managerial economics 07042011

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[Managerial Economics ]AMITY eLEARNING

Amity University


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Preface

This is an attempt to the integration of economic theory with business practices for the purpose

of facilitating Decision Making and Forward Planning by the management. As economics

provides as a set of concepts, these concepts furnish us the tools and techniques of analysis. It is

in this context economic analysis is an aid to understand business practices in a given

environment. As decision making is a basic function of manager, economics is a valuable guide

to the manager. In the following we shall be discussing the decision making process of the

management and how managerial economics and its various tools and techniques help a

manager in this process.


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Chapter-I

Managerial Decision Making

Contents:

1.1Introduction

1.2 Decision Making Process

1.3 Management Decision Problems

1.4 Corporate Decision Making: Ford Introduces the Taurus

1.5 Types of Decision

1.6 Conditions Affecting Decision Making1.7 The Steps of Decision Making

1.8 Selecting the Best Alternative

1.9 Implementing the Decision

1.10 Evaluating the Decision

1.11 Decision Making Model

1.11.1 The Classical Model

1.11.2 The Administrative Model

1.12 Decision Making Techniques1.12.1 Marginal Analysis

1.12.2 Financial Analysis

1.13 Group Decision Techniques

1.13.1 Brainstorming

1.13.2 Nominal Group Technique

1.13.3 Delphi Group Technique

1.14 Decision Making Tools

1.14.1 Linear Programming1.14.2Inventory Control


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1.4 Corporate Decision Making : Ford Introduces the Taurus

In late 1985 Ford Introduced the Taurus -a newly designed, aerodynamically styled, front-

wheel drive automobile. The car was a huge success at the time and helped Ford almost to

double its profits by 1987. The design and efficient production of this car involved not only

some impressive engineering advances, but a lot of economics as well. Ford, had to think

carefully about how the public would react to the Taurus design. Would consumers be swayed

by the styling and performance of the car? How strong would demand depend on the price

Ford changed? Understanding consumer preferences and trade-offs and predicting demand

and its responsiveness to price were essential parts of the Taurus program.

Ford had to be concerned with cost of the Car. How high would production costs be, how

would this depend on the number of cars for produced each year? How would union wage

negotiations or the prices of steel and other raw materials effect costs? How much and how fast

would costs decline as managers and workers gained experience with the production process?

To maximize profits, how many cars should Ford plan to produce each year?

Ford also had to design a pricing strategy for the car and consider how its competitors would

react to this strategy. For example, should Ford charge a low price for the basic stripped-down

version of the car but high prices for individual options, such as air conditioning and power

steering? Or would it be more comfortable to make these options "Standard" items and charge

a high price for the whole package? Whatever prices ford choose, how were its competitors

likely to react? Would GM and Chrystler try to under cut Ford by lowering prices? Might Ford

be able to deter GM and Chrysler from lowering prices by threatening to respond with its own

price cuts? The Taurus program required a large investment in new capital equipment and

Ford had to consider the risks involved and the possible outcomes. Some of this risk was due to

uncertainty over the future price of gasoline (Higher gasoline prices would shift demand to

smaller cars). What would happen if world oil prices doubled or tripled, or, if the government

imposed a new tax on gasoline? How should Ford take these uncertainties into account when

making its investment decisions? Ford also had to worry about organizational problems, Ford

is an integrated firm -separate divisions produce engines and parts, then assemble finished

cars. How should the managers of the different divisions be rewarded? What price should the

assembly division be charged for engines it receives from another division? Should all the parts

be obtained from the upstream divisions, or other firms? All these decision come under

managerial decision taking process.

1.5 Types of Decision

Managers make many decisions, in order to answer the following questions:

What goods shall firm produce?

How should firm raise the necessary capital and what shall be its legal form.

What technique shall be adopted, and what shall be the scale of operations?

Where production is located?


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How shall its product be distributed?

How shall resources be combined?

What shall be the size of output?

How shall it deal with its employees?

Managers make these decisions, and in order to obtain a clear understanding of the decision

making process, a classification system is useful. Three such systems are available; each based

on different types of decisions.

Organizational and personal decisions,

Basic and routine decisions

Programmed and non-programmed decisions.

Organizational decisions are those executives make in their official role as managers. The

adoption of strategies, the setting of objectives and the approval of plans constitute only a few

of these. Such decisions are often delegated to others, requiring the support of many people

throughout the organizational if they are to be properly implemented.

Personal decisions are related to the managers as an individual, not as a member of the

organizations. Such decisions are not delegated to others because their implementation does

not require the support of organizational personnel. Deciding to retire, taking a job offer from a

competitive firm, or slipping out and spending the afternoon on the golf course are all personal

decisions.

A second approach is to classify decisions into basic and routine categories. Basic decisions can

be viewed a much more important than routine ones. They involve long-range commitments,

large expenditures of funds, and such a degree of importance that a serious mistake might well

jeopardize the well being of the company. Selection of a product line, the choice of a new plant

site, or a decision to integrate vertically by purchasing sources of raw materials to complement

the current production facilities are all basic decisions.

Routine decisions are often repetitive in nature, having only a minor impact on the firm. For

this reason, most organizations have formulated a host of procedures to guide the manager in

handing these matters. Since some individuals in the organization spend most of their time

making routine decisions, these guidelines are very useful to them.

Taking a cue from computer technology, decision could be classified as computer technology

programmed and non-programmed. These two types can be viewed on a continuum,

programmed being at one end and non-programmed at the other. Programmed decisions

correspond roughly to the routine decisions, with procedures playing a key role. Non

programmed decisions are similar to the category of basic decisions, being highly novel,

important, and unstructured in nature. The value of viewing decision making in this manner is

that it permits a clearer understanding of the methods that accompany each type.


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1.6 Conditions Affecting Decision Making

In an ideal business situation, managers would have al of the information they need to make

decisions with certainty. Most business situations however are characterized by incomplete or

ambiguous information, which affects the level of certainty with which a manager makes a

decision. There are three conditions that affect decision making:

Certainty

Risk

Uncertainty

Certainty is the condition that exists when decision makes are fully informed about a problem

its alternative solutions, and their respective outcomes. Under this condition, individuals can

anticipate, and even exercise some control over, events and their outcomes.

In the context of decision making, risk is the condition .that exists when decision-makers must

rely on incomplete, yet reliable information. Under a state of risk, the decision-maker does not

know with certainty the future outcomes associated with alternative courses of action; the

results are subjects to chance. However, the manager has enough information to determine the

probabilities associated with each alternative. He or she can then choose. The alternative that

has the highest probability of success.

Uncertainty is the condition that exists when little or no factual information is available about a

problem, its alternative solution, and their respective outcomes. In a state of uncertainty, the

decision-maker does not have enough information to determine the probabilities associated

with each alternative. In actually, the decision-maker may have so little information that he or

she may be unable even to define the problem, let alone identify alternative solutions and

possible outcomes.

1.7 The Steps of Decision Making

Identifying the problem

Generating the alternative course of action

Evaluating the alternative

Selecting the best alternative

Implementing the decision; and

Evaluating the decision

The first step in the decision-making process is identifying the problem. Problem identification

is probably the most critical art of the decision making process, for it is what determines the

direction that the decision making process takes, and, ultimately, the decision that is made.

The second step in decision-making process is generating alternative solutions to the problem.

This step involves identifying items or activities that could reduce or eliminate the difference


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between the actual situation and the desired situation. For this step to be effective, the decision

makers must allot enough time to generate creative alternatives as well as ensure that all

individuals involved in the process exercise patience and tolerance of others and their ideas.

In the Pursuit of quick fix managers too often shortchange this step by failing to consider

more than one or two alternatives, which reduces the opportunity to identify effective

solutions. After generating a list of alternatives, the arduous task of evaluating each of them

begins. Numerous methods exist for evaluating the alternatives, including determining the

pros and cons of each; performing a cost-benefit analysis for each alternative; and weighting

factors important in the decision, ranking each alternative relative to its ability to meet each

factor, and then multiplying cumulatively to provide a final value for each alternative.

1.8 Selecting the Best Alternative

After the decision-makers have evaluated all the alternatives, it is time for the fourth step in the

decision-making process; choosing the best alternative. Depending on the evaluation method

used, the selection process can be fairly straightforward. The best alternative could be the one

with the most "pros" and the fewest "cons"; the one with the greatest benefits and the lowest

costs; or the one with the highest cumulative value, if using weighting.

1.9 Implementing the Decision

This is the step in the decision making process that transforms the selected alternative from an

abstract situation into reality. Implementing the decision involves planning and executing the

actions that must take place so that the selected alternative can actually solve the problem.

1.10 Evaluating the Decision

In evaluating the decision, the sixth and final step in the decision-making process, managers

gather information to determine the effectiveness of their decision. Has original problem

identified in the first step been resolved? If not, is the company closer to the situation it desired

than it was at the beginning of the decision-making process?

1.11 Decision Making Model

There are basically two major models of decision-making -the classical model and the

administrative model.1.11.1 The Classical Model

The classical model of decision making is a prescriptive approach that outlines how managers

should make decisions. Also called the rational model, the classical model is based on

economic assumptions and asserts that managers are logical, rational individuals who make

decision that are in the best interest of the organization. The classical model is characterized by

the following assumptions:


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Similarly, land's marginal -product is the change in total product resulting from one additional

unit of land with all other inputs held constant. The manager can use the concept to answer

questions such as how much more output will result if one more worker is hired? The answer

often called marginal physical product, provides a basis for determining whether or not one

new man will bring about profitable additional output.

1.12.2 Financial Analysis

The firms are supposed to safeguard their interest and avert the possibilities of risk or try to

minimize it. For this a firm needs to analyze the assets as well as liabilities, efficiency of capital

investment, choice of project and various vital ratios. The cost benefit analysis ensures the

firms to take prudent financial decision.

1.13 Group Decision Techniques

There are several group decision techniques:

1.13.1 Brainstorming

Brainstorming is a technique in which group members spontaneously suggest keys to solve a

problem. Its primary purpose is to generate a multitude of creative alternatives, regardless of

the likelihood of their being implemented.

1.13.2 Nominal Group Technique

The Nominal Group Technique involves, the use of highly structured meeting agenda and

restricts discussion or interpersonal communication during the decision making process. While

the group members are all physically present, they are required to operate independently.

1.13.3 Delphi Group Technique

The Delphi group Technique employs a written survey to gather expert opinions from a

number of people without holding a group meeting. Unlike in brainstorming and nominal

groups, Delphi group participants never meet fact to face; in fact, they may be located in

different cities and never see each other.

1.14 Decision Making Tools

The major decision- making tools are as under:


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Where:

D = expected annual demand

A = Administrative costs per order

V = Value per item

r = Estimate for taxes, insurance and other expenses

The EOQ formula is used by many firms in solving inventory control problems. However, it isonly one of many mathematical techniques that lave been developed to help the manager make

decisions.

Another important tool in taking one of the most economical decisions is "Decision Trees"

Many managers weight alternatives base don their immediate or short-run results, but a

decision- tree format permits a more dynamic approach because it makes some elements

explicit that are generally implicit in other analyses. A decision tree is a graphic method that

the manager. can employ in identifying the alternative courses of action available to him in

solving a problem; assigning payoff corresponding to each act-event combination.For example, consider the case of a firm that has expansion funds and must decide what to do

with them. After careful analysis, three alternatives identified:

Use the money to buy a new company

expand the facilities of the current firm

put the money in a saving account


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And wait for better opportunities. In deciding which alternative is best, the company has

gathered all the available information and constructed the decision tree.

In the figure there are four important components. One is the decision point, represented by a

square, which indicates where the decision maker must choose a course of action. second is a

chance point, represented by a circle, which indicates where a chance event is expected, such as

solid economic growth, stagnation, or high inflation. A third is the branch, represented by a

line flowing from the chance points, which indicates an event and its likelihood such as 0.5 per

solid growth, 0.3 for stagnation or 0.2 for high inflation. Finally, at the far right is a payoff

associated with the each branch. It is called a conditional payoff since its occurrence depends

on certain conditions. For example, in figure the conditional ROI (Return on Investment)

associated with buying a new firm and having solid economic growth is 15 per cent, but this

return is conditional on the two preceding factors (buying the firm and having solid growth).

In building a decision tree, the company will start by identifying the three alternatives, the

probabilities and events associated with each alternative, and the amount of return that can be

expected from each. Having then constructed the tree, the firm will roll back it from right to

left, analyzing as it goes.

This analysis is conducted, first by taking the conditional ROls at the far right of the tree and

multiplying them by the probability of their occurrence. For example, if the company buys a

new firm and there is solid growth in the economy, as seen in figure, it will obtain a 15 per cent

ROL However, the probability of such an occurrence is 0.5 Likewise, the probabilities

associated with stagnant growth, where the return will be 9 percent, and high inflation, where

the return will be 3 percent, are .3 and .2 respectively. In order to determine the expected return

associated with buying a new firm, each of the conditional ROl s is multiplied by its respective

probability and the products are then totaled. For alternative one, buying the firm, the

calculation is as follows:

Conditional ROI Probability Expected Return

15.0 0.5 7.5

9.0 0.3 2.7

3.0 .02 0.6

10.8

For alternative two, expanding current facilities, the calculation is:


10.0 0.5 5.0

12.0 0.3 3.6


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4.0 0.2 0.8

9.4

For alternative three, expanding current facilities, the calculation is:


6.5 0.5 3.25

6.0 0.3 1.80

6.0 0.2 1.20

6.25

These expected returns are often placed over the chance points on the decision tree. They can

be determined only after the tree has been drawn and the analysis of the branches has been

conducted. The first alternative is the best, because it offers the greatest expected return. In

evaluating alternatives, decision these help the manager identify both what can happen and thelikelihood of its occurrence .In building the tree we moved from left to right but in analyzing

we moved from right to left. In the final analysis the decision tree does not provide any

definitive answers. However, it does allow the manager to allow benefits against costs by

assigning probabilities to specific events and then ascertaining the respective payoff.


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End Chapter quizzes :

Q.1. The Technique that employs a written survey to gather expert opinions from a number of

people without holding a group meeting is known as -

(a) Brainstorming

(b) The Delphi group Technique

(c) The Nominal Group Technique

(d) None of the above

Q.2. Approval of Plans is the best example of -

(a) Organizational decisions,

(b) Basic decisions

(c) Programme decisions.

(d) Both (a) & (c)

Q.3. Which sort of decision does not require the organizational support-

(a) Basic decision

(b) Routine decision

(C) Personal decision

(d) Organizational decision

Q.4 In the context of formulation of an investment decision on a project, the availability of

land, plant, machinery, raw materials and technical know how etc. means-

(a) Technical Feasibility

(b) Financial feasibility

(c) Commercial feasibility



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(a) Nominal Group Technique,

(b) Brainstorming,

(c) Delphi Group Technique,

(d) Both (b) & (c)

Q.10. In identifying the alternative courses of action available to a manager while solving a

problem, a decision tree is

(a) More dynamic in nature,

(b) Graphical method,

(c) Assigns payoff corresponding to each act-event combination,

(d) All of the above.


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Chapter-II

Business Forecasting

Contents:

1.1 Introduction

1.2 Purpose and need of forecasting

1.2.1 Specific purposes of demand forecasting

1.3 Steps Involved in Forecasting

1.4 Period of forecasting

1.5 Levels of Forecasting

1.6 Methods of Forecasting1.6.1Qualitative Forecast

1.6.1.1 Survey techniques

1.6.1.2 Opinion pools

1.6.2 Statistical Forecast

1.6.2.1 Trend projection method

1.6.2.2 Barometric methods

1.6.2.3 Regression method

1.6.2.4. Simultaneous equation method (Econometric Models)1.6.2.5. Input Output Forecasting

1.7 Reasons for fluctuations in time series data

1.7.1 Cyclical fluctuations

1.7.2 Seasonal variation

1.7.3 Irregular and random variation

1.8 Smoothing Techniques

1.8.1 Moving average smoothing technique1.8.2 Exponential smoothing technique

1.9 Risks in Demand Forecasting


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1.1 Introduction

Estimation of demand for a product in a forecast year/ period is termed as Demand forecast.

Demand forecast is a must for a firm operating its business as today's market is competitive,

dynamic and volatile.

1.2 Purpose and need of forecastingForecasting is done both for long term as well as short term. The purpose of the two however

differs. In a short run forecast seasonal patters are of prime importance. Such a forecast helps in

preparing suitable sales policy and proper scheduling of output in order to avoid over-stocking

or costly delay in meeting the orders. It helps in arriving at suitable price for the product and

necessary modifications in advertising and sales techniques. Long run forecasts are helpful in

proper capital planning. It helps in saving the wastages in material, m -hours, machine time

and capacity. Long run forecasting is used for new unit planning, expansion of the existing

units, planning long run financial requirements and manpower requirements. Different set of

variables is used in than in short term forecasts.

1.2.1 Specific purposes of demand forecasting

Better planning and allocation of resources

Appropriate production scheduling

Inventory control

Determining appropriate pricing policies

Setting s les targets and establishing controls and incentives.

Planning a new unit or expanding existing one

Planning long term financial requirements

Planning Human Resource Development strategies.

1.3 Steps Involved in Forecasting

Identification of objective

Determining the nature of goods under consideration.

Selecting a proper method of forecasting.

Interpretation of results.

1.4 Period of forecasting

Short run forecasting: In short run forecasting, we look for factors which bring

fluctuation in demand pattern in the market for example weather conditions like

monsoon affecting the demand.

Medium run forecasting: In medium run forecasting is done basically for timing of an


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activity like advertising expenditure.

Long run forecasting: It is done to ascertain the validity of trend. It is done for decision

like diversification.

1.5 Levels of Forecasting

Macroeconomic forecasting is concerned with business conditions of the whole

economy. It is measured with the help of indices like wholesale price index, consumer

price index.

Industry demand forecasting gives indication to firm regarding direction in which the

whole industry will be moving. It is used to decide the way the firm should plan for

future in relation to the industry.

Firm demand forecasting is done for planning companies overall operations like sales

forecasting etc.

Product line forecasting helps the firm to decide which of the product or products should

have priority in the allocation of firm's limited resources.

General purpose or specific purpose forecast helps the firm in taking general factors

into consideration while forecasting for demand.

Forecast of established product or a new product

Types of commodity for which forecast is to be done. Goods can be broadly classified

into capital goods, consumer durable and Non-durable consumer goods. For each of

these categories of goods there is a distinctive pattern of demand.

1.6 Methods of Forecasting


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1.6.1Qualitative Forecast

1.6.1.1 Survey techniques

Survey of business executives, plant and equipment, expenditure plans.

Basically compilation of expenditure plans of related industries.Survey of plans for inventory changes and sales expectations.

Survey of consumer expenditure plans.

1.6.1.2 Opinion pools

Consumer survey: In this method the consumers are contacted personally to

disclose their future purchase plans. This could be of two types-Complete

enumeration and sample survey.

Sales force opinion method: In this method people who are closest to themarket are asked for their opinion on future demand. Then opinion of

different people is compiled to get overall demand forecast. This method has

advantage that it is based on first hand knowledge of sales people and also it

is cheap and easy. However the opinion of the concerned people could be

biased or twisted for their own benefit. Therefore a final ratification has to be

done by the head office.


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Experts opinion method: In this method opinion of experts' in the related

field is solicited and the final forecast based on their opinion. A special case

in this method is the Delphi Technique. In this different sets of experts are

given the relevant problem without each knowing about the other and their

opinions or conclusions are compared. If the opinion is matching then theopinion is accepted other wise the experts are asked to sit together and

arrive at a narrow range. Thus the experts giving a very high or a very low

value are concerned and the group argues until it comes up with a narrow

range of value. This process is continued till a sufficient range is reached.

Then the mean of the upper and lower values is computed to reach a point

estimate.

1.6.2 Statistical Forecast

1.6.2.1 Trend projection method

Under the trend method the time series data on the variable under forecast are used to

fit a trend line or curve either graphically or by means of a statistical technique known

as the Least Squares method. Trend projection method can be used when there is some

sort of correlation between the two variables. It could be linear, logarithmic or power

correlation. The linear regression model will take the form of

Y = a + bX

Fitting a trend line by observation: This method involves the plotting of thedata on the graph and estimating where the trend line lies. The line can be

extrapolated and the forecast read from the graph.

Trend through least squares method: This method uses statistical formulae to

find the trend line which best fits the available data. The trend line is the

estimating equation, which can be used for forecasting demand by extrapolating

the line for future and reading the corresponding values of variables on the

graph.

Time series analysis: This is an extension of linear regression which attempts to

build seasonal and cyclical variations into the estimating equation. This method

assumes that past data can be used to predict future sales. This is one of the

most frequently used forecasting methods. It refers to he values of variable

arrange chronologically by days, weeks, months, quarters or years. The first step

in time series analysis is usually to plot past values of the variable that we seek


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to forecast on vertical axis and the time on the horizontal axis in order to

visually inspect the movement of the time series over time. It assumption is that

the time series will continue to move as in the past. For this reason time series

analysis is often referred as "native forecasting.

1.6.2.2 Barometric methods

Barometric methods are used to forecast or anticipate short term changes in economic

activity by using leading economic indicators. These indicators are time series that tend

to precede changes in the level of economic activity. There are only three types of

indicators:

Leading economic indicator: These indicators tend normally to anticipate

turning points in a business cycle. There are certain problems associated with

this method. The major problem is not choosing the technique but choosing the

relevant indicator for the product in question. Secondly even if the relevant

indicator is found out the changes in factors may render the indicator redundant

over time. Thirdly the time lag between the indicator and forecast could be so

small that it could become useless.

Coincident indicators: These are indicators which move in step or coincide with

movements in general economic activity or business cycle.

Lagging indicator: These are indicators which lag the movements in economic

activity or business cycle.

1.6.2.3 Regression method

It is one of the statistical tools to fore cast demand. In this estimating equations are

established and tests can be carried out to observe any statistically significant. It

involves following steps

Identification of variables which influence the demand for the good whose

function is under estimation.Collection of historical data on all relevant variables.

Choosing an appropriate form of the function.

Estimation of the function

Regression method is popular because it is prescriptive as well as descriptive.


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Also it is not as subjective or objective as other methods. However if the

variables chosen are wrong then the forecast will also be wrong. A typical

demand equation could be :

Log d = -12.4 + 1.78 log y -1.22 log 0 + 2.20 log v + 0.8 log g + 1.62 log e

Y = National income

O = groundnut oil price

V = Vanaspati price

G = ghee price

E = egg, fish and meat price

The above equation is a demand forecast equation for groundnut oil

1.6.2.4.Simultaneous equation method (Econometric Models)

Econometric forecasting incorporates or utilizes the best features of other forecasting

techniques such as trend and seasonal variation, smoothing techniques and leading

indicators. Econometric forecasting models range from single equation models of the

demand that the firm faces for tits product to large multiple equation models describing

hundreds of sectors and industries of the economy.

Single equation models:The simplest form of econometric forecasting is with the

single equation model. The first step here is to identify the determinants of the variable

to be forecasted.

Q = a0 + a1P + a2Y +a3N + a4P5 + a5Pc + a6a + e

Q = demand

P = Price

Y = disposable income

N = size of population

Ps = price of a substitute


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Pc = price of complement

A = level of advertising by the firm

Multiple equation model: Sometimes economic relationships may be so complex that amultiple equation model may be required. This is particularly used in forecasting micro

variables or the demand and sales of major sectors or industries. Multiple equation

model for GNP

Ct = a1+b1GNPt+u1t

It =a2+b2IIt-1+U2t

GNPt= Ct+ It+Gt

C = consumption expenditures

GNP = Gross national product in year t

I = investment

II = Profit

G = Government expenditures

U = stochastic disturbance (random error term)

T = current year

t-1 = previous year

Variables to the left of the equal sign are called endogenous variable. These are

the variables that the model seeks to explain or predict from the solution of the

model. Exogenous variables are those determinants outside the model or right

of the equal sign of the equation.

1.6.2.5.Input Output Forecasting

Input output analysis was introduced by Prof. Leontief. With this technique the firm

can also forecast using Input output tables. It shows the use of the output of each

industry as input by other industries and for final consumption. Input and output

analysis allow us to trace through all these inter industry input and outputs flow


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though out the economy and to determine the total increase of all the inputs required to

meet the increased demand. In this technique we have two input output matrixes.

Direct Requirement Matrix

Total Requirement Matrix

1.6.2.5.1 Uses and shortcomings of input output forecasting

Input output analysis and forecasting has many uses and applications. It is used by the

firm to forecast the raw material, labor and capital requirement needed to meet the

forecasted change in the demand for their product. The shortcomings are that the direct

and total coefficients are assumed to be fixed and thus do not allow input substitution.

Input output tables are usually available with a time lag of many years and while the

input output coefficients do not change very rapidly they can become very biased.

1.7 Reasons for fluctuations in time series data

Changes occur in secular trend i.e. long run increase or decrease in data series.

1.7.1 Cyclical fluctuations

There are the major expansions and contractions in most economic time series data that

seem to re-occur every several years.. A typical cycle could last 15-20 years.

1.7.2 Seasonal variation

This refers to regularly recurring fluctuations in economic activity during each year e.g.

a typical factor could be weather and social customs.

1.7.3 Irregular and random variation

This is the variations in the data series resulting from unique events like wars, natural

disasters or strikes. The total variation in the time series is the result of all the above

four factors operating together. They are usually examined separately by qualitative

techniques.


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1.8 Smoothing Techniques

This technique predicts feature value of time series on the basis of some average of its

past value only. This technique is useful when the time series exhibits little trend or

seasonal variation but a great deal of random variation. There are two smoothing

techniques.

1.8.1 Moving average smoothing technique

The simplest smoothing technique is the moving average. Here the forecasted value of a

time series in a given period is equal to the average value of the time series in a number

of previous periods. This method is more useful the more erratic or random is the time-

series data.

1.8.2 Exponential smoothing technique

This technique is used more frequently than simple averages in forecasting. This

method is a refined version of moving average method. The disadvantage of moving

average method is that it gives equal weightage to thedata related to different periods

(i.e. months) in the past. According to exponential smoothing method more recent the

data the more relevant it is for forecasting and therefore it would be more appropriateto give more weightage to recent observations. The value given to weightage is

normally chosen to form a geometric progression.

With exponential smoothing, the forecast for period t +1 (i.e. Ft + 1) is a weighted

average of the actual and forecasted values of the time series in period. The value of the

time series at period t (i.e. At) is assigned the weight of 1-w6. The greater the value of

w, the greater is the weight given to the value of the time series in period as opposed to

previous periods. Thus, the value of the forecast of the time series in period t +1l is Ft +

1 = WA1 + (1-w) Ft.

In general, different values of W are tried, and the one that leads to the forecast with

smallest root-mean-square error (RMSE) is actually used in forecasting.


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1.9 Risks in Demand Forecasting

Demand forecasting faces two major risks

Overestimation of demand

Underestimation of demand

One risk arises from entirely unforeseen events such as war, political upheavals and

natural disasters. The second risk arises from inadequate analysis of the market.

All these forecasting errors could possibly have been avoided through:

Carefully defining the market for the product to include all potential users of the

market and considering the possibility of product substitution.

Dividing total industry demand into its components and analyzing each

component separately.

Forecasting the main driver or user of the product in each segment of the

market and projecting how they are likely to change in the future.


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1. Out of the given plannings, short run forecasting is required for

(a) Expansion of the existing units

(b) New unit planning

(c) Sales forecasting

(d) capital planning

2 This forecasting technique helps the firm to decide which of the product or

products should have priority in the allocation of firm's limited resources.

(a) Product line forecasting

(b) Industry demand forecasting

(c) Firms demand forecasting

(d) Sales Forecasting

3. In Sales force opinion method, opinion of sales people is collected to forecast the

future demand, because

(a) They cannot deny from providing the information.

(b) They are paid by the company.

(c) They are the only experts of consumer behaviour.

(d) Sales People are closely associated with the market.

4. Reasons for fluctuations in time series data may occur due to

(a) Seasonal variation

(b) Cyclical fluctuations

(c) Irregular and random variation

(d) All of the above


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5. Which one is not a type of Barometric Indicator?

(a) Leading economic indicator

(b) Coincident indicators

(c) Lagging indicator

(d) Climate indicator

6. The disadvantage of this technique is that it gives equal weightage to thedata

related to different periods (i.e. months) in the past.

(a) Moving average smoothing technique

(b) Exponential smoothing technique

(c) Input Output Forecasting


7. Which of the following step may help in avoiding or minimizing the errors

in business forecasting?

(a) Carefully defining the market for the product to include all potential users of

the market and considering the possibility of product substitution.

(b)Dividing total industry demand into its components and analyzing each

component separately.

(c) Forecasting the main driver or user of the product in each segment of the

market and projecting how they are likely to change in the future.

(d) All of the above

8. This forecasting technique incorporates or utilizes the best features of other

forecasting techniques such as trend and seasonal variation, smoothing techniques

and leading indicators.

(a) Regression Technique


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1.12 Exceptions to the Law of Demand Upward Sloping

Demand Curve

1.13 Theory of Consumer Behaviour

1.13.1The Cardinal Utility Theory

1.13.1.1 Equilibrium of Consumer

1.13.2The Ordinal Utility Theory

1.13.2.1Equilibrium of Consumer

1.13.2.2 Properties of Indifference Curve

1.14 The consumer surplus


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1.1 Meaning of Demand

Conceptually, demand can be defined as the desire for a good backed by the

ability and willingness to pay for it. The desire without adequate purchasing

power and willingness to pay do not become effective demand and only an

effective demand matters in economic analysis and business decisions.

1.2 Types of Demand

The demand for various commodities is generally classified on the basis of the

consumers of the product, suppliers of the product, nature of goods, duration of

the consumption of the commodity, interdependence of demand, period of

demand and nature of use of the commodity(intermediate or final).

Individual and Market Demand

Autonomous and derived demand

Demand for durable and nondurable goods

Demand for firms product and industry product

Demand for consumers and producers goods

1.2.1 Individual and Market Demand

The quantity of a commodity which an individual is willing to buy at a

particular price during a specific time period given his money income, his taste

and prices of other commodities is called individuals demand for a commodity.

On the other hand market demand of a commodity is the summation of

individual demand by all the consumers. Market demand is a multivariate

relationship and determined by many factors simultaneously. Some of the most

important determinants of the market demand for a particular commodity are


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all the firms of an industry as a whole. A Clear understanding of the relation

between company and industry demand necessitates the understanding of

different market structures. These structures can be differentiated the basis of

product differentiation and number of sellers.

1.2.5 Demand for consumers and producers goods

Consumer goods are those, which are, meant for the final consumption by the

consumers or the end users. Producer's goods on the other hand are used for the

production of consumer goods or they are intermediate goods, which are further

processed upon to convert them into a form to be used by the end user. Another

distinction is that the demand for producers goods is derived demand and it

indirectly depends on the demand for the consumer goods which the producergoods is used to produce. It may also be possible that this demand may be

accelerated or accentuated in the same proportion as the change in the demand

for the final consumer goods. A small change in the demand for consumer

goods may either completely wipes out the demand for the producer goods or

may accelerate it.

1.3 Determinants of Demand

Commoditys Own Price

Prices of related goods Substitutes and Complements

Income level of consumer

Tastes & Preferences

Expectations

Population

Other exogenous factors

1.4 Demand Function


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dozen) (dozen per month)

0.50 7.0

1.00 5.0

1.50 3.5

2.00 2.5

2.50 1.5

3.00 1.0

1.7 Demand Curve

Demand curve is the graphical representation of the relationship between price

and quantity demanded of a good, all other things being held constant. A

demand curve is said to be linear when its slope is constant all along the curve,

whereas for a nonlinear or curvilinear curve the slope never remains constant.

The linear demand curve may be written in the form of;

Q b0@b

1P

Q

P

Linear DemandQ

P

Non Linear Demand


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If 0 < ep < 1, the demand is inelastic total expenditure total expenditure and price

change move in the same direction.

If 1< ep


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If the demand is inelastic (e < 1) an increase in price leads to an

increase in total revenue and vice versa.

If the demand is elastic (e>1) an increase in price will lead to a

decrease in total revenue and vice versa.

If the demand has unitary elasticity (e =1), total revenue is not affected

by changes in price.

1.10.1.2 Determinants of Price Elasticity of Demand

Number and availability of Substitutes

The proportion of income spent on the particular commodity

Nature of the need that the product satisfies

Length of time period under consideration

The number of uses to which a commodity can be put

1.10.1.3 Price elasticity and Decision Making

Information about price elasticities can be extremely useful to managers

as they contemplate pricing decisions.

If demand is inelastic at the current price, a price decrease will result in a

decrease in total revenue.

Alternatively, reducing the price of a product with elastic demand would

cause revenue to increase.

Remember TR = P*Q


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Consumer surplus = PCA


Q.1. The demand curve of a normal commodity is

(a) Upward Sloping

(b) Downward sloping

(c) Horizontal

(d) Vertical

Q.2 What happens to demand when price of the commodity falls


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(d) Downward sloping and convex to the origin

Q.7 The shape of indifference curve implies

(a) Diminishing MRSxy

(b) Increasing MRSxy

(c) Constant MRSxy

(d) Infinite MRSxy

Q.8 The marginal utility from successive consumption of normal good

(a) Increases

(b) Decreases

(c) Remain constant

(d) Undefined

Q.9 According to the ordinal approach consumers equilibrium is where

(a)MUxMUy

ffffffffffffffff1PxPy

ffffffff

(b)

MUx

MUy

ffffffffffffffff

PxPy

ffffffff

Q.10 Given the demand function Q = 90-3p and P = 6, Q=?

(a) Q = 67

(b) Q = 72

(c) Q = 108

(d) Q = 81


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Fixed costs are those which are fixed in volume for a certain given output. It does not

vary with variation in the output for a certain scale. The fixed costs include the cost of

managerial and administrative staff, depreciation of fixed assets, maintenance of land

etc. Fixed costs are associated with the short run. Variable costs are those which varywith the variation in the total output. It include cost of raw material, cost of direct labor,

running cost of fixed capital such as fuel, repairs, routine maintenance etc.

1.3.3 Total, Average and Marginal Costs

1.3.3.1 Total Cost

Total cost is the total expenditure incurred on the production. It connotes both explicit

and implicit money expenditure and include fixed and variable costs.

C f X,T,Pf

,K

Where C total cost

X output

T technology

Pf

prices of factors

K fixed factors

TC TFC TVC

Total Cost Curves


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1.3.3.2 Average cost

Average cost is obtained by dividing the total cost by the total output.

ACTC

Q

fffffffff

Average cost further can be categorized as average fixed cost (AFC) and average

variable cost (AVC).

AFCTFC

Q

ffffffffffffff

AVCTVC

Q

ffffffffffffff

Average cost curves


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If capital is held constant (short run) then the marginal product of labor gives

the short run cost curves their shape.

The levels of cost curves are determined by market price of factor along with

technology.

AFC falls continuously

MC equals AVC and ATC at their minimum

Minimum AVC occurs at a lower output than minimum ATC due to FC

1.5 Short-Run Output Decision

Firm sets output at Q1, where MC=MR subject to checking the average condition:

If P > ATC, the firm produces Q1 at a profit

If ATC > P > AVC, the firm produces Q1 at a loss


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1.1Production Function

The creation of any good or service that has value to either producers or consumers is

termed as production. Production function is a technical relation between factor inputs

and outputs. It describes the laws of proportion that is the transformation of factor

inputs into outputs at any particular time period. The production function includes all

the technically efficient methods of production.

X f L, K, R, S, v, y

In the process of production, the manager is concerned with efficiency in the use of

inputs (Labor, Capital, Land and Entrepreneurship)

Technical Efficiency Occurs when it is not possible to increase output without

increasing inputs

Economic Efficiency Occurs when a given output is being produced at the lowestpossible cost. Improvement of Technology is reflected in an upward shift in the

Production Function. The same amount of input leads to a higher output

L

X f L


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1.2 Short Run Analysis

Short Run is the period of time in which one (or more) of the factors of production

employed in a production process is fixed or incapable of being varied. We usually

assume Capital (K) to be fixed and analyze how output varies with changes in Labor (L)

X f L

1.2.1 Marginal Product of Labor

The change in output resulting from a very small change in Labor keeping all other

factors constant.

MPL = XL

If MP > 0, total production is rising

If MP < 0, total production is falling

Total production is maximum when MP = 0

f L

f1 L

L

Q


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1.3.2 Laws of Returns to Scale

In the long run expansion of output may be achieved by varying all factors by the same

proportion or by different proportions. The laws of returns to scale refer to the effects of

scale relationship. Three types of returns to scale are observed.

Constant returns to scale

Increasing returns to scale

Decreasing returns to scale

1.3.2.1 Constant returns to scale

If the quantity of all inputs used in the production is increased by a given proportionand we have output increased in the same proportion; it is termed as constant returns

to scale.

1.3.2.2 Increasing returns to scaleIf output increases by a greater proportion in comparison to a change in the scale of

inputs it is termed as increasing Returns to Scale. The causes of increasing returns to

scale are:

Specialization of labor


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Inventory Economies

Managerial indivisibilities

Technical indivisibilities

1.3.2.3 Diminishing Returns to Scale

If output increases by a smaller proportion in comparison to the change in the scale of

inputs, it is described as diminishing returns to scale. The reasons of diminishing

returns to scale are:

Managerial inefficiency

Exhaustible natural resources

Increased bureaucratic

Labor inefficiency

Pressure on inputs market due to increasing demand

Pressure on inputs prices due to bulk purchase


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MRTSl

,k@ K/ L X/ LD X/ K

MRTSl ,kMP

l

MPk

fffffffffffffff

1.5 Equilibrium of the Firm

A profit maximizing firm will be using optimal amount of an input at the point at

which the monetary value of the inputs marginal product is equal to the additional cost

of using that input. Monetary value of the input is;

MPl

Px MPl

Profit Maximization requires

w Px CMPl

Px Price of final output


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w Wage rate (Cost of input)

1.6 Isocost

The isocost line is the locus of all combinations of factors the firm can purchase with a

given monetary cost outlay. If a firm uses only L & K, the total cost or expenditure of

the firm can be represented by:

C wL rK

One can solve Optimization problem for the combination of inputs that either

minimizes total cost subject to a given constraint on output

OR

maximizes output subject to a given total cost constraint.

1.7 Isocost Curve and Optimal Combination of L and K

Optimal input Combination Depends on the relative prices of inputs and the degree to

which they can be substituted for each other represented by the point of tangency

between Isocost and Isoquant.


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MPlMP

k

fffffffffffffff w

r

ffff

1.8 Production with Two(or more) Outputs-Economies of Scope

Economies of scope exist when the unit cost of producing two or more

products/services jointly is lower than producing them separately,

producing related products, and the products that are complementary.

The average total cost of production decreases as a result of increasing the

number of different goods produced


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Q.1. Production function states

(a) Qualitative relationship between input and output

(b) Quantitative relationship between input and output

(c) Technical relationship between input and output

(d) No relationship between input and output

Q.2 Total output is maximum where

(a) Marginal production is maximum

(b) Marginal production is zero

(c) Average production is maximum

(d) Average production is zero

Q.3 The law of variable proportions states that given at least one input constant the

marginal product of variable factor

(a) Increases

(b) Decreases

(c) Remain constant

(d) Fluctuates

Q.4 Returns to scale means

(a) Change in output due to change in one variable factor of production

(b) Change in output due to change in one constant factor of production

(c) Change in output due to change in all variable factors of production

(d) Change in output due to change in all constant factor of production

Q.5 The slope of isoquant is called

(a) Marginal rate of technical substitution


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(a)MP

l

MPk

fffffffffffffff>

w

r

ffff

(b)MPlMP

k

fffffffffffffff gd> gc

d) (d) ga6 gda6 gc

Q.7 The relationship between discretionary investment and managers utility

maximization is

a) Positively high

b) Positively low

c) Negatively high

d) Negatively low

Q.8 Owners utility maximization is determined by

a) Revenue maximization

b) Profit maximization

c) Investment maximization

d) Prices maximization

Q.9 Satisficing behavior theory states that

a) Firm is a coalition of harmonized interest groups

b) Firm is a coalition of conflicting interest groups

c) Firm is not a coalition of interest groups

d) Firm is a single goal entity

Q.10 Satisficing behavior theory focuses on


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Chapter-VIII

Market Structure

Contents:

1.1 Introduction1.2 Meaning of market

1.3 Classification of Market Structure

1.3.1 Perfect Competition

1.3.1.1 Price Output Determination Under Perfect

Competition

1.3.1.2 Equilibrium in Short Run

1.3.1.3 Perfect Competition in the Long Run1.3.1.4 Perfect Competition and Plant Size

1.3.1.5 Perfect Competition and the LR Supply Curve

1.3.1.6 Long Run Equilibrium

1.3.2 Monopoly Market

1.3.2.1 Why do Monopolies exist?

1.3.2.2 Equilibrium of the Firm

1.3.2.3 Price Discrimination

1.3.3 Monopolistic Competition

1.3.3.1 Structure

1.3.3.2 Short Run Equilibrium


1.3.3.4 Efficiency under Monopolistic Competition

1.3.4 Oligopoly Market

1.3.4.1 Structure

1.3.4.2 Mutual Interdependence

1.3.4.3 Collusion is difficult if

1.3.4.4 Explicit Collusion Cartels

1.3.4.5 Sweezeys Model of Kinked Demand Curve

1.3.4.6 Price Stability with a Kinked Demand

Curve


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1.3.4.7 Tacit Collusion: Price Leadership

1.3.4.7.1 Dominant Firm Price Leadership

1.3.4.7.2 Barometric Price Leadership


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1.3.1 Perfect Competition

Characteristics of Perfect Competition:

Large number of small sellers and buyers: The number of buyer as well as

seller is so large that the share of each buyer in total market demand and the

share of each seller in total market supply is insignificant and hence no

individual buyer or seller can influence the market price.

Homogeneous products: Products supplied by the firms are identical and are

regarded as perfect substitute to each other.

Perfect mobility of factors of production: For a market to be perfectly

competitive, the factors of production must be in the position of moving freely

into or out of the industry and from one firm to another.

Free entry and free exit of the firms: No legal or otherwise restrictions on the

entry and exit of the firms.

Perfect dissemination of the information: to the buyers and sellers.

No government intervention and Absence of collusion.

Examples: Agricultural commodities and Stock market

1.3.1.1 Price Output Determination Under Perfect Competition

In a perfectly competitive market, where large number of sellers selling homogeneous

product, no single seller can influence the market price. Similarly, each buyer has too

small share in total market demand to influence the price. Market Price is therefore

determined by the market demand and market supply for the industry and is given for

each individual firm and for each buyer. Thus, a seller in a perfectly competitive market

is a price-taker not a price maker. This means the individual firm will face a

horizontal demand curve. It will be horizontal at the market price, established by

supply and demand on the market as a whole.


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In the long run, entry and exit become possible. Why? Because potential firms can buy

fixed inputs and become actual firms. And existing firms can sell off or stop renting

their fixed inputs and go out of business.Firms will choose to enter the industry if the existing firms in the industry are making

economic profits. The profits are an incentive to enter. As a result the total market

supply will increase and, therefore, the market supply curve must shift to the right. It

drives down the price on the market, thereby reducing the profits of each firm.

Now the firms are making profits, but smaller profits than before. But if there are still

economic profits being made, more firms will enter. This must continue until there are

no economic profits. What has to be true when profits equal zero?

TR = TC

p*q = qATC

p* = ATC

So entry finally stops when firms are producing at their lowest average total cost. Here

is a diagram of the final, long-run equilibrium under perfect competition:


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What if typical firm is making losses? Then the reverse process will take place. Firms

will exit the market, causing a left shift of market supply, causing a rise in market price,

causing a reduction of losses. This continues until losses are zero. Thus, Long Run

competitive equilibrium consists of two conditions:

p* = MC

p* = minimum ATC

The first condition is caused purely by profit maximization, and its true in both the SR

and the LR. The second condition, however, is caused by entry and exit in the LR. Itwont necessarily be true in the SR.

These two conditions have important efficiency implications. Marginal-cost pricing (p*=

MC) means that consumers who buy the product face the true opportunity cost of their

choices. They will only buy the good if the value to them is greater than the price,

which represents the value of the resources that went into making the product.

Minimum average cost pricing (p* = minimum ATC) means that the product is being

made at the lowest average cost possible, so that no resources are being wasted in its

production.

The conclusion that firms make zero profit in the LR may seem odd, given the profits

that many firms earn in reality. What could explain the difference between theory and

reality? (1) Reality may differ from the perfectly competitive model, and to that extent


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economic profits can be made. But also, (2) the profits we generally hear about are

accounting profits, not economic profits. To find out whether these profitable firms

are really making economic profits, wed need more information about their implicit

costs.Finally, (3) we may be observing short-run profits, not long-run profits.

1.3.1.4 Perfect Competition and Plant Size

It turns out that the perfectly competitive firm produces not just at the minimum of its

SRATC, but also its LRATC. Why? Because any PC firm not at its minimum LRATC

will, in the LR, change its input combination to take advantage of lower average costs.

If firms are able to make positive profits by moving outward on the LRATC curve,

those profits will attract entrants into the industry in the usual fashion. So by the same

arguments as before, profits will eventually dissipate to zero. The price must be at the

bottom of the LRATC, not just the SRATC.

1.3.1.5 Perfect Competition and the LR Supply Curve

As we have seen, changes in demand in a PC market create profits and losses for firms.

In the SR, this has no effect on the supply curve; but in the LR, firms enter for profits

and leave to escape losses, leading to supply curve shifts. We want to use this

information to derive a LR supply curve. A LR supply curve, just like a SR supply

curve, shows the total quantity that will be supplied in a market at different prices; but

unlike the SR supply curve, it shows the quantity supplied after all long-term changes,

including entry and exit of firms, have been taken into account.

In the basic supply-and-demand framework, notice that we can use demand

curves and equilibrium points to trace out the supply curve. If you look at three

different demand curves, and then mark the equilibrium point on each one, you can

connect the equilibrium points to find where the supply curve must be.

Now were going to use the same basic technique to trace out the LR supply curve. We

can do this by changing demand, and then finding the equilibrium points after allowing

LR adjustments, including entry and exit. Start with an initial (short-run) supply and


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demand. If we are in long-run equilibrium, profits are zero. Now, let demand shift to

the right. In the short-run, price rises a lot. But the higher price creates profits, and

profits attract entry in the long run. So eventually supply shifts to the right as well,

pushing price back down (though possibly not as low as it was before). Once profits areback to zero again, youre in a new long-run equilibrium. Do this all again to find a

third long run equilibrium, and then connect the dots to get the long-run supply curve.

The interpretation of the LR supply curve is pretty much the same as the SR supply

curve: it shows the willingness of producers to sell at each price. But the LR supply

curve measures this willingness in the broadest sense, including all firms that might

potentially supply this product.

Notice that the LR supply curve is flatter than the SR supply curve. This must be so,

since the LR supply curve takes into account the quantity responses of all firms, not just

the ones currently in the market, but potential firms as well. It is even possible that the

LR supply curve can be downward-sloping. Why?


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Consider what must happen if entry and exit do not affect the cost curves of individual

firms. Then after all adjustment to a change in demand has taken place, the market

price must have returned to the lowest point on the LRATC, which is exactly where it

was before. So in this case, the LR supply curve must be horizontal. We call this aconstant--cost industry. This is most likely to be the case when the industry in question

constitutes only a small portion of the demand for its inputs.

If the industry in question has a large impact on the markets for its inputs, then the LR

supply curve may slope upward or downward. If the effect of entry into the industry is

tobid up the price of inputs, so that a firms cost curves rise as a result of the entry of

new firms, then the market price after adjustment will be higher than it was before. In

this case, the LR supply curve must be upward-sloping as in the picture above; this is

called an increasing-cost industry, which results from external diseconomies. On the

other hand, if entry into the industry creates a greater demand for inputs that allows

those inputs to be produced through mass production techniques (i.e., at lower average

cost), then the industry can benefit from lower costs of production. In this case, the LR

supply curve is downward-sloping. This is called a decreasing-cost industry, which

results from external economies. They face a perfectly elastic demand curve Market

prices change only if demand and supply change



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Normal profit is necessary to attract and maintain capital investment

Marginal Analysis

MR = MC => Normal Profits

Output will settle at the point where;

P = MC = AC = MR

1.3.1.7 Supply Curve under Perfect Competition

Short Run Firm Supply MC curve is the SR supply curve so long as P > AVC

Long Run firm Supply LMC curve is the LRsupply curve so long as P > ATC

In the LR, the firm must cover all necessary costs of production and earn a

normal profit

1.3.2 Monopoly Market

A monopoly market is one in which there is only one seller of a product having no close

substitutes. The firm has substantial control over the price. Further, if product is

differentiated and if there are no threats of new firms entering the same business, a

monopoly firm can manage to earn excessive profits over a long period.

Only one firm produces the product

Low cross elasticity of demand between the monopolists product and any other

product; that is no close substitute products.

Substantial barriers to entry that prevents competition from entering the

industry.

1.3.2.1 Why do Monopolies exist?

Barriers to Entry

a) Control of scarce resources or input

b) Economies of scale natural monopolies


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c) Technological superiority

d) Govt. created barriers

e) Patents

1.3.2.2 Equilibrium of the Firm

Monopoly firms ability to set price is limited by the demand elasticity

Supernormal profits may be earned in the Long Run since there is no entry

P > competitive price

Q < competitive quantity

The monopolist will always try to operate on the elastic portion of the demand

curve

1.3.2.3 Price Discrimination


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three firms is characterized by marked differentiation in products The nature of

products is such that very often one finds entry of new firms difficult. Oligopoly is

characterized by vigorous competition where firms manipulate both prices and

volumes in an attempt to outsmart their rivals. No generalization can be made aboutprofitability scenarios.

1.3.4.1 Structure

In an oligopoly there are very few sellers of the good.

The product may be differentiated among the sellers (e.g. automobiles) or

homogeneous (e.g. petrol).

Homogenous product Pure Oligopoly

Entry is often limited

by legal restrictions (e.g. banking in most of the world)

by a very large minimum efficient scale

by strategic behavior.

1.3.4.2 Mutual Interdependence

The essence of an oligopolistic industry is the need for each firm to consider

how its own actions affect the decisions of its relatively few competitors

To predict the outcome in such a market, economists need to model the

interaction between firms.

Oligopoly may be characterized by Collusion Cartels Or Non - Cooperation

1.3.4.3 Collusion is difficult if

There are many firms in the industry

The product is not standardized

Demand and cost conditions are changing rapidly

There are no barriers to entry

Firms have surplus capacity


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1.3.4.4 Explicit Collusion Cartels

A Cartel is a formal organization of sellers that seeks to restrict competition

Maximum possible profits that can accrue as a result of a cartel is the amount

that would prevail under Monopoly

If the firms compete vigorously on the basis of price, lowest possible

equilibrium price that could prevail is the competitive price and output

1.3.4.5 Sweezeys Model of Kinked Demand Curve

Explains Price Rigidity under Oligopoly

Starts with a predetermined Price Output

Demand Curve is kinked at current price:

The firm may expect rivals to respond if it reduces its price so, demand in

response to a price reduction is likely to be relatively inelastic

For a price rise, rivals are less likely to react, so demand may be relatively

elastic

1.3.4.6 Price Stability with a Kinked Demand Curve

For any MC between a and b, the profit maximizing price and output remain

unchanged.


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There is no one dominant firm

Price changes are in response to changes in some underlying market conditions,

obvious to all the firms

The critical requirement for being a leader is the ability to interpret marketconditions and propose price changes that other firms are willing to follow


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End Chapter quizzes

Q.1. Banking Sector is an example of

(a) Perfect Market

(b) Monopolistic Market

(c) Oligopoly Market

(d) Monopoly Market

Q.2 Which is not the characteristic of a perfect market

(a) Large number of small buyers and sellers

(b) Restricted entry and exit

(c) Homogeneous Products

(d) Free mobility of factors of production

Q.3. Profit maximizing condition for a firm is

(a) MR=MC.

(b) MR>MC

(c) MR


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(c) Profit maximizing Output in Oligopoly market

(d) Profit maximizing Output in Monopoly market

Q.6. A formal organization of sellers that seeks to restrict competition is known as

(a) Sellers Association

(b) Cartel

(c) Trade Union

(d) Trade Association

Q.7. Which condition is false in case of a monopoly firm to earn excessive profits

over a long period

(a) Only one firm produces the product

(b) Low cross elasticity of demand between the monopolists product and any

other product; that is no close substitute products.

(c) Free entry of new firms

(d) Substantial barriers to entry that prevents competition from entering the

industry.

Q.8. Price Discrimination under Monopoly is not possible if

(a) Different markets are separable.

(b) Elasticity of demand is same in different markets.

( c) Market is imperfect.

(d) Elasticity of demand is different in different markets.

Q.9. In a Perfectly competitive market, in long run, firm earns

(a) Abnormal Profits

(b) Supernormal Profits

(c) Normal Profits

(d) Economic Profits


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Q.10. Demand curve of a firm in perfect competitive market is

(a) Upward sloping

(b) Downward sloping

(c) Horizontal

(d) Vertical


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Key to End Chapter Quizzes

ChapterI Managerial Decision Making

1 (b ); 2(a ); 3(c ); 4(a ); 5(a ); 6(c ); 7(b ); 8(b ); 9(a ); 10(d )

ChapterII Business Forecasting

1 (c ); 2(a ); 3(d ); 4(d ); 5(d ); 6(a ); 7(d ); 8(b ); 9(b ); 10(c )

ChapterIII Demand Analysis

1 (b ); 2(a ); 3(b ); 4(b ); 5(c ); 6(d ); 7(a ); 8(b ); 9(c ); 10(b )

ChapterIV Cost Analysis

1 (b ); 2(a ); 3(a ); 4(c ); 5(a ); 6(b ); 7(c ); 8(a ); 9(b ); 10(a )

ChapterV Production Analysis

1 (c ); 2(b ); 3(b ); 4(b ); 5(a ); 6(d ); 7(a ); 8(d ); 9(c ); 10(b )

ChapterVI Pricing Policy of the Firm

1 (b ); 2(c ); 3(c ); 4(b ); 5(b ); 6(b ); 7(a ); 8(d ); 9(c ); 10(a )

ChapterVII Objectives of the firm

1 (b ); 2(b ); 3(b ); 4(d ); 5(d ); 6(b ); 7(a ); 8(b ); 9(b ); 10(b )

ChapterVIII Market Structure

1 (c ); 2(b ); 3(a ); 4(d ); 5(a ); 6(b ); 7(c ); 8(b ); 9(c ); 10(c )


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managerial economics 07042011

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