Economics

What is Economics?

Economics is a social science, which studies human behaviour in relation to optimizing allocation of available resources to achieve the given ends.

ECONOMICS

Social Science studying human behaviour

optimizing allocation of available resources

achieving the given ends

• Micro Economics

Micro economics deals with the analysis of small part or component of the whole economy such as individual customers, individual firms and small aggregates or groups of individual units such as various industries or markets.

• What is Macroeconomics?

• Macroeconomics is the study of economy as a whole.

• Macroeconomics is the study of the nature, relationships and behaviour of aggregates of economic quantities…

• Macroeconomics deals not with individual quantities as such, but aggregates of these quantities ….not with the individual income but with the national income, not with the individual prices, but with the price levels, not with individual output, but with the national output.

• Difference between Micro and Macro Economics

• Micro Economics

Subject Matter of Study:

Small segments of the total economy

Use of Techniques:

Partial Equilibrium to study the prices of a particular commodity or service on ceteris paribus assumption.

Assumption in the Analysis: Prevalence of Full Employment in the Economy

• Macro Economics

Subject Matter of Study:

Study of aggregates

Use of Techniques:

quasi –general equilibrium analysis to study the determination of aggregate prices and output levels.

Assumption in the Analysis: Under Employment

• Reconciliation of Micro and Macro Economics

• Micro Economics

• Not necessarily restricted to individual units say a household or a firm

• Also covers aggregates such as market demand, market supply

• Aggregates in micro economy relate to only a part of the economy.

• Macro Economics

• Deals with sub-aggregates of the economy. E.g. total consumption, total investment, total saving

• Deals with variable that are highly aggregated.

• “There is really no opposition between micro and macro economics. Both are absolutely vital. You are less than half-educated if you understand the one while being ignorant of the other.”

• - Paul A. Samuelson

• Managerial Economics

“The study of economic theories, logic and tools of economic analysis that are used in the process of rational business decision-making.”

• Definitions

“Managerial economics is concerned with the application of economic concepts and economics to the problem of formulating rational decision making.”

-Mansfield

“Managerial economics ….is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.”

Spencer and Seigelman

“ Managerial Economics applies the principles and methods of economics to analyze problems faced by management of a business, or other types of organizations and to help find solutions that advance the best interests of such organizations.”

Davis and Chang

Application of Economics to Managerial Decision -Making

Managerial Decision Areas

• Assessment of investible funds

• Selecting business area

• Choice of product

• Determining input-combination and technology

• Determining optimum output

• Determining price of the product

• Sales Promotion

Why do managers need to know Economics?

1. Provides models, analytical tools and techniques

• to achieve the goals of the organization

• To make optimum use of resources

• To predict the future course of market conditions and business prospects

• To take appropriate business decisions

• To formulate a business strategy in conformity with the goals of the firm

2.Builds analytical models

• To recognize the structure of managerial problems

• To eliminate the minor details that might obstruct decision-making

• To help concentrate on the main issue

3.Enhances the analytical capabilities of business analyst.

4.Clarifies various concepts used in business analysis and enables the managers to avoid conceptual pitfalls.

Nature of Managerial Economics

• Body of knowledge, techniques & practices to substantiate economic concepts helpful in deciding business strategies

• Integration of economic theory with business practices

• Applied Economics

Scope of Managerial Economics

Management Decision Problems

Identifying the problems faced by management

Analyzing the problems


Economic Theory:

• Microeconomics

• Macroeconomics

Decision Sciences:

• Mathematical Economics

• Econometrics

Managerial Economics:

Application of economic theory and decision science tools to solve managerial decision problems

Optimal Solution to Managerial Problems


Relationship to Economic Theories

Micro Economics Applied to Operational/ Internal Issues:

Theory of demand

Theory of production & production decision

Theory of cost

Analysis of market structure & pricing theory

Profit analysis & profit management

Theory of capital & investment decisions.


Economic Theory:

• Microeconomics

• Macroeconomics

Decision Sciences:


• Econometrics





Macro Economics Applied to Business Environment/ External Issues:

• Overall social, economic & political atmosphere

• Issues related to macro economic trends, foreign trade, govt. policies.


Economic Theory:

• Microeconomics

• Macroeconomics

Decision Sciences:


• Econometrics





Application of economic concepts, theories and tools of analysis:

• To analyse issues related to demand prospects, production and cost, market structure, level of competitive and general business environment

• To find solutions to practical business problems.


Economic Theory:

• Microeconomics

• Macroeconomics

Decision Sciences:


• Econometrics




Optimization

An optimization technique is one of maximizing and minimizing a function.

It’s a technique of finding the value of the independent variable that maximizes or minimizes the value of the dependent variable.

• Optimization of Output

The optimum output of a firm is one that minimizes its average cost of production.

The optimum output determines the most efficient size of the firm.

Optimum level of Output= Minimization of Average Cost

Average Cost =

Rule of Minimization= Derivation of Average Cost must be equal to zero.

TCQ

=0∂ AC∂Q

Suppose TC function of a firm is given as

How to find value of Q that minimizes AC

Technique of Maximizing Total Revenue

By substituting eq2. into eq.1, we get TR as follows

Maximized Total Revenue:

Maximization of Profit

Profit Maximization Conditions

• The necessary or the first order condition

The Supplementary or the second order condition

TC=400+60Q+4Q2

AC=400Q

+60+4Q

=−400

Q2+4=0∂ AC

∂Q∂ AC∂Q−400

Q2=−4

=0

Q2=−400−4

=100⇒Q=10

. .. .. . .. ..eq . 1TR=P .Q

. .. .. . .. ..eq . 2P=500−5Q

TR=(500−5Q )QTR=500Q−5Q2

∂TR∂Q

=500−10Q

500−10Q=0−10Q=−500Q=50

TR=500(50)−5(50)2

TR=25000−12500=12500

∏ ¿TR−TC ,. .. . .. .. . .. .. .. .∏ ¿ profit

∂TR∂Q

−∂TC∂Q

=0

∂TR∂Q

=∂TC∂Q

MR=MC

∂2TR∂Q2

¿¿

¿¿

• Opportunity Cost

“Opportunity Cost of anything is the next best alternative that could be produced instead by the same factors, costing the same amount of money.”

- Benham

• Example of Opportunity Cost

A farmer who is producing paddy can also produce sugarcane with same inputs. Therefore, the opportunity cost of a quintal of paddy is the amount of output of sugarcane given up.

• Criticism of Opportunity Cost

• Economic Model

A model is a simple description of a system which used for explaining how something works or calculating what might happen, etc: a mathematical model for determining the safe level of pesticides in food, a realistic model of evolution

“A formal framework for representing the basic features of a complex system by a few central relationships.”

Samuelson and Nordhaus (1998)

Models take the form of graphs, mathematical equation, and computer programs.

“A model or theory makes a series of simplification from which it deduces how people will behave. It is a deliberate simplification of reality.”

Begg, Fischer, and Dornbusch (2000)

• Types of Models in Economics

From the definition of a model, it has been said that models in economics have the wide range of forms including graphs, diagrams, and mathematical models.

Flow Chart

Flow chart is a diagram that shows the connections between the different stages of a process or parts of a system. Economists use a flow chart to explain how the economy is organized and how participants in the economy interact with one another.

One of the important flow chart using in economics is called the circular-flow diagram.

Circular-flow diagram is a visual model of the economy that shows how dollars flow through market among households and firms.

Graph

Graph is a planned drawing, consisting of a line or lines, showing how two or more sets of numbers are related to each other.

The main types of graphs in economics includeproduction possibilities frontier (PPF), time-series graph, scatter diagrams, and multicurve diagrams.

Production possibilities frontier or PPF is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Production Possibility Curve

•

•

Mathematical Model

A mathematical model can be broadly defined as a formulation or equation that expresses the essential features of a physical system or process in mathematical terms. In a very general sense, it can be represented as a functional relationship of the form

Dependent variable = f (independent variables, parameters, forcing functions)

• Why do Economists need a ‘Model’?

Explaining an economic process,

Examining an economic issue and,

Developing a new economic theory.

Static and Dynamic

In general,

dynamic means energetic, capable of action and/or change, or forceful,

while

static means stationary or fixed.

• Economic Statics

Static is derived from the Greek word 'Statike' which means fetching to a stand still. In physics, it means a state of rest where there is no movement.

In economics, it entails a state characterized by movement at a particular level without any change.

Static economy is an eternal economy where no transformation happens and it is essentially in equilibrium.

"Economic Statics concerns itself with the simultaneous and instantaneous or timeless determination of economic variables by mutually interdependent relations".

Samuel

Economists in general explain static analysis in terms of micro and macro economic models.

•

Economic Dynamics

"Dynamics is concerned essentially with states of disequilibrium and with change.“

Prof. Ackley

It is the study of change, of increase of rate or decrease in rate.

It is the examination of the method of change which persists through time or over time.

Economists explain dynamic investigation in terms of micro and macro dynamic models.

• Positive Statement

Positive statements are objective statements that can be tested or rejected by referring to the available evidence.

Positive economics deals with objective explanation and the testing and rejection of theories.

• Examples of Positive Statements

• A rise in consumer incomes will lead to a rise in the demand for new cars.

• A fall in the exchange rate will lead to an increase in exports overseas.

• More competition in markets can lead to lower prices for consumers.

• If the government raises the tax on beer, this will lead to a fall in profits of the brewers.

• A reduction in income tax will improve the incentives of the unemployed to search for work.

• A rise in average temperatures will increase the demand for chicken.

• Poverty in the UK has increased because of the fast growth of executive pay.

• Normative Statement

Normative statements express an opinion about what ought to be.

They are subjective statements rather than objective statements – i.e. they carry value judgments.

• Examples of Normative Statement

• The level of duty on petrol is too unfair and unfairly penalizes motorists.

• The government is right to introduce a ban on smoking in public places.

• The retirement age should be raised to 75 to combat the effects of our ageing population.

• The government ought to provide financial subsidies to companies manufacturing and developing wind farm technology.

• Marginal Analysis

Definition

A technique used in microeconomics by which very small changes in specific variables are studied in terms of the effect on related variables and the system as a whole.

http://www.bbc.co.uk/climate/adaptation/wind_power.shtml

http://news.bbc.co.uk/1/hi/uk_politics/4709258.stm

Marginal analysis is an analytical method developed in which the impact of small economic changes is evaluated.

Marginal analysis includes discussion of

– marginal utility,

– contribution margin,

– marginal cost and revenue,

– marginal benefit and cost,

– marginal propensity to consume and save, marginal product and

– marginal revenue product.

The first widely recognized application of marginal analysis was developed by the English economist Stanley Jevons who, in 1862, used marginal utility analysis to explain why the price of diamonds was so much higher than a necessity good such as water.

During the late 1800s and early 1900s, economists led by Alfred Marshall used the concept of diminishing marginal utility to explain the law of demand, the inverse relationship between price and quantity demanded that exists in markets.

• Break Even Analysis

• The objective of the firm is to maximize profit.

• It does not necessarily coincide with the minimum cost, as far as the traditional theory of firm is concerned.

• Besides, profit is maximum at a specific level f output which is difficult to know before hand.

• Even if it is known, it cannot be achieved at the anticipation of profit in the future.

• However, the firms can plan their production better if they know the level of production where cost and revenue break even, i.e. the profitable and non-profitable range of production.

• Break-even analysis or what is also known as profit contribution analysis is an important analytical technique used to study the relationship between the total cost, total revenue and total profit and losses over the whole range of stipulated output.

• It is a technique of having a preview of profit prospects and a tool of profit planning.

• It integrates the cost and revenue estimates to ascertain the profits and losses associated with different levels of output.

http://american-business.org/241-demand.html

Break-even point is that level of output at which total revenue is equal to total cost.

TR=TC

OR

QxP = TFC + TVC

P= (TFC+TVC)/Q

P= AFC+AVC

P=AC

AR=AC

• Profit Forecasting

Prof. Joel Dean mentions three main approaches of profit forecasting:

(1) Spot Projection

(2) Break-even Analysis

(3) Environmental Analysis

Spot Projection:

• This involves projecting the entire profit & loss statement for specific future periods and involves the forecasting of each important element separately.

• Volume of sales, prices and cost of producing the anticipated volume of sales are all subjected to forecasts behaviour of the costs in future, the magnitude of profits projected may be subject to wide margins of error.

• This is understandable because the errors in forecasting revenues and costs and those in the components of revenues and costs as taken from the income statements are bound to affect the profit forecast adversely.

3. Environmental Analysis

• This is like the barometric method of demand forecasting.

• There are some key variables in the economic environment surrounding the firm.

• Profit can be related to the general price level or the long-term trend in the stock market etc.

• These variables are external variables from the firm’s point of view, but they can show the direction in which the winds are blowing and as such, can be taken as indicators of profitability trends.

• Profits tend to move in a regular pattern along with the related variables such as level of output, prices, wage-rates and material costs.

• All these variables are inter-related because they are connected with the national market and also because of their interactions in the aggregate business activity.

• Production

• Production means transforming factor inputs into an output.

• It means a process by which resources(men, material, time etc.) are transformed into a different and more useful commodity or service.

• Inputs/Factors of Production

Factors of production include anything that the firm must use as part of the production process.

It is a good or service that goes into the process of production.

e.g. land, labour, raw materials, capital and entrepreneur.

• Production Function

• A mathematical presentation of input-output relationship.

Q= f(LB, L, K, M, T, t)

LB= land and building, L= labour, K=capital, M= raw material, T= technology and t= time.

• It states the technological relationship between inputs and output in the form of an equation, table or graph.

• A production function indicates the highest output q that a firm can produce for every specified combination of inputs.

• Law of Variable Proportion

• Laws of production state the relationship between output and input.

• In short-run, input-output relations are studies with one variable input (labour), other inputs (especially capital) held constant.

• Laws of Variable Proportions is also called the laws of Returns to a Variable Input or law of Diminishing Returns.

• Law of Variable Proportion states that when more and more units of a variable inputs are used with a given quantity of fixed inputs, the total output may initially increase at increasing rate and then at a constant rate but it will eventually increase at a diminishing rate. If even beyond this stage , more units of variable inputs are used, total output becomes maximum and it starts declining.

• The law of variable proportion also states the relationship between TP, AP and MP.

• AP: It is the total product per unit of variable factor(labour).

MP: It is the change in TP resulting from the use of an additional factor.

• Assumptions

• Labour is the only variable factor, capital remaining constant.

• All variable factors of production (labour) are homogeneous.

• Factors of production are imperfect substitutes of each other.

• It is possible to change the factor proportion.

• Technology is assumed to be constant.

• Three Stages of law of Variable Proportion

Stage-I

• Total production increases at an increasing rate.

• MP of labour increases, reaches its maximum point and then falls but is positive.

• AP of labour increases but increase in MP is more than the increase in AP.

• Since TP, AP and MP are increasing, it is a stage of increasing returns.

At the boundary line of stage I:

• AP is maximum

• MP cuts AP at its maximum point.

AP=TPL

MP= ΔTPΔL

Stage II

• TP increases at a decreasing rate.

• MP falls.

• AP falls but fall in MP is more than the fall in AP.

• Since AP and MP are falling, therefore it is a stage of decreasing returns.

At the boundary line of stage II

• TP is maximum

• MP=0

Stage III

• TP falls.

• AP falls.

• MP of labour is negative.

• Therefore it is a stage of negative returns.

• Thus, TP rises steadily first at an increasing rate and then at a decreasing rate and then after reaching its maximum point, it starts declining.

• Reasons for Increasing Returns to a Variable Factor

1.Indivisibility of Fixed Factor:

• Fixed factor can’t be divided

Y

XO

TP

APMPLabour

TP, AP, MP

• Optimum number of labour is required to utilise fixed factor fully.

• When more and more workers are added, utilization of capital increases and also the productivity of additional worker.

2.Division of labour: Employment of additional labour on fixed factor until optimum capital-labour combination is reached.

• Reason for Diminishing Returns to a Variable Factor

• Technically there is a limit to which one input can be substituted for another.

• Labour can’t substitute capital beyond a limit.

• Employing more labour on same capital beyond that limit decreases their marginal productivity.

• Law of Returns to Scale

• It explains the behaviour of output in response to a proportional and simultaneous change in inputs.

• When firm expands its scale, i.e., it increases both the inputs proportionately, then there are three technical possibilities:

(i) Total output may increase more than proportionately (Increasing returns to sacle).

(ii) Total output may increase proportionately(Constant returns to scale).

(iii) Total output may increase less than proportionately(Diminishing returns to scale).

• Factors Behind Increasing Returns to Scale

• Technical and Managerial Indivisibilities

• Higher Degree of Specialization

• Dimensional Relations

• Causes of Diminishing Returns to Scale

• Managerial diseconomies

As the size of firm expands, managerial efficiency decreases.

• Limitedness of exhaustibility of natural resources

e.g. Doubling of coal mining plant may not double the coal output because of limitedness of coal deposits or difficult accessibility to coal deposits.

• Returns to a Variable Factor

• It operates in the short run.

• Output can be increased only by increasing the variable factor.

• Scale of production doesn’t change.

• Proportion between fixed and variable factor changes.

e.g. 1K+10L=1:10

1K+20L=1:20

• Returns to Scale

• It operates in the long run.

• Output can be changed by increasing all the factors.

• Scale of production changes.

• Proportion between the factors doesn’t change.

e.g. 10K+10L=1:1

20K+20L=1:1

• Pricing Strategies and Methods

• Cost Plus Pricing

• Cyclical Pricing

• Skimming Price Policy

• Penetration Price policy

• Transfer Pricing

• Marginal cost pricing

• Price Leadership

• Cost-Plus Pricing

• Also known as ‘mark-up pricing’, ‘average cost pricing’ and ‘full cost pricing’.

• Most common method of pricing used by manufacturing firms.

• The general practice under this method is to add a ‘fair’ percentage of profit margin to the average variable cost(AVC).

• The formula for setting the price is given as

P=AVC+AVC(m),

m=mark up percentage

AVC(m)= gross profit margin (GPM).

• The mark-up percentage (m) is fixed so as to cover average fixed cost (AFC) and a net profit margin(NPM). Thus,

AVC(m)= AFC+NPM

Procedure by firms for arriving at AVC and Price Fixation:

1. Estimate the AVC.

2. Ascertain the volume of its output for a given period of time, usually one accounting or fiscal year.

• To ascertain output, the firm uses figures of its planned or budgeted output or takes into account its normal level of production.

• If the firm is in a position to compute its optimum level of output or the capacity output, the same is used as standard output in computing the AC.

• Compute the TVC of the standard output.

• TVC includes direct cost, i.e. the cost of labour and raw material and other variable costs e.g. electricity and transportation cost, etc. these costs added together give the TVC.

• AVC is then obtained by dividing the TVC by the standard output (Q).

• After AVC is obtained, a ‘mark-up’ of some percentage of AVC is added to it as profit margin and the price is fixed.

• While determining the ‘mark-up’, firm always takes into account ‘what the market will bear’ and the competition in the market.

• Cyclical Pricing

Life cycle of a product is generally divided into five stages:

(1) Introduction

(2) Growth

(3) Maturity

(4) Saturation

(5) Decline

• The pricing strategy varies from stage to stage over the life cycle of a product, depending on the market conditions.

• Form the pricing strategy point of view, growth and maturity stages may be treated likewise.

Pricing of a new product: Pricing policy in respect of a new product depends on whether or not close substitutes are available.

• In case of product with many close substitutes available in the market, market provides adequate information regarding cost, demand and availability of market etc.

Pricing in this case depends on nature of market.

• Problems generally arise in pricing a new product without close substitutes because, for lack of information, there is some degree of uncertainty.

Two kinds of pricing strategies are suggested in pricing a new product.

(i) Skimming Price Policy

(ii) Penetration Price policy

(1) Skimming Price policy: It is adopted where close substitutes of a new product are not available.

• It is intended to skim the cream off the market, i.e. consumer’s surplus, by setting a high initial price, three or four times the ex-factory price, and,

• a subsequent lowering of prices in a series of reduction, especially in case of consumer durables.

• initial high price be accompanied by heavy sales promoting expenditure.

• Post skimming strategy includes the decisions regarding the time and size of price reduction.

• The appropriate time for price reduction is the time of saturation of the total sales or when strong competition is apprehended.

• When the product is on its way to losing its distinctiveness, the price cut should be appropriately larger.

• If the product has retained its exclusiveness, a series of small and gradual price reduction would be more appropriate.

Reasons for the success of Skimming Policy

1. In the initial stage of the introduction of the product, demand is relatively inelastic because of consumers’ desire for distinctiveness by the consumption of a new product.

2. Cross elasticity is usually very low for lack of a close substitute.

3. Step-by-step price cuts help skimming consumers’ surplus available at the lower segments of demand curve.

4. High initial prices are helpful in recouping the development costs.

(ii) Penetration Price Policy:

• It is adopted where close substitutes of a new product are available.

• This policy requires fixing a lower initial price designed to penetrate the market as quickly as possible and is intended to maximize the profits in the long-run.

• Firms pursuing the penetration price policy set a low price of the product in the initial stage.

• As the product catches the market, price is gradually raised up.

Success of penetration price policy requires the existence of the following conditions.

• The short run demand for the product should have an elasticity greater than unity. It helps in capturing market at lower prices.

• Economies of large scale production should be available to the firm with the increase in sales. Increase in production will result in increase in costs which might reduce the competitiveness of the price.

• The potential market for the product ought to be fairly large and have a good deal of future prospects.

• The products by nature should be such that it can be easily accepted and adopted by the consumers.

Pricing in the maturity period:

• Maturity period is the second stage in the life cycle of a product.

• It is a stage between the growth period and decline period of sales.

• Sometimes maturity period is also characterized by saturation period or the period of decline in the growth rate of sales or the period of zero growth rate.

• So, manufacturers are advised to reduce real..price as soon as the system of deterioration appears.

• It doesn’t mean that manufacturer should declare open price war in the industry.

• He should rather move in the direction of product improvement and market segmentation.

Pricing a product in decline:

• Product in decline is one that enters the post maturity stage.

• During this stage, the total sale of the product starts declining.

• The first step is to reduce the price with the objective of retaining sales at some minimum level.

• The product should be reformulated and remodelled to suit the consumer’s preferences.

• The final step is to reduce the advertisement expenditure drastically or withdrawn completely, and the residual market may be relied on.

• However this requires a strong will of the producer.

• Transfer Pricing

• Large firms often divide their production into different product divisions or their subsidiaries.

• Growing firms add divisions or departments to the existing ones.

• Firms then transfer some of their activities to other divisions.

• Goods & services produced by the new divisions are used by the parent organization.

• Parent division buys the product of its subsidiaries.

• Such firms face the problem of determining an appropriate price for the product transferred from one division or subsidiary to the parent body.

• This problem becomes much more difficult when each division has a separate profit function to maximize.

• Pricing of intra-firm ‘transfer product’ is referred to as ‘transfer pricing’.

• Price Leadership

• As against the formal nature of agreement in respect of a Cartel, many oligopolistic industries accept an informal position of price leadership.

• Leadership of a firm may be acceptable to other firms due to its size, or efficiency or economies of scale available to it, or its ability to foresee changes in market conditions, etc.

• More often, the largest firm in the industry becomes the leader. It is referred to as the dominant firm.

• This firm takes all price related decisions and other smaller firms follow the dominant firm’s decision.

• Low cost firm may be accepted as the leader, since the cost advantage might enable to take away a sizeable chunk of the other high-cost firm’s market share.

• Third alternative model also known as barometric price leadership where in some one firm takes initiative in introducing a price change.

• It is just that the firm is able to read properly the signals of the markets and pushes ahead.

• Over the period of time, other firms realize that the action taken by this firm was a step in the right direction and that the firm’s ability to judge the need and timing of such changes is dependable.

• Such a firm then becomes a price leader.

An effective price leadership hinges upon the following conditions:

• Less number of firms in industry

• Barriers to entry of firms, if not impossible

• Homogeneous products but product differentiation is also not ruled out; but then the price differentials should commensurate with product differentiation.

• Demand for the product is inelastic.

• Cost curves faced by firms should be similar though not identical.

• Marginal Cost Pricing

• It suggests that price charged should be equal to the marginal cost.

• It sets the lower limit while the upper limit is given by the AR curve i.e. market demand. Within these two limits a firm can set a price that ensures the targeted or possible level of profitability.

• Marginal cost pricing should be viewed as a measure of suggesting the floor-price of a product and as a guide for modifying profit-maximizing price when market conditions so demand.

• Marginal cost pricing is different from incremental cost pricing.

• According to the incremental principle, the decision can be considered sound if incremental revenue i.e. increase in revenue exceeds incremental cost or increase in costs.

• It is possible that both these quantities would be negative.

• A course of action may involve a fall in cost as well a fall in revenue.

• However the action may be justified if a fall in revenue is less than the fall in costs.

• As against this MC refers to change in total revenue following a unit change in output.

• Need for Government Intervention

1. Failure of market mechanism in achieving optimal distribution of goods and services due to following reasons:

• Inoptimal distribution of goods and job opportunities

• Perfect competition does not exist

• Individuals are not necessarily the best judge

• Profit is the sole motivating force

• Public utilities get low priority

• Growth of monopolies

• Externalities

2. Pricing of public goods and services like schools, hospitals, fair price shops.

3. Pricing of essential goods, prices of food grains, sugar, kerosene, life saving drugs etc.

4. Developmental Needs of the Economy….pricing of inputs essential to the process of development like reasonable pricing of steel, fertilizers, fuel, diesel, coal etc.

5. Reconciling Social Obligation with Viability

6. Protecting the Interests of Producers

7. Prevention of Exploitation of child & female labours by providing support price.

8. Improving the Composition of Production by subsidizing the products which are desirable and taxing the products which are undesirable.

• Prevention and Control of Monopoly

1. Regulation by Controlling Price and Output

• Monopolists tend to restrict his output and raise the price.

• Government may therefore interfere to safeguard the interests of consumers.

• This method is used in case of natural monopolies.

• Govt. may appoint a committee or preferably a tribunal for fixing a fair price of a monopoly product.

• The tribunal may fix a price and leave the monopolist to fix his own output.

• The chances are that the monopolist will restrict his output.

• It is therefore desirable to fix both price and output.

• Theoretically, a price that is equal to the average cost of production will have to be fixed.

• This will enable the monopolist to earn only normal profits.

• But the monopolist will try to curtail his output so as to earn abnormal profits.

• This will create a gap between the average cost and price.

• Therefore, it is advisable to fix both output and the price.

• Alternatively, the tribunal can fix a price that is equal to the marginal cost of production.

2. Regulation through Taxation

• Govt. often controls a monopoly by taxing it.

• The tax imposed can either be a specific tax or a lump sum tax.

• A specific tax is a tax per unit of output.

• Such a tax obviously raises, the average and the marginal costs of production.

• Specific tax on monopoly serves to curtail the profits of the monopolist but the consumer is made to pay a higher price and the total output available to the society is also reduced.

• Alternatively, the Govt. can impose a lump-sum tax on a monopolist irrespective of output.

3. Anti-Monopoly Legislation

In various countries including India, efforts have been made to constrain monopolies through anti-monopoly legislation.

Such a legislation has three objectives:

• To prevent the emergence of monopolies

• To disintegrate or dissolve monopolies if they have already come into existence

• To restrain monopolies from resorting to unfair practices

MRTP Act is the Indian legislation designed to constrain monopoly powers in India.

4.Public Enterprise and Nationalization

• Monopoly can be desirable in certain circumstances.

• Public utilities are an important example of this type.

• Opportunity that monopoly powers confer on the monopolist can be abused.

• It is for this reason that the public utilities are organized as monopolies but in public sector.

e.g. Indian Railways, State Road Transport Corporations

Public Ownership of such public utilities is thought desirable because

• Competition in these areas is wasteful since it involves unnecessary duplication and multiplication of services.

• Monopolies entail cost advantages which a public enterprise can pass on to the society, and

• The existence of a private monopoly in such areas would mean permitting ruthless exploitation of the consumers.

5. Industrial Co-operatives

• Government can encourage the formation of industrial co-operatives.

• Workers or artisans can themselves form a co-operative society and manage the monopoly concern.

• An industrial co-operative has several advantages.

Workers themselves are owners, exploitation of workers can be avoided.

Co-operative form of organization is democratic in character and is therefore, found suitable in most of the democracies.

Efficiency is ensured because every worker gets an incentive in the form of a share in profits.

• Price Control

Control over prices means the pursuit of the objective of price stabilization either through market forces or by undertaking the responsibility of distribution.

• Support Prices

• System of support prices is designed to provide a rock-bottom below which the prices of goods concerned should not fall.

• It is followed to protect the interests of the producers.

• In respect of agriculture, this policy of providing support prices is of great importance for various reasons.

• Support prices aim at stabilizing the incomes of all these people.

• Secondly, with such a large majority of the country’s work force earning its income from the sale of farm produce, the demand for several industrial products would depend upon how much income these prople are earning and how stable their incomes are.

• Thirdly, agricultural commodities like cotton, sugarcane etc., are used as a raw materials would trigger off a chain of consequential fluctuations in case of these materials would trigger off a chain of consequential fluctuations.

• For fixing the support price, the price contemplated will have to be higher than the equilibrium price.

• If it is lower than the equilibrium price, it will have to no effect and the market price would rule the scene.

• Any price higher than equilibrium price will be acceptable to the producers.

• When support price is higher than the market price, the demand falls and supply rises.

• Excess supply over demand would tend to push the price down so that the price would ultimately reach the equilibrium level OP.

• Such a happening would obviously defeat the very purpose of announcing a support price.

• Govt. commits itself to purchasing any excess supply at the support price from the open market to be stored in the godowns as a buffer stock to be used in a lean harvest year.

• Alternatively, the govt. can export these goods or it can make them available for sale through fair price shops under the public distribution system.

• If food grains are to be disposed ff through the fair price shops, the selling prices will have to be lower than the market prices in the interests of the poorer sections of the society for whom PDS exists.

• System of Dual Price

• Open market prices create problem, when both the public and the private sectors are engaged in production and supply of certain goods or services which happen to be essential or basic.

• For example, essential goods like cooking gas, kerosene, sugar, etc. are of vital importance for the consumer and if the prices are left to the market forces, price rises beyond a level would exclude poorer strata of consumers.

• Basic goods like cement, steel, fertilizers etc. are important for industrial, agricultural and infrastructural development.

• Their prices, too, need some control.

• But price control in the form of a ceiling price has its own problems as already noted.

• Moreover, the interests of the producers also need to be safe guarded.

• Otherwise, if they are put to loss, they will stop production of the commodity concerned and turn to alternatives.

• Even the monopolists and oligopolists must get atleast normal profits so as to keep producing.

• A system of dual pricing attempts to protect the interests of the producers as well as consumers.

• Under this system, levy limits and prices are imposed by the government.

• A certain part of the output is bought at a controlled purchase price and sold at a price which is fixed by the govt.

• The remaining part can be sold by the producers as well as retailers at prices determined by the market forces.

• This system needs active participation by the govt.

• Thus, the govt. may impose a levy- which is like a tax in kind, and has to be compulsorily handed over to the specified collecting authority- and the goods so collected can be distributed against ration cards, through the public distribution system.

• The levy is imposed in terms of a percentage of output.

• The remaining part can then be sold in the open market as a free quota, at the market price.

• Whatever loss is incurred due to a low levy price can be made good by preparing a market supply schedule with prices covering production costs plus apportioned per unit loss caused by levy prices.

• Market Structure

Market structure refers to the type of market in which the firm operates.

• Perfect Competition

Features of Perfect Competition

• Very large number of sellers and very large number of buyers.

• Sell homogeneous product.

• Free entry and free exit of the firms from the industry.

• Perfect mobility of factors of production.

• Perfect dissemination of information.

• Firm is a price taker and industry is a price maker.

• No government intervention.

Perfect competition less than perfect mobility and perfect knowledge is regarded as pure competition.

•

Monopoly

Features:

• There exists single seller in the market.

• Product has no substitute.

• There is barrier to the entry of firms.

• As there is a single firm, therefore, the firm’s demand curve is the industry’s demand curve which is downward sloping.

• The shape of cost curve is U-shaped.

• As there is no competition, monopolist has the power to fix the price.

• To maximize profit, he can either fix the output or the price. However, he cannot decide both price and output at the same time.

• Monopolistic Competition

Features:

• Very large number of firms but less than the number of sellers found in perfect competition.

• The firms produce differentiated products which don’t have their close substitutes.

• Free entry and free exit of the firm from the industry.

• Perfect factor mobility.

• Complete dissemination of information.

• No uniform price as firm is a price maker and not a price taker. Firm fixes the price and demand determines the sales.

• Firm’s demand curve (AR) is negatively sloped but highly elastic because of availability of close substitutes.

• Non –price Competition

• Oligopoly

Oligopoly is defined as a market structure in which there are a few sellers selling homogeneous or differentiated products.

Types of oligopoly

• Pure Oligopoly

• Differentiated Oligopoly

• Sellers selling homogeneous products or close substitutes

• Sellers selling drentiateiffed products

Features:

• Numbers of sellers are few but less than ten.

• Duopoly is a special case of oligopoly where there exists only two sellers.

• Barriers to entry

• Indeterminate price and output.

• Interdependence of decision-making

• Equilibrium of firm and industry in short-run

Firm is in equilibrium in the short run when it maximises its profit.

Profit is maximum at that output level where:

MC=MR

MC cuts MR from below.

The extent of profit earned will vary depending on the relation between AR and AC curves.

If AR> AC, firms will earn super normal profit.

If AR=AC, firms will earn normal profit.

If AR< AC, firms will earn losses.

Output

AR = MR

MonopolyAR is negatively sloped.AR>MRAR and MR are relatively steep.Reason: No substitutes are available.

ARMR

AR

MR

Monopolistic AR is negatively sloped.AR>MRAR and MR are relatively flat.Reason: Availability of substitutes.

Output

Output

AR & MR

AR & MR

Perfect Comp.Firm’s equilibrium point = point at which profit is maximum OR, whereMR=MC Super normal profit, AR>AC, PMNE

Output

AR = MR

MonopolyFirm’s equilibrium & maximum profit at point T, where MR=MC.Super normal profit at point , AR>AC, PMNE

AR

MR

ARM

ROutput

MC

AC Rev. & cost

Q

P

Rev. & cost

MCAC

MC

P P

Q Q

E E

T T

E

Monopolistic Comp.Firm’s equilibrium & maximum profit at point T, where MR=MC.Super normal profit at point, AR=AC, PMNE

NM M NM N

Perfect Comp.Firm’s equilibrium point = point at which profit is maximum OR, whereMR=MC Loss, AR<AC, MPEN

Output

AR = MR

MonopolyFirm’s equilibrium & maximum profit at point T, where MR=MC.Loss, AR<AC, MPEN

AR

MR

AR

MR

Output

MC AC

Rev. & cost

Q

P

Rev. & cost

MC

AVC

MC

P P

Q Q

E E

TT

E

Monopolistic Comp.Firm’s equilibrium & maximum profit at point T, where MR=MC.Loss, AR<AC, MPEN

NMM N

M N

AVC

AC

• Supply

• Supply means the quantity of a commodity that its producers or sellers offer for sale at a given time at a given price.

• Market supply is the sum of supplies of a commodity made by all individual firms or their supply agencies.

Output

AR = MR

MonopolyFirm’s equilibrium & maximum profit at point T, where MR=MC.Normal profit at point E, AR=AC.

ARMR

AR

MR

MC

ACRev. & cost

Q

P

Rev. & cost

MCAC

MC

P P

Q Q

E E

TT

E

Monopolistic Comp.Firm’s equilibrium & maximum profit at point T, where MR=MC.Normal profit at point E, AR=AC.

• Law of Supply

The law of supply states that quantity supplied is positively related to price.

“ 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.”

• Supply Function

It is a mathematical statement which states the relationship between the quantity supplied of a commodity and the factors affecting its supply.

S=f (Pn , Pf ,T,G, S)

Pn =Price of a commodity

Pf = price of factor inputs.

T= Technology

G= Government Policy

S= Nature and size of the Industry.

• Factors affecting Supply/ Determinants of Supply

(i) Change in Input Prices

(ii) Technological Progress

(iii) Price of product substitutes

(iv) Nature and size of the Industry

(v) Government Policy

(vi) Non- Economic Factors.

• Change in Supply

• Extension and Contraction

• When quantity supplied changes due to change in price, it is called extension or contraction of supply curve.

• Characterized by upward or downward movement along the supply curve.

• Increase and Decrease

• When supply changes due to change in factors other than price, it is called increase or decrease in the price.

• Characterized by rightward or leftward shift in the supply curve.

• Elasticity of Supply

It is the degree of responsiveness of changes in supply to change in price on the part of seller.

• Types of Elasticities of Supply

Perfectly elastic Supply

Perfectly Inelastic Supply

Unit elastic Supply

More than unit elastic supply

Less than unit elastic supply

If a, change in the quantity supplied, and a change in the price vary in equal proportion, the ratio will be equal to one and the elasticity of supply will be equal

Unit Elastic Supply

E s=Proportionate change in quantity suppliedProportionate change in price

E s=ΔQΔP

×PQ

to unity.

Unit elastic supply

If the point on the arc supply curve is such that the tangent passes through the origin, the elasticity at the point will also be equal to unity.

•

Greater than Unity

• If the proportionate change in quantity supplied

is more than the proportionate change in price,

the elasticity is said to be greater than unity.

• If the supply curve is an arc, then the point on

the curve whose tangent cuts the price axis will

have elasticity greater than unity.

Greater Than Unity

• Less than Unity

• When the proportionate change in quantity supplied is less than the proportionate change in price, the elasticity is said to be less than one.

• The tangent at point C intersects the X-axis at the point d. This means elasticity of supply is less than one.

Factors of Elasticity of Supply

1. Cost of Production:

• If cost of production increases slowly with increase in output, supply will be inelastic.

• If cost increases at a very fast rate, supply will be elastic.

2. Natural Constraints:

Some products requires specific raw materials, soil etc, e.g. cotton requires black soil. Therefore, cotton can be produced only in black soil areas. Thus, supply of cotton will be inelastic.

3. Nature of the commodity:

In case of perishable commodity e.g. apples, tomatoes etc., supply will be inelastic.

Reasons:

• Supply can’t be increased in a short period of time.

• These goods can’t be stored.

In case of durable commodities e.g. computer, car etc. , supply will be elastic.

Reason: Excess of durable goods can be produced and stored.

ELASTICITY

• Elasticity is the concept economists use to describe the steepness or flatness of curves or functions.

• In general, elasticity measures the responsiveness of one variable to changes in another variable.

Types of Elasticity of demand

• Price Elasticit

• Income Elasticity

• Cross Elasticity

PRICE ELASTICITY OF DEMAND

• Measures the responsiveness of quantity demanded to changes in a good’s own price.

• The price elasticity of demand is the percent change in quantity demanded divided by the percent change in price that caused the change in quantity demanded.

• Elasticity is denoted by lower-case Greek letter eta (η)

Elasticity on a linear demand curve

• Perfectly inelastic (e=0)

A

PP1

Q Q1

∆Q∆P

o

price

CD

B

η=percentage change in quantity demandedpercentage change in price

η= ΔqΔp

× pq

η= Δqq

× pΔp

η=

Δqq

. 100

Δpp

. 100

• less than unit elastic (e<1)

• Unit Elastic (e=1)

• More than unit elastic (e>1)

• Perfectly inelastic (e=0)

Types of Elasticity

Perfectly Inelastic demand curve Elasticity is zero i.e.

N=0

Less Than Unit Elastic Demand

More Than Unit Elastic Demand

Unit Elastic Demand

e=1

o x

Y

D

D

quantity

pri

ce

quantity

pric

e

o x

d

d

1

η¿1¿

Income Elasticity of DemandThe responsiveness of demand to the changes in income is known as income-elasticity of demand.

• Income elasticity of demand is always positive except in the case of inferior goods.

• Essential Goods

• Less than one

o quantity

D

Dq q1

pp1

e y=percentage change in quantity demandedpercentage change in income

e y= ΔQΔY

×YQ

• ey < 1

• Comforts

• Almost equal to one

• ey =1

• Luxuries

• More than one

• ey >1

Cross Elasticity of Demand It refers to the responsiveness of quantity demanded of one product to change in the price of other products.

Types of Cross Elasticity

Cross elasticity varies from minus infinity to plus infinity.

FACTS ABOUT ELASTICITY

• It’s always a ratio of percentage changes.

• That means it is a pure number -- there are no units of measurement on elasticity.

η xy=percentage change in quantity demanded of product Xpercentage change in price of product Y

η xy= ΔQ x

ΔP y× P yQ x

η xy=positive→ In case of substitute goods .η xy=negative→ In case of complementary goods .

• Price elasticity of demand is computed along a demand curve.

Total Expenditure Method

• If, when price falls, total spending increases, demand is elastic.

If, when the price falls, total spending remains constant, demand is unit elastic.

If, when price falls, total spending decreases, demand is inelastic.

Point Elasticity of Demand

• A geometric way of measuring elasticity at a particular point on the demand curve.

Arc Elasticity of Demand

• It is used to measure the elasticity between two different points on the demand curve.

• Arc method is an average method.

“It is best approximate to the correct measure, when measured between two separate points on a demand curve. It is obtained by defining price and quantity as the average of prices and quantities at two points on the curve.”

- Source:Lipsey and Chrystal

P ↓ TQ ↑, there is inverse relationship between P and TQ .η> 1→ demand is elastic .

P ↓ TQ remains constant, η= 1→ demand is unit elastic .

P ↓ TQ ↓, there is positive relationship between P and TQ .η< 1→ demand is inelastic .

η=Lower segment of the demand curveUpper segment of the demand curve

η=ΔQΔP

×(P o+P1 )/2(Q o+Q1 )/2

η=Change in quantityChange in price

×Sum of pricesSum of quantities

Determinants of Elasticity of Demand

• Availability of substitutes

• Nature of product

• Time period

• Related products

• Weightage in the total consumption

• Range of commodity use

• Proportion of market supplied

Significance and Uses of Concept of Elasticity

Firms can use price elasticity of demand (Ped) estimates to predict:

• The effect of a change in price on the total revenue & expenditure on a product.

• The likely price volatility in a market following unexpected changes in supply - this is important for commodity producers who may suffer big price movements from time to time.

• The effect of a change in a government indirect tax on price and quantity demanded and

also whether the business is able to pass on some or all of the tax onto the consumer.

• Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination (also known as yield management). This is where a monopoly supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or yield management by many of our domestic and international airlines.

• Depending on the elasticity of a product, the firm can find an alternative marketing strategy that they can adopt to increase revenue.

• Demand

• Demand refers to the quantity of a commodity, the consumers are willing and able to buy at different prices during a given time.

Three points to consider:

Meaning of Demand:

desire to acquire

willingness

ability to pay

Demand is the desire/ want backed by money

Demand= (desire+ ability to pay + willingness to pay)

Definitions

According to Benham:

“The demand for anything, at a given price, is the amount of it, which will be bought per unit of time, at that price.”

According to Bobber:

“By demand we mean the various quantities of a given commodity or service which consumers would buy in one market in a given period of time at various prices.”

Demand Schedule:

A tabular presentation showing different quantities of a commodity that would be demanded at different prices.

Demand Schedule

Demand Schedule:

A tabular presentation showing different quantities of a commodity that would be demanded at different prices.

Types of Demand Schedules

Individual Demand Schedule:

Shows various quantities of a commodity that would be purchased at different prices by a household.

Market Demand Schedule

• Shows the various commodities that would be purchased at different prices by all the buyers of that commodity.

• It is composed of the demand schedules of all the individuals purchasing that commodity.

• Meaning of Demand Curve:

• A demand curve is a graphical depiction of the demand of schedule or the plotting of the demand schedule on graph is called the demand curve.

• It is the curve showing different quantities demanded at alternative prices.

Individual Demand Curve Negative slope

Slopes downward

Types of Demand Curve:

Individual Demand Curve:

Individual demand curve is a graphical depiction of the Individual demand schedule.

Market Demand Curve :

Market demand curve is a graphical depiction of the market demand schedule.

Factors Determining Demand

D = f (Px, Y , T,E, Pr, P )

1.Price of the commodity (Px)

Inverse relationship between the price of the commodity and the quantity demanded

2.Income of the Consumer (Y)

* Determines the purchasing power of the consumer

* Direct relationship between income and quantity demanded

• Normal goods

(Y increases, demand increases)

• Inferior goods

(Y increases, demand decreases)

3. Consumer’s taste and preference (T)

4. Price of related commodities (Pr)

• Substitute goods

(P increases, demand increases)

• Complementary goods

(P increases, demand decreases)

5. Consumer Expectation (expected change in price)

6. Size and composition of population (P)

7. Other Factors e.g., natural calamities

substitude goods

Complementary Goods

law of Demand

Prof. Samuelson:

“Law of demand states that people will buy more at lower price and buy less at higher prices, others thing remaining the same.”

Ferguson:

“According to the law of demand, the quantity demanded varies inversely with price”.

Assumptions:

No change in tastes and preference of the consumers.

q1 q2q

p1p2p

D

D

No. of Cars

3 4 5

252015

Quantity of coffee in Kg

Price of tea in Rs.

D

D

Consumer’s income must remain the same.

The price of the related commodities should not change.

The commodity should be a normal commodity.

Exceptions of the law of demand :

Inferior goods/ Giffin Goods

Articles of Distinction

Expectation regarding future prices

Emergencies

Habit/ Preference

Why does demand curve slope downwards?

Law of Diminishing Marginal Utility

Income effect

Substitution effect

Size of consumer group

Different uses of a product

Change In Demand -Expansion and Contraction in demand

• Movement along the demand curve

• Also called change in quantity demanded

• Rise in demand due to fall in price of the commodity, ceterius paribus is known as expansion in demand or downward movement along the demand curve.

Increase or decrease in Demand

• Shifts in demand curve

• Also called change in demand

• When demand increases due to change in other factor e.g. increase in income, decrease in price of complementary goods etc. with price of coommodity remaining constant is known as increase in demand.

• Fall in demand due to rise in price of commodity, ceterius paribus is known as contraction in demand or upward movement along the demand curve.

• When demand decreases due to change in other factor e.g. decrease in income etc. with the price of commodity remaining constant is known as decrease in demand.

BC

• Demand Forecasting

• Predicting the future demand for firm’s product.

• Demand forecasting seeks to investigate and measure the forces that determine sales for existing and new products.

• Thus, demand forecasting refers to an estimation of most likely future demand for product under given conditions.

• Important features of demand forecasting

• It is an informed and well thought out guesswork.

• It is in terms of specific quantities

• A forecast is made for a specific period of time which would be sufficient to take a decision and put it into action.

• It is based on historical information and the past data.

• Why Demand Forecasting?

Demand forecasting helps in the following areas of business decision-making.

• Planning and scheduling production

Generally companies plan their business - production or sales in anticipation of future demand. Hence forecasting future demand becomes important.

• In avoiding or minimizing the risks

The art of successful business lies in avoiding or minimizing the risks involved as far as possible and face the uncertainties in a most befitting manner.

• Acquiring inputs(labour, raw material and capital)

• Making provision for finances

• Formulating pricing strategy

• Planning advertisement

• Managerial uses of demand forecasting

In the short run:

• Production planning:

Helps in determining the level of output at various periods and

Helps in avoiding under or over production.

• Helps to formulate right purchase policy:

Helps in better material management, of buying inputs and

Helps in controlling its inventory level which cuts down cost of operation.

• Helps to frame realistic pricing policy: A rational pricing policy can be formulated to suit short run and seasonal variations in demand.

• Sales forecasting: It helps the company to set realistic sales targets for each individual salesman and for the company as a whole.

• Helps in estimating short run financial requirements: I

Helps the company to plan the finances required for achieving the production and sales targets.

Helps company to raise the required finance well in advance at reasonable rates of interest.

• Reduce the dependence on chances:

helps firm to plan its production properly and

Helps firm to face the challenges of competition efficiently.

• Helps to evolve a suitable labour policy: A proper sales and production policies help to determine the exact number of labourers to be employed in the short run.

In the long run: Long run forecasting of probable demand for a product of a company is generally for a period of 3 to 5 or 10 years.

1. Business planning:

Helps to plan expansion of the existing unit or a new production unit.

Capital budgeting of a firm is based on long run demand forecasting.

2. Financial planning:

Helps to plan long run financial requirements and

Helps to plan investment programs by floating shares and debentures in the open market.

3. Manpower planning:

Helps in preparing long term planning for imparting training to the existing staff and

Helps in recruiting skilled and efficient labour force for its long run growth.

4. Business control:

Effective control over total costs and revenues of a company

helps to determine the value and volume of business

helps to estimate the total profits of the firm

helps to regulate business effectively

helps to meet the challenges of the market

5.Determination of the growth rate of the firm :

A steady and well conceived demand forecasting determine the speed at which the company can grow.

6.Establishment of stability in the working of the firm :

Fluctuations in production cause ups and downs in business which retards smooth functioning of the firm.

Demand forecasting

reduces production uncertainties and

helps in stabilizing the activities of the firm.

7.Indicates interdependence of different industries :

Demand forecasts of particular products become the basis for demand forecasts of other related industries,

e.g., demand forecast for cotton textile industry supply information to the most likely demand for textile machinery, colour, dye-stuff industry etc.

8. More useful in case of developed nations:

It is of great use in industrially advanced countries where demand conditions fluctuate much more than supply conditions.

• Steps in Demand Forecasting

• Specifying the objective

• Determining the time perspective

• Making Choice of method for demand forecasting

• Collection of data and data adjustment

• Estimation and interpretation of results

• Survey Methods

Survey methods

• help us in obtaining information about the future purchase plans of potential buyers

through collecting the opinions of experts or

by interviewing the consumers.

• extensively used in short run and estimating the demand for new products.

Techniques of Demand ForecastingSurvey

MethodsStatistical MethodsConsumer

Survey: Direct Interview

Opinion Poll

Complete

Enumeration

Sample Survey

Expert

Opinion

Market Studies

& Experim

ents

Trend Projecti

on

Barometric

Methods

Econometric

methods

• There are different approaches under survey methods.

A. Consumers’ interview method/ Direct Interview Method :

Experience has shown that many customers do not respond to questionnaire addressed to them even if it is simple due to varied reasons. Hence, an alternative method is developed.

Under this method,

• Efforts are made to collect the relevant information directly from the consumers with regard to their future purchase plans.

• In order to gather information from consumers, a number of alternative techniques are developed from time to time.

• customers are directly contacted and interviewed.

• Direct and simple questions are asked to them.

• They are requested to answer specifically about

their budget,

expenditure plans,

particular items to be selected,

the quality and quantity of products,

relative price preferences etc. for a particular period of time.

There are three different methods of direct personal interviews.

They are as follows:

(i) Complete enumeration method

• Under this method, all potential customers are interviewed in a particular city or a region.

• The answers elicited are consolidated and carefully studied to obtain the most probable demand for a product.

• The management can safely project the future demand for its products.

• This method is free from all types of prejudices.

• The result mainly depends on the nature of questions asked and answers received from the customers.

(ii) End –Use Method

• Demand for the product from different sectors such as industries, consumers export and import are found out.

• This data helps in changing the future course of demand.

• Industries should provide their production plans and input-output co-efficients.

(iii) Sample Survey Method:

• A sample of survey is selected for interview.

• The sample may be random sampling or stratified sampling.

• This method is easy, less costly and also highly useful.

• Correct sampling and co-operation of he consumers are essential for success of this method.

B.“Opinion surveys”: Also called Survey of buyer’s intentions or preferences: It is one of the oldest methods of demand forecasting.

• Under this method, consumer buyers are requested to indicate their preferences and willingness about particular products.

• They are asked to reveal their ‘future purchase plans’

with respect to specific items.

• Generally, the field survey is conducted by the marketing research department of the company or hiring the services of outside research organizations consisting of learned and highly qualified professionals.

• The heart of the survey is questionnaire.

• It is a comprehensive one covering almost all questions either directly or indirectly in a most intelligent manner.

(i) Expert Opinion

• Apart from salesman and consumers, distributors or outside experts may also be used for forecasting.

• Firms in advanced countries make use of outside experts for estimating future demand.

• Various public and private agencies sell periodic forecast of short or long term business condition.

(ii)Market Studies and Experiments

• Firms first select some areas of the representative markets –three of four markets having similar features viz. population, income levels, cultural and social background etc.

• Carrying out market studies and experiments on consumer’s behaviour under actual, through controlled market conditions for ex. By changing the price , advertising exp. And other controllable variables.

• On the basis of data collected, elasticity coefficients are computed.

• These coefficients are then used along with the variables of the demand function to assess the future demand of a product.

• Delphi Method

• Extension of Expert opinion poll method.

• Used to consolidate the divergent expert opinions and to arrive at a compromise estimate of future demand.

• Experts are provided information on estimates of forecasts of other experts to revise their own estimates in the light of forecasts made by other experts.

• The consensus of experts constitutes the final forecast.

• Statistical Methods

• Based on statistical techniques.

• Element of subjectivity is minimum.

• Relatively more reliable.

• Scientific as it is based on scientific relationship between the dependent and independent variable.

• Trend Projection Methods

• Classical method of demand forecasting

• Concerned with the study of movement of variables through time.

• Requires long and reliable time series data.

• Used under assumption that the factors responsible for the past trends in the variable to be projected will continue to play their part in future.

Three techniques used for trend projection:

(a) Graphical method

(b) Fitting trend equation or least square method,

(c) Box- Jenkins method

(d) Graphical Method: Under this method

• Annual sales data is plotted on a graph paper a line is drawn through the plotted points.

• A free hand line is so drawn that the total distance between the line and the points is minimum.

• The dotted line M is drawn through the mid-values of variations.

• Line S is a straight trend, while the dotted lines show the secular trend.

• By extending the trend lines (M & S), we can forecast an approximate sale.

(i) Fitting Trend Equation: Least Square Method

• Formal technique of projecting the trend in demand.

• A trend line is fitted to the time-series sales data with the aid of statistical techniques.

• Quite popular in business forecasting because of its simplicity.

• Simple to apply because only time-series data on sales are required.

• Yields fairly reliable results of the future course of demand.

(ii)Box- Jenkins Method:

• Used for short term projections.

• Suitable for forecasting demand with only stationary time-series sales data.

• Used only in those cases in which time-series analysis depicts monthly or seasonal variations recurring with some degree of regularity. E.g: sale of desert coolers in summers, greeting cards in the month of December etc.

Steps in Box-Jenkins Approach

First, to create a stationary time-series and to eliminate trend from time series data by taking differences of time series data i.e. subtracting observed value of one period from the observed value of the preceding year.

Second, to make sure that there is seasonality in the stationary time-series. If a certain pattern is found to repeat over time, there is seasonality in the stationary time series.

Final, to use the models to predict sales in the intended period.

(b) Barometric Model of Forecasting:

• First developed and used in 1920s by the Harvard Economic Service,

• However, abandoned due to its failure to predict the Great Depression of the 1930s.

• Revived, refined and developed further in the late 1930s by the national Bureau of Economic Research (NBER) of the US.

• Follows the method meteorologists use in weather forecasting.

• Uses barometers to forecast weather conditions on the basis of movement of mercury in the barometer.

• Barometers are used as economic indicator to forecast trends in business activities.

(c) Econometric methods:

• Combines statistical tools with economic theories to estimate economic variables and to forecast the intended economic variables.

• Much more reliable than any other method.

• Used to forecast demand for a product, for a group of products and for the economy as a whole.

Methods:

• Regression method

• Simultaneous equations model

Regression Method:

• The most popular method of demand estimation.

• Combines economic theory and statistical techniques of estimation

• Employed to estimate the values of parameters in the estimated equation.

Simultaneous Equations Model:

Involves estimating several simultaneous equations.

These equations are behavioural equations, mathematical identities and market-clearing equations.

• Enables the forecaster to take into account the simultaneous interaction between dependent and independent variables.

• Complete and systematic approach to forecasting.

• Uses sophisticated mathematical and statistical tools.

• New Product Demand Forecasting

• Demand forecasting for new products is quite different from that for established products.

• Here the firms will not have any past experience or past data for this purpose.

• An intensive study of the economic and competitive characteristics of the product should be made to make efficient forecasts.

Forecasting the Demand for a New Product

For forecasting demand for a new product, Joel Dean has suggested six approaches.

1. Evolutionary Approach: Demand for new product is estimated on the basis of an existing product. E.g. Demand forecast of colour TV on the basis of demand for Black & White TV sets.

2. Substitute Approach

3. Growth Curve Approach: On the basis of growth rate of an established product.

4. Opinion Polling Method: Either on the basis of Expert’s opinion or on the basis of enquiry from the sample of prospective customer directly.

5. Sales Experience Approach: demand is estimated by supplying the product in a sample market by direct mail or through a chain store like departmental stores or co-operative society.

6. Vicarious Approach: consumer’s reactions for a new product are found out indirectly with the help of specialized dealers who are well informed about consumers’ needs, tastes and preferences.

In forecasting the demand for a new product, the firm will need to make

• a market survey of customer

• need analysis of sales records of potentially competing products or

• analysis of the life cycle of existing products which may be substitutes.

• The sales records of a comparable product may be used

as the basis for making an estimate or

a prediction of sales of a new product.

• The life-cycle approach is based on the theory that each product goes through a predictable growth pattern following its initial introduction.

• Application of this method assumes that a- product experiences an introductory phase, further development, growth, maturity, stabilization in acceptance and then decline.

• The key to using this method is to find a growth pattern in some established product which services the same market so as to use its record as a guide.

• In the case of an established product, changes in some key-variables such as customer's income or the level of economic activity may provide the required clues.

• Here forecasting becomes a matter of predicting possible elasticities or responsiveness to key variable changes.

Cost • Inputs multiplied by their respective prices and added together give the money value of

the inputs i.e. cost of production.

Theory of Cost: The Cost-Output Relationship

• The theory of cost deals with the behaviour of cost in relation to change in output.

• A cost function is a symbolic statement of the relationship between the cost and output.

• The general form of the cost function is written as:

TC = f (Q), where TC is the total cost and Q is the output.

Accounting Costs and Economic Costs

• Accounting Costs= Opportunity Cost + Actual or Explicit Cost

• Opportunity cost is the cost of next best alternative from the same inputs costing the same amount of money.

• Actual or Explicit Costs are the costs which are actually incurred by the firm in payment for labour, material, plant, building, machinery, equipment, travelling and transport etc.

• The total money expenses in the books of accounts are for all practical purposes, the actual costs.

• Economic Costs = Explicit Costs + Implicit Costs

• Implicit Costs: There are certain costs that don’t take the form of cash outlays nor do they appear in the accounting system, such costs are known as implicit or imputed costs.

• Implicit Costs = Cost of self employed resources + Opportunity Costs

Private Cost and Social Cost

• Costs that are actually incurred or provided for by an individual or a firm on the purchase of goods and services from the market.

• Private Costs= Explicit Costs + Implicit Costs

• Social costs refer to the total cost borne by society due to production of a commodity.

• Social costs include both private cost and the external cost.

Social cost includes

1. The cost of resources for which the firm is not required to pay, i.e atmosphere, rivers, lakes, etc. and also for the use of public utility services like roadways, drainage system etc.

2. The cost in the form of disutility created through air, water, noise and environment pollution etc.

3. It also includes the total private and public expenditure incurred to safeguard the individual and public interest against the various kinds of health hazards and social tension created by the production system.

Short Run and Long Run Costs

• Short run costs re those that have a short-run implication and in the process of production.

• Such costs vary with the variation in output, the size of the firm remaining the same.

• Such costs are made once and can’t be used again and again

• e.g. payment of wages, cost of raw materials etc.

Short run costs are treated as variable costs.

Long-run Costs

• Long run costs are those that have a long-run implication in the process of production i.e. they are used over a long range of output.

• The costs that are incurred on the fixed factors like plant, building, machinery etc. are long run costs.

• But the running cost and depreciation of the capital assets are included in the short run or variable costs.

Fixed Costs

• Fixed costs are the costs incurred on the fixed factors of production.

• Fixed cost doesn’t vary with variation in output.

• Also referred to as overhead costs or unavoidable costs.

• E.g. rent of a building, interest on capital, cost of building and machines etc.

Variable Costs

• Costs incurred on the variable factors of production.

• These cost vary positively with output.

• These cost are also referred as direct costs or avoidable costs.

• E.g. wages and salaries, depreciation, cost of raw materials etc.

TvC TVC

TC, AC & MC

Total cost:

The total actual cost incurred on the production of goods and services.

It includes both explicit and implicit costs.

TVC

TFC

output X

Ycost

o O X

Y

It includes both fixed and variable costs.

Average Cost:

• Cost per unit of output

• Obtained by dividing TC by the total output.

Marginal Cost:

Addition to the total cost on account of producing one additional unit of the product.

Cost of marginal unit produced.

MC = TCn – TCn-1

Short-Cost Cost-Output Relationship

Cost Components

Total Cost (TC)

Total Fixed Cost (TFC) and

Total Variable Cost (TVC)

Average Cost (AC)

Marginal Cost (MC)

Relationship between AC, AVC and MC

TCQ

MC= ΔTCΔQ

TC=TFC+TVC

AC=TCQ

=TFC+TVCQ

=TFCQ

+TVCQ

=AFC+AVC

MC= ΔTCΔQ

=∂TC∂Q

= ΔTFC+ΔTVCΔQ

= ΔTVCΔQ

∵ ΔTFC=0

• Relationship among AFC,AVC, AC, and MC

• Over the range of output AFC and AVC fall, AC also falls.

• When AFC falls but AVC increases, change in AC depends on the rate of change in AFC and AVC.

If decrease in AFC > increase in AVC, then AC falls.

If decrease in AFC= increase in AVC, AC remains constant.

If decrease in AFC< increase in AVC, then AC increases.

• 1. Initially when AC and AVC fall, MC also falls, but, MC lies below AC and AVC.

• AVC> MC and AC> MC

X

YOOutput

Cost MC AVC

q0 q q1

AFC

• 2. As output increases both AC and AVC rise, MC also rises, but MC lies above AC and AVC.

• AVC<MC and AC<MC

• 3. When AC and AVC are minimum, MC cuts AC and AVC at its minimum point.

• 4. Minimum level of MC occurs at a very low level of output as compared to AVC and AC.

Reason for U-shaped AC curve

• Till AVC reaches its minimum point, upto that output level , both AVC and AC are falling.

• After AVC reaches its minimum point, AVC starts rising but AC is still falling.

Reason: Fall in AFC strongly offsets the rise in AVC.

• AC falls till output level where AC is minimum.

• After reaching its minimum point, AC starts rising.

Reason: Rise in AVC strongly offsets the fall in AFC.

• Therefore, AC rises.

• Thus, AC is U-shaped because AC=AVC+AFC

• Long Run Cost-Output Function

• It implies the relationship between the changing scale of the firm and the total output.

• It also refers to the behaviour of TC, AC and MC in response to simultaneous and proportionate charge in both labour and capital costs.

• Long run is composed of a series of short run production decisions.

Long run cost curve is composed of a series of short run cost curves.

• Economies of Scale

(a) Internal or Real Economies

SAC3

SAC1

SAC2

Q0 Q Q1

Cost

Quantityo

(b) External or Pecuniary Economies

Internal Economies:

Also called real economies.

Arise from expansion of plant size of the firm and are internalized.

Available to the expanding firm.

Classification of Internal Economies:

• Economies in Production

Technological Advantages

Advantages of division of labour based on specialization and skill of labour.

• Economies in Marketing

Economies in advertisement cost

Economies in large-scale distribution through whole-salers

Other large scale economies.

• Managerial Economies

Specialization in managerial activities, i.e. the use of specialized managerial personnel

Mechanization of managerial functions

• Economies in transport and storage

Fuller utilization of transport and storage facility

External or Pecuniary Economies of Scale

• Arise outside the firm and accrue to the expanding firms.

• Appear in the form of money saving on inputs.

• Accrue to large size firms in the form of discounts and concessions on:

Large scale purchase of raw materials

Large scale acquisition of external finance, particularly from the commercial banks;

Massive advertisement campaigns;

Large scale hiring of means of transport and warehouses etc.

• Diseconomies of Scale

Internal Diseconomies

• Managerial Diseconomies

• Labour Diseconomies

External Diseconomies

Internal Diseconomies: Exclusive and internal to a firm- they arise within the firm.

• Managerial Inefficiency:

Appears at managerial level

Arise from expansion of scale

Fast expansion of scale limits or reduces the personal contacts and communications between

Owners and managers

Managers and labours

Managers and different departments or sections

Close control and supervision replaced by remote control management.

Inevitability of delayed and complex decision making process due to increase in managerial personnel.

Delay in implementation of decision due to co-ordination problem.

Expansion of scale results in professionalization beyond a point.

Owner’s objective of profit maximization function gets replaced by manager’s utility function.

Laxity in management leads to rise in the cost of production.

• Labour Inefficiency:

Loss of control over labour management

Loss of control over labour productivity

Increase in labour union activities which means loss of output per unit of time and thus rise in cost of production.

External Diseconomies:

• Originate outside the firm especially in the input market and due to natural constraints, specially in agriculture and extractive industries.

• Rise in cost of production due to rise in input prices because of increasing demand of inputs.

• When all firms expand, financial discounts and concessions on bulk purchases of inputs come to an end.

• Cost Reduction • Achievement of Real and Permanent Reduction in the unit cost of goods manufactured

or services rendered without impairing their suitability for the use intended or diminution in the quality of the product.

costs of manufacture, administration, distribution and selling,

elimination of wasteful and inessential elements Cost reduction implies:

• retention of essential characteristics and quality of the product

• permanent and genuine savings in the form the design of the product and from the techniques and

• Cost reduction, should therefore, not be confused with cost saving and cost control.

• Cost saving could be a temporary affair and may be at the cost of quality.

• Three Fold Assumption

The three fold assumption involved in the definition of cost reduction may be summarized as under:-

1. There is saving in a cost unit

2. Such saving is of a permanent nature

3. The utility and quality of goods remain unaffected, if not improved

• Advantages of Cost Reduction

1. Helps in profit improvement :

– more the profits, more stable a company becomes.

– enhances the share value,

– improves investment opportunities and

– facilitates the collection of capital.

2. Benefits to society:

– society will be benefited by the reduced prices which may be

– possible by savings form cost reduction programs.

– Competitive position will improve.

– The industry as a whole will strive to improve the productivity and pass on the advantage of such programs to the society.

– Workers and staff of the industry may also be benefitted through increased wages and improved staff welfare amenities.

3. Gains to country:

– Country gains immensely by the cost reduction programmes.

– Industry will be able to maintain the international parity in prices of exportable commodities.

– Consequential increase in export will result in increased foreign exchange savings.

– Also internal revenue will increase through more tax savings.

• Objectives of Cost Reduction

• Reducing the cost per unit

• Increasing productivity

• How to Reduce Costs

Elimination of wastes

Improving operations

Increase in productivity

Cheaper material

Improved standards of quality

Cost EstimationAn approximation of the probable cost of a product, program, or project, computed on

the basis of available information.

Four common types of cost estimates are:

(1) Planning estimate: A rough approximation of cost within a reasonable range of values, prepared for information purposes only. Also called ball par estimate.

(2) Budget estimate: An approximation based on well-defined (but preliminary) cost

data and established ground rules.

(3) Firm estimate: a figure based on cost data sound enough for entering into a binding contract.

(4) Not-to-exceed /Not-less-than estimate: the maximum or minimum amount required to accomplish a given task, based on a firm cost estimate.

What methods are available?

• Engineering estimates

• Account analysis

• Scattergraph

• High-low estimates

• Statistical methods (typically regression)

Cost Estimation: Engineering Method

• Requires direct physical observation of the production process

• Many indirect production costs are not directly observable from an engineering study.

• Generally expensive to implement.

• Used to improve the efficiency of the process not just to estimate costs.

Cost Estimation: Account Analysis

• Reviews each account

• Identifies it as fixed or variable (or mixed)

• Attempts to determine the relationship between the activity of interest and the cost

– Cost of building occupancy (Rent)

– Cost of quality inspections

– Cost of materials handling

Cost Estimation: Scatter graph

Suppose you have data on overhead costs and machine hours for the past 15 months and you believe there is a linear relation between the two.

Can you look at the numbers and tell me if there is a relation?

Can you easily determine whether the positive relationship exists?

Yes, plot the data and look for a relationship.

Cost Estimation: High-Low Method

Find the variable cost per unit of the cost driver (VC).

VC = O/H at highest level - O/H at lowest level

highest level units produced - lowest level units produced

• Cost Driver: A factor that can cause a change in the cost of an activity.

• An activity can have more than one cost driver attached to it. For example, a production activity may have the following associated cost-drivers: a machine, machine operator(s), floor space occupied, power consumed, and the quantity of waste and/or rejected output.

• High-Low method is one of the several techniques which are used to split a mixed cost into its fixed and variable components.

• It is very simple technique but relatively unreliable.

• This is because, in high-low method, two extreme data points are taken from a set of actual data of various production levels and their corresponding total cost figures.

• These figures are used to calculate the approximate variable cost per unit (b) and total fixed cost (a) for the cost volume formula:

Y=a+bx

Cost Estimation:

Simple Regression

Simple Regression estimates an equation of the form:

Y = a + b*X + e,

Y = dependent variable (“total cost”)

a = intercept (“fixed costs”)

b = coefficient (“variable cost per revenue hour”)

X = independent variable (“cost driver”)

e = random error

Simple linear regression

• One explanatory variable

• Cost estimation equation

• Coefficient of correlation (R)

• Coefficient of determination (R2)

– Goodness of fit

– Measure of importance

• F-statistic (hypothesis testing)

• p-value

Coefficient of correlation

Measures the correlation between the independentand the dependent variables

Coefficient of determination

Measures the percentage of variation in thedependent variable explained by the independentvariable

When the predicted values exactly equal theactual costs, R2 = 1.

A goodness of fit test: R2 > .3

The F statistic

• Goodness of fit hypothesis testing

• Compute a statistic for regression results

• Compute the associated p-value, or

• Look up a critical F-value and compare after matching on

– 1 numerator degree of freedom

– (n-2) denominator degrees of freedom

– alpha = .05

The F test:

• The null hypothesis is: The slope coefficient is zero. This means there is no relation between the y and the x measures.

• If F is large, the hypothesis is rejected.

The p-value

• This is the probability that the statistic we computed could have come from the population implied by our null hypothesis.

• Suppose we hypothesize that the slope coefficient is zero.

• If the p-value associated with the F-statistic is small, chances are the slope coefficient is not zero.

Cost Estimation:

Multiple Regression• Multiple Regression estimates an equation of the form:

Y = a + b1*X1 + b2*X2 + b3*X3+ … + e,

Where

Y = dependent variable

a = intercept

bi = coefficient for independent variable i

Xi = independent variable i

e = random error

Example: Multiple regression with indicator variables

• Suppose you have verified that there is a linear relation between overhead and machine hours, but there is no linear relation between overhead and DM$.

• You believe that the time of year also plays a factor in determining monthly overhead costs. Specifically, you believe that there is a different different relation during each of the seasons (winter, spring, summer, fall).

You want to estimate a multiple regression model. What is the form of the equation?

Indicator variables:

Effect on intercepts

Seasonality can be addressed with indicator (“dummy”) variables.

Value = 1 if condition met, 0 otherwise

Seasonality can affect the intercept, the slope, or both…

Suppose the fixed part of overhead is different for each season:

Add an indicator variable for three of the seasons

The omitted season acts as the baseline – its effect is combined with the intercept

Indicator variables: Effect on slopes

• The fixed part of overhead may be different for each season – this affects the intercept.

• Seasonality may affect the slope instead.

– Choose three seasonal dummy variables

– Create three new variables by multiplying each of the dummy variables by “machine hours”

– Add the three new variables to the regression

– The omitted new variable acts as the baseline – its effect is combined with “machine hours”

• Capital Budgeting

“Capital expenditure intended to benefit future periods in contrast to revenue expenditure which benefits a current period in addition to a capital asset.”

- Kohler

Capital budgeting is essentially a process of conceiving, analyzing, evaluating and selecting the most profitable project for investment.

• Significance of Capital Budgeting

1. Long-Term Implication

2. Involvement of Large Amount of Fund

3. Irreversible Decisions

4. Risk and Uncertainty

Steps involved in Project Evaluation

1. Identification of Potential Opportunities

2. Assembling of Investment Proposals

• Replacement investment

• Expansion investment

• New product investment

• Obligatory or welfare investment

3. Decision Making

4.Preparation of Capital Budget and Appropriations

5.Implementations:

Translation of investment proposals into concrete projects

6.Performance Review or Post-Completion Audit

Time Value of Money

• Based on the idea that the money received today is more than money receivable tomorrow.

• Cash in hand is valued more because it gives

Liquidity

Opportunity to invest it and earn return on it.

This is called ‘time value of money’.

This concept is applied to investment decisions.

• There is a time lag between investment and its returns.

• When an investment is made today, it begins to yield returns at some future data.

• The time gap between the investment and the first return from the investment is called ‘time-lag’.

• During this time lag, investor loses interest on the expected incomes.

• This implies that a rupee received today is worth more than a rupee receivable at some future date.

• In this context, the present value of a future income is lower than the value of the same amount received today.

Formula for computing Present Value

A= P(1+r)n

PV of Amount(A)= A/(1+r)n

• Methods of Investment Appraisal

• Net Present Value

• Internal Rate of Return

• Discounted Cash Flow

• Net Present Value

NPV= TPV- TPC

NPV= Net Present Value

TPC= Total cost of investment without any recurring expenditures.

TPV=Total Present value of annual stream

If NPV> 0, the project is acceptable.

If NPV=0, the project is accepted or rejected on non-economic considerations;

If NPV< 0, the project is rejected.

Internal Rate of Return(IRR)

• Also called Marginal Efficiency of Investment(MEI), Internal Rate of Project (IRP) and Break Even Rate (BER).

• For example, if a one year project costing Rs. 100 million yields Rs. 120 million at the end of the year,

• The IRR or MEI is defined as the rate of interest or return which renders the discounted present value of its expected future marginal yields exactly equal to the investment cost of project.

• IRR is the rate of return at which the discounted present value of receipts and expenditures are equal.

• IRR criterion is basically the same as Keynes’s Marginal Efficiency of Investment(MEI).

The IRR criterion says that so long as internal rate of return is greater than the market rate of interest, it is always profitable to borrow and invest.

120 million(1+r )

=Rs . 100 million

(1+r )100=120r=0 . 20

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