Managerial Economics: Definition, Nature, Scope Economics: Definition, Nature, Scope Managerial...

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Managerial Economics: Definition, Nature, Scope Managerial economics is a discipline which deals with the application of economic theory to business management. It deals with the use of economic concepts and principles of business decision making. Formerly it was known as “Business Economics” but the term has now been discarded in favour of Managerial Economics. Managerial Economics may be defined as the study of economic theories, logic and methodology which are generally applied to seek solution to the practical problems of business. Managerial Economics is thus constituted of that part of economic knowledge or economic theories which is used as a tool of analysing business problems for rational business decisions. Managerial Economics is often called as Business Economics or Economic for Firms. Definition of Managerial Economics: “Managerial Economics is economics applied in decision making. It is a special branch of economics bridging the gap between abstract theory and managerial practice.” – Haynes, Mote and Paul. “Business Economics consists of the use of economic modes of thought to analyse business situations.” - McNair and Meriam “Business Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.” - Spencerand Seegelman. “Managerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision.” – Mansfield Nature of Managerial Economics: The primary function of management executive in a business organisation is decision making and forward planning. Decision making and forward planning go hand in hand with each other. Decision making means the process of selecting one action from two or more alternative courses of action. Forward planning means establishing plans for the future to carry out the decision so taken. The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and managerial capacity) are limited and the firm has to make the most profitable use of these resources. The decision making function is that of the business executive, he takes the decision which will ensure the most efficient means of attaining a desired objective, say profit maximisation. After taking the decision about the particular output, pricing, capital, raw-materials and power etc., are prepared. Forward planning and decision-making thus go on at the same time. A business manager’s task is made difficult by the uncertainty which surrounds business decision-making. Nobody can predict the future course of business conditions. He prepares the best possible plans for the future depending on past experience and future outlook and yet he has to go on revising his plans in the light of new experience to minimise the failure. Managers are thus engaged in a continuous process of decision-making through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty. In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into service with considerable advantage as it deals with a number of concepts and principles which can be used to solve or at least throw some light upon the problems of business management. E.g are profit, demand, cost, pricing, production, competition, business cycles, national income etc. The way economic analysis can be used towards solving business problems, constitutes the subject-matter of Managerial Economics. Thus in brief we can say that Managerial Economics is both a science and an art. Scope of Managerial Economics: The scope of managerial economics is not yet clearly laid out because it is a developing science. Even then the following fields may be said to generally fall under Managerial Economics: 1. Demand Analysis and Forecasting 2. Cost and Production Analysis 3. Pricing Decisions, Policies and Practices 4. Profit Management 5. Capital Management These divisions of business economics constitute its subject matter. Recently, managerial economists have started making increased use of Operation Research methods like Linear programming, inventory models, Games theory, queuing up theory etc., have also come to be regarded as part of Managerial Economics. 1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics. 2. Cost and production analysis: A firm’s profitability depends much on its cost of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production and cost calculations. Production processes are under the charge of engineers but the business manager is supposed to carry out

Transcript of Managerial Economics: Definition, Nature, Scope Economics: Definition, Nature, Scope Managerial...

Managerial Economics: Definition, Nature, Scope Managerial economics is a discipline which deals with the application of economic theory to business management. It deals with the use of economic concepts and principles of business decision making. Formerly it was known as “Business Economics” but the term has now been discarded in favour of Managerial Economics. Managerial Economics may be defined as the study of economic theories, logic and methodology which are generally applied to seek solution to the practical problems of business. Managerial Economics is thus constituted of that part of economic knowledge or economic theories which is used as a tool of analysing business problems for rational business decisions. Managerial Economics is often called as Business Economics or Economic for Firms.

Definition of Managerial Economics: “Managerial Economics is economics applied in decision making. It is a special branch of economics bridging the gap between abstract theory and managerial practice.” – Haynes, Mote and Paul. “Business Economics consists of the use of economic modes of thought to analyse business situations.” - McNair and Meriam

“Business Economics (Managerial Economics) is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.” - Spencerand Seegelman. “Managerial economics is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision.” – Mansfield

Nature of Managerial Economics: The primary function of management executive in a business organisation is decision making and forward planning. Decision making and forward planning go hand in hand with each other. Decision making means the process of selecting one action from two or more alternative courses of action. Forward planning means establishing plans for the future to carry out the decision so taken. The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and managerial capacity) are limited and the firm has to make the most profitable use of these resources. The decision making function is that of the business executive, he takes the decision which will ensure the most efficient means of attaining a desired objective, say profit maximisation. After taking the decision about the particular output, pricing, capital, raw-materials and power etc., are prepared. Forward planning and decision-making thus go on at the same time. A business manager’s task is made difficult by the uncertainty which surrounds business decision-making. Nobody can predict the future course of business conditions. He prepares the best possible plans for the future depending on past experience and future outlook and yet he has to go on revising his plans in the light of new experience to minimise the failure. Managers are thus engaged in a continuous process of decision-making through an uncertain future and the overall problem confronting them is one of adjusting to uncertainty. In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into service with considerable advantage as it deals with a number of concepts and principles which can be used to solve or at least throw some light upon the problems of business management. E.g are profit, demand, cost, pricing, production, competition, business cycles, national income etc. The way economic analysis can be used towards solving business problems, constitutes the subject-matter of Managerial Economics. Thus in brief we can say that Managerial Economics is both a science and an art. Scope of Managerial Economics: The scope of managerial economics is not yet clearly laid out because it is a developing science. Even then the following fields may be said to generally fall under Managerial Economics:

1. Demand Analysis and Forecasting

2. Cost and Production Analysis

3. Pricing Decisions, Policies and Practices

4. Profit Management

5. Capital Management

These divisions of business economics constitute its subject matter. Recently, managerial economists have started making increased use of Operation Research methods like Linear programming, inventory models, Games theory, queuing up theory etc., have also come to be regarded as part of Managerial Economics. 1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in transforming productive resources into goods that are to be sold in the market. A major part of managerial decision making depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit base. Demand analysis also identifies a number of other factors influencing the demand for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics. 2. Cost and production analysis: A firm’s profitability depends much on its cost of production. A wise manager would prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates and choose the cost-minimising output level, taking also into consideration the degree of uncertainty in production and cost calculations. Production processes are under the charge of engineers but the business manager is supposed to carry out

the production function analysis in order to avoid wastages of materials and time. Sound pricing practices depend much on cost control. The main topics discussed under cost and production analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost control. 3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the correctness of the price decisions taken by it. The important aspects dealt with this area are: Price determination in various market forms, pricing methods, differential pricing, product-line pricing and price forecasting. 4. Profit management: Business firms are generally organized for earning profit and in the long period, it is profit which provides the chief measure of success of a firm. Economics tells us that profits are the reward for uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit measurement constitute the most challenging area of Managerial Economics. 5. Capital management: The problems relating to firm’s capital investments are perhaps the most complex and troublesome. Capital management implies planning and control of capital expenditure because it involves a large sum and moreover the problems in disposing the capital assets off are so complex that they require considerable time and labour. The main topics dealt with under capital management are cost of capital, rate of return and selection of projects.

Conclusion: The various aspects outlined above represent the major uncertainties which a business firm has to reckon with, viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty, and capital uncertainty. We can, therefore, conclude that the subject-matter of Managerial Economics consists of applying economic principles and concepts towards adjusting with various uncertainties faced by a business firm

Principles of Managerial Economics Introduction: Managerial Economics is both conceptual and metrical. Before the substantive decision problems which fall within the purview of managerial economics are discussed, it is useful to identify and under¬stand some of the basic concepts underlying the subject. Economic theory provides a number of concepts and analytical tools which can be of considerable and immense help to a manager in taking many decisions and business planning. This is not to say that economics has all the solutions. In fact, actual problem solving in business has found that there exists a wide disparity between economic theory of the firm and actual observed practice. Therefore, it would be useful to examine the basic tools of managerial economics and the nature and extent of gap between the economic theory of the firm and the managerial theory of the firm. The contribution of economics to managerial economics lies in certain principles which are basic to managerial economics. There are six basic principles of managerial economics. They are: Content: 1. The Incremental Concept 2. The Concept of Time Perspective 3. The Opportunity Cost Concept

4. The Discounting Concept 5. The Equi-marginal Concept 6. Risk and Uncertainty

1. The Incremental Concept: The incremental concept is probably the most important concept in economics and is certainly the most frequently used in Managerial Economics. Incremental concept is closely related to the mar¬ginal cost and marginal revenues of economic theory. The two major concepts in this analysis are incremental cost and incremental revenue. Incremental cost denotes change in total cost, whereas incremental revenue means change in total revenue resulting from a decision of the firm. The incremental principle may be stated as follows: A decision is clearly a profitable one if (i) It increases revenue more than costs. (ii) It decreases some cost to a greater extent than it increases others. (iii) It increases some revenues more than it decreases others. (iv) It reduces costs more than revenues. Illustration: Some businessmen hold the view that to make an overall profit, they must make a profit on every job. The result is that they refuse orders that do not cover full costs plus a provision of profit. This will lead to rejection of an order which prevents short run profit. A simple problem will illustrate this point. Suppose a new order is estimated to bring in an additional revenue of Rs. 10,000. The costs are estimated as under: Labour Rs. 3,000 Materials Rs. 4,000 Overhead charges Rs. 3,600

Selling and administrative expenses Rs. 1,400 Full Cost Rs.12, 000

The order appears to be unprofitable. For it results in a loss of Rs. 2,000. However, suppose there is idle capacity which can be utilised to execute this order. If order adds only Rs. 1,000 to overhead charges, and Rs. 2000 by way of labour cost because some of the idle workers already on the pay roll will be deployed without added pay and no extra selling and administrative costs, then the actual incremental cost is as follows: Labour Rs. 2,000 Materials’ Rs. 4,000

Overhead charges Rs. 1,000 Total Incremental Cost Rs. 7,000

Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of incremental reasoning. Incremental reasoning does not mean that the firm should accept all orders at prices which cover merely their incremental costs. The concept is mainly used by the progressive concerns. Even though it is a widely followed concept, it has certain limitations: (a) The concept cannot be generalised because observed behaviour of the firm is always vari¬able. (b) The concept can be applied only when there is excess capacity in the concern. (c) The concept is applicable only during the short period. 2. Concept of Time Perspective: The time perspective concept states that the decision maker must give due consideration both to the short run and long run effects of his decisions. He must give due emphasis to the various time periods. It was Marshall who introduced time element in economic theory. The economic concepts of the long run and the short run have become part of everyday language. Managerial economists are also concerned with the short run and long run effects of decisions on revenues as well as costs. The main problem in decision making is to establish the right balance between long run and short run. In the short period, the firm can change its output without changing its size. In the long period, the firm can change its output by changing its size. In the short period, the output of the industry is fixed because the firms cannot change their size of operation and they can vary only variable factors. In the long period, the output of the industry is likely to be more because the firms have enough time to increase their sizes and also use both variable and fixed factors. In the short period, the average cost of a firm may be either more or less than its average revenue. In the long period, the average cost of the firm will be equal to its average revenue. A decision may be made on the basis of short run considerations, but may as time elapses have long run repercussions which make it more or less profitable than it at first appeared. Illustration: The firm which ignores the short run and long run considerations will meet with failure can be explained with the help of the following illustration. Suppose, a firm having a temporary idle capacity, received an order for 10,000 units of its product. The customer is willing to pay only Rs. 4.00 per unit or Rs. 40,000 for the whole lot but no more. The short run incremental cost (ignoring the fixed cost) is only Rs. 3.00. Therefore, the contribution to overhead and profit is Rs. 1.00 per unit (or Rs.

10, 000 for the lot). If the firm executes this order, it will have to face the following repercussion in the long run: (a) It may not be able to take up business with higher contributions in the long run. (b) The other customers may also demand a similar low price. (c) The image of the firm may be spoilt in the business community. (d) The long run effects of pricing below full cost may be more than offset any short run gain. Haynes, Mote and Paul refer to the example of a printing company which never quotes prices below full cost due to the following reasons: (1) The management realized that the long run repercussions of pricing below full cost would more than offset any short run gain. (2) Reduction in rates for some customers will bring undesirable effect on customer goodwill. Therefore, the managerial economist should take into account both the short run and long run effects as revenues and costs, giving appropriate weight to most relevant time periods. 3. The Opportunity Cost Concept: Both micro and macro-economic make abundant use of the fundamental concept of opportunity cost. In everyday life, we apply the notion of opportunity cost even if we are unable to articulate its significance. In Managerial Economics, the opportunity cost concept is useful in decision involving a choice between different alternative courses of action. Resources are scarce; we cannot produce all the commodities. For the production of one commodity, we have to forego the production of another commodity. We cannot have everything we want. We are, therefore, forced to make a choice. Opportunity cost of a decision is the sacrifice of alternatives required by that decision. Sacrifice of alternatives is involved when carrying out a decision requires using a resource that is limited in supply with the firm. Opportunity cost, therefore, represents the benefits or revenue forgone by pursuing one course of action rather than another. The concept of opportunity cost implies three things: 1. The calculation of opportunity cost involves the measurement of sacrifices. 2. Sacrifices may be monetary or real. 3. The opportunity cost is termed as the cost of sacrificed alternatives. Opportunity cost is just a notional idea which does not appear in the books of account of the company. If resource has no alternative use, then its opportunity cost is nil. In managerial decision making, the concept of opportunity cost occupies an important place. The economic significance of opportunity cost is as follows: 1. It helps in determining relative prices of different goods. 2. It helps in determining normal remuneration to a factor of production. 3. It helps in proper allocation of factor resources. 4. Equi-Marginal Concept: One of the widest known principles of economics is the equi-marginal principle. The principle states that an input should be allocated so that value added by the last unit is the same in all cases. This generalisation is popularly called the equi-marginal.

Let us assume a case in which the firm has 100 unit of labour at its disposal. And the firm is involved in five activities viz., А, В, C, D and E. The firm can increase any one of these activities by employing more labour but only at the cost ifie., sacrifice of other activities. An optimum allocation cannot be achieved if the value of the marginal product is greater in one activity than in another. It would be, therefore, profitable to shift labour from low marginal value activity to high marginal value activity, thus increasing the total value of all products taken together. If, for example, the value of the marginal product of labour in activity A is Rs. 50 while that in activity В is Rs. 70 then it is possible and profitable to shift labour from activity A to activity B. The optimum is reached when the values of the marginal product is equal to all activities. This can be expressed symbolically as follows: VMPLA = VMPLB = VMPLC = VMPLD = VMPLE Where VMP = Value of Marginal Product.

L = Labour

ABCDE = Activities ifie., the value of the marginal product of labour employed in A is equal to the value of the marginal product of the labour employed in В and so on. The equimarginal principle is an extremely practical notion. It is behind any rational budgetary procedure. The principle is also applied in investment decisions and allocation of research expenditures. For a consumer, this concept implies that money may be allocated over various commodities such that marginal utility derived from the use of each commodity is the same. Similarly, for a producer this concept implies that resources be allocated in such a manner that the marginal product of the

inputs is the same in all uses. 5. Discounting Concept: This concept is an extension of the concept of time perspective. Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surrounding the future or the risk of inflation. It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’. The following example would make this point clear. Suppose, you are offered a choice of Rs. 1,000 today or Rs. 1,000 next year. Naturally, you will select Rs. 1,000 today. That is true because future is uncertain. Let us assume you can earn 10 per cent interest during a year. You may say that I would be indifferent between Rs. 1,000 today and Rs. 1,100 next year ifie., Rs. 1,100 has the present worth of Rs. 1,000. Therefore, for making a decision in regard to any investment which will yield a return over a period of time, it is advisable to find out its ‘net present worth’. Unless these returns are discounted and the present value of returns calculated, it is not possible to judge whether or not the cost of undertaking the investment today is worth. The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting. The formula of computing the present value is given below: V = A/1+i Where: V = Present value A = Amount invested Rs. 100 i = Rate of interest 5 per cent V = 100/1+.05 = 100/1.05 =Rs. 95.24 Similarly, the present value of Rs. 100 which will be discounted at the end of 2 years: A 2 years V = A/ (1+i) 2 For n years V = A/ (1+i) n

6. Risk and Uncertainty: Managerial decisions are actions of today which bear fruits in future which is unforeseen. Future is uncertain and involves risk. The uncertainty is due to unpredictable changes in the business cycle, structure of the economy and government policies. This means that the management must assume the risk of making decisions for their institution in uncertain and unknown economic conditions in the future. Firms may be uncertain about production, market prices, strategies of rivals, etc. Under uncertainty, the consequences of an action are not known immediately for certain. Economic theory generally assumes that the firm has perfect knowledge of its costs and demand relationships and of its environment. Uncertainty is not allowed to affect the decisions. Uncertainty arises because producers simply cannot foresee the dynamic changes in the economy and hence, cost and revenue data of their firms with reasonable accuracy. Also dynamic changes are external to the firm; they are beyond the control of the firm. The result is that the risks from unexpected changes in a firm’s cost and revenue data cannot be estimated and therefore the risks from such changes cannot be insured. But products must attempt to predict the future cost and revenue data of their firms and determine the output and price policies. The managerial economists have tried to take account of uncertainty with the help of subjective probability. The probabilistic treatment of uncertainty requires formulation of definite subjective expectations about cost, revenue and the environment. The probabilities of future events are influenced by the time horizon, the risk attitude and the rate of change of the environment.

Law of Equi Marginal Utility: Definition: "A person can get maximum utility with his given income when it is spent on different commodities in such a way that the marginal utility of money spent on each item is equal". It is clear that consumer can get maximum utility from the expenditure of his limited income. He should purchase such amount of each commodity that the last unit of money spend on each item provides same marginal utility. Assumptions of the Law of Equi Marginal Utility: 1. There is no change in the prices of the goods. 2. The income of consumer is fixed.

3. The marginal utility of money is constant. 4. Consumer has perfect knowledge of utility obtained from goods.

5. Consumer is normal person so he tries to seek maximum satisfaction.

6. The utility is measurable in cardinal terms. 7. Consumer has many wants. 8. The goods have substitutes.

Explanation with Schedule and Diagram: The law of substitution can be explained with the help of an example. Suppose consumer has six dollars that he wants to spend on apples and bananas in order to obtain maximum total utility. The following table shows marginal utility (MU) of spending additional dollars of income on apples and bananas: The above schedule shows that consumer can spend six dollars in different ways: 1. $1 on apples and $5 on bananas. The total utility he can get is: 2. [(10) + (8+7+6+5+4)] = 40. 3. $2 on apples and $4 on bananas. The total utility he can get is:

4. [(10+9) + (8+7+6+5)] = 45. 5. $3 on apples and $3 on bananas. The total utility he can get is: 6. [(10+9+8) + (8+7+6)] = 48. 7. $4 on apples and $2 on bananas. This way the total utility is: 8. [(10+9+8+7) + (8+7)] = 49. 9. $5 on apples and $1 on bananas. The total utility he can get is: 10. [(10+9+8+7+6) + (8)] = 48. Total total utility for consumer is 49 utils that is the highest obtainable with expenditure of $4 on apples and $2 on bananas. Here the condition MU of apple = MU of banana ifie 7 = 7 is also satisfied. Any other allocation of the last dollar shall

give less total utility to the consumer. The same information can be used for graphical presentation of this law: The diagram shows that consumer has income of six dollars. He wants to spend this money on apples and bananas in such a way that there is maximum satisfaction to the consumer. Limitations: 1. The law is not applicable in case of knowledge. Reading of books provides more satisfaction and knowledge to the scholar. Different books provide variety of knowledge and satisfaction. 2. The law is not applicable in case of indivisible goods. The consumer is unable to divide the goods to adjust units of utility derived from consumption of goods. 3. There is no measurement of utility. It is psychological concept. It is not possible to express it into quantitative form. 4. The law does not hold well in case fashion and customs. The people like to spend money on birthdays, marriages and deaths. 5. The does not hold well in case of very low income. The maximization of utility is not possible due to low income. 6. The law is not applicable in case of durable goods. The calculation of marginal utility of durable goods is impossible. 7. The law fails when goods of choice are not available. The consumer is bound to use commodity, which provides low utility due to non-availability of goods having high utility. 8. There are certain lazy consumers. They do not care for maximum utility. The law fails to operate in case of laziness of consumers. They go on consuming goods with comparing utility. 9. It does not work when there are frequent prices changes. The consumer is unable to calculate utility of different commodities. Changing price levels create confusion in the minds of consumers. 10. There may be unlimited resources. The does not work due to unlimited resources. There is no need to change the direction of expenditure from one item to another when there are gifts of nature. Importance: 1. The law of equi marginal utility is helpful in the field of production. The producer has limited resources. He uses limited resources to purchase production factors. He tries to equalize marginal utility of all factors. He wishes to get maximum output and profit. 2. National income is distributed among factors of production according to this law. An entrepreneur can pay factors of production equal to marginal product measured in money terms. He will substitute one factor for another until marginal productivity of all factors is equal to prices of their services. 3. The law is used in the field of exchange. The people like to exchange a commodity having low utility with a commodity having high utility. There is maximum benefit from exchange of commodities. The law is helpful in exchange of wealth, trade, import and export. 4. The law is applicable in consumption. A rational consumer tries to get maximum satisfaction when he spends his limited resources on various things. He tries to equalize weighted marginal utility of all the things. 5. The law is applicable in public finance. The government can spend its revenue to get maximum social advantage. The marginal utility of each dollar spent in one sector must be equal to marginal utility derived from all other sectors. 6. The law is useful for workers in allocating the time between work and rest. They can compare the marginal utility of work and the marginal utility of rest. They can decide working hours and rest hours.

7. The law holds well in case of saving and spending. The consumer can make choice between present wants and future wants. He can feel that a dollar saved has greater utility than a dollar spent, he can save more and spend less. He will substitute saving and spending till marginal utility of a dollar spent and a dollar saved are equal. 8. The law is helpful in prices. Due to scarcity of commodity its prices go up. The law tells us to use substitute commodity, which is less scarce. The result is that the price of commodity comes down

Meaning of the Law of Demand Law of demand states “while other things do not change, there is an inverse relationship between the price of a commodity and the quantity demanded at a specified time.” In simple terms, people tend to purchase more of goods or services when their prices decrease and tend to purchase less when the prices increase. However, the law of demand is valid only when the assumption “other things remaining the same” is fulfilled. Assumptions of the Law of Demand By the phrase “other things remaining the same”, law of demand assumes the following: 1. Consumer’s income, tastes and preferences are constant. 2. Prices of substitutes and complements do not change. 3. There are no new substitutes for the goods under consideration. 4. People do not speculate on prices. It means that if price of the commodity in question falls, people will not wait for further decline in prices. 5. The commodity under consideration does not have prestige value. 6. The law of demand will not work as expected if any one of the aforementioned assumptions is violated. Basis for the Law of Demand The foundation for law of demand is law of diminishing marginal utility. Marshall derived law of demand from law of diminishing marginal utility. Law of diminishing marginal utility states that utility derived from additional units of a commodity keeps declining. For example, when you eat the first apple, you get more satisfaction from it. Here satisfaction means utility. At the same time, when you start eating more apples, the utility you derive from every additional unit becomes less and less. This occurs because you reach the saturation level. From this diminishing marginal utility concept, you can derive law of demand. Let us consider the same apple example. Since the first apple gives more utility, you do not bother about the price of it. Hence, you tend to buy an apple even at a high price. However, additional units of apple give you less and less utility. Hence, you do not want to buy apples at a high price anymore. Now the seller has to lower the price of apples to increase the demand. When the price is declined, you start buying more apples again. In this manner, law of diminishing marginal utility paves a path to law of demand. Exceptions to the Law of Demand In general, people tend to buy more when the price declines. Also demand decreases when the price starts moving upwards. This causes the demand curve slope downwards from left to right. However, there are some exceptions to this rule. Because of these exceptional cases, demand curve takes unusual shape, which does not obey the law of demand. In the exceptional cases, demand curve slopes upwards from left to right. This means that demand decreases when there is a fall in price and demand increases when there is a rise in price. This type of demand curve is known as an exceptional demand curve or positively sloped demand curve. Causes 1. Giffen Paradox Sir Robert Giffen observed consumption pattern of low-paid British wage earners early in 19th century. He found that an increase in the price of bread caused wage earners to buy more of it. The wage earners supported themselves by consuming bread only. When the price of bread increased, they spent more money on a given quantity of bread by restricting other expenses. Marshall was unable to explain this scenario and called it ‘Giffen Paradox’. All Giffen goods are inferior goods, but not all inferior goods are Giffen goods. 2. Veblen Goods Another exception is based on the doctrine of conspicuous consumption attributed by Thorstein Veblen. People purchase certain goods for ostentation or showy purposes. Such goods are known as Veblen goods. Since these goods are used to impress others, people may not buy when the price falls. In other words, demand decreases when the price falls. 3. Speculation Speculation on prices is a also cause for upward sloping demand curve. A typical example for this scenario is stock market trading. When a price of a share rises, people tend to buy the share more on the expectation that the price will rise further. Similarly, when the price falls, people tend to sell the share expecting that the price will fall further. Elasticity of Demand Elasticity of demand is an important variation on the concept of demand. Demand can be classified as elastic, inelastic or unitary. An elastic demand is one in which the change in quantity demanded due to a change in price is large. An inelastic demand is one in which the change in quantity demanded due to a change in price is small.

The formula for computing elasticity of demand is: If the formula creates a number greater than 1,

the demand is elastic. In other words, quantity changes faster than price. If the number is less than 1, demand is inelastic. In other words, quantity changes

slower than price. If the number is equal to 1, elasticity of demand is unitary. In other words, quantity changes at the same rate as price. 1. Elastic Demand Elasticity of demand is illustrated in Figure 1. Note that a change in price results in a large change in quantity demanded. An example of products with an elastic demand is consumer durables. These are items that are purchased infrequently, like a washing machine or an automobile, and can be postponed if price rises. For example, automobile rebates have been very successful in increasing automobile sales by reducing price. An example of computing elasticity of demand using the formula above is shown below. When the price decreases from

$10 per unit to $8 per unit, the quantity sold increases from 30 units to 50 units. The elasticity coefficient is 2.25. Close substitutes for a product affect the elasticity of demand. It another product can easily be substituted for your product, consumers will quickly switch to the other product if the price of your product rises or the price of the other product declines. For example, beef, pork and poultry are all meat products. The declining price of poultry in recent years has caused

the consumption of poultry to increase, at the expense of beef and pork. So products with close substitutes tend to have elastic demand. 2. Inelastic Demand Inelastic demand is shown in Figure 2. Note that a change in price results in only a small change in quantity demanded. In other words, the quantity demanded is not very responsive to changes in price. Figure 2. Inelastic demand

An example of computing inelasticity of demand using the formula above is shown below. When the price decreases from

$12 to $6 (50%), the quantity of demand increases from 40 to only 50 (25%). The elasticity coefficient is .33. Examples of this are necessities like food and fuel. Consumers will not reduce their food purchases if food prices rise, although there may be shifts in the types of food they purchase. Also, consumers will not greatly change their driving behavior if gasoline prices rise. This does not mean that the demand for an individual producer is inelastic. For example, a rise in the price of gasoline at all stations may not reduce gasoline sales significantly. However, a rise of an individual station’s price will significantly affect that station’s sales. 3. Unitary Elasticity If the elasticity coefficient is equal to one, demand is unitarily elastic as shown in Figure 3. For example, a 10% quantity change divided by 10% price change is one. This means that a one percent change in quantity occurs for every one percent change in price

Demand Forecasting: It’s Meaning, Types, Techniques and Method Meaning: A forecast is a prediction or estimation of future situation. It is an objective assessment of future course of action. Since future is uncertain, no forecast can be percent correct. Forecasts can be both physical as well as financial in nature. The more realistic the forecasts, the more effective decisions can be taken for tomorrow. In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a specified future period which is tied to a proposed marketing plan and which assumes a particular set of uncontrollable and competitive forces”. Therefore, demand forecasting is a projection of firm’s expected level of sales based on a chosen marketing plan and environment. All forecasts are built on one of the three information bases: What people say? What people do? What people have done?

Types of Forecasting:

Forecasts can be broadly classified into: (i) Passive Forecast & Active Forecast. Under passive forecast prediction about future is based on the assumption that the firm does not change the course of its action. Under active forecast, prediction is done under the condition of likely future changes in the actions by the firms. From the view point of ‘time span’ (ii) Short term & long term demand forecasting. In a short run forecast, seasonal patterns are of much importance. It may cover a period of three months, six months or one year. It is one which provides information for tactical decisions. Which period is chosen depends upon the nature of business. Such a forecast helps in preparing suitable sales policy. Long term forecasts are helpful in suitable capital planning. It is one which provides information for major strategic decisions. It helps in saving the wastages in material, man hours, machine time and capacity. Planning of a new unit must start with an analysis of the long term demand potential of the products of the firm.

There are basically two types of forecast, (iii) External or national group of forecast & Internal or company group forecast. External forecast deals with trends in general business. It is usually prepared by a company’s research wing or by outside consultants. Internal forecast includes all those that are related to the operation of a particular enterprise such as sales group, production group, and financial group. The structure of internal forecast includes forecast of annual sales, forecast of products cost, forecast of operating profit, forecast of taxable income, forecast of cash resources, forecast of the number of employees, etc. At different levels forecasting may be classified into (i) Macro-level forecasting,

(ii) Industry- level forecasting,

(iii) Firm- level forecasting and

(iv) Product-line forecasting.

Macro-level forecasting is concerned with business conditions over the whole economy. It is measured by an appropriate index of industrial production, national income or expenditure. Industry-level forecasting is prepared by different trade associations. This is based on survey of consumers’ intention and analysis of statistical trends. Firm-level forecasting is related to an individual firm. It is most important from managerial view point. Product-line forecasting helps the firm to decide which of the product or products should have priority in the allocation of firm’s limited resources. Forecast may be classified into (i) general and (ii) specific. The general forecast may generally be useful to the firm. Many firms require separate forecasts for specific products and specific areas, for this general forecast is broken down into specific forecasts. There are different forecasts for different types of products like: (i) Forecasting demand for nondurable consumer goods, (ii) Forecasting demand for durable consumer goods, (iii) Forecasting demand for capital goods, and (iv) Forecasting demand for new-products. Non-Durable Consumer Goods: These are also known as ‘single-use consumer goods’ or perishable consumer goods. These vanish after a single act of consumption. These include goods like food, milk, medicine, fruits, etc. Demand for these goods depends upon household disposable income, price of the commodity and the related goods and population and characteristics. Symbolically, Durable Consumer Goods: These goods can be consumed a number of times or repeatedly used without much loss to their utility. These include goods like car, T.V., air-conditioners, furniture etc. After their long use, consumers have a choice either these could be consumed in future or could be disposed of. Forecasting Demand for Capital Goods: Capital goods are used for further production. The demand for capital good is a derived one. It will depend upon the profitability of industries. The demand for capital goods is a case of derived demand. In the case of particular capital goods, demand will depend on the specific markets they serve and the end uses for which they are bought. Forecasting Demand for New Products: The methods of forecasting demand for new products are in many ways different from those for established products. Since the product is new to the consumers, an intensive study of the product and its likely impact upon other products of the same group provides a key to an intelligent projection of demand. Joel Dean has classified a number of possible approaches as follows: (a) Evolutionary Approach:It consists of projecting the demand for a new product as an outgrowth and evolution of an existing old product. (b) Substitute Approach:According to this approach the new product is treated as a substitute for the existing product or service. (c) Growth Curve Approach:It estimates the rate of growth and potential demand for the new product as the basis of some growth pattern of an established product. (d) Opinion-Poll Approach:Under this approach the demand is estimated by direct enquiries from the ultimate consumers. (e) Sales Experience Approach:According to this method the demand for the new product is estimated by offering the new product for sale in a sample market. (f) Vicarious Approach: By this method, the consumers’ reactions for a new product are found out indirectly through the specialised dealers who are able to judge the consumers’ needs, tastes and preferences.

Forecasting Techniques: Techniques of Demand Forecasting (Survey and Statistical Methods) The first approach involves forecasting demand by collecting information regarding the buying behavior of consumers from experts or through conducting surveys. On the other hand, the second method is to forecast demand by using the past data through statistical techniques. Thus, we can say that the techniques of demand forecasting are divided into survey methods and statistical methods. The survey method is generally for short-term forecasting, whereas statistical methods are used to forecast demand in the long run.

1. Opinion Polling Method: In this method, the opinion of the buyers, sales force and experts could be gathered to determine the emerging trend in the market. The opinion polling methods of demand forecasting are of three kinds: (a) Consumer’s Survey Method or Survey of Buyer’s Intentions: In this method, the consumers are directly approached to disclose their future purchase plans. I his is done by interviewing all consumers or a selected group of consumers out of the relevant population. This is the direct method of estimating demand in the short run. Here the burden of forecasting is shifted to the buyer. The firm may go in for complete enumeration or for sample surveys. If the commodity under consideration is an intermediate product then the industries using it as an end product are surveyed. (i) Complete Enumeration Survey: Under the Complete Enumeration Survey, the firm has to go for a door to door survey for the forecast period by contacting all the households in the area. This method has an advantage of first hand, unbiased

information, yet it has its share of disadvantages also. The major limitation of this method is that it requires lot of resources, manpower and time. In this method, consumers may be reluctant to reveal their purchase plans due to personal privacy or commercial secrecy. Moreover, at times the consumers may not express their opinion properly or may deliberately misguide the investigators. (ii) Sample Survey and Test Marketing: Under this method some representative households are selected on random basis as samples and their opinion is taken as the generalised opinion. This method is based on the basic assumption that the sample truly represents the population. If the sample is the true representative, there is likely to be no significant difference in the results obtained by the survey. Apart from that, this method is less tedious and less costly. A variant of sample survey technique is test marketing. Product testing essentially involves placing the product with a number of users for a set period. Their reactions to the product are noted after a period of time and an estimate of likely demand is made from the result. These are suitable for new products or for radically modified old products for which no prior data exists. It is a more scientific method of estimating likely demand because it stimulates a national launch in a closely defined geographical area. (iii) End Use Method or Input-Output Method: This method is quite useful for industries which are mainly producer’s goods. In this method, the sale of the product under consideration is projected as the basis of demand survey of the industries using this product as an intermediate product, that is, the demand for the final product is the end user demand of the intermediate product used in the production of this final product. The end user demand estimation of an intermediate product may involve many final good industries using this product at home and abroad. It helps us to understand inter-industry’ relations. In input-output accounting two matrices used are the transaction matrix and the input co-efficient matrix. The major efforts required by this type are not in its operation but in the collection and presentation of data. (b) Sales Force Opinion Method: This is also known as collective opinion method. In this method, instead of consumers, the opinion of the salesmen is sought. It is sometimes referred as the “grass roots approach” as it is a bottom-up method that requires each sales person in the company to make an individual forecast for his or her particular sales territory. These individual forecasts are discussed and agreed with the sales manager. The composite of all forecasts then constitutes the sales forecast for the organisation. The advantages of this method are that it is easy and cheap. It does not involve any elabourate statistical treatment. The main merit of this method lies in the collective wisdom of salesmen. This method is more useful in forecasting sales of new products. (c) Experts Opinion Method: This method is also known as “Delphi Technique” of investigation. The Delphi method requires a panel of experts, who are interrogated through a sequence of questionnaires in which the responses to one questionnaire are used to produce the next questionnaire. Thus any information available to some experts and not to others is passed on, enabling all the experts to have access to all the information for forecasting. The method is used for long term forecasting to estimate potential sales for new products. This method presumes two conditions: Firstly, the panellists must be rich in their expertise, possess wide range of knowledge and experience. Secondly, its conductors are objective in their job. This method has some exclusive advantages of saving time and other resources.

2. Statistical Method: Statistical methods have proved to be immensely useful in demand forecasting. In order to maintain objectivity, that is, by consideration of all implications and viewing the problem from an external point of view, the statistical methods are used. The important statistical methods are: (i) Trend Projection Method: A firm existing for a long time will have its own data regarding sales for past years. Such data when arranged chronologically yield what is referred to as ‘time series’. Time series shows the past sales with effective demand for a particular product under normal conditions. Such data can be given in a tabular or graphic form for further analysis. This is the most popular method among business firms, partly because it is simple and inexpensive and partly because time series data often exhibit a persistent growth trend. Seasonal variations refer to changes in the short run weather pattern or social habits. Cyclical variations refer to the changes that occur in industry during depression and boom. Random variation refers to the factors which are generally able such as wars, strikes, flood, and famine and so on. The trend can be estimated by using any one of the following methods: (a) The Graphical Method, (b) The Least Square Method. a) Graphical Method: This is the simplest technique to determine the trend. All values of output or sale for different years are plotted on a graph and a smooth free hand curve is drawn passing through as many points as possible. The direction of this free hand curve—upward or downward— shows the trend. A simple illustration of this method is given in Table 2. (b) Least Square Method: Under the least square method, a trend line can be fitted to the time series data with the help of statistical techniques such as least square regression. When the trend in sales over time is given by straight line, the equation of this line is of the form: y = a + bx. Where ‘a’ is the intercept and ‘b’ shows the impact of the independent variable. We have two variables—the independent variable x and the dependent variable y. The line of best fit establishes a kind of mathematical relationship between the two variables .v and y. This is expressed by the regression у on x. In order to solve the equation v = a + bx, we have to make use of the following normal equations:

Σ y = na + b ΣX Σ xy =a Σ x+b Σ x2 (ii) Barometric Technique: A barometer is an instrument of measuring change. This method is based on the notion that “the future can be predicted from certain happenings in the present.” In other words, barometric techniques are based on the idea that certain events of the present can be used to predict the directions of change in the future. This is accomplished by the use of economic and statistical indicators which serve as barometers of economic change. Generally forecasters correlate a firm’s sales with three series: Leading Series, Coincident or Concurrent Series and Lagging Series: (a) The Leading Series: The leading series comprise those factors which move up or down before the recession or recovery starts. They tend to reflect future market changes. For example, baby powder sales can be forecasted by examining the birth rate pattern five years earlier, because there is a correlation between the baby powder sales and children of five years of age and since baby powder sales today are correlated with birth rate five years earlier, it is called lagged correlation. Thus we can say that births lead to baby soaps sales. (b) Coincident or Concurrent Series: The coincident or concurrent series are those which move up or down simultaneously with the level of the economy. They are used in confirming or refuting the validity of the leading indicator used a few months afterwards. Common examples of coinciding indicators are G.N.P itself, industrial production, trading and the retail sector. (c) The Lagging Series: The lagging series are those which take place after some time lag with respect to the business cycle. Examples of lagging series are, labour cost per unit of the manufacturing output, loans outstanding, leading rate of short term loans, etc. (iii) Regression Analysis: It attempts to assess the relationship between at least two variables (one or more independent and one dependent), the purpose being to predict the value of the dependent variable from the specific value of the independent variable. The basis of this prediction generally is historical data. This method starts from the assumption that a basic relationship exists between two variables. An interactive statistical analysis computer package is used to formulate the mathematical relationship which exists. (iv) Econometric Models: Econometric models are an extension of the regression technique whereby a system of independent regression equation is solved. The requirement for satisfactory use of the econometric model in forecasting is under three heads: variables, equations and data. The appropriate procedure in forecasting by econometric methods is model building. Econometrics attempts to express economic theories in mathematical terms in such a way that they can be verified by statistical methods and to measure the impact of one economic variable upon another so as to be able to predict future events. Utility of Forecasting: Forecasting reduces the risk associated with business fluctuations which generally produce harmful effects in business, create unemployment, induce speculation, discourage capital formation and reduce the profit margin. Forecasting is indispensable and it plays a very important part in the determination of various policies. In modem times forecasting has been put on scientific footing so that the risks associated with it have been considerably minimised and the chances of precision increased. Forecasts in India: In most of the advanced countries there are specialised agencies. In India businessmen are not at all interested in making scientific forecasts. They depend more on chance, luck and astrology. They are highly superstitious and hence their forecasts are not correct. Sufficient data are not available to make reliable forescasts. However, statistics alone do not forecast future conditions. Judgment, experience and knowledge of the particular trade are also necessary to make proper analysis and interpretation and to arrive at sound conclusions. Criteria of a Good Forecasting Method: There are thus, a good many ways to make a guess about future sales. They show contrast in cost, flexibility and the adequate skills and sophistication. Therefore, there is a problem of choosing the best method for a particular demand situation. There are certain economic criteria of broader applicability. They are: (i) Accuracy, (ii) Plausibility, (iii) Durability, (iv) Flexibility, (v) Availability, (vi) Economy, (vii) Simplicity and (viii) Consistency. (i) Accuracy: The forecast obtained must be accurate. How is an accurate forecast possible? To obtain an accurate forecast, it is essential to check the accuracy of past forecasts against present performance and of present forecasts against future performance. Accuracy cannot be tested by precise measurement but buy judgment. (ii) Plausibility: The executive should have good understanding of the technique chosen and they should have confidence in the techniques used. Understanding is also needed for a proper interpretation of results. Plausibility requirements can often improve the accuracy of results. (iii) Durability: Unfortunately, a demand function fitted to past experience may back cost very greatly and still fall apart in a short time as a forecaster. The durability of the forecasting power of a demand function depends partly on the reasonableness and simplicity of functions fitted, but primarily on the stability of the understanding relationships measured in the past. Of course, the importance of durability determines the allowable cost of the forecast.

(iv) Flexibility: Flexibility can be viewed as an alternative to generality. A long lasting function could be set up in terms of basic natural forces and human motives. Even though fundamental, it would nevertheless be hard to measure and thus not very useful. A set of variables whose co-efficient could be adjusted from time to time to meet changing conditions in more practical way to maintain intact the routine procedure of forecasting. (v) Availability: Immediate availability of data is a vital requirement and the search for reasonable approximations to relevance in late data is a constant strain on the forecaster’s patience. The techniques employed should be able to produce meaningful results quickly. Delay in result will adversely affect the managerial decisions. (vi) Economy: Cost is a primary consideration which should be weighed against the importance of the forecasts to the business operations. A question may arise: How much money and managerial effort should be allocated to obtain a high level of forecasting accuracy? The criterion here is the economic consideration. (vii) Simplicity: Statistical and econometric models are certainly useful but they are intolerably complex. To those executives who have a fear of mathematics, these methods would appear to be Latin or Greek. The procedure should, therefore, be simple and easy so that the management may appreciate and understand why it has been adopted by the forecaster. (viii) Consistency: The forecaster has to deal with various components which are independent. If he does not make an adjustment in one component to bring it in line with a forecast of another, he would achieve a whole which would appear consistent.

Contribution Analysis Contribution Analysis is an approach for assessing causal questions and inferring causality in real-life program evaluations. It offers a step-by-step approach designed to help managers, researchers, and policymakers arrive at conclusions about the contribution their program has made (or is currently making) to particular outcomes. The essential value of contribution analysis is that it offers an approach designed to reduce uncertainty about the contribution the intervention is making to the observed results through an increased understanding of why the observed results have occurred (or not!) and the roles played by the intervention and other internal and external factors. Contribution analysis is particularly useful in situations where the programme is not experimental, ifie. not in trial projects but in situations where the programme has been funded on the basis of a relatively clearly articulated theory of change and where there is little or no scope for varying how the program is implemented. Contribution analysis helps to confirm or revise a theory of change; it is not intended to be used to surface or uncover and display a hitherto implicit or inexplicit theory of change. The report from a contribution analysis is not definitive proof, but rather provides evidence and a line of reasoning from which we can draw a plausible conclusion that, within some level of confidence, the program has made an important contribution to the documented results. Steps Six steps are taken to produce a credible contribution story: 1: Set out the attribution problem to be addressed Determine the specific questions being addressed. Not all cause-effect questions are useful to pursue. Contribution analysis is less suitable for traditional causality questions such as: Has the program caused the outcome? To what extent, quantitatively, has the program caused the outcome? These often are not that useful because they treat the program as a black box and don’t get at the fact that there are usually many causes involved. Contribution analysis is more appropriate for contribution questions: Has the Program influenced the observed result? Has the program made an important contribution to the observed result? Why has the result occurred? What role did the intervention play? and for management questions: Is it reasonable to conclude that the program has made a difference? What does the preponderance of evidence say about how well the program is making a difference? What conditions are needed to make this type of program succeed? 2: Develop a theory of change and risks to it Develop the program logic/results chain describing how the program is supposed to work. Identify as well the main external factors at play that might account for the outcomes observed. Based on the results chain, develop the theory of change upon which the program is based. This theory of change should lead to a plausible association between the activities of the program and the outcomes sought. The theory of change must include the assumptions made in the results chain and the inherent risks as well as external influences such as donor pressure, influences of peers and resourcing levels. Some links in the theory of change will be fairly well understood or accepted. Others will be less well understood, contested or subject to significant influence other than from the program. In this way you acknowledge that attribution is indeed a problem 3: Gather the existing evidence on the theory of change It is useful to first use existing evidence such as from past related evaluations or research, and from prior monitoring, to test the theory of change. It sets out the intended results (outputs, intermediate and end outcomes). What evidence (information from performance measures and evaluations) is currently available about the occurrence of these various results? The links in the theory of change also need to be assessed. What evidence currently exists on the assumptions and risks behind these links? Which are strong (good evidence available, strong logic, or wide acceptance) and which are weak (little evidence available, weak logic, or little agreement among stakeholders)? What evidence exists about the identified other influencing factors and the contribution they may be making?

4: Assemble and assess the contribution story, or performance story, and challenges to it With this information, you will be able to assemble your contribution story that expresses why it is reasonable to assume that the actions of the program have contributed (in some fashion, which you may want to try and characterize) to the observed outcomes. Now you have to assess it. How credible is the story? Do reasonable people agree with the story? Does the pattern of results observed validate the results chain? Where are the main weaknesses in the story? There always will be weaknesses. Weaknesses in the story point to where additional data or information is needed. 5: Seek out additional evidence Having identified where the contribution story is less credible, additional evidence is now gathered to augment the evidence in terms of what results have occurred, how reasonable the key assumptions are, and what has been the role of external influences and other contributing factors. Augmenting evidence can include the collection of additional, new data such as from surveys, field visits, administrative data, focus groups, national statistical data, etc. as well as the synthesis of evidence from other research and evaluations. 6: Revise and, where the additional evidence permits, strengthen the contribution story With the new evidence, you should be able to build a more substantive and so more credible story, one that a reasonable person will be more likely to agree with. It will probably not be foolproof, but the additional evidence will have made it stronger and more plausible. Using a generative perspective on causality to infer that a program made an important contribution to an expected result that has been observed, contribution analysis argues that a reasonable contribution causal claim can be made if: 1. There is a reasoned theory of change for the intervention: the key assumptions behind why the intervention is expected to work make sense, are plausible, may be supported by evidence and/or existing research, and are agreed upon by at least some of the key players. 2. The activities of the intervention were implemented as set out in the theory of change. 3. The theory of change—or key elements thereof— is supported by and confirmed by evidence on observed results and underlying assumptions—the chain of expected results occurred. The theory of change has not been disproved. 4. Other influencing factors have been assessed and either shown not to have made a significant contribution or their relative role in contributing to the desired result has been recognized. Issues Some issues might arise when taking this approach with regards to: 1. Reducing uncertainty about the contribution the intervention is making to the observed results. 2. Inferring causality in real-life program evaluations. 3. Confirming or revising a programme’s theory of change – including its logic model. Risks and assumptions are labelled as [O] over which the intervention has no or very little influence, or [I], where the intervention can (should) have an

influence, direct or indirect, or [C] where the intervention should be able to directly control. Theory of Demand

Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period Each of us has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product, linked usually to the enjoyment or usefulness that we expect from consuming it. Economists give this a term -utility

Effective Demand Demand is different to desire! Effective demand is when a desire to buy a product is backed up by an ability to pay for it Latent Demand Latent demand exists when there is willingness to buy among people for a good or service, but where consumers lack the purchasing power to be able to afford the product. Derived Demand The demand for a product X might be connected to the demand for a related product Y – giving rise to the idea of a derived demand. For example, demand for steel is strongly linked to the demand for new vehicles and other manufactured products, so that when an economy goes into a recession, so we expect the demand for steel to decline likewise. Steel is a cyclical industry which means that market demand for steel is affected by changes in the economic cycle and also by fluctuations in the exchange rate. Zinc is a good example of a product with a strong derived demand. It has a wide-range of end users such as galvanised zinc used in cars and new buildings, die-casting used in door furniture and toys, brass and bronze used in taps and pipes. And also rolled zinc (used in roofing, guttering and batteries) and in chemicals used in making tyres and zinc cream. Transport as a Derived Demand The demand for transport is the number of journeys consumers or firms are willing and able to purchase at various prices in a given time period. Transport is rarely demanded for its own sake, the journey, but for what the journey enables e.g. commuting, taking a holiday or distribution. When an economy is growing, there is an increase in derived demand for commuting, business logistics and transport for holiday purposes.

The Law of Demand There is an inverse relationship between the price of a good and demand. 1. As prices fall, we see an expansion of demand. 2. If price rises, there will be a contraction of deman

Ceteris paribus assumption Many factors affect demand. When drawing a demand curve, economists assume all factors are held constant except one – the price of the product itself. Ceteris paribus allows us to isolate the effect of one variable on another variable The Demand Curve A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. There are two reasons why more is demanded as price falls: 1. The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain the same consumption for less expenditure. Provided that the good is normal, some of the resulting increase in real income is used to buy more of this product. 2. The Substitution Effect: There is a substitution effect when the price of a good falls because the product is now relatively cheaper than an alternative item and some consumers switch their spending from the alternative good or service.

The Law of Demand As price falls, a person switches away from rival products towards the product As price falls, a person's willingness and ability to buy the product increases As price falls, a person's opportunity cost of purchasing the product falls Note: Many demand curves are drawn as straight

lines to make the diagrams easier to interpret The chart below shows average season ticket prices for English Premier League clubs. What factors affect the willingness and ability to pay for a season ticket? Why is there such a large difference in prices?

Costs of production

Fixed and variable costs Fixed costs are those that do not vary with output and typically include rents, insurance, depreciation, set-up costs, and normal profit. They are also called overheads. Variable costs are costs that do vary with output, and they are also called direct costs. Examples of typical variable costs include fuel, raw materials, and some labour costs.

An example Consider the following hypothetical example of a boat building firm. The total fixed costs, TFC, include premises, machinery and equipment needed to construct boats, and are £100,000, irrespective of how many boats are produced. Total variable costs (TVC) will increase as output increases. Plotting this gives us Total Cost, Total Variable Cost, and Total Fixed Cost. Total fixed costs Given that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line on the cost graph. Total variable costs The total variable cost (TVC) curve slopes up at an accelerating rate, reflecting the law of diminishing marginal returns.

Total costs The total cost (TC) curve is found by adding total fixed and total variable costs. Its position reflects the amount of fixed costs, and its gradient reflects variable costs.

Average fixed costs Average fixed costs are found by dividing total fixed costs by output. As fixed cost is divided by an increasing output, average fixed costs will continue to fall. The average fixed cost (AFC) curve will slope down continuously, from left to right. Average variable costs Average variable costs are found by dividing total fixed variable costs by output.

The average variable cost (AVC) curve will at first slope down from left to right, then reach a minimum point, and rise again. AVC is ‘U’ shaped because of the principle of variable Proportions, which explains the three phases of the curve:

1. Increasing returns to the variable factors, which cause average costs to fall, followed by:

2. Constant returns, followed by: 3. Diminishing returns, which cause costs to rise.

Average total cost - Average total cost (ATC) is also called average cost or unit cost. Average total costs are a key cost in the theory of the firm because they indicate how efficiently scarce resources are being used. Average variable costs are found by dividing total fixed variable costs by output. Average total cost (ATC) can be found by adding average fixed costs (AFC) and average variable costs (AVC). The ATC curve is also ‘U’ shaped because it takes its shape from the AVC curve, with the upturn reflecting the onset of diminishing returns to the variable factor. Areas for total costs Total Fixed costs and Total Variable costs are the respective areas under the Average Fixed and Average Variable cost curves. Marginal costs Marginal cost is the cost of producing one extra unit of output. It can be found by calculating the change in total cost when output is increased by one unit.

It is important to note that marginal cost is derived solely from variable costs, and not fixed costs. The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable costs and are subject to the principle of variable proportions. The significance of marginal cost The marginal cost curve is significant in the theory of the firm for two reasons:

1. It is the leading cost curve, because changes in total and average costs are derived from changes in marginal cost.

2. The lowest price a firm is prepared to supply at is the price that just covers marginal cost. ATC and MC Average total cost and marginal cost are connected because they are derived from the same basic numerical cost data. The general rules governing the relationship are: 1. Marginal cost will always cut average total cost from below. 2. When marginal cost is below average total cost, average total cost will be falling, and when marginal cost is above average total cost, average total cost will be rising.

3. A firm is most productively efficient at the lowest average total cost, which is also where average total cost (ATC) = marginal cost (MC). Total costs and marginal costs Marginal costs are derived exclusively from variable costs, and are unaffected by changes in fixed costs. The MC curve is the gradient of the TC curve, and the positive gradient of the total cost curve only exists because of a positive variable cost. This is shown front: Sunk costs Sunk costs are those that cannot be recovered if a firm goes out of business. Examples of sunk costs include spending on advertising and marketing, specialist machines that have no scrap value, and stocks which cannot be sold off. Sunk costs are a considerable barrier to entry and exit.

Profit Maximisation Theory: Assumptions and Criticisms In the neoclassical theory of the firm, the main objective of a business firm is profit maximisation. The firm maximises its profits when it satisfies the two rules: (i) MC = MR and, (ii) MC curve cuts the MR curve from below. Maximum profits refer to pure profits which are a surplus above the average cost of production. It is the amount left with the entrepreneur after he has made payments to all factors of production, including his wages of management. In other words, it is a residual income over and above his normal profits. The profit maximisation condition of the firm can be expressed as: Maximise π (Q) Where π (Q)=R (Q)-C (Q) Where π (Q) is profit, R (Q) is revenue, C (Q) are costs, and Q are the units of output sold. The two marginal rules and the profit maximisation condition stated above are applicable both to a perfectly competitive firm and to a monopoly firm. Assumptions: 1. The objective of the firm is to maximise its profits where profits are the difference between the firm’s revenue and costs. 2. The entrepreneur is the sole owner of the firm. 3. Tastes and habits of consumers are given and constant. 4. Techniques of production are given. 5. The firm produces a single, perfectly divisible and standardised commodity. 6. The firm has complete knowledge about the amount of output which can be sold at each price. 7. The firm’s own demand and costs are known with certainty. 8. New firms can enter the industry only in the long run. Entry of firms in the short run is not possible. 9. The firm maximises its profits over some time-horizon. 10. Profits are maximised both in the short run and the long run. Given these assumptions, the profit maximising model of firm can be shown under perfect competition and monopoly. 1. Profit Maximisation under Perfect Competition Firm: Under perfect competition, the firm is one among a large number of producers. It cannot influence the market price of the product. It is the price-taker and quantity-adjuster. It can only decide about the output to be sold at the market price. Therefore, under conditions of perfect competition, the MR curve of a firm coincides with its AR curve. The MR curve is horizontal to the X-axis because the price is set by the market and the firm sells its output at that price. The firm is thus in equilibrium when MC= MR= AR (Price). The equilibrium of the profit maximisation firm under perfect competition is shown in Figure 1 where the MC curve cuts the MR curve first at point A. It satisfies the condition of MC = MR, but it is not a point of maximum profits because after point A, the MC curve is below the MR curve. It does not pay the firm to produce the minimum output when it can earn larger profits by producing beyond OM. It will, however, stop further production when it reaches the OM level of output where the firm satisfies both conditions of equilibrium. If it has any plans to produce more than OM1it will be including losses, for the marginal cost exceeds the marginal revenue after the equilibrium point B. Thus the firm maximises its profits at M1 B price at the output level OM1. 2. Profit Maximisation under Monopoly Firm: There being one seller of the product under monopoly, the monopoly firm is the industry itself. Therefore, the demand curve for its product is downward sloping to the right, given the tastes and incomes of its customers. It is a price-maker which can set the price to its maximum advantage. But it does not mean that the firm can set both price and output. It can do either of the two things. If the firm selects its output level, its price is determined by the market demand for its product. Or, if it sets the price for its product, its output is determined by what the consumers will take at that price. In any situation, the ultimate aim of the monopoly firm is to maximise its profits. The conditions for equilibrium of the monopoly firm are: (1) MC = MR<AR (Price), and

(2) The MC curve cuts the MR curve from below. In Figure 2, the profit maximising level of output is OQ and the profit-maximisation price is OP. If more than OQ output is produced, MC will be higher than MR, and the level of profit will fall. If cost and demand conditions remain the same, the firm has no incentive to change its price and output. The firm is said to be in equilibrium. Criticisms of the Profit Maximisation Theory: The profit maximisation theory has been severely criticised by economists on the following grounds: 1. Profits Uncertain: The principle of profit maximisation assumes that firms are certain about the levels of their maximum profits. But profits are most uncertain for they accrue from the difference between the receipt of revenues and incurring of costs in the future. It is, therefore, not possible for firms to maximise their profits under conditions of uncertainty. 2. No Relevance to Internal Organisation: This objective of the firm bears little or no direct relevance to the internal organisation of firms. For instance, some managers incur expenditures apparently in excess of those that would maximise wealth or profits of the owners of the firm. They are observed to emphasize growth of total assets of the firm and its sales as objectives of managerial actions. 3. No Perfect Knowledge: The profit maximisation hypothesis is based on the assumption that all firms have perfect knowledge not only about their own costs and revenues but also of other firms. But, in reality, firms do not possess sufficient and accurate knowledge about the conditions under which they operate. At the most, they may have a knowledge about their own costs of production, but they can never be definite about the market demand curve. They always operate under conditions of uncertainty and the profit-maximisation theory is weak in that it assumes that firms are certain about everything. 4. Empirical Evidence Vague: The empirical evidence on profit maximisation is vague. Most firms do not rank profits as the major goal. The working of modem firms is so complex that they do not think merely about profit maximisation. Their main problems are of control and management. The function of managing these firms is performed by managers and shareholders rather than by the entrepreneurs. They are more interested in their emoluments and dividends. Since there is substantial separation of ownership from control in modern firms, they are not operated so as to maximise profits. 5. Firms do not bother about MC and MR: It is asserted that the real world firms do not bother about the calculation of marginal revenue and marginal cost. Most of them are not even aware of the two terms. Others do not know the demand and marginal revenue curves faced by them. Still others do not possess adequate information about their cost structure. Empirical evidence by Hall and Hitch shows that businessmen have not heard of marginal cost and marginal revenue. After all, they are not greedy calculating machines. As aptly put by C.J. Hawkins: “To argue that all firms aim to do nothing else but maximise profits has not better basis in logic or intuition as to argue that all students aim only to maximise examination marks”. 6. Principle of Average-Cost Maximises Profits: Hall and Hitch found that firms do not apply the rule of equality of MC and MR to maximise short run profits. Rather, they aim at the maximisation of profits in the long run. For this, they do not apply the marginalistic rule but they fix their prices on the average cost principle. According to this principle, price equals AVC +AFC + profit margin (usually 10%). Thus the main aim of the profit maximising firm is to set a price on the average cost principle and sell its output at that price. 7. Static Theory: The neo-classical theory of the firm is static in nature. The theory does not tell the duration of either the short period or the long period. The time-horizon of the neo-classical firm consists of identical and independent time periods. Decisions are considered as temporally independent. This is a serious weakness of the profit maximisation theory. In fact, decisions are”temporally inter- dependent. It means that decisions in any one period are affected by decisions in past periods which will, in turn, influence the future decisions of the firm. This inter-dependence has been ignored by the neo-classical theory of the firm. 8. Not applicable to Oligopoly Firm: As a matter of fact, the profit-maximisation objective has been retained for the perfectly competitive, or monopolistic, or monopolistic competitive firm in economic theory. But it has been abandoned in the case of the oligopoly firm because of the criticisms levelled against it. Hence the different objectives that have been put forth by economists in the theory’ of the firm relate to the oligopoly or duopoly firm. 9. Varied Objectives: The basis of the difference between the objectives of the neo-classical firm and the modem corporation arises from the fact that the profit maximisation objective relates to the entrepreneurial behaviour while modem corporations are motivated by different objectives because of the separate roles of shareholders and managers. In the latter, shareholders have practically no influence over the actions of the managers. As early as in 1932, Berle and Means suggested that managers have different goals from shareholders. They are not interested in profit maximisation. They manage firms in their own interests rather than in the interests of shareholders. Shareholders cannot have much influence on managers because they do not possess adequate information about companies. The majority of shareholders cannot attend annual general meetings of companies and thus give their proxies to the directors. Thus modern firms are motivated by objectives relating to sales maximisation, output maximisation, utility maximisation, satisfaction maximisation and growth maximisation.

SALES MAXIMISATION

Sales maximisation is another possible goal and occurs when the firm sells as much as possible without making a loss. Not-for-profit organisations may choose to operate at this level of output, as may profit making firms faced with certain situations, or employing certain strategies. An example of this would be predatory pricing where, so long as costs are covered, a firm may reduce price to drive rivals out of the market. Sales maximisation means achieving the highest possible sales volume, without making a loss. To the right of Q, the firm will make a loss, and to the left of Q sales are not maximised where AC=AR. [1] Managers are more interested in firm size than profits. Size leads to greater monetary and non-monetary rewards. For example, managers usually have sales related bonuses. As well, the size of the firm they are managing gives them a greater sense of worth; rather than just making their boss richer. Firm is profitable between Q1 and Q2. At Q3 is the profit is at max point Managers take production right up to the point where TC=TR; if they can [2] Oligopolies can benefit most from going past the profit maximising output because it gives them a market share advantage over their competition. The economic climate can affect managers' ability to deploy this tactic. If a recession is on the cards then shareholders will be anxious and keeping them and profits high will be a priority to which managers must abide to keep their position. The Downsides: 1. Shareholders are worse off 2. Brummel can possibly explain the downfall of mergers. Evidence: Hay & Morris (1991) found that overall manager owned firms were less profitable than owner-controlled firms. 3. The size of the firm is linked to the size of pay Rationalisation of the Sales Maximisation Model There is evidence that salaries and other earnings of top managers are correlated more closely with sales than with profits. The banks and other financial institutions keep a close eye on the sales of firms and are more willing to finance firms with large and growing sales. Personnel problems are handled more satisfactorily when sales are growing. The employees at all levels can be given higher earnings and better terms of work in general. Large sales, growing over time, give prestige to the managers, while large profits go into the pockets of shareholders. [3] Arguments against Sales Maximisation Model In defence of this model, the following arguments are given.

Increase in sales and expansion in its market share is a sign of healthy growth of a normal company.

It increases the competitive ability of the firm and enhances its influence in the market. The amount of slack earnings and salaries of the top managers are directly linked to it.

It helps in enhancing the prestige and reputation of top management, distribute more dividends to share holders and increase the wages of workers and keep them happy. Assumptions of dynamic model: 1. Higher advertisement expenditure would certainly increase sales revenue of a firm. 2. Market price remains constant. 3. Demand and cost curves of the firm are conventional in nature. Generally under competitive conditions, a firm in order to increase its volume of sales and sales revenue would go for aggressive advertisements. This leads to a shift in the demand curve to the right. Forward shift in demand curve implies increased advertisement expenditure resulting in higher sales and sales revenue. A price cut may increase sales in general. But increase in sales mainly depends on whether the demand for a product is elastic or inelastic. A price reduction policy may increase its sales only when the demand is elastic and if the demand is inelastic; such a policy would have adverse effects on sales. Hence, to promote sales, advertisements become an effective instrument today. Managerial Satisfaction model An alternative view was put forward by Oliver Williamson (1981), who developed the concept of managerial satisfaction (or managerial utility). This can be enhanced by raising sales revenue.

Assuming that the firm’s costs remain the same, a firm will choose a lower price and supply a higher output when sales revenue maximisation is the main objective. The profit maximising price is P1 at output Q1, the revenue maximising price is P2 at output Q2 Consumer surplus is higher with sales revenue maximisation because output is higher and price is lower. Producer surplus is greater when profits are maximised. Difference Between Sales Maximization & Profit Maximization Sales maximization and profit maximization are distinct business objectives. Sales maximization is an approach to business where the company's primary objective is to generate as much revenue as possible. Profit maximization is an objective where the company intends to generate the highest net income over time.

Revenue vs. Profits The main difference between sales maximization and profit maximization is the financial intention. Sales, or

revenue, are the generation of cash flow through the sale of goods and services. A goal of maximizing revenue does not necessarily produce profits, because companies often sell products at a loss to generate revenue. Maximizing profits typically requires that you not only sell a significant volume, but that you also maintain reasonable profit margins.

Timeliness One of the more prominent differences between sales and profit maximization is time orientation. Sales maximization

objectives are typically intended to produce as much revenue as possible in a short time frame. Companies often have this objective to build their customer base, to steal customers from competitors, to drive quick cash flow and to sell excess inventory. Profit maximization is a longer-term objective where the company intends to position itself for long-term viability and success.

The Difference Between Profit & Profit Margin

Recurrence Profit maximization theoretically remains the primary long-term objective of any for profit business. However, sales

maximization objectives can come and go. Companies use sales objectives for various reasons and at different times. The launch of the business, near the end of a quarter or fiscal year, during typically slow times, when the business is slumping and when excess inventory builds up are common points at which a company may introduce sales maximization goals for a temporary period. Still, the long-term focus is earning income.

Risks Risks of profit maximization objectives are somewhat limited. The business does have to work diligently to build the perception

of value in the market. Sales maximization goals do pose significant risks to long-term profit potential. Companies advertise to build the sense of worth customers have for their products. Constantly cutting costs to drive revenue creates a price orientation in the market. If a business mismanages sales objectives, it can restrict the success of long-term profit maximization

MONOPOLY: A market structure characterized by a single seller of a unique product with no close substitutes. This is one of four basic market structures. The other three are perfect competition, oligopoly, and monopolistic competition. As the single seller of a unique good with no close substitutes, a monopoly has no competition. The demand for output produced by a monopoly is THE market demand, which gives monopoly extensive market control. The inefficiency that results from market control also makes monopoly a key type of market failure. Monopoly is a market in which a single firm is the only supplier of the good. Anyone seeking to buy the good must buy from the monopoly seller. This single-seller status gives monopoly extensive market control. It is a price maker. The market demand for the good sold by a monopoly is the demand facing the monopoly. Market control means that monopoly does not equate price with marginal cost and thus does not efficiently allocate resources.

Characteristics The four key characteristics of monopoly are: (1) a single firm selling all output in a market, (2) a unique product, (3)

restrictions on entry into the industry, and (4) specialized information about production techniques unavailable to other potential producers.

Single Supplier: First and foremost, a monopoly is a monopoly because it is the only seller in the market. The word monopoly actually translates as "one seller." As the only seller, a monopoly controls the supply-side of the market completely. If anyone wants to buy the good, they must buy from the monopoly.

Unique Product: A monopoly achieves single-seller status because the good supplied is unique. There are no close substitutes available for the good produced by a monopoly.

Barriers to Entry: A monopoly often acquires and generally maintains single seller status due to restrictions on the entry of other firms into the market. Some of the key barriers to entry are: (1) government license or franchise, (2) resource ownership, (3) patents and copyrights, (4) high start-up cost, and (5) decreasing average total cost. These restrictions might be imposed forefficiency reasons or simply for the benefit of the monopoly.

Specialized Information: A monopoly often possesses information not available to others. This specialized information comes in the form of legally-established patents, copyrights, or trademarks.

Reasons Monopolies achieve their single-seller status for three interrelated reasons: (1) economies of scale, (2) government decree,

and (3) resource ownership. While a monopoly can emerge and persist for any one of these reasons, most monopolies rely on two or all three.

Economies of Scale: Many real world monopolies emerge due to economies of scale and decreasing average cost. If average cost decreases over the entire range of demand, then a single seller can provide the good at lower per unit cost and more efficiently than multiple sellers. This often leads to what is termed a natural monopoly. The market might start with more than one seller, but it naturally ends up with a single seller that can best take advantage of decreasing average cost. Many public utilities (such as electricity distribution, natural gas distribution, garbage collection) have this natural monopoly inclination.

Government Decree: The monopoly status of a firm can be established by the mandate of government. Government simply gives one and only one firm the legal authority to supply a particular good. Such single seller legal status is usually justified on economic grounds, such as an electric company that naturally tends to monopolize a market. However, it might also result from political forces, such as mandating monopoly status to a firm controlled by a campaign donor or close political associate.

Resource Ownership: A monopoly is likely to arise if a firm has complete control over a key input or resource used in production. If the firm controls the input, then it controls the output. Monopolies have arisen over the years due to control over material resources (petroleum and bauxite ore), labour resources (talented entertainers and skilled athletes), or information resources (patents and copyrights).

Demand and Revenue Single-seller status means that monopoly faces a negatively-sloped demand curve, such as the one displayed in the exhibit to the right. In fact, the demand curve facing the monopoly is the market demand curve for the product. The top curve in the exhibit is the demand curve (D) facing the monopoly. The lower curve is the marginal revenue curve (MR). Because a monopoly is a price maker with extensive market, it faces a negatively-sloped demand curve. To sell a larger quantity of output, it must lower the price. For example, the monopoly can sell 1 unit for $10. However, if it wants to sell 2 units, then it must lower the price to $9.50. For this reason, the marginal revenue generated from selling extra output is less than price. While the price of the second unit sold is $9.50, the marginal revenue generated by selling the second unit is only $9. While the $9.50 price means the monopoly gains $9.50 from selling the second unit, it loses $0.50 due to the lower price on the first unit ($10 to $9.50). The net gain in revenue, that is marginal

Demand Curve, Monopoly

revenue, is thus only $9 (= $9.50 - $0.50).

Short-Run Production The analysis of short-run production by a monopoly provides insight into efficiency (or lack thereof). The key assumption is that a monopoly, like any other firm, is motivated by profit maximization. The firm chooses to produce the quantity of output that generates highest possible level of profit, given price, market demand,

cost conditions, production technology, etc.

The short-run production decision for monopoly can be illustrated using the exhibit to the right. The top panel indicates the two sides of the profit decision--revenue and cost. The hump-shaped green line is total revenue (TR). Because price depends on quantity, the total revenue curve is a hump-shaped line. The curved red line is total cost (TC). The difference between total revenue and total cost is profit, which is illustrated by the lower panel as the brown line. A firm maximizes profit by selecting the quantity of output that generates the greatest gap between the total revenue line and the total cost line in the upper panel, or at the peak of the profit curve in the lower panel. In this example, the profit maximizing output quantity is 6. Any other level of production generates less profit.

A Few Problems Three problems often associated with a market controlled totally by a single firm are: (1) inefficiency, (2) income inequality, (3) political abuse.

Inefficiency: The most noted monopoly problem is inefficiency. Market control means that a monopoly charges a higher price and produces less output than would be achieved under perfect competition. In addition, and most indicative of inefficiency, the price charged by the monopoly is greater than the marginal cost of production.

Income Inequality: A lesser known problem with monopoly is an inequitable distribution of income. To the extent that monopoly earns economic profit, consumer surplus is transferred from buyers to the monopoly. Buyers end up with less income and the monopoly ends up with more. In addition, because price is greater than marginal cost and a monopoly receives economic profit, factor payments to some or all of the resources used by the monopoly are greater than their contributions to production. A portion of this economic profit is often "paid" to the owners of the labour, capital, or land.

Political Abuse: A third potential problem, one tied directly to the concentration of income by the monopoly resources, is the abuse of political power. The monopoly could use its economic profit to influence the political process, especially policies that might prevent potential competitors from entering the market.

The Other Three Market Structures Monopoly is one of four common market structures. The other three are: perfect competition, oligopoly, andmonopolistic competition. The exhibit to the right illustrates how these four market structures form a continuum based on the relative degree of market control and the number of competitors in the market. At the far right of the market structure continuum is monopoly, characterized by a single seller and extensive market control.

Perfect Competition: To the far left of the market structure continuum is perfect competition, characterized by a large number of relatively small competitors, each with no market control. Perfect competition is an idealized market structure that provides a benchmark for efficiency.

Oligopoly: In the middle of the market structure continuum, residing closer to monopoly, is oligopoly, characterized by a small number of relatively large competitors, each with substantial market control. A substantial number of real world markets fit the characteristics of oligopoly.

Monopolistic Competition: Also in the middle of the market structure continuum, but residing closer to perfect competition, is monopolistic competition, characterized by a large number of relatively small competitors, each with a modest degree of market control. A substantial number of real world markets fit the characteristics of monopolistic competition.

Oligopoly Defining and measuring oligopoly An oligopoly is a market structure in which a few firms dominate. When a market is shared between a few firms, it is said to be highly concentrated. Although only a few firms dominate, it is possible that many small firms may also operate in the market. For example, major airlines like British Airways (BA) and Air France operate their routes with only a few close competitors, but there are also many small airlines catering for the holidaymaker or offering specialist services.

Short-Run Production, Monopoly

Market Structure Continuum

Concentration ratios Oligopolies may be identified using concentration ratios, which measure the proportion of total market share controlled by a given number of firms. When there is a high concentration ratio in an industry, economists tend to identify the industry as an oligopoly. Example - Telephone services While there are around 170 telephone service suppliers in the UK the fixed-line market is dominated

by two main suppliers, BT and Virgin Media, with a 3-firm concentration ratio for fixed-line telephone supply of 89% in 2006. Characteristics The main characteristics of firms operating in a market with few close rivals include: Interdependence Firms that are interdependent cannot act independently of each other. A firm operating in a market with just a few competitors must take the potential reaction of its closest rivals into account when making its own decisions. For example, if a petrol retailer like Texaco wishes to increase its market share by reducing price, it must take into account the possibility that close rivals, such as Shell and BP, may reduce their price in retaliation. An understanding ofgame theory and

the Prisoner’s Dilemma helps appreciate the concept of interdependence. Strategy Strategy is extremely important to firms that are interdependent. Because firms cannot act independently, they must anticipate the likely response of a rival to any given change in their price, or their non-price activity. In other words, they need to plan, and work out a range of possible options based on how they think rivals might react.

Oligopolists have to make critical strategic decisions: 1. Whether to compete with rivals, or collude with them. 2. Whether to raise or lower price, or keep price constant. 3. Whether to be the first firm to implement a new strategy, or whether to wait and see what rivals do. The advantages of ‘going first’ or ‘going second’ are respectively called 1st and 2nd-mover advantage. Sometimes it pays to go first because a firm can generate head-start profits. 2nd mover advantage occurs when it pays to wait and see what new strategies are launched by rivals, and then try to improve on them or find ways to undermine them. Examples of Oligopoly Oligopolies are common in the airline industry, banking, brewing, soft-drinks, supermarkets and music. For example, the manufacture, distribution and publication of music products in the UK, as in the EU and USA, is highly concentrated, with a 4-firm concentration ratio of around 75%, and is usually identified as an oligopoly. The key players in 2011 were: The disadvantages of oligopolies Oligopolies can be criticised on a number of obvious grounds, including: 1. High concentration reduces consumer choice. 2. Cartel-like behaviour reduces competition and can lead to higher prices and reduced output. 3. Given the lack of competition, oligopolists may be free to engage in the manipulation of consumer decision making.

By making decisions more complex - such as decisions about mortgages - individual consumers fall back on heuristics and rule of thumb processes, which can lead todecision making bias and irrational behaviour, including making purchases which add no utility or even harm the individual consumer. 4. Firms can be prevented from entering a market because of deliberate barriers to entry. 5. There is a potential loss of economic welfare. 6. Oligopolists may be allocatively and productively inefficient. The advantages of oligopolies However, oligopolies may provide the following benefits: 1. Oligopolies may adopt a highly competitive strategy, in which case they can generate similar benefits to more competitivemarket structures, such as lower prices. Even though there are a few firms, making the market uncompetitive, their behaviour may be highly competitive. 2. Oligopolists may be dynamically efficient in terms of innovation and new product and process development. The super-normal profits they generate may be used to innovate, in which case the consumer may gain. 3. Price stability may bring advantages to consumers and the macro-economy because it helps consumers plan ahead and stabilises their expenditure, which may help stabilise the trade cycle. Barriers to entry Oligopolies and monopolies frequently maintain their position of dominance in a market might because it is too costly or difficult for potential rivals to enter the market. These hurdles are calledbarriers to entry and the incumbent can erect them deliberately, or they can exploit natural barriers that exist.

Natural entry barriers include: Economies of large scale production. If a market has significant economies of scale that have already been exploited by the incumbents, new entrants are deterred. Ownership or control of a key scarce resource. Owning scarce resources that other firms would like to use creates a considerable barrier to entry, such as an airline controlling access to an airport. High set-up costs. High set-up costs deter initial market entry, because they increase break-even output, and delay the possibility of making profits. Many of these costs are sunk costs, which are costs that cannot be recovered when a firm leaves a market, and include marketing and advertising costs and other fixed costs. High R&D costs Spending money on Research and Development (R & D) is often a signal to potential entrants that the firm has large financial reserves. In order to compete, new entrants will have to match, or exceed, this level of spending in order to compete in the future. This deters entry, and is widely found in oligopolistic markets such as pharmaceuticals and the chemical industry. Artificial barriers include: Predatory pricing. Predatory pricing occurs when a firm deliberately tries to push prices low enough to force rivals out of the market. Limit pricing. Limit pricing means the incumbent firm sets a low price, and a high output, so that entrants cannot make a profit at that price. This is best achieved by selling at a price just below the average total costs (ATC) of potential entrants. This signals to potential entrants that profits are impossible to make. Superior knowledge An incumbent may, over time, have built up a superior level of knowledge of the market, its customers, and its production costs. This superior knowledge can deter entrants into the market. Predatory acquisition Predatory acquisition involves taking-over a potential rival by purchasing sufficient shares to gain a controlling interest, or by a complete buy-out. As with other deliberate barriers, regulators, like the Competition Commission, may prevent this because it is likely to reduce competition. Advertising Advertising is another sunk cost - the more that is spent by incumbent firms the greater the deterrent to new entrants. A strong brand A strong brand creates loyalty, ‘locks in’ existing customers, and deters entry. Loyalty schemes Schemes such as Tesco’s Club Card, help oligopolists retain customer loyalty and deter entrants who need to gain market share. Exclusive contracts, patents and licences These make entry difficult as they favour existing firms who have won the contracts or own the licenses. For example, contracts between suppliers and retailers can exclude other retailers from entering the market. Vertical integration Vertical integration can ‘tie up’ the supply chain and make life tough for potential entrants, such as an electronics manufacturer like Sony having its own retail outlets (Sony Centres), and a brewer likeHeineken owning its own chain of UK pubs, which it acquired from the brewers Scottish and Newcastle in 2008. Collusive oligopolies another key feature of oligopolistic markets is that firms may attempt to collude, rather than compete. If colluding, participants act like a monopoly and can enjoy the benefits of higher profits over the long term. Types of collusion Overt Overt collusion occurs when there is no attempt to hide agreements, such as the when firms form trade associations like the Association of Petrol Retailers. Covert Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid detection by regulators, such as when fixing prices. Tacit Tacit collusion arises when firms act together, called acting in concert, but where there is no formal or even informal agreement. For example, it may be accepted that a particular firm is the price leader in an industry, and other firms simply follow the lead of this firm. All firms may ‘understand’ this, but no agreement or record exists to prove it. If firms do collude, and their behaviour can be proven to result in reduced competition, they are likely to be subject to regulation. In many cases, tacit collusion is difficult or impossible to prove, though regulators are becoming increasingly sophisticated in developing new methods of detection.

Competitive oligopolies When competing, oligopolists prefer non-price competition in order to avoid price wars. A price reduction may achieve strategic benefits, such as gaining market share, or deterring entry, but the danger is that rivals will simply reduce their prices in response. This leads to little or no gain, but can lead to falling revenues and profits. Hence, a far more beneficial strategy may be to undertake non-price competition. Pricing strategies of oligopolies Oligopolies may pursue the following pricing strategies: 1. Oligopolists may use predatory pricing to force rivals out of the market. This means keeping price artificially low, and often below the full cost of production. 2. They may also operate a limit-pricing strategy to deter entrants, which is also called entry forestalling price. 3. Oligopolists may collude with rivals and raise price together, but this may attract new entrants.

4. Cost-plus pricing is a straightforward pricing method, where a firm sets a price by calculating average production costs and then adding a fixed mark-up to achieve a desired profit level. Cost-plus pricing is also called rule of thumb pricing. There are different versions of cost-pus pricing, including full cost pricing, where all costs - that is, fixed and variable costs - are calculated, plus a mark-up for profits, and contribution pricing, where only variable costs are calculated with precision and the mark-up is a contribution to both fixed costs and profits. Cost-plus pricing is very useful for firms that produce a number of different products, or where uncertainty exists. It has been suggested that cost-plus pricing is common because a precise calculation of marginal cost and marginal revenue is difficult for many oligopolists. Hence, it can be regarded as a response to information failure. Cost-plus pricing is also common in oligopoly markets because it is likely that the few firms that dominate may often share similar costs, as in the case of petrol retailers. However, there is a risk with such a rigid pricing strategy as rivals could adopt a more flexible discounting strategy to gain market share.

Non-price strategies Non-price competition is the favoured strategy for oligopolists because price competition can lead to destructive price wars – examples include: 1. Trying to improve quality and after sales servicing, such as offering extended guarantees. 2. Spending on advertising, sponsorship and product placement - also called hidden advertising – is very significant to many oligopolists. The UK's football Premiership has long been sponsored by firms in oligopolies, including Barclays Bank and Carling. 3. Sales promotion, such as buy-one-get-one-free (BOGOF), is associated with the large supermarkets, which is a highly oligopolistic market, dominated by three or four large chains. 4. Loyalty schemes, which are common in the supermarket sector, such as Sainsbury’s Nectar Card and Tesco’s Club Card. Each strategy can be evaluated in terms of: 1. How successful is it likely to be? 2. Will rivals be able to copy the strategy?

3. Will the firms get a 1st - mover advantage?

4. How expensive is it to introduce the strategy? If the cost of implementation is greater than the pay-off, clearly it will be rejected.

5. How long will it take to work? A strategy that takes five years to generate a pay-off may be rejected in favour of a strategy with a quicker pay-off.

Price stickiness The theory of oligopoly suggests that, once a price has been determined, will stick it at this price. This is largely because firms cannot pursue independent strategies. For example, if an airline raises the price of its tickets from London to New York, rivals will not follow suit and the airline will lose revenue - the demand curve for the price increase is relatively elastic. Rivals have no need to follow suit because it is to their competitive advantage to keep their prices as they are. However, if the airline lowers its price, rivals would be forced to follow suit and drop their prices in response. Again, the airline will lose sales revenue and market share. The demand curve is relatively inelastic in this context. Kinked demand curve The reaction of rivals to a price change depends on whether price is raised or lowered. The elasticity of demand, and hence the gradient of the demand curve, will be also be different. The demand curve will be kinked, at the current price. Even when there is a large rise in marginal cost, price tends to stick close to its original, given the high price elasticity of demand for any price rise. At price P, and output Q, revenue will be maximised. Maximising profits If marginal revenue and marginal costs are added it is possible to show that profits will also be maximised at price P. Profits will always be maximised when MC = MR, and so long as MC cuts MR in its vertical portion, then profit maximisation is still at P. Furthermore, if MC changes in the vertical portion of the MR curve, price still sticks at P. Even when MC moves out of the vertical portion, the effect on price is

minimal, and consumers will not gain the benefit of any cost reduction.

Theory of Inflation and Employment 1 Introduction Inflation is a phase of rapid rise in prices arising under conditions of full employment. It can lead to no further rise in incomes and employment in the economy. In other words, inflation is generally associated with rapidly rising prices which causes a decline in the purchasing power of money. Changes in the value of money have far reaching social and economic effect on different sections of the community. Since everyone is a consumer and producer, debtor and creditor, wage earner or employer, at one and the same time, the individuals affected differently in different capacities by the same change in the price level. The misery of wage earner and the renter class and the prosperity of business class may be accounted for the same phenomenon. The distribution of wealth, production, investment etc. is all affected by the changes in the value of money. A state in which value of money is falling and prices are rising is termed as inflation. If all prices change in the same direction at the same time and in the same degree, the problems presented by fluctuation in their value of money would be minor. Even then, certain maladjustments would arise, for the burden of outstanding indebtedness would grow lighter with a rise in the general price level and heavier with a fall. 2 Types of Inflation 1. Creeping Inflation: when prices rises by about 1-3 percent per annum, it is called Creeping Inflation. Economists do not consider it harmful as it has very little adverse effect on economic activities. So it is not considered so harmful. 2. Walking Inflation: When the price rise is about 3-5 percent per annum, it is called Walking Inflation. Even this is not considered so dangerous as it also has a little adverse effect on economic activities. 3. Running Inflation: When prices rise by about 10 percent per annum, it is called Running Inflation. This type of inflation is not considered favorable for the economy as it brings fall in the living standard in the real terms. 4. Galloping Inflation: When price rise is more than 10 percent per annum and prices rise every day and every month, it is called Galloping Inflation. It is also called Hyper- Inflation. It is considered as an extreme stage of inflationary condition which prevails in the economy. 5. Other Inflation: under this we include the following types of inflation a) Cost Push Inflation: This is caused by an increase in production cost. It is caused by two factors due to the increase in the wages or due to an increase in the profit margins of the industrialist. An increase in wages and the prices of raw material leads to emergence of cost push inflation b) Demand Pull Inflation: The aggregate demand of goods increases as a result of increase in population and due to other factors but the production does not increase at the desired level. This results in increase in the price and is called demand pull inflation. 3 Causes of Inflation (A) Factors responsible for increase in Money Income Inflation emerges on account of the increase in money incomes of certain sections of the community without any corresponding increase in their productivity giving rise to an increase in the aggregate demand for goods and services which cannot be at current prices by the total available supply of goods and services in the economy. Increase in money income take place because of the following reasons: 1. Monetary and Credit policy of the Government: When the government of the under-developed and developing countries fall short of financial resources for the implementation of their development programme, then the government of these countries float new currency into circulation. The circulation of new currency is the result of monetary policy. The circulation of new currency increases monetary income but no increase is noticed in the increase of real income. This creates inflationary situation in the economy. 2. Increase in the Velocity of Money: Increase in the propensity to consume in the society and the fall in liquidity preference of the people increases velocity of money. Increase in the velocity increases monetary income of the people, which creates inflationary situation in the economy. 3. Credit Policy of Commercial Bank: Commercial banks with the help of their credit policy create inflationary situation in the economy. When the demand of or credit increases, commercial banks by reducing their cash reserve ratio can create the credit. This credit creation policy of the bank increases quantity of money which further results in inflation. 4. Deficit Financing: It refers to the financing of the excess expenditure over total revenue receipts of the government. The financing of this excess expenditure is covered with the help of issue of new currency in irculation. This issue of new currency increases monetary income, which results in inflationary situation in the economy. 5. Increase in unproductive expenditure: Supply may suddenly decrease on account of some natural calamities or some similar things. Flood, draught, diseases of crops, etc. can reduce supply of essential goods and feed inflationary forces. 6. Import of Foreign Capital: When a country continuously imports foreign capital, or borrows heavy loans from outside, the inflationary forces start emerging in the economy. This results in increase in monetary income. 7. Financial Disorder: When the government fails to collect the full amount of levied taxes, the quantity of unaccounted money increases. In the absence of any control on this created unaccounted money, undue pressure is built on demand of goods and services. This increases price level in the country and situation of inflation starts emerging.

8. Favorable Balance of Payments: As a result of favorable Balance of Payment (exports>Imports), the supply of Foreign Exchange in surplus in country increases. The increase in Foreign Exchange reserve creates inflationary situation in the economy. 9. Rise in Import Price: If prices of importable commodities rise, it leads to what is called Imported Inflation. If the imported commodities are inputs or raw materials in domestic production, cost of production would rise in general resulting in higher domestic prices and inflation. (B) Factors Responsible for Fall in Production 1. Natural Factors: Floods, Draughts, Famine, Earthquake, and similar happenings reduce supply of essential goods in the market. Due to these natural factors, production goes down but the monetary income remains constant. This feeds inflationary forces in the economy. 2. Increase in population: When population of the country increases at a faster rate and production of the goods and services remain constant, the scarcity of such goods is realized. This scarcity results in increase of prices, and thus inflation. 3. Black Marketing and Hoarding: sometimes inflation is caused by socio-economic reason viz. Black marketing and hoarding. The commodities which are in demand are hoarded by the traders and businessmen, with the result that their prices rise which in turn would lead to general rise in prices. 4. Shortage of Raw Material: Sometimes due to shortage of raw material, production and supplies of goods is adversely affected. This results in increase in prices of such goods and the occurrence of Inflation. 5. Industrial Unrest: Many a time production in the country is adversely affected by industrial unrest like strikes and lockouts. This reduces supply of essential goods and feeds inflationary forces. 6. Trade and Fiscal Policy of the government: To boost country's export and reduce the imports, the government makes necessary changes in its trade policy. As a result of such changes exports start increasing at the cost of domestic economy. This creates shortage of essential goods in the economy and domestic price level starts rising. 7. Shortage and Bottlenecks in Productive process: In underdeveloped countries, Structural inadequacies lead to shortage of inputs and resources, which in turn would result in inflation. 18.4 Effects of Inflation Inflation affects all the sections of the society. While for some it brings good fortune, for others, it may prove to be disastrous. Inflation initially activates the economy. However, continuous inflation shakes the foundation of the economic system. This system makes the rich richer and the poor poorer. Effects of inflation could be discussed under four heads: (A) Effect of inflation on different sections of society: Inflation does not hit all sections of the society alike. While a section of society may tend to gain, another section would invariably lose. The effect of inflation on different sections of society can be discussed as follows: 1. Producers: In this category of people industrialist, traders, farmers, and employers are included. Inflation is a boon to the producers because it serves as a tonic for business enterprise. During inflation, corporate and non-corporate profits rise sharply and businessmen react to this rising prices by building up inventories. 2. Investors: Investors could be classified in two categories: a) Investors dealing in Speculative activities (Equity Shares ) b) Investors in fixed interest yielding securities ( Bonds, Debentures ) The former category of investors gains during inflation because dividend on equities increases with increase in prices and corporate earnings. Investors in fixed interest yielding securities have to be content with the fixed income and they cannot share the fruits of prosperity in the economy arising as a result of inflation. Thus, investors in fixed interest yielding securities tend to lose during inflation. 3. Consumers: Every individual in the society is consumer. Fixed income group consumer is the worst sufferers during inflation because their purchasing power goes down with the increase in price leveling the economy. Consumers, whose income increases during inflation are not affected so much. 4. Wage and Salary Earners: People getting fixed income, ifie. wages and salaries, pensioners, suffer most from inflation. Although, with increase in price level, wages and salaries rise, but they do not rise in the same proportion in which the cost of living rises. This results in fall in real wages and as a result, the living standard of fixed income class declines. 5. Debtors and Creditors: During inflation, debtors are the gainers and the creditors are the losers. The debtor when borrowed money before inflation had set in it commanded more purchasing power than what it commands now. So when it is returned creditor receives less in real terms, hence he is the loser. (B) Other effect of inflation 1. Redistribution of wealth: During inflation, inequality in society arises. Wage and salary earners and consumers had to suffer a lot during inflationary situations, because of tremendous rise in prices. Thus, during inflation the rich become richer and the poor become poorer. 2. Increase in Government expenditure: During inflation, government expenditure rises tremendously. On the one hand, the government has to pay higher wages to its employees and on the other hand, the cost of various projects under construction also increases. 3. Increasing tax revenue to the Government: In a progressive tax system, the government is able to add to its tax revenue simply on account of increasing money incomes. Since, tax liabilities are based on money incomes, therefore, tax payers keep moving into higher income brackets, for tax purpose without any addition of their real incomes. In such situation,

government collects more of revenue without reason of tax rates on imposition of new taxes. Hence, tax-payers are worst affected during inflationary situation. 4. Increase in Public Debts: During inflationary period,the government generally find that their tax receipts are lagging behind their requirements of expenditure. As a result, the government has to resort to borrowing. But it is found that with the progress of inflation, it becomes increasingly difficult to borrow from the market. 5. Distortion of Financial Institutions: Inflation has the effect of distorting financial institution. Inflation is a monetary phenomenon. Interest is an integral part of monetary and credit structure. During inflation, when interest rate start moving upwards, financial institution are put to great difficulties as they had to pay the increased interest rates on the matured liabilities immediately. The revision of their receipts from interest takes time, while their interest expenses start increasing more rapidly. This disrupts the smooth functioning of financial institutions. 6. Hoarding of Goods: In anticipation of rise in prices, during inflationary situation, both traders and consumers start hoarding essential goods. The traders hoard of stocks of essential commodities with a view to making higher profits or with a view to selling scare items in the black market. 7. Stimulation to Speculative activities: On account of the uncertainty generated by a continuous rising price level inflation gives stimulus to speculative activities. Producer during this period try to maximize their profit with the help of speculative activities. 8. Fall in Saving Rate: Inflation is a great damper on saving activity. The savers find that the value of their saving is getting eroded on account of inflation. Though rate of interest also goes up, yet it is not able to keep pace with the fall in the value of money and the savers suffer a net loser. 9. Adverse Balance of Payments: Inflation leads to balance of payment difficulties. Because of increased prices, exports of the countries do not remain competitive in the world market and the exports start declining. The rate of exchange also moves against the home currency and increasing trade deficit. However, inflationary conditions can impose severe balance of payment problems upon an underdeveloped country. 10. Employment effect: During inflation, more employment is generated because the producers in anticipation of larger profits expand the size of output. (C) Moral Effect: Moral effect of inflation is very bad. Inflation when wipes out savings, the effected persons oppose the government and the society. They try to adopt illegal and immoral ways of collecting money. Inflation is said to be the powerful agent of evil. It is a paradise for speculators and profiteers who are enriched through no effects of their own, partly at the expense of wage earners because prices go up by the lift but wages by the stairs, but still at the expense of those who have a fixed earning. (D) Social and Political Effect: Inflation has not only economic and moral effect but it has certain social and political effect .During inflation because of inequality, society divides into categres viz. rich and poor. The rich becomes more richer and poor becomes poorer. This creates class conflict. There are many examples in history, when the governments are also shaken as a result of inflation. The German hyperinflation was an important factor in the fall of Dr. Cuno' s liberal government and in Hitler's coming to power after the first world war. 5 Measures to Check Inflation We have seen that the effects of inflation are economically unsound, politically dangerous, socially disastrous and morally indefensible. It generates inequalities of wealth; it paralyses the machinery of wealth production and even as a source of revenue it soon gets dried up. It is therefore, obvious that inflation is a serious disease which needs to be effectively controlled before it is too late. The subject of controlled inflation can be viewed from two angles: the general controls and the specific controls. The general control is concerned principally with currency and credit fixing. Various measures can be adopted to control inflation. These measures can be grouped into three categories: (A) Monetary Measures: These are adopted by the central bank (RBI) of the country. Following are the monetary measures which help in controlling inflationary situation. 1. Making Note Issue Policy Strict: The central bank should adopt strict note issue policies so that it may not issue additional money. For making note issue more stringent, the gold or foreign exchange reserve should be enhanced. If there is no provision of keeping reserve, it should be started. Adoption of such measures makes note issue system a difficult one. These measures also check inflationary situation. 2. Issue of New Currency: When the inflation reaches to a uncontrollable situation, the government issues new currency and squeeze out old currency out of circulation. These measures are also called demonetization. It is an unusual method of controlling inflation. 3. Control on Credit Money: To controll inflation, it is essential to control credit money also. For this purpose the central bank of the country adopts the following measures: i) Increase in Bank Rate: Bank rate is the rate of which the central bank rediscounts the bills of commercial bank or at which it extends financial accommodation to the commercial banks. If there is much expansion of credit in the banking system, in such cases to control credit central bank increases bank rate. Increase in bank rate will check rising inflationary situation ii) Open Market Operations: Another method to check inflation is that the central bank of the country resorts to selling government securities to the public and the banks. When the public and the banks purchase the securities, they have to

make payments for these securities to the central bank. The result is that the cash moves from the commercial banks to the central bank. This reduces commercial bank ability to create credit iii) High Reserve Requirement: The central bank in order to reduce the money supply in the economy increases the limit of the reserve requirement of commercial banks. This method prevents the commercial bank from forming a basis for further credit expansion (B) Fiscal Measures: The following fiscal measures could be adopted by the government for combating inflation: (i) Taxation: During inflation, efforts should be made to reduce the size of disposable income in the hands of public. This can be done either by imposing new taxes on by increasing the existing rates of taxation. This will leave less money supply with the public (ii) Government Expenditure: To control inflation, government should reduce its expenditure especially nproductive expenditure. Any drastic cut in the government expenditure to curb inflationary situation may land the economy in the slump. (iii)Balanced Budget: To control inflationary situation, government should adopt the policy of Balanced Budget because deficit budget further increases inflation in the economy. In case of inflationary boon, government should also try to prepare surplus budget (iv)Increase in Savings: To provide a positive incentive to promote saving which will reduce outlays and curb inflation, the government should have in its budgetary policy incentives for savings also. (v) Increase in Public Debts: To check inflation, the government should also issue debentures and bonds and encourage the public for its purchase. By issue of debentures and bonds, the government can take back additional purchasing power. The amount collected by the government through these sources, should be utilized in productive channels. (vi)Control on Investment: During inflation, in anticipation of future rise in prices, traders and industrialists increase their investment activity. Such investment increases money supply in the market and this increase in money supply further increases inflation. Hence, to check inflation, the government should control unusual investments in the economy. (vii) Overvaluation of Currency: An overvaluation of domestic currency in terms of foreign currencies also servs as anti-inflationary measure. This will discourage exports and encourage imports, resulting g in increase in domestic supply of goods in the economy. This will check rise in prices. (viii) Income and Prices Policy: Another method to control inflation is to purchase a policy of incomes and prices. The tendency for wages to rise beyond the marginal product of labour has to be curbed by relating wages to productivity. Similarly, the factorial incomes in general are to be related to their marginal product and an excessive rise in factorial incomes has to be curbed. Close scrutiny on prices should also be pursued. Thus, by controlling factor incomes and unwarranted price rise, inflation can be cured. (ix)Other Fiscal Controls: Other fiscal measures for the control of inflation are introduction of rationing system, reducing exports, fixing of price of essential commodities by the government and shifting of productive resource to the production of more sensitive goods, etc. (c) Other measures: In addition to above fiscal and monetary measures, following measures can be adopted for controlling inflation: (i) Increase in Production: By increasing production the inflationary pressure can be reduced. Increase in production increases the supply of goods, which helps in establishing prices. (ii) Price control and Rationing System: The government can control the rise in prices by prohibiting any unwarranted price rises or by putting a ceiling on prices of selected commodities. The government can also impose price control along with rationing of the commodities. (iii) Export-Import Control: By restricting exports and promoting imports, government can increase the supply of goods in the country. This helps in controlling the rise in prices. (iv) Improvement of Distribution System: The public distribution system in the country should be strengthened. So that the commodities are made available at reasonable prices. From the economic point of view inflation is less harmful for the economy up to certain extent. Inflation is referred to a state in which value of money is falling that is prices are rising. These increased prices will increase national income and per capita income. This will signifies improvement in living standard. But it will have positive result only when it will remain in a controlled stage. But as soon as we reaches the galloping or running inflation stage, it will show us the real picture. It will have the negative consequences of increase in inequality, artificial prosperity, invisible robbery, degrades moral values, and overall support corruption in the economy. So we can say that inflation is unjust.

Theory of Employment In order to understand the meaning of the term employment, we should first try to know the various types of un employment that prevail in an advanced economy because full employment, may co-exist with any or all of them. The different types of unemployment that afflict an advanced economy may be classified under the following heads: 1. Frictional Unemployment: It is the type of unemployment which is caused by industrial friction, such as, immobility of labour, ignorance of job opportunities, shortage of raw material, and breakdown of machinery. 2. Seasonal Unemployment: It is the type of unemployment which is due to seasonal variation in the activities of particular industries caused by climatic changes or changes in fashion or by the inherent nature of such industries.

3. Structural Unemployment: It is the type of unemployment which arises due to structural change in the economy of the country. Example- If there is a long-term decline in the export trade of a country; this may be considered a structural change in the economy of that country. 4. Technological Unemployment: It is the type of unemployment which is caused by changes in the technique of production. Example- Innovations, Inventions etc.

Classical Theory of Employment The classical theory of employment assumes that there is always full employment of labour and other resources. In fact, full employment is considered to be the normal situation and any lapses from full employment are considered to be abnormal. Even if at any time, there is not actual full employment, the classical theory asserts that there is always a tendency towards full employment. The free play of economic forces itself brings about the fuller utilization of economic resources including labour. The assumption that there is always full employment of resources is justified in classical economics by Say's Law of Market. This law is, in fact the core of classical Economic Theory. According to Say's Law, general overproduction and, hence, general unemployment are logical impossibilities. J.B.Say believes in the fact that "supply always creates its own demand "Say explains that the main source of demand is the flow of factor income generated from the process of production itself. Whenever any new productive process is initiated and a certain output results, the demand for the output is also simultaneously generated on account of the payment of remuneration to the factors of production. In other words, every output brought into existence injects an equivalent amount of purchasing power in circulation which ultimately leads to its sale so that there is no surplus output or overproduction. The process of manufacture, thus, also brings into being an equivalent amount of purchasing power In the form of wages, profits, etc. which would ultimately lead to purchases. Hence, there can be no overproduction of any commodity at any time. This is the essence of Say's Law. General overproduction, according to Say, is impossible. As a result, there is no possibility of unemployment. Implication of Say's Law: 1. The first implication of the law is that there is Automatic adjustment of every element with the working of the economy. For example: If the supply increases, the demand shall also increase and there shall be adjustment between the two. 2. The second implication of the law is that general overproduction is impossible. As production increases, the income of the concerned factor also increases. As a consequence, new demand is created and increased stock sold off in the market. 3. The third implication of the law is that since general over production is impossible, there shall be no general unemployment. Even if there is some unemployment somewhere, it shall be purely temporary and shall automatically disappear in course of time. 4. The fourth implication of the law is that the employment of unemployed resources shall pay its own way. 5. Finally, Say's law has important policy implication. The economic system, according to Say, is automatic and works itself without any external stimulus. Criticism 1. The theory has been criticized on the ground that economy is self-adjusting, because there are two principal classes of rich and poor, and wealth is unequally distributed between them. 2. The law is based on the assumption that 'supply creates its own demand', this law assumes that people spend their entire income on the purchases. But in reality they save a part of income for future use. 3. This theory is based on unrealistic approach to the problems of contemporary capitalist world. 4. The equilibrium between savings and investment is brought, according to this theory, through flexible exchange rate. But in reality, it is brought through changes in income rather than through changes in interest rate. 5. J.B.Say argued that since general over-production was impossible, general unemployment was out of question. The critics point out that this thesis cannot be accepted because unemployment is found in all the capitalist ountries. Even a reduction in the money-wages does not remedy the situation.

Keynes's Theory of Employment The first theory of employment is that put forward by Keynes. It is also known as Demand Deficiency Theory. It attributes unemployment to a 'lack of effective demand, to a deficiency of outlay on consumption and on investment'. Keynes measured the total output of an economy in terms of employment for want of any better unit of measurement. The greater the output, the greater shall be the employment resulting there from and vice versa. The national output, on the other hand, depends upon the effective demand. Effective demand, in its turn, comprises i) consumption demand, and ii) investment demand. The former comprises the demand for consumption goods, while the latter is the demand for capital goods. It is the effective demand upon which the volume of employment depends. Since employment is governed by the effective demand, it is clear that unemployment is due to lack of sufficient effective demand and if unemployment is to be cured, the remedy is an increase in effective demand. Effective demand is determined by two factors which Keynes called it as Aggregate Demand Function and Aggregate Supply Function. Aggregate demand function is a schedule of the various amounts of money which the entrepreneurs in an economy expect from the sale of their output at varying levels of employments. It refers to the receipt which the entrepreneurs taken together expect from the sale of the output. Aggregate Supply Function, on the other hand, is a schedule of the various amounts of money which the entrepreneur in an economy must receive from the sale of output at varying levels of employment. Aggregate Supply Function, thus, represents the costs while Aggregate demand Function represents the receipt of the entrepreneur in an economy. It is

ordinary common sense that the costs must in no case be more than the receipts. If, at any particular level of employment, entrepreneur finds that the receipts are less than the cost, they shall stop production and refuse to offer employment to that particular number of workers. It goes without saying that so long as the costs remain less than the receipts, the employment in an economy shall go on increasing till both of them are equalized. In no case would the employers offer employment to workers if the costs are greater than the receipts So long as A.D.F. is greater than A.S.F., entrepreneur shall go on employing more and more workers till A.D.F. and A.S.F. are exactly equal. The movement A.S.F. exceeds A.D.F. further expansion of business activity and employment shall come to an end. Assumptions of the Theory 1. There exists perfect competition in the society 2. There exists underemployment in the society 3. There exists a closed economy in the country Features of Keynes Theory of Employment 1. Short-term Analysis: This theory deals with the short period alone. It ignores the long period altogether. He assumes that the quality and quantity of labour, capital, equipment, existence techniques, consumer's taste, the extent of competition and the social structure remain unchanged. Now these elements are never remain constant in real life. They do change, but change very little in the short period. Since Keynesian economics is of a short term Character, he regards them as given. 2. Macro-Economic Theory: The Keynesian economics deals with the economic system as a whole. As it is Keynesian Economics it deals with the aggregates of consumption, production, income, demand, saving and investment. As such, it is also referred to as aggregating economics. 3. Theory of Monetary Economics: Money occupies a central position in Keynes theory of income, output and employment. To Keynes, money was, no doubt, a medium of exchange and a unit of account, but it was more important as a store of value. Money was the simplest form in which wealth could be stored. Moreover, money was the most secured type of asset. It is on account of this reason that money comes to occupy a pivotal position in the economy of the country. It is money which provides the driving force to the economy. 4. Economics is a Comprehensive System of Thought: It is a comprehensive system of thought in the sense that it deals with all sorts of situations and provides remedies for all sorts of problems. It deals as effectively with inflation as it goes with deflation. Keynesian economics is a comprehensive system of thought in another sense as well. It deals with all levels of employments as against the classical economics which concerns itself only with the special case of full employment. 5. Economics is investment oriented: Other important characteristics of Keynes economics is the important role that it assigns to investments as a determinant of employment. According to Keynes consumption is more or less stable in the short run. As such, it plays no important role in the determination of employment. Investment, thus, assumes greater importance as a determinant of the volume of employment. 6. Economics is built on Strong Empirical Foundation Keynesian Economics is not merely theoretical; it is based on facts. It has practical implication. In a more positive sense, it stands up well before the facts of life.

Economic Growth A country's economic health can usually be measured by looking at that country's economic growth and development. This lesson defines and explains economic growth and economic development, including the role of U.S. foreign aid. A country's general economic health can be measured by looking at that country's economic growth and development. Let's take a separate look at what indicators comprise economic growth versus economic development. Let's first examine economic growth. A country's economic growth is usually indicated by an increase in that country's gross domestic product, or GDP. Generally speaking, gross domestic product is an economic model that reflects the value of a country's output. In other words, a country's GDP is the total monetary value of the goods and services produced by that country over a specific period of time.

Example of Economic Growth For example, let's say that a special berry grows naturally only in the country of Utopia. Natives to Utopia have used this berry for many years, but recently a wealthy German traveller discovered the berry and brought samples back to Germany. His German friends also loved the berry, so the traveller funded a large berry exporting business in Utopia. The new berry exporting business hired hundreds of Utopians to farm, harvest, wash, and box and ship the berries to grocers in Germany. In one calendar year, the berry exporting business added over one million dollars to Utopia's GDP because that's the total value of the goods and services produced by the new berry exporting business. Since Utopia's GDP increased, this means that Utopia experienced economic growth. In the United States, our periods of large economic growth are mostly associated with new technology. The Industrial Revolution and the development of the Internet are two examples. When new developments bring an increase in output capacity, economic growth usually follows.

Economic Development Now let's take a look at economic development. A country's economic development is usually indicated by an increase in citizens' quality of life. 'Quality of life' is often measured using the Human Development Index, which is an economic model that considers intrinsic personal factors not considered in economic growth, such as literacy rates, life expectancy and poverty rates. While economic growth often leads to economic development, it's important to note that a country's GDP doesn't include intrinsic development factors, such as leisure time, environmental quality or freedom from oppression. Using the Human

Development Index, factors like literacy rates and life expectancy generally imply a higher per capita income and therefore indicate economic development.

Example of Economic Development For example, before the berry exporting business, most Utopians lived in small villages many miles from one another. Few Utopians had access to schools, fresh water or healthcare. Utopian men worked long hours attempting to farm land that was naturally unsuitable for most crops, just to feed their immediate families. After the berry exporting business, many Utopians found work through the new industry. Newly employed villagers relocated closer to the business, giving them better access to schools, healthcare and fresh water produced for the plant and surrounding areas. Most Utopian men were able to trade labour-intensive hours in the fields for easier eight-hour shifts. Besides earning a salary, the new work enabled them more leisure time and contributed to longer life spans. Thus, Utopia experienced economic development through economic growth.

The Short-Run Costs of Automobile Assembly • Automobile assembly plants rarely change the speed of the line (the rate of production), the number of shifts run. • If the open for the week, they rarely operate fewer than 5 days a week. • They also use overtime quite often and the shutdown for week at time quite frequently. • Consider a single assembly plant. • Firm wishes to minimize costs for a given level of output. • Weekly production function is linear: cars per week = days open per week × shifts per day × hours per shift × cars per

• While the production function is linear, the firm faces a peculiar cost function due to its labour contract. • Workers on the second (evening) shift receive a 5 percent premium. • Any work in excess of eight hours in a day and all Saturday work is paid at a rate of time and an half. • Employees working fewer than 40 hours per week must be paid 85 percent of their hourly wage times the difierence between 40 and the number of hours worked. • This “short-week compensation” is in addition to the wages the worker receives for the hours s/he actually worked.

Cost in the Long Run • In the long-run the firm can change all of its inputs. • We will focus on two costs: labour cost and capital costs. The User Cost of Capital • The user cost of capital is cost of owning and using a capital asset. It is equal to the sum of the economic depreciation and the forgone interest. • What is a capital asset? An asset is something that maintains value over time. A capital asset is either a structure (e.g. a building, a house) or equipment (e.g. machines, furniture). • So consider Yale’s decision to buy an AV system. Let’s say it cost $20,000. • What is Yale’s annual cost of using this capital? • Yale incurs two costs. 1. The value of this AV system falls or depreciates each year for two reasons. (a) The more the AV system is used, the more it wears out. (b) As it gets older, the equipment becomes out of date. 2. Yale could have invested the $20,000 used to purchase the AV system and received the interest income of Interstate × $20, 000 each year. This is the opportunity cost of buying the AV system. • So User cost of capital = Economic Depreciation + (Interest Rate) × (Value of Cap • We often divide both sides of this equation by the value of capital to express the user cost of capital as a rate per dollar of capital r = Depreciation rate + (Interest Rate)

• We often assume capital depreciates at a rate of 7.5 percent per year. The rate is higher for computers, lower for buildings. Cost Minimization • Suppose the firm want to produced a given level of output. It wants to .nd the quantities of capital and labour that produce this much output at the minimum cost. • Assume the pool of workers is large enough and the firm is small enough that anything the firm does will not afiect the going wage rate. Let’s say that the firm take the going wage rate was given. • Let’s assume the firm rents its capital (ifie. its o.ce space, computers, machines, ...) at the user cost of capital r. – The owner of the capital will need to be compensated for the rate of return she could have earned investing her money elsewhere and for the depreciation of her capital. • So we write the total cost as C = w × L + r × K • We can write this as an isocost line K = C/r - (w/r)L An iso cost line is the set of combinations of labour and capital that yield the same total cost to the firm. • The slope of each one of these isocost lines is -w/r. That is, if the firm gave up one unit of labour (and thus saved w dollars in cost) to rent w/r unit of capital at a cost of r dollars per unit, its total cost of production would remain unchanged. • Suppose the firm wishes to produce q1 of output. What is the cost minimizing combination of capital and labour?

Changes in Input Prices • Suppose we increase the price of one of the two inputs. • Isoquant stays fixed.

• Slope of the iso cost curve changes and total cost changes. • Firm substitutes away from the more now relatively more expensive input. Changes in Output • Plot the firm’s expansion path and the long-run (fully fixable) cost curve. • In the short run we assume at least one factor is fixed cost so the short run expansion path is either horizontal or vertical. (We usually assume capital is fixed and labour is variable in the short run) Long-Run versus Short Run Average Cost Curves • Short-run average cost curve relates average cost of production to output when the level of capital is fixed. • Of course, over time all costs become variable. • The long run average cost curve (LAC) relates average cost of production to output when all inputs, including capital are variable.

• Consider three cases: 1. Increasing returns to scale: In this case a doubling of the inputs leads to a more than doubling of output. If the prices of capital and labour (ifie. user cost of capital and wages) do not depend on the size of the firm, then average cost must be decreasing with output. 2. Constant returns to scale: In this case a doubling of the inputs leads to exactly a doubling of output. In this case, average cost must be independent of the level of output. 3. Decreasing returns to scale: In this case a doubling of the inputs leads to a less than doubling of output. In this case, average cost must be increasing with output. • The long-run marginal cost curve (LMC) can be determined from the long-run average cost curve. – When LMC < LAC LAC is decreasing – When LMC > LAC LAC is increasing

Returns to scale In economics, returns to scale and economies of scale are related but different terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable (chosen by the firm). The term returns to scale arises in the context of a firm's production function. It explains the behavior of the rate of increase in output (production) relative to the associated increase in the inputs (the factors of production) in the long run. In the long run all factors of production are variable and subject to change due to a given increase in size (scale). While economies of scale show the effect of an increased output level on unit costs,returns to scale focus only on the relation between input and output quantities. The laws of returns to scale are a set of three interrelated and sequential laws: Law of Increasing Returns to Scale, Law of Constant Returns to Scale, and Law of Diminishing returns to Scale. If output increases by that same proportional change as all inputs change then there are constant returns to scale (CRS). If output increases by less than that proportional change in inputs, there are decreasing returns to scale (DRS). If output increases by more than that proportional change in inputs, there are increasing returns to scale (IRS). A firm's production function could exhibit different types of returns to scale in different ranges of output. Typically, there could be increasing returns at relatively low output levels, decreasing returns at relatively high output levels, and constant returns at one output level between those ranges.

In mainstream microeconomics, the returns to scale faced by a firm are purely technologically imposed and are not influenced by economic decisions or by market conditions (ifie., conclusions about returns to scale are derived from the specific mathematical structure of the production function in isolation). Example When all inputs increase by a factor of 2, new values for output will be: Twice the previous output if there are constant returns to scale (CRS) Less than twice the previous output if there are decreasing returns to scale (DRS) More than twice the previous output if there are increasing returns to scale (IRS) Assuming that the factor costs are constant (that is, that the firm is a perfect competitor in all input markets), a firm experiencing constant returns will have constant long-run average costs, a firm experiencing decreasing returns will have increasing long-run average costs, and a firm experiencing increasing returns will have decreasing long-run average costs. However, this relationship breaks down if the firm does not face perfectly competitive factor markets (ifie., in this context, the price one pays for a good does depend on the amount purchased). For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

Increasing, Decreasing, and Constant Returns to Scale [Q:]I was wondering if you could help me. If I have a production function that has both labour and capital as factors, how can I tell if it is increasing returns to scale, constant returns to scale, or decreasing returns to scale?

[A:] These three definitions look at what happens when you increase all inputs by a multiplier of m. Suppose our inputs are capital or labour, and we double each of these (m = 2), we want to know if our output will more than double, less than double, or exactly double. This leads to the following definitions: Increasing Returns to Scale When our inputs are increased by m, our output increases by more than m. Constant Returns to Scale When our inputs are increased by m, our output increases by exactly m. Decreasing Returns to Scale When our inputs are increased by m, our output increases by less than m. Our multiplier must always be positive, and greater than 1, since we want to look at what happens when we increase production. An m of 1.1 indicates that we've increased our inputs by 10% and an m of 3 indicates that we've tripled the amount of inputs we use. Now we will look at a few production functions and see if we have increasing, decreasing, or constant returns to scale

Summary of Short Run vs. Long Run in Microeconomics In microeconomics, the long run and the short run are defined by the number of fixed inputs that inhibit the production output as follows: short run, some inputs are variable, while some are fixed. New firms do not enter the industry, and existing firms do not exit. In the long run , all inputs are variable, and firms can enter and

exit the marketplace.

Scope and Nature of Managerial Economics

1.1 - Defining Managerial Economics Refers to the use of economic theory (micro and macro) and the tools of analysis of decision science (mathematical

economics and econometrics) to examine how an organization can achieve its aims and objectives most efficiently. Microeconomics – Is the study of decisions of individual people and businesses and the interaction of these decisions:

• Price & quantities of individual goods and services. • Effects of government regulation & taxation on prices and quantities of goods and services produced.

Macroeconomics - Is the study of the national economy and the global economy. • Effects of taxation and government spending on the economy and is measured through jobs, labour, output, income etc… • Effects of money and interest rates.

Mathematical Economics – Is used to formalize the economic models postulated by economic theory. Econometrics – applies statistical tools (regression analysis) to real world data to estimate models postulated by

economic theory and forecasting. Managerial economics combines or applies economic tools and techniques to business and administrative decision

making using micro, macro, mathematical and econometric models. Prescribes rules for improving managerial decisions and public policy. Integrates and applies microeconomic theory and methods to decision making problems faced by private, public, and

not-for-profit organizations. Managerial economics deals with microeconomic reasoning on real world problems such as pricing decisions selecting

the best strategy in different competitive environments. 1.2 - Relationship of Managerial Economics to other fields of study.

Managerial economics uses concepts and quantitative methods to solve managerial problems. Management Decision Problems - Product selection, output and pricing - Internet strategy

- Organizational design - Product development and promotion

- HR – hiring and training - Investment and financing

Economic Concepts Quantitative Methods - Marginal analysis - Numerical analysis - Theory of consumer demand - Statistical estimation - Theory of the firm - Forecasting procedures - Industrial organization - Game theory and firm behaviour - Optimization techniques - Public choice theory - Information systems Managerial Economics = Optimal Solutions to Management Decisions

To make good economic decisions, managers need to be able to forecast & estimate relationships. Seven steps in the decision making process. 1.3 - Theory of the firm

A firm may seek to maximize profits subject to limitations on the availability of essential inputs (skilled labour, land, capital and raw materials) and legal constraints (minimum wage laws, health and safety, and pollution). Value of the firm = Present value of expected future profits Such that: PV = Present value of all expected future profits

of the firm. Expected profits in each of

the n years considered. r = discount rate.

Example 1: The owner of a small business expects to generate a profit of $100,000 per year for 2 years and is going to sell the firm at the end of the second year for $800,000. The owner believes that the appropriate discount rate for the firm is 10 percent per year. What is the value of the small business

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7.710,834$

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based on the assumptions that the owner has set? Goals in the Public Sector and the Not-For-Profit (NFP) Enterprise

Public Goods are goods that can be consumed or used by more than one person at the same time with no extra cost.

Instead of profit, NFP organizations may have as their goals: 4. Maximization of output, subject to a budget constraint. 5. Maximization of the utility of NFP administrators.

6. Maximization of cash flows. 7. Maximization of the utility of contributors to the NFP organization.

•Which goal a NFP manager selects affects decisions made.

»A food bank manager may maximize the utility of clients by selecting only "healthy foods"

•Public sector managers are performance monitored.

»Hospital administrators are rewarded for reducing the cost per bed over a year. Hence, they become efficient with respect to costs.

»The "friendliness" of the hospital staff is harder to measure, so friendliness will tend not be a high priority of the public sector manager. Examples of NFPs

Not for profit organizations (NFP) Hospitals Universities / Colleges Museum

NFPs seek to reach some goal or objective subject to a constraint. What are the objectives of NFPs?

Hospital – objective (patients) University / college (students) Museum (customers) What are the constraints NPOs face?

Hospital (doctors, nurses, beds, facilities, equipment etc…)

University / college (Faculty, staff, funding sources, facilities, etc….)

Museum (funding, space etc…)

1.4 – Nature and Function of Profits Economic Profit

Economic profit = Total Revenue – Economic Costs Total Revenue = Price * Quantity

Economic costs include:

Explicit costs Are the actual out-of-pocket expenditures of the firm to hire labour, borrow capital, rent land and buildings and purchase raw materials. Implicit costs Are the money value of inputs owned and used by the firm in its own production processes.

Economic profit = Total Revenue – explicit costs - implicit costs

Accounting profit = Total Revenue – explicit costs Economic profit = Accounting profit – implicit costs

Normal profit = implicit costs = opportunity cost of owner-supplied resources

Economic profit = Accounting profit – normal profit

Example 2: The costs for a typical full-time student attending Trent University for their first yr of study in 2006-07 is $4,372 for tuition fees, $1,184 for compulsory and student fees, $8,500 for a residence room and a meal plan, and $650 for textbooks. As an alternative to attending University that same student could have earned $28,000 by getting a job in the labour market. In addition, they could have earned 4.5% interest by investing the money not spent on attending Trent University. Calculate explicit costs, implicit costs and economic costs. a) Explicit costs EC = $4,372 + $1,184 + $8,500 + $650 EC = $14,706 b) Implicit costs IC = Income Earned + Investing University Costs @ rate of return of 4.5% IC = $28,000 + ($14,706 * .045) IC = $28,000 + $661.77 IC = $28,661.77 c) Total economic cost that the student faces for that one year? Economic Costs = Explicit costs + Implicit Costs Economic Costs = $14,706 + $28,661.77 Economic Costs = $43,367.77

Profit Maximization Profit maximization and value maximization are equivalent in the long run If costs and revenue are independent of decisions made in other periods, short-run profit-maximization is equivalent

to value maximization Incentives

Separation of ownership and control Principal-agent problem

– Shareholders (principals) want profit – Managers (agents) want leisure & security

Moral hazard problem Incentive compatibility

– Equity ownership

– Outside directors Tie CEO pay to value of the firm Debt finance

Adds risk of bankruptcy and loss of job for managers Loans must be repaid Lenders provide monitoring

Market structure and decisions Economic theory postulates that the quantity demanded of a product (Q) is a function of, or depends upon, the price (P), the income of consumers (Y), and the prices of related commodities (complementary

and substitutes). Such that: ),,,( sc PPYPfQ

Control over price varies by market structure o Price-setting firms o Price-taking firms

Market = any arrangement through which buyers and sellers exchange goods or services

Transactions costs affect market outcomes and price dispersion

Alternative market structures # of and size of firms Degree of product differentiation

Likelihood of entry of new firms in response to economic profits

Perfect competition Large number of firms Homogeneous product No barriers to either entry or exit

Monopoly Single seller No close substitutes Barriers to entry

–Economies of scale

–Exclusive ownership of raw material

–Licensing, patents, copyrights, legal franchise

Local monopolies may exist

Monopolistic competition Many firms Differentiated product Free entry and exit

Oligopoly Few firms produce most output Homogeneous or differentiated product

Barriers to entry Recognized mutual interdependence

Globalization Increased global integration Growth of imports and exports in all industrialized

economies

Reduction in trade barriers Internet and reduced transaction costs NAFTA, FTAA, EU, EMU

Michael Porter - The 5 forces that determine competitive advantage are: Substitutes Potential Entrants

Buyer Power Supplier Power

Intensity of Rivalry

Business Cycle The term business cycle is referred to the recurrent ups and downs in the level of economic activity that extend over a period of time. The business fluctuations occur in aggregate variable such as national income, employment and price level. Business cycle is also called as “Trade Cycle” 4 Phases of Business Cycle Prosperity Phase : Expansion or Boom or Upswing of economy. Recession Phase : from prosperity to recession (upper turning point). Depression Phase : Contraction or Downswing of economy. Recovery Phase : from depression to prosperity (lower turning Point). Prosperity: Expansion & Peak When there is an expansion of output, income, employment, prices and profits, there is also a rise in the standard of living. This period is termed as Prosperity phase.

Rise in the national output & trade

Rise in consumer and capital expenditure

Rise in the Price of raw materials and finished goods

Rise in the level of income & employment Recession & Turning Point During a recession period, the economic activities slow down. When demand starts falling, the overproduction and future investment plans are also given up. There is a steady decline in the output, income, employment, prices and profits. Depression & Trough When there is a continuous decrease of output, income, employment, prices and profits, there is a fall in the standard of living and depression sets in. During the phase of Depression:

The growth rate become negative The level of national income and expenditure declines

Price of consumer and capital goods decline

Workers lose their job

Recovery Phase As the recovery gathers momentum, some firms plan additional investment; some undertake renovation programs, and some undertake both. These activities generate construction activities in both consumer & capital goods sector. As a result more employment is generated and wage rates moving upward.

DIFFERENCE B/W PERFECT COMPITITON, MONOPOLY MARKET AND MONOPOLISTIC MARKET

Basis of PERFECT COMPITITION MONOPOLY MARKET MONOPOLISTIC MARKET

Buyers Large no. Large no. Large no.

Seller Large no. Single seller Large no.

Product Homogeneous product Only one product Product differentiation of similar product

Substitute Perfect substitute No close substitute Many substitute

Entry and exit of new firm in industry

Freedom of both entry and exit (perfect mobility)

Fully restriction on entry & exit term not possible

Freedom of entry and exist is possible

Consumer knowledge Perfect consumer knowledge among buyer

Low of consumer knowledge Lack of perfect knowledge

Pricing decision Price taker Price maker Non price competition -competition -quality -brand name etc.

Selling cost Absence of selling cost Selling cost is high