Fy b Com Business Economics i

F.Y.B.Com.Lecture Notes Dr. Ranga Sai Vaze College, Mumbai Business Economics Paper I As per 201 Revised June 2010 Dr.Ranga Sai Revised Business Economics I Syllabus for F.Y.B.Com from June 2008 onwards University of Mumbai Section I Module I: Demand analysis Utility: Cardinal and ordinal approaches Indifference Curve Analysis Properties of IC, Consumer Equilibrium, Price Effect, Derivation of demand curve from PCC Consumer surplus Elasticity of demand, Income, cross, promotional. Case studiesDemand forecasting: meaning significance and methods-case studies Module II Theory of production Production function-short run and long run- Law of variable proportions- Isoquantproducers’ equilibrium- returns to scale-economies of scale- economies of scope- case studies Module III Cost of production Concepts: social costs private costs, economic and accounting costs- fixed and variable cost curves in short and long run costs- Learning curve- producers’ surpluscase studies Section II Module IV Revenue Concepts Average Revenue, Marginal Revenue, Total Revenue- Relationship between Average Revenue and Marginal revenue and elasticity of demand Objectives of firm: Profit, sales and Growth Maximization, Break even analysis Module V Markets Equilibrium under perfect competition in the long run, Monopoly, Equilibrium in the long run, Monopolistic competition: features, Oligopoly: features, Globalization: cartels and price leadership in oligopoly Case studies Module VI Pricing Methods Marginal cost, Full Cost, Discriminatory, multi-product and transfer pricing Capital Budgeting- Meaning and importance- Investment criteria: Payback period, Net present value and internal rate of return methods Available for free and private circulation At www. rangasai.com and www. vazecollege.net Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 2 Dr.Ranga Sai CONTENT Section I Module I: Demand analysis Indifference Curve Analysis Properties of IC Consumer Equilibrium, Income Effect Price Effect Derivation of demand curve from PCC Consumer surplus Elasticity of demand, Income, cross, promotional. Case studiesDemand forecasting Module II Theory of production Production function Law of variable proportions Isoquant- producers’ equilibrium- returns to scale Economies of scale Economies of scope Module III Cost of production Concept of costs Behavior of short cost curves Behavior of long run cost curves Learning curve Producers’ surplus Case studies Section II Module IV: Revenue Concepts Relationship between AR and MR Objectives of firm Break even analysis Module V: Markets Equilibrium under perfect competition Long run, Monopoly Equilibrium in the long run, Monopolistic competition Oligopoly, Duopoly Case studies Module VI: Pricing Methods Marginal cost, Full Cost, Price discrimination Multi-product Project Planning Payback period, Net present value Internal rate of return Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 3 Dr.Ranga Sai Dear Student friends… During these days of commercialization it becomes very difficult to find information on web which is relevant, authentic as well as free. We believe that knowledge should be free and accessible to all those who need. With this intention the notes, which are originally intended for the students of Vaze College, Mumbai, are made available to all, without any restrictions. These notes will be useful to all the F.Y.B.Com students of University of Mumbai, who will be writing their Business Economics Paper I examinations on or after March 2009. Distance Education students are advised to refer the recommended syllabus. This is neither a text book nor an original work of research. It is simple reading material, complied to help the students readily understand the subject and write the examinations. We no way intend to replace text books or any reference material. This is purely for academic purposes and do not have any commercial value. Feel free to use and share. We solicit your opinions and suggestions on this endeavor. Dr. Prof. Ranga Sai [email protected] June 2010 Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 4 Dr.Ranga Sai Module I: Demand analysis Utility analysis of consumer behavior given by Marshall is based on the cardinal measure of utility. The theory is based on the basic assumption that the utility can be measured. Accordingly, the theory describes utility as the want satisfying capacity of a good. Such utility is classified as time utility- a good changes form time to time depending on the seasons; place utility- a good changes utility form place to place; form utility- where the good changes utility with changing form. Use value is the value of a good in use. It depends on the want satisfying capacity of the good. Exchange value, on the other hand deals with what a good can get in return in the market. The value paradox states that use value and exchange value are inversely proportional. With increasing use value of good its exchange value decreases. e.g. water, air. Similarly with increasing exchange value its use value decrease .e.g. diamonds, gold But a transaction can take place only when use value is equal to exchange value. This conflict is called as value paradox. Under the utility theory the consumer behavior is explained by the Law of diminishing marginal utility. According to the law ‘with the increasing use of a good its marginal utility decreases’. The consumer maximizes his satisfaction by equating marginal utilities of all the goods he consumes. This is called the law of equi-marginal utilities. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 5 Dr.Ranga Sai Indifference Curve Analysis Consumption theory in economics contains two parts. Firstly, the theory studies the consumer behavior and secondly, the theory will suggest the consumer the way in which satisfaction van be maximized. In utility analysis, the Law of Diminishing marginal utility studies consumer behavior and the law of Equi-marginal utilities suggested a method of maximizing consumer satisfaction. Indifference curve analysis is a consumption theory given by Hicks and RGD Allen. The theory is an improvement over Utility analysis. Utility analysis had a major draw back that it measured utility in cardinal terms. Indifference curve analysis measures utility in ordinal terms. Further, IC analysis provides wider descriptions and details as compared to utility analysis. IC deals with various combinations of two goods which give the consumer the same amount of satisfaction. Indifference Schedule X 1 2 3 4 Y 12 10 7 3 All these combinations give the consumer same amount of satisfaction. In this case the consumer will not be able to choose any combination as better than other. The consumer will be indifferent between these combinations. The curve drawn indifference schedule is called the IC. Hicks use an IC to explain the consumer behavior. ICs can be understood better with the help of its properties. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 6 Dr.Ranga Sai Properties of Indifference curves 1. Indifference curves towards the axis represent lower satisfaction and IC away from the axis represents higher satisfaction. In the diagram IC 1 represents lower satisfaction and IC2 represents higher satisfaction. This is because on higher IC the consumption increases and on lower IC consumption decreases. It can be seen that for the same amount of Y the consumer gets +2 on IC2 and gets -2 on IC1. Higher the consumption higher the satisfaction and lower the consumption lower the satisfaction 2. Indifference curves never touch the axis. By touching the axis the indifference curve will represent only one good. In fact an IC should necessarily represent two goods always. 3. Indifference curve is a down ward sloping curve. It slopes down from left to right. A consumer has to sacrifice one goods to gain the Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 7 Dr.Ranga Sai other. This is essential to keep the level of satisfaction constant on an IC. 4. On an indifference curve the marginal rate of substitution decreases. The marginal rate of substitution, is the rate at which a substitutes one commodity with the other. By gaining one commodity the consumer shall sacrifice the other. This is needed to keep the level of satisfaction constant on an IC. the slope of an indifference curve, MRS = ∆y/∆x. The marginal rate of substitution decreases on an IC. On the diagram it can be seen that On the upper half, the consumer sacrifices 4 Y for 1 X, that is the rate of substitution is 4/1 Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 8 Dr.Ranga Sai On the Lower half it can be seen that the rate of substitution is 1/ 4 i.e. the consumer equates 1Y with 4 X. This is because on the upper half the consumer has more of Y so he likes more of X and lower half he has more of X so he likes more of Y. In this process the rate of substitution decreases from 4/1 to 1/ 4. On an IC the consumer expresses his utility behavior through decreasing Marginal rate of substitution. Comparing the IC analysis and the Utility analysis it can be seen that the marginal rate of substitution is equal to the ratio of the marginal utilities, MRS = ∆Y = - MUx ∆X MUy 5. An indifference curve is convex to the origin. Only on a convex curve the marginal rate of substitution decreases. Slope of an IC is found by drawing a tangent. The slope of the tangent is the slope of IC at that point. On a concave curve the slope of IC increases that is MRS increases. So it is not an IC. Similarly, a straight line has constant slope or constant MRS hence not an IC. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 9 Dr.Ranga Sai A curve convex to the origin has decreasing slope or decreasing MRS, hence, an IC. 6. Indifference curves need not be parallel. Converging indifference curves are accepted to be correct. 7. Indifference curves do not intersect. Indifference curves need not be parallel. Converging indifference curves are accepted to be correct but they shall not intersect. Intersection of Indifference curves is considered to be illogical, inconsistent and irrational. In the diagram it can be seen that Combination A gives larger satisfaction, because it is on a higher indifference curve IC1 And Combination B gives smaller satisfaction, because it is on a lower indifference curve IC2 But Combination C gives same satisfaction, yet it is on two indifference curves IC1 and IC2. Two indifference curves can not give same satisfaction. This is illogical, inconsistent and irrational. Foundations of Assumptions of Indifference curves: Indifference curve analysis is based on the following assumptions: 1. Transitivity: It is assumed that the combinations are continuous to form a curve. The combinations between two tested sets are given. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 10 Dr.Ranga Sai 2. Ordinality: The indifference curve analysis considers ordinal measure of utility. That is utility is compared but not qualified. 2. Rationality: The consumer is rational. He always prefers higher satisfaction to the lower and he knows all the combinations giving him same satisfaction or different satisfactions. 3. Convexity: A convex indifference curve represents the consumer behavior. The convex IC shows the utility behavior with out actually measuring utility in cardinal terms. 4. Scale of preference: On a series of indifference curves the consumer has a preference increases from low to high. The consumer always prefers higher satisfaction to lower. This is called the scale of preference. Price Line The price line represents the budget of the consumer. It is made up of the money income of the consumer and the prices of two goods. The price line deals with various combinations of two good that a consumer can buy with in his limited income. This is only the possibility of buying and does not represent the choice of the consumer. Given the price line, the consumer can buy any combination on the line or combinations below the line. When the price of a good decreases the real income of the consumer increases. Real income is what the consumer can buy with his money income. With this, the price line will shift upwards on a single axis (shift on X axis if the price of X decreases) Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 11 Dr.Ranga Sai Similarly, if the money income increases the price line will shift upwards parallel on both axes. Consumer equilibrium The consumer equilibrium suggests the method in which he consumer can maximize satisfaction with in the given limitations of money income and prices. The indifference curve analysis is an improvement over the utility analysis. It is given by Hicks and RGD Allen. As an improvement IC analysis uses ordinal measure of utility in place of cardinal measure. Assumptions Consumer equilibrium is based on the following assumptions: 1. The prices of two goods are given and constant. 2. The money income of the consumer remains constant 3. The tastes and preferences of the consumer remain same 4. The consumer is rational, i.e. the consumer prefers larger satisfaction to smaller satisfactions. 5. The theory follows all the foundations of indifference curves, like convexity, transitivity, ordinality and scale of preference. The consumer equilibrium considers the indifference map and the price line. The indifference map represents the consumer behavior, tastes and preferences of the consumer. On the other hand the price line represents income and the prices of two goods. The indifference curve is made up of combinations the consumer wants to consume on the other hand the hand the price line denote the combinations the consumer can buy. Consumer equilibrium determines Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 12 Dr.Ranga Sai such combinations which the consumer can buy, those which he likes and finally gets maximum satisfaction. The consumer equilibrium is derived by combing the indifference curves and the price line. In the diagram IC3 is possible because the consumer can not reach this with his limited income. IC1 is possible because there are several combinations with in the budget; price line IC2 and the price line have one combination common. At the point of tangency between the IC and price line i.e. E. This is the consumer equilibrium. A combination which offers maximum satisfaction and is also falls with in the price line. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 13 Dr.Ranga Sai Conditions of Consumer Equilibrium The consumer equilibrium is found at a place where Indifference Curve (IC) and Price Line (PL) are tangential. Or Slope of the price line = Slope of the Indifference curve Slope of the price line = Marginal Rate of substitution [Equilibrium condition] In the diagram E1 is not equilibrium because slope of IC > Slope of PL E2 is not equilibrium because slope of IC < Slope of PL At E Slope of IC= Slope of PL, hence equilibrium There are two conditions of consumer equilibrium Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 14 Dr.Ranga Sai a. Necessary Condition: Tangency is a necessary condition. It is case of optimizing satisfaction. In the diagram E2 is a necessary condition. Yet it is not the equilibrium. b. Sufficient condition: Tangency + convexity is sufficient condition. Tangency represents mathematical optimization and convexity denotes consumer behavior. In the diagram E2 is necessary condition. It fulfills tangency as well as convexity. Such consumer equilibrium remains valid as long as the price and money income remain unchanged. Income Effect Income effect shows the effect of changes in the money income of a consumer on his consumption. All other things remaining constant if the money income of the consumer increases, the price line will shift upwards parallel. An upward shift of price line indicates an increase in the income. With an increase in the income the consumer will consume more. The IC will shift upwards on the new price line. The increase in the consumption of a commodity is called income effect. When the money income increases the consumer shifts on to IC2. The increase in consumption of X is called income effect. If we join the points of equilibrium an income consumption curve can be drawn. Income consumption curve shows changes in the consumption of a commodity for changes in money income. The nature shape of the ICC indicates the nature of commodity, whether normal good, inferior or Giffen’s good. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 15 Dr.Ranga Sai With increase in the money income if the consumption increases it is called positive income effect and if consumption decreases with increasing income it is called negative income effect. The nature of income effect determines the shape of the Income Consumption Curve. ICC1: If the ICC slopes upwards to the right both X and Y are normal goods with positive income effect. ICC2: If the ICC slopes backwards, Y is inferior with negative income effect and X is normal with positive income effect. ICC3: If the ICC slopes forwards to the right, X is inferior with negative income effect and Y is normal with positive income effect. Assumptions Income effect is based on the following assumptions: 1. The prices of two goods are given and constant. 2. The money income of the consumer is given and subject to changes. 3. The tastes and preferences of the consumer remain same 4. The consumer is rational, i.e. the consumer prefers larger satisfaction to smaller satisfactions. 5. The theory follows all the foundations of indifference curves, like convexity, transitivity, ordinality and scale of preference. Substitution Effect When the price of commodity decreases the consumer substitutes a costlier commodity with a cheaper commodity with out affecting the level of satisfaction. This is called Substitution effect. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 16 Dr.Ranga Sai In the diagram, the movement from Eq1 to E2 is called substitution effect. The consumer consumes more of X by sacrificing Y. The movement is on the same IC showing that the level of satisfaction remains same. The substitution effect is always positive for normal as well as inferior goods. For Giffen’s goods substitution effect is positive but very weak. Substitution effect together with income effect constitutes the price effect. Price Effect Price effect shows the effect of changes in the price of a good on consumption. All other things remaining constant if the price of a commodity increases, the price line will shift upwards on that axis. An upward shift of price line indicates an increase in the real income. With an increase in the real income the consumer will consume more. The IC will shift upwards on the new price line. The increase in the consumption of a commodity is called price effect. When the price decreases the consumer shifts on to IC2. The increase in consumption of X is called price effect. If we join the points of equilibrium a price consumption curve can be drawn. Price consumption curve shows changes in the consumption of a commodity for changes in price. The nature shape of the PCC indicates the nature of commodity, whether normal good, inferior or Giffen’s good. Assumptions Price effect is based on the following assumptions: Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 17 Dr.Ranga Sai 1. The prices of two goods are given and the price of one good only changes. 2. The money income of the consumer is given and constant. 3. The tastes and preferences of the consumer remain same 4. The consumer is rational, i.e. the consumer prefers larger satisfaction to smaller satisfactions. 5. The theory follows all the foundations of indifference curves, like convexity, transitivity, ordinality and scale of preference. Composition of Price Effect Price effect is made up of income effect and substitution effects. When the price of a commodity decreases: a. The real income increases and the consumer consume more of a commodity. This is called income effect. b. When a commodity becomes cheaper the consumer has a natural tendency to substitute the costlier commodity with a cheaper commodity. This is called as substitution effect. Thus, Price Effect= Income Effect+ Substitution Effect In the diagram E1 is the consumer equilibrium With a decrease in the price of X the price line shifts upwards and the consumer will shift on to IC2 at equilibrium E2. The movement from E1 to E2 is called Price effect To separate income effect from price effectShift the price line parallel from E2 downwards, so as to reach IC1 at E3. A parallel downward shift indicates decrease in the income. The price line shall be shifted to such level on IC1 that the consumer comes back on to his original level if satisfaction. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 18 Dr.Ranga Sai With a decrease in income effect the consumption is reduced to E3, The consumption from E1 to E3 is substitution effect, found on the same IC. According to Hicks the price line should be shifted on to lower IC such that the ‘consumer is neither better off nor worse off’ Nature of Price Effect Positive price effect means with a decrease in the price the consumption increases. This is same as the law of demand. The exception to the law of demand is negative price effect. The price effect is positive for normal goods and inferior goods. There are some inferior goods where the price effect is negative. These goods with negative price effect are called Giffen’s goods. The price effect depends on the components - income and substitution effects. Income Effect Substitution Effect Price effect Normal Goods Inferior goods Giffen’s Goods +ve -ve (weak) -ve (strong) +ve +ve (strong) +ve (weak) +ve +ve -ve Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 19 Dr.Ranga Sai For normal goods the price effect is positive because the components income and substitution effects are positive. Inferior Goods In case of inferior goods in general, the price effect is positive. The income effect is negative but very weak. The substitution effect is positive and very strong. So finally, the price effect remains positive. In the diagram: The movement from E3 to E2 is negative income effect. This is negative The movement from E1 to E2 is positive substitution effect which positive and strong. So, finally, the movement from E1 to E2 is positive price effect. Inferior goods in general follow the law of demand with positive price effect. Giffen’s Goods Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 20 Dr.Ranga Sai Giffen’s goods are those inferior goods where the income effect is strongly negative and substitution effect is weak. Giffen’s goods re inferior goods but all inferior goods are not Giffen’s goods. Giffen’s goods are those inferior good which have a negative price effect. In the diagram: The movement from E3 to E2 is negative income effect. This is negative and strong The movement from E1 to E2 is positive substitution effect which positive but week. So, finally, the movement from E1 to E2 is negative price effect. Derivation of demand curve from Price Consumption Curve For drawing the demand curve there is a need for a set of prices and corresponding quantities. The Price Consumption curve shows different price lines. Each price line represents one price of commodity X. The corresponding quantities can be read fro the X axis at different equilibriums. The quantities from different equilibriums are drawn on the lower graph with X axis marked quantity. The price at different quantities can be plotted on the Y axis. By joining all the points the demand curve can be drawn on the lower panel. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 21 Dr.Ranga Sai Elasticity of Demand Elasticity of demand measures intensity of changes in the quantity of a commodity for changes in the price, income or the price of a related commodity. Accordingly, it is called price elastic, income elasticity or cross price elasticity of demand. Price Elasticity of demand Price elasticity of demand measures proportionate changes in the quality of a commodity for proportionate changes in the price. Price elasticity relates quantity demanded and the price. Price elasticity is measured as The price elasticity has a negative value, because the price decreases for an increase in the quantity demanded. ep = 1, Unitary elastic, reference elasticity ep > 1, Relatively elastic, luxury goods ep < 1, Relatively inelastic, necessary goods ep = ∞, Perfectly elastic, hypothetical ep = 0, Perfectly inelastic, hypothetical Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 22 Dr.Ranga Sai The value of elasticity changes with changing responsiveness of quantity changes for changes in the price. Larger the responsiveness greater will be the elasticity. No change in the quantity the elasticity will be zero. For highly sensitive quantity, the elasticity will be infinity. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 23 Dr.Ranga Sai Income Elasticity of demand Price elasticity of demand measures proportionate changes in the quality of a commodity for proportionate changes in the income. Income elasticity relates quantity demanded and the income. With an increase in the income the consumer increases the consumption. This happens in case of normal goods. Incase of inferior goods with increase in the income the consumer degreases the consumption. This is called negative income effect. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 24 Dr.Ranga Sai For normal goods the value of income elasticity is positive for inferior goods it is negative, ey = 1, Unitary elastic, reference elasticity ey > 1, Relatively elastic, luxury goods ey < 1, Relatively inelastic, necessary goods ey < 0, Inferior goods effect ey = 0, Perfectly inelastic, hypothetical ey = ∞, Perfectly elastic, hypothetical positive income effect positive income effect positive income effect negative income Cross Price Elasticity of Demand Price elasticity of demand measures proportionate changes in the quality of one commodity for proportionate changes in the price of a related commodity. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 25 Dr.Ranga Sai Cross Price elasticity relates quantity demanded of one commodity and the price of a related commodity. The value of cross price elasticity depends on the type of relationship between the goods. exy < 0, Complementary goods When the price of X increases, the demand for x decreases, the consumer decreases the demand for Y. Since, X and Y are complementary goods. Complementary goods are those which give utility only in combinations. These are called joint goods having joint demand. e.g. shoe and shoe lace, pen and ink exy > 0, Substitute goods When the price of X increases, the demand for x decreases, the consumer increases the demand for Y. Since, X and Y are substitutes. Substitute gods are those goods which give similar utility. Since the goods give similar utility the consumer can consume one in the place of the other. exy = 0, Unrelated goods Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 26 Dr.Ranga Sai If the price of X increase the demand for Y remains unchanged this is because the goods are unrelated and independent in consumption and utility. Point Elasticity of Demand According to Lucas all goods tend to be elastic at higher prices and inelastic at lower prices. This principle can be shown geometrically on a demand curve using point elasticity of demand method. It is ratio of lower segment to the upper segment. The elasticity increase as it moves upon the demand curve to the left. The demand curve is extended on both sides so as to make a right angle triangle. Then the elasticity at point is measured as E= Or Lower segment Upper segment BC AB So e = 1, Unitary elastic, reference elasticity e = 0, Perfectly inelastic, hypothetical e > 1, Relatively elastic, luxury goods e < 1, Relatively inelastic, necessary goods e = ∞, Perfectly elastic, hypothetical Promotional Elasticity of Demand Promotional elasticity of demand measures proportionate changes in the sales of a commodity for proportionate changes in the promotional budget. Price elasticity relates sales and the promotional budget. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 27 Dr.Ranga Sai Promotional elasticity is a managerial tool of corporate decision making. It enables the enterprise to decide whether a sales promotion budget is desirable or not in terms of generating corporate incomes and sales. An elastic promotional elasticity means that the sales are in larger proportions than the promotional budget and desirable. If the promotional elasticity is less than one that inelastic it means that the promotional budget has failed in promoting proportionate sales, hence undesirable. The promotional budget may have components like media, advertising, sales promotions, free samples, gifts, promotional offers etc. Consumer Surplus Consumer surplus is the excess of Utility drawn over the price paid. According to the law of demand the price decreases with increasing quantity. This is because the utility decrease with in creasing consumption as per the law of diminishing marginal utility. A consumer pays the price according to the utility drawn on the last commodity. This price is uniform for all the earlier units. In this process the consumer derives surplus utility over the price paid on earlier units. This surplus utility is called the Consumer Surplus. Consumer surplus = Utility derived – price paid Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 28 Dr.Ranga Sai Consumer surplus is the excess of utility derived by consumer. The producer surplus is the surplus of price charged by the producer over the supply price. The supply curve shows that the price increases with increasing quantity. The price is charged as per the last unit produced, whereas the producer receives a surplus over the supply price. This is called producers’ surplus. The producers’ surplus can be increased by reducing consumer surplus. This is called consumer exploitation. Assumptions 1. The concept believes in the law of diminishing marginal utility 2. The law of demand is considered for determining the price. 3. The price remains uniform. 4. The supply of goods is uniform. 5. The tastes of the consumer remain constant 6. There is perfect competition. Limitations The concept of consumer surplus has several limitations due to its rigid assumptions. 1. The utility can not be measured 2. Consumer surplus can not be easily quantified. 3. Market imperfections deny consumer surplus to the consumer. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 29 Dr.Ranga Sai 4. Marketing techniques increase consumer surplus by showing greater utility and then in crease price. 5. Consumer surplus encourages the government to levy tax. Applications: Consumer surplus is a very useful concept applied in marketing, product design and pricing. 1. It helps in determining the price. Larger the consumer surplus, greater the possibility of increasing the price. 2. The Government can determine tax based on consumer surplus. 3. Under monopoly, the producer charges different prices for the same commodity depending on the consumer surplus. It helps on price discrimination. 4. Necessities have larger consumer surplus than luxury goods. 5. Consumer surplus helps in demand forecasting. Demand forecasting Demand forecasting refers to future market situation. Demand forecasting is an important technique of corporate decision making. It enables a firm decide upon a commodity for production among several or helps in understanding the future market of a given product. Nature and significance of demand forecasting 1. Demand forecasting starts with defining the product or the product mix. This will depend on the nature of firm and its corporate image. 2. Once the product is decided the forecast will now describe the buying objectives of the product. The buying objectives will determine the target population for whom the product is being produced. 3. The buying objectives will influence the product design, the cost and ultimately, the price. 4. Depending on the product design, the inputs are drawn. The factors need to be imported or domestically procured. The demand forecast will provide the sources and the costs. 5. To define the market prospects the product is identified with the product cycle. The product may belong to any of the states of product cycle: interdiction, growth, competition, stagnation or Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 30 Dr.Ranga Sai decay. The stage to which the product belongs will determine the selection of the product and forecast. 6. Specialized inputs and labour may require efforts in procuring and training. 7. The production and delivery schedule is drawn depending on the market. Seasonal good may have different delivery schedule as compared with a regular good of consumption. 8. The price is decided and the cash flows are estimated. The sales, revenue profits, costs and the rates of return are estimated for period of three to five years. 9. The market is described with respect to risk of competition, Government policy, future prospects. In case of any risk the possible methods of overcoming risk will be indicated. Such demand forecast will be useful for a firm in taking decisions. Process of demand forecasting The process of demand forecasting depends on the nature of product and nature of firm. The process differs from firm to firm and product to product. 1. The demand forecast has to first consider the corporate policy. The product to be produced depends on the firm and the nature of market image it carries. 2. There after the approach to demand forecast changes between an existing firm and a new firm. An existing firm will have historical data which can be used for future analysis, where as a new firm has to generate relevant data from the market. 3. Depending on the product, firm and market the method of demand forecasting will be selected. Thus a model is built with all required parameters. 4. The tolerance limits are defined. These are the accuracy levels of the forecast. The accuracy level will determine whether to accept or reject the model. 5. The Model goes for sample testing in a limited region to see all the needed information is got. The trial run will help in making modifications to the model, if need be. 6. When the model is successful, the larger study is conduced and the results are analyzed. 7. Finally, the forecast will provide projected cash flows for five years to come. Notes, definitions are given together with risk and methods to risk management. A detailed description on the market trends and the prospects of the product to be marketed is appended. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 31 Dr.Ranga Sai Methods of Demand forecasting There are different types of demand forecast each meant for a specific objective and has a specific data requirement and ha specific information to offer. The methods of demand forecasting can be classified into two groups: A. Statistical or Quantitative methods of demand forecasting B. Survey methods of demand forecasting A. Quantitative OR Statistical methods of Demand forecasting Quantitative methods of demand forecasting need a large data base for analysis. It is more suited for older firms with historical data. Quantitative methods provide accurate results but skills in analysis and interpretation will it more effective. Some of the quantitative methods are static and consider only limited variables. The active forecasts use highly developed mathematical tools of analysis and provide accurate and dependable results. 1. Linear equation Linear equation is the simplest of quantitative methods of demand forecasting applied on time series data. It assumes a constant rate of change of sales and based on the change coefficient, the sales for any future year is estimated. Illustration Given, initial sales (a) of 1500 tons and an annual increase (b) of 500 tons, the out put can be estimated for any future year, with the equation: Sales, Y = a + bt, Where a is the initial sales, b is the annual expected change and t is the time period. The projected sales after 5 years will be Sales, Y = 1500 + ( 500 x 5 ) = 1500 + 2500 = 3,500 The linear equation is a static method of quantitative demand forecasting. It assumes a constant rate of change. Though it is not the most accurate method, it is commonly used as preliminary estimate. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 32 Dr.Ranga Sai 2. Trend line Seasonality is a characteristic of time series data. It prevents the usage of any liner method of demand fore casting. For this reason, the data needs to be corrected for the seasonality before any method is applied. The seasonality is time series data can be corrected in different ways. One method is applying the statistical method of trend fitting or least squares method. A trend line is fitted in such a manner that the positive variations are same as the negative variations. In other words the trend should be an average of the seasonal changes. In other words the trend line should be so fitted that the square of the deviations is least. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 33 Dr.Ranga Sai 3. Moving averages The seasonality is time series data can be corrected by applying the statistical method of moving averages. The date is studied to first find out the period of seasonality. Then a moving average is calculated by taking average of that period, sequentially, each year. Each year one earlier observation is dropped and a later observation is included. This way, the set of averages of the reference period is computed. Normally, after applying the moving averages the trend becomes clear. If the trend can not be found the moving averages is repeated with different time period or on the same period again. In the illustration a moving average of three years is applied and the trend is brought out. 4. Regression equation Regression equation deals with the relation between the quantity demanded and the factors determining it. The process begins with the demand function Quantity demanded, Qd = f( P, Pc,T,A) Once the demand function is identifies the nature of effect is describes and the intensity of relation is qualified in terms of figures. Then the regression equation is cast as an input output relation Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 34 Dr.Ranga Sai Quantity demanded, Qd = a – 0.8 P + 0.3 Pc + 0.2 T + 0.9 A + E Where, P - is the price Pc - the price of the competitors, T - tax , A advertising, and E - stochastic variable, explaining the change not explained by the existing variables With this equation all the factors re brought out. The demand forecast can be managed with the help of these parameters. B. Survey methods of demand forecasting The survey methods of demand forecasting provide descriptive analysis. The method is suitable for consumer gods, for firms which are new. Hence there is no need for historical data, the methods uses cross sectional data. There are several survey methods which collect information from those whose decisions determine the market demand. 1. Consumer survey The consumer survey collects information form the consumer directly on the nature of product price payable, qualities and attributes, the position of a given product with respect to other competing goods, customer satisfaction and the utility. The consumer opinions can be collected in questionnaire designed specific to the purpose and the opinions can be solicited in three different ways. a) By mail: Collecting information from consumers through post is most economical and the methods can provide large information. This method gives enough time for the respondent. But the method may consume more time and information can be, at times, spurious. b) By telephone: Telephonic interviews help in getting candid opinions. This method gives quick results and it is very economical. However the method may be confined to those consumers having telephone facility. c) By personal interviews: Interviews are by far the best method of collecting consumer opinion. The method can provide more information than the study expect. However, the method can be very expensive and time consuming Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 35 Dr.Ranga Sai 2. Expert opinion study This is also called the Delphi methods. The method depends on the opinion of experts in determining the nature of demand forecast. In case of certain good, the consumer opinions may not be important. The consumer may depend on the experts for advice. Medicines, sport equipment, text books, health drinks belong to this category. 3. End use study The method collects opinions of the user sector in estimating the demand for a given product. The method is suitable for industrial products/ intermediate goods; those goods which become input for some other firm to become consumer goods. For such goods the demand for the end product will determine the demand for the intermediate goods. E.g. steel, cotton, cement etc. 4. Simulated market / Consumer clinics Simulated market is a model market which represents the actual market. In a simulated (artificial) market the consumers are let in predetermined amounts of money. The consumers buy goods with this money. The choice of the consumers provides valuable and most dependable information for the study. This method is most dependable, accurate and quick in giving information 5. Export potential study Export potential studies generally apply linear models with large descriptive notes on the cultural pattern of consumption and Government/local practices. These are statistical models as well as opinion studies. Active and Passive forecasts Quantitative methods provide accurate results but skills in analysis and interpretation will it more effective. Some of the quantitative methods are static and consider only limited variables. The active forecasts use highly developed mathematical tools of analysis and provide accurate and dependable results. Static fore casts are simple mathematical models which are mostly used for the ease. They provide quick estimates for preliminary studies. Active forecasts are non linear models which are advanced models using more variables. They provide dependable estimates. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 36 Dr.Ranga Sai In the diagram it can be seen that a and b are active forecasts for similar static forecast. As non linear forecasts they can show larger variation in rate of change. A static model is a linear relation which can give only an average growth. Features of an ideal demand forecast An ideal demand forecast should fulfill the following characteristics: 1. Accuracy: A demand forecast shall be accurate. Te accuracy is given by the tolerance limit. The percentage of tolerance will determine the accuracy. 2. Comprehensive: A comprehensive demand forecast will provide details on the product, product mix and a detailed study f the market. The risks and the prospects for growth shall be also made clear. 3. Economical: The cost of conducting survey shall be low so that the demand fore cast will be in the reach of even the smaller firms. 4. Time: The demand forecast shall take as little time as possible so that the data and analysis remain relevant to the market and the policies of the Government. 5. Flexibility: The demand forecast shall be flexible enough to accommodate small changes and also adjust itself to the need of future demand forecasts. 6. Durability: A demand forecast shall be durable. A good model of demand forecast should be useful for a long time to come. Any changes should be adapted as per the need in future. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 37 Dr.Ranga Sai Module II: Theory of production Production function A production function provides the relationship between out put and various factors of production. A production function is a functional relation between the inputs and out put. The production function can be classified as per time period. There can be short run production function and the long run production function. Between time periods the nature of factors can change. In the long run all factors change; when all factors change there can be large changes in the out put can be brought, the technology can change, the cost structure may be totally renewed. So, the expression of long run production function will be Quantity of out put, Q = f ( Labour, raw material, power, land, buildings, machinery / T) Where T, is technology; an embedded (associated) factor of production. It is the qualitative description of capital, In the short run certain factors are fixed certain other variable. Fixed factors remain fixed even with changing out put. On the other hand variable factors change with changes in the out put. So the expression of production function will have fixed and variable factors. Quantity of out put, Q, = f ( labour, raw material, power/ F , T) Where F represents the fixed factors which remain unchanged in the short run and T is the level of technology given and constant. The short run production function will always carry the expression fixed and variable, separately. Law of variable proportions The law of variable proportions studies the relationship between one variable factor and the out put. It studies the behavior of out put for changing variable factor. It deals with a short run production function Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 38 Dr.Ranga Sai with one variable factors with all other factors are given and kept constant. Q, = f ( labour / F , T) Where F represents the fixed factors which remain unchanged in the short run and T is the level of technology given and constant. According to the law of variable proportions, ‘all other factors remaining constant, if the usage of one variable factor increases, the out put will increase rapidly, then slowly and finally decreases’. Total Labour Product Units TP Average Product AP Marginal Product MP Production Elasticity Stages of production 1 2 3 4 5 6 7 5 8 15 24 30 30 28 5 4 5 6 6 5 4 0 3 7 9 6 0 -2 Ep>1 Increasing returns I Stage Ep<1 Ep<0 Diminishing returns II Stage Negative returns III Stage I Stage: Stage of increasing returns During the first stage the out put increase rapidly because a. The variable factors become more and more productive, initially. b. The fixed factors become more productive. c. The elasticity of production is more than 1 ( Ep>1) During the first stage AP, MP and TP are increasing. MP reaches a maximum called as the point of inflexion. From this point onwards there will be a change in the level of factor productivity. At the end of the stage, AP=MP and TP continues to increase. II Stage: Stage of diminishing returns During the second stage the out put increase slowly because a. The factor substitution becomes limited b. Other factors become less and less productive c. The elasticity of production is more less 1 ( Ep<1) During the second stage AP decreases but it is slower than MP. Further, MP<AP, MP decreases and TP is increasing, but slowly. At the end of the stage MP=0 Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 39 Dr.Ranga Sai III Stage: Stage of negative returns During the third stage the out put decreases because a. There will overcrowding of one variable factor b. Fixed factors also become less productive. c. The elasticity of production is less than o ( Ep<0) During the third stage, AP, MP and TP are all decreasing. Assumptions: 1. All factors re given and remain constant and only labour changes 2. The level of technology remains same. 3. There is perfect competition in product and factor markets. 4. Variable factors are of similar productivity. Isoquants An isoquant is made up of various combinations of two factors which give rise to a fixed amount of out put. Isoquant deals with a production function with two variable factors. Output = f (K,L / F ,T) where K - Capital, L – labour, F – fixed factors, kept constant in the short run and T – the technology given. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 40 Dr.Ranga Sai Each Isoquant deal with a specific level of out put. Isoquants away from the origin represent higher out put and isoquants towards the axis represent lower out put. The Isoquant depends on the level of factor substitutability. Factors of production are not perfect substitutes. The ridge lines give the limits of factor substitutability. The area between the ridge lines is called the economic zone. This is the area where there is factor substitutability. The analysis is confined to this area alone. The area out side the ridgelines can not be used for any study, because the factor substitutability ends. The slope of the Isoquant represents the Marginal rate of technical substitution (MRTS). It is the ratio of change in K for changes in L. The Marginal rate of technical substitution is the manner one factor is substituted by the other factor so as to give a fixed output through out the isoquant. Such slope of isoquant depends on the nature of factors and intensity of production. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 41 Dr.Ranga Sai Producers' equilibrium (Least cost combination) Producers’ equilibrium deals with a least cost combination of producing a specific level of out put the producer would like to produce. A producer will be a t a state of equilibrium when he produces a desired level of out put at a cost which is least. This can be done by using isoquants. By choosing isoquant we consider a production function with two variable factors all other factors and technology remaining constant. Output = f (K,L / F ,T) Where K - Capital, L – labour, F – fixed factors, kept constant in the short run and T – the technology given. Firstly the producer will determine the level of out put to be produced; the isoquant is selected. The producers' equilibrium is found at a place where the slope of the isoquant is same as the factor price ratio line. Mathematically, the slope of the isoquant is equal to the slope of the price ratio line. Or the slope of the price ratio line is same as the Marginal rate of Technical Substitution. The producers' equilibrium finds the least cost combination. Least cost combination is the combination of two factors which will produce a given level of out put at least cost. There are different least cost combinations for different levels of out put. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 42 Dr.Ranga Sai Assumptions 1. Producers’ equilibrium considers a production function with two variable factors. 2. The level of technology remains same 3. All other factors are given and constant 4. There is perfect competition in factor and product markets. The prices of two factors are given and remain unchanged. Least cost combinations are found at different levels of out put by following the condition of producers’ equilibrium. When all the points of equilibriums or the least cost combinations at different levels of out put are joined, the production path or the scale line can be derived. The shape and position of the scale line will indicate the type of technology or the intensity of factor usage. If the production path is towards the capital axis it is capital intensive, if it is toward the labour axis the technology is labour intensive. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 43 Dr.Ranga Sai Laws of Returns to Scale The laws of returns to scale deals with the long run production function. In the long run all factors change; when all factors change there can be large changes in the out put can be brought, the technology can change, the cost structure may be totally renewed. So, the expression of long run production function will be Quantity of out put, Q = f ( Labour, raw material, power, land, buildings, machinery / T) Where T, is technology; an embedded (associated) factor of production. It is the qualitative description of capital, According to the laws of returns to scale In the long run when the scale of production increase, a. The out put may increase in larger proportions than the inputs used called Increasing returns to scale OR b. The out put may increase in the same proportions as the inputs used called Constant returns to scale OR c. The out put may increase in lesser proportions than the in puts used called Diminishing returns to scale. The laws of returns to scale can be explained with the help of isoquants. By choosing isoquant we consider a production function with two variable factors all other factors and technology remaining constant. Output = f (K,L / F ,T) Where K - Capital, L – labour, F – fixed factors, kept constant in the short run and T – the technology given. 1. Increasing returns to Scale According to Increasing returns to scale In the long run when the scale of production increase, the out put may increase in larger proportions than the inputs used called increasing returns to scale Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 44 Dr.Ranga Sai Increasing returns to Scale - The gap between E1, E2, E3, and E4 decreases - Economies of scale - Decreasing costs The out put responds positively because; it operates on economies of scale. In the long run the firm derives certain advantages called economies of scale. These economies of scale can come from within called internal economies or come from out side the firm called external economies. Due to economies of scale the costs keep on decreasing. This is called decreasing costs. In the diagram it can be seen that the gap between the isoquants keep on decreasing thus showing that lesser and lesser factors are needed for producing additional output. 2. Constant returns to scale In the long run when the scale of production increase, the out put may increase in the same proportions as the inputs used called Constant returns to scale Constant returns to Scale - The gap between E1, E2, E3, and E4 remains constant - Neutral Economies of scale - Constant costs Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 45 Dr.Ranga Sai In case of constant returns to scale the out put increases in the same proportions as the inputs. The firm is a said to be operating on neutral economies. The firms neither get nor loose any advantages due to large scale production. In the diagram it can be seen that the gap between the isoquants remain constant thus showing that same ratio of factors are needed for producing additional output. The per unit costs remain constant. This is case of constant costs 3. Diminishing returns to scale. In the long run when the scale of production increase, the out put may increase in lesser proportions than the in puts used called Diminishing returns to scale. Diminishing returns to Scale - The gap between E1, E2, E3, and E4 increases - Diseconomies of scale - Increasing costs The out put responds discouragingly, because; it operates on diseconomies of scale. In the long run the firm may face certain disadvantages called diseconomies of scale. These diseconomies of scale can come from within called internal diseconomies or come from out side the firm called external diseconomies. Due to diseconomies of scale the costs keep on increasing. This is called increasing costs. In the diagram it can be seen that the gap between the isoquants keep on increasing thus showing that more and more factors are needed for producing additional output. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 46 Dr.Ranga Sai Assumptions: 1. It is case of long run production function 2. The scale of production increases 3. Technology remains same 4. There is a perfect completion in factor and product markets. 5. Each isoquant represents a fixed increment of output. Economics of Scale In the long run all factors becomes viable and the firm can increases its scale of production. When the firm increases the scale of production it gets certain advantages. These advantages are called economies of scale. A. Internal economies of scale These are the advantages the firm gets from the factors within the firm. These factors are endogenous to the production function. 1. Managerial economies: In the long run the firm will have better managerial talent in organizing factors for better productivity. 2. Technical economies: The firms will have improved technology in the long run and the firm will progressively reduce costs. 3. Economies of by product: The firm will be able to develop waste into marketable by product in the long run. This will add to the revenues of the firm. 4. Economies of supervision: Better supervision will improve the factor productivity in the long run. 5. Economies of cost: With improved supply chain and labour productivity the costs will reduce in the long run. 6. Economies of integration: In case of forward integration the firm will undertake an additional process of production and add value o the out put. The revenue will increase Similarly, backward integration will enable a firm produce such factors which were earlier bought form the factor markets. This again reduces the cost and adds to the profit margins. 7. Risk bearing economies: Firms will greatly increase capacity to take risk with new products and technologies in the long run. This is due to established market and strong finances. 8. Economics of specialization: The firm may develop certain specialization in the long run depending on the production function and acceptance in the market. This may create niche and better price. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 47 Dr.Ranga Sai B. External economies of scale These are the advantages the firm gets from the factors out side the firm. These factors are exogenous to the production function. 1. Economies of marketing: The firms will be able to market with ease due to establishment of brand and dealership network 2. Economies of finance: The firms will have better financial position in the long run due to accumulated profits. The firm will also have better institutional axis for raising more finance easily. 3. Economies of environment: In the long run the firm becomes more environmentally friendly with larger investment on pollution control and resource conservation Economies of Scope Economies of scope deals with the advantage a firm receives by producing a product mix of two goods instead of two firms producing them separately. When a single firm produces two products it gets advantages arising out of production function, managerial and technological reasons. In the diagram, the linear curve denotes the combinations of two products the firms can produce separately. If the firm produces together the production possibility is found on the concave curve. The advantage of producing together is marked as extra. The rate of advantage can be measured as C(a) + C(b) – C (a+b) C(a+b) Where, C(a) – cost of product a , C(b) – cost of product b, C(a+b) – cost of products a and b. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 48 Dr.Ranga Sai This is different from the economies of scale a firm enjoys in the long run. This advantage of scope can be derived by a firm even in the short run. This is the advantage of having multiple product mix instead of a single product. Module III Cost of production There are several concepts of cost developed, each suitable for a different purpose. There are financial cost and social costs, accounting cost and economic costs, short run and long run costs and the opportunity cost. 1. Accounting cost and economic costs: Accounting costs consider documentation of expenditure for purpose of future analysis. It is the analysis in retrospection. The analysis deals with spent money. As against this, the economic cost study the nature of costs, their behavior and methods of optimizing cists for minimizing cost of production and maximizing profits. 2. Financial cost and social costs: Financial costs are private costs, the costs paid by a firm to procure factors for creating out put. The major consideration is optimizing usage of factors for cost reduction and maximizing profits. On the other hand the social cost deal with the burden of production on the society, environment, and resource conservation. Most of the social costs can not be quantified. But these cots are very important in terms of social objectives and justice. 3. Financial costs and physical costs: Financial costs are economic costs mentioned in uniform value terms. Since all the factors are mentioned in uniform terms, it is easy to apply any quantitative or statistical method for regulating their usage and optimizing for profits. Physical costs on the other hand are factors mentioned in dissimilar units. Since they are dissimilar in expression and quantitative, it is not easy to apply techniques of quantitative analysis. Yet physical costs are important for production planning and procurement of factors. 4. Opportunity Cost: Opportunity cost is the cost of a factor in its alternative use. This is the minimum which needs to be paid to bring a factor in use. Any payment less than this will make the factor leave the production function and join an alternative use. The concept of opportunity cost is useful in determining the factor price. The factor price needs to be equal to or greater than the opportunity cost. Larger the opportunity cost higher will be the factor price. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 49 Dr.Ranga Sai Short run Cost curves In the short run certain factors are fixed certain other variable. Accordingly, certain costs are fixed and certain costs variable. In the shot run there are three costs - total fixed cost, total variable cost and total cost. In addition there are four per unit costs- average fixed cost, average variable cost, average cost and the marginal cost. Illustration: for a given TFC of 100 and TVC over 8 units, the costs will be Out put 1 2 3 4 5 6 7 8 TFC 1000 “ “ : “ “ “ “ TVC 100 180 240 340 480 680 980 1480 TC 1100 1180 1240 1340 1480 1680 1980 2480 AFC 1000 500 333 250 200 166 142 125 AVC 100 90 80 85 96 113 140 185 AC 1100 590 413 335 296 179 282 310 MC 80 60 100 140 200 300 500 1. Total Fixed cost The fixed cost remains constant in the short run at level of out put. The fixed cost curve is a horizontal curve parallel to x axis. At zero level of out put the total cost is equal to total fixed cost. 2. Total variable cost Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 50 Dr.Ranga Sai The total variable cost increases with increasing cost. The shape of the variable cost curve is drawn form the law of variable proportions. This it has three segments. At zero level of out put the variable cost is zero. 3. Total cost Total cost = Total fixed cost + Total variable cost The total cost is the sum of total fixed cost and total variable cost. At zero level of out put the total cost is equal to total fixed cost. The shape and size of total cost is similar to total variable; cost but it starts form total fixed cost. 4. Average Fixed cost Average Fixed Cost = Total fixed cost Out put Average fixed cost curve is a downward sloping curve. It keeps on decreasing, but never touches the axis. It is asymptotic to x axis. Geometrically, on this curve the product of coordinates always a constant. 5. Average Variable Cost Average Variable Cost = Total Variable Cost output Average variable cost is a broad U shaped curve; the shape of the curve is drawn from the behavior of variable facto and the law of variable proportions. 6. Average Cost Average Cost = Total cost Out put Or Average Cost = Average Fixed cost + Average Variable Cost Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 51 Dr.Ranga Sai Average cost curve is a U shaped curve; the shape is derived by the combination AC and AVC. AC curve lies above AVC. Average cost is minimum when AC = MC 7. Marginal cost Marginal cost = TC (n-1) - TC n Marginal cost curve is a J shaped curve. It passes through the minimum point of AC. When AC=MC, Marginal cost is minimum. The shape is derived from the behavior of marginal product in the law of variable proportions. The short run Average Cost Curve is a U shaped Curve The U shape of the average cost curve is made up of three segments; down ward part, change in the trend and upward trend: a. Initially, AVC and AFC are both decreasing so the resultant AC also decreases b. There after, AFC continues to decrease but AVC increases. There is a change it the trend. The decreasing curve now changes trend towards increase. c. Finally, the increasing AVC is stronger than decreasing AFC and AC now continues to increase. The Ac curve takes a U shape. Further, Average Cost = Average Fixed cost + Average Variable Cost So, the gap between AVC and AC is equal to AFC. Long run costs Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 52 Dr.Ranga Sai The long run cost curves are derived from the short run cost curves. The long run AC is derived from the short run AC. In the long run when the scale of production increases, the AC curves shift down wards showing decreasing costs. This is due to economies of scale. This is case of decreasing costs In the long run, when the scale of production increases, the AC curves may shift horizontally to the right. This is due to neutral economies of scale. This is case of constant costs. In the long run when the scale of production increases, the AC curves shift upwards showing increasing costs. This is due to diseconomies of scale. This is case of decreasing costs Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 53 Dr.Ranga Sai The long run AC is made up of these three segments. Thus the LAC is flatter than the SACs. The LAC is also called the envelope curve. For this reason “The long run average cost curve is flatter than the short run average cost curve.” Long run Marginal cost curve passes through the minimum point of LAC. Following are the long run factors responsible for flatter long run average cost curve: 1. Population Though population changes even in the short run. The effect of population can be seen only in the ling run, by way of changes in the pattern of demand and labor force. 2. Technology Technology helps in the ling run in reducing costs and making production function efficient. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 54 Dr.Ranga Sai 3. Alternative sources of raw material and energy Alternative and cheaper sources of raw material and energy change the production function and help in expanding out put and making it economical. 4. Expanding markets Expanding markets provide purpose for the industry to produce and distribute. In the long run, mass consumption in the economy increases. Producers’ surplus The producer surplus is the surplus of price charged by the producer over the supply price. The supply curve shows that the price increases with increasing quantity. The price is charged as per the last unit produced, whereas the producer receives a surplus over the supply price. This is called producers’ surplus. Producers’ surplus is the area above the producers supply curve and below the market price. The producers’ surplus depends on the elasticity of factor availability, factor prices, the demand for the goods and the Government regulation on the price. Large producers’ surplus will shift the burden of tax on to the seller. Large consumer surplus will put he burden of tax on the consumer. The producers’ surplus can be increased by reducing consumer surplus. This is called consumer exploitation. Assumptions 1. The quantity of supply increases with price 2. There is perfect competition in factor and product markets Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 55 Dr.Ranga Sai 3. The is perfect knowledge on price quantity demanded and supply Learning curve Learning curve refers to progressive decrease in the cost of production over a period of time, as experienced by firms. Learning curve shows the relationship between the cost of production and time. The costs tend to decrease with passing time because: 1. Repetitive production of a commodity leads to specialization 2. The usage of raw martial becomes more efficient 3. Wastages in production can be reduced due to specialization. 4. Supply chain improves and inputs will help better productivity. Learning curve is different from economies of scale. Economies of scale are found in the long run where as learning curve can be experienced even in the short run due to specialization In the diagram there is a change in the incremental costs between a and b. At b the incremental costs have become lesser than at a. This is the learning curve. Case study Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 56 Dr.Ranga Sai Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 57 Dr.Ranga Sai Section II Module IV: Revenue concepts Total revenue (TR): This is the revenue got by the firm by selling certain amount of out put. Average Revenue (AR): This is the average proceeds per unit. This is same as the price. For this reason, the demand curve is same as the average revenue curve. Marginal Revenue (MR): This is the additional revenue got by affirm by selling an additional unit. Revenue relationships under perfect competition The price under perfect competition is determined by the industry. A single firm is too insignificant to determine the price. Larger number of firms together determines the price. Under perfect competition the number of firms is so large that no single firm can, alone, influence the price. A firm can produce only an insignificant part of the total out put. This is the reason why a firm continues to get the same price at any level of out put. It means that the fir has a demand curve with infinite elasticity. Quality 1 2 3 4 5 6 Price 10 10 10 10 10 10 TR 10 20 30 40 50 60 AR 10 10 10 10 10 10 MR 10 10 10 10 10 10 Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 58 Dr.Ranga Sai Under perfect completion the firm is a price taker and it has to determine that level of out put which will give maximum profits. The firm has also AR=MR in revenue relationships. Revenue relationships under imperfect competition A monopolist faces a downward sloping demand curve: Under monopoly, there is no distinction between firm and industry. The demand is direct on to the firm. Incase of perfect competition, the industry faces down ward sloping demand curve and the firm gets the perfectly elastic demand curve. In case of monopoly the firm directly faced the downward facing demand curve. It means that the firm can sell more only by reducing price. With this difference, the relation ship between AR and MR also changes Quality 1 2 3 4 5 Price 10 9 8 7 6 TR 10 18 24 28 30 AR 10 9 8 7 6 MR 10 8 6 4 2 Relationship between AR and MR Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 59 Dr.Ranga Sai AR and MR are downward sloping curves. MR curve lies below AR curve. MR curve cuts the plane below AR curve into two halves. Geometrically, it has a property: A perpendicular drawn on Y axis will show ab = bc. Relationship between Elasticity of demand and Revenues Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 60 Dr.Ranga Sai Where e – is the point elasticity of Demand, AR is average revenue and MR is Marginal Revenue. Objectives of Firm The firm may have several objectives ranging from, economic, short run, long run material and non material in nature. All objectives are important. However the firm may decide its own priorities in objectives. Certain firms may have material objectives significant certain other firms may have normative objectives significant. Some objectives are uniformly significant for all firms. Following are some of the important objectives of a firm. a. Economic objectives Economic objectives are material objectives which may be short as well as long run. Economic objectives are normally considered by all firms. These economic objectives can be classified as follows: 1. Profit maximization: Each firm tries to maximize profits. This is a universal objective for firms. The firms aim at maximizing the difference between total revenue and total cost. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 61 Dr.Ranga Sai The firm will produce such out put which will give maximum profit. The gap between TR and TC can be maximized by drawing two tangents, one on each with same slope. The slope of TC is MC and slope of TR is MR. By equating slopes; MC is equated with MR. So, MC=MR emerges as equilibrium condition for optimizing out put for a firm. Firms may aim at maximizing rate of profit or profit. The rate of profit is maximized by pricing so that there is larger gross profit margin. On the other hand maximizing profit may be attained by maximizing out put. 2. Workers welfare Workers welfare helps in maintaining harmonious relationships and also maintaining high levels of productivity and loyalty. 3. Consumer satisfaction Consumer satisfaction helps in maintaining brand image, market share, prevents defection of consumers to another brand. 4. Investors benefit In case of joint stock companies, the firm will aim at increasing the net asset value of the company. Accordingly, it will have a investor friendly policy in dividends and bonus. 5. Specialization Specializing in certain product or service will be useful in establishing brand image, market share and growth. 6. Creating brand equity Every firm aims at creating a brand and as large consumer following as possible. This is in the long run interest of the firm. b. Long run objectives 1. Survival The basic objective of firm is to survive in the long run. In the long run the competition may increase, in such a market the basic principle is to survive. 2. Market leadership Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 62 Dr.Ranga Sai The firm wills always aim at being the market leader. This is a material objective as well as normative objective. In most cases profit depends on this objective. 3. Increasing market share The firms will initially aim at increasing market share. This is the objective before aspiring for market leadership. 4. Growth: forward and backward integration The firm may go for forward integration thus adopting an additional process of production or take up backward integration whereby, produce locally such component which was earlier brought form the factor market. c. Non material objective 1. Social responsibility The forms may assume social responsibility as an important factor. It is give back from the society from where the firm makes a living. 2. Environmental protection The firm may work in the direction of protecting the environment. This is dome by being eco-friendly and having less pollution. 3. Resource conservation The resource conservation may help in reducing costs but it also helps in reducing social costs. The society benefits form resource conservation 4. Creating social infrastructure The firm may create social infrastructure by constructing educational institutions, hospitals, townships, and aforestation. Module V: Markets Perfect Competition Perfect competition refers to a competition between large umber of buyers and sellers dealing in homogenous product at uniform price. Features of perfect competition 1. Large number of buyers and sellers The number of buyers and sellers should be so larger that no firm can determine the supply or no single buyer can determine demand and no singe person can determine the price. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 63 Dr.Ranga Sai 2. Homogenous product The product is homogenous, so that no form has a reason to charge a different price. 3. Free entry and exit of firms: When there is free entry and exit of firms, the firms keep joining the production as long as there are profits. With new firms joining the super normal profits, get distributed among more and more firms. At the same time when the profits decrease the less efficient firms leave the industry. So in the long run, efficient firms which can operate at normal profits only exist. In the long run the perfect competition has only firm which operate on normal profits. 4. Perfect knowledge The buyers and sellers have perfect knowledge of \demand, supply and price. 5. Free mobility of factors of production Free mobility of factors ensures that the cost of factors is same across all the regions. Equal factor prices give all the firms same opportunity to make profits and survive. So, efficiency of firms will determine the profitability of firms. 6. No transport cost The transport cost should be insignificant as compared wt the cost of production. This is possible only when the firms cater to local markets. 7. No advertising The firms need not advertise, because each firm will have infinite market at the given price. Advertising will add to cost and reduce profits 8. Uniform price Uniform price ensures that the consumers have choice between firms and the firms have no reason to charge different price due to homogenous product. 9. No Government restrictions There are no government interventions by way of taxes or mobility of goods. Price determination under perfect competition (Industry) The price under perfect competition is determined by the industry. Perfect competition is a market condition where the buyers and sellers are equally important in the determination of price. It is an ideal situation whether both the buyers and the sellers are equally represented. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 64 Dr.Ranga Sai Under perfect competition the price is determined by the firms and buyers, no single firm or buyer can influence the price. The buyers are represented by demand curve and the firms are represented by supply curve. The demand curve indicates The choice and tastes of the consumers The utility of the good The utility behavior of the consumer The capacity and willing of the consumer to pay the price Similarly, the supply curve indicates The willing ness of the firm, to sell goods at different price The cost conditions Nature of factor markets Supply and demand curve together determine the equilibrium price. The equilibrium price is the one which is acceptable to both buyers and sellers. This is determined by the large number of buyers and spellers. Price 10 9 8 Quantity demanded 600 700 800 Quantity Supplied 1000 900 800 D<S D<S D=S Market Surplus Surplus Equilibrium 65 Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) Dr.Ranga Sai 7 900 700 D>S Scarcity 6 1000 600 D<S Scarcity At P1 D<S, Goods are not being sold, price is high At P2 D<S, there is scarcity, the firms do not accept low price At P3 D=S, the price is acceptable to both sellers and buyers This is the equilibrium price. The price remains unchanged as long as the demand and supply remain constant. Nature of perfect competition: Demand and supply are both responsible in the determination of equilibrium. According to classical economics, the equilibrium is a natural process; the demand and supply get equated automatically. Perfect competition encourages efficiency of firms. It leads to efficient allocation of resources. Perfect competition is an assumption for all the theories of economics. The equilibrium quantity and price remain unchanged as long as the demand and supply remain constant. Out put determination under perfect competition by a firm Perfect competition is a market condition where the buyers and sellers are equally important in the determination of price. It is an ideal situation whether both the buyers and the sellers are equally represented. The price under perfect competition is determined by the industry. A single firm is too insignificant to determine the price. Larger number of firms together determines the price. Under perfect competition the number of firms is so large that no single firm can, alone, influence the price. A firm can produce only an insignificant part of the total out put. This is the reason why a firm continues to get the same price at any level of out put. It means that the fir has a demand curve with infinite elasticity. Quality 1 2 3 4 5 6 Price 10 10 10 10 10 10 TR 10 20 30 40 50 60 AR 10 10 10 10 10 10 MR 10 10 10 10 10 10 66 Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) Dr.Ranga Sai Under perfect completion the firm is a price taker and it has to determine that level of out put which will give maximum profits. The firm has also AR=MR in revenue relationships. Given, these condition the firm will optimize its out put at a point where MC=MR, Conditions of out put determination: While maximizing out put the firm shall follow two conditions I Order condition: MC=MR II Order Condition: MC cuts MR from below. At a point where MC=MR the difference between TC and TR will be maximum. The gap between TR and TC can be maximized by drawing two tangents, one on each with same slope. The slope of TC is MC and slope of TR is MR. By equating slopes; MC is equated with MR. So, MC=MR emerges as equilibrium condition for optimizing out put for a firm. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 67 Dr.Ranga Sai Nature of firm A firm can make profits or incur losses depending on the price and costs. A firm can earn profits; normal profits and super normal profits or incur losses; maximum bearable loss and shut down condition. Each on of this will determine the nature of firm. This is true in case of any firm, whether perfect competition or imperfect competition. Normal profit: A firm is said to be making normal profit when AR = AC. The price (AR) covers the costs. The cost includes the managers’ remuneration. However there is no surplus above managers’ remuneration. If the entrepreneur him self is the manager, he will receive normal profit as his share of remuneration Normal profit is also called ‘no profit no loss’ condition or break even point in managerial economics. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 68 Dr.Ranga Sai Super Normal profit: A firm is said to be making supernormal profits if AR > AC. The price charged by the firm covers all the costs and also generates a surplus over the expenditure. In this case the firm receives the managers’ remuneration (normal profits) and also a surplus over it. Hence it is called super normal profits. Losses A firm is said to be making losses if, AR < AC. In case of loss there is a need for further analysis. The firm needs to decide whether to stay in production or shut down. In such a case Average variable cost (AVC) is considered. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 69 Dr.Ranga Sai Maximum bearable loss: If AR = AVC the firm is said to be at maximum bearable loss. The price received covers the AVC and the fixed cost is not covered. So even if the firm closes down, in the short run the fixed cost remains as loss. This is a case where, the loss remains same (fixed cost) whether the firm stays in production or shuts down. This is called the maximum bearable loss. Shut down Condition If AR < AVC, the firm needs to close down. The price received fails to cover fixed cost as well as a part of variable cost. So if the firm closes down the loss is equal to fixed cost. If the firm continues to produce the loss will be fixed cost and a part of variable cost. So, the firm can reduce losses by closing down. This is called Shut down condition. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 70 Dr.Ranga Sai Long run equilibrium under perfect competition In the long run the following factors operate: The supply becomes more elastic: With time, supply becomes more and more elastic. So the price tends to decrease. The AR=MR received by the firm also decrease. However, at the same time the average cost curve also becomes flatter, showing decline in costs. Flatter AVC means more out put being produced at lesser cost. There is free entry and exit of firms: When there is free entry and exit of firms, the firms keep joining the production as long as there are profits. With new firms joining the super normal profits, get distributed among more and more firms. At the same time when the profits decrease the less efficient firms leave the industry. So in the long run, efficient firms which can operate at normal profits only exist. In the long run the perfect competition has only firm which operate on normal profits. The long run average cost curve becomes flatter than short run cost curve Following are the long run factors responsible for changes in average cost curve in the long run: 1. Population Though population changes even in the short run. The effect of population can be seen only in the ling run, by way of changes in the pattern of demand and labor force. 2. Technology Technology helps in the ling run in reducing costs and making production function efficient. 3. Alternative sources of raw material and energy Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 71 Dr.Ranga Sai Alternative and cheaper sources of raw material and energy change the production function and help in expanding out put and making it economical. 4. Expanding markets Expanding markets provide purpose for the industry to produce and distribute. In the long run, mass consumption in the economy increases. Hence in the long run the equilibrium of the firm is arrived at a point where: LAC = MR (long run) = LMC = AR(long run) Where MR (long run) =MC represents determination of optimum out put, LAC = LMC indicate the firm operating at optimum level, and LAC = AR (long run) means the firm is operating on normal profits Monopoly Monopoly refers to an imperfect market situation where a single seller sells the product in different markets at uniform or discriminating prices. Monopoly is identified with single firm large number of buyers and the monopolist as the price maker. Following are the features of monopoly market. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 72 Dr.Ranga Sai Features of Monopoly 1. Single seller: The monopoly market has a single firm. There is no distinction between firm and industry. Since a single firm supplies to the large number of buyers, the firm tends to be large and specializing in its production 2. Large number of buyers: There is a large market even under monopoly. However there may be differences in the elasticity of demand in each segmented market. 3. Product: The product may be homogenous or even differentiated depending on the nature of market and division of submarkets. 4. Monopoly power: The entry into monopoly market for other firms is restricted. This is due to the monopoly power the firm has. The monopoly power is got by the firm due to following factors. a. Legal restriction: The law may prevent other firms from entering. E.g. Government monopolies on entry b. Exclusive ownership of technology of production: If the technology of production is known only to a single firm the monopoly power remains un effected. c. Exclusive ownership of raw material: Access to raw material is held by a single firm, the monopoly power remains intact d. Registered trade marks and brands: I case of registered trade marks; firms can not duplicate and compete in a market. It remains as monopoly. e. Personal monopolies: Personal monopolies have individual branding. They can not be duplicated. The personal monopolies continue 5. Price discrimination: With price discrimination a monopolist sells the same product at different prices in different markets at the same time. The objective of price discrimination is profit maximization. 6. A monopolist faces a downward sloping demand curve: Under monopoly, there is no distinction between firm and industry. The demand is direct on to the firm. Incase of perfect competition, the industry faces down ward sloping demand curve and the firm gets the perfectly elastic demand curve. In case of monopoly the firm directly faced the downward facing demand curve. It means that the firm can sell more only by reducing price. With this difference, the relation ship between AR and MR also changes Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 73 Dr.Ranga Sai Relationship between Average revenue and Marginal revenue under monopoly A monopolist faces a downward sloping demand curve, so he can sell more only by reducing the price. This will change the AR and MR relationship. Since it is an imperfect market, AR is not equal to MR. It can be seen that AR is greater than MR. Further, AR and MR are related through elasticity of demand. Q 1 2 3 4 5 Price 10 9 8 7 6 TR 10 18 24 28 30 AR 10 9 8 7 6 MR 8 6 4 2 Geometrically, AR curve cuts the plain below AR into two halves. So any perpendicular drawn on Y axis will show the property, ab = bc Equilibrium under simple monopoly Under monopoly, the demand curve is downward sloping, so the AR and MR curves also slope down wards and look different. However the optimizing condition for out put remains same as in case of perfect competition. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 74 Dr.Ranga Sai At a point where MC = MR the firm finds its equilibrium out put. When MC = MR the difference between TC and TR will be maximum. The output is found on the x axis. The price determination is done by AR curve. This is the demand curve which will tell the maximum price that can be charged for this level of out put. In case of simple monopoly, there will be only one product and single price. In case of differentiated monopoly Nature of firm A firm can make profits or incur losses depending on the price and costs. A firm can earn profits; normal profits and super normal profits or incur losses; maximum bearable loss and shut down condition. Each on of this will determine the nature of firm. This is true in case of any firm, whether perfect competition or imperfect competition. Normal profit: A firm is said to be making normal profit when AR = AC. The price (AR) covers the costs. The cost includes the managers’ remuneration. However there is no surplus above managers’ remuneration. If the entrepreneur him self is the manager, he will receive normal profit as his share of remuneration Normal profit is also called ‘no profit no loss’ condition or break even point in managerial economics. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 75 Dr.Ranga Sai Super Normal profit: A firm is said to be making supernormal profits if AR > AC. The price charged by the firm covers all the costs and also generates a surplus over the expenditure. In this case the firm receives the managers’ remuneration (normal profits) and also a surplus over it. Hence it is called super normal profits. Losses A firm is said to be making losses if, AR < AC. In case of loss there is a need for further analysis. The firm needs to decide whether to stay in production or shut down. In such a case Average variable cost (AVC) is considered. Maximum bearable loss: Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 76 Dr.Ranga Sai Shut down Condition If AR < AVC, the firm needs to close down. The price received fails to cover fixed cost as well as a part of variable cost. So if the firm closes down the loss is equal to fixed cost. If the firm continues to produce the loss will be fixed cost and a part of variable cost. So, the firm can reduce losses by closing down. This is called Shut down condition. Long run equilibrium under monopoly In the long run the monopolist will find his equilibrium at a point where MR (Long run) = MC (Long run) Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 77 Dr.Ranga Sai In the long run the AC curve becomes flatter an the firm will be able to produce more out put at lesser cost. At the equilibrium the monopolist can Determine price P1 by restricting the out put at Q1. In this case the monopolist will have super normal profits. OR Determine price P2 price with larger output Q2 and optimize the cost by producing at minimum AC in the long run. In this case the monopolist will have normal profits. Monopolistic Competition Monopolistic competition is a case of imperfect competition where limited number of firms, compete with differentiated product at dissimilar prices. Following are the features of monopolistic competition: 1. Large number of buyers: The number of buyers is large. It is a large market where firms compete. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 78 Dr.Ranga Sai 2. Limited number of firms: The number of firms remains limited due to intense competition. The entry is not restricted by law, but competition discourages new firms. 3. The prices need not be uniform. Each firm produces goods as per their own market, so the product quality, utility differ. In such a case the prices also differ. 4. Product differentiation Product differentiation means the same product being projected different, by modifying with additional utility, quality or term of sale. The product differentiation is done in flowing ways: a. By an additional quality: the firm may show a different quality of the product which may not exist in the market. The quality should be such that the utility of the product gets enhanced. b. Additional quality: The product can be designed with an additional utility. Products with different utilities have elastic and larger demand. This is one method of improving the appeal of the product. It is seen that dual utilities have improved the quality of the product like the two-in-one products. c. By different term of sale: the fir may offer a different terms of sale. It may be by way of guarantees, after sale service, quizzes, contests, prices, Etc. The objective of price differentiation is to claim monopoly power in an imperfect market. This is done by creating unique selling proposition. Product differentiation means differences in cost. With differences in cost the price also changes. Firms sell at different prices. The competition between firms with different prices is called non-price competition. The firms justify the price by either different image/ brand equity or by different qualities/utility of the product. Non-price competition benefits the firms. The consumer is made to pay higher pries which are falsely justified through advertising. 5. Selling cost Selling cost is the cost of generating demand. Under monopolistic competition, the firms engage in non price competition. The firms charging different prices justify their prices by advertising, publicity, field campaign and similar promotional activities. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 79 Dr.Ranga Sai Selling cot helps in generating demand, brand image and justifying the price. Selling cost does not give utility. Selling cost is a burden on the consumer. Production cost on the other hand generates utility. The production cost decreases with increasing out put in, proportion. This is due to economies of scale. Whereas, the selling cost increases in larger proportions to increasing out put. This is because, advertising becomes more and more expensive, with increasing out put. Selling cost makes demand elastic and shifts demand curve u wards. In the diagram it can be seen that, selling cot has increased the average cost. Yet, the demand curve has shifted upwards and also became elastic. This is the advantage the firm receives by spending selling cost. Wastages in Monopolistic competition A comparison between perfectly competitive firm and that of imperfect competition shows that there are wastages and exploitation under, imperfect competition. 1. The price monopolistic competition is higher than the competitive price. The AR being high at the equilibrium out put the firm charges higher price. 2. The out put under imperfect competition is lesser than the competitive output. By restricting the out put the firm can charge higher price. 3. Imperfect competition leads to less than optimum size of out put: The monopoly firm restricts the out put so that it can realize higher price. In the process it produces less than optimum size of out put. The firm will be producing at higher cost, but the price Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 80 Dr.Ranga Sai charged, will be much higher granting larger profits to the monopoly firm. 4. Imperfect competition will lead to unfair competition. Monopolistic competition has wasteful advertising. Advertising leads to increases in cost and dos not yield any utility to the consumer. 5. Non price competition leads to price exploitation of consumers. Under non price competition the firms sell goods at different price and justify higher price by advertising. In case of perfect competition the prices are low and uniform. Oligopoly Oligopoly is an imperfect market condition identified with limited number of firms with high interdependence competing with differentiated or uniform product at uniform prices. Following are the features of oligopoly market 1. Limited number of firms: The number of firms is limited due to intense competition. The industry remains as a small group of firms. 2. Large number of buyers Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 81 Dr.Ranga Sai The number of buyers will be very large. There will be huge market for which the firms compete. 3. High degree of interdependence between firms The firms will have high degree of interdependence in terms of price and product design. The firms almost share the same demand curve. However, the demand is made elastic or remains inelastic depending on the nature of advertising. No firm can deviate and change the product description. Any change made by the firm will lead to the consumer shifting to other competing firms. The demand remains very flimsy for a firm. The demand is maintained carefully by maintaining the same price, similar product details and advertising. 4. Rigid and uniform prices The price will remain uniform and rigid. When the price is accepted by the firms and the buyers, it continues for a long time. A consumer will not pay a higher price because he can continue to get the same price from other firms. A firm will not reduce the price because the consumer is willing to pay the given price. On the other hand reduction in the price may be treated as a loss of quality. This is called as price illusion. 5. Advertising Advertising is an essential part of oligopoly market. Advertising is essential for registering the product with the consumer. Advertising allows the product to have the required exposure to the consumer so that the consumer can include the product in his options. Further, advertising make the demand elastic. By making the demand elastic, the firm will be able to sell more goods at the given price. 6. Types of oligopoly There are different types of oligopoly each based in a different marketing practices followed to manage competition. a. Pure and differentiated oligopoly Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 82 Dr.Ranga Sai Pure oligopoly deals with goods are homogenous whereas differentiated oligopoly may have apparent product differentiation. The market offers flexibility the firms to change the nature of the product keeping the base utility same. In ace of pure oligopoly it is easy to maintain price uniformity. With product differentiation, the price tends to change because of cost variations. Even in theses conditions the firms need to maintain the uniform prices. For this reasons the firma can only adopt apparent product differentiation without changing the cost structure. b. Complete and partial oligopoly Complete oligopoly refers to market where all the firms are equally placed in terms of competition, price and market share. Whereas in case of partial oligopoly, there can be one large firm emerging as the leader. The leader will have the advantage of giving a lead price to the product which other firma will follow. The leadership firm will have the privilege of designing the product, price and the nature of competition. Pure oligopoly may at times change to partial oligopoly by frequent mergers. Firms merge among themselves to form a large firm so that a leadership role can be achieved. c. Collusive and Non collusive oligopoly Non collusive oligopoly refers to a market where the forms operate independently, however with interdependence. In case of collusive oligopoly, the firms may collide, enter into agreements to lessen competition and share the market to exploit the consumers. 7. Cartels Cartels are a case of collusive oligopoly. Firms in market with intense competition form arrangements to avoid competition by making agreements so that all firms tend to benefit at the cot of the consumer. Cartels are harmful business organization formed to enhance exploitation and increase profits. There can be different types of cartels depending on agreements. a. In a cartel, the firms with high price may insist that its price prevail, so that all firms can maximize profits. b. At the same time the firm with lesser price may insist on its price to be followed so that larger out put can be sold. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 83 Dr.Ranga Sai These are price cartels. In both these cases competition is avoided and market becomes lucid. c. The firms may divide the market geographically and restrict mutual entry in respective territory. In this case the market has one monopoly firm selling the product. d. The firms may have system of marketing royalties as consideration for sharing territory for attaining monopoly power. A firm operating in market as an exclusive monopolist may have to pay market royalty to other firms restricting entry. The cartels can be operating at international levels, where the regions are shared on the basis of trading currencies or countries. The counter may form commodity agreements, bilateral agreements, and multilateral agreements for a specific time. All these agreements where the firms or the counties get captive markets belong to cartels. Duopoly Duopoly is a model of oligopoly market with two firms designed to study the interdependence of firms for pricing. Following are the feature of a model duopoly market: 1. Two firms: The number of firms is limited to two. This is for the purpose of studying the details of interdependence. Hence it is a model of oligopoly. 2. Large number of buyers The number of buyers will be very large. There will be huge market for which the firms compete. 3. High degree of interdependence between firms The two firms will have high degree of interdependence in terms of price and product design. Two firms almost share the same demand curve. However, the demand is made elastic or remains inelastic depending on the nature of advertising. Single firm can deviate and change the product description. Any change made by the firm will lead to the consumer shifting to other competing firm. The demand remains very flimsy for a firm. The demand is maintained carefully by maintaining the same price, similar product details and advertising. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 84 Dr.Ranga Sai 4. Rigid and uniform prices The price will remain uniform and rigid. When the price is accepted by both the firms and the buyers, it continues for a long time. A consumer will not pay a higher price because he can continue to get the same price from other firm. A firm will not reduce the price because the consumer is willing to pay the given price. On the other hand reduction in the price may be treated as a loss of quality. This is called as price illusion. 5. Advertising Advertising is an essential part of oligopoly market. Advertising is essential for registering the product with the consumer. Advertising allows the product to have the required exposure to the consumer so that the consumer can include the product in his options. Further, advertising make the demand elastic. By making the demand elastic, the firm will be able to sell more goods at the given price. 6. Kinky demand curve The demand curve for the duopoly market is med up of the individual demand curves of two forms. These are the demand curves made by the firms by the independent advertising campaigns and publicity. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 85 Dr.Ranga Sai Yet the firms will have demand curves with different elasticities. The demand curve for the market is made up of these tow demand curves. The inelastic segment of the demand curve at lower price s and the elastic segment of demand curve ay higher prices form the segmented demand curve in duopoly. It is learn in point elasticity of demand that all goods tend to be elastic at higher prices and inelastic at lower prices. The firms will be operating on the segmented demand curve which forms a kink at P. P is the point which is common on both the demand curves. This is the price which can be followed on both the firms. P is the uniform and rigid price followed by firms under duopoly. Case Studies Illustrative case study I (Objectives of firm) Tata group of Companies are regular in paying their taxes to the Government. They have a clean track record of tax remissions over years. In compliance with the environmental laws the company is serious and has ISO 14000 certification. In general Hr management and productivity is good with least attrition harmonious relations. Customer care and customer relations are held high the company documents reveal. However, the company has been making profits with good dividend record and net worth. Illustrative Case Study II (perfect competition) Goldmine Inc. launched its new range of gold jewelry in Indian market. In a market which is governed by seasonal demand and fluctuating gold prices, Goldmine inc. had two product ranges. The ethnic designs which were priced 12 percent more than the trendy designs. Goldmine Inc joined the manufacturers’ guild to advertise for gold jewelry and contributed 3 percent of its cost of production for common product promotion. Liberal gold import policy helped Goldmine keep its products in competitive range. Illustrative Case study III (Monopolistic Competition) Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 86 Dr.Ranga Sai Venus Soaps and detergents entered the Indian market recently with its new brand of toilet soap ‘Rainbow’. The soap had multiple layers, each with a different color and fragrance. It claimed that the soap will provide a variety of fragrances to alleviate the consumer from boredom. The soap contained a small 10 mm plastic toy in it, which could be revealed after continuous usage. The consumers are advised to collect these toys and exchange for a larger 18” rose wood replica. Three such rosewood replicas would entail the consumer for a cruise in a luxury liner for ten days. Being a new entrant in the market Venus soaps provided an advertising/promotional budget of Rs 12 crores which is 18 percent of market price of the product. The price of the soap was priced at Rs. 18. The price is ten rupees more than the average price of soap in the market. Illustrative Case Study IV (Oligopoly- Collusive- cartel) Swiss Spring Aqua bottles mineral water in India. The company found that the product could not afford a lavish promotional budget due to slender profit margins. However the company proposed a moderate advertising budget of Rs 3.5 crores which could help register its product with consumers. Swiss Spring Aqua knew it no longer afford the advertising budget on a regular basis, so it negotiated with a leading Indian company Aqua-pura and bought territory right of Western India for a royalty of Rs 1.5 crores, which is much less than it’s advertising budget. Swiss Spring Aqua could sell the product at 10 percent higher price. With a 40 percent market share now Swiss Spring Aqua could sustain price and other companies hiked their price by ten percent. Illustrative case study V (Monopoly) Dr Anant Malhotra, a neurologist, treats Parkinson’s disease with guarantee. He developed his own sonic pulsar for stimulating neural activity. Two months basic treatment costs Rs 2,25,000. To visiting patients from other countries the fees amount to $ 45,000. Dr Malhotra has a nursing home where poorer patients are offered out patient treatment for a fee of Rs.15, 000. Dr Malhotra runs Anant Ashram at Neral where older patients are houses and treated free. He visits the Ashram twice each week. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 87 Dr.Ranga Sai Break even Analysis Break even out refers to the level of output where TR = TC. This is the minimum out put the firm need to produce its costs. Any output there after will grant profit to the firm. Usage of break even point for corporate decision making is called Break even analysis. At break even point total cost is equal to total revenue. After break even point the profitability begins. The out put less than break even out put shows losses. Every firm aims at break even level of output in the beginning. The break even level is a no profit no loss condition. In other words it is case of normal profits. The costs cover only the manager’s remuneration and there is no surplus over that. It is similar to the condition AR = AC. At break even point there are no profits, so TR = TC Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 88 Dr.Ranga Sai Where, TR is total revenue TC is total cost P is price AVC is average variable cost TFC is total fixed cost Q is out put Break even analysis is based on the following assumptions 1. The cost and revenue functions are linear functions. This is for the sake of simplicity. 2. The firm can estimate the cost and revenues in advance. 3. Price remains uniform at all levels of out put. 4. The costs are made up of fixed and variable costs. Angle of Incidence The angle of incidence is the angle made by the TR and TC functions at the break even point. In break even analysis the angle of incidence is very important in selecting a project among various competing projects. The angle of incidence decides the nature of break even point. If the angle of incidence is larger the break even out put will be smaller. In other words, if the angel of incidence is smaller the break even out put will be larger. While comparing competing projects on the basis of break even points, a project with larger angle of incidence will be selected. Because a firm will always wishes to keep the Break even out put small so that, it can operate on profits hat sooner. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 89 Dr.Ranga Sai Application of Break even analysis A firm will firstly, attain the break even out put so that it can be out of losses and start making profits. However, the firm needs to allot revenues for different purposes depending on the earnings of profit or revenue. Firstly, the firm will slot revenue for depreciation on assets. Depreciation is a nominal expenditure. It is that part of fixed assets that is consumed during the year and that part of fixed cost that can be charged to the out put. Depreciation is the first priority after attaining break even out put. When a firm makes profits it has to pay taxes. The firm now provides for taxes after deducting depreciation. Thereafter, marketing overheads can be deducted. These marketing overheads are for more than one year. So if the revenue permits the firm may provide for durable marketing overheads. Finally, the revenue in excess of all these provisions yield profits that can be distributed among owners or retained as reserves and surplus. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 90 Dr.Ranga Sai Limitations 1. Break-even analysis is only a supply side analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. 2. It assumes that the price remains uniform at levels of out put 3. It assumes that fixed costs are constant 4. It assumes average variable costs are constant per unit of output, 5. It assumes that the quantity of goods produced is equal to the quantity of goods sold 6. In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 91 Dr.Ranga Sai Module VI: Pricing Methods Marginal Cost Pricing The Conventional pricing is followed when MC = MR, the price is determined by AR curve. The conventional pricing is described by the theory of firm and pricing. Independent of markets and competition the pot put is determined by equating MC and MR. This as an optimizing output will help in determining the price as per the AR (demand) curve. Marginal Cost pricing: when AR=MC, the price is equated with Marginal Cost. The Marginal cost pricing is more advantageous than conventional pricing because, the out put tends to be larger than the conventional method. Further, the price tends to be smaller. This is the method followed by the Government in most administered pricing methods. Administered pricing refers to the pricing adopted by the government in determining the price of a product independent of market and profitability considerations. The resources are put to efficient use when the price equated with MC. The price is lower and the out put is higher. Thus way the government can encourage the consumption of a product and also utilize the production capacity fully, thus achieving efficient Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 92 Dr.Ranga Sai allocation of resources. The Government follows this method for pricing petroleum prices. Under administered pricing the Government can also follow Average cost pricing: when AR=AC, the price is equated with Average Cost. This is a pricing where the firm will be operating at normal profits. In this case the out put is highest and the price is lowest. The government follows this method for pricing products like fertilizers. The consumption of fertilizers is desirable in the national interests in increasing the output of agriculture. Full Cost Pricing The corporate pricing practices are mostly based on the cost sheet approach, where the price includes all the costs chargeable to the product. The considerations of average and marginal costs are no more valid. The cost sheet approach to pricing includes relevant inputs of production and overheads. Out line of cost sheet: Direct labour + direct material+ direct expenses Prime cost + Production over heads Works cost + administration overheads = Prime cost = Works cost = Cost of production Cost of production + selling and distribution over heads = Cost of sales Full cost pricing considers all relevant costs and over heads. The costs include all the variable costs and part of fixed cots. The fixed cost is represented in different ways As per the standard accounting procedures, the fixed cost is represented as depreciation. It is that part of the fixed capital that is consumed during that year on out put. The amount charged on the out put pit depends on the life span of the asset and cost of replacement. Alternatively, the fixed cost can be represented as the interest on fixed capital for that year. In both the cases the fixed capital is represented in the cost of production. To this cost the firm will add a profit mark up. The price so determined is called as the price of the product as per full cost pricing or profit mark-up method. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 93 Dr.Ranga Sai Price = Mc + Lc+ FC+ π q Where, Mc is the cost of material Lc is the labour cost FC is the fixed cost apportioned to the out put q π is the profit mark-up Full cost pricing a popular method of pricing method. This is because of its several advantages 1. Represents all costs As against the conventional pricing methods, full cost pricing is realistic 2. Fixed costs Fixed costs are correctly represented. The costs which can be assigned to the out put are correctly drawn. 3. Realistic representation of creation of utility The cost represents the actual inputs going into production representing their scarcities and productivities. 4. Easy for firms to adopt Since it is simple and provides great scope for analysis of cost of production it is commonly adopted by firms. 5. Flexible The system is very flexible. Simple cost sheet method enables the firm to apply the system across time and products. 6. Extendable to multi commodity or multi location pricing A firm producing multiple goods or producing from various locations can use the method easily. The system can be integrated in multiproduct pricing and branch accounting. Profit mark-up Profit mark-up is the rate of return expected by the firm on its sales. It is the gross profit margin. Determination of Profit mark-up is matter of great care and risk. Firms determine the Profit mark-up depending on several factors. The profit mark-up depends on several factors 1. Corporate policy The policy of the firm will determine the level of profit mark-up 2. Nature of product Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 94 Dr.Ranga Sai The product can be consumer good, further, consumer durable, luxury good, perishable or similar. Profit mark-up changes in each case. 3. Nature of market and competition Market and competition have great bearing on the Profit mark-up. Highly competitive markets will have lower Profit mark-ups. 4. Pricing strategy Having a certain degree of Profit mark-up can be matter of corporate strategy. It is an internal matter for a firm. 5. Industry standard Every industry has its own standard of Profit mark-up. May it be hospitality, automobile, housing or consumer goods; each has its own degrees of Profit mark-up. 6. Product life cycle The product life cycle decides the degree of Profit mark-up. Whether the product is at introduction, growth, competition, stagnant or decay will all have a Profit mark-up of their own. 7. Cost of capital The cost of capital has a direct bearing on the levels of Profit mark-up expected. There is a direct relation between these. 7. Expected rate of return or profitability Each firm will have its own expected rate pf return on investment. The Profit mark-up will depend on that. Strategic pricing Corporate pricing policies consider several practices which may include corporate policy and corporate ambitions more than simple cost and profit margin. Strategic pricing considers market, product, corporate policy/image and ambitions of the firm. Accordingly, the pricing strategy may follow a set of procedures. Strategic pricing has the following objectives: a. Increasing the market share competition Strategic pricing helps in increasing the competition, market share, independent of profit or profitability. b. Incasing the volume of sales Profit may increase on volume of sales in certain pricing policies. c. Managing competition Strategic pricing is most suited for managing competition. In case of new firms or new launch of a product, the company Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 95 Dr.Ranga Sai d. e. f. g. needs to establish its image. Proper pricing policy helps in forming an image. Managing the market The pricing policy changes with changes in the trends in the market. The market is made up of consumer choices, government policies, other firms and technology. Corporate policy The policy of the firm decides the kind of pricing it needs to adopt at a given point of time. This may change from time to time. Product launch When a new product is launched the strategic policy enables the firm decide among various alternatives of pricing. Growth strategy Pricing strategy can aim at the growth of the company. The growth in turn defines strategy in corporate policy. The pricing strategies are of different types 1. 2. 3. 4. Penetration pricing policy Skimming price policy Flexible price policy Follow-the-leader price policy These are different pricing strategies each having its own advantage the firm will adopt such pricing strategy that suits its corporate policy. Penetration price policy The penetration price policy aims at capturing the market by keeping the price as low as possible. The basic objective of penetration price policy is to increase sales and market share, irrespective of profit or profitability. Penetration price aims at margins on volumes. Low rates of profits but higher profits due to volume of sales. Further, it helps in increasing market share of company. This is one of the major objectives of any firm. A firm launching the product for the first time may follow penetration price. With penetration price policy the rim will be able to register the product with the consumer. It is like an introductory offer. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 96 Dr.Ranga Sai Skimming price policy In case of skimming price policy, the firm will determine a higher price. The objective will be to target the product at a specific consumer group that can pay a higher price. Such higher price is always justified with the help of advertising and media support. The skimming price is also called as the niche pricing. The firm only targets a small portion of the market and the product will be accordingly designed. The skimming price carries a product image for the higher income groups. Flexible price policy In case of flexible pricing policy, the firm may follow one system and switch over to the other. The firm may launch the product with penetration price and thereafter increase the price. The firm may keep changing the price as per season, competition or costs of production. However the efficiency of this pricing depends on the acceptability at the market, Follow-the-leader price policy In certain markets one firm is larger than the others. The firm will have a larger share and it leads the market. This is similar to partial oligopoly. In such case other firms have no choice but to follow the leader. Firms in general will follow the price adopted by the leader or determine such price that will be acceptable in the market. However, the leadership price continues to be the shadow price; a bench mark price for other firms to take cue from. All pricing strategies have their own advantages and justifications. It depends on the firm to choose the right kind of pricing strategy that suits the corporate need. Discriminative Pricing Price discrimination means the firm selling the same product in different markets at the same time at different prices. The objective of price discrimination is profit maximization. Price discrimination is generally followed by a monopolist. Price discrimination is not always possible. There are certain conditions to be fulfilled for practice of price discrimination. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 97 Dr.Ranga Sai Price discrimination is possible only under the following conditions 1. Legal sanction The practice of price discrimination shall be accepted by the law. In absence of legal sanction price discrimination will be called cheating. 2. Geographically distant markets The markets with different pieces shall be geographically far. The markets should be far enough to prevent resale of goods. 3. No possibility of resale Resale should be prohibited. In case of resale the monopoly profits will be drained out by those reselling the goods. 4. No storage possible Resale is not possible only I those goods whether storage is not possible. 5. Apparent product differentiation The firm shall follow apparent product differentiation. In such cases the buyers will find justification for paying a different price. 6. Let go attitude of the consumer The consumers should have a let go attitude. In case of consumer resistance, price discrimination is not possible. 7. Difference in elasticities of demand Difference in elasticities is an essential condition for price discrimination. There will be as many sub markets as the differences in elasticities. In an elastic market, the firm can not charge higher price. Any increase in price will greatly decrease quantity demanded. So the price tends to be low. In an inelastic market, the quantity is not sensitive to price, so the firm will charge a higher price. The inelastic market: Market A has higher price and lower out put. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 98 Dr.Ranga Sai The elastic market; Market B has lower price and higher out put Equilibrium with price discrimination Firstly, the market is divided into sub markets depending on the elasticity of demand. Each market will have a different elasticity of demand. Suppose the firm can divide the markets into two sub markets: market A an inelastic market and Market B - an elastic market. 1. Out put determination MC = Σ MR 2. Out put distribution Σ MR = MRa = MRb 3. Price determination The prices are determined as per ARs. Though the markets are different, the place of production is centralized. The firm will produce at a single place. Depending on the component markets, the aggregate market is constructed. The firm will determine the equilibrium out put; this is the out put which will be distributed among different markets. The firm will consider the aggregate MR i.e. Σ MR for determining the equilibrium. 1. Out put determination MC = Σ MR This is the optimum out put determined at the aggregate market. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 99 Dr.Ranga Sai 2. Out put distribution Σ MR = MRa = MRb The out put is distributed in different markets by equating Marginal revenues. The equilibrium level of MR is passed over to different markets, this way the equilibrium is created in sub markets. The equilibrium level of MR will indicate the out put in different markets. 3. Price determination The prices are determined in different markets as per the Average revenues (demand) in different markets. It can be seen that the The inelastic market: The elastic market: Market A has higher price and lower out put. Market B has lower price and higher out put Dumping Dumping is a special case of price discrimination where the firm is a monopolist in the home market and faces competition in the foreign market. In the home market the firm faces a downward sloping (demand) AR curve whereas in the foreign market the AR curve is perfectly elastic with AR=MR=Price relation. The firm firstly, determines the out put to be produced for the local as well as the foreign markets. There after, the out put needs to be distributed among home and foreign markets. Finally, the price is determined. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 100 Dr.Ranga Sai 1. Out put determination MC = MR ( maximum possible MR) 2. Out put distribution MRh = MRf 3. Price determination The prices are determined as per AR in the home market and at the existing price at the foreign market. The out put is determined by equating MC=MR. This is the profit maximizing out put. The out put is distributed by equating MRs in different markets. i.e. MRf = MRh At this point the out put is allotted for home market and he price is determined as per the downward sloping demand curve. The remaining out put is sold in the foreign market at the price prevailing as per AR=MR=Price. It can be seen that the firm sells a small out put in the home market at high price and a large out put in the foreign market at low price. This is called dumping. Multi product pricing When a firm has more than one product the pricing method will be interdependent. The firm will have different AR curves for different products. The demand is generated by nature of product and the consumer acceptance. So firstly, the firm will determine the equilibrium level of out put, by equating MC and Marginal revenue. MC = MR There after the firm will equate equilibrium level of Marginal Revenues of different products. This is done by equating Marginal revenues of different products at equilibrium level. MRa = MRb = MRc = MRd = MR…. This way, the out put of different products is determined as per the markets for these different products. Finally, the prices are determined as per the Average Revenues. The respective demand curves will determine respective prices. It is assumes that the MC is common for all the products and the demand is different for different markets and products. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 101 Dr.Ranga Sai Capital budgeting Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research and development projects are worth. The non recurring expenditure can be evaluated by methods of project evaluation. In fact all projects are desirable but due to scarcity of resources all projects can not be implemented. The projects need to be prioritized depending on their worth. For this purpose, project evaluation or capital budgeting becomes essential. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 102 Dr.Ranga Sai Basic Steps of Capital Budgeting 1. Estimate the cash flows Every project generates cash in flows and cash out flows. The difference between these in and out flows refer to the net flows. 2. Assess the risk in of the cash flows. The cash flows need to be regular. This is a matter of liquidity of the project. The project needs to be evaluated for its risk in yielding cash in flows 3. Determine the appropriate discount rate Discount rate is used to reduce the value of future returns to present value. The rat can be based on the cost of capital or the expected rate of return or profitability. 4. Estimates Find the PV of the expected cash flows. This is done by calculating the annuities. These are annual returns. These returns need to be discounted as per the waiting time involved. The discounts shall be so designed that they increase with increasing waiting time. 5. Evaluation Accept the project if Internal Rate of Return satisfies expected Internal Rate of Return or the Present Value is lowest or the pay back period is low Payback period Pay back period is the time period during which the sum of the net cash flows equals the investment. Payback period refers to the time required for the project to return back the investment. Every project generates cash in flows and cash out flows. The difference between these in and out flows refer to the net flows. A project which has a low pay back period is selected. It is method based on the liquidity of the project. I Year II Year III Year IV Year Project A 30,000 35,000 35,000 30,000 Project B 40,000 40,000 20,000 30,000 Project C 30,000 30,000 30,000 30,000 103 Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) Dr.Ranga Sai Among three projects Project C is rejected firstly, because the payback period is larger than three years. For Projects A and B the pay back period is three years. Among Projects A and B, the project which offers larger returns in lesser time is Project B. It gives back 80% of the investment in two years. So, Project B is selected against A. In turn Project A gives only 65% of the investment. So pay back period considers recovering investment in lesser time, further, the project should return most past of the investment in lesser and lesser time. Hence pay back period totally depends on the liquidity of the project. The draw back of payback period is that it neglects profitability. However this method is most popular means project evaluation only because of its simplicity. Net Present Value Net present value refers to the present value of future returns. NPV as method of project evaluation means that the sum of the future returns shall be equal to the present value of the project. Every income yielding asset has three properties: a. The assets yields returns over its life time, different each year b. The asset has a fixed life span during which it gives returns c. A price is payable for the asset before it yields returns. These are important issues in making investment decisions. Net present value refers to the present value of future returns. The present value of any future returns is always low. To arrive at the present value the future value needs to be discounted. The discounts should be such that they should increase with increasing time, The sum of such discounted future returns is called as the net present value. In this case the rate of discount is determined by the firm. So larger the discount rate, lower will be the net present value. The present value of the project cash flows of the future, Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 104 Dr.Ranga Sai Where Q1, Q2, Qn are expected returns over n years, are discounts over n years. is discounted annual return Internal Rate of Return The internal rate of return (IRR) is a popular method in capital budgeting. The IRR is a discount rate that makes the present value of estimated cash flows equal to the initial investment. Every income yielding asset has three properties: a. The assets yields returns over its life time, different each year b. The asset has a fixed life span during which it gives returns c. A price is payable for the asset before it yields returns. These are important issues in making investment decisions. The cost of the project, Where Q1, Q2, Qn are expected returns over n years are discounts over n years. is discounted annual return And r is the internal rate of return The Internal rate of return method will result in the same decision as the Net present value method. The decision rule of taking the project with the highest internal rate of return, this may be same as the project with a lower Net present value. Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 105 Dr.Ranga Sai Internal rate of return is commonly used in the evaluation of projects by banks for financing. The banks have bench mark internal rate of returns for each kind of enterprise. If the project fulfills the minimum required internal rate of return, the project is financed. In case of own funds the enterprise may have the cost of funds as the bench mark for accepting or rejecting the project. (21202)5-5-2010 Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 106 Dr.Ranga Sai Other books in this series Business Economics Paper II Business Economics Paper III B.Com Second Year B.Com Third Year Introduction to Economics B.M.M. First Year Micro Economics B.A. First Year Micro Economics First Year B.Com Accounting and Finance I Semester First Year B.Com Banking and Insurance I Semester Macro Economics First Year B.Com Banking and Insurance II Semester Second Year BCom Accounting and Finance IIISemester Based on University of Mumbai curriculum Available for free and private circulation At www. rangasai.com and www. vazecollege.net Business Economics Paper I, F.Y.B.Com (w.e.f. June 2008) 107