LECTURE_NOTES_ON_MANAGERIAL_ECONOMICS.docx

LECTURE NOTES
ON
MANAGERIAL ECONOMICS

UNIT-I
INTRODUCTION TO MANAGERIAL ECONOMICS
Imagine for a while that you have finished your studies and have joined as an engineer in a
manufacturing organization. What do you do there? You plan to produce maximum quantity of goods of a
given quality at a reasonable cost. On the other hand, if you are a sale manager, you have to sell a maximum
amount of goods with minimum advertisement costs. In other words, you want to minimize your costs and
maximize your returns and by doing so, you are practicing the principles of managerial economics.
Managers, in their day-to-day activities, are always confronted with several issues such as how much
quantity is to be supplied; at what price; should the product be made internally; or whether it should be
bought from outside; how much quantity is to be produced to make a given amount of profit and so on.
Managerial economics provides us a basic insight into seeking solutions for managerial problems.
Managerial economics, as the name itself implies, is an offshoot of two distinct disciplines:
Economics and Management. In other words, it is necessary to understand what these disciplines are, at least
in brief, to understand the nature and scope of managerial economics.
Introduction to Economics
Economics is a study of human activity both at individual and national level. The economists of
early age treated economics merely as the science of wealth. The reason for this is clear. Every one of us in
involved in efforts aimed at earning money and spending this money to satisfy our wants such as food,
Clothing, shelter, and others. Such activities of earning and spending money are called
“Economic activities”. It was only during the eighteenth century that Adam Smith, the Father of Economics,
defined economics as the study of nature and uses of national wealth’.
Dr. Alfred Marshall, one of the greatest economists of the nineteenth century, writes “Economics is a
study of man’s actions in the ordinary business of life: it enquires how he gets his income and how he uses
it”. Thus, it is one side, a study of wealth; and on the other, and more important side; it is the study of man.
As Marshall observed, the chief aim of economics is to promote ‘human welfare’, but not wealth. The
definition given by AC Pigou endorses the opinion of Marshall. Pigou defines Economics as “the study of
economic welfare that can be brought directly and indirectly, into relationship with the measuring rod of
money”.
Prof. Lionel Robbins defined Economics as “the science, which studies human behaviour as a relationship
between ends and scarce means which have alternative uses”. With this, the focus of economics shifted from
‘wealth’ to human behaviour’.
Lord Keynes defined economics as ‘the study of the administration of scarce means and the determinants of
employments and income”.
Microeconomics
The study of an individual consumer or a firm is called microeconomics (also called the Theory of
Firm). Micro means ‘one millionth’. Microeconomics deals with behavior and problems of single individual
and of micro organization. Managerial economics has its roots in microeconomics and it deals with the micro
or individual enterprises. It is concerned with the application of the concepts such as price theory, Law of
Demand and theories of market structure and so on.
Macroeconomics
The study of ‘aggregate’ or total level of economics activity in a country is called macroeconomics.
It studies the flow of economics resources or factors of production (such as land, labour, capital, organisation
and technology) from the resource owner to the business firms and then from the business firms to the
households. It deals with total aggregates, for instance, total national income total employment, output and
total investment. It studies the interrelations among various aggregates and examines their nature and

behaviour, their determination and causes of fluctuations in the. It deals with the price level in general,
instead of studying the prices of individual commodities. It is concerned with the level of employment in the
economy. It discusses aggregate consumption, aggregate investment, price level, and payment, theories of
employment, and so on.
Though macroeconomics provides the necessary framework in term of government policies etc., for the firm
to act upon dealing with analysis of business conditions, it has less direct relevance in the study of theory of
firm.
Management
Management is the science and art of getting things done through people in formally organized
groups. It is necessary that every organisation be well managed to enable it to achieve its desired goals.
Management includes a number of functions: Planning, organizing, staffing, directing, and controlling. The
manager while directing the efforts of his staff communicates to them the goals, objectives, policies, and
procedures; coordinates their efforts; motivates them to sustain their enthusiasm; and leads them to achieve
the corporate goals.
Welfare Economics
Welfare economics is that branch of economics, which primarily deals with taking of poverty,
famine and distribution of wealth in an economy. This is also called Development Economics. The central
focus of welfare economics is to assess how well things are going for the members of the society. If certain
things have gone terribly bad in some situation, it is necessary to explain why things have gone wrong. Prof.
Amartya Sen was awarded the Nobel Prize in Economics in 1998 in recognition of his contributions to
welfare economics. Prof. Sen gained recognition for his studies of the 1974 famine in Bangladesh. His work
has challenged the common view that food shortage is the major cause of famine.
In the words of Prof. Sen, famines can occur even when the food supply is high but people cannot buy the
food because they don’t have money. There has never been a famine in a democratic country because leaders
of those nations are spurred into action by politics and free media. In undemocratic countries, the rulers are
unaffected by famine and there is no one to hold them accountable, even when millions die.
Welfare economics takes care of what managerial economics tends to ignore. In other words, the growth for
an economic growth with societal up liftment is countered productive. In times of crisis, what comes to the
rescue of people is their won literacy, public health facilities, a system of food distribution, stable
democracy, social safety, (that is, systems or policies that take care of people when things go wrong for one
reason or other).
Managerial Economics
Introduction
Managerial Economics as a subject gained popularity in USA after the publication of the book
“Managerial Economics” by Joel Dean in 1951.
Managerial Economics refers to the firm’s decision making process. It could be also interpreted as
“Economics of Management” or “Economics of Management”. Managerial Economics is also called
as “Industrial Economics” or “Business Economics”.
As Joel Dean observes managerial economics shows how economic analysis can be used in

formulating polices.
Meaning & Definition:
In the words of E. F. Brigham and J. L. Pappas Managerial Economics is “the applications of
economics theory and methodology to business administration practice”.
Managerial Economics bridges the gap between traditional economics theory and real business
practices in two days. First it provides a number of tools and techniques to enable the manager to
become more competent to take decisions in real and practical situations. Secondly it serves as an
integrating course to show the interaction between various areas in which the firm operates.
C. I. Savage & T. R. Small therefore believes that managerial economics “is concerned with business
efficiency”.
M. H. Spencer and Louis Siegelman explain the “Managerial Economics is the integration of
economic theory with business practice for the purpose of facilitating decision making and forward
planning by management”.
It is clear, therefore, that managerial economics deals with economic aspects of managerial decisions
of with those managerial decisions, which have an economics contest. Managerial economics may
therefore, be defined as a body of knowledge, techniques and practices which give substance to those
economic concepts which are useful in deciding the business strategy of a unit of management.
Managerial economics is designed to provide a rigorous treatment of those aspects of economic
theory and analysis that are most use for managerial decision analysis says J. L. Pappas and E. F.
Brigham.
Managerial Economics, therefore, focuses on those tools and techniques, which are useful in
decision- making.
Nature of Managerial Economics
Managerial economics is, perhaps, the youngest of all the social sciences. Since it originates from
Economics, it has the basis features of economics, such as assuming that other things remaining the
same (or the Latin equivalent ceteris paribus). This assumption is made to simplify the complexity of
the managerial phenomenon under study in a dynamic business environment so many things are
changing simultaneously. This set a limitation that we cannot really hold other things remaining the
same. In such a case, the observations made out of such a study will have a limited purpose or value.
Managerial economics also has inherited this problem from economics.
Further, it is assumed that the firm or the buyer acts in a rational manner (which normally does not
happen). The buyer is carried away by the advertisements, brand loyalties, incentives and so on, and,
therefore, the innate behaviour of the consumer will be rational is not a realistic assumption.
Unfortunately, there are no other alternatives to understand the subject other than by making such
assumptions. This is because the behaviour of a firm or a consumer is a complex phenomenon.

The other features of managerial economics are explained as below:
(a) Close to microeconomics: Managerial economics is concerned with finding the solutions for
different managerial problems of a particular firm. Thus, it is more close to microeconomics.
(b) Operates against the backdrop of macroeconomics: The macroeconomics conditions of the
economy are also seen as limiting factors for the firm to operate. In other words, the managerial
economist has to be aware of the limits set by the macroeconomics conditions such as government
industrial policy, inflation and so on.
(c) Normative statements: A normative statement usually includes or implies the words ‘ought’ or
‘should’. They reflect people’s moral attitudes and are expressions of what a team of people ought to
do. For instance, it deals with statements such as ‘Government of India should open up the economy.
Such statement are based on value judgments and express views of what is ‘good’ or ‘bad’, ‘right’ or
‘ wrong’. One problem with normative statements is that they cannot to verify by looking at the facts,
because they mostly deal with the future. Disagreements about such statements are usually settled by
voting on them.
(d) Prescriptive actions: Prescriptive action is goal oriented. Given a problem and the objectives of
the firm, it suggests the course of action from the available alternatives for optimal solution. If does
not merely mention the concept, it also explains whether the concept can be applied in a given
context on not. For instance, the fact that variable costs are marginal costs can be used to judge the
feasibility of an export order.
(e) Applied in nature: ‘Models’ are built to reflect the real life complex business situations and these
models are of immense help to managers for decision-making. The different areas where models are
extensively used include inventory control, optimization, project management etc. In managerial
economics, we also employ case study methods to conceptualize the problem, identify that
alternative and determine the best course of action.
(f) Offers scope to evaluate each alternative: Managerial economics provides an opportunity to
evaluate each alternative in terms of its costs and revenue. The managerial economist can decide
which is the better alternative to maximize the profits for the firm.
(g) Interdisciplinary: The contents, tools and techniques of managerial economics are drawn from
different subjects such as economics, management, mathematics, statistics, accountancy, psychology,
organizational behavior, sociology and etc.
(h) Assumptions and limitations: Every concept and theory of managerial economics is based on
certain assumption and as such their validity is not universal. Where there is change in assumptions,
the theory may not hold good at all.
Scope of Managerial Economics:
The scope of managerial economics refers to its area of study. Managerial economics refers to its
area of study. Managerial economics, Provides management with a strategic planning tool that can be
used to get a clear perspective of the way the business world works and what can be done to maintain
profitability in an ever-changing environment. Managerial economics is primarily concerned with the
application of economic principles and theories to five types of resource decisions made by all types
of business organizations.
a. The selection of product or service to be produced.
b. The choice of production methods and resource combinations.
c. The determination of the best price and quantity combination

d. Promotional strategy and activities.
e. The selection of the location from which to produce and sell goods or service to consumer.
The production department, marketing and sales department and the finance department usually
handle these five types of decisions.
The scope of managerial economics covers two areas of decision making
a. Operational or Internal issues
b. Environmental or External issues
a. Operational issues:
Operational issues refer to those, which wise within the business organization and they are under the
control of the management. Those are:
1. Theory of demand and Demand Forecasting
2. Pricing and Competitive strategy
3. Production cost analysis
4. Resource allocation
5. Profit analysis
6. Capital or Investment analysis
7. Strategic planning
1. Demand Analyses and Forecasting:
A firm can survive only if it is able to the demand for its product at the right time, within the right
quantity. Understanding the basic concepts of demand is essential for demand forecasting. Demand
analysis should be a basic activity of the firm because many of the other activities of the firms
depend upon the outcome of the demand fore cost. Demand analysis provides:
1. The basis for analyzing market influences on the firms; products and thus helps in the adaptation
to those influences.
2. Demand analysis also highlights for factors, which influence the demand for a product. This
helps to manipulate demand. Thus demand analysis studies not only the price elasticity but also
income elasticity, cross elasticity as well as the influence of advertising expenditure with the advent
of computers, demand forecasting has become an increasingly important function of managerial
economics.
2. Pricing and competitive strategy:
Pricing decisions have been always within the preview of managerial economics. Pricing policies are
merely a subset of broader class of managerial economic problems. Price theory helps to explain how
prices are determined under different types of market conditions. Competitions analysis includes the
anticipation of the response of competitions the firm’s pricing, advertising and marketing strategies.
Product line pricing and price forecasting occupy an important place here.
3. Production and cost analysis:
Production analysis is in physical terms. While the cost analysis is in monetary terms cost concepts
and classifications, cost-out-put relationships, economies and diseconomies of scale and production
functions are some of the points constituting cost and production analysis.
4. Resource Allocation:
Managerial Economics is the traditional economic theory that is concerned with the problem of
optimum allocation of scarce resources. Marginal analysis is applied to the problem of determining
the level of output, which maximizes profit. In this respect linear programming techniques has been
used to solve optimization problems. In fact lines programming is one of the most practical and
powerful managerial decision making tools currently available.

5. Profit analysis:
Profit making is the major goal of firms. There are several constraints here an account of competition
from other products, changing input prices and changing business environment hence in spite of
careful planning, there is always certain risk involved. Managerial economics deals with techniques
of averting of minimizing risks. Profit theory guides in the measurement and management of profit,
in calculating the pure return on capital, besides future profit planning.
6. Capital or investment analyses:
Capital is the foundation of business. Lack of capital may result in small size of operations.
Availability of capital from various sources like equity capital, institutional finance etc. may help to
undertake large-scale operations. Hence efficient allocation and management of capital is one of the
most important tasks of the managers. The major issues related to capital analysis are:
1. The choice of investment project
2. Evaluation of the efficiency of capital
3. Most efficient allocation of capital
Knowledge of capital theory can help very much in taking investment decisions. This involves,
capital budgeting, feasibility studies, analysis of cost of capital etc.
7. Strategic planning:
Strategic planning provides management with a framework on which long-term decisions can be
made which has an impact on the behavior of the firm. The firm sets certain long-term goals and
objectives and selects the strategies to achieve the same. Strategic planning is now a new addition to
the scope of managerial economics with the emergence of multinational corporations. The
perspective of strategic planning isglobal.
It is in contrast to project planning which focuses on a specific project or activity. In fact the
integration of managerial economics and strategic planning has given rise to be new area of study
called corporate economics.
B. Environmental or External Issues:
An environmental issue in managerial economics refers to the general business environment in which
the firm operates. They refer to general economic, social and political atmosphere within which the
firm operates. A study of economic environment should include:
a. The type of economic system in the country.
b. The general trends in production, employment, income, prices, saving and investment.
c. Trends in the working of financial institutions like banks, financial corporations, insurance
companies
d. Magnitude and trends in foreign trade;
e. Trends in labour and capital markets;
f. Government’s economic policies viz. industrial policy monetary policy, fiscal policy, price
policy etc.
The social environment refers to social structure as well as social organization like trade unions,
consumer’s co-operative etc. The Political environment refers to the nature of state activity, chiefly
states’ attitude towards private business, political stability etc.

The environmental issues highlight the social objective of a firm i.e.; the firm owes a responsibility
to the society. Private gains of the firm alone cannot be the goal.
The environmental or external issues relate managerial economics to macro economic theory while
operational issues relate the scope to micro economic theory. The scope of managerial economics is
ever widening with the dynamic role of big firms in a society.
Managerial economics relationship with other disciplines:
Many new subjects have evolved in recent years due to the interaction among basic disciplines.
While there are many such new subjects in natural and social sciences, managerial economics can be
taken as the best example of such a phenomenon among social sciences. Hence it is necessary to
trace its roots and relationship with other disciplines.
1. Relationship with economics:
The relationship between managerial economics and economics theory may be viewed form the point
of view of the two approaches to the subject Viz. Micro Economics and Marco Economics.
Microeconomics is the study of the economic behavior of individuals, firms and other such micro
organizations. Managerial economics is rooted in Micro Economic theory. Managerial Economics
makes use to several Micro Economic concepts such as marginal cost, marginal revenue, elasticity of
demand as well as price theory and theories of market structure to name only a few. Macro theory on
the other hand is the study of the economy as a whole. It deals with the analysis of national income,
the level of employment, general price level, consumption and investment in the economy and even
matters related to international trade, Money, public finance, etc.
The relationship between managerial economics and economics theory is like that of engineering
science to physics or of medicine to biology. Managerial economics has an applied bias and its wider
scope lies in

applying economic theory to solve real life problems of enterprises. Both managerial economics and
economics deal with problems of scarcity and resource allocation.
2. Management theory and accounting:
Managerial economics has been influenced by the developments in management theory and
accounting techniques. Accounting refers to the recording of pecuniary transactions of the firm in
certain books. A proper knowledge of accounting techniques is very essential for the success of the
firm because profit maximization is the major objective of the firm.
Managerial Economics requires a proper knowledge of cost and revenue information and their
classification. A student of managerial economics should be familiar with the generation,
interpretation and use of accounting data. The focus of accounting within the firm is fast changing
from the concepts of store keeping to that if managerial decision making, this has resulted in a new
specialized area of study called “Managerial Accounting”.
3. Managerial Economics and mathematics:
The use of mathematics is significant for managerial economics in view of its profit maximization
goal long with optional use of resources. The major problem of the firm is how to minimize cost, hoe
to maximize profit or how to optimize sales. Mathematical concepts and techniques are widely used
in economic logic to solve these problems. Also mathematical methods help to estimate and predict
the economic factors for decision making and forward planning.
Mathematical symbols are more convenient to handle and understand various concepts like
incremental cost, elasticity of demand etc., Geometry, Algebra and calculus are the major branches of
mathematics which are of use in managerial economics. The main concepts of mathematics like
logarithms, and exponentials, vectors and determinants, input-output models etc., are widely used.
Besides these usual tools, more advanced techniques designed in the recent years viz. linear
programming, inventory models and game theory fine wide application in managerial economics.
4. Managerial Economics and Statistics:
Managerial Economics needs the tools of statistics in more than one way. A successful businessman
must correctly estimate the demand for his product. He should be able to analyses the impact of
variations in tastes. Fashion and changes in income on demand only then he can adjust his output.
Statistical methods
provide and sure base for decision-making. Thus statistical tools are used in collecting data and
analyzing them to help in the decision making process.
Statistical tools like the theory of probability and forecasting techniques help the firm to predict the
future course of events. Managerial Economics also make use of correlation and multiple regressions
in related variables like price and demand to estimate the extent of dependence of one variable on the

other. The theory of probability is very useful in problems involving uncertainty.
5. Managerial Economics and Operations Research:
Taking effectives decisions is the major concern of both managerial economics and operations
research. The development of techniques and concepts such as linear programming, inventory models
and game theory is due to the development of this new subject of operations research in the postwar
years. Operations research is concerned with the complex problems arising out of the management of
men, machines, materials and money.
Operation research provides a scientific model of the system and it helps managerial economists in
the field of product development, material management, and inventory control, quality control,
marketing and demand analysis. The varied tools of operations Research are helpful to managerial
economists in decision- making.
6. Managerial Economics and the theory of Decision- making:
The Theory of decision-making is a new field of knowledge grown in the second half of this century.
Most of the economic theories explain a single goal for the consumer i.e., Profit maximization for the
firm. But the theory of decision-making is developed to explain multiplicity of goals and lot of
uncertainty.
As such this new branch of knowledge is useful to business firms, which have to take quick decision
in the case of multiple goals. Viewed this way the theory of decision making is more practical and
application oriented than the economic theories.
7. Managerial Economics and Computer Science:
Computers have changes the way of the world functions and economic or business activity is no
exception. Computers are used in data and accounts maintenance, inventory and stock controls and
supply and demand predictions. What used to take days and months is done in a few minutes or hours
by the computers. In fact computerization of business activities on a large scale has reduced the
workload of managerial personnel. In most countries a basic knowledge of computer science, is a
compulsory programme for managerial trainees.

To conclude, managerial economics, which is an offshoot traditional economics, has gained strength to be a
separate branch of knowledge. It strength lies in its ability to integrate ideas from various specialized
subjects to gain a proper perspective for decision-making.
A successful managerial economist must be a mathematician, a statistician and an economist. He must be
also able to combine philosophic methods with historical methods to get the right perspective only then; he
will be good at predictions. In short managerial practices with the help of other allied sciences.
THE ROLE OF MANAGERIAL ECONOMIST
Making decisions and processing information are the two primary tasks of the managers. Managerial
economists have gained importance in recent years with the emergence of an organizational culture in
production and sales activities.
A management economist with sound knowledge of theory and analytical tools for information system
occupies a prestigious place among the personnel. A managerial economist is nearer to the policy-making.
Equipped with specialized skills and modern techniques he analyses the internal and external operations of
the firm. He evaluates and helps in decision making regarding sales, Pricing financial issues, labour relations
and profitability. He helps in decision-making keeping in view the different goals of the firm.
His role in decision-making applies to routine affairs such as price fixation, improvement in quality,
Location of plant, expansion or contraction of output etc. The role of managerial economist in internal
management covers wide areas of production, sales and inventory schedules of the firm.
The most important role of the managerial economist relates to demand forecasting because an analysis of
general business conditions is most vital for the success of the firm. He prepares a short-term forecast of
general business activity and relates general economic forecasts to specific market trends. Most firms require
two forecasts one covering the short term (for nest three months to one year) and the other covering the long
term, which represents any period exceeding one-year. He has to be ever alert to gauge the changes in tastes
and preferences of the consumers. He should evaluate the market potential. The need to know forecasting
techniques on the part of the managerial economics means, he should be adept at market research. The
purpose of market research is to provide a firm with information about current market position as well as
present and possible future trends in the industry. A managerial economist who is well equipped with this
knowledge can help the firm to plan product improvement, new product policy, pricing, and sales promotion
strategy.
The fourth function of the managerial economist is to undertake an economic analysis of the industry. This is
concerned with project evaluation and feasibility study at the firm level i.e., he should be able to judge on the
basis of cost benefit analysis, whether it is advisable and profitable to go ahead with the project. The
managerial economist should be adept at investment appraisal methods. At the external level, economic
analysis involves the knowledge of competition involved, possibility of internal and foreign sales, the
general business climate etc.

Another function is security management analysis. This is very important in the case of defense-oriented
industries, power projects, and nuclear plants where security is very essential. Security management means,
also that the production and trade secrets concerning technology, quality and other such related facts should
not be leaked out to others. This security is more necessary in strategic and defense-oriented projects of
national importance; a managerial economist should be able to manage these issues of security management
analysis.
The sixth function is an advisory function. Here his advice is required on all matters of production and trade.
In the hierarchy of management, a managerial economist ranks next to the top executives or the policy maker
who may be doyens of several projects. It is the managerial economist of each firm who has to advise them
on all matters of trade since they are in the know of actual functioning of the unit in all aspects, both
technical and financial.
Another function of importance for the managerial economist is a concerned with pricing and related
problems. The success of the firm depends upon a proper pricing strategy. The pricing decision is one of the
most difficult decisions to be made in business because the information required is never fully available.
Pricing of established products is different from new products. He may have to operate in an atmosphere
constrained by government regulation. He may have to anticipate the reactions of competitors in pricing. The
managerial economist has to be very alert and dynamic to take correct pricing decision in changing
environment.
Finally the specific function of a managerial economist includes an analysis of environment issues. Modern
theory of managerial economics recognizes the social responsibility of the firm. It refers to the impact of a
firm on environmental factors. It should not have adverse impact on pollution and if possible try to
contribute to environmental preservation and protection in a positive way.
The role of management economist lies not in taking decision but in analyzing, concluding and
recommending to the policy maker. He should have the freedom to operate and analyze and must possess full
knowledge of facts. He has to collect and provide the quantitative data from within the firm. He has to get
information on external business environment such as general market conditions, trade cycles, and behavior
pattern of the consumers. The managerial economist helps to co-ordinate policies relating to production,
investment, inventories and price.
He should have equanimity to meet crisis. He should act only after analysis and discussion with relevant
departments. He should have diplomacy to act in advisory capacity to the top executive as well as getting co-
operation from different departments for his economic analysis. He should do well to have intuitive ability to
know what is good or bad for the firm.
He should have sound theoretical knowledge to take up the challenges he has to face in actual day to day
affairs. “BANMOL” referring to the role of managerial economist points out. “A managerial economist can
become a for more helpful member of a management group by virtue of studies of economic analysis,
primarily because there he learns to become an effective model builder and because there he acquires a very
rich body of tools and techniques which can help to deal with the problems of the firm in a far more rigorous,
a far more probing and a far deeper manner”.

QUESTIONS
1. What is managerial economics? Explain its focus are as
2. Point out the importance of managerial economics in decision making
3. What are the contributions and limitations of economic analysis in business decision making
4. Managerial Economics is the discipline which deals with the applications of economic theory to business
management discuss.
5. Explain the fundamental concepts of managerial economics
6. Discuss the nature & Scope of Managerial economics
7. Managerial Economics is the study of allocation of resources available to a firm or other unit of
management among the activities of that unit explains.
8. Explain the nature of problems studies in managerial economics. What is the importance of the study of
such problems in business management?
9. Explain the role and responsibilities of a managerial economics?
10. “Managerial Economics is integration of economic theory and with business practice for
the purpose of facilitating decision making and forward planning” explain.
QUIZ
1. Managerial Economics as a subject gained popularity first in . ( )
(a) India (b) Germany (c) U.S.A (d) England
2. When the subject Managerial Economics gained popularity? ( ) (a) 1950 (b) 1949
3. Which subject studies the behavior of the firm in theory and practice? ( )
(a) Micro Economics (b) Macro Economics
(c) Managerial Economics (d) Welfare Economics
4. Which subject bridges gap between Economic Theory and
Management Practice? ( )
(a) Welfare Economics (b) Micro Economics
(c) Managerial Economics (d) Macro Economics
5. Application of Economics for managerial decision-making is called . ( )
(a) Macro Economics (b) Welfare Economics
(c) Managerial Economics (d) Micro Economics
6. Which areas covered by the subject “Managerial Economics”. ( )
(a) Operational issues (b) Environmental issues
(c) Operational & Environmental issues (d) None
7. The relationship between Managerial Economics and Economic Theory is
like that of Engineering Science to Physics (or) Medicine to . ( )
(a) Mathematics (b) Economics
(c) Biology (d) Accountancy

8. Making decisions and processing information are the two Primary tasks of
the Managers . It was explained by the subject . ( )
(a) Physics (b) Engineering Science
(c) Managerial Economics (d) Chemistry
9. Managerial Economics is close to Economics ( )
(a) National (b) Business (c) Micro (d) Industrial
10. The theory of firm also called as . ( )
(a) Welfare Economics (b) Industrial Economics
(c) Micro Economics (d) None
11. “Any activity aimed at earning or spending money is called activity”. ( )
(a) Service activity (b) Accounting activity
(c) Economic activity (d) None
Note: Answer is “C” for all the above questions.
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DEMAND ANALYSIS
Introduction & Meaning:
Demand in common parlance means the desire for an object. But in economics demand is something
more than this. According to Stonier and Hague, “Demand in economics means demand backed up
by enough money to pay for the goods demanded”. This means that the demand becomes effective
only it if is backed by the purchasing power in addition to this there must be willingness to buy a
commodity.
Thus demand in economics means the desire backed by the willingness to buy a commodity and the
purchasing power to pay. In the words of “Benham” “The demand for anything at a given price is the
amount of it which will be bought per unit of time at that Price”. (Thus demand is always at a price
for a definite quantity at a specified time.) Thus demand has three essentials – price, quantity
demanded and time. Without these, demand has to significance in economics.
LAW of Demand:
Law of demand shows the relation between price and quantity demanded of a commodity in the
market. In the words of Marshall, “the amount demand increases with a fall in price and diminishes
with a rise in price”.
A rise in the price of a commodity is followed by a reduction in demand and a fall in price is
followed by an increase in demand, if a condition of demand remains constant.
The law of demand may be explained with the help of the following demand schedule.
Demand Schedule.
Price of Appel (In. Rs.) Quantity Demanded
10 1
8 2
6 3
4 4
2 5
When the price falls from Rs.
10 to 8
quantity demand increases from 1
to 2. In
the same way as price falls, quantity
demand
increases on the basis of the demand
schedule
we can draw the demand curve.

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Price
The demand curve DD shows the inverse relation between price and quantity demand of apple. It is
downward sloping.
Assumptions:
Law is demand is based on certain assumptions:
1. This is no change in consumers taste and preferences.
2. Income should remain constant.
3. Prices of other goods should not change.
4. There should be no substitute for the commodity
5. The commodity should not confer at any distinction
6. The demand for the commodity should be continuous
7. People should not expect any change in the price of the commodity
Exceptional demand curve:
Some times the demand curve slopes upwards from left to right. In this case the demand curve has a
positive slope.
Price
When price increases from OP to Op1 quantity demanded also increases from to OQ1 and vice versa.
The reasons for exceptional demand curve are as follows.

1. Giffen paradox:
The Giffen good or inferior good is an exception to the law of demand. When the price of an inferior
good falls, the poor will buy less and vice versa. For example, when the price of maize falls, the poor
are willing to spend more on superior goods than on maize if the price of maize increases, he has to
increase the quantity of money spent on it. Otherwise he will have to face starvation. Thus a fall in
price is followed by reduction in quantity demanded and vice versa. “Giffen” first explained this and
therefore it is called as Giffen’s paradox.
2. Veblen or Demonstration effect:
‘Veblan’ has explained the exceptional demand curve through his doctrine of conspicuous
consumption. Rich people buy certain good because it gives social distinction or prestige for example
diamonds are bought by the richer class for the prestige it possess. It the price of diamonds falls poor
also will buy is hence they will not give prestige. Therefore, rich people may stop buying this
commodity.
3. Ignorance:
Sometimes, the quality of the commodity is Judge by its price. Consumers think that the product is
superior if the price is high. As such they buy more at a higher price.
4. Speculative effect:
If the price of the commodity is increasing the consumers will buy more of it because of the fear that
it increase still further, Thus, an increase in price may not be accomplished by a decrease in demand.
5. Fear of shortage:
During the times of emergency of war People may expect shortage of a commodity. At that time,
they may buy more at a higher price to keep stocks for the future.
5. Necessaries:
In the case of necessaries like rice, vegetables etc. people buy more even at a higher price.
Factors Affecting Demand:
There are factors on which the demand for a commodity depends. These factors are economic, social
as well as political factors. The effect of all the factors on the amount demanded for the commodity is
called Demand Function.
These factors are as follows:

1. Price of the Commodity:
The most important factor-affecting amount demanded is the price of the commodity. The amount of
a commodity demanded at a particular price is more properly called price demand. The relation
between price and demand is called the Law of Demand. It is not only the existing price but also the
expected changes in price, which affect demand.
2. Income of the Consumer:
The second most important factor influencing demand is consumer income. In fact, we can establish
a relation between the consumer income and the demand at different levels of income, price and
other things remaining the same. The demand for a normal commodity goes up when income rises
and falls down when income falls. But in case of Giffen goods the relationship is the opposite.
3. Prices of related goods:
The demand for a commodity is also affected by the changes in prices of the related goods also.
Related goods can be of two types:
(i). Substitutes which can replace each other in use; for example, tea and coffee
are substitutes. The change in price of a substitute has effect on a commodity’s
demand in the same direction in which price changes. The rise in price of coffee
shall raise the demand for tea;
(ii). Complementary foods are those which are jointly demanded, such as pen and
ink. In such cases complementary goods have opposite relationship between price of
one commodity and the amount demanded for the other. If the price of pens goes
up, their demand is less as a result of which the demand for ink is also less. The
price and demand go in opposite direction. The effect of changes in price of a commodity
on amounts demanded of related commodities is called Cross Demand.
4. Tastes of the Consumers:
The amount demanded also depends on consumer’s taste. Tastes include fashion, habit, customs, etc.
A consumer’s taste is also affected by advertisement. If the taste for a commodity goes up, its amount
demanded is more even at the same price. This is called increase in demand. The opposite is called
decrease in demand.
5. Wealth:

The amount demanded of commodity is also affected by the amount of wealth as well as its
distribution. The wealthier are the people; higher is the demand for normal commodities. If wealth is
more equally distributed, the demand for necessaries and comforts is more. On the other hand, if
some people are rich, while the majorities are poor, the demand for luxuries is generally higher.
6. Population:
Increase in population increases demand for necessaries of life. The composition of population also
affects demand. Composition of population means the proportion of young and old and children as
well as the ratio of men to women. A change in composition of population has an effect on the nature
of demand for different commodities.
7. Government Policy:
Government policy affects the demands for commodities through taxation. Taxing a commodity
increases its price and the demand goes down. Similarly, financial help from the government
increases the demand for a commodity while lowering its price.
8. Expectations regarding the future:
If consumers expect changes in price of commodity in future, they will change the demand at present
even when the present price remains the same. Similarly, if consumers expect their incomes to rise in
the near future they may increase the demand for a commodity just now.
9. Climate and weather:
The climate of an area and the weather prevailing there has a decisive effect on consumer’s demand.
In cold areas woolen cloth is demanded. During hot summer days, ice is very much in demand. On a
rainy day, ice cream is not so much demanded.
10. State of business:
The level of demand for different commodities also depends upon the business conditions in the
country. If the country is passing through boom conditions, there will be a marked increase in
demand. On the other hand, the level of demand goes down during depression.

ELASTICITY OF DEMAND
Elasticity of demand explains the relationship between a change in price and consequent change in
amount demanded. “Marshall” introduced the concept of elasticity of demand. Elasticity of demand
shows the extent of change in quantity demanded to a change in price.
In the words of “Marshall”, “The elasticity of demand in a market is great or small according as the
amount demanded increases much or little for a given fall in the price and diminishes much or little

for a given rise in Price”

Elastic demand: A small change in price may lead to a great change in quantity demanded. In this
case, demand is elastic.
In-elastic demand: If a big change in price is followed by a small change in demanded then the demand in
“inelastic”.
Types of Elasticity of Demand:
There are three types of elasticity of demand:
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
1. Price elasticity of demand:
Marshall was the first economist to define price elasticity of demand. Price elasticity of demand
measures changes in quantity demand to a change in Price. It is the ratio of percentage change in
quantity demanded to a percentage change in price.
Proportionate change in the quantity demand of commodity
Price elasticity = ------------------------------------------------------------------
Proportionate change in the price of commodity There are five
cases of price elasticity of demand
A. Perfectly elastic demand:
When small change in price leads to an infinitely large change is quantity demand, it is called
perfectly or infinitely elastic demand. In this case E=∞

The demand curve DD1 is horizontal straight line. It shows the at “OP” price any amount is demand
and if price increases, the consumer will not purchase the commodity.
B. Perfectly Inelastic Demand
In this case, even a large change in price fails to bring about a change in quantity demanded.
When price increases from ‘OP’ to ‘OP’, the quantity demanded remains the same. In other words
the response of demand to a change in Price is nil. In this case ‘E’=0.
C. Relatively elastic demand:
Demand changes more than proportionately to a change in price. i.e. a small change in price loads to
a very big change in the quantity demanded. In this case
E > 1. This demand curve will be flatter.
When price falls from ‘OP’ to ‘OP’, amount demanded in crease from “OQ’ to “OQ1’ which is
larger than the change in price.

D. Relatively in-elastic demand.
Quantity demanded changes less than proportional to a change in price. A large change in price
leads to small change in amount demanded. Here E < 1. Demanded carve will be steeper.
When price falls from “OP’ to ‘OP1 amount demanded increases from OQ to OQ1, which is smaller
than the change in price.
E. Unit elasticity of demand:
The change in demand is exactly equal to the change in price. When both are equal E=1 and elasticity
if said to be unitary.

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When price falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OP’ to ‘OP1’, quantity
demanded increases from ‘OQ’ to ‘OQ1’. Thus a change in price has resulted in an equal change in
quantity demanded so price elasticity of demand is equal to unity.
2. Income elasticity of demand:
Income elasticity of demand shows the change in quantity demanded as a result of a change in
income. Income elasticity of demand may be slated in the form of a formula.
Proportionate change in the quantity demand of commodity
Income Elasticity = ------------------------------------------------------------------
Proportionate change in the income of the people Income
elasticity of demand can be classified in to five types.
A. Zero income elasticity:
Quantity demanded remains the same, even though money income increases. Symbolically, it can be
expressed as Ey=0. It can be depicted in the following way:
As income increases from
OY to
OY1, quantity demanded never changes.
B. Negative Income elasticity:
When income increases, quantity demanded falls. In this case, income elasticity of demand is
negative. i.e., Ey < 0.

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When income increases from OY to OY1, demand falls from OQ to OQ1.
c. Unit income elasticity:
When an increase in income brings about a proportionate increase in quantity demanded, and then
income elasticity of demand is equal to one. Ey = 1
When income increases from OY to OY1, Quantity demanded also increases from OQ to OQ1.
d. Income elasticity greater than unity:
In this case, an increase in come brings about a more than proportionate increase in quantity
demanded. Symbolically it can be written as Ey > 1.

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It shows high-income elasticity of demand. When income increases
from OY to OY1, Quantity demanded increases from OQ to OQ1.
E. Income elasticity leas than unity:
When income increases quantity demanded also increases but less than proportionately. In this case E < 1.
An increase in income from OY to OY, brings what an increase in quantity demanded from OQ to
OQ1, But the increase in quantity demanded is smaller than the increase in income. Hence, income
elasticity of demand is less than one.
3. Cross elasticity of Demand:
A change in the price of one commodity leads to a change in the quantity demanded of another
commodity. This is called a cross elasticity of demand. The formula for cross elasticity of demand is:
Proportionate change in the quantity demand of commodity “X” Cross
elasticity = -----------------------------------------------------------------------
Proportionate change in the price of commodity “Y”
a. In case of substitutes, cross elasticity of demand is positive. Eg: Coffee and Tea
When the price of coffee increases, Quantity
demanded of
tea increases. Both are substitutes.

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Price of Coffee
b. Incase of compliments, cross elasticity is negative. If increase in the price of one
commodity leads to a decrease in the quantity demanded of another and vice versa.
When price of car goes up from OP to OP!, the quantity demanded of petrol decreases from OQ to
OQ!. The cross-demanded curve has negative slope.
c. In case of unrelated commodities, cross elasticity of demanded is zero. A change in the
price of one commodity will not affect the quantity demanded of another.
Quantity demanded of commodity “b” remains unchanged due to a change in the price of ‘A’, as both are
unrelated goods.
Factors influencing the elasticity of demand

Elasticity of demand depends on many factors.
1. Nature of commodity:
Elasticity or in-elasticity of demand depends on the nature of the commodity i.e. whether a commodity is
a necessity, comfort or luxury, normally; the demand for Necessaries like salt, rice etc is inelastic. On the
other band, the demand for comforts and luxuries is elastic.
2. Availability of substitutes:
Elasticity of demand depends on availability or non-availability of substitutes. In case of commodities,
which have substitutes, demand is elastic, but in case of commodities, which have no substitutes,
demand is inelastic.
3. Variety of uses:
If a commodity can be used for several purposes, than it will have elastic demand. i.e. electricity. On the
other hand, demanded is inelastic for commodities, which can be put to only one use.
4. Postponement of demand:
If the consumption of a commodity can be postponed, than it will have elastic demand. On the contrary, if
the demand for a commodity cannot be postpones, than demand is in elastic. The demand for rice or
medicine cannot be postponed, while the demand for Cycle or umbrella can be postponed.
5. Amount of money spent:
Elasticity of demand depends on the amount of money spent on the commodity. If the consumer spends a
smaller for example a consumer spends a little amount on salt and matchboxes. Even when price of salt or
matchbox goes up, demanded will not fall. Therefore, demand is in case of clothing a consumer spends a
large proportion of his income and an increase in price will reduce his demand for clothing. So the
demand is elastic.
6. Time:
Elasticity of demand varies with time. Generally, demand is inelastic during short period and elastic
during the long period. Demand is inelastic during short period because the consumers do not have
enough time to know

about the change is price. Even if they are aware of the price change, they may not immediately switch
over to a new commodity, as they are accustomed to the old commodity.
7. Range of Prices:
Range of prices exerts an important influence on elasticity of demand. At a very high price, demand is
inelastic because a slight fall in price will not induce the people buy more. Similarly at a low price also
demand is inelastic. This is because at a low price all those who want to buy the commodity would have
bought it and a further fall in price will not increase the demand. Therefore, elasticity is low at very him
and very low prices.
Importance of Elasticity of Demand:
The concept of elasticity of demand is of much practical importance.
1. Price fixation:
Each seller under monopoly and imperfect competition has to take into account elasticity of demand while
fixing the price for his product. If the demand for the product is inelastic, he can fix a higher price.
2. Production:
Producers generally decide their production level on the basis of demand for the product. Hence elasticity
of demand helps the producers to take correct decision regarding the level of cut put to be produced.
3. Distribution:
Elasticity of demand also helps in the determination of rewards for factors of production. For example, if
the demand for labour is inelastic, trade unions will be successful in raising wages. It is applicable to other
factors of production.
4. International Trade:
Elasticity of demand helps in finding out the terms of trade between two countries. Terms of trade refers
to the rate at which domestic commodity is exchanged for foreign commodities. Terms of trade depends
upon the elasticity of demand of the two countries for each other goods.
5. Public Finance:

Elasticity of demand helps the government in formulating tax policies. For example, for imposing tax on a
commodity, the Finance Minister has to take into account the elasticity of demand.
6. Nationalization:
The concept of elasticity of demand enables the government to decide about nationalization of industries.
Demand Forecasting
Introduction:
The information about the future is essential for both new firms and those planning to expand the scale of
their production. Demand forecasting refers to an estimate of future demand for the product.
It is an ‘objective assessment of the future course of demand”. In recent times, forecasting plays an
important role in business decision-making. Demand forecasting has an important influence on production
planning. It is essential for a firm to produce the required quantities at the right time.
It is essential to distinguish between forecasts of demand and forecasts of sales. Sales forecast is important
for estimating revenue cash requirements and expenses. Demand forecasts relate to production, inventory
control, timing, reliability of forecast etc. However, there is not much difference between these two terms.
Types of demand Forecasting:
Based on the time span and planning requirements of business firms, demand forecasting can be classified
in to 1. Short-term demand forecasting and
2. Long – term demand forecasting.
1. Short-term demand forecasting:
Short-term demand forecasting is limited to short periods, usually for one year. It relates to policies
regarding sales, purchase, price and finances. It refers to existing production capacity of the firm. Short-
term forecasting is essential for formulating is essential for formulating a suitable price policy. If the
business people expect of rise in the prices of raw materials of shortages, they may buy early. This price
forecasting helps in sale policy formulation. Production may be undertaken based on expected sales and
not on actual sales. Further, demand forecasting assists in financial forecasting also. Prior information
about production and sales is essential to provide additional funds on reasonable terms.
2. Long – term forecasting:
In long-term forecasting, the businessmen should now about the long-term demand for the product.
Planning of a new plant or expansion of an existing unit depends on long-term demand. Similarly a multi
product firm must take

into account the demand for different items. When forecast are mode covering long periods, the
probability of error is high. It is vary difficult to forecast the production, the trend of prices and the nature
of competition. Hence quality and competent forecasts are essential.
Prof. C. I. Savage and T.R. Small classify demand forecasting into time types. They are 1. Economic forecasting,
2. Industry forecasting, 3. Firm level forecasting. Economics forecasting is concerned with the economics,
while industrial level forecasting is used for inter-industry comparisons and is being supplied by trade
association or chamber of commerce. Firm level forecasting relates to individual firm.
Methods of forecasting:
Several methods are employed for forecasting demand. All these methods can be grouped under survey
method and statistical method. Survey methods and statistical methods are further subdivided in to
different categories.
1. Survey Method:
Under this method, information about the desires of the consumer and opinion of exports are collected by
interviewing them. Survey method can be divided into four type’s viz., Option survey method; expert
opinion; Delphi method and consumers interview methods.
a. Opinion survey method:
This method is also known as sales-force composite method (or) collective opinion method. Under this
method, the company asks its salesman to submit estimate of future sales in their respective territories.
Since the forecasts of the salesmen are biased due to their optimistic or pessimistic attitude ignorance
about economic developments etc. these estimates are consolidated, reviewed and adjusted by the top
executives. In case of wide differences, an average is struck to make the forecasts realistic.
This method is more useful and appropriate because the salesmen are more knowledge. They can be
important source of information. They are cooperative. The implementation within unbiased or their basic
can be corrected.
B. Expert opinion method:
Apart from salesmen and consumers, distributors or outside experts may also e used for forecasting. In the
United States of America, the automobile companies get sales estimates directly from their dealers. Firms
in advanced countries make use of outside experts for estimating future demand. Various public and
private agencies all periodic forecasts of short or long term business conditions.
C. Delphi Method:

A variant of the survey method is Delphi method. It is a sophisticated method to arrive at a consensus.
Under this method, a panel is selected to give suggestions to solve the problems in hand. Both internal and
external experts can be the members of the panel. Panel members one kept apart from each other and
express their views in an anonymous manner. There is also a coordinator who acts as an intermediary
among the panelists. He prepares the questionnaire and sends it to the panelist. At the end of each round,
he prepares a summary report. On the basis of the summary report the panel members have to give
suggestions. This method has been used in the area of technological forecasting. It has proved more
popular in forecasting. It has provided more popular in forecasting non-economic rather than economic
variables.
D. Consumers interview method:
In this method the consumers are contacted personally to know about their plans and preference regarding
the consumption of the product. A list of all potential buyers would be drawn and each buyer will be
approached and asked how much he plans to buy the listed product in future. He would be asked the
proportion in which he intends to buy. This method seems to be the most ideal method for forecasting
demand.
2. Statistical Methods:
Statistical method is used for long run forecasting. In this method, statistical and mathematical techniques
are used to forecast demand. This method relies on post data.
a. Time series analysis or trend projection methods:
A well-established firm would have accumulated data. These data are analyzed to determine the nature of
existing trend. Then, this trend is projected in to the future and the results are used as the basis for
forecast. This is called as time series analysis. This data can be presented either in a tabular form or a
graph. In the time series post data of sales are used to forecast future.
b. Barometric Technique:
Simple trend projections are not capable of forecasting turning paints. Under Barometric method, present
events are used to predict the directions of change in future. This is done with the help of economics and
statistical indicators. Those are (1) Construction Contracts awarded for building materials (2) Personal
income (3) Agricultural Income. (4) Employment (5) Gross national income (6) Industrial Production (7)
Bank Deposits etc.
c. Regression and correlation method:
Regression and correlation are used for forecasting demand. Based on post data the future data trend is
forecasted. If the functional relationship is analyzed with the independent variable it is simple correction.
When there are several independent variables it is multiple correlation. In correlation we analyze the
nature of relation between the variables while in regression; the extent of relation between the variables is
analyzed. The results are

expressed in mathematical form. Therefore, it is called as econometric model building. The main
advantage of this method is that it provides the values of the independent variables from within the model
itself.

UNIT - II
PRODUCTION FUNCTION
Introduction: The production function expresses a functional relationship between physical inputs and
physical outputs of a firm at any particular time period. The output is thus a function of inputs.
Mathematically production function can be written as
Q= f (A, B, C, D)
Where “Q” stands for the quantity of output and A, B, C, D are various input factors such as land, labour,
capital and organization. Here output is the function of inputs. Hence output becomes the dependent
variable and inputs are the independent variables.
The above function does not state by how much the output of “Q” changes as a consequence of change of
variable inputs. In order to express the quantitative relationship between inputs and output, Production
function has been expressed in a precise mathematical equation i.e.
Y= a+b(x)
Which shows that there is a constant relationship between applications of input (the only factor input
‘X’ in this case) and the amount of output (y) produced.
Importance:
1. When inputs are specified in physical units, production function helps to estimate the level of
production.
2. It becomes is equates when different combinations of inputs yield the same level of output.
3. It indicates the manner in which the firm can substitute on input for another without
altering the total output.
4. When price is taken into consideration, the production function helps to select the least
combination of inputs for the desired output.
5. It considers two types’ input-output relationships namely ‘law of variable proportions’
and ‘law of returns to scale’. Law of variable propositions explains the pattern of output in the short-run
as the units of variable inputs are increased to increase the output. On the other hand law of returns to
scale explains the pattern of output in the long run as all the units of inputs are increased.
6. The production function explains the maximum quantity of output, which can be
produced, from any chosen quantities of various inputs or the minimum quantities of various inputs that
are required to produce a given quantity of output.
Production function can be fitted the particular firm or industry or for the economy as whole. Production
function will change with an improvement in technology.
Assumptions:

Production function has the following assumptions.
1. The production function is related to a particular period of time.
2. There is no change in technology.
3. The producer is using the best techniques available.
4. The factors of production are divisible.
5. Production function can be fitted to a short run or to long run.
Cobb-Douglas production function:
Production function of the linear homogenous type is invested by Junt wicksell and first tested by C. W. Cobb and
P. H. Dougles in 1928. This famous statistical production function is known as Cobb-Douglas
production function. Originally the function is applied on the empirical study of the American
manufacturing industry. Cabb
– Douglas production function takes the following mathematical form.
Y= (AKX L1-x)
Where Y=output K=Capital L=Labour
A, ∞=positive constant
Assumptions:
It has the following assumptions
1. The function assumes that output is the function of two factors viz. capital and labour.
2. It is a linear homogenous production function of the first degree
3. The function assumes that the logarithm of the total output of the economy is a
linear function of the logarithms of the labour force and capital stock.
4. There are constant returns to scale
5. All inputs are homogenous
6. There is perfect competition
7. There is no change in technology
ISOQUANTS:
The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and ‘quent’ implies
quantity. Isoquant therefore, means equal quantity. A family of iso-product curves or isoquants or
production difference curves can represent a production function with two variable inputs, which are
substitutable for one another within limits.

Iqoquants are the curves, which represent the different combinations of inputs producing a particular
quantity of output. Any combination on the isoquant represents the some level of output.
For a given output level firm’s production become,
Q= f (L, K)
Where ‘Q’, the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.
Thus an isoquant shows all possible combinations of two inputs, which are capable of producing equal or
a given level of output. Since each combination yields same output, the producer becomes indifferent
towards these combinations.
Assumptions:
1. There are only two factors of production, viz. labour and capital.
2. The two factors can substitute each other up to certain limit
3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.
4. The technology is given over a period.
An isoquant may be explained with the help of an arithmetical example.
Combinations Labour (units) Capital (Units) Output (quintals)
A 1 10 50
B 2 7 50
C 3 4 50
D 4 4 50
E 5 1 50
Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’ quintals of a product
all other combinations in the table are assumed to yield the same given output of a product say ‘50’
quintals by employing any one of the alternative combinations of the two factors labour and capital. If we
plot all these combinations on a paper and join them, we will get continues and smooth curve called Iso-
product curve as shown below.

Labour is on the X-axis and capital is on the Y-axis. IQ is the ISO-Product curve which shows all the alternative
combinations A, B, C, D, E which can produce 50 quintals of a product.
Producer’s Equilibrium:
The tem producer’s equilibrium is the counter part of consumer’s equilibrium. Just as the consumer is in
equilibrium when be secures maximum satisfaction, in the same manner, the producer is in equilibrium
when he secures maximum output, with the least cost combination of factors of production.
The optimum position of the producer can be found with the help of iso-product curve. The Iso-product
curve or equal product curve or production indifference curve shows different combinations of two factors
of production, which yield the same output. This is illustrated as follows.
Let us suppose. The producer can produces the given output of paddy say 100 quintals by employing any
one of the following alternative combinations of the two factors labour and capital computation of least
cost combination of two inputs.
L
Units
K
Units
Q
Output
L&LP (3Rs.)
Cost of labour
KXKP(4Rs.)
cost of capital
Total cost
10 45 100 30 180 210
20 28 100 60 112 172
30 16 100 90 64 154
40 12 100 120 48 168

50 8 100 150 32 182
It is clear from the above that 10 units of ‘L’ combined with 45 units of ‘K’ would cost the producer Rs.
20/-. But if 17 units reduce ‘K’ and 10 units increase ‘L’, the resulting cost would be Rs. 172/-.
Substituting 10 more units of ‘L’ for 12 units of ‘K’ further reduces cost pf Rs. 154/-/ However, it will not
be profitable to continue this substitution process further at the existing prices since the rate of substitution
is diminishing rapidly. In the above table the least cost combination is 30 units of ‘L’ used with 16 units
of ‘K’ when the cost would be minimum at Rs. 154/-. So this is they stage “the producer is in
equilibrium”.
LAW OF PRODUCTION:
Production analysis in economics theory considers two types of input-output relationships.
1. When quantities of certain inputs, are fixed and others are variable and
2. When all inputs are variable.
These two types of relationships have been explained in the form of laws.
i) Law of variable proportions
ii) Law of returns to scale
I. Law of variable proportions:
The law of variable proportions which is a new name given to old classical concept of “Law of
diminishing returns has played a vital role in the modern economics theory. Assume that a firms
production function consists of fixed quantities of all inputs (land, equipment, etc.) except labour which is
a variable input when the firm expands output by employing more and more labour it alters the proportion
between fixed and the variable inputs. The law can be stated as follows:
“When total output or production of a commodity is increased by adding units of a variable input while
the quantities of other inputs are held constant, the increase in total production becomes after some point,
smaller and smaller”.
“If equal increments of one input are added, the inputs of other production services being held constant,
beyond a certain point the resulting increments of product will decrease i.e. the marginal product will
diminish”. (G. Stigler)
“As the proportion of one factor in a combination of factors is increased, after a point, first the marginal
and then the average product of that factor will diminish”. (F. Benham)
The law of variable proportions refers to the behaviour of output as the quantity of one Factor is increased
Keeping the quantity of other factors fixed and further it states that the marginal product and average
product will

eventually do cline. This law states three types of productivity an input factor – Total, average and
marginal physical productivity.
Assumptions of the Law: The law is based upon the following assumptions:
i) The state of technology remains constant. If there is any improvement in technology,
the average and marginal out put will not decrease but increase.
ii) Only one factor of input is made variable and other factors are kept constant. This
law does not apply to those cases where the factors must be used in rigidly fixed proportions.
iii) All units of the variable factors are homogenous.
Three stages of law:
The behaviors of the Output when the varying quantity of one factor is combines with a fixed quantity of
the other can be divided in to three district stages. The three stages can be better understood by following
the table.
Fixed factor Variable factor
(Labour)
Total product Average Product Marginal Product
1 1 100 100 - Stage I
1 2 220 120 120
1 3 270 90 50
1 4 300 75 30 Stage II
1 5 320 64 20
1 6 330 55 10
1 7 330 47 0 Stage
III
1 8 320 40 -10
Above table reveals that both average product and marginal product increase in the beginning and then
decline of the two marginal products drops of faster than average product. Total product is maximum
when the farmer employs 6th
worker, nothing is produced by the 7th
worker and its marginal productivity
is zero, whereas marginal product of 8th worker is ‘-10’, by just creating credits 8th worker not only fails to
make a positive contribution but leads to a fall in the total output.
Production function with one variable input and the remaining fixed inputs is illustrated as below

From the above graph the law of variable proportions operates in three stages. In the first stage, total
product increases at an increasing rate. The marginal product in this stage increases at an increasing rate
resulting in a greater increase in total product. The average product also increases. This stage continues up
to the point where average product is equal to marginal product. The law of increasing returns is in
operation at this stage. The law of diminishing returns starts operating from the second stage awards. At
the second stage total product increases only at a diminishing rate. The average product also declines. The
second stage comes to an end where total product becomes maximum and marginal product becomes zero.
The marginal product becomes negative in the third stage. So the total product also declines. The average
product continues to decline.
We can sum up the above relationship thus when ‘A.P.’ is rising, “M. P.’ rises more than “ A. P; When
‘A. P.” is maximum and constant, ‘M. P.’ becomes equal to ‘A. P.’ when ‘A. P.’ starts falling, ‘M. P.’
falls faster than ‘ A. P.’.
Thus, the total product, marginal product and average product pass through three phases, viz., increasing
diminishing and negative returns stage. The law of variable proportion is nothing but the combination of
the law of increasing and demising returns.
II. Law of Returns of Scale:
The law of returns to scale explains the behavior of the total output in response to change in the scale of
the firm, i.e., in response to a simultaneous to changes in the scale of the firm, i.e., in response to a
simultaneous and proportional increase in all the inputs. More precisely, the Law of returns to scale
explains how a simultaneous and proportionate increase in all the inputs affects the total output at its
various levels.
The concept of variable proportions is a short-run phenomenon as in these period fixed factors can not be
changed and all factors cannot be changed. On the other hand in the long-term all factors can be changed
as made variable. When we study the changes in output when all factors or inputs are changed, we study
returns to scale. An increase in the scale means that all inputs or factors are increased in the same
proportion. In variable proportions, the cooperating factors may be increased or decreased and one faster
(Ex. Land in agriculture (or) machinery in industry) remains constant so that the changes in proportion
among the factors result in certain changes in output. In returns to scale all the necessary factors or
production are increased or decreased to the same extent so that whatever the scale of production, the
proportion among the factors remains the same.

When a firm expands, its scale increases all its inputs proportionally, then technically there are three possibilities.
(i) The total output may increase proportionately (ii) The total output may increase more than proportionately and
(iii) The total output may increase less than proportionately. If increase in the total output is
proportional to the increase in input, it means constant returns to scale. If increase in the output is greater
than the proportional increase in the inputs, it means increasing return to scale. If increase in the output is
less than proportional increase in the inputs, it means diminishing returns to scale.
Let us now explain the laws of returns to scale with the help of isoquants for a two-input and single output
production system.
ECONOMIES OF SCALE
Production may be carried on a small scale or o a large scale by a firm. When a firm expands its size of
production by increasing all the factors, it secures certain advantages known as economies of production.
Marshall has classified these economies of large-scale production into internal economies and external
economies.
Internal economies are those, which are opened to a single factory or a single firm independently of the
action of other firms. They result from an increase in the scale of output of a firm and cannot be achieved
unless output increases. Hence internal economies depend solely upon the size of the firm and are
different for different firms.
External economies are those benefits, which are shared in by a number of firms or industries when the
scale of production in an industry or groups of industries increases. Hence external economies benefit all
firms within the industry as the size of the industry expands.
Causes of internal economies:
Internal economies are generally caused by two factors
1. Indivisibilities 2. Specialization.
1. Indivisibilities
Many fixed factors of production are indivisible in the sense that they must be used in a fixed minimum
size. For instance, if a worker works half the time, he may be paid half the salary. But he cannot be
chopped into half and asked to produce half the current output. Thus as output increases the indivisible
factors which were being used below capacity can be utilized to their full capacity thereby reducing costs.
Such indivisibilities arise in the case of labour, machines, marketing, finance and research.
2. Specialization.
Division of labour, which leads to specialization, is another cause of internal economies. Specialization
refers to the limitation of activities within a particular field of production. Specialization may be in labour,
capital, machinery and place. For example, the production process may be split into four departments
relation to manufacturing, assembling, packing and marketing under the charge of separate managers who
may work under

the overall charge of the general manger and coordinate the activities of the for departments. Thus
specialization will lead to greater productive efficiency and to reduction in costs.
Internal Economies:
Internal economies may be of the following types.
A). Technical Economies.
Technical economies arise to a firm from the use of better machines and superior techniques of
production. As a result, production increases and per unit cost of production falls. A large firm, which
employs costly and superior plant and equipment, enjoys a technical superiority over a small firm.
Another technical economy lies in the mechanical advantage of using large machines. The cost of
operating large machines is less than that of operating mall machine. More over a larger firm is able to
reduce it’s per unit cost of production by linking the various processes of production. Technical
economies may also be associated when the large firm is able to utilize all its waste materials for the
development of by-products industry. Scope for specialization is also available in a large firm. This
increases the productive capacity of the firm and reduces the unit cost of production.
B). Managerial Economies:
These economies arise due to better and more elaborate management, which only the large size firms can
afford. There may be a separate head for manufacturing, assembling, packing, marketing, general
administration etc. Each department is under the charge of an expert. Hence the appointment of experts,
division of administration into several departments, functional specialization and scientific co-ordination
of various works make the management of the firm most efficient.
C). Marketing Economies:
The large firm reaps marketing or commercial economies in buying its requirements and in selling its final
products. The large firm generally has a separate marketing department. It can buy and sell on behalf of
the firm, when the market trends are more favorable. In the matter of buying they could enjoy advantages
like preferential treatment, transport concessions, cheap credit, prompt delivery and fine relation with
dealers. Similarly it sells its products more effectively for a higher margin of profit.
D). Financial Economies:
The large firm is able to secure the necessary finances either for block capital purposes or for working
capital needs more easily and cheaply. It can barrow from the public, banks and other financial
institutions at relatively cheaper rates. It is in this way that a large firm reaps financial economies.
E). Risk bearing Economies:

The large firm produces many commodities and serves wider areas. It is, therefore, able to absorb any
shock for its existence. For example, during business depression, the prices fall for every firm. There is
also a possibility for market fluctuations in a particular product of the firm. Under such circumstances the
risk-bearing economies or survival economies help the bigger firm to survive business crisis.
F). Economies of Research:
A large firm possesses larger resources and can establish it’s own research laboratory and employ trained
research workers. The firm may even invent new production techniques for increasing its output and
reducing cost.
G). Economies of welfare:
A large firm can provide better working conditions in-and out-side the factory. Facilities like subsidized
canteens, crèches for the infants, recreation room, cheap houses, educational and medical facilities tend to
increase the productive efficiency of the workers, which helps in raising production and reducing costs.
External Economies.
Business firm enjoys a number of external economies, which are discussed below:
A). Economies of Concentration:
When an industry is concentrated in a particular area, all the member firms reap some common economies
like skilled labour, improved means of transport and communications, banking and financial services,
supply of power and benefits from subsidiaries. All these facilities tend to lower the unit cost of
production of all the firms in the industry.
B). Economies of Information
The industry can set up an information centre which may publish a journal and pass on information
regarding the availability of raw materials, modern machines, export potentialities and provide other
information needed by the firms. It will benefit all firms and reduction in their costs.
C). Economies of Welfare:
An industry is in a better position to provide welfare facilities to the workers. It may get land at
concessional rates and procure special facilities from the local bodies for setting up housing colonies for
the workers. It may also establish public health care units, educational institutions both general and
technical so that a continuous supply of skilled labour is available to the industry. This will help the
efficiency of the workers.
D). Economies of Disintegration:

The firms in an industry may also reap the economies of specialization. When an industry expands, it
becomes possible to spilt up some of the processes which are taken over by specialist firms. For example,
in the cotton textile industry, some firms may specialize in manufacturing thread, others in printing, still
others in dyeing, some in long cloth, some in dhotis, some in shirting etc. As a result the efficiency of the
firms specializing in different fields increases and the unit cost of production falls.
Thus internal economies depend upon the size of the firm and external economies depend upon the
size of the industry.
DISECONOMIES OF LARGE SCALE PRODUCTION
Internal and external diseconomies are the limits to large-scale production. It is possible that expansion of
a firm’s output may lead to rise in costs and thus result diseconomies instead of economies. When a firm
expands beyond proper limits, it is beyond the capacity of the manager to manage it efficiently. This is an
example of an internal diseconomy. In the same manner, the expansion of an industry may result in
diseconomies, which may be called external diseconomies. Employment of additional factors of
production becomes less efficient and they are obtained at a higher cost. It is in this way that external
diseconomies result as an industry expands.
The major diseconomies of large-scale production are discussed below:
Internal Diseconomies:
A). Financial Diseconomies:
For expanding business, the entrepreneur needs finance. But finance may not be easily available in the
required amount at the appropriate time. Lack of finance retards the production plans thereby increasing
costs of the firm.
B). Managerial diseconomies:
There are difficulties of large-scale management. Supervision becomes a difficult job. Workers do not
work efficiently, wastages arise, decision-making becomes difficult, coordination between workers and
management disappears and production costs increase.
C). Marketing Diseconomies:
As business is expanded, prices of the factors of production will rise. The cost will therefore rise. Raw
materials may not be available in sufficient quantities due to their scarcities. Additional output may
depress the price in the market. The demand for the products may fall as a result of changes in tastes and
preferences of the people. Hence cost will exceed the revenue.

D). Technical Diseconomies:
There is a limit to the division of labour and splitting down of production p0rocesses. The firm may fail to
operate its plant to its maximum capacity. As a result cost per unit increases. Internal diseconomies
follow.
E). Diseconomies of Risk-taking:
As the scale of production of a firm expands risks also increase with it. Wrong decision by the
management may adversely affect production. In large firms are affected by any disaster, natural or
human, the economy will be put to strains.
External Diseconomies:
When many firm get located at a particular place, the costs of transportation increases due to congestion.
The firms have to face considerable delays in getting raw materials and sending finished products to the
marketing centers. The localization of industries may lead to scarcity of raw material, shortage of various
factors of production like labour and capital, shortage of power, finance and equipments. All such external
diseconomies tend to raise cost per unit.
QUESTIONS
1. Why does the law of diminishing returns operate? Explain with the help of a diagram.
2. Explain the nature and uses of production function.
3. Explain and illustrate lows of returns to scale.
4. a. Explain how production function can be mode use of
to reduce cost of Production.
b. Explain low of constant returns? Illustrate.
5. Explain the following (i) Internal Economics (ii) External Economics (or)
Explain Economics of scale. Explain the factor, which causes increasing returns to scale.
6. Explain the following with reference to production functions
(a) MRTS
(b) Variable proportion of factor
7. Define production function, explain is equate and is cost curves.
8. Explain the importance and uses of production function in break-even analysis.
9. Discuss the equilibrium of a firm with isoquants.
10. (a) What are isocost curves and iso quants? Do they interest each other
(b) Explain Cobb-Douglas Production function.
QUIZ
1. How many types of input-output relations discussed by the
Law of production. ( )

(a) Five (b) Four
(c) Two (d) Three
2. How many stages are there in ‘Law of Variable Proportions’? ( )
(a) Five (b) Two
(c) Three (d) Four
3. Congregation of body of persons assembling together to work at a certain
Time and place is called as ( )
(a) Firm (b) Industry
(c) Plant (d) Size
4. When a firm expands its Size of production by increasing all factors,
It secures certain advantages, known as ( )
(a) Optimum Size (b) Diseconomies of Scale
(c) Economies of Scale (d) None
5. When producer secures maximum output with the least cost combination
Of factors of production, it is known as ( )
(a) Consumer’s Equilibrium (b) Price Equilibrium
(c) Producer’s Equilibrium (d) Firm’s Equilibrium
6. The ‘Law of Variable Proportions’ is also called as . ( )
(a) Law of fixed proportions (b) Law of returns to scale
(c) Law of variable proportions (d) None
7. Is a ‘group of firms producing the same are slightly
Different products for the same market or using same raw material’. ( )
(a) Plant (b) Firm
(c) Industry (d) Size
8. When proportionate increase in all inputs results in an equal
Proportionate increase in output, then we call . ( )
(a) Increasing Returns to Scale (b) Decreasing Returns to Scale
(c) Constant Returns to Scale (d) None
9. When different combinations of inputs yield the same level of output
Known as . ( )
(a) Different Quants (b) Output differentiation
(c) Isoquants (d) Production differentiation
10. Conversion of inputs in to output is called as . ( )
(a) Sales (b) Income
(c) Production (d) Expenditure
11. When Proportionate increase in all inputs results in more than
equal Proportionate increase in output, then we call . ( )
(a) Decreasing Returns to Scale (b) Constant Returns to Scale
(c) Increasing Returns to Scale (d) None
12. When Proportionate increase in all inputs results in less than Equal
Proportionate increase in output, then we call . ( )
(a) Increasing Returns to Scale (b) Constant Returns to Scale
(c) Decreasing Returns to Scale (d) None

13. A curve showing equal amount of outlay with varying Proportions of
Two inputs are called . ( )

(a) Total Cost Curve (b) Variable Cost Curve
(c) Isocost Curve (d) Marginal Cost Curve
Note: Answer is “C” for all the above questions.

COST ANALYSIS
Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon its ability to
earn sustained profits. Profits are the difference between selling price and cost of production. In general
the selling price is not within the control of a firm but many costs are under its control. The firm should
therefore aim at controlling and minimizing cost. Since every business decision involves cost
consideration, it is necessary to understand the meaning of various concepts for clear business thinking
and application of right kind of costs.
COST CONCEPTS:
A managerial economist must have a clear understanding of the different cost concepts for clear business
thinking and proper application. The several alternative bases of classifying cost and the relevance of each
for different kinds of problems are to be studied. The various relevant concepts of cost are:
1. Opportunity costs and outlay costs:
Out lay cost also known as actual costs obsolete costs are those expends which are actually incurred by
the firm these are the payments made for labour, material, plant, building, machinery traveling,
transporting etc., These are all those expense item appearing in the books of account, hence based on
accounting cost concept.
On the other hand opportunity cost implies the earnings foregone on the next best alternative, has the
present option is undertaken. This cost is often measured by assessing the alternative, which has to be
scarified if the particular line is followed.
The opportunity cost concept is made use for long-run decisions. This concept is very important in capital
expenditure budgeting. This concept is very important in capital expenditure budgeting. The concept is
also useful for taking short-run decisions opportunity cost is the cost concept to use when the supply of
inputs is strictly limited and when there is an alternative. If there is no alternative, Opportunity cost is
zero. The opportunity cost of any action is therefore measured by the value of the most favorable
alternative course, which had to be foregoing if that action is taken.
2. Explicit and implicit costs:
Explicit costs are those expenses that involve cash payments. These are the actual or business costs that
appear in the books of accounts. These costs include payment of wages and salaries, payment for raw-
materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc.
Implicit costs are the costs of the factor units that are owned by the employer himself. These costs are not
actually incurred but would have been incurred in the absence of employment of self – owned factors. The
two normal implicit costs are depreciation, interest on capital etc. A decision maker must consider implicit
costs too to find out appropriate profitability of alternatives.
3. Historical and Replacement costs:

Historical cost is the original cost of an asset. Historical cost valuation shows the cost of an asset as the
original price paid for the asset acquired in the past. Historical valuation is the basis for financial
accounts.
A replacement cost is the price that would have to be paid currently to replace the same asset. During
periods of substantial change in the price level, historical valuation gives a poor projection of the future
cost intended for managerial decision. A replacement cost is a relevant cost concept when financial
statements have to be adjusted for inflation.
4. Short – run and long – run costs:
Short-run is a period during which the physical capacity of the firm remains fixed. Any increase in output
during this period is possible only by using the existing physical capacity more extensively. So short run
cost is that which varies with output when the plant and capital equipment in constant.
Long run costs are those, which vary with output when all inputs are variable including plant and capital
equipment. Long-run cost analysis helps to take investment decisions.
5. Out-of pocket and books costs:
Out-of pocket costs also known as explicit costs are those costs that involve current cash payment. Book
costs also called implicit costs do not require current cash payments. Depreciation, unpaid interest, salary
of the owner is examples of back costs.
But the book costs are taken into account in determining the level dividend payable during a period. Both
book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of self-owned
factors of production.
6. Fixed and variable costs:
Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the
changes in the volume of production. But fixed cost per unit decrease, when the production is increased.
Fixed cost includes salaries, Rent, Administrative expenses depreciations etc.
Variable is that which varies directly with the variation is output. An increase in total output results in an
increase in total variable costs and decrease in total output results in a proportionate decline in the total
variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour, direct expenses, etc.
7. Post and Future costs:
Post costs also called historical costs are the actual cost incurred and recorded in the book of account
these costs are useful only for valuation and not for decision making.

Future costs are costs that are expected to be incurred in the futures. They are not actual costs. They are
the costs forecasted or estimated with rational methods. Future cost estimate is useful for decision making
because decision are meant for future.
8. Traceable and common costs:
Traceable costs otherwise called direct cost, is one, which can be identified with a products process or
product. Raw material, labour involved in production is examples of traceable cost.
Common costs are the ones that common are attributed to a particular process or product. They are
incurred collectively for different processes or different types of products. It cannot be directly identified
with any particular process or type of product.
9. Avoidable and unavoidable costs:
Avoidable costs are the costs, which can be reduced if the business activities of a concern are curtailed.
For example, if some workers can be retrenched with a drop in a product – line, or volume or production
the wages of the retrenched workers are escapable costs.
The unavoidable costs are otherwise called sunk costs. There will not be any reduction in this cost even if
reduction in business activity is made. For example cost of the ideal machine capacity is unavoidable cost.
10. Controllable and uncontrollable costs:
Controllable costs are ones, which can be regulated by the executive who is in change of it. The concept
of controllability of cost varies with levels of management. Direct expenses like material, labour etc. are
controllable costs.
Some costs are not directly identifiable with a process of product. They are appointed to various processes
or products in some proportion. This cost varies with the variation in the basis of allocation and is
independent of the actions of the executive of that department. These apportioned costs are called
uncontrollable costs.
11. Incremental and sunk costs:
Incremental cost also known as different cost is the additional cost due to a change in the level or nature
of business activity. The change may be caused by adding a new product, adding new machinery,
replacing a machine by a better one etc.
Sunk costs are those which are not altered by any change – They are the costs incurred in the past. This
cost is the result of past decision, and cannot be changed by future decisions. Investments in fixed assets
are examples of sunk costs.
12. Total, average and marginal costs:

Total cost is the total cash payment made for the input needed for production. It may be explicit or
implicit. It is the sum total of the fixed and variable costs. Average cost is the cost per unit of output. If is
obtained by dividing the total cost (TC) by the total quantity produced (Q)
TC
Average cost = ------
Q
Marginal cost is the additional cost incurred to produce and additional unit of output or it is the cost of the
marginal unit produced.
13. Accounting and Economics costs:
Accounting costs are the costs recorded for the purpose of preparing the balance sheet and profit and ton
statements to meet the legal, financial and tax purpose of the company. The accounting concept is a
historical concept and records what has happened in the post.
Economics concept considers future costs and future revenues, which help future planning, and choice,
while the accountant describes what has happened, the economics aims at projecting what will happen.
COST-OUTPUT RELATIONSHIP
A proper understanding of the nature and behavior of costs is a must for regulation and control of cost of
production. The cost of production depends on money forces and an understanding of the functional
relationship of cost to various forces will help us to take various decisions. Output is an important factor,
which influences the cost.
The cost-output relationship plays an important role in determining the optimum level of production.
Knowledge of the cost-output relation helps the manager in cost control, profit prediction, pricing,
promotion etc. The relation between cost and its determinants is technically described as the cost function.
C= f (S, O, P, T ….)
Where;
C= Cost (Unit or total cost)
S= Size of plant/scale of production O=
Output level
P= Prices of inputs T=
Technology
Considering the period the cost function can be classified as (a) short-run cost function and (b) long-run
cost function. In economics theory, the short-run is defined as that period during which the physical
capacity of the firm is fixed and the output can be increased only by using the existing capacity allows to
bring changes in output by physical capacity of the firm.

(a) Cost-Output Relation in the short-run:
The cost concepts made use of in the cost behavior are total cost, Average cost, and marginal cost.
Total cost is the actual money spent to produce a particular quantity of output. Total cost is the summation
of fixed and variable costs.
TC=TFC+TVC
Up to a certain level of production total fixed cost i.e., the cost of plant, building, equipment etc, remains
fixed. But the total variable cost i.e., the cost of labour, raw materials etc., Vary with the variation in
output. Average cost is the total cost per unit. It can be found out as follows.
AC=
TC
Q
Q
The total of average fixed cost (TFC/Q) keep coming down as the production is increased and average
variable cost (TVC/Q) will remain constant at any level of output.
Marginal cost is the addition to the total cost due to the production of an additional unit of product. It can
be arrived at by dividing the change in total cost by the change in total output.
In the short-run there will not be any change in total fixed cost. Hence change in total cost implies
change in total variable cost only.
Cost – output relations
Units of
Output Q
Total fixed
cost TFC
Total
variable
cost TVC
Total cost
(TFC +
TVC) TC
Average
variable
cost (TVC
/ Q) AVC
Average
fixed cost
(TFC / Q)
AFC
Average
cost
(TC/Q)
AC
Marginal
cost MC
0 - - 60 - - - -
1 60 20 80 20 60 80 20
2 60 36 96 18 30 48 16
3 60 48 108 16 20 36 12
4 60 64 124 16 15 31 16
5 60 90 150 18 12 30 26
6 60 132 192 22 10 32 42
The above table represents the cost-output relation. The table is prepared on the basis of the law of
diminishing marginal returns. The fixed cost Rs. 60 May include rent of factory building, interest on
capital, salaries of permanently employed staff, insurance etc. The table shows that fixed cost is same at
all levels of output but the

average fixed cost, i.e., the fixed cost per unit, falls continuously as the output increases. The expenditure
on the variable factors (TVC) is at different rate. If more and more units are produced with a given
physical capacity the AVC will fall initially, as per the table declining up to 3rd
unit, and being constant up
to 4th
unit and then rising. It implies that variable factors produce more efficiently near a firm’s optimum
capacity than at any other levels of output.
And later rises. But the rise in AC is felt only after the start rising. In the table ‘AVC’ starts rising from
the 5th
unit onwards whereas the ‘AC’ starts rising from the 6th
unit only so long as ‘AVC’ declines ‘AC’
also will decline. ‘AFC’ continues to fall with an increase in Output. When the rise in ‘AVC’ is more than
the decline in ‘AFC’, the total cost again begin to rise. Thus there will be a stage where the ‘AVC’, the
total cost again begin to rise thus there will be a stage where the ‘AVC’ may have started rising, yet the
‘AC’ is still declining because the rise in ‘AVC’ is less than the droop in ‘AFC’.
Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing returns or
diminishing cost in the second stage and followed by diminishing returns or increasing cost in the third
stage.
The short-run cost-output relationship can be shown graphically as follows.
In the above graph the “AFC’ curve continues to fall as output rises an account of its spread over more
and more units Output. But AVC curve (i.e. variable cost per unit) first falls and than rises due to the
operation of the law of variable proportions. The behavior of “ATC’ curve depends upon the behavior of
‘AVC’ curve and ‘AFC’ curve. In the initial stage of production both ‘AVC’ and ‘AFC’ decline and hence
‘ATC’ also decline. But after a certain point ‘AVC’ starts rising. If the rise in variable cost is less than the
decline in fixed cost, ATC will still continue to decline otherwise AC begins to rise. Thus the lower end of
‘ATC’ curve thus turns up and gives it a U-shape. That is why ‘ATC’ curve are U-shaped. The lowest
point in ‘ATC’ curve indicates the least-cost combination of inputs. Where the total average cost is the
minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the maximum output level rather it
is the point where per unit cost of production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.
2. When ‘AFC’ falls and ‘AVC’ rises
a. ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
b. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
c. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’
b. Cost-output Relationship in the long-run:
Long run is a period, during which all inputs are variable including the one, which are fixes in the short-
run. In the long run a firm can change its output according to its demand. Over a long period, the size of
the plant can be changed, unwanted buildings can be sold staff can be increased or reduced. The long run
enables the firms to expand and scale of their operation by bringing or purchasing larger quantities of all
the inputs. Thus in the long run all factors become variable.
The long-run cost-output relations therefore imply the relationship between the total cost and the total
output. In the long-run cost-output relationship is influenced by the law of returns to scale.
In the long run a firm has a number of alternatives in regards to the scale of operations. For each scale of
production or plant size, the firm has an appropriate short-run average cost curves. The short-run average
cost (SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes in to
consideration many plants.
The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.
To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure it is
assumed that technologically there are only three sizes of plants – small, medium and large, ‘SAC’, for the
small size, ‘SAC2’ for the medium size plant and ‘SAC3’ for the large size plant. If the firm wants to
produce ‘OP’ units of output, it will choose the smallest plant. For an output beyond ‘OQ’ the firm wills
optimum for medium size plant. It does not mean that the OQ production is not possible with small plant.
Rather it implies that cost of production will be more with small plant compared to the medium plant.

For an output ‘OR’ the firm will choose the largest plant as the cost of production will be more with
medium plant. Thus the firm has a series of ‘SAC’ curves. The ‘LCA’ curve drawn will be tangential to
the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve touches each ‘SAC’ curve at one point, and thus it
is known as envelope curve. It is also known as planning curve as it serves as guide to the entrepreneur in
his planning to expand the production in future. With the help of ‘LAC’ the firm determines the size of
plant which yields the lowest average cost of producing a given volume of output it anticipates.
BREAKEVEN ANALYSIS
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted in two
senses. In its narrow sense, it is concerned with finding out BEP; BEP is the point at which total revenue
is equal to total cost. It is the point of no profit, no loss. In its broad determine the probable profit at any
level of production.
Assumptions:
1. All costs are classified into two – fixed and variable.
2. Fixed costs remain constant at all levels of output.
3. Variable costs vary proportionally with the volume of output.
4. Selling price per unit remains constant in spite of competition or change in the volume of
production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains constant.
Merits:
1. Information provided by the Break Even Chart can be understood more easily then those
contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals
how changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs – direct
material, direct labour, fixed and variable overheads.
Demerits:

1. Break-even chart presents only cost volume profits. It ignores other considerations such
as capital amount, marketing aspects and effect of government policy etc., which are necessary in
decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines.
In actual practice, this may not be so.
3. It assumes that profit is a function of output. This is not always true. The firm may
increase the profit without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of multiple products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there may be
openingstock.
10. When production increases variable cost per unit may not remain constant but may
reduce on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-known defect of
BEC.
1. Fixed cost
2. Variable cost
3. Contribution
4. Margin of safety
5. Angle of incidence
6. Profit volume ratio
7. Break-Even-Point
1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed
expenses. Eg. Manager’s salary, rent and taxes, insurance etc. It should be noted that fixed changes are
fixed only within a certain range of plant capacity. The concept of fixed overhead is most useful in
formulating a price fixing policy. Fixed cost per unit is not fixed.
2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production of
sales are called variable expenses. Eg. Electric power and fuel, packing materials consumable stores. It
should be noted that variable cost per unit is fixed.
3. Contribution: Contribution is the difference between sales and variable costs and it
contributed towards fixed costs and profit. It helps in sales and pricing policies and measuring the
profitability of different proposals. Contribution is a sure test to decide whether a product is worthwhile to
be continued among different products.
Contribution = Sales – Variable cost
Contribution = Fixed Cost + Profit.
4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be
expressed in absolute sales amount or in percentage. It indicates the extent to which the sales can be
reduced without

resulting in loss. A large margin of safety indicates the soundness of the business. The formula for the
margin of safety is:
Present sales – Break even sales or Profit
. ratio
Margin of safety can be improved by taking the following steps.
1. Increasing production
2. Increasing selling price
3. Reducing the fixed or the variable costs or both
4. Substituting unprofitable product with profitable one.
5. Angle of incidence: This is the angle between sales line and total cost line at the Break-even
point. It indicates the profit earning capacity of the concern. Large angle of incidence indicates a high rate
of profit; a small angle indicates a low rate of earnings. To improve this angle, contribution should be
increased either by raising the selling price and/or by reducing variable cost. It also indicates as to what
extent the output and sales price can be changed to attain a desired amount of profit.
6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for
studying the profitability of business. The ratio of contribution to sales is the P/V ratio. It may be
expressed in percentage. Therefore, every organization tries to improve the P. V. ratio of each product by
reducing the variable cost per unit or by increasing the selling price per unit. The concept of P. V. ratio
helps in determining break even- point, a desired amount of profit etc.
The formula is,
Contribution
Sales X 100
7. Break – Even- Point: If we divide the term into three words, then it does not require
further explanation. Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It is a point of no profit, no
loss. This is also a minimum point of no profit, no loss. This is also a minimum point of production
where total costs are recovered. If sales go up beyond the Break Even Point, organization makes a profit.
If they come down, a loss is incurred.
1. Break Even point (Units) =
Fixed Expenses Contribution
per unit
Fixed expenses
2. Break Even point (In Rupees) = Contribution X sales
UNIT – III
INTRODUCTION TO MARKET AND PRICING STRATEGIES

Pricing
Introduction
Pricing is an important, if not the most important function of all enterprises. Since every enterprise is
engaged in the production of some goods or/and service. Incurring some expenditure, it must set a price
for the same to sell it in the market. It is only in extreme cases that the firm has no say in pricing its
product; because there is severe or rather perfect competition in the market of the good happens to be of
such public significance that its price is decided by the government. In an overwhelmingly large number
of cases, the individual producer plays the role in pricing its product.
It is said that if a firm were good in setting its product price it would certainly flourish in the market. This
is because the price is such a parameter that it exerts a direct influence on the products demand as well as
on its supply, leading to firm’s turnover (sales) and profit. Every manager endeavors to find the price,
which would best meet with his firm’s objective. If the price is set too high the seller may not find enough
customers to buy his product. On the other hand, if the price is set too low the seller may not be able to
recover his costs. There is a need for the right price further, since demand and supply conditions are
variable over time what is a right price today may not be so tomorrow hence, pricing decision must be
reviewed and reformulated from time totime.
Price
Price denotes the exchange value of a unit of good expressed in terms of money. Thus the current price of
a maruti car around Rs. 2,00,000, the price of a hair cut is Rs. 25 the price of a economics book is Rs. 150
and so on. Nevertheless, if one gives a little, if one gives a little thought to this subject, one would realize
that there is nothing like a unique price for any good. Instead, there are multiple prices.
Price concepts
Price of a well-defined product varies over the types of the buyers, place it is received, credit sale or cash
sale, time taken between final production and sale, etc.
It should be obvious to the readers, that the price difference on account of the above four factors are more
significant. The multiple prices is more serious in the case of items like cars refrigerators, coal, furniture
and bricks and is of little significance for items like shaving blade, soaps, tooth pastes, creams and
stationeries. Differences in various prices of any good are due to differences in transport cost, storage cost
accessories, interest cost, intermediaries’ profits etc. Once can still conceive of a basic price, which would
be exclusive of all these items of cost and then rationalize other prices by adding the cost of special items
attached to the particular transaction, in what follows we shall explain the determination of this basis price
alone and thus resolve the problem of multiple prices.
Price determinants – Demand and supply

The price of a product is determined by the demand for and supply of that product. According to Marshall
the role of these two determinants is like that of a pair of scissors in cutting cloth. It is possible that at
times, while one pair is held fixed, the other is moving to cut the cloth. Similarly, it is conceivable that
there could be situations under which either demand or supply is playing a passive role, and the other,
which is active, alone appear to be determining the price. However, just as one pair of scissors alone can
never cut a cloth, demand or supply alone is insufficient to determine the price.
Equilibrium Price
The price at which demand and supply of a commodity is equal known as equilibrium price. The demand
and supply schedules of a good are shown in the table below.
Demand supply schedule
Price Demand Supply
50 100 200
40 120 180
30 150 150
20 200 110
10 300 50
Of the five possible prices in the above example, price Rs.30 would be the market-clearing price. No other
price could prevail in the market. If price is Rs. 50 supply would exceed demand and consequently the
producers of this good would not find enough customers for their demand, thereby they would accumulate
unwanted inventories of output, which, in turn, would lead to competition among the producers, forcing
price to Rs.30. Similarly if price were Rs.10, there would be excess demand, which would give rise to
competition among the buyers of good, forcing price to Rs.30. At price Rs.30, demand equals supply and
thus both producers and consumers are satisfied. The economist calls such a price as equilibrium price.

It was seen in unit 1 that the demand for a good depends on, a number of factors and thus, every factor,
which influences either demand or supply is in fact a determinant of price. Accordingly, a change in
demand or/and supply causes price change.
MARKET
Market is a place where buyer and seller meet, goods and services are offered for the sale and transfer of
ownership occurs. A market may be also defined as the demand made by a certain group of potential
buyers for a good or service. The former one is a narrow concept and later one, a broader concept.
Economists describe a market as a collection of buyers and sellers who transact over a particular product
or product class (the housing market, the clothing market, the grain market etc.). For business purpose we
define a market as people or organizations with wants (needs) to satisfy, money to spend, and the
willingness to spend it. Broadly, market represents the structure and nature of buyers and sellers for a
commodity/service and the process by which the price of the commodity or service is established. In this
sense, we are referring to the structure of competition and the process of price determination for a
commodity or service. The determination of price for a commodity or service depends upon the structure
of the market for that commodity or service (i.e., competitive structure of the market). Hence the
understanding on the market structure and the nature of competition are a pre-requisite in price
determination.
Different Market Structures
Market structure describes the competitive environment in the market for any good or service. A market
consists of all firms and individuals who are willing and able to buy or sell a particular product. This
includes firms and individuals currently engaged in buying and selling a particular product, as well as
potential entrants.
The determination of price is affected by the competitive structure of the market. This is because the firm
operates in a market and not in isolation. In marking decisions concerning economic variables it is
affected, as are all institutions in society by its environment.
Perfect Competition

Perfect competition refers to a market structure where competition among the sellers and buyers prevails
in its most perfect form. In a perfectly competitive market, a single market price prevails for the
commodity, which is determined by the forces of total demand and total supply in the market.
Characteristics of Perfect Competition
The following features characterize a perfectly competitive market:
1. A large number of buyers and sellers: The number of buyers and sellers is large and the
share of each one of them in the market is so small that none has any influence on the market price.
2. Homogeneous product: The product of each seller is totally undifferentiated from those of the
others.
3. Free entry and exit: Any buyer and seller is free to enter or leave the market of the commodity.
4. Perfect knowledge: All buyers and sellers have perfect knowledge about the market for the
commodity.
5. Indifference: No buyer has a preference to buy from a particular seller and no seller to
sell to a particular buyer.
6. Non-existence of transport costs: Perfectly competitive market also assumes the non-
existence of transport costs.
7. Perfect mobility of factors of production: Factors of production must be in a position to
move freely into or out of industry and from one firm to the other.
Under such a market no single buyer or seller plays a significant role in price determination. One the other
hand all of them jointly determine the price. The price is determined in the industry, which is composed of
all the buyers and seller for the commodity. The demand curve facing the industry is the sum of all
consumers’ demands at various prices. The industry supply curve is the sum of all sellers’ supplies at
variousprices.
Pure competition and perfect competition
The term perfect competition is used in a wider sense. Pure competition has only limited assumptions.
When the assumptions, that large number of buyers and sellers, homogeneous products, free entry and exit
are satisfied, there exists pure competition. Competition becomes perfect only when all the assumptions
(features) are satisfied. Generally pure competition can be seen in agricultural products.
Equilibrium of a firm and industry under perfect competition
Equilibrium is a position where the firm has no incentive either to expand or contrast its output. The firm
is said to be in equilibrium when it earn maximum profit. There are two conditions for attaining
equilibrium by a firm. They are:
Marginal cost is an additional cost incurred by a firm for producing and additional unit of output.
Marginal revenue is the additional revenue accrued to a firm when it sells one additional unit of output. A
firm increases its output so long as its marginal cost becomes equal to marginal revenue. When marginal
cost is more than marginal revenue, the firm reduces output as its costs exceed the revenue. It is only at
the point where marginal cost is equal to marginal revenue, and then the firm attains equilibrium.
Secondly, the marginal cost curve must cut the

marginal revenue curve from below. If marginal cost curve cuts the marginal revenue curve from above,
the firm is having the scope to increase its output as the marginal cost curve slopes downwards. It is only
with the upward sloping marginal cost curve, there the firm attains equilibrium. The reason is that the
marginal cost curve when rising cuts the marginal revenue curve from below.
The equilibrium of a perfectly competitive firm may be explained with the help of the fig. 6.2.
In the given fig. PL and MC represent the Price line and Marginal cost curve. PL also represents Marginal
revenue, Average revenue and demand. As Marginal revenue, Average revenue and demand are the same
in perfect competition, all are equal to the price line. Marginal cost curve is U- shaped curve cutting MR
curve at R and T. At point R marginal cost becomes equal to marginal revenue. But MC curve cuts the
MR curve fro above. So this is not the equilibrium position. The downward sloping marginal cost curve
indicates that the firm can reduce its cost of production by increasing output. As the firm expands its
output, it will reach equilibrium atpoint
T. At this point, on price line PL; the two conditions of equilibrium are satisfied. Here the
marginal cost and marginal revenue of the firm remain equal. The firm is producing maximum output and
is in equilibrium at this stage. If the firm continues its output beyond this stage, its marginal cost exceeds
marginal revenue resulting in losses. As the firm has no idea of expanding or contracting its size of out,
the firm is said to be in equilibrium at point T.
Pricing under perfect competition
The price or value of a commodity under perfect competition is determined by the demand for and the
supply of that commodity.
Under perfect competition there is large number of sellers trading in a homogeneous product. Each firm
supplies only very small portion of the market demand. No single buyer or seller is powerful enough to
influence the price. The demand of all consumers and the supply of all firms together determine the price.
The individual seller is only a price taker and not a price maker. An individual firm has no price policy of
it’s own. Thus, the main problem of a firm in a perfectly competitive market is not to determine the price
of its product but to adjust its output to the

given price, So that the profit is maximum. Marshall however gives great importance to the time element
for the determination of price. He divided the time periods on the basis of supply and ignored the forces of
demand. He classified the time into four periods to determine the price as follows.
1. Very short period or Market period
2. Short period
3. Long period
4. Very long period or secular period
Very short period: It is the period in which the supply is more or less fixed because the time available to
the firm to adjust the supply of the commodity to its changed demand is extremely short; say a single day
or a few days. The price determined in this period is known as Market Price.
Short Period: In this period, the time available to firms to adjust the supply of the commodity to its
changed demand is, of course, greater than that in the market period. In this period altering the variable
factors like raw materials, labour, etc can change supply. During this period new firms cannot enter into
the industry.
Long period: In this period, a sufficiently long time is available to the firms to adjust the supply of the
commodity fully to the changed demand. In this period not only variable factors of production but also
fixed factors of production can be changed. In this period new firms can also enter the industry. The price
determined in this period is known as long run normal price.
Secular Period: In this period, a very long time is available to adjust the supply fully to change in
demand. This is very long period consisting of a number of decades. As the period is very long it is
difficult to lay down principles determining the price.
Price Determination in the market period
The price determined in very short period is known as Market price. Market price is determined by the
equilibrium between demand and supply in a market period. The nature of the commodity determines the
nature of supply curve in a market period. Under this period goods are classified in to (a) Perishable
goods and (b) Non- perishable goods.
Perishable Goods: In the very short period, the supply of perishable goods like fish, milk vegetables etc.
cannot be increased. And it cannot be decreased also. As a result the supply curve under very short period
will be parallel to the Y-axis or Vertical to X-axis. Supply is perfectly inelastic. The price determination
of perishable goods in very short period may be shown with the help of the following fig. 6.5

In this figure quantity is represented along X-axis and price is represented along Y-axis. MS is the very
short period supply curve of perishable goods. DD is demand curve. It intersects supply curve at E. The
price is OP. The quantity exchanged is OM. D1 D1 represents increased demand. This curve cuts the
supply curve at E1. Even at the new equilibrium, supply is OM only. But price increases to OP1. So, when
demand increases, the price will increase but not the supply. If demand decreases new demand curve will
be D2 D2. This curve cuts the supply curve at E2. Even at this new equilibrium, the supply is OM only.
But price falls to OP2. Hence in very short period, given the supply, it is the change in demand that
influences price. The price determined in a very short period is called Market Price.
Non-perishable goods: In the very short period, the supply of non-perishable goods like cloth, pen,
watches etc. cannot be increased. But if price falls, preserving some stock can decrease their supply. If
price falls too much, the whole stock will be held back from the market and carried over to the next
market period. The price below, which the seller will refuse to sell, is called Reserve Price.
The Price determination of non-perishable goods in very short period may be shown with the help of the
following fig 6.6.

In the given figure quantity is shown on X-axis and the price on Y-axis. SES is the supply curve. It slopes
upward up to the point E. From E it becomes a vertical straight line. This is because the quantity existing
with sellers is OM, the maximum amount they have is thus OM. Till OM quantity (i.e., point E) the
supply curve sloped upward. At the point S, nothing is offered for sale.
It means that the seller with hold the entire stock if the price is OS. OS is thus the reserve price. As the
price rises, supply increases up to point E. At OP price (Point E), the entire stock is offered for sale.
Suppose demand increases, the DD curve shift upward. It becomes D1D1 price raises to OP1. If demand
decreases, the demand curve becomes D2D2. It intersects the supply curve at E3. The price will fall to
OP3. We find that at OS price, supply is zero. It is the reserve price.
Price Determination in the short period
Short period is a period in which supply can be increased by altering the variable factors. In this period
fixed costs will remain constant. The supply is increased when price rises and vice versa. So the supply
curve slopes upwards from left to right.
The price in short period may be explained with the help of a diagram.

In the given diagram MPS is the market period supply curve. DD is the initial demand curve. It intersects
MPS curve at E. The price is OP and out put OM. Suppose demand increases, the demand curve shifts
upwards and becomes D1D1. In the very short period, supply remains fixed on OM. The new demand
curve D1D1 intersects MPS at E1. The price will rise to OP1. This is what happen in the very short-
period.
As the price rises from OP to OP1, firms expand output. As firms can vary some factors but not all, the
law of variable proportions operates. This results in new short-run supply curve SPS. It interests D1 D1
curve at E4. The price will fall from OP1 to OP4.
It the demand decreases, DD curve shifts downward and becomes D2D2. It interests MPS curve at E2.
The price will fall to OP2. This is what happens in market period. In the short period, the supply curve is
SPS. D2D2 curve interests SPS curve at E3. The short period price is higher than the market period price.
Price determination in the long period (Normal Price)
Market price may fluctuate due to a sudden change either on the supply side or on the demand side. A big
arrival of milk may decrease the price of that production in the market period. Similarly, a sudden cold
wave may raise the price of woolen garments. This type of temporary change in supply and demand may
cause changes in market price. In the absence of such disturbing causes, the price tends to come back to a
certain level. Marshall called this level is normal price level. In the words of Marshall Normal value
(Price) of a commodity is that which economics force would tend to bring about in the long period.
In order to describe how long run normal price is determined, it is useful to refer to the market period as
short period also. The market period is so short that no adjustment in the output can be made. Here cost of
production has no influence on price. A short period is sufficient only to allow the firms to make only
limited output

adjustment. In the long period, supply conditions are fully sufficient to meet the changes in demand. In the
long period, all factors are alterable and the new firms may enter into or old firms leave the; industry.
In the long period all costs are variable costs. So supply will be increased only when price is equal to average cost.
Hence, in long period normal price will be equal to minimum average cost of the industry. Will this price
be more or less than the short period normal price? The answer depends on the stage of returns to which
the industry is subject. There are three stages of return on the stage of returns to which the industry is
subject. There are three stages of returns.
1. Increasing returns or decreasing costs.
2. Constant Returns or Constant costs.
3. Diminishing returns or increasing costs.
1. Determination of long period normal price in decreasing cost industry:
At this stage, average cost falls due to an increase in the output. So, the supply curve at this stage will
slope downwards from left to right. The long period Normal price determination at this stage can be
explained with the help of a diagram.
In the diagram, MPS represents market period supply curve. DD is demand curve. DD cuts LPS, SPS and
MPS at point E. At point E the supply is OM and the price is OP. If demand increases from DD to D1D1
market price increases to OP1. In the short period it is OP2. In the long period supply increases
considerably to OM3. So price has fallen to OP3, which is less than the price of market period.
2. Determination of Long Period Normal Price in Constant Cost Industry:

In this case average cost does not change even though the output increases. Hence long period supply
curve is horizontal to X-axis. The determination of long period normal price can be explained with the
help of the diagram. In the fig. 6.9, LPS is horizontal to X-axis. MPS represents market period supply
curve, and SPS represents short period supply curve. At point ‘E’ the output is OM and price is OP. If
demand increases from DD to D1D1 market price increases to OP1. In the short period, supply increases
and hence the price will be OP2. In the long run supply is adjusted fully to meet increased demand. The
price remains constant at OP because costs are constant at OP and market is perfect market.
3. Determination of long period normal price in increase cost industry:
If the industry is subject to increasing costs (diminishing returns) the supply curve slopes upwards from
left to right like an ordinary supply curve. The determination of long period normal price in increasing
cost industry can be explained with the help of the following diagram. In the diagram LPS represents long
period supply curve. The industry is subject to diminishing return or increasing costs. So, LPS slopes
upwards from left to right. SPS is short period supply curve and MPS is market period supply curve. DD
is demand curve. It cuts all the supply curves at E. Here the price is OP and output is OM. If demand
increases from DD to D1D1 in the market period, supply will not change but the price increases to OP1.
In the short period, price increase but the price increases to OP1. In the short period, price increases to
OP2 as the supply increased from OM to OM2. In the long period supply increases to OM3 and price
increases to OP3. But this increase in price is less than the price increase in a market period or short
period.

Monopoly
The word monopoly is made up of two syllables, Mono and poly. Mono means single while poly implies
selling. Thus monopoly is a form of market organization in which there is only one seller of the
commodity. There are no close substitutes for the commodity sold by the seller. Pure monopoly is a
market situation in which a single firm sells a product for which there is no good substitute.
Features of monopoly
The following are the features of monopoly.
1. Single person or a firm: A single person or a firm controls the total supply of the
commodity. There will be no competition for monopoly firm. The monopolist firm is the only firm in the
wholeindustry.
2. No close substitute: The goods sold by the monopolist shall not have closely
competition substitutes. Even if price of monopoly product increase people will not go in far substitute.
For example: If the price of electric bulb increase slightly, consumer will not go in for kerosene lamp.
3. Large number of Buyers: Under monopoly, there may be a large number of buyers in
the market who compete among themselves.
4. Price Maker: Since the monopolist controls the whole supply of a commodity, he is a
price-maker, and then he can alter the price.
5. Supply and Price: The monopolist can fix either the supply or the price. He cannot fix
both. If he charges a very high price, he can sell a small amount. If he wants to sell more, he has to charge
a low price. He cannot sell as much as he wishes for any price he pleases.
6. Downward Sloping Demand Curve: The demand curve (average revenue curve) of
monopolist slopes downward from left to right. It means that he can sell more only by lowering price.

Types of Monopoly
Monopoly may be classified into various types. The different types of monopolies are explained below:
1. Legal Monopoly: If monopoly arises on account of legal support or as a matter of legal
privilege, it is called Legal Monopoly. Ex. Patent rights, special brands, trade means, copyright etc.
2. Voluntary Monopoly: To get the advantages of monopoly some private firms come
together voluntarily to control the supply of a commodity. These are called voluntary monopolies.
Generally, these monopolies arise with industrial combinations. These voluntary monopolies are of three
kinds (a) cartel
(b) trust (c) holding company. It may be called artificial monopoly.
3. Government Monopoly: Sometimes the government will take the responsibility of
supplying a commodity and avoid private interference. Ex. Water, electricity. These monopolies, created
to satisfy social wants, are formed on social considerations. These are also called Social Monopolies.
4. Private Monopoly: If the total supply of a good is produced by a single private person or
firm, it is called private monopoly. Hindustan Lever Ltd. Is having the monopoly power to produce Lux
Soap.
5. Limited Monopoly: if the monopolist is having limited power in fixing the price of his
product, it is called as ‘Limited Monopoly’. It may be due to the fear of distant substitutes or government
intervention or the entry of rivals firms.
6. Unlimited Monopoly: If the monopolist is having unlimited power in fixing the price of
his good or service, it is called unlimited monopoly. Ex. A doctor in a village.
7. Single Price Monopoly: When the monopolist charges same price for all units of his
product, it is called single price monopoly. Ex. Tata Company charges the same price to all the Tata
Indiaca Cars of the same model.
8. Discriminating Monopoly: When a Monopolist charges different prices to different
consumers for the same product, it is called discriminating monopoly. A doctor may take Rs.20 from a
rich man and only Rs.2 from a poor man for the same treatment.
9. Natural Monopoly: Sometimes monopoly may arise due to scarcity of natural resources.
Nature provides raw materials only in some places. The owner of the place will become monopolist. For
Ex. Diamond mine in South Africa.
Pricing under Monopoly
Monopoly refers to a market situation where there is only one seller. He has complete control over the
supply of a commodity. He is therefore in a position to fix any price. Under monopoly there is no
distinction between a firm and an industry. This is because the entire industry consists of a single firm.

Being the sole producer, the monopolist has complete control over the supply of the commodity. He has
also the power to influence the market price. He can raise the price by reducing his output and lower the
price by increasing his output. Thus he is a price-maker. He can fix the price to his maximum advantages.
But he cannot fix both the supply and the price, simultaneously. He can do one thing at a time. If the fixes
the price, his output will be determined by the market demand for his commodity. On the other hand, if he
fixes the output to be sold, its market will determine the price for the commodity. Thus his decision to fix
either the price or the output is determined by the market demand.
The market demand curve of the monopolist (the average revenue curve) is downward sloping. Its
corresponding marginal revenue curve is also downward sloping. But the marginal revenue curve lies
below the average revenue curve as shown in the figure. The monopolist faces the down-sloping demand
curve because to sell more output, he must reduce the price of his product. The firm’s demand curve and
industry’s demand curve are one and the same. The average cost and marginal cost curve are U shaped
curve. Marginal cost falls and rises steeply when compared to average cost.
Price output determination (Equilibrium Point)
The monopolistic firm attains equilibrium when its marginal cost becomes equal to the marginal revenue.
The monopolist always desires to make maximum profits. He makes maximum profits when MC=MR. He
does not increasing his output if his revenue exceeds his costs. But when the costs exceed the revenue, the
monopolist firm incur loses. Hence the monopolist curtails his production. He produces up to that point
where additional cost is equal to the additional revenue (MR=MC). Thus point is called equilibrium point.
The price output determination under monopoly may be explained with the help of a diagram.

In the diagram 6.12 the quantity supplied or demanded is shown along X-axis. The cost or revenue is
shown along Y-axis. AC and MC are the average cost and marginal cost curves respectively. AR and MR
curves slope downwards from left to right. AC and MC and U shaped curves. The monopolistic firm
attains equilibrium when its marginal cost is equal to marginal revenue (MC=MR). Under monopoly, the
MC curve may cut the MR curve from below or from a side. In the diagram, the above condition is
satisfied at point E. At point E, MC=MR. The firm is in equilibrium. The equilibrium output is OM.
The above diagram (Average revenue) =
MQ or OP Average cost = MR
Profit per unit = Average Revenue-Average cost=MQ-
MR=QR Total Profit = QRXSR=PQRS
The area PQRS resents the maximum profit earned by the monopoly firm.
But it is not always possible for a monopolist to earn super-normal profits. If the demand and cost
situations are not favorable, the monopolist may realize short run losses.
Through the monopolist is a price marker, due to weak demand and high costs; he suffers a loss equal
to PABC. If AR > AC -> Abnormal or super normal profits.
If AR = AC ->
Normal Profit If AR <
AC -> Loss
In the long run the firm has time to adjust his plant size or to use existing plant so as to maximize profits.

Monopolistic competition
Perfect competition and pure monopoly are rate phenomena in the real world. Instead, almost every
market seems to exhibit characteristics of both perfect competition and monopoly. Hence in the real world
it is the state of imperfect competition lying between these two extreme limits that work. Edward. H.
Chamberlain developed the theory of monopolistic competition, which presents a more realistic picture of
the actual market structure and the nature of competition.
Characteristics of Monopolistic Competition
The important characteristics of monopolistic competition are:
1. Existence of Many firms: Industry consists of a large number of sellers, each one of
whom does not feel dependent upon others. Every firm acts independently without bothering about the
reactions of its rivals. The size is so large that an individual firm has only a relatively small part in the
total market, so that each firm has very limited control over the price of the product. As the number is
relatively large it is difficult for these firms to determine its price- output policies without considering the
possible reactions of the rival forms. A monopolistically competitive firm follows an independent price
policy.
2. Product Differentiation: Product differentiation means that products are different in
some ways, but not altogether so. The products are not identical but the same time they will not be
entirely different from each other. IT really means that there are various monopolist firms competing with
each other. An example of monopolistic competition and product differentiation is the toothpaste
produced by various firms. The product of each firm is different from that of its rivals in one or more
respects. Different toothpastes like Colgate, Close-up, Forehans, Cibaca, etc., provide an example of
monopolistic competition. These products are relatively close substitute for each other but not perfect
substitutes. Consumers have definite preferences for the particular verities or brands of products offered
for sale by various sellers. Advertisement, packing, trademarks, brand names etc. help differentiation of
products even if they are physically identical.
3. Large Number of Buyers: There are large number buyers in the market. But the buyers
have their own brand preferences. So the sellers are able to exercise a certain degree of monopoly over
them. Each seller has to plan various incentive schemes to retain the customers who patronize his
products.
4. Free Entry and Exist of Firms: As in the perfect competition, in the monopolistic
competition too, there is freedom of entry and exit. That is, there is no barrier as found under monopoly.
5. Selling costs: Since the products are close substitute much effort is needed to retain the
existing consumers and to create new demand. So each firm has to spend a lot on selling cost, which
includes cost on advertising and other sale promotion activities.
6. Imperfect Knowledge: Imperfect knowledge about the product leads to monopolistic
competition. If the buyers are fully aware of the quality of the product they cannot be influenced much by
advertisement or other sales promotion techniques. But in the business world we can see that thought the
quality of certain products is the same, effective advertisement and sales promotion techniques make
certain brands

monopolistic. For examples, effective dealer service backed by advertisement-helped popularization of
some brands through the quality of almost all the cement available in the market remains the same.
7. The Group: Under perfect competition the term industry refers to all collection of firms
producing a homogenous product. But under monopolistic competition the products of various firms are
not identical through they are close substitutes. Prof. Chamberlin called the collection of firms producing
close substitute products as a group.
Price – Output Determination under Monopolistic Competition
Since under monopolistic competition different firms produce different varieties of products, different
prices for them will be determined in the market depending upon the demand and cost conditions. Each
firm will set the price and output of its own product. Here also the profit will be maximized when
marginal revenue is equal to marginal cost.
Short-run equilibrium of the firm:
In the short-run the firm is in equilibrium when marginal Revenue = Marginal Cost. In Fig 6.15 AR is the
average revenue curve. NMR marginal revenue curve, SMC short-run marginal cost curve, SAC short-run
average cost curve, MR and SMC interest at point E where output in OM and price MQ (i.e. OP). Thus
the equilibrium output or the maximum profit output is OM and the price MQ or OP. When the price
(average revenue) is above average cost a firm will be making supernormal profit. From the figure it can
be seen that AR is above AC in the equilibrium point. As AR is above AC, this firm is making abnormal
profits in the short-run. The abnormal profit per unit is QR, i.e., the difference between AR and AC at
equilibrium point and the total supernormal profit is OR X OM. This total abnormal profits is represented
by the rectangle PQRS. As the demand curve here is highly elastic, the excess price over marginal cost is
rather low. But in monopoly the demand curve is inelastic. So the gap between price and marginal cost
will be rather large.

If the demand and cost conditions are less favorable the monopolistically competitive firm may incur loss
in the short-run fig 6.16 Illustrates this. A firm incurs loss when the price is less than the average cost of
production. MQ is the average cost and OS (i.e. MR) is the price per unit at equilibrium output OM. QR is
the loss per unit. The total loss at an output OM is OR X OM. The rectangle PQRS represents the total
loses in the short run.
Long – Run Equilibrium of the Firm:
A monopolistically competitive firm will be long – run equilibrium at the output level where marginal
cost equal to marginal revenue. Monopolistically competitive firm in the long run attains equilibrium
where MC=MR and AC=AR Fig 6.17 shows this trend.
Oligopoly
The term oligopoly is derived from two Greek words, oligos meaning a few, and pollen meaning to sell.
Oligopoly is the form of imperfect competition where there are a few firms in the market, producing either
a homogeneous product or producing products, which are close but not perfect substitute of each other.

Characteristics of Oligopoly
The main features of oligopoly are:
1. Few Firms: There are only a few firms in the industry. Each firm contributes a sizeable
share of the total market. Any decision taken by one firm influence the actions of other firms in the
industry. The various firms in the industry compete with each other.
2. Interdependence: As there are only very few firms, any steps taken by one firm to
increase sales, by reducing price or by changing product design or by increasing advertisement
expenditure will naturally affect the sales of other firms in the industry. An immediate retaliatory action
can be anticipated from the other firms in the industry every time when one firm takes such a decision. He
has to take this into account when he takes decisions. So the decisions of all the firms in the industry are
interdependent.
3. Indeterminate Demand Curve: The interdependence of the firms makes their demand
curve indeterminate. When one firm reduces price other firms also will make a cut in their prices. So he
firm cannot be certain about the demand for its product. Thus the demand curve facing an oligopolistic
firm loses its definiteness and thus is indeterminate as it constantly changes due to the reactions of the
rival firms.
4. Advertising and selling costs: Advertising plays a greater role in the oligopoly market
when compared to other market systems. According to Prof. William J. Banumol “it is only oligopoly that
advertising comes fully into its own”. A huge expenditure on advertising and sales promotion techniques
is needed both to retain the present market share and to increase it. So Banumol concludes “under
oligopoly, advertising can become a life-and-death matter where a firm which fails to keep up with the
advertising budget of its competitors may find its customers drifting off to rival products.”
5. Price Rigidity: In the oligopoly market price remain rigid. If one firm reduced price it is
with the intention of attracting the customers of other firms in the industry. In order to retain their
consumers they will also reduce price. Thus the pricing decision of one firm results in a loss to all the
firms in the industry. If one firm increases price. Other firms will remain silent there by allowing that firm
to lost its customers. Hence, no firm will be ready to change the prevailing price. It causes price rigidity in
the oligopoly market.
OTHER MARKET STRUCTURES
Duopoly
Duopoly refers to a market situation in which there are only two sellers. As there are only two sellers any
decision taken by one seller will have reaction from the other Eg. Coca-Cola and Pepsi. Usually these two
sellers may agree to co-operate each other and share the market equally between them, So that they can
avoid harmful competition.
The duopoly price, in the long run, may be a monopoly price or competitive price, or it may settle at any
level between the monopoly price and competitive price. In the short period, duopoly price may even fall
below the level competitive price with the both the firms earning less than even the normal price.

Monopsony
Mrs. Joan Robinson was the first writer to use the term monopsony to refer to market, which there is a
single buyer. Monoposony is a single buyer or a purchasing agency, which buys the show, or nearly whole
of a commodity or service produced. It may be created when all consumers of a commodity are organized
together and/or when only one consumer requires that commodity which no one else requires.
Bilateral Monopoly
A bilateral monopoly is a market situation in which a single seller (Monopoly) faces a single buyer
(Monoposony). It is a market of monopoly-monoposy.
Oligopsony
Oligopsony is a market situation in which there will be a few buyers and many sellers. As the sellers are
more and buyers are few, the price of product will be comparatively low but not as low as under
monopoly.
PRICING METHODS
The micro – economic principle of profit maximization suggests pricing by the marginal analysis. That is
by equating MR to MC. However the pricing methods followed by the firms in practice around the world
rarely follow this procedure. This is for two reasons; uncertainty with regard to demand and cost function
and the deviation from the objective of short run profit maximization.
It was seen that there is no unique theory of firm behavior. While profit certainly on important variable for
which every firm cares. Maximization of short – run profit is not a popular objective of a firm today. At
the most firms seek maximum profit in the long run. If so the problem is dynamic and its solution requires
accurate knowledge of demand and cost conditions over time. Which is impossible to come by?
In view of these problems economic prices are a rare phenomenon. Instead, firms set prices for their
products through several alternative means. The important pricing methods followed in practice are
shown in the chart.

Cost Based Pricing
There are three versions of the cost – based pricing. Full – cost or break even pricing, cost plus pricing
and the marginal cost pricing. Under the first version, price just equals the average (total) cost. In the
second version, some mark-up is added to the average cost in arriving at the price. In the last version,
price is set equal to the marginal cost. While all these methods appear to be easy and straight forward,
they are in fact associated with a number of difficulties. Even through difficulties are there, the cost-
oriented pricing is quite popular today.
The cost – based pricing has several strengths as well as limitations. The advantages are its simplicity,
acceptability and consistency with the target rate of return on investment and the price stability in general.
The limitations are difficulties in getting accurate estimates of cost (particularly of the future cost rather
than the historic cost) Volatile nature of the variable cost and its ignoring of the demand side of the
market etc.
Competition based pricing
Some commodities are priced according to the competition in their markets. Thus we have the going rate
method of price and the sealed bid pricing technique. Under the former a firm prices its new product
according to the prevailing prices of comparable products in the market. If the product is new in the
country, then its import cost – inclusive of the costs of certificates, insurance, and freight and customs
duty, is used as the basis for pricing, Incidentally, the price is not necessarily equal to the import cost, but
to the firm is either new in the country, or is a close substitute or complimentary to some other products,
the prices of hitherto existing bands or / and of the related goods are taken in to a account while deciding
its price. Thus, when television was first manufactures in India, its import cost must have been a guiding
force in its price determination. Similarly, when

maruti car was first manufactured in India, it must have taken into account the prices of existing cars,
price of petrol, price of car accessories, etc. Needless to say, the going rate price could be below or above
the average cost and it could even be an economic price.
The sealed bid pricing method is quite popular in the case of construction activities and in the disposition
of used produces. In this method the prospective seller (buyers) are asked to quote their prices through a
sealed cover, all the offers are opened at a preannounce time in the presence of all the competitors, and the
one who quoted the least is awarded the contract (purchase / sale deed). As it sound, this method is totally
competition based and if the competitors unit by any change, the buyers (seller) may have to pay (receive)
an exorbitantly high (too low) price, thus there is a great degree of risk attached to this method of pricing.
Demand Based Pricing
The demand – based pricing and strategy – based pricing are quite related. The seller knows rather well
that the demand for its product is a decreasing function of the price its sets for product. Thus if seller
wishes to sell more he must reduce the price of his product, and if he wants a good price for his product,
he could sell only a limited quantity of his good. Demand oriented pricing rules imply establishment of
prices in accordance with consumer preference and perceptions and the intensity of demand.
Two general types demand oriented pricing rules can be identified.
i. Perceived value pricing and
ii. Differential pricing
Perceived value pricing considers the buyer’s perception of the value of the product ad the basis of
pricing. Here the pricing rule is that the firm must develop procedures for measuring the relative value of
the product as perceived by consumers. Differential pricing is nothing but price discrimination. In
involves selling a product or service for different prices in different market segments. Price differentiation
depends on geographical location of the consumers, type of consumer, purchasing quantity, season, time
of the service etc. E.g. Telephone charges, APSRTC charges.
Strategy based pricing (new product pricing)
A firm which products a new product, if it is also new to industry, can earn very good profits it if handles
marketing carefully, because of the uniqueness of the product. The price fixed for the new product must
keep the competitors away. Earn good profits for the firm over the life of the product and must help to get
the product accepted. The company can select either skimming pricing or penetration pricing.

While there are some firms, which follow the strategy of price penetration, there are some others who opt for price
– skimming. Under the former, firms sell their new product at a low price in the beginning in
order to catch the attention of consumers, once the product image and credibility is established, the seller
slowly starts jacking up the price to reap good profits in future. Under this strategy, a firm might well sell
its product below the cost of production and thus runs into losses to start with but eventually it recovers all
its losses and even makes good overall profits. The Rin washing soap perhaps falls into this category. This
soap was sold at a rather low price in the beginning and the firm even distributed free samples. Today, it is
quite an expensive brand and yet it is selling very well. Under the price – skimming strategy, the new
product is priced high in the beginning, and its price is reduced gradually as it faces a dearth of buyers
such a strategy may be beneficial for products, which are fancy, but of poor quality and / or of
insignificant use over a period of time.
A prudent producer follows a good mix of the various pricing methods rather than adapting any once of
them. This is because no method is perfect and every method has certain good features further a firm
might adopt one method at one time and another method at some other accession.

BUSINESS AND NEW ECONOMIC ENVIRONMENT
Imagine you want to do business. Which are you interested in? For example, you want to get into
InfoTech industry. What can you do in this industry? Which one do you choose? The following are
the alternatives you have on hand:
 You can bye and sell
 You can set up a small/medium/large industry to manufacture
 You can set up a workshop to repair
 You can develop software
 You can design hardware
 You can be a consultant/trouble-shooter
If you choose any one or more of the above, you have chosen the line of activity. The next step for
you is to decide whether.
 You want to be only owner (It means you what to be sole trader) or
 You want to take some more professionals as co-owners along with you (If means
you what to from partnership with others as partners) or
 You want to be a global player by mobilizing large resources across the country/world
 You want to bring all like-minded people to share the benefits of the common
enterprise (You want to promote a joint stock company) or
 You want to involve government in the IT business (here you want to suggest
government to promote a public enterprise!)
To decide this, it is necessary to know how to evaluate each of these alternatives.
Factors affecting the choice of form of business organization
Before we choose a particular form of business organization, let us study what factors affect such a
choice? The following are the factors affecting the choice of a business organization:
1. Easy to start and easy to close: The form of business organization should be such that it
should be easy to close. There should not be hassles or long procedures in the process of setting up
business or closing the same.
2. Division of labour: There should be possibility to divide the work among the available owners.
3. Large amount of resources: Large volume of business requires large volume of
resources. Some forms of business organization do not permit to raise larger resources. Select the one
which permits to mobilize the large resources.
4. Liability: The liability of the owners should be limited to the extent of money invested in
business. It is better if their personal properties are not brought into business to make up the losses of the
business.

5. Secrecy: The form of business organization you select should be such that it should
permit to take care of the business secrets. We know that century old business units are still surviving only
because they could successfully guard their business secrets.
6. Transfer of ownership: There should be simple procedures to transfer the ownership to
the next legal heir.
7. Ownership, Management and control: If ownership, management and control are in the
hands of one or a small group of persons, communication will be effective and coordination will be easier.
Where ownership, management and control are widely distributed, it calls for a high degree of
professional’s skills to monitor the performance of the business.
8. Continuity: The business should continue forever and ever irrespective of the uncertainties in
future.
9. Quick decision-making: Select such a form of business organization, which permits you
to take decisions quickly and promptly. Delay in decisions may invalidate the relevance of the decisions.
10. Personal contact with customer: Most of the times, customers give us clues to improve
business. So choose such a form, which keeps you close to the customers.
11. Flexibility: In times of rough weather, there should be enough flexibility to shift from
one business to the other. The lesser the funds committed in a particular business, the better it is.
12. Taxation: More profit means more tax. Choose such a form, which permits to pay low tax.
These are the parameters against which we can evaluate each of the available forms of business organizations.
SOLE TRADER
The sole trader is the simplest, oldest and natural form of business organization. It is also called sole
proprietorship. ‘Sole’ means one. ‘Sole trader’ implies that there is only one trader who is the owner of
the business.
It is a one-man form of organization wherein the trader assumes all the risk of ownership carrying out the
business with his own capital, skill and intelligence. He is the boss for himself. He has total operational
freedom. He is the owner, Manager and controller. He has total freedom and flexibility. Full control lies
with him. He can take his own decisions. He can choose or drop a particular product or business based on
its merits. He need not discuss this with anybody. He is responsible for himself. This form of organization
is popular all over the world. Restaurants, Supermarkets, pan shops, medical shops, hosiery shops etc.
Features
 It is easy to start a business under this form and also easy to close.
 He introduces his own capital. Sometimes, he may borrow, if necessary
 He enjoys all the profits and in case of loss, he lone suffers.
 He has unlimited liability which implies that his liability extends to his personal properties in
case ofloss.
 He has a high degree of flexibility to shift from one business to the other.
 Business secretes can be guarded well
 There is no continuity. The business comes to a close with the death, illness or insanity of
the sole trader. Unless, the legal heirs show interest to continue the business, the business cannot be
restored.

 He has total operational freedom. He is the owner, manager and controller.
 He can be directly in touch with the customers.
 He can take decisions very fast and implement them promptly.
 Rates of tax, for example, income tax and so on are comparatively very low.
Advantages
The following are the advantages of the sole trader from of business organization:
1. Easy to start and easy to close: Formation of a sole trader from of organization is
relatively easy even closing the business is easy.
2. Personal contact with customers directly: Based on the tastes and preferences of the
customers the stocks can be maintained.
3. Prompt decision-making: To improve the quality of services to the customers, he can
take any decision and implement the same promptly. He is the boss and he is responsible for his business
Decisions relating to growth or expansion can be made promptly.
4. High degree of flexibility: Based on the profitability, the trader can decide to continue or
change the business, if need be.
5. Secrecy: Business secrets can well be maintained because there is only one trader.
6. Low rate of taxation: The rate of income tax for sole traders is relatively very low.
7. Direct motivation: If there are profits, all the profits belong to the trader himself. In
other words. If he works more hard, he will get more profits. This is the direct motivating factor. At the
same time, if he does not take active interest, he may stand to lose badly also.
8. Total Control: The ownership, management and control are in the hands of the sole
trader and hence it is easy to maintain the hold on business.
9. Minimum interference from government: Except in matters relating to public interest,
government does not interfere in the business matters of the sole trader. The sole trader is free to fix price
for his products/services if he enjoys monopoly market.
10. Transferability: The legal heirs of the sole trader may take the possession of the business.
Disadvantages
The following are the disadvantages of sole trader form:
1. Unlimited liability: The liability of the sole trader is unlimited. It means that the sole
trader has to bring his personal property to clear off the loans of his business. From the legal point of
view, he is not different from his business.
2. Limited amounts of capital: The resources a sole trader can mobilize cannot be very
large and hence this naturally sets a limit for the scale of operations.
3. No division of labour: All the work related to different functions such as marketing,
production, finance, labour and so on has to be taken care of by the sole trader himself. There is nobody
else to take his burden. Family members and relatives cannot show as much interest as the trader takes.

4. Uncertainty: There is no continuity in the duration of the business. On the death,
insanity of insolvency the business may be come to an end.
5. Inadequate for growth and expansion: This from is suitable for only small size, one-
man-show type of organizations. This may not really work out for growing and expanding organizations.
6. Lack of specialization: The services of specialists such as accountants, market
researchers, consultants and so on, are not within the reach of most of the sole traders.
7. More competition: Because it is easy to set up a small business, there is a high degree of
competition among the small businessmen and a few who are good in taking care of customer
requirements along can service.
8. Low bargaining power: The sole trader is the in the receiving end in terms of loans or
supply of raw materials. He may have to compromise many times regarding the terms and conditions of
purchase of materials or borrowing loans from the finance houses or banks.
PARTNERSHIP
Partnership is an improved from of sole trader in certain respects. Where there are like-minded persons
with resources, they can come together to do the business and share the profits/losses of the business in an
agreed ratio. Persons who have entered into such an agreement are individually called ‘partners’ and
collectively called ‘firm’. The relationship among partners is called a partnership.
Indian Partnership Act, 1932 defines partnership as the relationship between two or more persons who
agree to share the profits of the business carried on by all or any one of them acting for all.
Features
1. Relationship: Partnership is a relationship among persons. It is relationship resulting out
of an agreement.
2. Two or more persons: There should be two or more number of persons.
3. There should be a business: Business should be conducted.
4. Agreement: Persons should agree to share the profits/losses of the business
5. Carried on by all or any one of them acting for all: The business can be carried on by
all or any one of the persons acting for all. This means that the business can be carried on by one person
who is the agent for all other persons. Every partner is both an agent and a principal. Agent for other
partners and principal for himself. All the partners are agents and the ‘partnership’ is their principal.
The following are the other features:
(a) Unlimited liability: The liability of the partners is unlimited. The partnership and
partners, in the eye of law, and not different but one and the same. Hence, the partners have to bring their
personal assets to clear the losses of the firm, if any.
(b) Number of partners: According to the Indian Partnership Act, the minimum number of
partners should be two and the maximum number if restricted, as given below:
 10 partners is case of banking business

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