticipated changes in trends; and (ii) use of regression method is
not possible because of lack of historical data or because of managements is
inability to predict or even identify causal factors. Even when statistical methods
are used. It might be desirable to supplement them by use of judgment for the
following reasons (a) Even the most sophisticated statistical methods cannot
incorporate all the potential factors affecting demand as, for example, a major
technological breakthrough in product or process design. (b) For industrial
products demand may be concentrated in a small number of buyers if the
management anticipates loss or addition of a few such large buyers. It would be
taken into account only through the judgmental approach. (c) Statistical forecasts
are more reliable for larger levels of aggregations. Thus while it may be possible
to forecast the total national demand more or less accurately. It may be more
difficult to accurately forecast demand by sales territory, sizes and models. In

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such cases, there is no alternative but to depend upon judgment for developing
more detailed forecasts.

APPROACH TO FORECASTING

1. Identify and clearly state the objectives of forecasting-short-term or long-

term; market share or industry as a whole.

2. Select appropriate method of forecasting.

3. Identify the variables affecting the demand for the product and express
them in appropriate forms.

4. Gather relevant data for approximations to relevant data to represent the

variables.

5. Through the use of statistical techniques, determine the most probable

relationship between the dependent and the independent variables.

6. Prepare the forecast and interpret the results. Interpretation is more

important to the management.

7. For forecasting the company’s share in the demand, two different

assumptions may be made:

(a) The ratio of the company sales to the total industry sales will
continue as in the past.

(b) On the basis of an analysis of likely competition and industry

trends, the company may assume a market share different from
that of the past.

If would; however, be useful to prepare alternative forecasts. They are

more meaningful than a single forecast. As forecasts are based on certain
assumptions, forecasts must be revised when improved information is
available. In long-term forecasts, the projections may be revised every
year. These are sometimes known as rolling forecasts.

8. Forecast may be made either in terms of physical units or in terms of

rupees of sales volume. The latter may be converted into physical units by
dividing it by the expected selling price.

9. Forecasts may be made in terms of product groups and then broken for
individual products on the basis of past percentages. Product group may

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be divided into individual products in terms of sizes, brands, labels,

colours, etc. (See illustration below.)

10. Forecasts may be made on annual basis and then divided month-wise or
week-wise on the basis of past records.

11. For determining the month-wise break-up of the forecast sales of a new
product, either; (i) use may be made of other firms data, if available, or (ii)
some survey may be necessary. Similar will be the situation when the
forecast sales of a product line have to be divided product wise.

LENGTH OF FORECASTS

1. Short-term forecasts, involving a period up to twelve months, are

useful for determining sales quotas. Inventory control, production schedules,
judge ting and planning cash flows.

2. Medium term forecasts, involving a period from on to two years, are

useful for determining the rate of maintenance, schedule of operations and
budgetary control over expenses.

3. Long-term demand forecasts, involving a period of three to ten years,

are useful for determining capital expenditures, personnel requirements, financial
requirements, raw material requirements and the size and scope of R & D
programs.

However, the longer the forecast period, the more uncertain is the future. In the
absence of any other evidence, the long-term trend will tend towards the
horizontal. This is so for two reasons: (1) in the long-term market forces such as
competition, market situation, etc., will provide a barrier to continuous growth. (2) No
company will allow a product to decline indefinitely without taking some action, either
by increased promotion activity, new product development or by discontinuing the brand.

FORECASTING DEMAND FOR NEW PRODUCTS

Joel Dean has suggested a number of possible approaches to the problem of

forecasting demand for new products:

1. Project the demand for the new product as an outgrowth of an existing old
product.

2. Analyze the raw product as a substitute for some existing product or

service.

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3. Estimate the rate of growth and the ultimate level of demand for the new
product on the basis of the pattern of growth of established products.

4. Estimate the demand by making direct enquiries from the ultimate

purchasers, either by the used of samples or on a full scale.

5. Offer the new product for sale in a sample market, e.g. by direct mall or
through one multiple shop organization

6. Survey consumer’s reactions to a new product indirectly through the eyes

of specialized dealers who are supposed to be informed about consumers
need and alternative opportunities.

These methods are not mutually exclusive and it would be desirable to try to combine
several of them so that crosschecking is possible. To some extent, the methods of
forecasting demand for an established product may also be applied or adapted for new
products.

CRITERIA OF A GOOD FORECASTING METHOD

1. Accuracy. It is necessary to check the accuracy of past forecasts against

present performance and of present forecasts against future of performance. Some
comparisons of the model with what actually happens and of the assumptions with what
is borne out in practice are more desirable. The accuracy of the forecast is measured by:
(a) the degree of deviations between forecasts and actual, and (b) the extent of success in
forecasting directional changes.

2. Simplicity and Ease of Comprehension. Management must be able to

understand and have confidence in the techniques used. Understanding is also needed for
a proper interpretation of the results. Elaborate mathematical and econometric procedures
may be judged less desirable if management does not really understand what the
forecaster is doing and falls to understand the procedure.

3. Economy. Costs must be weighed against the importance of the forecast to the
operations of the business. A question may arise; how much money and managerial effort
should be allocated to obtain a high level of forecasting accuracy? The criterion here is
the economic consideration of balancing the benefits from increased accuracy against the
extra cost of providing the improved forecasting.

4. Availability. The techniques employed should be able to produce meaningful

results quickly; techniques which take a long time to work out may produce useful
information too late for effective management decisions.

5. Maintenance of Timeliness. The forecast should be capable of being

maintained on an up-to-date basis. This has three aspects.

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(a) The relationships underlying the procedure should be stable so that

they will carry into the future for a significant amount of time

(b) Current data required to use these underlying relationships should be

available on timely basis.

(c) The forecasting procedure should permit changes to be made in the

relationships as they occur.

ROLE OF MACRO-LEVEL FORECASTING IN DEMAND FORECASTS

Macro-level forecasting precedes micro-level demand forecasting for a firm or an

industry. The macro-parameters such as Gross National Product (GNP). Population
growth, per capita income, aggregate savings, level of investment, etc. provide the
boundaries within which projections of demand for an industry, a firm or a product fit in.
for instance, if the level of national savings is projected to rise fast, the disposable
consumer expenditure on products will in all probability decline. Thus savings parameter
has a bearing on future demand for consumer goods, especially durable consumer goods.
Likewise, rising population indicates that the market for various commodities is in
general expanding. Various macro-parameters found useful for demand forecasting are as
under:

(i) National income and per capita income. Increase in these parameters
indicates rising market potential consumer goods.

(ii) Savings, if the level of savings is high, this would dampen consumer
goods demand.

(iii) Investment. An increase in investment would raise demand for

intermediate goods or vice versa.

(iv) Population Growth. The future demand for all types of goods would rise
with population growth.

(v) Government expenditure. High level of public expenditure would

stimulate investment in the private sector. In the context of Indian
economy, the increase in public expenditure has a decisive role in
stimulating private investment, aggregate demand and the level of
spending in general.

(vi) Taxation. Taxation can also influence demand pattern. Certain taxes
would depress the demand of commodities taxed. For example, high level
of excise duties on semi-luxury and luxury goods such as electrical
appliances refrigerators, air-conditioners, etc, would depress the demand
for these goods. Further this in turn would depress investment in these

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industries and as such demand for capital goods employed in these

industries.

(vii) Credit policy. Such policies influence cost of credit, credit availability and
company finance. The time pattern of investment is largely affected by
credit policies again; inventories are largely affected by credit policies
through their effects on carrying costs of inventors. Credit policies affect
holding capacities of all business sections-producers, dealers and retailers.

It should thus be clear how forecasts regarding national parameters would influence and
determine firm’s demand projections. A good crop forecast and higher rural incomes
would lower cost of materials and boost demand for various products. The data pertaining
to national income, per capita income, production, prices, taxes, etc., present a reasonable
basis for good forecasts.

In India, information and data about macro parameters are mostly available in
various publications of Government organizations. National Council of Applied
Economic Research and Central Statistical Organization.

RECENT TRENDS IN DEMAND FORECASTING

1. More firms are giving importance of demand forecasting than a decade

ago.

2. Since forecasting requires closer co-operation and consultation with many

specialists, a team spirit has developed.

3. Better kind of data and improved forecasting techniques have been

developed.

4. There is a greater emphasis on sophisticated techniques such as using

computers.

5. New products forecasting is still in infancy.

6. Forecasts are usually broken down in monthly forecasts.

7. However, in spite of the application of newer and modern techniques,

demand forecasts are still not too accurate.

8. The usefulness of personal feel or subjective touch has been accepted.

9. Top down approach is more popular than bottom up approach.

Top down approach starts by analyzing national economy, then the industry
and finally the individual firm.

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Bottom up approach is preferred by small firms because (i) they are closer
to the customers. (ii) They cannot afford more sophisticated techniques, and
(iii) very often; the small firms manufacture a single product.

Question Bank

1 What is demand forecasting? Explain in brief the various methods of forecasting

demand

2 Explain Delphi method .what the advantages ad disadvantages of this method

3 Write a short note on survey method of demand forecasting

4 Write short note statistical methods of demand forecasting

5 Write short note sample survey of consumer’s intention demand forecasting

6 What is demand forecasting? How do you estimate demand for a new product

BREAK EVEN ANALYSIS

The fundamental objective of any business is to earn more and more profit. Profit
mainly depends on three factors namely cost of production, amount of output and
revenue. The value of these components depends on the level of various activities
performed in the organization. There is need to analyze fixed costs, variable costs
and costs and revenues at different levels of output to determine optimum profit.
Cost of production is composed of two components viz. fixed costs and Variable
costs. Fixed costs are assumed to constant at all levels of output e.g. expenditure on
permanent labour and overheads, But with the increase in output fixed cost per unit
of output decreases ,variable costs tend to vary with output e.g. material costs etc.
Cost of production can be minimized by (i) increase in output (ii) using alternative
cheaper material without affecting the quality (iii) Maintaining optimum inventory
levels (iv) standardization and mass production (v) Developing human resources by
training and incentive schemes and .One of the techniques to study the total cost,
total revenue and output relationship is break even analysis.. It is also termed as cost
volume pro/it analysis. The break-even analysis is the study of Cost-volume-profit
(CVP) relationship.
Break-even analysis can be carried out in two ways:(a) Algebraic method(b}
Graphical method usually, a break-even Analysis is presented graphically, as this
method of visual presentation well-suited to the need of managers to appraise the
situation at a glance.

ASSUMPTIONS IN BREAK-EVEN ANALYSIS: The following assumptions arc

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made while plotting a break-even chart:

1The total cost of production can be divided into two categories- (a) Fixed cost,
(b) Variable cost
2. Fixed cost remains constant i.e. it is independent of the quantity produced and
include executive salaries, rent of building, depreciation of plant and equipment
etc
3 The variable cost varies directly and proportionately with the volume of
production
If V =variable cost per unit and Q is the quantity produced, variable cost = V X
Q.
4 The selling price does not change with change in the volume of sales. If P is the
selling price total sales income = P X Q
5 The firm deals with only one product, or the sales mix remains unchanged
6 There is a perfect synchronization between production and sales. This assumes
that everything produced is sold and there is no change in the inventory of
finished goods
7 The productivity per worker and efficiency of plant. etc., remains mostly
unchanged.

PLOTTING BREAK-EVEN CHART

1 The cost and the sales income (revenue) in rupees are plotted along the vertical axis
2 the quantity (volume of production) is plotted along the horizontal axis
3 the fixed cost are represented by a straight line parallel to the horizontal axis
4 variable costs are superimposed upon the horizontal line representing the fixed cost.
This top
line represents the total cost line
5 the sales income line passes through the origin
6 the point of intersection of the sales income line and the total cost line represents the
break even point
7 the shaded area between the total cost line and the sales income line on the left hand
side of B.E.P .indicates loss whereas the shaded area on the right hand side of B.E.P.
shows profit.

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Margin of safety it is a distance between the break even point and the out put being
produced margin of safety is generally expressed as
1 Ratio of budgeted sales to sales at BEP
2 Ratio of actual sales to sales at BEP
3 Percentage of budget to BEP
4 Percentage of budget to actual sales at BEP

In case of unsatisfactory Margin of safety the following measures can be taken

Increase in sales price
Reduction in fixed cost
Reduction in variable costs
Increase in output

Margin of safety =
sales – sales at BEP x100

Sales

= profit
x sales
Sales
– variable cost

Angle of Incidence:
The angle between the sales income line and the total cost line is called as
angle of Angle of Incidence .A large angle of Incidence indicates large profit and
extremely favorable business position .A narrow angle shows that even though overheads
are recovered, the profit accrued shows a low rate of return. This indicates a large part of
variable costs in total costs

Profit Volume (P/V Ratio):

Profit volume ratio measures the profitability in relation to sales.
The contribution at given output is defined as difference between total sales and total
variable costs. The P/V ratio is the ratio of contribution to sales. It represents the
relationship between contribution and turn-over. So, it is a measure to compare
profitability of different products. Higher the P/V ratio the high yielding is the product

P/V ratio = Contribution = Increase in profit

----------------- ---------------------
Sales Increase In sales

= Total sales – Total variable costs

---------------------------------------
Total sales

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Price unit- Cost per unit

= ----------------------
Price per unit

Uses of P/V ratio

The P/V ratio can be used to study a variety of problems viz
1. Determination of B.E.P.
2. To know profit for given sales volume.
3. To now sales volume for achieving some desired profit.
P/V ratio can be increased by
1. Increasing the selling price.
2. Changing the mix of sales.
3. Reduction In variable costs.

COST
Cost is the amount of resources sacrificed or given up to achieve a
specific objective which may be the acquisition of goods or services. Costs are always
expressed in money terms.
Types of cost include

Direct material cost direct material refers to the cost of materials which become
a major part of finished product. e.g. raw cotton in textiles, steel for automobile parts

Direct labour. Direct labour is defined as the labour associated with workers who
are engaged in the production process. It is the labour costs for specific work performed
on products that is traceable to end products.e.g. Labour of machine operators, assembly
operators.

Factory overheads these are also called as manufacturing costs. These include the
cost of indirect materials, indirect labour and indirect expenses. e.g. foreman, shop clerks,
material handlers, cutting oils

Fixed cost The cost which don’t change for a given period in spite of change in
volume of production. This cost is independent of volume of production. E.g. fixed costs
are rent, taxes, insurance etc.
Variable costs These vary directly and proportionality with output. There is
constant ratio between the change in the cost and change in level of output. Direct
material cost and direct labour cost are generally variable cost.

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Opportunity cost opportunity cost is defined as the benefits lost by rejecting the
best competing alternative to the one chosen. The benefit lost is usually the net earnings
or profits that might have been earned from rejecting alternative

Sunk cost. It as expenditure for equipment or productive resources which has no

economic relevance to the present decision making process. It is the cost that has either
already been incurred or is yet be incurred but will be same no matter which alternative
course of action is selected. It is also known as unavoidable cost.

Controllable and non controllable cost a controllable cost is the cost over which
a manager has direct and complete decision authority.
A cost which cannot be influenced by the action of the specified member of na
organisationis referred as uncontrollable cost.

Numerical

1 A manufacturing firm incurs a fixed cost of Rs 18000. The variable cost accounts Rs 8
per unit and selling price is Rs 13. Find the number of pieces to be produced to brake
even

Solution
Fixed cost = 18000
Variable cost =8
Selling price = 13

BEP = Fixed cost / contribution

= 18000 / ( 13-8)
= 3600

2Total fixed cost for the year is Rs 1200000. This includes depreciation of Rs 200000,
write off of goodwill 100000. Selling price of good is Rs 80 per unit and variable cost is
Rs 60 find BEP and p/v ratio.

BEP= Fixed cost / contribution

= (1200000-200000-100000) / (80-60)
= 45000 Units

P/Vratio = (s-v)/s
= (80-60) / 80
= 0.25
25 %

3 for the particular product following information is given.

Selling price Rs 10
Variable cost per unit Rs 6
Fixed cost 100000

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Due to inflation variable cost increases by 10% while fixed cost increases by 5%. if the
break even quantity is remain constant by what percentage should the sales price to be
raised
Solution
BEP= Fixed cost / contribution
= 100000/( 10-6)
= 25000
New variable cost = Rs 6.6
New fixed cost = Rs 105000
At BEP sales = total cost
Total cost = 25000* 6.6 + 105000
= 2, 70000
so
Sales = 2, 70000
Revised sales price = 270000/ 25000
= 10.80
Increase in sales price to maintain same BEP = 10.8/10 - 10 =8 %

QUESTION BANK

1 Write a short note on Break even analysis

2 what is BEP? What is its significance?

3 Explain fixed cost, Variable costs, Sunk cost, Opportunity cost , actual cost,
incremental cost.

4 From the following calculate P/V, BEP, and Margin of safety

Sales 100000
Fixed cost 20000
Variable cost 60000

5 A company estimates that next year it will earn a profit of Rs 50000. The
budgeted fixed cost and sales are 250000 and 993000 resp. Find out the break
even point for the company

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